Taking Stock / Stranger Than Fiction

Say you had a crystal ball, and a year ago, it told you that the situation was going to change, and for the worse. It predicted that a Qassam missile would land on an Ashkelon school, that a soldier would be kidnapped, and that networks the world wide would time and again air pictures of Palestinian women and children wounded by Israeli air force attacks.

Say we were to tell you that this is the backdrop for a period in which interest on the dollar is climbing fast, toward the level of interest on the shekel; and that as Israel and the Palestinians exchange gunfire, interest on the shekel and dollar were to stabilize at 5.25 percent.

For the coup de grace, say we were to tell you that emerging markets the world wide crashed, losing 10 to 30 percent of their value. Hundreds of billions of dollars suddenly whooshed out of the emerging markets' exchanges. Over at the developing nation closest to Israel's, Turkey, the currency imploded, shrinking by 20 percent.

And now, say were to ask you to predict one simple thing. Under those horrible circumstances, how much should the shekel lose against the dollar? By how many percent should the shekel devalue in order to reflect the increase in Israel's risk premium?

Or put it this way: By how many percent should the Bank of Israel kick up interest on the shekel beyond interest on the dollar so as to prevent the domestic currency from collapsing like the Turkish lira?

Horror scenarios

Probably any number of scenarios are racing through your head. How likely would you be to say that the local currency is entirely unmoved by all the horrors; to predict that the shekel would strengthen by 5 percent against the dollar; that local investors would continue to hunker down in the shelter of the shekel; that foreign investors wouldn't be frightened by the explosion in Gaza, and that the Bank of Israel would leave Israeli interest rates at the same level as U.S. rates, as is only proper for a proud Zionist economy.

How could that be? Why is the shekel remaining so robust despite interest rate parity, and the rising level of risk in the emerging markets and the Middle East?

The trivial answer is that it isn't the shekel that is gaining ground, it's the dollar that is losing it in world markets, mainly against the euro. Naturally, then, it would weaken compared with the shekel too.

But that's only part of the picture. Even if we set aside the dollar's collapse in the world, the shekel still remains remarkably strong considering the nonexistent interest rate gaps between it and other major currencies, and considering the marked deterioration of the region's security situation.

The key to the riddle does not lie in the crosses of exchange rates, but in investors' perception of risk, and of Israel too.

Safe as houses

The latest ranking of the British weekly, The Economist, published last week, shows that Israel is considered to be one of the safest emerging markets in the world.

Its risk is very close to that of powerful economies such as South Korea, Taiwan and Singapore, and is streets ahead of Turkey, Brazil, China, Poland and India.

But we didn't need The Economist to tell us about our situation: The Israeli forex market has long since been controlled by foreign banks, and the fact is, they do not view the military escalation, the interest rate parity, and the collapse of emerging markets as grounds to dump shekels. This demonstrates dramatic change in Israel's financial profile in recent years.

The fact that the Bank of Israel can leave interest on the shekel the same as interest on the dollar despite the flare-up in Gaza is another blow to the theory that Israel's economic situation depends entirely on the security situation.

Lie down with the lamb

Proponents of the "security only" theory counsel that painful economic reforms, public-sector cutbacks, inflation-taming methods and the adoption of international standards are a waste of time.

What we should do is sit around waiting for the wolf to lie with the lamb, for heavenly harmony with our neighbors, at which point the economic dividend will be so great and wondrous that we shall forget all about piddling minutiae such as sane macroeconomic policies.

Since everything depends on "diplomatic vision" and "the peace process," we can continue in the meantime to fritter billions and billions away on a bloated defense system; we can continue to pump up the public sector and hand out state assets to cronies of the people in power. None of that matters compared with the Herculean effort to bring peace to the Middle East.

As the "peace is paramount" theory collapsed, so did the "mountain of shekels" theory that had been drummed into our heads for some 10 years. We were told that if Israeli interest rates were to fall below western levels, the Great Mountain of Shekels would melt down, hundreds of billions would flee to the greenback pastures, inflation would skyrocket, and all the achievements of the painful monetary policy of the 1990s would be erased.

And look what's happened. The diplomatic process is going nowhere, Gaza is burning and the emerging markets around us are wilting. Yet we're on ladders, harvesting the fruits of the economic policy instituted in recent years.

The Bank of Israel is not being forced to jack up interest rates, the shekel is not collapsing, and foreign investors continue to pour tremendous sums into Israel.

Yet none of this can or should be taken for granted. If the present government fails to advance further reforms, and fast, if it doesn't channel more resources to the private sector by reducing the public sector, if it doesn't demonstrate its commitment to all that, then in the next economic cycle, we'll be back to square one - a flight from the shekel, rapid interest rate hikes, wild cutbacks and tax increases.

The good news is that most investors, Israeli and foreign, continue to believe in the shekel, even when interest on it is identical to that on the dollar.

The bad news is that accepted dogma today could become controversial again tomorrow.