Taking Stock / When Cannons Roar

Inflation, interest rates, deficit, debt, capital adequacy ratio - just a month ago, these were relegated to the realm of economic gibberish. Politicians, pundits and the public snorted when economists tried to explain how important it is to protect our achievements regarding the above.

Euphoria reigned and the reforms of the last three years looked like voodoo orchestrated by loopy economists who had no idea what was really going on.

Yet these five parameters, and many other more complex ones, describe the structure of the Israeli economy and capital market. They are the true shield of the home front - and the battlefront, too.

Tel Aviv stocks have fallen 14 percent from their peak in May 2006. The dollar has risen 1.9 percent against the shekel from its nadir of two weeks ago. The deeper Israel trudges into the mud of Lebanon, the more stocks and the shekel are likely to erode.

Yet Israel's economy has proved resilient, and to understand why, we have to take a longer view - beyond the rates of the shekel and stocks in the last two months.

Pricing levels on the Tel Aviv Stock Exchange are high by any historic parameter. The shares in the big banks have lost 20 percent from their peak, but they're still 30 to 40 percent above their shareholders' equity.

Far, far from the Katyushas

For the sake of comparison, throughout the gay 1990s, the banks generally traded at around their equity value. During the intifada four years ago, their share prices imploded to 50 percent of their equity.

In the last two months, the entire Tel Aviv Stock Exchange has taken a beating. Blue chips have fallen to 775 points. But note that that was their level at the end of 2005, and nobody saw a military conflict coming back then.

In general, the TASE's reaction to the war in the north seems very relaxed - and indeed so, if we recall that Wall Street, which is nowhere near the Katyushas, had been slithering south. Nasdaq lost 6.5 percent in the last two months, returning to its level of a year before. Well before the first shot was fired, asset prices in emerging markets were tumbling the world wide.

The price of capital must be seen from the longer perspective too. Short-term interest rates have risen from 5.7 to 5.9 percent in the last month. Long-run interest rates rose from 6.4 to 6.6 percent. But the interest rate gap between the shekel and dollar is zero, roughly the lowest it's ever been. During the last intifada, the interest rate gap widened to about 4 percent.

Forward, ram head into sand!

One might put down the remarkable resilience of Israeli stocks as Israeli soldiers march into Lebanon to the irrepressible optimism of investors as they ram their heads into the sand, and refuse to notice the change in regional risk premiums.

Or one might say that the optimism of Israeli and foreign investors alike relies on the very same fundamentals with which we began.

* The government's low budget deficit and the treasury's commitment to keeping it that way: Before the war, the treasury figured it could almost balance the books this year, running almost no deficit at all. It has room to maneuver if the war drags on.

* The national debt to GDP ratio has been declining. Israeli debt remains high by international standards, but its declining trend and the commitment by the Finance Ministry and Bank of Israel to reducing it further are of tremendous importance.

* After 10 years of painful disinflationary policy, Israeli inflation has been contracting for three years now, to Western levels. Everybody remembers the first Lebanon War as the days of hyper-inflation and the government's loss of control. In these days of Lebanon War II, we have come to take Western levels of inflation for granted, and the markets are fully confident that Bank of Israel governor Stanley Fischer will keep it there.

* Four years ago, the banks were the weakest link in Israel's financial chain. The credit sprees during the boom years, and corporate Israel's total dependence on the banks for loans, threatened the very stability of the system. But the leverage at the banks has been reduced and a whole market of credit outside the banks has developed, thus reducing the risks of another credit crisis, even if we sink in the mud of Lebanon up to our knees.

Since Israel opened its economy fully to capital movements at the end of the last decade, we have been hit by two extreme security situation-related shocks. We failed the first test of the first intifada; the economy fell back into protracted recession and extreme steps had to be taken in order to avert financial meltdown.

The second shock is happening now, just as we're wider open than ever before to capital flows. Tens of billions of shekels belonging to foreigners and hundreds of billions belonging to Israeli investors could up and flee at any moment, at the click of a mouse, if confidence in our resilience crumbles.

When the cannons roar, it is time to truly appreciate how important it is to preserve responsible economic policy. The public and government need to concentrate on the northern front and the fight with Hezbollah, without worrying about a new front of battle opening up - an economic one.