What's the Bank of Israel's Exit Strategy?

Bank of Israel officials agree that forex purchasing can't go on forever, and at some point it could start causing harm.

Beyond its titanic battle to convince Hapoalim's owners to fire the bank's chairman, the Bank of Israel has other missions, no less important than protecting Israel's banks from allegedly bad management. One is to find a way to end its daily forex intervention without jolting the market.

To recap, since the summer of 2008, the Bank of Israel has been buying $100 million a day on the local forex market, paying with newly issued shekels.

For public relations reasons, the Bank of Israel wrapped the acquisitions in a cover story, stating they were designed to increase Israel's foreign currency reserves.

But everybody knows the truth. Even the Bank of Israel doesn't bother to deny it anymore: the purchases are designed to weaken the shekel, thus helping Israeli exports compete in the global market.

The Bank of Israel's leap into the forex market took everybody by surprise.

It was thinking outside the box: The central bank wasn't copying any other central bank, anywhere else in the world.

To sum up so far, it's been a stunning success. The results are that from the shekel's high of NIS 3.25 to the dollar, when the Bank of Israel began its purchases, the Israeli currency has depreciated to NIS 4.26 to the dollar as of last month, which means it lost almost one-third of its value.

Naturally, the Bank of Israel can't take all the credit. During that time, the dollar appreciated almost everywhere, mainly against the emerging markets' currencies. But this appreciation explains only one-third of its climb against the shekel.

The other two-thirds have to be ascribed to the Bank of Israel's daily purchases, as ordered by Governor Stanley Fischer, who stayed a step ahead of the financial crisis and probably mitigated its effect here.

Bank of Israel people like to ask, not without a smile of pride, "What would have happened if the crisis had caught Israel's exporters at an exchange rate of NIS 3.20?"

What indeed? In hindsight, the governor's move was brilliant, and gave us the bonus of robustly padded foreign currency reserves, which is a crucial asset in times of crisis. It wouldn't be surprising if Fischer receives an award for his services some day.

But the move seems to have played itself out. The Bank of Israel's cover story doesn't work anymore. The central bank said it would stop buying dollars when the foreign currency reserves reach $40 billion. Then it said $45 billion. That milestone has been passed, too. Now the central bank's official position is that it will keep buying dollars as long as it thinks it should.

Which means what? Bank of Israel officials agree that the purchasing can't go on forever, and at some point it could start causing harm. They claim the central bank has an exit strategy to use when the time is ripe.

Absent any hints from the Bank of Israel, forex players have to guess. Last Thursday, for example, Deutsche Bank's analyst sent an e-mail to her clients, projecting that the central bank would keep buying $100 million a day for at least two more months. Local players tend to agree.

In fact the locals have become addicted to the Bank of Israel's buying. They're the reason for the 25% drop in transaction volume in the last month, they say, reducing turnover from more than $2 billion a day to $1.4 billion this month.

"Once, if you wanted to sell dollars, the same dollar would make the rounds of the market a few times, passing from one bank to another," says a trader. "Today the trader just waits for the Bank of Israel and sells it the dollars. The central bank taps into the market several times a day, in the morning and the afternoon."

Moreover, its activities have flattened the fluctuations, rendering the forex arena almost dull. This is is deeply disappointing for forex traders, but Bank of Israel officials like it.

Theoretically, if the Bank of Israel's buying weakened the shekel by 15% (remember, the dollar's appreciation did some of the work), shouldn't ending the purchases lead to the shekel gaining ground again? The market doesn't think that's necessarily so.

"Because the Bank of Israel will stop buying dollars soon enough, what will set the trend in the forex market is the strength of the dollar against the euro and other foreign currencies," says a banker.

Meaning, if the dollar climbs to $1.20 per euro, the shekel will weaken against the dollar. If the dollar weakens to $1.50 per euro, the shekel will gain ground.

What about the Bank of Israel?

"Fischer can't fight all his battles at once," says the banker. "He's facing inflation, a problematic government and deficit, and is continuing to buy long-term government bonds, hoping to lower their yields. The shekel-dollar exchange rate is yesterday's battle." It doesn't interest him that much anymore, says the banker.

Maybe, but Fischer himself has said his monitor always shows exchange rates in real time, and adds that he doesn't take his eyes off the figures.

We may assume Fischer has his fingers on the dollar's pulse and is hoping it won't drop overseas, so the Bank of Israel can execute its exit strategy.