Another Battle on a Different Front: An Update on the Israeli Shekel

I find it amazing how a country of only 7.1 million people with the geographical size of New Jersey has to defend itself from so many battles on many fronts. Israel is surrounded by what appears to be sworn enemies. Under Israeli law, Yemen, Syria, Saudi Arabia and Iraq are considered enemy countries. Next door, the Lebanon-based Hezbollah confrontation appears to have no end in sight. A leader of the Palestinian Authority Fatah organization was recently quoted as saying "all of Israeli society is a military society, and therefore a military target." Welcome to the neighborhood. Even Bolivia and Venezuela have jumped on the radical band wagon and have suspended political and economic relations with Israel, one of the most stable and prosperous nations in the Middle East. I am by no means an expert on Middle East relations, nor do will I attempt to describe the long-term conflict between Israel and its neighbors. However, there is another battle in Israel that is a bit closer to my line of work - the battle of Israel's currency, the shekel (ILS).

Historical Perspective
In order to understand the current situation, we need a bit of background. Back in early 2008, the Bank of Israel (BoI) embarked on an intervention policy to buy 25 million dollars a day against the ILS. The purpose was to help weaken the shekel in order to a help prop up exports, which had been hurt by the drop in demand brought on by the global financial crisis. With Israel dependence on exports, some industry experts estimate that every tenth of a shekel translates to 6,000 jobs over time. The second purpose was to increase Israel's foreign currency reserves. A few months later, the ILS hit a 10-year high of 3.2 ILS per one dollar, clearly not the result the central bank had anticipated. The next logical step was to increase the intervention amount. The BoI has been buying 100 million dollars a day since July of last year. This additional foreign exchange intervention kicker helped the ILS to achieve a twenty percent decline in the shekel's value against the dollar.

In late April, 2009, the ILS weakened to near 4.28. The USD buying spree appeared to help the Israeli economy. It was easier to export products with a weaker currency. In addition, the program doubled its foreign currency reserves, to an estimated $52 billion. Now, to be honest, we cannot give the BoI all the credit or blame for the ILS value. There is a pretty strong correlation between USD/ILS strength with the overall value of the dollar. The ILS as also has risen in step with many other emerging market currencies over the past couple of months.

Recent Developments
However, things got strange over the past couple of weeks as tactics changed again. It started when the shekel started gaining strength against the dollar in tandem with the other currencies around the globe. On August 3, the BoI decided it would make some surprisingly larger purchases of dollars to prop up the dollar against the ILS. The following day, BoI Governor Fischer announced the old intervention strategy has been thrown out the window. He said Israel would end the scheduled purchasing of dollars. Immediately, the Shekel rose 2.5 percent vs. the dollar. Now, the BoI asserted it would act if market rates were "inconsistent with underlying economic conditions." In determining its new intervention policy, the bank said it would consider a number of factors including the level of economic activity and export activity. In particular it would consider the level of inflation, financial stability and the functioning of foreign exchange markets. The short-term result was chaos. From August 4 to August 6, the ILS reversed course and lost almost 5 percent of its value, making it one of the "worst performing" currencies that week as tracked by Bloomberg, a title usually reserved for a country experiencing a political coup or some economic disaster.

Over the past week, the market has started to digest and accept the new policy. Spreads between bids and offers have narrowed, intraday volatilities have subsided, and volumes are almost normal. There is a clear attempt by the BoI to use more discretion, less transparency and fewer rules in its approach to the foreign exchange market. It will now intervene as it sees fit and without notice. The central bank is also trying to keep those nasty currency speculators uncomfortable with a policy that is less predictable. This new policy is another tool to help cope with speculators that make short term bets on a stronger shekel.

The Fundamentals of the Israeli Economy
The BoI has cut interest rates nearly 3.75 percent since October to a meager 0.5 percent in an attempt to revive an economy that shrank. Things are looking brighter. In July, Israel printed it first budget surplus in six months as tax revenue increased more than expected. The latest minutes of the BoI suggested there are signs the economy is recovering. According to Fischer, Israel's economy "has weathered the worst of the global economic slump and growth is likely to resume by the end of 2009 or the beginning of next year." Local bond yields are higher and there is growing speculation the central bank may need to raise interest rates before year end as indicators show economic growth is returning and inflation may start to accelerate, currently at 3.5 percent.

This leads me to believe the shekel is on a strong footing as Israel is well-positioned to grow as the current crisis winds down. Despite the recent drop in exports, there are signs the economy has proven resilient and that the macro outlook has improved. The BoI recently announced it will stop buying government bonds. The latest step in ending its regular intervention in the FX market will provide more support for the ILS. It has been proven time and again, in the long run, government intervention cannot control the direction of its currencies. Markets are driven by supply and demand and the market always wins. Unless there is an unexpected turn in the global recovery, I would expect the ILS to remain strong. ILS reaching 3.50 against the dollar by year end is not out of the question.