Israel on a Confident Path

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates.  

I find it amazing how a country of just over 7.5 million people with the geographical size of New Jersey has to defend itself on so many fronts. Israel is surrounded by its sworn enemies. Under Israeli law Yemen, Syria, Saudi Arabia and Iraq are considered enemy countries. Next door, the Lebanon-based Hezbollah conflicts appear to have no end in sight. The leader of the Palestinian Authority Fatah organization was quoted as saying "all of Israeli society is a military society, and therefore a military target." Israel is concerned about its neighbor to the south as Egypt tries to find its way with a newfound democracy. Welcome to the neighborhood. Even Bolivia and Venezuela have jumped on the radical band wagon and have suspended political and economic relations with Israel.

Despite such obstacles, Israel has become one of the most stable and prosperous nations in the Middle East. I am by no means an expert on Middle East relations, nor can I attempt to describe the long-term conflict between Israel and its neighbors. However, there is another topic that is closer to my line of work. That is the battle of Israel's growth, inflation, and the affect on its currency, the Israeli shekel (ILS).

Boom  

Israel's economic recovery from the recent global economic downturn has been tremendous. The latest GDP number was slower than the 7.6 percent in the fourth quarter, the fastest in four years. However, GDP has still managed to expand an impressive 4.8 percent for the first quarter of 2011, higher than what was previously estimated. The central bank of Israel expects the economy to expand 5.2 percent this year. Unemployment fell to 6 percent in the first quarter from 6.5 percent in the fourth of 2010. Consumer prices rose 0.5 percent in May and annual inflation is growing to 4.1 percent from 4 percent. This is the fifth month inflation has exceeded the target rate of 1 percent to 3 percent target range.

Inflation and higher interest rates have been the driving force behind the ILS move higher, now trading near 3.42 ILS per 1 U.S. dollar. The euro region has raised rates only 25 basis points in 2011 to 1.25 percent, while Federal Reserve Chairman Ben S. Bernanke said this month that stimulus is still needed to help a "frustratingly slow" U.S. recovery. Israel's accelerating growth has pushed central bank Governor Stanley Fischer to raise the benchmark interest rate four times this year to 3.25 percent, the fourth biggest increase after Belarus, Chile and Brazil. Israel's interest-rate swaps continue rising above contracts of the U.S. by the most on record. The average spread since 2005 between the two swaps, which investors use to fix borrowing costs in the future, has been 135 basis points. The spread between Israel's five-year interest-rate swaps and similar maturity U.S. notes rose to 282 basis points, the biggest gap on record. These higher rates have enticed capital from offshore and kept demand for the shekel. The ILS is up over 12 percent in the past year, making it the best performer among Middle East currencies.

The Old Guy 

It was only a few weeks ago Bank of Israel Governor Fischer wrote, "An exceptional and unplanned opportunity has crossed my path, one that may never again present itself, to run for the head of the IMF. After much deliberation, I have decided to pursue it, despite the fact that it is a complicated process and despite the possible obstacles." Israel's most respected central banker had thrown his hat into the ring after Dominique Strauss-Kahn, who resigned last month as managing director, after he was charged with attempted rape in New York. Fischer, who was the IMF's first deputy managing director in 1994, helped end crises in Mexico, Russia and Southeast Asia. He seemed like a qualified replacement. Not so fast. The IMF rejected him because Fischer, 67, is older than the maximum age limit of 65. The rejection was not what he had hoped, but will be beneficial to the ILS. His presence will provide continued economic stability in Israel. Since Fischer took office as Bank of Israel governor six years ago, the local stock index has gained about 80 percent while the shekel strengthened 29 percent during the same period. Many believe his skills helped Israel recover from the global recession faster than many other developed economies. The IMF loss and Israel's gain should maintain market confidence, creating more demand for the ILS.

Slowdown 

Without doubt, the widening interest-rate differentials between Israel and developed economies will continue to favor the shekel. In an attempt to reduce the appreciation pressures, the Israeli government has introduced measures to curb the influx of "hot money." A 10 percent reserve has been placed on banks' derivative transactions with non-residents. The Ministry of Finance is also pressing ahead with its plan to eliminate a tax exemption that foreigners currently enjoy on their profits from short-term government debt. However, the legislative approval for this is unlikely until later this summer. The conclusion is until the U.S. economy turns around and/or the Israeli cools off, there should be little reprieve for demand of Israel's currency.