Citi analyst David Lubin points to the dilemma facing Governor of the Bank of Israel Prof. Stanley Fischer, as the Bank of Israel continues its dollar purchase program, while inflation risks appear to be growing.
Facing the risk of inflation as well as a shekel which is weaker against the dollar, Lubin says that the Bank of Israel may find itself in a position where it is "neither desirable nor necessary to keep accumulating reserves." One reason for the original move to begin buying dollars was to weaken the shekel, and help Israel's export-oriented economy. An obvious risk is that if the Bank of Israel ends its dollar purchases, the shekel will appreciate sharply against the dollar. According to Lubin, the recent drop in the shekel-dollar exchange rate suggests that traders are anticipating this dilemma.
The Bank of Israel forecasts GDP to contract 1.5% in 2009, similar to Citi expectations. Yet at the same time, inflation expectations are rising. The rising expecations may stem from recent positive economic data, which is giving investors the sense that the worst of the fall in economic growth, in terms of GDP contraction, is over. Other inflation concerns are the proposed rise in VAT to 16.5%, which Citi expects to add 0.5-1% to Consumer Price Index (CPI), and a sharp rise in money supply - one measure, M1, grew 51% year on year in April.
Though the Bank of Israel has consistently said the dollar purchases are not a permanent policy, and will be reviewed regularly, one way of interpreting the shekel’s very sharp appreciation recently is that the market is unconvinced that there is an easy way for the Bank to withdraw from its market activity.
Lubin notes that while a "gradualist" strategy seems to be most appropriate, any strategy will be difficult to manage. A sudden and complete withdrawal from the foreign currency market by the Bank of Israel would risk a very sharp appreciation of the exchange rate. Yet Lubin says that "even a gradualist strategy may be destined to lead to shekel appreciation: merely the expectation of fewer dollar purchases by the central bank seems to be enough to induce a stronger exchange rate."
Paradoxically, points out Lubin, the dilemma the Bank faces may be more acute now that it has a large stock of foreign exchange reserves, since that strengthens the bank's external balance sheet, which helps to reduce the country risk premium. "Since a lower country risk premium will be associated with a stronger equilibrium exchange rate, the paradox is that foreign exchange interventions may end up causing the exchange rate to strengthen in the medium term rather than weaken."
What this means is that the Bank may be inclined to keep buying foreign exchange for some time to come, but the market is likely to remain focused on the risk of shekel appreciation. It is unlikely that the Bank of Israel will move quickly towards raising interest rates as long as inflation expectations stay below the 3% ceiling of the Bank’s inflation target range.
Lubin adds, "The most painful dilemma will be created if and when inflation expectations breach the ceiling on a consistent basis. That situation will call for monetary tightening, but the Bank may still be disinclined to see a heavy shekel appreciation that might result from its withdrawal from the foreign exchange market. The Bank will be unwilling, we think, to risk choking the recovery."
The analyst concludes that the Bank of Israel will need at some stage to clarify the exit strategy from its policy of reserves accumulation, and it will be difficult to shake off the market’s view that a central bank withdrawal from the foreign exchange market will lead to a stronger shekel. In the short run, however, the Bank of Israel is likely to sit tight and sustain its program of foreign exchange purchases for as long as possible.
Published by Globes [online], Israel business news - www.globes-online.com - on June 4, 2009
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