Now that the exchange rate slant mechanism has been modified, and the key lending rate reduced, the Bank of Israel has reason to be pleased with the results of foreign currency trading in the past few days. From the time the new regulations were made public, and until the end of trading today (Tuesday), foreign currency supply has been in abeyance. Demand has even resulted, in the past few days, in a devaluation.
Even so, it would still be premature to conclude that the move that caused Dan Meridor to resign as Minister of Finance has managed to extricate the central bank from the Catch-22 situation engendered by its own policy. It should not be forgotten that about one billion dollars was converted into shekels in the days precedent to the changes. Since the fluctuation band was not extended in a southerly direction, some of the players that recently converted foreign currency loans into shekels will now, very likely, seek to reverse that procedure.
The foreign currency demand of recent days pales into insignificance compared to the $20 billion converted into shekels since the beginning of the year. The "mountains of foreign currency" imported into Israel to be converted into shekels and generate financial gains courtesy of he high shekel interest rate, are still in possession of the Bank of Israel. The central bank had no choice but to buy the foreign currency so as to "protect" the lower limit of the fluctuation band, a state of affairs it naturally found very burdensome.
It is difficult, of course, to assess how long the recent foreign currency trading trend will persist. As is, it is undoubtedly good for the Bank of Israel, which is indirectly trying to promote it by emphasising the risks inhering in the foreign currency market. The Bank’s moves on a practical level, however, prove this to be mere lip service.
The key lending rate reduction was announced by Bank of Israel Governor Yaakov Frenkel well in advance of schedule. The idea was to dam the flood of foreign currency supply injected for the purpose of amassing shekel interest gains, which was forcing the Bank of Israel to purchase hundreds of millions of high-priced dollars daily. The Governor explained that his motive in bringing forward the announcement of the 1.2% lowering of the interest rate was "so as to introduce certainty and stability into the interest and foreign currency markets". At the same time, the central bank announced that the gradient of the lower half of the fluctuation band was being reduced. The projected rate of devaluation would thus be slowed from 6% to 4% per annum.
This, however, was a prearranged waltz in which the Bank and the Governor complemented one another’s footwork perfectly. There now exists, in fact, an even greater incentive to continue to convert foreign currency into shekels, and enjoy shekel interest gains. This is how it works: if the sum of the cost of the foreign currency loan (in the form of interest), plus the declared rate of devaluation, is smaller than the interest rate obtainable in Israel on a shekel deposit, then it is worth continuing to inject foreign currency. The foreign currency can be converted into shekels, which still bear a high rate of interest. If the annual devaluation rate is slowed to a greater degree than the interest rate was recently reduced, then the profitability of foreign currency conversion increases to the extent of the difference between the two figures (currently 0.8%).
Is the Bank of Israel not conversant with the profitability formula? It most certainly is. Which is why it is taking care to gloss over the fact that the projected rate of devaluation has been slowed. Rather than providing a pertinent explanation, the central bank prefers to highlight the elevation of the upper level of the fluctuation band to 15% over the "mid-rate". It also pontificates about how far the exchange rate can travel from the lower limit of the band to its upper extremity. This serves to emphasise the risk assumed by anyone converting foreign currency in order to obtain shekel interest gains, out of reliance on the stability or revaluation of the exchange rate.
Foreign currency conversion into shekels for the purpose of interest gains was risky in the past too, also engendering lofty exhortations. Those bent on conversion were not deterred in the past by a 14% risk coefficient. Even then, the foreign currency market trend could have reversed, and the exchange rate could have leapt from the lower limit to the topmost point of the fluctuation band. These people are not likely to be deterred now. A quick calculation will show them that the conversion is more worthwhile, even if the risk percentage is higher. He who does not balk at a possible tumble from a height of 14 storeys, probably won’t care if the 14 lengthens to 25 or more.
The Bank of Israel still says it is adhering to its monetary restraint policy, designed to suppress inflation. To that end, it is keeping the capital and money markets in a state of imbalance, with a high key lending rate, a slowing of the devaluation rate and a low growth rate. As long as this pattern persists, so will the Catch-22 situation and the Bank is perfectly well aware of the fact. But where prestige and power plays are the prime motivation, other considerations must give way.
Recent events have proved that the Governor is perfectly well able to cite purely professional arguments, having nothing to do with prestige or politics, both for and against reducing the key lending rate, in favour of lowering the bottom end of the fluctuation band and in favour of not changing it. He will have no difficulty in finding the requisite professional explanation in the future either. Alternatively, he will of course be able to implement an interest rate reduction in such a way as to eliminate the imbalance currently prevailing on the financial markets. But, in that case, he will be called upon to explain the bona fides of his policy, its transparency and its achievements.