On August 23, 2000 a government body issued a press release, claiming that eliminating the exchange rate fluctuation band would harm “primarily the traditional industries located in development towns.”
When the fluctuation band was first established in early 1989, no one had in mind, and certainly no one published any announcements to the effect, an exchange rate as required by “the traditional industries in development towns.” That was still the period in which the exchange rate was considered a “nominal anchor”, and the Bank of Israel was the main architect of this approach. This concept was adopted in the 1985 stabilization plan, and played a key role in reducing annual inflation from 450% to 20%.
According to this concept, stabilizing/anchoring the exchange rate was designed to stabilize inflation. The interest rate? Its role was to direct capital movements to help stabilize the exchange rate, i.e. not to prevent a shekel appreciation, not to encourage development, but to stabilize the exchange rate, in order to achieve price stability.
This is not the proper place to clarify reasons for the resounding failure of this concept, after it was given the opportunity of proving itself for five long years. We turned the Israeli economy into a laboratory, and we went on experimenting. We linked exchange rates to the dollar, to the currency basket, we began a horizontal fluctuation band, we widened it, we started a sloped fluctuation band, we inserted a line in the middle, we moved it, we tried various and sundry adjustments. We played around with this toy for 15 years!
There are those who have not had enough, and are planning a new edition, perhaps even harking back to those memorable days when a stable exchange rate was king, and perhaps – why not? – with a horizontal fluctuation band and median exchange rate for decoration.
What important function did we not assign to the exchange rate? Price stability has already been mentioned. Preservation of the Israeli economy’s competitiveness is obvious. Protection against competing imports is definite included. A positive psychological effect on foreign currency market players is unquestionable. Providing extra insurance for proper functioning of the manufacturing sector is of course a factor. Finally, protection of the traditional industries in the development areas definitely heads the list.
Meanwhile, something in Israel has changed
We have almost eliminated foreign currency controls. The remnant can be cancelled according to a given timetable, following which full convertibility of the shekel can be announced. What are we waiting for?
The local foreign currency market is expanding, with an average daily turnover reaching $1 billion and participation of foreign financial concerns. The presence of these concerns in the market is an integral part of the real investment activity in the Israeli market, and is necessary for these concerns in order to protect themselves. If the foreign currency market goes awry, it will affect the ability of these concerns to contribute to the growth of the Israeli economy.
The Bank of Israel has not interfered in the foreign currency market for three years. It has no target exchange rate, and has no pretensions of affecting its course.
The public now grasps that a devaluation can be succeeded by an appreciation (something new after 50 years of Israel’s independence) and that exchange rate changes can sometimes be both large and rapid.
A financial derivatives market is therefore developing, both negotiable and non-negotiable, which provides protection against exchange rate fluctuations, as in the entire developed world.
Now a new problem is making itself felt – the Israeli economy is growing. This growth rests on the accompanying ongoing raising of capital overseas, on the sale of companies to foreign investors, and on exports. No one contends that this growth is undesirable. On the contrary - it is the type of growth that does not require a larger balance of payments deficit or accelerated inflation – factors which cut short other periods of growth in the Israeli economy – and is therefore sustainable. The problem is that it requires imports, which promote a shekel appreciation, and is unaffected by interest rate gaps between the shekel and the dollar. Inflation gaps make no impression on it, as long as people know that the government has set a goal of price stability, and the Bank of Israel is implementing the policy necessary to achieve that stability without interference.
The resulting shekel appreciation is regarded by part of the public as a blessing and as a curse by a different sector. The structure of economic growth dictates appreciation of the shekel, because this growth is led by exports and fed by capital imports. Short-term employment considerations, on the other hand, require prevention of that appreciation. No one can predict what will happen in the foreign currency market, and therefore no one can say for sure whether and when the current fluctuation band will interfere with the proper functioning of that market. It is incumbent upon those of us responsible for managing the economy, however, to make our judgement and implement the change as much as possible when the market is not under pressure.
In this context, the controlled relaxation of the fluctuation band restrictions can be considered, with the declared intent of eliminating them over time. In any event, a working assumption must be that we cannot have our cake and eat it too. We cannot register our satisfaction with the growth of the economy and the import of capital for the accompanying investments, while channeling the imported capital outside the market and requiring the Bank of Israel to buy it at a fixed price.
Actually, why can’t we have our cake and eat it, too?
First of all, because the moment the exchange rate reaches the lower limit of the fluctuation band and the Bank of Israel begins purchasing foreign currency, we will acquire a senior partner in managing monetary policy – all the capital importers. The new partner is an uninvited one; he will force us to inject shekels, regardless of our monetary plan, since he obviously will convert foreign currency according to his needs. He will be happy to have us free him from the risk of a shekel appreciation accompanying the conversion of foreign currency to shekels, however, and it is reasonable to assume that the existence of the lower limit for the exchange rate will increase the volume of conversions. The business sector currently has $12 billion in foreign currency deposits, both in Israel and overseas, excluding current capital raising overseas. Part of this has not been converted to date, due to the shekel appreciation risk.
An exchange rate floor requires the Bank of Israel to acquire foreign currency in order to prevent the appreciation, which means payment of shekels, for which there is no source, except by the printing of money. Printing this money will unquestionably require a retreat from the price stability target established by the government.
If we abandon the price stability target, we must immediately absorb with one hand the stream of shekels created by the other. This absorption involves additional interest payments, which will in effect enlarge (although we conceal the fact, due to the special accounting rules we have adopted) the budget deficit, in contravention of the government decision to lower it.
The decision to fix the exchange rate at the lower limit means perpetuating an arbitrary exchange rate, which in time will produce ever-increasing distortions in the economy, producing great uncertainty in managing monetary policy. The uncertainty is due to the automatic injections caused by capital imports, which are not, and should not be, subject to our control. Such a decision expressly contradicts the European standard recently adopted by the government. It is no accident that the European Union conducts a mobile external exchange rate policy, and the central European Bank is unwilling to announce an exchange rate target for the euro.
This contradiction will constantly bring into question the reliability of our monetary policy:
- Will we truly be able to achieve and maintain stable prices?
- Does the Bank of Israel have the necessary tools to absorb the potential quantities of foreign currency conversions? The answer is undoubtedly negative, due to our limited ability to issue short-term loans. In addition, this limitation constitutes a millstone hampering the development and streamlining of the financial market and negatively affecting savers and borrowers.
- Will the government really be able to meet the budget deficit target? The Bank of Israel still carries in its financial statements the deficit created by the necessity of purchasing and converting $16.5 billion during 1995-1997, in order to protect the lower limit of the fluctuation band, together with its duty to achieve the inflation target. The time bomb prepared at the time, which was revealed this year, when those in charge of policy decided to reveal the horrifying spectacle of the contribution made by the Bank of Israel’s “profits” to the budget deficit. Will we insist on adding another chapter to this saga?
- To what degree will the government be able to prevail over market forces in fixing the exchange rate at an arbitrary level, despite the welcome existence of an foreign currency surplus? What will happen to the economy, the stability of the banks, and the financial markets when the government finally gives in? It should be kept in mind that a quarter of the banks’ unlinked assets today are already held in Bank of Israel deposits, and a fifth of their revenues in this sector come from the Bank of Israel. Most of these are due to foreign currency purchases forced on us in 1995-1997 and the need to absorb the resulting surplus liquidity. How much can these rates rise before analysts begin wondering what a bank in Israel consists of and where the financial market is?
These questions are reflected principally in the interest rate. Risks have a price, and the interest rate is the way the market reflects risks. No one wishes us to deviate from the path leading to stability, which we have worked so hard to enter. Such a deviation will tar us as unable to reach simple economic decisions required to remain on the road of advancement we have chosen, from which we all derive satisfaction.
There are those who think that we are taking credit for the high tech and start-up breakthrough. That is not precisely true. The accomplishment is not due to the government, but the private sector, which is the only way it can be. We do, however, take credit, both the government of Israel and the Bank of Israel, for a policy that restrained the deficit, spending and taxes in the budget; lowered barriers, both tax and others, preventing imports of goods; led the economy to verge of price stability; developed the local financial markets; and almost eliminated control over foreign currency.
Without all these accomplishments, we would still be stagnating in our provincial swamp. Without all these, the “economic risk” would not be free of the shadow of the “political risk” in the eyes of foreign investors. Without all these, there would not today be a growth engine, nor a restructuring economy, with the accompanying distress. We very much hope that the exchange rate fluctuation band, another remnant of past days, will be abandoned, to our benefit. It is in our hands.
The words of US President John Fitzgerald Kennedy in his inauguration speech have become history: “Do not ask what America can do for you; ask what you can do for America.” To paraphrase this sentence, the government must now say to the public: “Do not ask what the State of Israel can do for you; ask what you can do for yourselves.”
The government should then add: “We will help by not hampering you.”
From a speech by the Governor of the Bank of Israel Dr. David Klein yesterday at the Economic Forum in Jerusalem.
Published by Israel's Business Arena on September 11, 2000