Are Israel's swelling currency reserves good or bad?

Andrew Abir

Some argue that the Bank of Israel's actions to protect Israeli exporters carry too high a cost.

The Bank of Israel's foreign currency reserves rose to a record $206 billion in August, and that at a time when the central bank is close to the lower limit of its foreign currency purchasing program aimed at restraining the appreciation of the shekel. Between 2013 and 2019, the Bank of Israel's foreign currency reserves rose by $50 billion. Since the beginning of 2020, they have risen by $80 billion.

The foreign currency reserves represent an emergency stock in the event of a crisis, such as war, a natural disaster, or even a pandemic. At the height of last year's financial crisis, for example, when alarm at the spread of Covid-19 was widespread, and on the financial side there was a shortage of US dollars, the Bank of Israel used its reserves for the first time in order to provide financial institutions with liquidity. In an emergency, it may be necessary to increase imports while exports and revenue in foreign currency might drop steeply. Such a situation would make it hard for the government and the private sector to raise debt overseas. In such circumstances, the Bank of Israel's reserves would be the main source of foreign currency finance for the country. Accumulating foreign currency reserves thus makes the economy more resilient at times of crisis.

That being so, what's bad about the reserves growing?

The reserves are being accumulated through the intervention of the Bank of Israel in the foreign exchange market, in an attempt to moderate the effects of substantial movements of capital that are liable to harm the economy's stability. From time to time, the Bank of Israel buys dollars on the market in order to curb the appreciation of the shekel, which harms exporters by making their goods and services more expensive for overseas buyers. The appreciation is driven by the flood of dollars from the sale of Israeli gas and from exits by Israeli technology companies. This year alone, the Bank of Israel's foreign currency reserves have risen by $32 billion, $27 billion of which is attributed to currency purchases.

In the 1990s, the Bank of Israel transferred profits to the state budget. Nowadays, the central bank has negative shareholders' equity because of losses in the foreign currency market, and it's only natural that it should meet with criticism. Avi Tiomkin, an adviser to international hedge funds, estimated in 2017 that the State of Israel lost $15 billion in the course of the previous decade as a result of the way in which its foreign currency reserves were managed, and he even called for the resignation of Andrew Abir, head of the Bank of Israel's market operations division and now deputy governor of the bank. At the time, the Bank of Israel explained that the reserves were managed in accordance with the assessment of risk applying to the State of Israel's reserves portfolio, and mentioned the award that the bank had received from the magazine "Central Banking" for the management of the reserves.

"In general, opinion is divided on the Bank of Israel's intervention in the foreign exchange market," says Bank Hapoalim chief economist Victor Bahar. "To some extent, this intervention amounts to a subsidy to exporters, and the question arises whether the cost of such intervention is worthwhile. There are those who will say, 'Just as government carries a cost, so intervention in the foreign exchange market is like a cost to the Bank of Israel in achieving growth targets.' For example, if the Bank of Israel did not support exporters, there would perforce be fewer exporting companies, paying less tax, and so the economy would be damaged in that way."

While the level of the reserves keeps climbing, the Bank of Israel continues to buy dollars on the market, amassing $27 billion so far this year, as mentioned, bringing it close already to the $30 billion lower limit of the range it set for currency purchases in 2021. The Bank of Israel's determination in the face of the market players can be seen from the rate of currency purchases at the start of the program. In the first half of 2021, currency purchases were running at a average rate of $4.2 billion monthly. In the past couple of months, however, the Bank of Israel has taken its foot off the gas, with an average level of purchases of $1.1 billion a month.

When stock market rise globally, the currency exposure of financial institutions also rises. When markets fall, institutions exposed to them, partly through derivatives, have to provide higher margins and buy foreign currency - or at least, not sell - in order to reduce their exposure. This leads to a weakening of the shekel against the US dollar. "The Bank of Israel has made it clear that it is still a player in the market to cushion rapid and sharp appreciation," Bahar adds. "On its behalf it should be said that no-one could have foreseen the rises in the financial markets, and it's hard to withstand them. When the financial institutions are hedging their activity in dollars, the Bank of Israel has a hard time dealing with the hedging and the movements of capital. From the point of view of the market, the players see that there are other tools, and that the program has not finished, although the Bank of Israel declares that the end of the program does not mean the end of purchases."

Nevertheless, Bahar says, "Over time, it will be hard to deal with the weakening of the dollar. From the point of view of the Bank of Israel, sharp falls in the markets will halt the appreciation of the shekel, but the bank looks at the US and sees that there's high inflation there, deficits in the double digits as a percentage of GDP, and that in no year in the near future will the deficit fall below 5%. In addition, the Americans are printing money. It's not inconceivable that the Bank of Israel will say to itself that the basic laws of economics justify a weaker dollar. Were it not for the Bank of Israel's purchases, I wouldn't be surprised to see an exchange rate of three shekels to the dollar. Israeli consumers and importers would benefit from that, but on the other hand many exporting companies would be damaged in the long term.

"Ultimately, the Bank of Israel has slowed the trend of an appreciating shekel. The question is, what happens from now on? Either there will be a market correction, in which case the market will do the Bank of Israel's work for it, or there will be no correction in the markets, and then we are back to the basic conditions of the economy in which the Bank of Israel very slowly takes its foot off the purchases accelerator and allows a gradual appreciation of the shekel."

It will not be a simple matter for the Bank of Israel to cope with movements of capital to Israel when the forces acting to strengthen the shekel grow more powerful. The cumulative surplus on the current account, together with the surplus in direct investment and investment in the Israeli stock market from overseas over investment by Israelis in the other direction, reached a record $53 billion in the past year. In the period 2018-2019, the cumulative surplus averaged just $16 billion. In August, the Bank of Israel bought $1.6 billion, bringing total purchases to $27.3 billion since the beginning of the year, after purchases fell substantially in July.

Gil Bufman, chief economist at Bank Leumi, says, "It's not inconceivable that the substantial decline in the Bank of Israel's intervention was one of the causes of the shekel's renewed appreciation to the peak levels seen in January this year. It could be that the decline in intervention in currency trading derives from an attempt by the Bank of Israel to return to a 'normal' monetary policy such as prevailed before the coronavirus pandemic, that is to say, using the interest rate tool, and using intervention in trading from time to time as needed. Nevertheless, given the continued existence of the forces acting to strengthen the shekel, particularly the continuing rise in exports of technology services, it's not clear to what extent the Bank of Israel can adhere to this policy if it is determined to prevent the shekel from strengthening further."

Published by Globes, Israel business news - - on September 19, 2021

© Copyright of Globes Publisher Itonut (1983) Ltd. 2021

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