Last week, the shekel strengthened sharply against the world's leading currencies. Against the US dollar, it broke through the psychologically significant NIS 3.20 barrier, with the rate falling to below NIS 3.16/$ at the weekend, while against the euro the shekel is at its strongest for twenty years.
Apart from the positive state of the Israeli economy, there are several factors that account for the appreciation of the shekel in recent years, some of which have become even stronger recently, as the economy emerges from the fourth wave of the Covid-19 pandemic and aid programs designed to support the economy during the pandemic become unnecessary and are set to expire.
1. Greater expectations of an interest rate hike
Although the Bank of Israel expects that in a year's time its key lending rate will be in the range of 0.1-0.25%, higher than the current rate of 0.1% but low from a historical perspective, the local bond market is pricing in expectations of higher rates, which tends to strengthen the shekel in anticipation of higher inward movements of capital.
In setting its interest rate, the Bank of Israel examines the effective exchange rate, that is, the rate against a basket of the currencies of Israel's main trading partners. The effective rate is at an all-time low, meaning that the shekel is stronger than it has ever been against Israel's trading partners' currencies. The stronger the shekel becomes against the basket of currencies, the lower the shekel amount that exporters receive for their products, so that, if the Bank of Israel wants to continue to protect exporters, the shekel's current level is a warning sign.
On the other hand, the Bank of Israel is under no pressure to raise interest rates. Unlike central banks in other countries, that have raised their rates in order to curb sharply rising inflation, the Bank of Israel has more room for maneuver before raising its rate, since inflation in Israel is lower, mainly because the strong shekel makes imported goods cheaper. Besides, the source of the current price inflation lies in supply problems rather than in demand, which means that a rise in interest rates at this point would be liable to choke economic activity and result in unemployment. And what of the exporters? So far this year, exports have only risen, despite the shekel's strength.
2. Massive inward investment
Hardly a week goes by without the report of an exit by an Israeli technology company in the tens if not hundreds of millions of dollars. The movement of capital into Israel as a result of acquisitions of companies, mainly in the technology sector, entails a rise in demand for shekels, since the dollars coming to Israel need to be converted to local currency. Last year, direct inward investment in the Israeli economy totaled $24 billion. For the first half of this year, it was already $14 billion. If the trend persists, inward investment this year will exceed last year's total.
But one person's good news is another person's bad news. Among the companies that have made exits are exporters, in the technology sector too, that have been harmed by the strength of the shekel. At the beginning of the year, during the third lockdown, senior technology company executives called on the Bank of Israel to intervene in the foreign exchange market to moderate the appreciation of the shekel and avoid damage to the sector. Since then, the background conditions have changed as both the local and global economies recovered strongly, and exports have risen sharply over the past year despite the strength of the shekel. The question is whether the Bank of Israel distinguishes between exporters when it comes to aiding them.
3. The Bank of Israel has reduced intervention in the foreign exchange market
Although the Bank of Israel has bought nearly $30 billion since the beginning of this year in order to moderate the appreciation of the shekel, the local currency has strengthened by 4% against the basket of currencies over that period, which indicates that the basic forces supporting a strong shekel are here to stay. The program designed to moderate the appreciation of the shekel to help Israeli exporters reached the amount set, $30 billion, although the door remains open to further intervention.
Governor of the Bank of Israel Amir Yaron says that as the economy becomes stronger, the Bank of Israel will let market forces play out, but in the same breath he left open the option of intervening in the foreign exchange market from time to time. If on the market the perception was that the NIS 3.20/$ level had been marked by the Bank of Israel as a level below which the rate should not fall, since otherwise the blow to exporters would be too heavy to bear, the downward breakthrough of this level signals a new era.
To a great extent, inflation is currently affected by rises in import prices, and it Is not inconceivable that the Bank of Israel is allowing the shekel to appreciate in order to ease this pressure. In other words, taking into account that the stronger shekel serves to moderate inflation in Israel, it may be that the Bank of Israel feels comfortable letting market forces operate freely. The question is to what level of exchange rate the Bank of Israel will show such tolerance.
4. Rise in global equities markets
Investments by Israeli financial institutions in stocks in the US lead to a rise in demand for foreign currency on the local foreign exchange market. When overseas markets rise, the currency exposure of the institutions rises, and since their exposure is already high, they tend to sell foreign currency
Last week, the leading indices on Wall Street reached record levels. So far this year, the Nasdaq has risen about 21% and the Dow Jones 18.8%. The S&P 500 completed a year to date rise of 24% on Friday. Over the past year, the correlation between the US equities market and the shekel-dollar exchange rate has been high, and this trend is not expected to change in the near future.
The main question therefore is whether the Bank of Israel will return to intervention in the foreign exchange market despite the fact that the background conditions in the economy are better than they were in January, when the Bank of Israel launched its grandiose currency purchasing program.
Published by Globes, Israel business news - en.globes.co.il - on October 31, 2021.
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