Cutting ties to the dollar: A case for delinking the shekel

Dollar-linkage is making it hard for the Bank of Israel to keep up with the inflation targets and adds a measure of uncertainty to the economic activity in the country.

By BANK ON IT WITH RONEN TAIEB
May 22, 2007 07:23
4 minute read.
ronen taieb 88

ronen taieb 88. (photo credit: )

The currency basket was first introduced in 1976 by the Bank of Israel based on the shares of five currencies: the US dollar, the German mark, the pound sterling, the French franc and the Dutch guilder. The currency basket exchange-rate served for monitoring and analytical purposes. In 1985, with the start of the economic stabilization program, a regime of a fixed exchange-rate against the US dollar was introduced and, in 1986, a new currency basket was introduced. Since the inception of the basket, the parameters of the exchange-rate regime (today, the exchange-rate band) have been set in terms of the basket rather than in terms of a specific currency. The number of units of each currency in the basket is determined according to its share in trade during the previous calendar year and to international cross rates at the time the basket's composition is fixed. The number of units of each currency in the basket is constant, but the weight of each currency can change daily according to changes in cross rates. For example, when the US dollar gains strength, its share in the basket rises, and vice versa. Effective May 1, the Foreign Currency Department ended publication of the currency basket exchange rate, as the exchange-rate band (which related to the exchange-rate of the currency basket) was abolished a year-and-a-half ago, and as the currency basket is no longer used for monitoring or analysis. With the end of the publication of the basket exchange rate, the current calculation of the exchange rate will also end, and the weights of the currencies that comprised the basket will no longer be updated. The representative exchange rates of foreign currencies will continue to be published as normal, for indication purposes only. This is mostly done to help the Bank of Israel preserve inflation levels. In the past, Israel suffered from high levels of inflation, thus causing its currency to lose value since inflation erodes purchasing power and, therefore, demand for that particular currency. As a result, real estate prices were linked to the dollar to preserve the value of property. Today, the population, having a hard time forgetting the historical inflation crisis, doesn't seem to want to cease dollar linking even though the shekel is now much more stable than the dollar in many ways and there is no need to use the dollar as reference. A similar crisis took place in Turkey; a rising level of inflation caused dollar-linkage but, today, even though its inflation level is much higher than in Israel, they have returned to the local currency. It seems, Israelis need to make extra effort. Dollar-linkage is making it hard for the Bank of Israel to keep up with the inflation targets and adds a measure of uncertainty to the economic activity in the country. Therefore, the central bank is considering ending the publication of the representative exchange rate so as to minimize the damages caused by the linkage. The Bank of Israel's inflation level target stands at 1%-3%. Such an economic environment would enable the Bank to lead a low interest rate while preserving stability in the whole financial system. In addition, there will be tremendous influence on the foreign exchange (Forex) market, which exists wherever one currency is traded for another. It is by far the largest market in the world, in terms of cash-value traded, and includes trading between large banks, central banks, currency speculators, multinational corporations, governments and other financial markets and institutions. Daily trade in the Forex markets around the globe currently exceeds US$1.9 trillion, on average. The US dollar is the most dominant currency in the world with 89% of the foreign currency business transactions, followed by the euro with 37% and the yen with 20%. Given a large and ever-changing mix of current events, supply and demand factors are constantly shifting and the price of one currency in relation to another shifts accordingly. Exchange rate fluctuations are usually caused by actual monetary flows, as well as by expectations of changes in monetary flows caused by changes in GDP (a region's gross domestic product) growth, inflation, interest rates, budget and trade deficits or surpluses, large cross-border mergers and acquisitions and other macroeconomic conditions. The influence on the market can be divided into the wholesale trade market and the retail trade market. Regarding the wholesale market, ending the publication of the representative exchange rate is not expected to influence as it conducts itself in an excellent consistent manner, as even during difficult days, the trade has been good and political events in the country haven't caused any crisis. The wholesale market is prepared to deal with the canceling of the representative exchange rate. In the retail trade market there is a factor of uncertainty. The Bank of Israel is preparing for the cancellation very carefully; it is a long process that will need gradual adapting. The application of this decision isn't simple as there are different linking systems in the foreign exchange market, such as foreign exchange-linked contracts. These days, a charting of contracts is being conducted in the Bank of Israel in order to find solutions towards the change. Also, there is no disregarding the fact that many financial tools in the banking systems reevaluate business transactions based on representative exchange rate reports. The Bank is not rejecting the possibility that an external group will provide representative exchange rate services and will probably be supervised by regulators as a result of the extent of trades in the foreign exchange market. Bank of Israel Governor Stanley Fischer is inviting the public to send suggestions and comments on the subject and to take a stand and express themselves on the representative exchange rate issue through "Kol Koreh," the central bank's Web site. The author is an adviser in the Information Risk Management Department at KPMG Somekh Chaikin. The article is published under his responsibility only.


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