USD-ILS (white) vs. DXY Index (orange. represent t.
(photo credit: none)
The current weakening trend of the dollar against
the shekel worries the Bank of Israel (BOI). The bank has been
intervening in the foreign exchange market since March 2008. It
increased its foreign currency reserves by 75% to about 50 billion
dollars during that period to strengthen the dollar in order to support
the export sector.
Although BOI continues to implement its policy,
the dollar has depreciated by 10% against the shekel in the last 3
months, in accordance with the trend of the dollar against the main
international currencies (as shown by the DXY index below).
This development suggests that the BOI's "dollar policy" is
losing its effectiveness, either in its physical context or
psychological. In other words, if the dollar will keep depreciating in
the international foreign exchange arena, it will also depreciate
against the shekel, and vice versa.
As a result, policy makers face a huge dilemma with regard to
the dollar policy. There are two important tools that may be used by
BOI in the near term which may affect the movements of the domestic
foreign exchange market. The first is the change in foreign reserves.
BOI has to decide whether to keep on with its current policy of
purchasing (US$100 million per day, and US$50 on Fridays) or bring the
policy to an end. The option of increasing the purchase rate or selling
dollars is not discussed because in the current environment these sort
of steps will be politically incorrect.
Then, if BOI decides to carry on with the current
policy, it exposes its balance sheet to a foreign exchange risk, market
risk and inflation risk. Buying dollars means selling shekels and
increase market liquidity, which can push inflation up. In the current
stabilizing environment, where inflation can be across the corner, such
a step would be wrong.
On the other hand, discontinuing the purchases may be a
negative signal to foreign exchange investors, and it may cause a
further depreciation of the dollar against the shekel. Stronger shekel
will reduce the attractiveness of Israel
i goods and services for
As a consequence, the Israeli export sector may suffer great revenue losses which will drive up recessionary pressures.
The other tool is the interest rate. Sooner or later the BOI
will have to raise the interest rate. Raising the rates will increase
the spread between Israel
and the US Federal bank rates. Such a step
will support a further appreciation of the shekel.
Certainly, BOI would prefer to start its tightening campaign
after the Federal Bank, because this could drive the dollar up and
provide some oxygen to the domestic export sector. However, BOI may not
have this privilege because of rising inflation pressures. Nowadays,
short run expectations are above BOI inflation target. If it continues,
interest rate will be raised much sooner than previously expected -
September to October.
To conclude, policy makers face a foreign exchange policy trap.
Interest rate will go up soon, probably before the tightening abroad.
Keeping on with the current dollar policy may drive up inflationary
pressures and put BOI's balance sheet in risk. Moreover, the market
response may not be significantly negative in case BOI announces that
it plans to reconsider future purchases or reduce dollar purchases. The
market probably has discounted already such scenarios. In order to
diminish the intensity of potentially future dollar depreciation, the
BOI should reduce the amount of purchases, consider the right timing,
and be less transparent with regard to its dollar policy since it fuels
FX speculators' activity.
The writer is Chief Analyst and Strategist at Alumot-Sprint Investment House and also a regular writer for several leading financial papers and Web sites