Catch 22: The BOI and the foreign exchange market

By ARIE TAL
August 4, 2009 13:41
2 minute read.
USD-ILS (white) vs. DXY Index (orange. represent t

USD-ILS (white) vs. DXY Index (orange. represent t. (photo credit: none)

 
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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).



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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 Israeli goods and services for foreigners.



As a consequence, the Israeli export sector may suffer great revenue losses which will drive up recessionary pressures.



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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


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