Commentary: The right exit strategy

September 8, 2009 10:34
Bank of Israel Governor Stanley Fischer

Bank of Israel Governor Stanley Fischer . (photo credit: Ariel Jerozolimksi)


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Bank of Israel Governor Stanley Fischer has a problem. For the last 17 months straight, the BOI has been buying up dollars in the foreign exchange market to stop the free fall of the greenback against the local shekel.

This fall threatened to destroy the crucial export sector, which accounts for almost 30 percent of the nation's GDP. The BOI's purchases have brought Israel's foreign reserves to a record of almost $50 billion.

At first, officials in the central bank insisted that this policy had nothing to do with aspirations to artificially regulate the exchange rate, but was meant to strengthen Israel's foreign reserves.

No one really bought this argument at the time, but now, when these reserves can cover imports for almost 10 months, a depreciation of the shekel has become an official stance.

At first, Fischer's moves were very successful. The shekel, which had reached 3.2 against the dollar, turned around and fell to a low of 4.2 at the beginning of April after the governor of the central bank convinced local dealers he was serious, increasing the level of the daily dollar dose to 100 million.

But in the last four months, the trend has reversed. The dollar, which had weakened across the world, started recovering to its current 3.75 level, despite the continuing purchases by the BOI.

There is a limit to Fischer's ability to continue his support of the American currency. When we say that the BOI buys $100m. a day, we actually mean that our central bank is printing about NIS 400m. for the purchaser of the dollars.

This is a classic inflationary activity. The BOI can offset money-printing by increasing the issuing of its own bonds (the famous Makam) to the public, but it hasn't done this so far, so the inflationary effect still remains. Fischer believes that in the current economic atmosphere of recession, deflation is a far more serious danger than inflation, so he can keep pumping shekels to the money markets.

So far, this belief has proved to be correct. But now, as we can learn from the latest read of the consumer price index and from the inflation expectations derived from bond market prices, things have changed. Let us not forget that the prime responsibility of our central bank, as clearly stated in the BOI Law, is to maintain price stability. Printing so much money is the opposite of that.

A first sign of the growing concern of such an effect on prices was the BOI announcement last week that it would stop buying government bonds in the free market. This was another measure Fischer implemented in the stormy months of late 2008, when he poured money into the bond market to improve the institutional investor's (pension and provident funds and insurance companies) liquidity.

But the bonds repurchase is small potatoes compared to the challenges Fischer faces in the forex market. It is clear to everyone that if the Israeli currency were to skyrocket again toward a rate of NIS 3 to the dollar, many industrial companies could collapse, and others - including in the prominent hi-tech sector - would suffer heavy losses that would force them to lay off tens of thousands of workers. In the current fragile economic environment, this would be a national nightmare.

The task of supporting the dollar is getting even more difficult if you consider two other important factors. The first is the global trend against the dollar in the world's forex markets. This trend is likely to continue due to the monstrous deficit in US trade and the budget, which is growing bigger by the day.

Among the factors that have an extremely negative influence on the value of the dollar are massive money injections by the Federal Reserve, huge liabilities taken by the federal government from the car industry, AIG and the mortgage market, ambitious health-care plans and supporting the crippling state budgets.

The second factor is the relative strength of the Israeli economy, which, together with the growing appetite for risk in the world's financial system, will probably tempt more and more foreign investors to divert money toward the Holy Land.

Indeed, this is something that has been going on for a few months now, and it is a primary reason for the current appreciation of the shekel.

No wonder that in the last few weeks we have witnessed a wave of "macro studies" from prominent foreign banks that predict a further appreciation of the shekel in the coming months. These banks usually open their financial positions and then flood the market with so-called "professional" studies in order to support their investments, trying to tempt the masses to flow in the desired direction.

As we can see, Fischer's dilemma isn't simple. His ability to buy more dollars is reaching its end, and the mighty forces of the foreign exchange markets are threatening to ruin his achievement of saving exporters from a disaster so far.

But the answer, in my view, is surprisingly simple. There is an alternative to direct intervention in the forex market. Instead of printing billions of shekels, Fischer should adopt a method that is a common practice in places such as China and Thailand, which also rely heavily on exports and apply a 35% tax on short-term (12 months is a reasonable limit) foreign investment.

Under this regulation, a foreign investor who withdraws his money in less than a year will leave 35% of it in the government's hands. Since a huge part of the dollar inflow nowadays comes from foreign speculators who convert billions of dollars to shekels, if they are invested in short-term local bonds, the new tax is likely to be very effective in driving "hot" dollars away.

The argument that this step would be a regression to a government-controlled market is ridiculous. First of all, direct purchases by the BOI are themselves a means of control, so there is no regression here. Moreover, short-term speculations like the ones foreign banks conduct from their mother bases in London have nothing do with the real economy. They are merely financial raids made by sharks who usually use shady practices such as those that destroyed the financial system just a year ago.

The central government's duty to protect its population from this kind of financial terror is the same as in the case of physical terror. The notion that these steps will scare real foreign investors away has proven to be wrong in the Asian countries that have tried them out. It will only scare away the hyenas who have no idea how to make money by actually creating something real.

Adopting the idea of fining short-term capital movements is not a guarantee to a weaker shekel. A global collapse of the dollar will eventually take its toll here as well, and there is no way to completely control a foreign exchange market without returning to a fixed rate and a black market on back streets such as Lilienblum in Tel Aviv.

But it would certainly soften the punch, and more importantly, it would not make us pay an extremely high price on the inflation front.

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