Commentary: The right exit strategy

Bank of Israel Governor Stanley Fischer has aproblem. For the last 17 months straight, the BOI has been buying updollars in the foreign exchange market to stop the free fall of thegreenback against the local shekel.

This fall threatened to destroy the crucialexport sector, which accounts for almost 30 percent of the nation'sGDP. The BOI's purchases have brought Israel's foreign reserves to arecord of almost $50 billion.

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

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

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

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

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

This is a classic inflationary activity. The BOI can offsetmoney-printing by increasing the issuing of its own bonds (the famousMakam) to the public, but it hasn't done this so far, so theinflationary effect still remains. Fischer believes that in the currenteconomic atmosphere of recession, deflation is a far more seriousdanger than inflation, so he can keep pumping shekels to the moneymarkets.

So far, this belief has proved to be correct. But now, as wecan learn from the latest read of the consumer price index and from theinflation expectations derived from bond market prices, things havechanged. Let us not forget that the prime responsibility of our centralbank, 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 priceswas the BOI announcement last week that it would stop buying governmentbonds in the free market. This was another measure Fischer implementedin the stormy months of late 2008, when he poured money into the bondmarket to improve the institutional investor's (pension and providentfunds and insurance companies) liquidity.

But the bonds repurchase is small potatoes compared to thechallenges Fischer faces in the forex market. It is clear to everyonethat if the Israeli currency were to skyrocket again toward a rate ofNIS 3 to the dollar, many industrial companies could collapse, andothers - including in the prominent hi-tech sector - would suffer heavylosses that would force them to lay off tens of thousands of workers.In the current fragile economic environment, this would be a nationalnightmare.

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

Among the factors that have an extremely negative influence onthe value of the dollar are massive money injections by the FederalReserve, huge liabilities taken by the federal government from the carindustry, AIG and the mortgage market, ambitious health-care plans andsupporting the crippling state budgets.

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

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

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

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

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

Under this regulation, a foreign investor who withdraws hismoney in less than a year will leave 35% of it in the government'shands. Since a huge part of the dollar inflow nowadays comes fromforeign speculators who convert billions of dollars to shekels, if theyare invested in short-term local bonds, the new tax is likely to bevery effective in driving "hot" dollars away.

The argument that this step would be a regression to agovernment-controlled market is ridiculous. First of all, directpurchases by the BOI are themselves a means of control, so there is noregression here. Moreover, short-term speculations like the onesforeign banks conduct from their mother bases in London have nothing dowith the real economy. They are merely financial raids made by sharkswho usually use shady practices such as those that destroyed thefinancial system just a year ago.

The central government's duty to protect itspopulation from this kind of financial terror is the same as in thecase of physical terror. The notion that these steps will scare realforeign investors away has proven to be wrong in the Asian countriesthat have tried them out. It will only scare away the hyenas who haveno idea how to make money by actually creating something real.

Adoptingthe idea of fining short-term capital movements is not a guarantee to aweaker shekel. A global collapse of the dollar will eventually take itstoll here as well, and there is no way to completely control a foreignexchange market without returning to a fixed rate and a black market onback 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.