Will Israel catch euro flu?

Israel is watching with concern the financial crisis in Europe, its main export destination.

Will Israel catch the euro flew (photo credit: AVI KATZ)
Will Israel catch the euro flew
(photo credit: AVI KATZ)
In Paris and Berlin the lights in finance ministry buildings burn late into the night, as officials in the euro zone’s core economies strain to contend with a financial crisis that has lasted far longer than expected and threatens to drag the region and perhaps the world into a major recession.
The euro crisis is being watched very carefully by Israeli government officials and business leaders.
The latest round of bailout money to Spain, to the tune of €100 billion, barely managed to halt upward pressure on Spanish bond yields. It is still unclear how the Greek election results will affect expected negotiations between the Greek government and the European Union on renegotiating, yet again, Greek debt repayment schedules.
Israel managed to withstand the world economic crisis centered on the United States 2008 debt crisis to an extent that surprised many. Positive GDP growth in Israel was regained as early as 2009, unemployment dropped to historically low levels and the country maintained a sterling credit rating while giants like France saw their ratings drop.
Given this record of resilience in the face of international crisis, can Israelis rest confident that they can weather the worst of any financial storm emanating from Europe? Many Israeli analysts, noting that Europe is the number one market for the country’s heavily export-oriented economy, fear that a second consecutive smooth glide through troubled economic waters is too much to expect.
Stanley Fischer, the governor of the Bank of Israel, is very careful to avoid giving away details of any preparations by the bank to contend with a significant European financial crisis, but he has gone on record as stating that it is definitely a concern that he cannot ignore.
“If European banks crash, that will affect us too,” Fischer told the Knesset Finance Committee earlier this year. Conservative Bank of Israel decisions on interest rate levels and other factors seem to suggest that the mood among decision makers is far from optimistic.
“Even under a positive future scenario, Europe is headed towards recession as a result of austerity policies adopted throughout Europe, including France and Germany. Growth will continue to be weak,” Ori Greenfeld, head of the macro-economic department at Psagot Investment House in Tel Aviv, tells The Jerusalem Report.
Greenfeld reports that a slowdown in Israel’s economy is already being registered, especially in the export sector, as economic sluggishness in Europe and uncertainty regarding the future of the euro hampers demand. “We are a small and open economy, dependent on export markets. We are dependent on the European economy,” says Greenfeld. “If the world sneezes, we will get wet. And that is under a positive scenario.”
Ezra Gardner, co-founder and managing partner at Omnium Capital Management, an Israel-based hedge fund, confirms that weakened demand in Europe will undoubtedly have negative consequences for Israel.
“There is no question that Europe’s issues are affecting Israel – indeed, they have been for over a year now,” says Gardner. “I spoke to an Israeli software CFO yesterday and they are showing weakness in their business because upwards of 40 percent of their clients are in Europe.” He says similar patterns are likely across the high-tech sector.
Highly-placed sources in major capitals in Europe stress to The Report that there is no reason to panic. From the perspective of the forest rather than the details of the trees, they say the euro will survive because too much is riding on its continued existence. At the same time, a weariness can be discerned in their voices. In more candid moments, the never-ending Greek tragedy emerges in particular as a source of frustration. In official statements, all the European countries say they do not want to see any euro country leave the currency; in private, there is a hint that at this point if the Greeks on their own accord insist on leaving, no one will make too great an effort to force them to remain.
“Frustration over Greek policy responses over the past two years has led quite a number of people who started with good will a few years ago to become completely frustrated and say, let them do whatever they want,” says a senior academic economist in Germany, who has served as a consultant to the German government. “The question is whether that frustration survives television pictures of things turning really badly inside the country.”
Could Greece realistically go back to the drachma as its currency? The German economist tells The Report that in his opinion it is too late for that. “Suppose that the Greek parliament at 11 p.m. one day passes a law stating that as of one minute after midnight, all euro-denominated contracts under Greek jurisdiction are held to be concluded in drachmas,” he says. “And suppose this law was passed without anyone leaking the information beforehand. Then they could have done it.”
That “unrealistic” scenario, he says, is now impossible. By switching back from the euro to the drachma, Greece would find it even more difficult to pay off its renegotiated foreign debt.
What makes the euro crisis so complicated is that it is not one crisis but three interlocking crises that are difficult to disentangle: the Greek foreign debt problem, the crisis in countries such as Ireland, Portugal and Spain, where states are on the hook for covering bank debts, and a potential crisis in Germany and France, whose banks are exposed to a staggering amount of foreign debt that would need to be written off under the worst-case scenario. These complications put France and Germany in the unenviable position of needing to choose between two unpalatable options: the financial burden of bailing out ailing peripheral euro-zone countries will mostly fall on them, but if they refuse to do that they may end up paying even more if their banking systems collapse as a result.
In addition, there is the burden of recent European history. “For everything one might say about Greece, one can find a parallel in the Weimar republic,” says the German economist, furrowing his brow. “I grew up with the notion that the Weimar economy was completely stifled by reparations payments. ‘All these foreigners wanting money.’ The fact is that prior to 1930, in every single year capital imports, mostly from the United States, exceeded reparation payments.In foreign currency considerations, Germany was borrowing what it needed to pay. But domestic policy discussion in the Weimar republic was dominated by an aversion to paying the tribute for the Treaty of Versailles.”
Viewed from Israel, the biggest fear is that paralysis in Europe will lead to a financial contagion that take down Spain and Italy, which together comprise one-third of the euro zone.
”If debt-repayment issues in those countries get out of control, they can threaten a collapse of the banking system, just as in the United States in 2008,” says Greenfeld, admitting that this possibility makes him very uncomfortable. “The large European banks, like Paribas for example, are not only European banks, they are global banks. If they go down, they can drag down the entire global financial system, causing a global economic crisis.
Refusing to rescue
“In 2008, the United States poured money into the financial system to save it. But European governments today do not have the resources that the United States had in 2008. The European Central Bank (ECB) so far has not been willing to undertake a rescue role, refusing to save European governments. But it may find itself having no choice if and when a real crisis emerges. The likeliest scenario is one in which the ECB will have to pour euros into the system, because it has no alternative,” he says.
What can Israel do to protect its economy in case a serious euro-zone crisis drags down most of the world? Greenfeld points out that Israel is one of very few developed countries that has not suffered a bursting property bubble in recent years.
“There was no credit bubble here. Banks were very conservative and did not give out worthless loans and mortgages,” says Greenfeld. “The Bank of Israel is very aware of the situation, and is taking steps to protect the Israeli economy in case a European crisis occurs. One explanation for the reason that the central bank is keeping interest rates at around 2 percent is to give it room to effect a sharp reduction in interest rates in the future, if a need arises.”
Greenfeld regards Israeli government debt and deficit burdens as too heavy at the moment to enable a significant fiscal policy response to a major crisis. “That has been the situation for many years, so it is not really anything new,” he adds.
The markets in Israel have also been taking steps to protect themselves. “Investment portfolio managers are investing more in the United States to avoid exposure to the euro zone,” says Greenfeld. “If they must invest in Europe they are placing money in France, Germany and Scandinavia, avoiding other countries. Another response we have seen to the European situation is an increase in relative Israeli exports to emerging markets in Asia and South America, to avoid overreliance on the European market. It will be interesting to see if that trend continues.”
Joseph Zeira, a professor specializing in macroeconomics at the Hebrew University, tells The Report that a crisis can affect Israel in several ways. Overexposure by Israeli banks to European assets could trigger financial contagion; overinvestment by Israeli tycoons in Europe could weaken their position; a reduction in European demand for Israeli exports might be offset by a change in fiscal policy from the Bank of Israel.
Zeira was a prominent economic adviser to the 2011 social justice protest movement.
He regards the potential danger of the effects of a painful euro crisis as yet another argument in favor of greater income equality.
“In the long run, the best protection is a more equal distribution of income,” he says, “because it increases aggregate demand and serves as a cushion to reductions in global demand.