​Summary:
 
The NIS exchange rate was notably stable in 2004 under the effects of mutually offsetting forces. Domestic factors that tended to weaken the currency were accompanied by a set of domestic and global factors that had the opposite effect. The domestic factors that favored a strong NIS include improvement in a number of long-term parameters in the forex market, the expansion of real domestic activity, and greater credibility in macroeconomic policy. In view of the global economic recovery including high-tech, these factors favored the continuation long-term foreign investment,1 largely portfolio and in small part direct. Long-term forex supply increased due to the perseverance of long-term foreign investment and the continued improvement in the current account. This supply generated underlying appreciation pressure and helped to ease the relative effect of short-term capital movements,2 which by nature are more volatile, on the changes in the exchange rate. 

Domestic factors that had a pro-depreciation effect included the tax reform, which reduced the relative attractiveness of NIS investments as opposed to those in forex, and the narrowing of the interest spread. During the period reviewed, the NIS-dollar interest spread narrowed by 2.25 percentage points and came to 1.45 percent. During the first few months of the year, these factors prompted households, which transact mainly by means of forex mutual funds, to adjust their portfolios. This process stopped later in the year, however, despite two factors that should have caused it to accelerate: an increase in certainty about the completion of legislation to advance the elimination of tax discrimination between domestic and foreign securities to the beginning of 2005 and the continued contraction of the interest spread. The process ended due to a series of factors, mostly global: slowdown and rising uncertainty in global stock markets, an increase in the dollar exchange-rate risk against main currencies, and an upturn in expectations of a rise in short-term yields in the U.S. bond market. These developments, coupled with the favorable trends in the domestic capital market, made investing in foreign securities relatively less advisable. The market's response to the narrowing of the interest spread was usually moderate during the year, since it was accompanied by a decrease in the exchange-rate risk of the NIS and an improvement in the underlying variables in the forex market. 

As the domestic economic environment remained relatively stable and the geopolitical situation improved, the global financial environment had a relatively greater effect on the NIS exchange rate. The effects of developments in exchange rates among main monetary blocs and the behavior of prices in global financial markets were especially important. The impact of the global financial environment was reflected in both the extent of long-term capital inflows and the extent and direction of short-term flows. The trend in nonresident portfolio investment, particularly that related to issues by Israeli firms abroad, usually moved in tandem with the trend in prices in main global financial markets. Thus, external issues by Israeli firms slowed after the NASDAQ market lost altitude in the second quarter and accelerated when the NASDAQ market recovered in the fourth quarter. The level and direction of short-term nonresident capital flows were also strongly affected by general global trends in investment in emerging-market economies. Thus, in the second quarter, as yields in the U.S. bond market climbed, international financial players became less willing to invest in emerging-market economies, including Israel. Consequently, the nonresident short-term NIS position fell to zero during the second quarter. As the dollar depreciated against the main currencies in the second half of the year and especially in the fourth quarter, due to factors including the American "twin deficits" (budget and trade), these institutions began to reinvest in emerging-market economies and helped to strengthen these countries' currencies against the dollar. As a result, nonresidents built up both their investments in shares on the domestic exchange and their NIS positions in short-term instruments during the last quarter. Notably, however, the NIS gained less against the dollar than other emerging-market currencies did. 

In one of the most conspicuous developments in 2004-one that helped to consolidate the financial stability in the forex market- the business sector reduced its liabilities surplus by $ 6.5 billion, to $ 0.7 billion at year's end. The reduction in the business sector's depreciation exposure traces to a buildup in forex assets, especially by companies that tend to have forex assets surpluses due to the nature of their activity. This abetted the consolidation of financial stability in the forex market since in past years the business sector's aggregate exposure to depreciation had been a potential threat to market stability due to concern that rapid closure of the exposure would make the exchange rate severely volatile. Importantly, however, even though its aggregate exposure to depreciation fell to low levels, the business sector is still badly exposed in both directions. Unlike the past, however, its exposure today is strongly heterogeneous. 

The relative stability that typified the forex market during the period reviewed was reflected in the continued downtrend of exchange-rate risk to a historic low at the end of the third quarter. During the last quarter, an upturn in exchange-rate risk came into sight, evidently due to increases in uncertainty about the exchange rate of the main monetary blocs and domestic uncertainty factors