To press release as a Word document
Presentation (Hebrew)
Mr. Andrew Abir, Director of the Bank of Israel’s Market Operations Department delivered a speech today at the Small and Medium Business Conference hosted by the Calcalist newspaper. The following are the main points of his remarks:
The Bank of Israel’s Market Operations Department carries out all of the Bank of Israel’s activities in the financial markets. The department implements monetary policy, manages foreign exchange reserves, and implements the exchange rate policy. Despite these many roles, wherever people meet me, almost the only question they ask is, “What will be with the dollar?” This shows the importance of the exchange rate to the Israeli economy, both for exporters and for those who products that compete with imports. But we can also learn what the questioners are focusing on: They ask me “What will be with the dollar”, and not “what will be with the shekel”. I will try to focus on this point and to explain the difference between these questions.
The development of the shekel’s exchange rate vis-à-vis the dollar in the past 15 years fluctuated in a relatively broad range, between a low of 3.22 in 2008 and a high of 5.00 in 2002. The public tends to focus on the changes in the most recent period, and to forget sharp changes that took place in the past. In the past two years, we have seen the shekel strengthen due to improvement in the current account of the balance of payments and the import of capital, mainly of direct investments. With that, it is interesting to look at periods in the not-too-distant past, when the exchange rate was very different, and it is important to understand the background that caused the exchange rate to reach such levels, and how quickly things can change.
The first example upon which I will focus is the period from 2001 to 2002, when the exchange rate vis-à-vis the dollar increased from around 4 to around 5 shekels to the dollar. The background for the increase was first the collapse of shares on the NASDAQ exchange in the US, and then the outbreak of the second Intifadah. These two “hits” led to sharp changes in the exchange rate.
The second example is the years 2008 and 2009, against the background of the global financial crisis, when then the shekel depreciated from 3.25 to 4.25 shekels to the dollar. When analysts provide forecasts of the exchange rate for the coming year, the main factor in their projection is the current rate. With that, the past shows us that the exchange rate can fluctuate very quickly, and it is very difficult to predict these fluctuations.
As I noted, the shekel/dollar exchange rate gets the majority of the public’s attention. But is it the correct rate to be looking at for the purpose of conducting policy? This rate is obviously affected by what is happening to the dollar on world markets, and does not necessarily reflect changes in the domestic economy. The Bank of Israel focuses on the effective exchange rate of the shekel against a basket of currencies, which represents Israel’s main trading partners. There are periods when the shekel/dollar rate is disconnected from the effective exchange rate as a result of global changes in the dollar’s exchange rate. For instance, at the beginning of 2011, a gap of 5 percent opened between the two indices due to the weakness of the dollar vis-à-vis the euro, in view of the improving situation in Europe and the weakness of the dollar globally. A similar phenomenon has been taking place recently: the shekel was stable against the basket of currencies, with sharp fluctuations of the dollar vis-à-vis other currencies.
It is therefore important to understand that what is happening in the domestic foreign exchange market is only part of the picture. The international foreign exchange market is very volatile—its fluctuations are sometimes much sharper than those of the shekel/dollar rate. A business owner needs to consider precisely what currencies are relevant to his business, and what currencies are relevant to his competitors. For instance, if the company exports to South Africa or Japan (or competes with companies from those countries), the changes that have taken place in the currencies of those countries in the past two years will certainly have an impact on him.
Now let’s go back to the Bank of Israel’s exchange rate policy. Between 1997 and 2008, the Bank of Israel did not intervene in the foreign exchange market. Following the rapid appreciation of the shekel during the second half of 2007 and the beginning of 2008, the Bank of Israel resumed its intervention in the market. In the first stage, the objective of the intervention was to increase foreign exchange reserves. A few years before the program started, we reached the conclusion that the level of the reserves (between $25 billion and $30 billion) was too low. For instance, according to an index of import months, the reserves covered just four months of imports, which is a low level by international standards.
Foreign exchange reserves can be thought of as the country’s economy emergency warehouse, which is supposed to provide foreign exchange liquidity during periods of financial crisis or, for instance, G-d forbid, war. We wouldn’t want to open the emergency warehouse during an emergency and find it empty. Against this background, a program to increase the level of the reserves was decided upon, in view of the fact that the stronger shekel provided the ideal timing for implementing the program.
In 2009, we announced a halt to the program of regular foreign exchange purchases in order to increase the reserve levels, and we moved to a new policy that is still in effect today, according to which “the Bank of Israel will act in the foreign exchange market in cases of excessive volatility in the exchange rate that are not consistent with the fundamental economic conditions, or when the foreign exchange market is not operating properly (market failure).” The intention was that when there are sharp changes in the exchange rate, and it is important to emphasize that we are talking about the effective exchange rate, that are not explained by the fundamental conditions, there is room to intervene in the market in order to enable the private sector, both exporters and those competing with imported goods, to adjust themselves to the sharp changes in the exchange rate.
Another layer was added to the exchange rate policy in May 2013, following the rapid appreciation of the nominal effective exchange rate of the shekel (about 11.5 percent between September 2012 and May 2013). At the beginning of the process, the appreciation was also influenced by the geopolitical situation, due to the dissipation of the tension that was prevalent at the beginning of the period. As the start of natural gas production from the Tamar site drew closer, the foreign exchange market began pricing in the expected return from dozens of years of natural gas production as if it would happen all at once, and we understood this to be an immediate sharp appreciation. The objective of the new program was to prevent what is called “Dutch Disease”. As we know, in the 1960s and 1970s, large amounts of natural gas were found in the Netherlands, which led to a strengthening of the Dutch currency and negatively impacted domestic low technology manufacturing, thereby reducing the Dutch economy’s ability to benefit from the blessing of natural gas production. Our objective was to create the conditions whereby the Israeli natural gas would be a blessing for the economy, and not a curse. As part of the program, the Bank of Israel offsets any impact of natural gas production on the balance of payment. The Bank purchased $2.1 billion in 2013, and announced that we will purchase $3.5 billion in 2014. In Norway, as we know, they established a sovereign wealth fund that offset the entire effect of natural gas discoveries on the domestic exchange rate, and the results were much better than in the Netherlands. It is clear to us that we want to learn from the Norwegian example, and not from the Dutch example.
Taken together, the natural gas program and the policy of intervention in cases of excessive volatility have succeeded in moderating the pressure for appreciation in the past year. As stated, the intention is to enable domestic companies to make the adjust themselves in a gradual manner to structural changes, and to make it easier for them to cope with sharp changes in the exchange rate that are not connected to the fundamental conditions of the economy.
In summation, we saw that conditions in the domestic foreign exchange market could change rapidly. The Bank of Israel’s intervention in the foreign exchange market led to a level of foreign exchange reserves that better fits the needs of the Israeli economy. We intervene in the market when the exchange rate is not consistent with the fundamental economic conditions, and in addition, we run the natural gas program that is moderating the pressure on the exchange rate that results from the production of natural gas in Israel. With that, the volatility in the global foreign exchange market is a fact, and the business plans of both large and small businesses must take it into account.