September 13, 2000


THE LONG-TERM INTEREST RATE IN ISRAEL COMPARED TO THE EUROPEAN STANDARD


The spread between the yield to maturity on local-currency unindexed long-term bonds and that on German government bonds is currently similar to that between German bonds and Italian and Spanish bonds in 1996-three years prior to the formation of the European Monetary Union-and is now 3.4 percentage points, compared with a maximum spread of 2 percentage points specified in the European standard. In the light of the decline in the rate of inflation in Israel, now is the time to issue fixed-interest bonds for periods of 10 years or more. The existence of such bonds in the capital market, issued with a narrowing yield-to-maturity spread over the European norm, is one of the signs of a country with an advanced economy.

As part of a series of studies of the extent to which Israel is complying with the criteria of the Maastricht Treaty, the Foreign Currency Department of the Bank of Israel recently examined the spread between the yield to maturity on local-currency unindexed, fixed-interest long-term bonds (“Shahar" bonds) and that on government bonds of member countries of the European Monetary Union (EMU). The study showed that Israel does not yet meet the yield criterion, although it is not far from doing so. In this respect Israel’s current position is similar to that of certain countries some years ago prior to their joining the EMU. In the planning of the Monetary Union, the prior convergence of several important financial and economic indicators was seen as necessary for its success. Among these were a low rate of inflation, defined as price stability, a government deficit not exceeding 3 percent of GDP, and a debt/GDP ratio of no more than 60 percent. Another criterion related to the long-term rate of interest; among the conditions set in the Maastricht Treaty for acceptance into the EMU was the requirement that the yield on long-term government bonds of a country wishing to join the Union not exceed the yield on bonds in the three member countries with the lowest rates of inflation by more than 2 percentage points. In the years of planning the Union, the yield in Germany was generally used as the standard, because the difference between it and that in other countries with low inflation was minimal. Long-term interest was explicitly defined as the nominal yield.

The Foreign Currency Department notes that the yield on unindexed, interest bearing government bonds can be divided into three elements: the real yield, which compensates the investor for delaying consumption; the inflation premium, which compensates for the expected erosion in the real value of the bond due to the rise in the price level; and the risk premium, which compensates the investor for carrying various risks, mainly the risk that actual inflation will exceed his forecast. Assuming that real yield does not differ significantly between industrialized countries, a comparison of yields is intended to check the difference in expected inflation between the countries and the different degrees of credibility which the public ascribes to their economic policies.

The EU decided to interpret the term “long-term bonds" as referring to 10-year bonds. In Israel, however, the government has not yet issued Shahar bonds with a maturity of more than 7 years. The Foreign Currency Department notes that until fixed-interest bonds are issued for longer periods, any attempt to analyze the extent to which Israel is complying with this criterion of the Maastricht Treaty is of limited significance.

The spread between the yield to maturity on 7-year bonds in Israel and in Germany is currently 3.4 percentage points. This is less than the spread between Germany and Italy and that between Germany and Spain at the beginning of 1996, which were 4.7 percentage points and 3.7 percentage points respectively. The commitment of Italy and Spain to tight monetary and fiscal policies in accordance with the European standard led to the narrowing of the spreads between them and Germany to less than 2 percentage points by the beginning of 1997. The reduction in the spreads also led to the convergence of yields on 10-year bonds in Italy and Spain to the required range-a spread of less than 2 percentage points.

The Bank of Israel also points out that in the light of the decline in the rate of inflation in Israel and the need to increase the share of unindexed bonds in the government debt, now is the time to issue unindexed bonds for 10 years or more. This is particularly the case as the regular issue of unindexed, fixed-interest government bonds for 10 years or longer is a sign of a developed, mature economy. Hence, the ability of the financial markets to absorb issuance of unindexed, fixed-interest 10-year bonds at a narrowing yield spread over the norm in Europe will be an important test for Israel’s capital market and the economy as a whole. If Israel succeeds in passing this test, it will not only provide a better assessment of the extent to which Israel is satisfying the Maastricht criteria, but more importantly will serve as a milestone along the road leading to the end of Israel’s period of inflationary uncertainty.