​Summary:

The exchange rate responded in 2003 to rather large-scale nonresident activity in short-term instruments and long-term direct and portfolio investment. This activity was affected by global trends and domestic developments that reduced the estimate of Israel’s country risk and exchange-rate risk-the dispelling of the Iraqi threat, the establishment of a stable government, the formulation of a new economic plan-and a global process of redirection of capital to emerging markets, prompted by lower yields in developed countries and a change in the perception of global risk. These factors induced a short-term capital inflow from the middle of February until the end of the first half of the year, manifested in a 13 percent depreciation of the NIS against the dollar and against the five-currency basket. The contraction of the yield spread between Israel and developed economies brought the trend to a halt during the second half of the year and led to mild depreciation.

Favorable trends in several long-term factors also contributed to stability in the forex market. They include the capital-mobilization guarantee arrangement with the US Government, the expansion of foreign direct investment (FDI), and the balancing of the current account. As a result, the basic account, a reflection of long-term forex supply, returned to a positive level in 2003 after declining steadily from October 2000 and tumbling into deficit in late 2002. Nonresidents’ patterns of activity in the forex market show that they quickly noticed the change in the economy’s underlying factors-reversal of the direction of nonresidents’ short-term exposure to the NIS, from a position against the NIS, as in recent years, to a pro-NIS position from June 2003 on.

Nonresidents’ and residents’ behavior in the forex market also reflected an upturn of confidence in macroeconomic policy after a decline in 2002. The improvement traces to the Government’s demonstration of a commitment to a declining path of deficit and debt and gradual and transparent rate-cutting by the Bank of Israel, which caused the NIS-forex spread to narrow by 3.7 percentage points during the year. Exchange-rate risk sank steeply to the December 2001 level, a conspicuous development in view of the narrowing of the interest spread. The decline, reflecting among other things the restoration of confidence in macroeconomic policy, allowed the Bank of Israel to cut the rate considerably without leading to rapid adjustment of the public’s portfolio. In the last quarter of the year and in early 2004, however, residents’ response to the narrowing of the interest spread intensified somewhat, as reflected in the amassing of forex assets by individuals and a drawdown of forex liabilities by the business sector. Institutional investors continued to increase their external investments as part of their long-term strategy of portfolio diversification. Their activities in 2003 were influenced by the narrowing interest spread and the transition to forex assets that it induced, the redemption of Gilboa bonds, and expectations of continued price increases in global markets. However, some institutionals still had low rates of external investment, mainly because their external investments were more heavily taxed than their domestic investments.

The balance of nonbanking private-sector assets in forex increased by $ 5 billion in 2003 and their share in the portfolio decreased, for the first time in several years, by 2 percent. Household assets expanded by $ 2 billion after a $ 3 billion upturn in 2002.
Part 2 is divided into two chapters.

Chapter 1 presents a comprehensive analysis of developments in the NIS-forex market and attempts, by ex post argumentation, to draw a connection between trends in the NIS exchange rate against the five-currency basket and changes in forex supply and demand by various market sectors and those who affect them.
Chapter 2 reviews developments in the main components of residents’ portfolios of forex assets and liabilities and nonresidents’ portfolios in NIS.