More than a year ago, the Bank of Israel began to buy foreign currency at a rate of $25,000 a day. The Governor of the bank announced that he had identified a herd mentality among foreign exchange traders. In a press release (March 2008), the bank revealed that, after an in-depth examination of the needs of the economy, and in the light of its rapid rate of growth (does anyone recall?) and the need to integrate into the global financial system (does anyone know of one?), foreign currency reserves needed to be raised by some $10 billion to $35-40 billion, within two years. All this was really just a cover story for the bank's real concern, namely the harm it saw to the profitability of exports and to growth from a too strong shekel.
Following those announcements, I expressed, on several occasions, severe criticism of the bank's decision to intervene in the foreign currency market. I warned at the time that intervention was liable to harm the bank's credibility and its policy, and that, like any gambler, it would have to up the ante and pay a heavy price for it.
A few months passed, and in July 2008, the bank announced that it was raising its intervention to $100 million a day, shortening the timetable for reaching the foreign currency reserves target it had set from two years to a few months. I will admit that, for a while, I drew considerable encouragement from the apparent success of the intervention policy. I thought that it was possible that the global crisis and the breakdown of the known rules governing economic policy around the world justified thinking 'outside the box' of the kind the Bank of Israel demonstrated. But as time has gone on, it has become clear that my initial perception that there should be no intervention in a properly functioning market was correct after all. The foreign currency reserves now total $45 million, and counting.
Intervention like this is like riding on the back of tiger. Once you jumped on its back, you were safe from its claws and sharp teeth. But at some point, you have to get off. Dismounting from the tiger is the most dangerous moment, and the chance of surviving doesn't depend of the rider, but on the tiger and the surrounding circumstances.
If some other prey passes by that will distract the tiger's attention, the rider can seize the opportunity and jump off safely. Thus, if forces arise that put downward pressure on the shekel, such as, for example, a severe security threat or a financial crisis and a downgrading of the country's credit rating, that will serve as an opportunity for ending intervention. However, the Bank of Israel can't rely on economic crises; it is supposed to be part of the effort to reduce the risk of them happening.
Some believe that the Bank of Israel has an orderly plan for getting off the tiger's back. In my view, that's an illusion. Gradually stopping intervention and the expectation that intervention will stop will have a similar effect. They will lead to a sharp appreciation of the shekel, such as we have seen in recent days. It follows that the Bank of Israel has no choice at the moment but to continue intervention, constantly expanding the scope of it. We are back to the gambler who becomes more and more entangled.
One interesting option is to continue with intervention while considerably reducing the degree of transparency that the Bank of Israel has practiced up to now. An announcement of intervention in variable amounts, with a substantial widening of the intervention range, raises the level of uncertainty on the part of market players. But however we look at it, the Bank of Israel has a problem.
One of the dangers lying in wait is a return to outmoded methods, such as devaluations or fluctuation bands. One of the greatest supporters of intervention and exchange rate engineering, Dr. Yaakov Sheinin, has expressed the dimensions of the risk very well. I heard him propose setting a floor for the shekel-dollar exchange rate (say, 4.20), with the Bank of Israel undertaking to buy any amount needed to prevent the rate from falling below that level. Although one can rely on the Governor of the Bank of Israel to oppose any such fantastic plan, the more time goes by, the more experts will pop up with such magic solutions.
The question is whether the wisdom of the Governor and of the Bank of Israel will be enough to ensure them and us a dignified descent from the back of the tiger charging towards the abyss.
The writer was formerly a member of the Bank of Israel's management.
Published by Globes [online], Israel business news - www.globes.co.il - on May 27, 2009
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