The summer heat of July and August reached the foreign currency market last week. Traders decided to test the Bank of Israel's red lines and got their answer in the form of a dramatic change in its foreign currency purchasing policy.
One of the interesting results of the policy change, which even the Bank of Israel did not anticipate, was the unintended tax on speculators.
In order to understand how this happened, it is necessary to understand the pattern of activity of foreign banks.
In contrast to past years, when foreign banks sold foreign currency and bought shekel bonds and short-term deposits in order to profit on interest rate gaps, the vast majority of the billions of dollars sold in the current wave in March-August 2009 did not go to the capital market, but remained in the local banks, through the following technique:
A foreign bank sold dollars and deposited the shekels received for them in overnight deposits. At the end of the business day, the foreign bank bought the dollars from the local bank and again deposited them in an overnight deposit. It would then repeat the process.
This technique maximized liquidity and minimized risk compared with investing in the capital market. Investing in the capital market carries the risk of exposure to falling bond prices, not to mention the risk of changes in exchange rates. Depositing the money in daily interest accounts is suitable for investors seeking quick profits on the shekel.
In normal times, this is a simple procedure, and because of the negligible interest rate gap between the shekel and dollar, it carries no price. But these are not normal times - the dollar purchases by the Bank of Israel emptied the commercial banks' dollar reserves, and in order to carry out the simple procedure, the local banks were forced to borrow the dollars from foreign banks.
And a loan is a loan. When demand is high, the interest rate gap widens, and that is what happened to the foreign banks last week. The interest rate gap on overnight deposits rose, to be quickly followed by the gap on weekly deposits (where they sought refuge), and by the gap on monthly deposits. The interest rate differential rose to 60 basis points per month, amounting to a negative annual interest rate of 1.5% against the depositors. This is tantamount to a fine, or if you like, a tax on transactions.
The pressure was most felt in the middle of last week when the Bank of Israel made massive purchases of dollars. The pressure greatly eased later in the week and the interest rate differential narrowed to 30 basis points (0.75% annual interest rate). This happened because the Bank of Israel greatly reduced its dollar purchases and because many traders closed their dollar positions, which the Bank of Israel wanted.
It seems that in this instance the Bank of Israel obtained an unplanned bonus. The pressure on the foreign banks was considerable, and there is no doubt that so long as the massive dollar purchasing policy continues, the hoped-for results will arrive, and speculators will cease their activity.
I believe that the foreign banks are relying on indecisiveness at the Bank of Israel and assume that the Bank of Israel will soon end its dollar purchasing program. If the central bank refutes this assumption and shows determination and consistency, it will achieve its objective in full - and fast.
Yesterday, too, the media reported plans for further measures, which only strengthens what I have asserted here for a long time: the moment that a spade is called a spade and the decisive role of speculators is pointed out, it will be much easier to deal with them.
Finally, I wish to comment on the criticism of the Bank of Israel's actions. I was amused to read a quote from the research department of a foreign bank that is active in Israel, which claimed, "I see no evidence of speculative activity in Israel."
Less amusing from my perspective was to read that an executive of a large Israeli bank, a former Bank of Israel official, had called the dealing room of the bank where he worked, and found no evidence of speculation. This is quite worrying in light of the fact that this bank is one of the main profiteers of speculative activity.
The biggest problem in my view was a critique by Nehemia Strasler in "TheMarker". He compared the present situation in the Israeli foreign currency market to the Bank of England's foreign currency actions in the early 1990s, which brought on the famous aggressive assault by George Soros. However, Strassler failed to distinguish the considerable differences between the two cases: the Bank of Israel is trying to weaken the shekel, whereas the Bank of England was trying to strengthen the pound.
There is a world of difference between an attempt by a central bank to strengthen the local currency, which was doomed to failure because its foreign currency reserves were limited; and an attempt by a central bank to weaken the local currency. There is a greater chance for the latter attempt to work, if it is implemented wisely. People who live in the world of the foreign currency market know this well. Hedge funds also know this well, and if Governor of the Bank of Israel Prof. Stanley Fischer knows how to play the game from now on, he'll succeed.
Yossi Frank is CEO of Energy Finance
Published by Globes [online], Israel business news - www.globes-online.com - on August 10, 2009
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