Prof. Zvi Eckstein supports NIS 3.30-3.40/$ floor rate

The former deputy Bank of Israel Governor is the first senior figure from the financial system to advocate a floor rate.

"According to my analysis, there is room for setting a shekel-dollar exchange rate floor at NIS 3.30-3.40/$. The exchange rate floor must be part of a Bank of Israel strategy for supporting the second objective - support for growth and jobs under the constraints of the inflation target," said Prof. Zvi Eckstein, former Deputy Governor of the Bank of Israel, in an exclusive interview with “Globes.”

This is the first public statement made by a senior official within the financial system to support an initiative to set an exchange rate floor, which, until this point, Governor of the Bank of Israel Dr. Karnit Flug has refused to consider.

Prof. Eckstein did not criticize the Bank of Israel or its governor during the interview, and said: “I respect Karnit, who is an excellent governor, and the monetary committee, which is working in an outstanding manner. This is simply my recommendation, and I am putting it on the table.”

Eckstein was nominated, along with Prof. Mario Blejer, as a candidate to replace outgoing Governor Stanley Fischer, who did not support his candidacy, and recommended Flug instead.

According to Eckstein, an exchange rate floor, or a minimal rate, “can change, and the Bank of Israel will prevent it dropping below the rate in a manner that will lend exports - an important factor in economic growth - a certain degree of security, which will allow for an increase in investment in exports, and in the market’s export potential, particularly in the current conditions of low interest and ongoing shekel appreciation.”

The dollar has been treading water for a number of weeks, a phenomenon that has amplified criticism of the new Governor, who claims, via the Bank of Israel spokesperson, that, since last May, there has been no change in the nominal effective exchange rate (unadjusted weighted average value of Israel’s currency relative to the currencies of Israel’s primary trade partners). The dollar weakened yesterday by 0.2% during inter-bank trading, and is trading NIS 3.46/$, a rate that has not been recorded since August, 2011. Over the course of just the last month, the dollar has weakened by more than 2% against the shekel, and has reached a 28 month low.

Eckstein explains why the shekel-dollar exchange rate is not of the same significance as the shekel-euro rate

“Studies have been done,” he explains, “that show that the exchange rate must hold at NIS 3.74/$. These studies are based on an examination of wages per hour in Israel, versus the US. According to OECD data, the output for one work hour in Israel is 55% of a US work hour, on average (in dollar-adjusted terms). Therefore, this figure means that the long-term exchange rate is NIS 4-4.1/$. If we factor in a 10% margin of error and correction for the short term, then I think we need an exchange rate floor of NIS 3.3-3.4 to provide security for exports.”

Eckstein explains that the “the monetary committee is the deciding body, and it must ensure other factors as well, and its members are the ones who would set the actual floor rate. They have the same data I have, or better.”

A strong economy with a weak currency

Eckstein doesn’t try and evade one of the main criticisms of the exchange rate floor: the matter of cost; when the dollar rate sinks below the floor rate, the Bank of Israel must “protect” it by purchasing dollars, until the rate rises above the floor. In order to do so, the central bank must print shekels and hoard dollars. Printing shekels is equivalent to reducing interest rates, unless “sterilization” action is taken - taking money out of the market by issuing makam (short-term Treasury notes)

However, for makam, the Bank of Israel must pay higher interest than it received for the dollars it has just purchased. In other words, the Bank of Israel has a “loss” or a “cost” associated with this action. “Because the reason we need an exchange rate floor is not to increase our reserves, the accrued money must be invested by different means than the reserves,” explains Eckstein.

According to Eckstein, these dollars must be invested in assets with risk that is equivalent to the Government of Israel’s risk. “Then,” says Eckstein, “the return on these assets will be similar to what the Bank of Israel pays on makam.” Thus, Eckstein recommends investing these dollars in more risky products than the reserve dollars, “because the reserves are for emergency situations, and, therefore, it is important that they be invested in a very, very liquid manner, with very, very low risk.”

Regarding the question of what sort of financial products the “exchange rate floor dollars” should be invested in, Eckstein says, “given Israel’s low risk rates, there are a number of countries with similar risk rates, and we can buy their government bonds. Experience shows that when a central bank takes such steps, the markets, particularly the speculative markets, understand matters well, and do not push too much to make quick profit, because the risk is great. This does not mean that the Bank of Israel does not need to intervene beforehand. The Bank of Israel has a lot of credibility in the markets, and I expect that such a step would only increase its credibility.”

Eckstein added that this is a “correct step that can work well when low interest is expected to continue for at least a year and half. This would be a step that allows the Bank of Israel to meet its goals. In Switzerland, it works exceptionally well.”

Eckstein emphasizes that the measure is correct, and is necessary, as the shekel’s strengthening stems from three factors, whose impact on employment is inconsequential: the first is a phenomenon referred to as the “Dutch disease” - an effect of the gas flow, which is reducing the cost of fuel in the economy, but greatly strengthens the shekel, and the expectation of continued gas flow is already causing the shekel to strengthen more. The second factor, according to Eckstein, is the sale of start-ups, which brings dollars into the market, but has little impact on employment.

The third factor is capital flow: “Due to the macro-economic stability of the Israeli economy and the ongoing uncertainty in the world, coupled with the relatively high interest rates in Israel, which increase the attractiveness of these holding following the continued reduction in debt-production ratio and the expectation of setting up a sovereign wealth fund, which is expected to further reduce the new national debt. Moreover, we see Israel’s credit default swap (CDS) level of risk, which is dropping markedly. And the gap between returns on US government bonds and Israeli government bonds is dropping as well.

Published by Globes [online], Israel business news - www.globes-online.com - on January 2, 2014

© Copyright of Globes Publisher Itonut (1983) Ltd. 2014

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