"BoI cannot regulate the exchange rate"

Shekels Photo: Shutterstock

Halting the shekel appreciation will help exports at the expense of the standard of living explains former Finance Ministry state revenue division head Yoram Gabay.

The rapid appreciation of the shekel in the past decade has caused great concern among industrialists and farmers, but has greatly boosted the standard of living in Israel (imports of consumer and investment goods, overseas travel, etc.). I will attempt to assess the economic model used to "set" the exchange rate, and to reach appropriate conclusions.

Theoretically and empirically, trading in the forex market, like the capital markets, takes place continuously and in accordance with supply and demand. As a rule, the two main elements that determine the trend are the current account surplus or deficit of the balance of payments and capital movements, which are affected by the relative interest rate in Israel and the rest of the world (for example, an interest rate hike here "attracts" financial capital investments to Israel). Speculative activity sometimes takes place, but usually has no long-term effect.

Net capital movements have had no recent substantial effect on the exchange rate. The main factor in the appreciation pressures is in any case the $12 billion annual surplus for the past three years in the balance of payments, which is strengthening the shekel. Part of this is offset by the Bank of Israel's purchases.

In general, the demand for foreign currency grows when we, as private individuals or importers, buy dollars to pay for overseas trips or goods imported to Israel. The supply of foreign currency grows when the exporters, startup entrepreneurs, and tourists convert foreign currency into shekels.

Over the past decade, we have seen the shekel appreciate by 30% against the basket of currencies, and the current account surpluses are nevertheless growing. We are not getting close to a stable equilibrium point in the forex market.

Theoretically, the appreciation process should increase the demand for foreign currency by making imports cheaper (this is taking place), thereby reducing the supply and foreign currency proceeds as a result of lower profit margins for the exporters (this is not happening), and balancing the current account of the balance of payments. In practice, this is not taking place.

In my opinion, the main reason why the appreciation process is not bringing us near to equilibrium is that there are four sectors in Israel that suffer from the Dutch disease, in other words, sectors whose proceeds in foreign currency strengthen the shekel, while the volume of revenue in foreign currency in these sectors remains high, even when the appreciation process reduces proceeds per dollar exported (similar to the oil situation in the Netherlands and Norway). The result is that the appreciation process is detracting from the exporters' profit margins in all the "other" sectors as a result of this foreign currency revenue.

The sectors in the Dutch disease category are (1) foreign currency proceeds from startups; (2) most weapons exports; (3) US aid; (4) natural gas, and low sensitivity to multinational companies. The strengthening of the shekel has almost no effect on total foreign currency proceeds in these areas.

The conclusion from this is surprising: even if the exchange rate reaches NIS 3/$, for example, the surplus in the current account and the appreciation pressure will probably continue. Even when the consumers and importers increase their demand for foreign currency, the foreign currency proceeds (the supply) will continue to be very large. The principal conclusion from this is that the Bank of Israel cannot be an important factor in regulating the exchange rate in the long term, and other means available to the Ministry of Finance or other ministries are therefore required. These parties will have to employ other means of reducing conversions of foreign currency to shekels. Some even assert that a foreign currency fund should be established, like the Norwegian fund, which will invest most of the proceeds from foreign currency overseas, thereby neutralizing the appreciation process.

Theoretically, another legitimate argument holds that the shekel should be allowed to strengthen without any intervention by the state or the Bank of Israel, which will quickly increase people's standard of living, lower prices, increase demand in the economy, and expand the services sector. In this case, the ration of production and exports to GDP will fall, but net growth and employment will be almost unaffected.

In my opinion, there is no theoretical or empirical economic answer to the question of which is good for the economy - an accelerated appreciation process or exchange rate stability. An accelerated appreciation process will continue, and will increase the standard of living and bolster the volume of activity in the (business and public) services sector, while further reducing the activity of exporters and local producers. Halting the appreciation process will encourage exports and local producers at the expenses of the standard of living.

Which is preferable? Each of us has a different economic, professional, and social opinion on the issue.

The author is a former Ministry of Finance state revenue division head.

Published by Globes [online], Israel Business News - www.globes-online.com - on July 4, 2017

© Copyright of Globes Publisher Itonut (1983) Ltd. 2017

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Shekels Photo: Shutterstock
Shekels Photo: Shutterstock
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