The Bank of Israel's sporadic purchases of dollars are ineffective in weakening the shekel. Israel's central bank has two options left for achieving a devaluation, Psagot chief economist Ori Greenfeld assets in his weekly macroeconomic survey.
"As the Bank of Israel itself admits, the strengthening trend in the shekel is not a result of speculative capital movements. The cause is a fundamental macroeconomic environment that supports the currency, particularly the current accounts surplus, which in the first quarter reached its highest level since 2007," Greenfeld writes. "Therefore, if the Bank of Israel decides that further strengthening of the shekel is a scenario its wishes to avoid, sporadic purchases of foreign currency on the market will be of no avail. What will help? There are two main possibilities:
"One is enhancing communication with the markets. As we have learned in recent years, in an environment of negligible interest rates, a central bank's strongest tool is its communication with the markets. By using clear and decisive language, the European central bank succeeded in stabilizing the euro bloc without buying even a single cent of bonds. The US Federal Reserve System also now realizes that Bernanke and Yellen slips of the tongue contributed nothing to certainty in the markets, and took the subject of directing the markets one step forward. If the Bank of Israel wishes to devalue the shekel, it must therefore signal to the markets that it will do everything necessary to change the direction of the trend.
"The problem with this method is of course that if the markets lack complete confidence in the bank's ability to change the direction of the trend, the declaration very quickly becomes empty. In order to maintain confidence in it, the bank will have to begin buying foreign currency on a much larger scale than planned>
"The second is to shorten the processes and move to the final stage of the preceding possibility by setting a floor exchange rate. The announcement of a floor rate by itself is obviously insufficient, and the Bank of Israel will have to show that it intends to maintain this exchange rate. That's how it was in Switzerland, and that's how it was in the Czech Republic when the central banks in those countries had to buy billions of euros in order to combat speculators. In both cases, however, the speculators desisted after a short time, and the exchange rate has been fluctuating about the floor rate for a long time already. Beyond this, the problem with a floor rate is primarily technical. First of all, support from the political system is very important in order to maintain a long-term exchange rate floor. Secondly, how will a floor exchange rate be managed in an economy with large trading volumes in the world's two leading currencies? Will the floor rate be set against the dollar, the euro, or a basket of currencies?
"As of now, the scenario of setting floor exchange rate does not appear the most likely one, but there is no doubt that its likelihood is increasing."
Published by Globes [online], Israel business news - www.globes-online.com - on August 10, 2014
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