The appreciation of the shekel against the US dollar is not just a matter of the latter's weakness, says US investment house Morgan Stanley in a report dated yesterday. The report says that the shekel remains undervalued against both the dollar and the euro, and that Israel's economy has the strength to withstand a global slowdown.
"Imbalances in the US economy and the dollar’s depreciation have become an overwhelming theme in global financial markets, triggering significant shifts in portfolio allocations. However, although the dollar is likely to remain weak in the near future, our currency economics team expects it to get stronger towards the end of this year and especially in 2008. Of course, such a turnaround in the dollar’s valuation and the reasons behind it would have a range of implications for Israel’s economy and financial markets. Nevertheless, we do not see a major risk to our call for the shekel’s continuing strength," writes Morgan Stanley analyst Serhan Cevik.
" The dollar’s weakness may have been a trigger, but the shekel’s appreciation is certainly not just about what has happened to the dollar. As we have long argued, the shekel is fundamentally undervalued against the dollar and even more so against the euro. Therefore, we still expect economic fundamentals and financial developments to keep supporting the shekel and the country’s domestic assets. Israel has the strength and dynamism to weather a global slowdown," the report continues.
"Despite geopolitical constraints and indeed the eruption of a guerilla war in Lebanon, the Israeli economy has continued to grow at a robust pace… The strength of the global economy is certainly an important factor for Israel’s export growth and overall economic performance, but it would be unfair to dismiss the effect of fiscal consolidation and structural reforms in accelerating the private sector-driven expansion cycle. With the correction in the budget deficit from 5.4% of GDP in 2003 to 0.9% last year, the corporate and household sectors have benefited from a more rational, predictable macroeconomic outlook. This is why we believe that Israel has the strength and dynamism to weather a slowdown in the global economy," Cevik writes.
"The current account surplus is not just a cyclical Phenomenon," he continues. "Israel’s current account balance moved from a deficit of -0.5% of GDP in 2002 to a surplus of 2.9% in 2005 and about 6% last year. This is an amazing performance, especially considering the worsening in the country’s terms of trade because of higher commodity prices.
"Although the global business cycle has been an important determinant of trade flows all around the world, Israel’s specialization in high-tech tech goods and services is far more important than the volume effect, in our view. In other words, higher value-added in technology-intensive sectors brings a structural improvement in the current account.
"Of course, this is only one aspect of a greater story in progress. For example, the current account surplus is also a reflection of the downward trend in domestic investment relative to GDP after the immigration-driven increase in capital accumulation in the 1990s. Another important factor that we need to consider is the increase in net income from investments abroad, as Israel has become a capital-exporting country.
"Financial globalization has led to a secular decline in home bias. Structural changes in the capital markets, particularly the equalization of taxation on investment abroad, have accelerated residents’ portfolio diversification… While residents kept accumulating assets abroad, foreign capital flows to Israel surged from $3.2 billion in 2002 to $11.6 billion in 2005 and a record level of $23.4 billion last year. However, since assets abroad increased faster than liabilities, the country’s net international position improved significantly from $50.3 billion in 2000 to $30.1 billion in 2005 and $17.3 billion in the first three quarter of 2006.
"Even though the decline in home bias in residents’ portfolio allocations is a headwind against the shekel, the increase in net income from investments abroad and foreign participation in Israel’s financial markets will continue to support the valuation of shekel-denominated assets, in our view.
"Currency appreciation has lowered inflation and allowed for monetary easing. Consumer price inflation declined from 3.8% in April to -0.3% in November, as the shekel’s strengthening lowered dollar-linked prices across the economy Facing such a currency-driven correction in inflation dynamics, the Bank of Israel has opted for monetary easing and lowered short-term interest rates even below those in the US. Even so, we believe that the economy’s underlying strength still supports lower real interest rates," the report concludes.
Published by Globes [online], Israel business news - www.globes.co.il - on January 11, 2007
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