UBS sees a risk to the Israeli economy from its high level of index-linked debt, now that inflation in the country is on the rise. The risk is faced by all sectors: government, companies, and consumers, according to UBS analyst Darren Shaw.
"Israel’s economy is unique as around 50% of total debt is CPI linked. We believe the recent spike in CPI in Q2 (2.5% in Q2 = 10% annualised) surprised most market participants, and we are concerned that further upside surprises to inflation, could be negative for the Israeli economy," Shaw writes.
Shaw notes a high correlation between inflation in Israel and the shekel-dollar exchange rate. The recent strength of the shekel has so far mitigated inflationary pressures, but if the shekel were to weaken, those pressures would rise.
"Despite the drop in inflation over the past twenty years, lenders and borrowers have retained their preference for CPI-linked debt. Most of the corporate debt raised from capital markets during 2005-2006 was CPI-linked and Israeli companies enjoyed relatively low financial expenses due to the low CPI. However the spike in CPI in the second quarter could affect the bottom lines of many Israeli corporates and we are concerned that a continued high inflation could continue to weigh on the profitability of many Israeli companies," the UBS report says.
"We are concerned that the Israeli consumer will be hit both by a rise in food and energy prices, and also by either a rise in mortgage payments which are CPI linked, or higher rental costs. This could significantly curb consumer spending that has driven GDP growth over the past few years. We believe the rise in CPI will also have fiscal implications as the government could be squeezed by paying more on its CPI linked debts as well as collecting less corporate taxes.
Among corporates, Shaw identifies leveraged companies without the ability to pass on higher costs as the most vulnerable to the effects of higher inflation on their debt. On the other hand, banks and companies with low exposure to the CPI will emerge as winners.
One company seen as at particular risk is Delek Group Ltd. (TASE: DLEKG), which has 32% of its debt index linked.. "A rise in financial expenses together with a drop in earnings at key subsidiaries and a lack of one time gains poses a risk to 2008 earnings," the report says. MA Industries (Makhteshim Agan) (TASE: MAIN), which has 86% index-linked debt, is also seen as liable to incur higher financial expenses.
On the banks in particular, Shaw writes, "A significant portion of corporate debt and mortgages are CPI linked. Bank deposits, on the other hand, are mainly non CPI linked and Israeli banks are effectively long CPI. Due to this exposure Israeli banks usually perform better in a positive inflationary environment, though they are impacted by slowing GDP, and risk to consumer confidence."
Other companies that Shaw sees as "relatively immune" to a rising level of inflation are telecommunications companies Partner Communications (Nasdaq: PTNR; TASE: PTNR; LSE:PCCD), Cellcom( and Bezeq (TASE: BZEQ).
Published by Globes [online], Israel business news - www.globes.co.il - on July 10, 2008
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