In a foreign exchange strategy report on the shekel, US investment house Merrill Lynch attributes the Israeli currency's robustness despite a record low interest rate differential with the US chiefly to recent political developments in Israel and the region.
"The Israeli shekel has held up well despite a number of unfavourable developments in recent weeks," the report says. "First, on December 27 2004,the Bank of Israel cut its key lending rate by 20bp to 3.7%,the lowest level in history. The nominal gap between Israeli and US short-term interest rates has now fallen to a record low of 145 basis points.The last time rates were nearly this low, at 3.8%in late December 2001, the shekel experienced sharp weakness, falling about 7%against the USD by early February 2002.Second, tax rates on capital gains from domestic and overseas securities were equalised as of January 1,2005.The amendments to the income tax law lowers the tax rate on capital gains on the sale of foreign securities from 35%to 15%, which is the same rate applied to Israeli securities. The substantial change in tax rates does not appear to have led to a significant shift in the composition of domestic investors’ financial asset portfolios.
"The shekel has been relatively stable against an equally-weighted basket of euro and the US dollar since the interest rate cut and amendments to the tax code. So what has changed? What makes shekel so resilient? In our view, the resilience reflects a reduction in the country’s risk premium on the back of a) improved prospects of new peace initiatives in the Middle East, b) strengthened macro fundamentals, and c) the US loan guarantees.
Shifting Geopolitical Landscape
"The American military victory in Iraq, President Bush’s re-election and the death of the Palestinian Authority President Yasser Arafat appear to have improved prospects of new peace initiatives for the Middle East, which would obviously have a significant positive impact on Israel’s macroeconomic prospects. In particular, the developments since the death of Mr.Arafat have been important.
"First, Israel and the US regard Mr. Abbas, the newly appointed head of the Palestinian Liberation Organisation (PLO), as a moderate who opposed the use of violence in the four-year-old Palestinian uprising. Mr. Abbas, who assumed the PLO leadership following Arafat’s death, is also the leading candidate to become president of the Palestinian Authority. The presidential elections, which could pave the way for new peace talks, are scheduled for January 9. Second, Syria has recently indicated a willingness to resume peace negotiations with Israel after more than four years of deadlock. Finally, Israel, Egypt and the US have recently signed a free trade agreement. Needless to say that progress in the Middle East peace process would significantly reduce Israel’s risk premium, leading to rating agency upgrades as well as increased foreign investment. This is probably one of the chief reasons for the shekel’s resilience.
Parting Domestic Political Clouds
"Domestic political clouds also appear to be parting. Prime Minister Sharon seems to have succeeded in forming a new coalition, which includes the centre-left Labour party and the ultra-Orthodox United Torah Judaism party. The new coalition, or unity government, will give Mr Sharon a comfortable majority in the 120-seat parliament (Mr Sharon’s Likud party has 40 Knesset seats, with Labour and UTJ having 21 and 5 seats, respectively). A broad coalition, which is largely priced in the markets, would clearly be positive. The first task of the new government is the approval of the 2005 budget before end-March to avoid early general elections, which should be easy. PM Sharon may still find it difficult to secure the support for his plan to withdraw from the Gaza Strip and four West Bank settlements in 2005. Some 13 hard core Likud "rebel deputies"have already indicated that they would vote against the evacuation and compensation law. However, the new government strengthens prospects of Middle East peace talks.
Strong Macro Fundamentals
"Thanks largely to favourable global growth, the US loan guarantees, and structural reforms there has been a strong turnaround in the Israeli economy. According to preliminary estimates by the Central Bureau of Statistics, Israel’s real GDP growth rate reached 4.2% in 2004. Excluding 2000, when start-up companies boosted Israel’s economic growth, this is the highest growth rate in almost a decade. Low interest rates, planned cuts in direct taxes, improved business sentiment and consumer confidence, and falling unemployment suggest that the recovery is likely to be sustained through 2005. Although the expected slowdown in global growth argues for some moderation in the pace of growth, GDP growth is likely to remain respectable, at around 3.4% in 2005.
"Despite the strong recovery, there is little evidence of inflationary pressures, as rising productivity and a falling USD have helped keep prices in check. As of November 2004, the Consumer Price Index was up 0.9% yoy, well below the government target range of 1-3% . The Central Bureau of Statistics estimates show that the so-called core CPI, which excludes housing and fruits and vegetables, fell to the lowest level in four years. The core CPI was up a mere 0.4% yoy in 2004, compared with 2.6% yoy in 2003 and 3.9% yoy in 2002.
"Inflation expectations have also improved. The 12-month forward inflation expectations -derived from capital markets -fell to an average of 1.2% in December 2004, down from 1.9% in November and 2% in October. This is close to the lower limit of the government's 1-3% inflation target for 2005. The near-term inflation outlook appears to be fairly benign. Shekel strength, softening energy prices and seasonally low clothing prices argue for falling month-on-month CPI in the first quarter of the year.
"For the full year, inflation is likely to remain well within the target band in 2005. Israel’s budget deficit for 2004 amounted to 3.9% of GDP, slightly below the official target of 4% . The deficit would have been significantly lower, at around 3.5% of GDP, had the government not brought forward some 2005 expenditures. This was the first time the government was able to beat its fiscal targets since 2000 (Chart 2). We expect the cost of coalition building to be manageable. Furthermore, the government appears determined to keep the budget deficit below 3.5% in 2005, including the cost of the disengagement plan.
"Reflecting improved external competitiveness and the recovery in the tourism sector, Israel’s current account posted a surplus of $ 600 million in the first nine months of 2004 compared to a deficit of $ 200 million in the same period of 2003. The country is likely to have posted a small surplus for the whole of 2004. Equally important, non-resident investments in Israel reached $ 4. 3 billion in the first nine months of 2004, compared to $ 3.8 billion in the corresponding period the previous year. We expect Israel’s current account to post a deficit of around 0. 7% of GDP in 2005, reflecting a larger trade gap. Considering the US loan guarantees, high international reserves and the country’s strong external credibility, even larger current account deficits would be manageable.
"Finally, the country’s strong export performance and Merrill Lynch’s trade weighted real exchange rate index indicate that the currency is possibly undervalued.
Interest Rate Outlook
"After an eight-month pause, the Bank of Israel resumed interest rate cuts in November 2004 mainly on the back of lower-than-expected inflation figures. The near-term inflation outlook remains favourable. This may make policymakers at the Bank of Israel feel that they have room to cut short-term rates once more. It is worth noting that the Bank of Israel in its previous easing cycle in 2001 went too far, triggering significant currency weakness. Further rate cuts, at a time when the Fed is tightening policy, are unlikely to be sustained. We expect the bank to be on hold through the first quarter with the risk of some monetary tightening (50-70bp) increasing through the remainder of the year.
"With the 10-year bond yield spread to the US at a historic low and considering that the tax rates on capital gains from domestic and overseas securities have been equalised, we think further rate cuts would make the shekel vulnerable.
Conclusion and Risks
"Improvements in the political and macroeconomic fundamentals fully justify the shekel’s recent resilience. However, the main risk to the currency in the absence of progress on the peace process, would be further narrowing of the interest rate gap with the US, along with a global economic slowdown. Further risks arise as the current Governor of the Bank of Israel David Klein’s term ends this week and a new central bank governor is due to be appointed no later than January 12. Investors would be concerned if the new governor adopts an expansionist policy, which would unsettle the currency."
Published by Globes [online], Israel business news - www.globes.co.il - on January 9, 2005