Barring a slump here and there, for two months the shekel has been gaining ground. From a low of almost five shekels to the dollar in mid-June, the Israeli currency clawed up to NIS 4.62 last week, although it sagged a tad afterwards.

The shekel's appreciation resulted from a combination of factors: the surge in the Bank of Israel's key lending rate, the cabinet's approval of a tight budget for 2003, the relative quiet in Israeli-Palestinian hostilities, hesitant signs of recovery on the stock exchange, and the release of financial reports that were not as bad as had been feared.

It is difficult to weigh the importance of each factor, but the conventional wisdom is that the the main factor was the three-stage increase in the central bank's lending rate from 3.8% at the beginning of the year to 9.1% in July, which created a 7.35% gap between dollar and shekel interest rates.

After subtraction of financial risk, the gap narrows to 6%. But a differential that size is still large enough to divert short-term investments from the dollar to the shekel, and run up the value of the shekel even more.

Is the increase in interest rates the main factor behind the appreciation of the shekel?

Probably. But one must not make a post hoc rationalization. There may be other, no less important factors. What about, for example, the most natural factor - heavy demand for the shekel created by the dollar's ascent to the NIS 5 level?

There are of course speculators (all of them of course respectable and contributing their part to the economy) who made a killing by cashing in their profits from the depreciation of the shekel - a depreciation that they themselves helped to create during the first few months of 2002.

Aside from causing a panic, the accelerated depreciation of the first few months of 2002 was in fact of great benefit to the real economy: exporters for example received increased recompense for goods and services after a long period of erosion in the profitability of exports. This is a benefit that can not be underestimated; the economy's chances of extracting itself from the claws of recession depend to a large measure on the export sector's ability to increase its activities and employ a larger number of people.

The benefit of the shekel's depreciation to exporters shrinks as the shekel's value rises. Last week the shekel-dollar rate was back at the same level as in mid-February 2002. It won't take much for it to head back to its level at the end of 2001.

If that happens, the terms of trade will erode, because prices in Israel have gone up since January 2002 by 7%, three or even four times as much as in the target markets for Israeli exports.

In normal times, one can never tell which way currency rates will go - and this is even truer in abnormal times.

Deterioration in the security situation, an attack on Iraq, a failure to get the budget passed, early elections - any of these could lead to a speedy deterioration of the shekel for the wrong reasons and have unwanted side-effects.

However, it wouldt be healthy for the shekel to continue to climb, either. Policy makers, namely the Bank of Israel, should act promptly to put a brake on it, insofar as its capacity allows.

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