It is exactly one month today since the dramatic announcement by Governor of the Bank of Israel David Klein that he would cut interest rates by a whole 2%. The announcement took the entire business sector by storm, in particular the capital and foreign currency markets, and led to rapid 6% devaluation of the shekel.
Some view the cut as one of the most important policy-making measures taken recently.
Many in the foreign currency and capital markets believe it is too soon to tell what the results of that dramatic move will be, especially as the foreign exchange market has fluctuated as much as it has in the last few days, and the general public has been so confused. No one is dismissing a possible 5% to 10% additional devaluation, and even the cautious governor himself told us at the end of the week he would not even be fazed by a "NIS 5 to the dollar rate."
Still, we are of the opinion certain initial inferences can be made here.
The first one is that the so-called shekel mountain is a natural phenomenon rather than a financial bubble. The prevailing theory according to which the growing balance of shekel assets in the public hands is a financial time bomb artificially maintained by Bank of Israel's high interest rates, is fast dissolving.
With the interest rate below 4%, and bank deposits offering the public 2% to 3% on their investment, we don't see massive migration from the shekel to any foreign currency or to CPI linked bonds.
The shekel is dropping at a rate one cannot ignore, the market is jittery, and yet the public keeps most of its assets in the local currency ¿ as it would do anywhere in the world where prices are generally stable.
In the first week after the interest cut, capital market estimates were the public would depart all shekel instruments as soon as it realized the interest on them was "nil". But the days are going by, and "nil" now appears to be a relative term. The foreign currency market may be alluring when devaluation reaches 5% in two weeks, but the public understands it's a free, open market where prices can plummet just as quickly as they soared.
The second fact to remember is the foreign currency market is working. It's been four years since the bank of Israel and the Ministry of Finance decided on full liberalization of the foreign currency market, and only in the last month did it become evident liberalization has succeeded.
If up until one month ago, one could claim the market was functioning only because it was "protected" by a high interest rate, then in the last month it proved it could do its thing even though the interest rate was slashed by a third in a single day.
The Israeli foreign currency market is exposed to foreign investors free of all sentimentality. The sharp interest rate slash was a significant test for the market, and it passed it with flying colors. In the entire last month, not one incident of market hysteria was recorded, daily turnover was in the billions of shekels, and on every given trade day one could buy and sell foreign currency at a reasonable spread.
Third, David Klein made a deal with PM Ariel Sharon. After a month of denying and squirming, the Governor half-heartedly admitted the 2% interest rate slash was a deal he made with the PM to lower the ceiling on short-term debt certificates, and to expand the fluctuation band.
Yet somehow his arguments are not convincing. At first he named the budget cuts as one impetus for the interest cut. Then he took it back and said it was those short-term certificates and the fluctuation band. Now he is again pinning it on the budget cut.
In reality, his argument that ties the interest cut to the budget cut is a flimsy one. The Bank of Israel would never give monetary benefits in exchange for declarations of fiscal restraint. The central bank rightfully said fiscal restraint can only be measured by the actual deficit, not based on the press releases from the PM's bureau or the Finance Minister's chambers.
And indeed, both the PM's and the finance minister's announcements of fiscal discipline have turned out inane at best. 2002 might be a year of fiscal anarchy, in which the deficit may reach 3%, 4% or even as much as 5%. Klein had to lower the interest rate because of mistakes he has made in the last 12 months, because he and his monetary division failed to predict the market's economic direction, and because he was under constant pressure from both the public and the political system.
The last but not least factor is that the key to foreign currency trading and the budget is in the hands of the government. The theory claiming the Bank of Israel is the sole ruler of financial markets is also collapsing. Though Bank of Israel slashed its interest by 2% in one day, still the long-term real interest, which finances a large portion of the market, has dropped by 0.5% to 1% at the most. Its more moderate decline stems from fear of over expansion of the government deficit, which would lead to superfluous supply of government bonds. In the foreign exchange market the one variant that explains the current nervousness is the fear of losing the grip on the budget.
These are the very reasons why in the past the Bank of Israel was a lot more prudent in its management of monetary policy. They also explain why the bank regarded that prudent conduct as the basic guideline of the financial policy, and why everyone was so surprised and disappointed with the deal David Klein made with Ariel Sharon.