Easy math

In the end, the event that sent the dollar up a grade was surprising ¿ a combination of confusing declarations about capital gains tax and the collapse of Trade Bank, and not a security event or macroeconomic data, but as we wrote here two weeks ago, some such event was inevitable.

After the shekel's losses last week and yesterday, the U.S. currency is grazing by underneath the NIS 5 mark and most currency market players have no doubt it will cross the psychological barrier in the coming weeks and we will all need to get used to a new state of affairs. For three and a half years, since the big devaluation of October 1998, we have been accustomed to thinking of the dollar as ¿four-and-something¿ shekels. Now the math will be much easier: 5 shekels to the dollar, a nice round number, easy to calculate. Tourists, if they ever come back here, will also have it easy.

During trade yesterday, Sunday options trading and some direct transactions made between bank dealing rooms or between them and their big customers, the dollar climbed to NIS 4.95, less then 1% below the NIS 5 barrier. Near the end of trade, the shekel regained a little ground to trade at NIS 4.92, a significant gain over morning prices but still a record.

The gain left some dealers thinking the shekel could sustain a little strength in the next few days. With the end of the month approaching, always characterized by corporate currency conversions, and mostly due to the cabinet decision to end the siege on Arafat¿s compound ¿ several players think there could be some profit taking and the dollar could retreat a few agorot.

Another reason cited by those who believe in shekel strength is the interest rate differences. Bank of Israel has not officially raised lending rates, but rates have risen in practice on the markets and by a sharp increment. In a response reflecting lack of confidence in the Ministry of Finance¿s emergency economic plan and fears of the flight of capital abroad, many investors withdrew their money yesterday from shekel-based mutual funds, causing shekel-based bond prices to plummet.

At the end of trading yesterday the three-month debt certificates reflected yields of more than 7% annually, while long-term shekel bonds already offer buyers more than 9%. For investors, always seeking the best instrument, shekel bonds offer better yields than the 5% they will get on foreign currency investments linked to the dollar or the euro.

That is a big difference, even if a 10% tax is imposed and cuts down some of the yield. In past years, differences of 4-5% between dollar and shekel interest rates were enough to stabilize the shekel for long periods, maintaining its high level despite appearing expensive, in terms of buying power, in comparison with the dollar and European currencies.

But considerations of yields, interest rate differences and investment alternatives work well only in times of economic stability, while the financial system is now in state of uncertainty that borders on outright panic.

It started with the miserable economic plan that Finance Minister Silvan Shalom presented last week, a plan in which no one in Israel believes any more than they believe the things he said at the press conference where he unveiled the plan. Despite the clear necessity of cutting government spending and payments to various populations, the capital markets are convinced the plan will eventually only increase taxes and the deficit, which will naturally be financed by more and more government bonds. Capital gains tax, primarily on income from interest-bearing deposits, scares some dealers, although the cynical ones don¿t believe the finance minister can or even wants to complete the necessary legislation.

It continued with the collapse of Trade Bank, primarily in the affair¿s effect on depositers¿ mood. As early as yesterday Bank of Israel was forced to increase the volume of loans to the banks, due to fears of a liquidity crunch in the entire banking system as the public withdrew funds at an accelerated pace from the small and medium-sized banks.

About six months ago, long before the Trade Bank scandal, the trend of taking money out of Israel and depositing it in foreign banks began and there is no doubt that trend will increase. Adding security and economic alarm to capital gains tax and fears of collapsing banks and total loss of savings ¿ it¿s no wonder many are panicking. The small group of foreign banks working in Tel Aviv will probably have a hard time this week answering all the calls for information.

These trends won¿t easily turn around. The Minister of Finance will not surprise and suddenly present a serious economic plan, planned in advance in cooperation with Bank of Israel, since he is at odds with the governor, which increases the public¿s lack of confidence in the economic leadership.

Silvan Shalom will also not suddenly bend the religious parties or cut the huge budgets for the settlements. The most Shalom will do is make use of parliamentary gimmick to resign from the job and run far and fast from the treasury, a job that every day eats away at whatever small political credibility he still has. Many in the foreign currency market believe that in just a few weeks international ratings agencies will make good on their threat to lower Israel¿s sovereign credit rating, once they understand the economic plan will not deal with the most important issue from their perspective ¿ the deficit. There is no doubt therefore, that even if there is a little profit taking on the dollar this week, the shekel is basically headed south, to NIS 5 and beyond.