Can the dollar surprise and drop significantly? Isn't it possible that in a few weeks or months we could find ourselves with a NIS 4.6-4.7 dollar on the local currency market? This afternoon Bank of Israel governor David Klein will announce key lending rates for June, while the range of expectations is a very wide 0.8% (will undercut shekel) to 1.3% (will boost shekel). Isn't there a possibility that Klein will raise interest rates by 1.5%, maybe even 2%, wreaking an overnight turnaround in the past year's foreign currency trend?
After months of focusing on what weakened the shekel, we asked market players what needs to happen to turn the trend around. In October 1998, then-Bank of Israel governor Jacob Frenkel stopped galloping depreciation that had sliced the shekel from NIS 3.85 to the dollar to NIS 4.5 in a matter of days, by hiking interest rates 4%. In the months that followed, the shekel climbed back to NIS 4 against the U.S. currency, where it remained for quite some time. Could we see a rerun of that story?
Where would the dollars come from?
"If interest rates rise to 10%, the shekel could really move into a long term revaluation trend," one trader at one of the foreign banks told us, but hurried to add, "but even then it isn't clear from where dollars would come into Israel". During the tech boom, foreign investors injected billions of dollars in foreign currency into Israeli technology companies.
The interest rate hike, especially if it is higher than expected, may have the power to stop the shekel in its tracks, and even strengthen it a little, but it won't bring new dollars into Israel. Higher interest won't renew technology investments, and will not bring back the hundreds of millions of dollars transferred to overseas bank accounts in the past half year. It's very simple: citizens who took hundreds of thousands of dollars to banks in London, New York and Geneva did it due to their worries and to diversify risk, not for the extra 0.5% yield. They won't bring that money back to Israel until there is ongoing stability in the security arena.
And maybe they will have no choice? This weekend the Rabinovitch Committee will publish its tax reform recommendations, among other things slated to close the loopholes enabling Israelis to enjoy interest gains abroad without paying taxes. However, only the transition from geographic tax to personal tax will lead to that result, and it is unlikely the Rabinovitch Committee, which has emphasized its recommendation will all be easy to implement, is headed in that direction. In addition, the Rabinovitch recommendations have a good chance of encouraging foreign currency investments: taxing the stock market and shekel instruments is the equivalent of lowering interest rates as dollar schemes are now taxed at 35% and shekel schemes ¿ are not taxed at all.
What about foreign currency borrowers? During the entire second half of the 90s, more and more businesspeople adopted the ingenious trick for cheap financing: instead of draining shekel credit, take a foreign currency-linked loan with low interest and sometimes even make a capital gain on it if the currency weakens globally. Gad Zeevi, for instance, apparently financed more than half the loan he took to buy 20% of Bezeq with a yen-linked loan with base interest of 0.25%. If shekel interest rises and foreign currency interest stays low, then maybe businesspeople will again rush to foreign currency-linked loans? From the currency market perspective, that is the equivalent of selling dollars and could create foreign currency supply in dealing rooms.
But it is also an unlikely story. With the Israeli economy's deteriorating state and fears of reduced sovereign credit ratings, the local banks' credit lines from their foreign counterparts are shrinking. Some of the banks estimate that this is a real crunch in foreign currency sources: Israeli banks are simply having a hard time getting their hands on foreign currency and even in intra-bank dealings, some of the banks have cut the foreign currency credit lines they grant their colleagues.
This pressure on foreign currency credit lines shouldn't surprise anyone. After the ratings agencies put Israel in the "negative outlook" category, it is clear that the Israeli banking sector's credit quality was eroded. When we add to the rating the huge write offs on doubtful debt and the Trade Bank collapse, it is clear that foreign banks are more cautious and demand higher interest from their Israeli counterparts than in the past.
How much higher? That depends on the bank, the sum, and the term of the loan, but the increase in the past month is in the 0.25% to 0.5% range. The banks have to roll the entire increase onto their clients. Therefore, a construction contractor who comes into a bank today looking for a yen-linked loan, may get a positive answer, but the bank will demand a risk premium of 3%. Since on top of that cost, the borrower must acquire an expensive hedge against the loan ¿ just last week the yen surprisingly dropped 3% in a matter of days ¿ the whole deal isn¿t worthwhile.
Despite the desire to find a combination of factors that will lead to dollar supply on the Israeli currency market, it is doubtful one can be found in today¿s reality. If there is improvement in the security situation, brave economic decisions are made, and technology investment resumes, maybe we will again see waves of dollars flooding Tel Aviv dealing rooms. Right now that looks like a scene from a science fiction movie.