"The policy of complete deregulation of capital movements has brought much more damage than benefit, including crises and instability. The Bank of Israel's adherence to this policy has brought about a situation in which the stability of the shekel, and the economy, is entirely dependent on foreign investors." This is the main message that Dr. Ehud Kaufman, a senior banker and formerly head of the international division of Israel's Finance Ministry, seeks to convey.
Kaufman's remarks appear particularly important because of the unique period that the economy is going through. On the one hand, foreign speculators are having a ball, and control the exchange rate. On the other hand, the Bank of Israel is being cagey, not allowing transparency, and shrouding in fog its policy and the goals it seeks to achieve. At the same time, those who should be its critics are maintaining a resounding silence and avoiding asking the hard questions. Talking to "Globes", Kaufman makes clear how it will end (a currency crisis as in Thailand, Russia, and Mexico in the 1990s), how it will happen (you only have to look at how those crises developed), and who is to blame (Stanley Fischer, twice over).
Is the strength of the shekel to be explained by the relative robustness of the Israeli economy, or is it an illusion liable to be shattered?
"The story that the shekel is strong because the Israeli economy is a relatively safe haven in a time of crisis is a fairy tale that the teller, and most of the listeners, know is made up but enjoy hearing. This story has become a deeply held belief in Israel largely thanks to the fact that the teller is Professor Stanley Fischer, a man with an international reputation and a dominant figure among the group of economists that in the past twenty years has shaped the financial concepts that the US sought to promote in the world. In fact, however, the shekel has strengthened because of a flow of speculative capital into the Israeli economy, in accordance with deliberate Bank of Israel policy of full deregulation of short-term capital movements."
And this recalls the story of Thailand at the end of the 1990s?
The crisis hit Thailand after years of fantastic economic performance, and, like us, they too thought that they were the fifth Asian tiger and that their currency was at least as strong as the US dollar. The economy of an emerging market, even if its performance is exceptional, cannot over time maintain stability in the face of speculative capital movements. The notion that a country's currency can, in the long run, be stronger than the currencies of its export markets, is an illusion.
"The result of such deregulation is a situation in which hedge funds and the big investment houses like Merrill Lynch, Barclays, and their ilk, are sitting in Israel with $75 billion in liquid financial assets. The fact that these investors won’t stay here forever will sooner or later cause a currency crisis."
How exactly?
"When a critical mass of investors reaches the conclusion that a currency is overvalued, that there is a profit to be made by toppling it, a currency crisis occurs. It is already clear to everybody that the value of the shekel is inflated. At the moment, it is in the foreigners' interests that it should strengthen further. They back their actions with "professional" commentary and forecasts about further strengthening of the shekel. Once some of them reach the conclusion that, as far as they are concerned the process has run its course, they will buy exchange rate hedges, make a last speculative push, and then sell. The panic will bring in train a massive sell off. Those who are late will, as always, be the losers, and among the latecomers will certainly be the Israeli investors. In the case of Thailand, it took George Soros and his pals a few billion dollars to bring about a collapse of the currency. Out of $75 billion, there will be hedge funds that will do a Soros to us too."
There's a problem with your theory. The shekel-dollar rate has already reached 3.2. That was the time to "do a Soros". What happened?
"The Governor of the Bank of Israel intervened swiftly, and it's clear now that he didn't do so to save exports but out of fear of a crisis. Fischer himself said recently that he sleeps better at night, now that the reserves have reached their current level, even though at a time of crisis there is no knowing what the desirable level of reserves is. It follows that he admits that stability was in danger. Furthermore, despite the criticism of the size of the currency reserves, the risk they pose, and the high cost to the economy, he keeps on buying dollars. He too understands that stability is under threat."
You mean Fischer increased the foreign currency reserves in order to be prepared for the final battle against Soros and co.?
"Fischer understands that stability is in danger. The higher the reserve, the larger a safety cushion you have in a greater crisis."
Even with a $50 billion reserve stability is endangered?
"The liquid financial assets held by foreigners amount to $75 billion, as I said. They have the right to realize these assets whenever they want. When the reserve is smaller than the economy's short term external debt, there is liquidity risk. When it comes to long-term stability, the situation there is problematic too. Direct investment by Israelis overseas shot up between the beginning of 2005 and the end of 2008 from $18 billion to $53 billion. These investments are now counted among the economy's external assets.
"However, as the heads of the banking system explained to the minister of finance in a meeting held at the beginning of June, most of the credit for investment overseas won't be repaid. The heads of the banks made it clear to the minister that they will not be able to shoulder the burden of recycling the non-bank debt that will not be repaid. They estimate that repayments will amount to NIS 14 billion in 2009, and NIS 26 billion in 2010. A reasonable estimate is that NIS 30 billion of these assets will go down the tubes. So if we look at Israel as a firm, we can sum things up succinctly: negative shareholders' equity with high liquidity risk."
Fischer completed deregulation
How do you think we got ourselves into such a problematic situation?
"As I said, deregulation of capital movements, which enabled a foreign investor to invest in marketable securities and other short-term investments without restriction, is to blame. This is the policy of the International Monetary Fund, of which Fischer was among the heads, that led Thailand, Russia, and Mexico to financial crises at the end of the 1990s. This policy was controversial even before the crisis, and after the events in Thailand, the critics outnumbered the supporters and it lost some of its standing.
"In Israel, the policy was adopted by the previous governors, Jacob Frenkel and David Klein, who promoted it in their day, when at every stage they were aware of the risks involved. Deregulation was completed with the advent of Fischer, whose appointment as Governor of the Bank of Israel sent a signal to the major investment houses that Israel was a safe market. Before Fischer came along, the credibility of this policy was always perceived in foreign financial circles as subject to change because of internal political pressures. But they saw Fischer as someone they could rely on. He is perceived as stronger than the local politics, and he is.
"The other plank of the policy comes with flexible inflation targeting. Every time inflation exceeds the declared target, it is put back on track by means of an interest rate hike. Since an emerging market like Israel is more exposed to imported inflation, the interest rate will almost always be higher than in the developed countries. For speculative investors, there's an attractive deal: a stable market, a completely liquid currency making it possible to get in and out, and higher interest than can be obtained in the wealthy countries."
How will it end?
So how do you break the circle? How do you prevent a currency collapse?
"In the near term, the process will continue to mark time in its current format, with Fischer continuing to buy foreign currency and not retreating from the policy. The Ministry of Finance and the Bank of Israel, together with the economic press, will continue to spread partial information that confirms optimistic scenarios. Exports will continue to weaken, in volume and profitability. How will it end? Either in a crisis, or in a change of policy that will mean a reversal on exchange rate management."
You mean measures like a one-time devaluation or a return to the currency fluctuation band? There's no chance of that.
"I agree. The politicians have neither the will nor the strength to confront Fischer, because he won't do this of his own accord. Therefore, the profitability of exports and their volume will continue to fall, and in that case there is no stability for the Israeli economy. The illusion that has taken hold that Israel is an economy that, in a built-in way, generates a current account surplus, is part of the made-up story we talked about at the beginning."
Published by Globes [online], Israel business news - www.globes.co.il - on September 7, 2009
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