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The end of the shekel is nigh

Dr. Ehud Kaufman sees a currency crisis coming, and knows who's to blame. Adrian Filut 7/9/2009 "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

and Mexico to financial crises at the end of the 1990s. the larger a safety cushion you have in a greater crisis. most of the credit for investment overseas won't be repaid. and it's clear now that he didn't do so to save exports but out of fear of a crisis. Out of $75 billion. But they saw Fischer as someone they could rely on. there will be hedge funds that will do a Soros to us too. This is the policy of the International Monetary Fund. Deregulation was completed with the advent of Fischer. A reasonable estimate is that NIS 30 billion of these assets will go down the tubes. now that the reserves have reached their current level. as the heads of the banking system explained to the minister of finance in a meeting held at the beginning of June. What happened? "The Governor of the Bank of Israel intervened swiftly. we can sum things up succinctly: negative shareholders' equity with high liquidity risk. the policy was adopted by the previous governors. When the reserve is smaller than the economy's short term external debt. when at every stage they were aware of the risks involved. despite the criticism of the size of the currency reserves." Even with a $50 billion reserve stability is endangered? "The liquid financial assets held by foreigners amount to $75 billion. In the case of Thailand. he keeps on buying dollars. Fischer himself said recently that he sleeps better at night. That was the time to "do a Soros". and NIS 26 billion in 2010. the situation there is problematic too. it took George Soros and his pals a few billion dollars to bring about a collapse of the currency. of which Fischer was among the heads. The higher the reserve.? "Fischer understands that stability is in danger. So if we look at Israel as a firm." You mean Fischer increased the foreign currency reserves in order to be prepared for the final battle against Soros and co. It follows that he admits that stability was in danger. is to blame. Jacob Frenkel and David Klein. as I said. The shekel-dollar rate has already reached 3. When it comes to long-term stability. Direct investment by Israelis overseas shot up between the beginning of 2005 and the end of 2008 from $18 billion to $53 billion. Russia. He too understands that stability is under threat. These investments are now counted among the economy's external assets. there is liquidity risk. "In Israel. They have the right to realize these assets whenever they want. This policy was controversial even before the crisis. . whose appointment as Governor of the Bank of Israel sent a signal to the major investment houses that Israel was a safe market. and he is. 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. the critics outnumbered the supporters and it lost some of its standing.the latecomers will certainly be the Israeli investors." There's a problem with your theory. and after the events in Thailand." Fischer completed deregulation How do you think we got ourselves into such a problematic situation? "As I said. Furthermore. the credibility of this policy was always perceived in foreign financial circles as subject to change because of internal political pressures. and the high cost to the economy. even though at a time of crisis there is no knowing what the desirable level of reserves is. Before Fischer came along. which enabled a foreign investor to invest in marketable securities and other short-term investments without restriction. They estimate that repayments will amount to NIS 14 billion in 2009.2. deregulation of capital movements. the risk they pose. who promoted it in their day. He is perceived as stronger than the local politics. that led Thailand. "However.

"The other plank of the policy comes with flexible inflation targeting. in volume and profitability. in a built-in way. there's an attractive deal: a stable market. generates a current account surplus. The Ministry of Finance and the Bank of Israel. the profitability of exports and their volume will continue to fall. Exports will continue to weaken. together with the economic press." 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. and in that case there is no stability for the Israeli economy." You mean measures like a one-time devaluation or a return to the currency fluctuation band? There's no chance of that." . with Fischer continuing to buy foreign currency and not retreating from the policy. For speculative investors. Since an emerging market like Israel is more exposed to imported inflation. Every time inflation exceeds the declared target. is part of the made-up story we talked about at the beginning. "I agree. the interest rate will almost always be higher than in the developed countries. Therefore. The illusion that has taken hold that Israel is an economy that. or in a change of policy that will mean a reversal on exchange rate management. it is put back on track by means of an interest rate hike. and higher interest than can be obtained in the wealthy countries. The politicians have neither the will nor the strength to confront Fischer. because he won't do this of his own accord. will continue to spread partial information that confirms optimistic scenarios. a completely liquid currency making it possible to get in and out. How will it end? Either in a crisis.