In his latest review of the Israeli economy, Morgan Stanley analyst Serhan Cevik warns the Bank of Israel against using interest rate cuts as a means of curbing the strength of the shekel.
"The Israeli economy is growing at an above-trend pace, creating real inflation pressures. Judging from the prevailing inflation figures and the near-term outlook, the Bank of Israel could continue cutting interest rates, as expected, to weaken the shekel and thereby create inflation. However, we beg to differ on the wisdom of such a strategy that has so far failed to deliver its promise," Cevik writes.
According to Cevik, the reasons behind the shekel’s appreciation are not very sensitive to interest rates. "Second, and more importantly, with low interest rates and improvements in the labor market, the acceleration in domestic demand is pushing the rate of real GDP growth well above the potential growth rate and narrowing the output gap," he says. Cevik sees GDP growth of around 6% this year.
Cevik was the only analyst who, in October 2006, predicted that the shekel-dollar exchange rate would fall below 4.0. In his previous review, at the beginning of this month, he said that the downward trend in the exchange rate would continue to 3.8, but that the dollar would recover next year against world currencies.
In the current review, Cevik writes, "After years of undervaluation, the shekel is now in line with our long-standing, once out-of-consensus estimation for its fair value against the dollar. This is a justified outcome, in our opinion, supported by economic and financial improvements as well as the dollar’s weakness around the world. Fiscal normalization lowering the budget deficit from 5.4% of GDP in 2003 to 0.9% last year and the structural shift in the current account balance from an average deficit of 2% of GDP a year in the 1990s to 4.9% in 2006 have turned Israel into a net creditor but also a point of attraction for foreign capital flows.
"The latest figures show that capital inflows remain robust, reaching $3.3 billion in the first four months of this year, on top of $24.4 billion last year. Therefore, even though the shekel remains undervalued against the trade-weighted currency basket and the strength of foreign capital inflows could still push it even to a stronger level, the risk of volatility is now higher and requires a cautious approach," Cevik's report says.
Published by Globes [online], Israel business news - www.globes.co.il - on May 21, 2007
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