From Incredible to Unthinkable
Oct 12, 2006
Serhan Cevik (from Frankfurt)
The shekel has appreciated, but remains undervalued, in our opinion. Everything looks obvious in retrospect, but our long-standing bullish call on the shekel was certainly out of consensus, particularly considering residents’ reluctance to appreciate the underlying value of their own currency. The shekel has not only become a safe-haven asset in the midst of military shocks and the worst wave of risk reduction in the global financial markets, but also started moving towards its fair value. Especially with the end of hostilities in Lebanon, it has appreciated by almost 10% against the dollar and even more so against the currency basket. Such realignment would have been unthinkable just a few months ago, but nevertheless shows the underlying strength of the Israeli economy. According to our calculations, the shekel’s fair value is 3.90 against the dollar and 3.45 against the euro. That means, even after significant gains in recent weeks, that the shekel is still undervalued by 9.5% against the dollar and about 27.5% against the trade-weighted currency basket (see The Incredible Shekel, August 28, 2006).
Look beyond geopolitical speculations, and you would see strong economic fundamentals. Israel is certainly a small country with big political risks, but sometimes those threats are exaggerated beyond rational analysis. Indeed, this is one of the reasons why the shekel diverged as much as 16.5% from its fair value against the dollar and more than 30% against the currency basket. Of course, exogenous factors and domestic policy mismanagement also played a role in depressing the shekel’s valuation. However, with the introduction of more rational economic policies and structural reforms, Israel has achieved internalising price stability — even to the extent of experiencing a period of deflation, consolidating fiscal imbalances, and accelerating the rate of output growth. In turn, all these positive factors, coupled with an undervalued exchange rate, have resulted in an annual current account surplus of 3.5% of GDP. But being a net creditor to the world is just one aspect of our positive call on the shekel. As important, the inflow of high-quality foreign investments is now a key driver of the move towards a better valuation. The Israeli economy has not only enjoyed a marked increase in foreign investment flows from US$7.2 billion in 2004 to US$10 billion last year and US$16.8 billion in the first nine months of this year, but also the share of direct investment more than doubled from 25% in 2004 to 56% last year and 52% so far this year. Put differently, the latest figures are even far better than what the country received during the peak of the global technology bubble in 2000, when the shekel was in fact trading at 4.08, on average, and overvalued by 3.3% against the dollar. This is why, even with the narrowest interest rate differential vis-à-vis more advanced economies, the shekel’s recent appreciation is no surprise to us. The shekel’s strength curtails inflation pressures in the domestic economy. The consumer price index remained unchanged on a month-on-month basis in August, coming in slightly better than our estimate for a 0.1% increase. As a result, the annual inflation rate eased to 2.2%, from 2.4% in July and 3.5% in June. We are likely to see it declining below 2% in September and then 1.4% by the end of the year. Even though such an outcome would be encouragingly close to the lower bound of the central bank’s target range of 1-3%, there are still underlying inflationary pressures in the domestic economy. First, the shekel’s appreciation — lowering inflation in currency-linked sectors — is the most important factor driving disinflation from the peak of 3.8% in April. For example, consumer prices excluding the housing category are still running at an annual rate of 2.9%, just below the upper bound of the target range. Second, the correction in oil prices will have contributed to lower inflation rates in recent months, after the transportation category increased by 5.3% in the first eight months of the year. Nevertheless, strengthening domestic demand remains a source of concern that needs to be closely monitored, especially after the exchange-rate effect becomes less pronounced. The ‘Fed link’ may be less relevant, but the shekel’s gain is not enough to justify monetary easing. No one can deny the influence of monetary conditions in the US on other countries, but an obsession with interest rate differentials could lead to policy miscalculations as well as sub-optimal investment decisions. Despite geopolitical uncertainties and a possible US-led slowdown in global growth, we expect the Israeli economy to grow by 4.8% in 2006 and 4.2% next year. The productivity acceleration — from 2.9% in 2005 to 6.5% this year — is an important factor supporting non-inflationary growth and a lower risk premium, even in today’s challenging global environment. Therefore, although we do not necessarily see America’s short-term interest rates as a natural bound for Israel’s monetary stance, it would be premature to start cutting interest rates just because of the shekel’s recent appreciation. According to our estimates, Israel’s monetary policy rate is still at around the ‘neutral’ level and hence presents no obstacle to growth. Asset prices may provide valuable information, but following the ebb and flow in financial markets is never a sound strategy for policymakers.
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Too Early to Look for Rate Cut
Oct 12, 2006
Sharon Lam (Hong Kong)
As expected, the Bank of Korea left the interest rate unchanged at its monthly meetingtoday. In our view, the overnight call rate, which currently stands at 4.5%, is already at a neutral level. Given the current difficult situation with North Korea, we had hoped that the BoK would sound more dovish today, possibly with a clearer indication of an end to the rate hike cycle. However, the BoK opted to give a rather mixed message in order to leave the door open for a more flexible monetary policy. On the one hand, the BoK said that export growth would remain solid to support the economy, but consumption is weakening. It expects sentiment and consumption to weaken further after the recent nuclear test in North Korea. This should indicate no more rate hikes. Yet, on the other hand, the BoK also said that inflationary pressure is still present while housing prices appear to be rising again. This could mean that rate hikes are still possible. Our view: From the BoK’s statements, it appears that the central bank does not think the economy will plunge after the nuclear test, and thus there is no need for any artificial boost. This is in line with our central-case growth assumption after the nuclear test, i.e., business as usual. We believe that this rate hike cycle has ended, as it will become more and more difficult for the BoK to justify another rate hike in the coming months. While the BoK still expressed concerns over property and inflation, we believe that this is not an indication for another possible rate hike. Rather, we interpret this to mean that the BoK does not appear willing to cut rates any time soon. We think that the market’s speculation on BoK easing is premature. While we believe that the next move will be a cut, we do not expect the BoK to act until 2H07 because we feel that growth willturn out to be more stable than market expectations. Also, it is too early for the government to relax over property market issues, as this would hurt its policy credibility.
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