Activity in the NIS-Forex Market

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1 PART 2, CHAPTER 1, COMPREHENSIVE ANALYSIS OF NIS-FOREX MARKET Part 2 Activity in the NIS-Forex Market 85

2 BANK OF ISRAEL, CONTROLLER OF FOREIGN EXCHANGE, ANNUAL REPORT

3 PART 2, CHAPTER 1, COMPREHENSIVE ANALYSIS OF NIS-FOREX MARKET Activity in the NIS-Forex Market Developments in the NIS-forex market in 2001 reflected the maturing of various processes in recent years. Since the middle of 1997, when the exchange-rate regime was eased, the rate has been set freely by market forces. This development, which along with the contraction of the NISforex interest spread led to an increase in exchange-rate risk, acted in concert with foreign-currency liberalization, globalization, and solidification of the credibility of macroeconomic policy to make the NIS-forex market more efficient. Additional progress was made in 2001: trading volumes increased substantially, the market became deeper, and a new class of players foreign financial institutions made their debut. The exchange-rate changes in 2001 led in two directions with no significant trend, due to equilibrium among market forces that made central-bank intervention unnecessary. The market did experience external and domestic shocks that, however, affected it for relatively short periods of time only. The forces at work in the market in recent years will probably remain operative in the near future and will allow the market to continue to perform soundly and without intervention provided that the fiscal and economic policies not deviate from accepted international standards. On December 25, the key rate was lowered suddenly and surprisingly, in conjunction with the announcement of related measures in regard to liberalization and the exchange-rate band. The rate cut had a substantial impact on the relative rate of return on assets, and immediately after it was announced households began to generate demand for forex. This demand lasted into January 2002 and caused the currency to depreciate steeply. The business sector, by engaging in net sales of foreign currency, countered the exchange-rate trend much as it had during previous shocks. 87

4 BANK OF ISRAEL, CONTROLLER OF FOREIGN EXCHANGE, ANNUAL REPORT 2001 Part 2 is divided into two chapters. Chapter 1 presents a comprehensive analysis of developments in the NIS-forex market and attempts, by ex post argumentation, to draw a connection between trends in the NIS exchange rate against the fivecurrency basket and changes in forex supply and demand by various market sectors and those who affect them. (The framework of the analysis is described in the appendix at the end of this part of the report.) The effect of the December 25 rate cut on the NIS-forex market is analyzed separately at the end of the chapter. Chapter 2 reviews developments in main components of residents portfolios of forex assets and liabilities and nonresidents portfolios in NIS. 88

5 PART 2, CHAPTER 1, COMPREHENSIVE ANALYSIS OF NIS-FOREX MARKET Chapter 1 Comprehensive Analysis of the NIS- Forex Market The year in review, 2001, witnessed a turnabout in activity of the various sectors in the NIS-forex market and the behavior of the nominal exchange rate (Figure 1.1). The characteristic developments of the year began in October 2000, due to adverse events in the United States and Israel a growth slowdown and steep decreases in share prices in the U.S., and cessation of the political process and security deterioration in Israel. Accordingly, the analysis of the NIS-forex market in 2001 includes data from the fourth In September 2000, a protracted appreciation trend ended and a protracted trend of depreciation began. 89

6 BANK OF ISRAEL, CONTROLLER OF FOREIGN EXCHANGE, ANNUAL REPORT 2001 quarter of 2000 to November 2001 as the survey period and those in the twelve months preceding October 2000 as the comparison period. 1. EXCHANGE-RATE DEVELOPMENTS The NIS-forex market experienced a turnaround in October 2000, as protracted appreciation of the NIS against the five-currency basket during the comparison period (10 percent) was succeeded by depreciation. Despite several months of grave developments in the U.S. and Israel, the depreciation of the NIS did not persist in the long term; the cumulative depreciation against the basket during the survey period was 4 percent amidst bidirectional volatility: External and domestic shocks in the market had short-term effects only, as appreciation succeeded depreciation. The rather gentle response of the exchange rate in October 2000 and from then until November 2001 stands out especially in comparison with the shocks that the market absorbed in previous years. In 1998, for example, in the aftermath of an externality a shock in the international financial markets, related to the crisis in Russia and the bailout of the LTCM hedging fund the NIS lost 12 percent against the basket in October 1998 and 20 percent in cumulative terms in August October. 2. SECTORAL ACTIVITY IN THE NIS-FOREX MARKET Since October 2000, nonresidents have reduced their investments in Israeli shares perceptibly and increased their activity in futures, due to short-term considerations. The transition from appreciation to moderate depreciation was occasioned by a perceptible change in the market behavior of nonresidents and residents. Since these sectors were affected by different factors and considerations, their responses to the exchange-rate change led to a heterogeneity that contributed to market stability. Nonresidents considerably reduced their long-term activity investments in the shares of Israeli companies, an activity related to the economy s underlying factors during the survey period. These investments, an important component in the foreigncurrency inflow in the comparison period, were affected mainly by the Nasdaq index, which reflects demand for high-tech products and affects Israeli companies assessments of the prospects of issuing in the American market. (These investments came to $258 million on monthly average in the survey period as against $690 million on average in the comparison period; see Table 1.1.) Concurrently, nonresidents became more active in vehicles related to short-term considerations of exchange-rate risk and interest spreads: they began to purchase forex by concluding forwards transactions and, for the first time, amassed a surplus of short-term NIS liabilities. Short-term forwards activity which became possible due to the repeal of the restriction on forex-denominated forwards for terms exceeding thirty days also indicates that nonresidents became more sensitive to the implicit interest spread and exchange-rate risk that forwards carry by their very definition. This activity was apparently influenced by the decline in political and security conditions, which convinced nonresidents that the NIS was about to depreciate at a rate exceeding that implicit in the forward exchange rate derived from the interest spreads. Analysis of forwards activity during the year indicates, with a 90

7 PART 2, CHAPTER 1, COMPREHENSIVE ANALYSIS OF NIS-FOREX MARKET high degree of reasonability, that the weight of speculation in nonresident forwards purchases of forex was decisive and the portion related to hedging activity was marginal. The nonbanking private sector reduced its net foreign-currency purchases by $450 million on monthly average in the survey period relative to the comparison period: it cut back on its long-term activity (chiefly investment in foreign shares) but, unlike nonresidents, severely downscaled its net forex purchases in short-term activity credit, deposits, and forwards a form of activity that is influenced in the long term mainly by the NIS-dollar interest spread and the exchange-rate risk. This risk is measured in terms of the implicit standard deviation in NIS-dollar options, which was rather low in 2001, as in 2000, despite volatility in response to various events. The interest spread was affected in 2001 (until the rate cut in late December) mainly by changes in dollar interest rates: dollar interest declined by 4.5 percentage points in cumulative terms during the year (as against a 2 percent decrease in NIS interest) and was the main contributing factor in the 2.5 percent widening of the NIS-dollar interest spread (Figure 1.2). These risk and interest-spread developments made NIS assets more worth holding Since October 2000, the business sector reduced its forex purchases and countered the exchange-rate trend during times of rapid depreciation. 91

8 BANK OF ISRAEL, CONTROLLER OF FOREIGN EXCHANGE, ANNUAL REPORT 2001 in relative terms and prompted the business sector to downsize its accumulation of short-term forex assets (Figure 1.3). Indeed, this sector acquired $137 million in shortterm assets during the survey period, in net monthly average terms, as against $550 million in the comparison period. The business sector also took more of its credit in forex and made more forwards sales, especially in months when nonresidents heightened demand generated depreciation pressure. The non-business sector contributed to the relative stability of the exchange rate by refraining, in most months, from massive accumulation of foreign currency in deposits, which would have aggravated the depreciation. This is in contrast to the prior behavior of this sector, e.g., in October However, this year, especially in the third quarter, the non-business sector bought $550 million by investing in mutual funds that specialize in foreign-currency assets in Israel. The banks, which since the second half of 1997 have served as market makers in the NIS-forex market and not only as intermediaries between the public and the Bank of Table 1.1 Activity of Sectors in NIS Forex Market: Forex a Sales (+) and Purchases ( ), ($ billion) Special periods Years (monthly averages) /99 09/00 10/00 11/01 Forex sales by nonresidents (purchase of NIS assets) 2,888 1,891 4,232 7,697 2, Investments in Israeli shares (in Israel and abroad) 2,750 2,005 4,145 7,841 2, Acquisition of short-term NIS assets of which 2.1 forward acquisition of NIS against forex, net Forex sales by nonbanking private sector 3,050 4,665 5,185 6,628 2, of which 1. Investments in foreign shares abroad ,824 1, Sale of short-term forex assets 1,976 4,465 5,533 3,856 1, of which:2.1withdrawal of forex deposits in Israel and abroad 662 3,196 4,735 4,814 3, Taking of forex credit from domestic banking system 3,254 1,589 2,948 1,760 2, Forward sale of forex against NIS , Banks Government 780 1, , Current account and capital account of the private sector 1,617 2, Bank of Israel: sale of forex against NIS 6, a The structure of this table is explained in the Appendix to Part 2. SOURCE: Based on reports to Bank of Israel. 92

9 PART 2, CHAPTER 1, COMPREHENSIVE ANALYSIS OF NIS-FOREX MARKET Israel, have been avoiding a long-term exchange-rate position in their activity in the forex market. However, at times when large changes occur in this market, the banks create limited positions by meeting demand for foreign currency and absorbing supply in the course of their nostro activity amidst exchange-rate changes. Three additional sectors are active in the market: the Government, the private sector (in the current and capital account), and the Bank of Israel. The Government had $0.9 billion in net redemptions and non-rollover of forex-indexed Gilboa bonds in the course of The private sector had a small positive balance in net activity in the current account and capital account. The Bank of Israel did not intervene in foreign-currency trading, in view of its policy in recent years to intervene only to defend the limits of the exchange-rate band. In sum, the transition from appreciation in the comparison period to moderate depreciation in the survey period originated in a decline in nonresident investments. The decline was influenced by the slump in demand for high-tech products and in share prices in the U.S., and by nonresident demand for forex by means of forwards in view of uncertainty about the security situation. The bidirectional volatility of the exchange rate during the survey period and the mildness of the depreciation, despite the shocks and aforementioned behavior of nonresidents, were occasioned by the moderate behavior of the nonbanking private sector. The persistence of market stability despite the shocks is traceable to an improvement in the underlying conditions of the NIS-forex market in recent years, which made the market much less sensitive to shocks. The improvement was evident in various aspects of market performance and macroeconomic policy, and its important contribution to market stability in the two years preceding October 2000 stems from the substantial contraction of external financial vulnerability of the private sector a vulnerability related to this sector s forex and external activity. (See Part 1, Chapter 4.) Due to this factor, the market greeted the October 2000 shocks at a totally different point than its situation on the eve of the shocks in October The decrease in vulnerability is evident in various indicators, most importantly the business sector s exposure to depreciation risk, measured by the surplus of its forex liability over its forex assets. This position contracted steadily from $14 billion to $9 billion in the two-year period that began with the rapid depreciation in October 1998 (Figure 1.4). Another reason for greater stability in the NIS-forex market is an improvement in various aspects of economic performance in the past two years. The main aspects are an improvement in the credibility of macroeconomic policy management, continued enhancements of efficiency in the NIS-forex market, and the internalization of exchangerate risk and the possibility of bidirectional volatility of the exchange rate. The lastmentioned improvement originates, among other things, in the Bank of Israel s policy of non-intervention in trading since early 1998, even during the rapid depreciation that occurred at the end of that year. The non-business sector contributed to exchange-rate stability in 2001 by refraining, in most months, from massive accumulation of foreign currency in deposits in contrast to its prior behavior. The persistence of market stability despite the shocks is traceable to an improvement in the underlying conditions of the NIS-forex market in recent years, which made the market much less sensitive to shocks. 93

10 BANK OF ISRAEL, CONTROLLER OF FOREIGN EXCHANGE, ANNUAL REPORT 2001 Conclusions 1. The mildness of the depreciation since October 2000, despite reversals in the U.S. and in Israel and despite nonresident purchases of forex by means of forwards, is neither a random nor an ephemeral effect but rather evidence from the market of a substantial improvement in Israel s economic and financial stability since late Thus, the NIS-forex market and the exchange rate have become less sensitive to shocks. 2. The effect of events external to the NIS-forex market on forex supply by nonresidents was illustrated more emphatically in 2001 than in past years. Accordingly, when the American economy and the Nasdaq index (to which the Israeli economy corresponds strongly via its technology companies) recover, capital inflows along this channel will probably increase. 3. The steep increase in nonresident activity in forwards and short-term positions against the NIS has important implications. This activity makes the NISforex and derivatives market more efficient by improving its depth and augmenting it with large players who approach it from diverse points of view. However, the steadily escalating involvement of foreign financial institutions, which respond swiftly to any new information about the Israeli economy, and the financial power that they possess may inflict stronger shocks on the forex market and, therefore, make it more important than ever to adhere to accepted standards of macroeconomic management. 3. ACTIVITY IN THE NIS-FOREX MARKET BETWEEN DEC. 20, 2001, AND JAN. 31, On December 25, 2001, the Bank of Israel, in an exceptional move, lowered the key rate by 2 percentage points. Concurrently, additional economic measures affecting financial markets were announced: (1) elimination of the ceiling on Treasury bill issues; (2) further easing of the exchange-rate regime, including flattening of the lower limit 1 At the present writing, the short-term effects of the NIS rate cut on the NIS-forex market have not yet ended. 94

11 PART 2, CHAPTER 1, COMPREHENSIVE ANALYSIS OF NIS-FOREX MARKET of the band and a 2 percentage point decrease so as to position it permanently at NIS 4.1 against the currency basket; and (3) raising the permitted rate of institutional-investor investment in forex-denominated and external assets to 20 percent, and elimination of the restriction altogether as of January 1, The rate cut changed the relative return on assets and the relative cost of NIS credit vs. forex credit perceptibly, and between the time it was announced and January 31, 2002, the NIS exchange rate against the dollar and the currency basket depreciated by 8 percent in cumulative terms. The implicit standard deviation in NIS-dollar options also climbed steeply to 7.5 percent during this time, as against 5 percent in the month preceding the rate cut. The data on activity show that individuals generated considerable forex demand. From the time of rate cut to the end of January, they accumulated $1.8 billion, mainly by accrual in mutual funds that specialize in forex in Israel and abroad, and in forexindexed deposits and savings plans, most of which were concluded for long terms (three to five years). The business sector sold forex during the survey period, mainly in forwards and Gilboa bonds. Notably, although the rate cut narrowed the interest spread considerably, the business sector did not respond by paying back net forex credit on a large scale. However, it also refrained from selling forex by taking credit and converting it into NIS, in contrast to its response to previous shocks; instead, it took action by means of other instruments. Institutional investors (other than mutual funds) invested $350 million in foreign bonds in January About 80 percent of this sum was invested by insurance After the key rate was cut by 2% on Dec. 25, the NIS began to depreciate rapidly due to forex purchases by individuals; the business sector countered the exchangerate trend by selling forex. Table 1.2 Forex Sales (+) by Sectors (Selected Components), a December 20, 2001 January 31, 2002 Individuals 1,772 Accrual ( ) in forex funds in Israel 640 Accrual ( ) in forex funds abroad 630 Forex-indexed deposits 266 Savings plans 236 ($ million) Institutional investors 350 Insurance companies 280 Business sector: selected components 1,157 Gilboa bonds 600 Forward transactions 800 Forex credit 123 Deposits in Israel and abroad 118 Nonresidents 76 Banks 145 a For the time being, the market cannot be closed because mutual funds cover themselves for some accrual that was invested in NIS assets by acquiring tradable NIS-dollar warrants. We have no precise information about the value of the warrants, but it is estimated at $600 million $900 million in underlying asset terms. The sectors that issued the warrants (banks, business sector, nonresidents) are not known. 95

12 BANK OF ISRAEL, CONTROLLER OF FOREIGN EXCHANGE, ANNUAL REPORT 2001 companies that acquired government and corporate bonds in the euro market and the U.S. The pace of investment abroad accelerated due to falling interest rates and the higher investment ceiling. Nonresidents acquired $339 million in forwards in the first week after the rate cut. Afterwards, they sold small quantities of foreign currency during almost all of January. Their net activity in the market during the six weeks at issue was negligible. In January 2002, however, nonresident trading volumes in the forex market increased, as did the share of foreign financial institutions in total activity in NIS-dollar spot and forward transactions. Notably, since the short-term effects of this development on activity in various sectors have not yet ended, it is premature to analyze its effect on economic stability. Box 1.1 The NIS-Forex Market from a Long-Term Perspective The following description of long-term developments in the NIS-forex market focuses on the years , in which significant processes led to a change in the exchange-rate trend. Until October 1998, the NIS exchange rate against the currency basket moved in one direction only depreciation but since then there has been equilibrium with volatility in both directions (Figure 1). 96

13 PART 2, CHAPTER 1, COMPREHENSIVE ANALYSIS OF NIS-FOREX MARKET Below we describe the main processes that caused this profound change, which reflects the transition to a more efficient market in which the exchange rate is set in response to market forces and without outside intervention. Developments in the NIS-forex market in trace largely to three factors: economic policy, global effects, and the consolidation of Israel s comparative advantages. Economic policy affected the market directly by liberalizing the forex rules, making the exchange-rate regime more flexible, and halting intervention in forex trading as long as the exchange rate stayed within the band. It also had two indirect effects, manifested by the disinflationary monetary policy and a fiscal policy that is mindful of the overarching goal of lowering the budget deficit. The global effects on the NIS-forex market were reflected in greater integration among global financial markets, portability of capital and private investments in foreign markets, and greater demand for hightech products. The consolidation of Israel s comparative advantages, foremost in high-tech, made it possible to take advantage of opportunities to raise capital abroad. During the survey period, these processes affected the NIS-forex market along four main paths of transmission: the NIS-forex interest spread, exchange-rate risk, the Nasdaq exchange, and Israel s country 97

14 BANK OF ISRAEL, CONTROLLER OF FOREIGN EXCHANGE, ANNUAL REPORT 2001 rating. This led to changes in resident and nonresident activities in the market and, consequently, to intervention or non-intervention by the Bank of Israel in the market and changes in the exchange rate trend. The nonbanking private sector sold forex in , perceptibly lowering its forex assets surplus and moving into a surplus of forex liabilities. This sector changed its behavior in the middle of 1997 and, since then, has been buying forex, building up its forex asset surplus, and reducing its exposure to depreciation risk. The change in behavior traces to two factors acting in concert: an increase in the exchange-rate risk, due to the relaxation of the exchange-rate regime, and the narrowing of interest spreads, chiefly due to the lowering of NIS interest rates (Figure 2). This resident activity focused mainly on short-term instruments (credit and deposits). Resident investments in foreign companies shares have been climbing in the past two years, abetted by the liberalization and globalization processes. Nonresidents invested in Israel as part of global processes especially U.S. economic processes that were manifested, among other things, in the Nasdaq index (Figure 3). The investments were also related to domestic processes including the consolidation of Israel s comparative advantages, chiefly in export-oriented high-tech growth industries; changes in domestic economic and financial conditions, as reflected in the country s risk rating; 98

15 PART 2, CHAPTER 1, COMPREHENSIVE ANALYSIS OF NIS-FOREX MARKET and geopolitical developments, foremost the peace process. These processes influenced nonresidents behavior both in , when investments rose, and in 1998 and 2001, when they declined. The NIS-forex interest spread did not prompt nonresidents to invest in Israel until late 2000; until then, their investments focused on shares of Israeli companies. Since the last quarter of 2000, nonresidents have also been taking actions for reasons related to the interest spread and exchange-rate risk, mainly in short-term financial instruments (forwards). Until early 1996, the Bank of Israel intervened in the NIS-forex market directly. Since then, its intervention has been limited to defense of the limits of the exchange-rate band. Defense of the lower limit of the band became necessary in late 1996 and in the first half and the last few days of 1997, when all sectors of the economy sold forex that the central bank had to buy in order to prevent the exchange rate from slipping under the bottom of the band. After the middle of 1997, the private sector exhibited greater demand for forex and absorbed the escalating supply provided by nonresidents without central-bank intervention (except for several days at the end of that year). The depreciation trend that persisted until the middle of 1998 was mainly the result of the positive-slope exchange-rate band policy that forced the Bank of Israel, during some of that time, to absorb rather large quantities of foreign currency that reached the market. Since then, the exchange rate has been volatile in both directions and has shown no consistent trend, due to equilibrium among market forces with no need for central-bank intervention. The transition from de facto managed depreciation to a floating exchange rate shows how much progress the market has made due to the aforementioned processes and economic policies. If similar policies and international standards are applied in the future, market efficiency will continue to improve and the exchange rate will be set with no need for intervention in trading. 99

16 BANK OF ISRAEL, CONTROLLER OF FOREIGN EXCHANGE, ANNUAL REPORT

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