Will Israel Shackle the Shekel?

So far, Israel's central bank is resisting demands from business and labor to restrain the shekel's soaring rise against the dollar

For decades Israelis have viewed the U.S. dollar almost as a second national currency. Everything from rents to savings were linked to the greenback, which for many people represented financial stability in a country traditionally wracked with high inflation.

But in the past two years, Israelis have undergone an unprecedented challenge as the value of their own currency, the shekel, has soared against the dollar and more recently even against the euro. The dollar bought 4.7 shekels in November, 2005. Now the greenback is worth 3.6 shekels. In other words, the shekel has risen by more than 20% in that time—and 6% in the past month alone. Now both business and labor are calling loudly for a weaker currency. On Feb. 7 Prime Minister Ehud Olmert convened an emergency meeting of the country's top economic leadership to discuss what is being dubbed the "dollar crisis." At the same time Olmert and Finance Minister Ronnie Bar-On came out strongly in support of Bank of Israel Governor Stanley Fischer, who is opposed to any government intervention in the foreign currency market.

Exports Greatly Impacted

Behind the shekel's strength is the Jewish state's stellar economic performance, fueled by a growth rate of 5% or more in each of the last four years. Israel's balance of payments is strongly in the black, unemployment is at its lowest level in more than a decade, the government had a balanced budget in 2007, and the country's debt as a percentage of gross domestic product has dropped sharply.

But a supershekel threatens exports of all sorts of commodities, including textiles, diamonds, software, and weapons. Israeli business executives say the sharp appreciation of the shekel is already having a negative impact on future growth prospects. With exports accounting for 40% of the growth in the economy in recent years, many fear that the economic engine may lose steam. "The dollar's weakness already cost us $2.5 billion in potential export sales in 2007, and that amount could double this year," predicts Shraga Brosh, president of the Manufacturers' Assn. of Israel.

Israeli companies are finding it increasingly difficult to compete in global markets. While the U.S. accounts for about a third of exports, the prices of around 75% of all exports are negotiated in dollars. Typically, most Israeli companies sell in dollars, while a majority of their expenses, like salaries, are in shekels. "Every 1% strengthening in the value of the shekel costs us an additional $4 million to $5 million on an annualized basis," says Avi Doitchman, chief financial officer of Israel Chemicals (ICL.TA). That could translate into an $80 million drop in operating profits for the Tel Aviv-based fertilizer and industrial chemical maker if the exchange rate remains at its current level through 2008.

Companies Forced to Make Cutbacks

For Israel Chemicals, at least, the rise in the shekel was partially offset in 2007 by the increase in world fertilizer prices. But most companies have not been so fortunate. "We're in a highly competitive market and up against producers from the Far East, so there's no way we can pass along our higher costs," says Moshe Birenboim, chief financial officer at Arad Textile Industries. The privately owned towel maker exported 90% of its $100 million in production last year to the U.S. and the European Union.

Some companies have already been forced to cut back to stay in the market. "We've reduced overtime, frozen new investments as well as plans to hire additional manpower," says Nachman Pundak, CEO of Ricor Cryogenic and Vacuum Systems, a maker of components for the electro-optic and semiconductor industries. Ricor also has started trying to negotiate at least some of its Far Eastern deals in euros.

The country's thriving high-tech industry—which accounts for about 50% of Israel's $34 billion in industrial exports—also has been affected. "We're only one month into the new year and there's already around a $1 million shortfall in our budget," says Liam Galin, CEO of Flash Networks, a developer of software for enhancing mobile Internet service. The company sells in dollars, but 120 employees of its 160-member workforce are in Israel and are paid in shekels.

Business and Labor Demand Action

The dollar's sharp decline has led the country's business community to join forces with the powerful Histadrut labor federation. They want the government to intervene in the foreign currency market by either buying dollars directly or convincing the central bank, the Bank of Israel, to cut rates. Fearing thousands of layoffs in the coming months, Histadrut Chairman Ofer Eini threatened on Feb. 4 to call a general strike if the central bank and the government fail to take action.

Economists are divided as to whether a cut in interest rates is what is needed. "Intervention in the foreign currency markets by central banks has never proven useful and is usually counterproductive," notes Leo Leiderman, chief economist at Bank Hapoalim. But Knesset member Avishai Braverman, a former World Bank economist, argues that unless the Bank of Israel takes swift action the local economy will face a slowdown that could be further aggravated by a recession in the U.S.

In the meantime, Fischer and Bar-On are putting up a united front against taking action to curb the shekel's rise. The central bank has not intervened in the foreign exchange market since 1997. But if the dollar continues its downward spiral, the Bank of Israel and the government may yet have to come to the rescue.