Shekel: A High-Tech EM Safe Haven

Summary

• High-tech boom a key factor of Israel’s BoP improvement.
• Israeli investors partially hedge the C/A recycling, supporting the shekel.
• FX intervention will continue, but watch out for short-term risks.
• Israel’s second lockdown came at a high economic cost

Market Implications

• Medium term; Positive FX – structural inflows and strong NIIP support the shekel.
• Short term; Neutral FX – expect volatility given 2020/21 budget, BOI meeting, US elections.

Israel is the most tech-oriented economy in the world, with 13% of the GDP and 30% of all exports originating in the high-tech sector. Unsurprisingly, the country ranks first in the number of venture capital investments per capita. In 2018, the high-tech sector raised $414 per capita, well above the US ($282).

The Israeli high-tech boom has been a very important driver of the balance of payments. Capital raising by Israel tech companies has grown 15% annually since 2010, reaching $8.3bn in 2019 or 2.5% of GDP. Venture capital investment, and on a larger scale foreign direct investment (FDI), have been crucial for developing the Israeli high-tech industry, which cannot rely on the local capital markets alone.

The US and EU are the main sources of the FDI inflows, but China’s share has grown rapidly in recent years. Overall, inward FDI in Israel has increased from $3.3bn in 2003 to $20bn in 2019 – well above the outward FDI of $8.8bn in 2019. As such, the basic BoP (current account + net FDI, narrow definition) increased from 1% of GDP in 2006 to 6% in 2019, creating strong structural shekel inflows. Moreover, Israel recently started pumping natural gas from the massive Leviathan field. The supply of gas to its partners, including Egypt and Greece, could boost the current account by 1% of GDP annually.

Positive BoP Dynamics Have Supported the Shekel

This recent FDI comes on the back of a longer trend towards a current account surplus. Historically, Israel exhibited a large current account deficit. Over the first 40 years of its existence, the country had to build local infrastructure and maintain a large defence force. After the 1973 Yom Kippur war, an economic crisis hit the country and the government introduced a stabilization program to preserve the BoP. In 1990, high immigration from the Soviet Union put pressure on the current account, but the government reacted quickly to avoid a BoP crisis. In 2003, the current account definitively shifted to a surplus, supported by a surge in the services account driven by the technology and tourism sectors. Last year, the country exported as many services as goods for the first time.

These sound macroeconomic policies and the current account reversal restored foreigners’ confidence in the Israeli economy. Following the dramatic improvement in the basic BoP, the country became a net lender to the world: NIIP rose from -40% of GDP in 1999 to +41% of GDP in 2020. Only HK, Singapore and Taiwan lend more to the world as a percentage of GDP among the emerging countries.

Overall, the historical developments and the more recent high-tech boom have had two important consequences on the shekel: a 40% real appreciation over 15 years and an increasing correlation with the US tech stocks.

Institutional Hedging Limit Shekel Outflows

The increase of overseas portfolio investments from local investors drove the shift in Israel’s NIIP stock. In 2017-19, portfolio outflows averaged $7.5bn annually, compared with $0.3bn in 2007-09. These outflows used to be more volatile than direct investments. For instance, the widening of the US/Israel interest differential rates in 2012-15 (from -2.60% to 0.50%) created $10bn annual outflows from Israeli investors during this period.

The institutional investors’ exposure to foreign assets rose from 2.5% of their total assets in 2002 to 28% in 2020. However, they continue to hedge partially their foreign currency exposure with a ratio oscillating between 30% and 45%. Therefore, this limits the shekel current account recycling, providing a tailwind to the currency. Unsurprisingly, the ratio is correlated to the interest rates differential between Israel and the rest of the world. The widening of the US/Israel rates differential during the previous Fed hike cycle decreased the hedging ratio by more than 10%. Since the outbreak of the pandemic, the hedging cost has fallen considerably and should remain flat for longer. Institutional investors will increase their hedge and provide additional support for the shekel.

Deflationary Pressures Persist Despite BOI Intervention

Israel’s low / negative inflation environment in recent years is in sharp contrast with the past. Until 2000, the Israeli economy suffered from rising prices. Implementation of the stabilization program in 1985 reduced core inflation from 76% annually during 1971-85 to 16% annually during 1985-1995. Actually, over the last 10 years, core prices grew by 0.9% annually, one of the lowest averages in the world. Since 2014, inflation has never reached the 1% lower bound of the BOI’s target, despite quasi-full employment. CPI currently stands at -0.3% YoY and the negative output gap and the shekel recovery should keep inflation in negative territory going forward.

To fight against the recent ILS appreciation and the low inflation rate, the BOI implemented FX purchases in 2013. However, given the basic BoP surplus, they only managed to slow down the currency appreciation. In 2020, intervention has been sizable, with purchases of $14.4bn YTD.

The BOI will meet on 22 October for the first time since the second lockdown. However, the coalition is locked in a power struggle over the 2020/21 budget. The BOI governor urged the government to open small businesses and to approve a fiscal plan. In this context, markets are pricing a rate cut in Q4 despite the lack of enthusiasm from the BOI for lower rates.

Watch Out for the Lifting of the Second Lockdown, and the US Elections

After the second lockdown, the OECD revised Israel’s 2020/21 GDP forecasts to -6% and +2.9% leaving the Israeli economy set to contract by more than many other countries. The severe second COVID wave and the Nasdaq correction weighed on the shekel in September. It weakened by 2.2% versus the dollar and underperformed compared with the Taiwan dollar. However, ILS has rebound 1.6% so far in October. The September announcement of the second lockdown also weighed on Israel’s stock market. But that too has rebounded alongside the shekel.

Lastly, a Joe Biden win in the upcoming US presidential election will impact the shekel through two mechanisms: a potential sell-off in US tech stocks and the end of the exceptional relationship between Israel and the Trump administration.

Stay tuned.