News Analysis: Shekel plunges, Israelis worry as world financial crisis brews

JERUSALEM — Israel's economy is on the verge of getting sucked into the global economic crisis, even though the country's leaders have reacted with relative calm to international market turmoil during the past months.

Finance Minister Ya'acov Ne'eman and Prime Minister Benjamin Netanyahu have repeatedly insisted that Israel's economy is an "island of stability" in the global economic storm because of what they call the government's "responsible" economic policies during the past two years.

Indeed, many economists believe that Israel would have been in far worse danger today had the government not moved in the past to reduce the budget deficit.

But the global storm that started to hit Israel's shores hard last week sent the stock market and the shekel plunging.

The shekel has fallen more than 10 percent against the dollar since the beginning of October and 20 percent since the beginning of the year.

On Oct. 8, it slid an unprecedented 5.25 percent in one day — to 4.31 shekels to the dollar — and the decline was even more dramatic considering that the dollar itself was weakening on world markets.

By early this week, the shekel had recovered slightly, rising to 4.19 to the dollar.

However, the sharp devaluation proved that Israel cannot be isolated from world market sentiment now that it is tightly integrated into the global economy.

Indeed, the devaluation is already leaving its mark.

Importers of goods such as appliances and cars have started to raise prices. Israelis who rent apartments with monthly payments quoted in dollars but paid in shekels will pay more this month. And prices of basic commodities such as food are also expected to rise soon.

Ne'eman and Jacob Frenkel of the Bank of Israel tried to stay calm as they attended the International Monetary Fund's annual conference last week in Washington.

They did not rush back home, and they pledged not to intervene in foreign currency trading after liberalizing the foreign exchange market earlier this year.

"The Israeli public is not panicking and is not buying large amounts of foreign currency," Ne'eman told Israeli television. "I assume things will calm down."

At last week's International Monetary Fund conference, Arie Mientkavich, chairman of Israel Discount Bank, the country's third largest, painted a far gloomier scenario than what is being presented by Israeli economic officials.

"We are on the edge of the abyss," he said, warning that the stability of Israel's banks has been compromised by the falling shekel and stock exchange.

"Whoever thinks Israel can remain an island of stability in a stormy world is living in a fantasy. We will also get hit — and we will get hit hard."

Reacting similarly, the Knesset prepared to convene a special session this week to discuss the crisis.

The shekel began to slide when foreign investors recently started liquidating their investments in Israeli stocks, as they have been doing in emerging markets across the globe.

First, they sold shares on the Tel Aviv Stock Exchange. Then they bought dollars with the shekels received from the shares, pushing down the price of the shekel.

Israeli companies nervously watched the shekel's movements. Many, lulled into a false sense of security during the past two years when the shekel was relatively stable, took out foreign currency-linked loans to finance their activities.

As the shekel depreciates, these loans quickly become more expensive to repay, and high financing costs could take a bite out of corporate earnings.

That is why many companies have been buying foreign currency — to protect themselves should the shekel sink lower. However, that also contributed to the shekel's further decline.

So far, financial analysts say, the general public has yet to join the rush for the dollar.

If that happens, the shekel could further devalue with disastrous effects.

Before the shekel's depreciation, inflation was expected to total 4 to 5 percent in 1998 — the lowest in 30 years — and the Bank of Israel has steadily lowered interest rates accordingly.

But with inflation on the horizon again, analysts predict the central bank will have no choice but to raise interest rates again, both to keep inflation down and to get Israelis to hold onto their shekels at better interest rates.

However, higher interest rates — with the higher costs they entail for business loans — will deal a blow to overall economic growth.

Israel's economy is already suffering from a severe slowdown. It was expected to grow only 1.5 percent this year after growing an annual average of 6 percent during the mid-1990s.

But when interest rates rise, money becomes more expensive, putting a damper on growth by making it more difficult for companies to finance new activities.

And if the shekel continues to fall, the Bank of Israel could also be forced to intervene in trading.

Analysts say the central bank's $20 billion in foreign currency reserves should be enough to defend the shekel if a massive rush from the currency materializes.

All of those factors have led some Israeli businessmen and bankers to begin preparing for the worst.