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Currency markets warn Israel's Netanyahu

JERUSALEM (MarketWatch) -- The shekel, long the emblem of Israel's economic miracle, is coughing.

For nearly a decade, this formerly hyperinflationary coin has been one of the world's strongest currencies. Over the six years up to the 2008 global meltdown, the shekel had gained 35% and 30% respectively against the dollar and the yen. In the two years before the crunch, the shekel surged 20% and 40% respectively against the euro and the British pound.

The shekel's pre-meltdown surge reflected half a decade of nearly 5% annual GDP growth, animated by unemployment's plunge from 10.6% to 6%, inflation's slumber between 3.8% and a negative 1.9%, the budget deficit's shrinkage to 0.1% of GDP from 5.1%; and government debt's drop to 77% of GDP from nearly 100%.

The shekel arrived at the global meltdown so solid that economists feared it would become excessively strong, as the profitability of exports, the backbone of Israel's knowledge-led economy, would rapidly erode.

Back then the Bank of Israel averted that scenario by officially and continuously purchasing billions of dollars. The stratagem worked: By winter 2009 the artificially inflated shekel lost nearly a third of its dollar value, to local exporters' relief.

Then again, once the interventions eased, the shekel rapidly rebounded, and by spring 2011 it had appreciated 31%, thus demonstrating that macroeconomic fundamentals ultimately outweigh market manipulations.

Fundamentals weaken

Now, however, the fundamentals have lost some of their shine -- and the markets are responding in kind. Over the past 12 months the shekel has been skidding steadily, losing a bit more than 20% of its dollar value since last summer. Last week it broke the psychological barrier of 4 to the dollar, and on Thursday it traded at 4.09 to the dollar.

Before scolding Prime Minister Benjamin Netanyahu for his role in this saga, as we will shortly, it should be said in all fairness that some very non-Israeli reasons underlie this turn of events. Chief among these is the euro crisis.

Europe's ongoing difficulties in rehabilitating its weaker economies have been feeding the dollar's resurgence and not only in Israel. And more ominously, the euro crisis has depressed demand across the European Union, which ordinarily buys about a third of Israel's exports. The result of this has been a sharp decline in Israeli exports.

From 2003 through last year, overall annual Israeli exports more than doubled to $78.7 billion from $35 billion, a trend that even the 2008 meltdown could only disrupt for one year.

Now, however, the Central Bureau of Statistics reports that exports declined 0.7% in first-quarter 2012 and 3.3% in the second quarter. As of mid-year, the annualized trade deficit was estimated at 76 billion shekels, as opposed to 52 billion the previous year and 29 billion in 2010.

This alone means a decline in foreign-currency inflows, which in turn offsets the balance of payments and weakens the local currency – for the wrong reasons. But that circumstance, albeit on a smaller scale, existed also in 2008, when the shekel would not decline until the Bank of Israel sold it wholesale.

Three key changes

What, then, has changed? Three things:

First, in 2008 the Greek crisis had yet to erupt and shake Europe. Secondly, the Arab world had yet to quake. And lastly, there was no hint yet of last year's social upheaval in Israel.

The Arab upheaval has not hurt Israel's economy directly, as Arab-Israeli trade remains sadly negligible. The only commercial association it has disrupted, natural-gas sales from Egypt, has made Israel buy more fuel elsewhere, but this shift in the origins of one import is not a major factor in the shekel's decline.

The big elephant in the room here is the defense budget.

Israeli defense spending was supposed to grow no more than 1.5% a year, following the adoption of an expert committee's recommendations in 2008. In reality, these limits were repeatedly breached, with the excess totaling 3.2 billion in 2008 through 2011.

Now, with the Middle East awash with civil strife and religious agitation, the defense establishment is pressuring for even greater spending.

This is where a prime minister has to put his foot down and tell the generals that the 15% of the budget they already get is hefty enough and should suffice, whatever unfolding circumstances might demand.

Netanyahu hesitates

Netanyahu has not done this, fearful that regional challenges, particularly a potential clash with Iran, require more money. The generals, for their part, are sniffing his reluctance -- and are exploiting it. The navy, for instance, now tasked with defending Israel's newly found Mediterranean gas fields, is preposterously asking for $1 billion for that purpose alone.

And not only has Netanyahu failed to cut defense spending, he raised social spending.

Responding to last year's social protests, which were about income gaps between rich and poor and about the middle class's cost of living, Netanyahu launched several programs, most notably extending the start of free education to age 3 from age 6 at an estimated annual cost of 3.7 billion shekels.

This and other unplanned social expenses, coupled with increased defense spending, declining exports, and shrinking tax returns, led the government to double the budget-deficit target to 3% of GDP from 1.5%.

Such a deficit, like Israel's expected growth rate for this year, 3.1%, would be the dream of most developed economies today. However, those very economies' recent experience shows that doubling the deficit once prompts further expansion, and before long it breeds uncontrolled borrowing and a debt crisis.

At that point Bank of Israel Gov. Stanley Fischer, the Israeli macroeconomy's high priest, released a blunt statement calling the deficit expansion "neither good nor reasonable." Needless to say his statement intensified the alarm in the markets and thus raised awareness of Netanyahu's fiscal misadventures.

Taxes are up, budget is cut

Netanyahu, for his part, realized he had to restore his image as a financially savvy and fiscally responsible politician. This week he therefore went to the media, stated "there are no free lunches," and said "painful" measures will have to be taken to finance the growing deficit.

Two days on, Finance Minister Yuval Steinitz raised taxes on cigarettes and alcohol; next week the value-added tax is expected to be raised a percentage point to 17%, and the budget will reportedly be cut by nearly 1 billion shekels. Such measures, while praised by Fischer, are mild at best, as demonstrated by a skeptical Bank of Israel's decision this week to leave interest rates unchanged.

Since he returned to the premiership in winter 2009, Netanyahu has responded more than he has initiated regarding the economy.

This trend was signaled when he effectively shelved his bold plan to sell state lands, a scheme that was opposed by the country's socialists, nationalists, populists and religious politicians.

Had he demonstrated resolve and ignored them, Netanyahu would have shown he is the landlord, sold enough land to flood the property markets, and thus prevented the subsequent social protest, which was triggered by an outcry over soaring housing prices.

Having lost his strategic bearings, Netanyahu found himself mired in tactical maneuvering, facing growing deficits, a reprimanding central bank, and disapproving markets.

Analysts now assume Netanyahu is waiting with much more drastic measures for the morning after the next general election, which is expected to take place between winter 2012 and fall 2013 and result in his reelection.

Unfortunately for Netanyahu, the markets these days have little patience for political developments. Increasingly, they prefer to shape them.