A snapshot of the life of an ‘applied’ economist The Goldman Sachs Group, Inc. Goldman Sachs Research A snapshot of the life of an ‘applied’ economist Kasper Lund-Jensen +44 (0) 20 7552 0159 kasper.lund-jensen@gs.com Goldman Sachs International December 2014 Investors should consider this research as only a single factor in making investment decisions. For Reg AC certification and other important disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html. 1

The costs and motives behind The costs and motives behind FX interventions: the case of Bank of Israel

Growth has slowed in Israel in recent years… driven partly by weak exports Source: CBS, Haver Analytics

The stagnation in Israel’s exports is driven by weak external demand… A weaker currency leads to higher exports after a few quarters (as the ‘quantity effect’ kicks in)… Impact on exports following a 1% depreciation of the real effective exchange rate …while stronger external demand increases exports instantaneously Impact on exports following a 1pp improvement (qoq ann.) in external demand Source: Goldman Sachs Global Investment Research, Haver Analytics Source: Goldman Sachs Global Investment Research, Haver Analytics

… but is also a function of the strong Shekel appreciation Source: Goldman Sachs Global Investment Research

The (labor intensive) low-tech manufacturing goods are particularly sensitive to Shekel appreciation The manufacturing sector is more sensitive to the real effective exchange rate… Impact on exports following a 1% depreciation of the real effective exchange rate … except high technology exports, which have a low price elasticity Impact on exports following a 1pp improvement in external demand Source: Goldman Sachs Global Investment Research, Haver Analytics Source: Bank of Israel

Bank of Israel’s “tool box” to fight FX pressures: The strong Shekel is therefore a significant concern for the Bank of Israel Bank of Israel’s “tool box” to fight FX pressures: A. Monetary policy (Cut rates by 300bp since mid-2011) B. FX interventions (Re-introduced this tool in April 2013) Policy mix has important implications for asset prices.

The BoI has eased monetary policy since mid-2011… Source: Haver Analytics, Goldman Sachs Global Investment Research

… and the BoI re-introduced FX interventions as a policy tool back in early 2013 Source: Bank of Israel, Haver Analytics

Lower interest rates may fuel the booming housing market in Israel Lower interest rates may fuel the booming housing market in Israel. Why has the BoI not relied more aggressively on FX interventions? Source: OECD

A build-up in FX reserves is likely to be driven by three motives: Flow motives: To boost competitiveness: FX interventions designed to weaken the currency may be used to stimulate economic growth via higher net exports. This motive is particularly strong in current account surplus economies, which naturally experience large capital inflows. Reduce FX Volatility: FX interventions can also be used to reduce exchange rate volatility that arises as a result of speculative behaviour or ‘overshooting’ effects (in both directions). Stock motive: Precautionary reserves: Large FX reserves reduce the likelihood of a ‘sudden-stop’ in capital inflows. Given the substantial economic costs associated with such 'sudden-stops', countries may seek to hold substantial foreign currency reserves and this could have been an important driver of the acceleration in FX accumulation from the mid-1990s.

There are ‘fiscal’ costs associated with FX reserves… The costs have risen as the BoI has accumulated larger FX reserves Costs of FX reserves, per year, for different spreads Source: Goldman Sachs Global Investment Research

…and the benefits diminish arguably after a certain point. Source: Goldman Sachs Global Investment Research

Approach I: The ‘optimal’ FX reserves level (which balances the ‘costs’ and the precautionary benefits) depends on different factors The optimal level of FX reserves is inversely related to the ‘opportunity cost’ spread… Optimal FX reserves as a function of the opportunity costs …but depends positively on the degree of risk aversion. Optimal FX reserves as a function of the risk aversion Source: Goldman Sachs Global Investment Research, Jeanne and Ranciere (2006) CORRECT SOURCE

The cost-benefit trade-off of FX interventions is less appealing today than it was back in 2008 The BoI’s FX reserves are above the optimal precautionary savings level. BoI’s FX reserves vs. optimal level Source: Goldman Sachs Global Investment Research

Approach II: Quantifying the ‘precautionary’ benefits associated with FX reserves Source: Goldman Sachs Global Investment Research

Optimal level of CB FX reserves across EMs (note that the Czech National Bank recently introduced a ‘peg’ against the Euro) Source: Goldman Sachs Global Investment Research, IMF

Central banks in emerging markets have increased their FX reserves over the past decades Source: Goldman Sachs Global Investment Research

Shekel Outlook

Shekel Outlook – where are we going from here. GS F’cast: $/ILS at 4 Shekel Outlook – where are we going from here? GS F’cast: $/ILS at 4.00 in 12 months. Source: Goldman Sachs Global Investment Research

The Shekel continues to be overvalued according to our preferred valuation metrics Source: Goldman Sachs Global Investment Research, World Bank

Institutional investors have bough large amounts of foreign assets in recent years (but since end-2012 they have been hedged). Source: Bank of Israel

Institutional investors' hedging demand weakened in August and, especially, in September. Source: Bank of Israel

Deflation risks have strengthened the BoI’s motive to weaken the currency…

… and the BoI may hit the ‘zero lower bound’ and cut rates by 20bp (to 0.05%) in December or 2015Q1… Source: Bank of Israel, Goldman Sachs Global Investment Research

… as the Shekel sell-off will not be strong enough to prevent headline inflation from moving into negative territory (due to fall in FX pass-through to inflation).

Disclaimer I, Kasper Lund-Jensen, hereby certify that all of the views expressed in this report accurately reflect my personal views, which have not been influenced by considerations of the firm’s business or client relationships. 1