1. 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)
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 1

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

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

4. 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

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

6. 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

7. 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.

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

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

10. 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

11. 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.

12. 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

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

14. 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

15. 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

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

17. 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

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

19. Shekel Outlook

20. 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

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

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

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

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

25. … 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

26. … 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).

27. 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