Finance & Economics Division December 10, 2013 Department of Economics Establishing a Sovereign Wealth Fund for Israel as Part of a Mechanism for Dealing with the Forces Supporting Appreciation of the Shekel Introduction Israel and the Dutch Disease One of the main challenges faced in recent years by Israel's economic policymakers, and most specifically the Bank of Israel (BoI), involves the issue of the strengthening of the shekel. The shekel s strength has been a burden to Israel s export sector and has also hurt domestic manufacturers that produce for the local market, as they must compete with cheap imports into Israel. It is expected this matter will remain to be an important economic agenda item to be dealt with in the coming years. The strengthening of the shekel over recent years, and particularly in the past year, stems from a combination of basic factors that apparently will not be alleviated anytime soon. These factors include foreign currency inflows to Israel due to the strategic acquisitions of Israeli companies by foreign investors (FDI), and the transition of the current account of the balance of payments from a small deficit to an increasing surplus. It is worth noting that the current pressures for appreciation of the shekel are not related to "hot-money" portfolio inflows by foreign parties. Israel's experience with strong inflows of portfolio investments, mainly to the T-bill market, was short lived in 2010, and was dealt with through changes in taxation. The return to a surplus in the current account stems primarily from a decline in imports, which is also the result of the transition to the use of natural gas rather than relatively expensive imported fuel. Looking ahead, the expected recovery of global economic growth is likely to contribute to an increase of Israeli exports, which will further contribute to the rise of Israel's current account surplus. In addition, with the continued expansion of the use of domestically produced natural gas instead of imported energy products, the current account surplus will continue to grow and will increasingly support appreciation of the shekel. In the more distant future, the export of natural gas will further strengthen the forces supporting appreciation of the shekel exchange rate. This appreciation is likely to hurt the competitiveness of other export sectors, as well as a number of local 1
industrial sectors, and to have an impact on the domestic economy and employment. This phenomenon is known by the name Dutch Disease 1. Attempts Until Now at Dealing With the Forces of Appreciation Until now attempts by the BoI to prevent the shekel from strengthening were focused on the use of two main instruments: direct intervention in the foreign currency market through the purchase of US dollars in inter-bank trade, and the reduction of the shortterm interest rate. Regarding the latter, the central bank carried out two main rounds of interest rate cuts between October-March 2009, and from September 2011 through today. These instruments used by the BoI are primarily recognized for their effectiveness that is limited to the short-term; however, once they begin to be used as long-term instruments, they lose their effectiveness and occasionally even cause unwanted consequences such as asset price inflation. For a number of years already the BoI has been dealing with the shekel s appreciation by purchasing substantial amounts of foreign currency, and also to a certain degree by means of interest rate policy. The foreign currency purchases create quasi-fiscal costs, roughly estimated at an annual average of at least half a percent of GDP per year since 2008. With these intervention costs in mind, it is asked whether this is indeed the optimal way to deal with the appreciation of the shekel and the related impacts on the local economy. It can also be asked, what is the optimal level of foreign reserves that Israel should hold? This is not a topic for narrow monetary considerations only, but instead a topic with national importance. It is interesting that the new BoI Law (2010) gives its opinion on the matter and includes the minister of finance as the party responsible for approving the BoI's principles for deciding on the desired level of foreign exchange reserves. It is important to stress that the strengthening of the shekel is an issue that demands a long-term solution in light of the fact that according to all signs this is an issue that will continue for years to come. Consequently, it appears the economic policy makers in Israel the BoI in cooperation with the Ministry of Finance must try to find other instruments in addition to those used until now, because according to all signs the 1 Dutch disease is a term coined in the 1970s used to describe the problems that occurred in Holland following the discovery of gas fields in the North Sea in 1959. Revenues from the export of natural gas that streamed into the coffers of the Dutch government led within a number of years to a substantial strengthening in the Dutch currency. This strengthening damaged the competitiveness of other export sectors as their prices increased in foreign currency terms. As a result, exports from these other sectors were hurt and unemployment climbed. An additional problem resulting from the gas discovery occurred as the revenues from gas exports were used to increase local demand within Holland. This demand led to a rise in land prices, as well as in the prices of local services (restaurants, hospitality, and similar services). Consequently, labor wages in the local service sectors, which do not compete with import prices, increased. That in turn led to a wage increase also in other industries as employees began to switch over to the service industries. In other words, the use of revenue inflows from gas exports in the local market led to a rise in wages and to additional damage to the competitiveness of exports. 2
usefulness of these instruments is close to be fully exhausted. In particular it is worthwhile to note that even after the substantial foreign currency purchases by the BoI, to the point at which the country s foreign reserves are at a peak level while the interest rate has been cut very close to its historical low, the exchange rate of the shekel vis-à-vis the effective basket of currencies has appreciated substantially. Possible Solutions 2 It appears the best means for dealing with the forces of appreciation involves a combination of a number of long-term policy instruments, together with the continued use, although to a limited degree only and in short periods of time, of short-term instruments such as intervention in the foreign exchange market. That is to say, in contrast to the situation today, in which dealing with the forces of appreciation is based entirely on the use of short-term instruments, it is preferable that the actions taken include an increasing share of long-term instruments, together with a reduction in the relative proportion of short-term instruments 3. One of the long-term approaches is to reduce the BoI s intervention in the foreign exchange market, and in this manner also reduce the associated costs, and to earmark the savings to targeted assistance in the export sectors and import substitution sectors; but to do this in a uniform manner that is completely transparent so that it does not breach international trade agreements. For example, the cost savings may be directed to funds to assist in marketing Israeli companies overseas (such as helping small and medium-sized business in penetrating new markets such as Africa, Latin America, and the Far East). Assistance could also be provided in management of financial and other risks (very relevant for small and medium-sized businesses); or also tax benefits could be granted to workers and employers in the industrial sectors, in particular in the export sectors and in import substitution. Another use for the cost savings could be to accelerate the deployment of the gas distribution network in Israel in order to increase the degree of energy competitiveness and more. The focus of the support must be on the industrial sectors that are hurt the most from the strengthening of the shekel, with an emphasis on the traditional, low and medium-tech, industrial sectors, which also happen to be labor intensive. High-tech sectors, according to the BoI (in its annual report), are less sensitive to the exchange rate. Another solution, which is apparently essential over the long-term, is the creation of a sovereign wealth fund that will act to invest overseas, and will create foreign currency outflows that will offset a portion of the pressures for appreciation that stem from the capital inflows. Norway is one example of a country that successfully implemented such a plan, after it suffered from the Dutch Disease, particularly from deterioration in 2 This section makes use of the article published in Leumi Outlook, March 2013: The Norwegian Cure for the Dutch Disease, written by Sagit Erel. 3 Heads of central banks around the world, including the former governor of the BoI, Stanley Fischer, see foreign currency purchases (intervention) as an efficient means for preventing strengthening of the local currency. See the speech given by Stanley Fischer in Prague, February 7, 2013. 3
its terms of trade due to the export of its oil. Furthermore, the Norwegian economy developed a high dependency on oil revenues, and when oil prices fell sharply, the country s economic growth was severely hurt. Norway s solution was to establish a sovereign wealth fund. This fund does not permit the entrance of foreign currency revenues deriving from the export of natural resources into the local economy, by requiring that the revenues instead be invested in overseas assets. This solution became accepted worldwide, including in countries such as Chile, where there are large copper mines, and Singapore, which maintains a large surplus in its balance of payments (which does not stem from the export of natural resources). The sovereign wealth fund acts in accordance with 26 principles that relate to public transparency in the management of the fund s money, to strict monitoring and reporting, to independence and separation of the investment management from the current activities of the government. With the discovery of the large gas reservoirs in Israel, followed by discussions surrounding the possibility of exporting some of the gas, plans began to be made for establishing a sovereign wealth fund for Israel, with the goal of distributing the state s revenues from the gas resources across future generations. The government will receive three types of revenue flows from gas exports. The first type of flow involves royalties, the second flow will come from corporate tax, and the third flow includes income tax from surplus profits (that is to say, profits that will be created after the return on investment in the reservoirs). According to the protocol from the government's finance committee meeting in February 2012 (hereinafter: the protocol), royalties will reach US$30bn, with the contribution of gas activities to corporate tax reaching a similar level, during the period of operation of the reservoirs (at current prices). Taxes on surplus profits are expected to reach US$70-80bn, although it is estimated these revenues will begin only in 2018 from the "Tamar reservoir and not before 2025 from the Leviathan reservoir since until those periods the profits are expected only to cover the initial investments in the reservoirs. Whereas the royalties and corporate taxes are intended to be regularly incorporated into the government budget, the taxes on surplus profits will be directed to the sovereign wealth fund. Israel is planning to adopt the Norwegian model, according to which the fund will be managed by the central bank. This is in contrast to the Singaporean model, for example, according to which the fund is managed by a non-governmental statutory authority 4. It can be learned from the protocol that this decision stems from, among other things, the fact that management costs associated with a separate statutory body are high, and only in another 15 years a substantial sum is expected to accumulate in the fund. However, the Norwegian model is expected to be implemented in Israel with 4 Details can be found in the following article: Sovereign Wealth Funds: Aspects of Governance Structures and Investment Management, Abdullah Al-Hassan, Michael Papaioannou, Martin Skancke, and Cheng Chih Sung, International Monetary Fund, WP/13/231, November 2013. 4
one difference. At the head of the fund s investment committee a professional is to be appointed, rather than a representative of the central bank. The members of the investment committee will include representatives from the BoI as well as from the finance ministry, and also two non-government professional representatives from the public. This committee, similar to the provident funds, will set individual investment policy and will guide an operational unit that will sit at the BoI, which will carry out the investment policy. The body that will guide the investment committee will be the fund s board of directors. At the head of this board will be the minister of finance, and the members will include a representative of the BoI, the head of the National Economic Council, and three representatives from the public who will be chosen by an appointment committee headed by a judge. Together with the board of directors there will also be an oversight committee that will be headed by the general controller of the state. This committee will monitor activity at all levels. Proposal to Advance the Establishment of Israel s Sovereign Wealth Fund Against the Backdrop of the Immediate and Short-run Negative Effects of the Shekel Appreciation on Exporters and on Local Industry Further to what is noted above, the main tool that is supposed to serve the long-term interests of the country and prevent the spread of Dutch Disease to Israel is the creation of a sovereign wealth fund. A wealth fund of this type is supposed to invest state revenues deriving from local gas production, primarily from future gas exports, in overseas assets. These investments abroad will offset the net inflow of foreign currency into Israel. However, as presented above, the problem is that most revenues to the state from natural gas will flow only after many years. Consequently, these future revenues cannot provide an immediate source for creating a fund already in the near term, operating at significant levels, to assist in curbing the strengthening of the shekel already in the foreseeable future. We note the BoI has been purchasing foreign currency to offset the effects of the decline in fuel imports caused by the supply of gas from the Tamar reservoir. With the foreign currency purchased the central bank created a separate fund of sorts within the framework of the bank s general foreign currency reserves, but for now these efforts have not led to any weakness in the shekel. This is possibly the result of the relatively low volume of foreign exchange purchases within this framework (only US$3.5bn per year, as per the target for 2014). In addition, the manner in which the BoI acts in the foreign exchange market may create factors that increase the incentives for speculating on the strengthening of the shekel due to the BoI s role as a "market maker", prepared to absorb large amounts of foreign currency supply, thus reducing the foreign exchange risk and inviting speculation. As a substitute measure, and apparently more effective, it is recommended the government of Israel (The Ministry of Finance) to issue shekel-denominated bonds 5
already in the near term and make use of the proceeds from these bonds to immediately establish a fund for the purchase of foreign currency, and allocate to strategic investments overseas. We believe that outflow from the fund should be similar in magnitude to Israel's FDI inflows that represent a dominant factor impacting on the appreciation of the shekel (approximately US$10bn per year). In other words, this move would securitize the future tax revenues from local gas production, with the proceeds earmarked exclusively for the purpose of establishing a sovereign wealth fund, and in no way will the funds be used to finance the budget deficit. Thus, this is a different type of bond issuance, intended for a specific purpose. In order to contribute to the attractiveness of these bonds, and also in order to make it clear these moves do not represent a regular increase in the debt of the state for financing the deficit, which it is preferred to be decreased, it is possible to create a new, unique bond series that will be backed by the future proceeds from gas exports. It is preferable the duration of these new bonds will be especially long, this while matching the long period of time within the framework of which the state will benefit from the tax revenues from the domestically produced gas, and thus will create a situation in which there is a clear, public matching between the expected timing of tax proceeds and the planned timing of the main portion of payment of the capital and the interest on these bonds. The long duration will add to the attractiveness of these bonds to pension funds and other institutional investors, which require long-term government bonds with fixed rates as a means for anchoring the yields in their portfolios over time. Regarding the management of investments, here also the process can be accelerated, since it is not necessary to wait to establish a complex mechanism of investment management by a new unit that will be set up by the BoI. Instead, the implementation of the investment committee s guidelines for use can be carried out also by private financial institutions where investment management represents a substantial area of activity. The use of private financial institutions for the purpose of managing the investments of a sovereign wealth fund is an acceptable practice among more than half of the countries that manage such funds. These countries include Singapore, Australia, New Zealand, and Canada. Israeli banks, which already manage large nostro portfolios with overseas investments, have experience in the realm of financial and real investments, as well as specific knowledge in approaching global investment from an Israeli standpoint. There are Israeli institutions that already have the required infrastructure for the purpose of providing international investment management of very large sums: research departments (macro- and micro-) that specialize in identifying investment opportunities and analyzing financial and tangible assets attractiveness; high accessibility to international investments by means of branches and representative offices of banks overseas; extensive contacts with government organizations and international financial bodies that operate in investments; and advanced systems for investment, measurement, reporting, oversight, risk management, and more. It is worthwhile to take advantage of this economy of scale. Use of this option can be carried out immediately upon the receipt of proceeds from the bond issues 6
mentioned above, and in this manner it will already be possible to begin using this instrument in order to offset the forces of appreciation on the shekel and not to wait many years until a sovereign wealth fund can be established, will accumulate funds, will create a complete system of investment manage, and will initiate activity, this during a time when the degree of competitiveness of the shekel is quickly eroding and increasing economic risks. Author: Dr. Gil Michael Bufman, Chief Economist 7