Is government endangering the economy? What are the signs?

Commentators and businesspeople have expressed concern recently about the possible economic consequences of the government’s plans. They are specifically about the effects of proposed changes to the judicial system and the generous coalition agreements the Likud Party signed with the ultra-Orthodox parties. Some warn that the government’s measures spell the end of democracy in Israel and prophesy economic devastation. But how will we know if the threat is real? Here are some economic indicators that will tell decision-makers within a short time where the Israeli economy is heading.

The currency market – first to respond

The economic indicators are bound up in a complex whole, and they will be listing them shortly. In general, though, the market that responds fastest to deterioration in the financial stability of a country or in the sovereignty of its institutions is the currency market. It is, however, difficult to determine the precise cause of volatility in the market, which itself is affected by a wide variety of indicators.

For example, the shekel weakened in December from NIS 3.41/$ to NIS 3.53/$. It’s difficult to determine whether this was because of rising fears on the part of investors over political developments in Israel, or whether it was a reaction to drops in the stock markets, or to a slight decline in exports. It could be that the right answer is all of the above, but the relative weight of each factor remains hidden in obscurity.

If so, how can the exchange rate be used as an indicator of actual danger? Weakness in the shekel, as in any currency, becomes worrying when it continues steadily for a long period, or when there are exceptional movements in the exchange rate in comparison to the currencies of similar countries.

On the subject of the exchange rate, it’s important to remember that the foreign exchange reserves of the Bank of Israel have swollen in recent years to a huge $194 billion. This happened as a result of large purchases of dollars as the central bank tried to stop the shekel from strengthening excessively versus the basket of currencies of Israel’s main trading partners.

In the extreme circumstances of a crisis that leads to a weakening of the shekel, which would fuel inflation and necessitate higher interest rates, foreign-exchange reserves can be used in the opposite direction. Theoretically, the Bank of Israel could sell its dollars to shore up the shekel. On the one hand, this has never happened in the past, but on the other hand, Israel’s foreign-exchange reserves have never been so high. They are currently much higher than the minimum level recommended by the International Monetary Fund.

Debt:GDP ratio is comparatively good

When GDP is much larger than government debt, investors can be more certain that a country will be able to service its debt. Last week, the Accountant General Department at the Finance Ministry celebrated the release of fantastic numbers for Israel’s debt:GDP ratio. This ratio, which serves as an important indicator of a country’s financial stability, fell from 68% in 2021 to just 60.9% in 2022, almost bringing it back to where it was before the COVID-19 pandemic began. Most developed countries are contending with debt amounting to 80%-90% of GDP.

When the debt:GDP ratio rises, the capital market responds accordingly. This is what happened in Italy, for example. Rising government debt in relation to GDP led to investors demanding a high-risk premium, and yields on Italian government debt instruments soared. In a situation like that, if a country wants to embark on a plan to support its economy, it has to pay much higher interest rates on the debt that it raises for this purpose. This can snowball: High interest rates mean higher government expenditure, and the government then has to raise further debt at even higher rates, and so on.

A low debt:GDP ratio means the decision-makers can be fairly relaxed about an approaching economic slowdown, because the government is able to raise debt to support the economy without fearing economic collapse. This was Israel’s position when the COVID-19 pandemic started, but then a policy of unrestrained spending sent its debt:GDP ratio shooting upward in 2020, from a historically low level of 59.5% to 71.7%.

Fiscal deficit – a signal next month

The debt:GDP ratio goes hand in hand with the fiscal deficit. In general, the debt finances the deficit. Last year, it was the other way around; a fiscal surplus repaid debt. 2022 was the first year since 1987 in which, rather than a deficit, Israel recorded a fiscal surplus of nearly NIS 10b., about 0.6% of GDP.

No one expects the surplus to continue into 2023, but we will probably receive some indication of where we are heading next month, when Finance Minister Bezalel Smotrich sets out the deficit framework for the next state budget. Smotrich has already signaled to foreign investors that he will not breach normal frameworks and will maintain a balanced fiscal policy, but he faces a stiff challenge from the welter of budgetary demands from his partners in the government.

What level of deficit will start warning lights flashing for investors?

“If they set a deficit framework of 3% of GDP, that will be fine, and for a certain period Israel can even reach 4%, on condition that it’s a matter of expenditure that generates economic growth,” said Psagot chief economist Ori Greenfeld. “If the deficit is fairly low, then the debt:GDP ratio will probably not rise in 2023, and may even fall slightly. As far as 2024 is concerned, that will very much depend on what the government does during the year, but I don’t see a situation in which the fiscal deficit balloons in an unprecedented way.”

Government bond yields – steady investor confidence

Government bond yields are not so much an economic indicator as the capital market’s reflection of the various indicators. Since investors always try to anticipate developments, the bond market responds swiftly when a country is under pressure, and bond yields climb. As mentioned, this is what happened in Italy. It also happened in Turkey, in the period before economic crises broke.

A clear illustration of the brakes the capital market applies when political developments are perceived by analysts as dangerous was provided by Britain. Last October, Liz Truss resigned as prime minister, after just a few weeks in the post. What led to her resignation was the controversial tax-cuts plan that she and then-chancellor of the Exchequer Kwasi Kwarteng presented, which triggered a steep rise in government bond yields. That caused Kwarteng’s downfall, and, shortly afterward, Truss’s resignation.

By global comparison, Israel’s situation is still good. Although yields on Israel government bonds have been at their highest levels for some years, that is part of a worldwide trend of rising interest rates. In relation to other countries, government bond yields in Israel are still low, and reflect steady confidence on the part of investors.

The most recent manifestation of that came a week ago, when the accountant general successfully completed a $2b. debt offering of foreign investors, consisting for the first time of green bonds. Amid high demand from some of the world’s largest financial institutions, the spread between interest rates on Israeli government bonds and equivalent US government bonds remained stable. That is to say, current events are not making the market charge an additional risk premium. On the other hand, in the lead-up to the offering, investors asked repeatedly whether the government intended to set a normal deficit framework.

Another indicator is provided by the yield curve – the yield in relation to time to redemption of government bonds. In Israel’s case, the curve falls for longer-term bonds, which means the market sees a positive horizon for Israel. It hasn’t always been that way. Before 2006, when interest rates were high, the curve went the other way; that is to say, in order to invest in longer-term government debt, investors demanded a higher risk premium from Israel. Happily, that is not the case at present. (Globes/ TNS)