Taking a closer look at the shekel-dollar exchange rate and current risks in the Israeli economy

The recent approval of the state budget for 2023 and 2024 by the Knesset brought a sense of relief to the Israeli government. However, it did little to quell the volatility in the foreign exchange market, resulting in a weakened shekel against the U.S. dollar. While this may initially benefit exporters and tourists, who can now get more shekels for their dollars, it raises concerns from a broader perspective.

The decline in the exchange rate highlights the prevailing uncertainty and investor apprehensions in Israel, despite seemingly positive economic indicators. With the shekel hitting its lowest point against the dollar this year at 3.73, it becomes crucial to examine the factors behind this devaluation and the potential consequences it may entail.

Israel's politics and security

The impact of recent security and political developments has become increasingly prominent in influencing the shekel's exchange rate, overshadowing economic factors at this stage. This observation was underscored when the approval of the budget failed to translate into gains in the foreign exchange and capital markets. Economists worldwide have expressed growing concerns about the persistent political uncertainty in Israel. They foresee that if governance continues to deteriorate and political crises intensify, it may lead to the withdrawal of capital by external investors, further straining the shekel.

The shekel's decline against the dollar was further fueled by the Israel Defense Forces Chief of Staff Herzi Halevi's message to Iran during the Herzliya conference, hinting at potential actions on the horizon. This statement, instead of instilling confidence, intensified negative sentiment among investors, resulting in a 1.3% increase in the dollar rate. The Israeli stock market also experienced a downturn, with the Tel Aviv 35 index falling throughout the last week and losing a total of 3.5%. Although a slight recovery was observed yesterday, May 28, it remains uncertain.

Additionally, the increased volatility observed in the foreign exchange market has been attributed to the impact of legal reforms advocated by the government. The Bank of Israel's projections, released in April, emphasize that the proposed judiciary overhaul plan not only threatens market stability but also carries the potential for a significant 2.8% annual decline in GDP over the next three years.

 In a recent report by Israel's Start-Up Nation Policy Institute, it was highlighted that venture capital investment in Israeli start-ups has experienced a notable downturn during Q1 of 2023. The figures reveal a decrease to $1.7 billion, marking the lowest level since 2018 and a significant drop from the record-breaking investment of $6.7 billion recorded in the corresponding period last year. While the cause of this decline remains uncertain, it is worth considering its potential connection to the ongoing judicial reform.

 Furthermore, the U.S. Federal Reserve's recent interest rate announcement, indicating a possible rate hike, has influenced the dollar's strength globally, which had its impact on the shekel. The economic trends in the US, characterized by the expansion of service industries, a tight labor market, and wage pressures, indicate a probable continuation of inflation in service prices. Consequently, this upward pressure on prices is likely to contribute to the strengthening of the dollar. While the tentative agreement on the US debt ceiling has provided some relief in the markets, with investors seeking riskier assets, there are still potential obstacles on the horizon. If the deal fails to be finalized officially, it could have repercussions not only on the American economy but also on Israel and its economic landscape.

Israel's stubbornly high inflation

The weakening of the shekel against the dollar poses challenges for the Bank of Israel's efforts to control inflation. The recent interest rate increase by the Bank of Israel to 4.75% was partly influenced by the shekel's devaluation. Experts predict that if the shekel does not strengthen in the near future, another interest rate increase is likely in July, which would raise the base interest rate to 5%. And since the large portion of products imported to Israel is denominated in dollars, a continued devaluation of the shekel will likely lead to higher inflation rates. 

Overall, the current shekel/dollar exchange rate reflects the prevailing uncertainties in Israel, particularly in the political and security domains. These uncertainties, coupled with global economic factors, are creating risks for the Israeli economy, including potential capital outflows and increased inflationary pressures. The decisions and actions of both domestic and international stakeholders will play a crucial role in shaping the future trajectory of the shekel's exchange rate and its consequences for Israel.

This article originally appeared here and is reposted with permission.