Israel: The shekel tumbles in February
The ILS traded at 3.67 per USD on 3 March, down 6.9% month on month, 11.6% year on year and 3.9% year-to-date. This reflected a steady depreciation of the shekel throughout February.
Uncertainty over the government’s proposed judicial reform was likely a key driver behind the depreciation. The reform would give Parliament the ability to override Supreme Court decisions and increase the ruling coalition’s sway over judicial appointments. This is generating fears over corruption and the weakening of the rule of law, with some firms reportedly pulling funds from the country in recent weeks.
In addition, the U.S. stock market trended down in February: The S&P 500 index fell from over 4,100 points at the start of February to below 4,000 at the end of the month. This likely led Israeli institutional investors to hedge their large exposure to foreign markets by selling shekels. Broad-based U.S. dollar strength was another factor behind shekel weakness; higher-than-expected figures for U.S. inflation, retail growth and job gains in January spurred expectations of more Fed hikes and supported the greenback.
Looking ahead, our analysts expect the local currency to regain ground by year-end. The U.S. stock market is seen recovering, with a Reuters poll from late February projecting the S&P 500 to rebound to 4,200 by end-2023; this should boost shekel demand among institutional investors. The likely end of the Fed’s tightening cycle in the coming quarters could further aid the shekel. However, the approval of proposed judicial changes in their current form poses a downside risk, as this could spark capital outflows and weaken the country’s credit rating. In contrast, the discarding of the reform would be positive for the currency, as it would likely reduce the risk premium that the shekel has accumulated in recent weeks.
On the judicial reform, Fitch Ratings analysts said:
“The reform could have a negative impact on Israel’s credit profile by weakening governance indicator or if the weakening of institutional checks leads to worse policy outcomes or sustained negative investor sentiment. Some countries that have passed major institutional reforms reducing institutional checks and balances have seen a significant weakening of World Bank governance indicators (WBGI), the most influential indicators in our Sovereign Rating Model.”
On the consequences for monetary policy, Goldman Sachs analysts said:
“As we think that the exchange rate plays a crucial role in shaping the inflation outlook in Israel and is one of the main monetary policy transmission channels, if the recent FX weakness persists, this will continue to cast a hawkish shadow over rate prospects in Israel and skews the balance of risks towards higher rates, in our view.”