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Bank of Israel: Political uncertainty worsening inflation

The central bank's Financial Stability report for the first half year states that the judicial overhaul legislation "caused a rise in uncertainty that was expressed in negative sentiment towards Israel.”

The Bank of Israel’s Financial Stability Report, published twice a year, covers the risks to financial stability in Israel and the central bank’s assessment of the likelihood of them materializing, the likely effects if they do materialize, and whether the financial system will withstand these effects.

The report for the first half of 2023 published today presents the harm to the economy and to the financial sector resulting from the political crisis over the judicial overhaul.

"Summing up the developments in the first half of 2023, the local financial system remained stable," the report says in its introduction. The main reasons for this stability are the financial strength of the banking system and the insurance companies. All the same, the financial system was affected by several factors: continued tightening of monetary policy, the slowdown in economic growth in Israel and globally and the rise in interest rates in Israel; and by the uncertainty about the consequences of the changes being legislated in the system of justice for the economy and the financial system. The report says that if these factors strengthen, they will represent a challenge to the stability of the system in the future.

"The financial system in Israel was affected during the period by the legislative processes concerning the system of justice being introduced by the government," the report states explicitly. "These processes caused a rise in uncertainty in the business sector and for important players in the financial markets in Israel and around the world, uncertainty that was expressed in negative sentiment towards Israel."

As it has done in the past, the Bank of Israel points out in the Financial Stability Report that the economic literature stresses "the risks involved in permanent structural changes perceived as weakening the independence of the institutions." As evidence of this phenomenon, the Bank of Israel cites the credit rating agencies that have warned of the possible consequences of the legislation and the lack of a consensus about it.

The report mentions that, during the first half of 2023, the Tel Aviv 125 stock index fell 2.1% while all the main stock indices around the world rose; and the shekel depreciated by 2.7% against the US dollar while the dollar weakened against other currencies during the period. According to the report, the extra impact on shekel exchange rates was about 10%, and also contributed to inflation.

"The uncertainty concerning the legislation raised the economy’s risk premium and was accompanied by depreciation in the exchange rate that contributed to the rise in inflation, by a decline in stock prices, and by higher volatility on the foreign exchange market and financial markets," the report states.

The main fears: The tech sector and exchange rates

In Bank of Israel report focuses on two main areas that it says will be highly impacted by the consequences of the legislation: the technology industry, and the foreign exchange market.

First of all, the report points out the importance of the technology sector to the Israeli economy: its large share of GDP, exports, and state revenues. The bank shows that, from the second half of 2022, there was a marked decline in investment in technology companies globally, and in Israel, but that while the data show recovery in capital raising elsewhere in the world, in Israel the decline has been maintained.

The bank states, however, that the sources of finance for technology companies are outside the local banking and financial systems, and that therefore the direct effect of the harm to the balance sheets and financial position of companies in this sector on the financial system will be limited.

On the foreign exchange market, the report states: "The developments in the foreign exchange market during the surveyed period mostly stemmed from the dynamic in the legislative processes." Governor of the Bank of Israel Amir Yaron has said similar things in the past. In addition, the depreciation trend in the shekel that began in December 2022 was also accompanied by a sharp rise in exchange rate volatility. Until then, the bank says, volatility in shekel exchange rates was low by international comparison.

The bank’s analysis of foreign exchange trading in the first half of the year shows that there were net purchases of foreign currency mainly by financial institutions. Unlike their behavior in the past, the institutions continued to buy foreign currency and reduce the hedging of their overseas investments despite rising stock prices on overseas markets since the beginning of the year. In the past, the shekel exchange rate has been positively correlated with rises on overseas stock markets, as Israeli financial institutions sold foreign currency and bought shekels to balance the currency exposure resulting from the rise in the value of their foreign currency-denominated assets.

Monetary policy

Monetary policy also naturally had an effect on financial stability in Israel. "Continued monetary tightening, required because of high inflation, low expected global growth, challenges in the global banking system, and the slowdown in the technology sector, increase the probability of a degree of slowdown in economic activity, as reflected in the growth forecast," the report states.

The report cites the latest forecast of the Bank of Israel Research Department, from July, which projects growth in GDP of 3% in both 2023 and 2024. It also points out that inflation in Israel remains high, and that inflation expectations are currently around the upper limit of the Bank of Israel’s target range of 1-3% annually.

On fiscal policy, the report states that tax collection up to May was lower than the forecasts accompanying the state budget. Nevertheless, it says, "the level is still high looking at the long term, and the decisions by the government so far can be expected to lead, according to current revenue forecasts, to a fairly low fiscal deficit of 1-3% of GDP in 2023."

The bank sums up the main risk to its economic forecasts as the materializing of the scenario in which legal and institutional changes will be accompanied by a rise in the country’s risk premium, further depreciation of the shekel, damage to exports, and a decline in local investment and in private consumption. Should this risk materialize, the bank estimates that the hit to Israel’s GDP in each of the coming three years will be between 0.8% and 2.8%.