The Goldman Sachs Group, Inc. Goldman Sachs Research A snapshot of the life of an ‘applied’ economist Kasper Lund-Jensen +44 (0) 20 7552 0159 kasper.lund-jensen@gs.com Goldman Sachs International December 2014 Investors should consider this research as only a single factor in making investment decisions. For Reg AC certification and other important disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html. Goldman Sachs Global Investment Research 1 The costs and motives behind FX interventions: the case of Bank of Israel Goldman Sachs Global Investment Research 2 Growth has slowed in Israel in recent years… driven partly by weak exports 10% 30% GDP growth 9% GDP grow th 8% 20% 7% 17.4% 15.1% 6.3% 5.8% 6% 15% 5.8% 10.4% 5.1% 5% 4.3% 3.0% 5% 3.2% 3% 2.2% 1.9% 0.9% 1.5% 0% -0.2% 1.1% -5% -2.2% 1% -10% 0% -0.1% 02 Export growth -11.9% -15% 03 6.5% 6.4% 4.6% 4.8% 3.5% 2% 8.0% 10% 4.2% 4% -1% Export growth 25% 04 05 06 07 08 09 10 11 12 13 14 02 03 04 05 06 07 08 09 10 11 12 13 14 Source: CBS, Haver Analytics Goldman Sachs Global Investment Research 3 The stagnation in Israel’s exports is driven by weak external demand… A weaker currency leads to higher exports after a few quarters (as the ‘quantity effect’ kicks in)… Impact on exports following a 1% depreciation of the real effective exchange rate …while stronger external demand increases exports instantaneously Impact on exports following a 1pp improvement (qoq ann.) in external demand Source: Goldman Sachs Global Investment Research, Haver Analytics Source: Goldman Sachs Global Investment Research, Haver Analytics Goldman Sachs Global Investment Research 4 … but is also a function of the strong Shekel appreciation 4.1 $/ILS 4.00 4.0 Gas production from the Tamar field (March 2013) $/ILS 30 per. Mov. Avg. ($/ILS) 3.9 3.8 3.7 3.6 3.5 3.45 Nov-14 Aug-14 May-14 Feb-14 Nov-13 Aug-13 May-13 Feb-13 Nov-12 Aug-12 3.3 May-12 3.4 Source: Goldman Sachs Global Investment Research Goldman Sachs Global Investment Research 5 The (labor intensive) low-tech manufacturing goods are particularly sensitive to Shekel appreciation The manufacturing sector is more sensitive to the real effective exchange rate… Impact on exports following a 1% depreciation of the real effective exchange rate … except high technology exports, which have a low price elasticity Impact on exports following a 1pp improvement in external demand Source: Bank of Israel Source: Goldman Sachs Global Investment Research, Haver Analytics Goldman Sachs Global Investment Research 6 The strong Shekel is therefore a significant concern for the Bank of Israel Bank of Israel’s “tool box” to fight FX pressures: A. Monetary policy (Cut rates by 300bp since mid-2011) B. FX interventions (Re-introduced this tool in April 2013) Policy mix has important implications for asset prices. Goldman Sachs Global Investment Research 7 The BoI has eased monetary policy since mid-2011… % BoI Policy Rate, lhs 4 3 2 1 0 08 09 10 11 12 13 14 15 Source: Haver Analytics, Goldman Sachs Global Investment Research Goldman Sachs Global Investment Research 8 … and the BoI re-introduced FX interventions as a policy tool back in early 2013 Bn USD Bn USD / % 100 90 4 80 70 3 Jul 08 - Oct 09 Avg: $1.8bn 60 50 2 40 30 1 20 10 0 0 08 09 10 11 FX Interventions (bn US$), lhs Low cost' FX gas program (scheduled) BoI Policy Rate, lhs 12 13 14 15 'Low cost' FX gas program QE FX reserves (bn US$), rhs Source: Bank of Israel, Haver Analytics Goldman Sachs Global Investment Research 9 Lower interest rates may fuel the booming housing market in Israel. Why has the BoI not relied more aggressively on FX interventions? 10% Real house price growth (per year) Since 2008Q1 8% Since 2012Q1 6% 4% 2% 0% -2% -4% -6% -8% IRL GRC ESP NLD DNK ITA USA JPN GBR PRT FRA FIN KOR NZL BEL AUS SWE NOR CAN DEU AUT CHE ISR -10% Source: OECD Goldman Sachs Global Investment Research 10 A build-up in FX reserves is likely to be driven by three motives: Flow motives: To boost competitiveness: FX interventions designed to weaken the currency may be used to stimulate economic growth via higher net exports. This motive is particularly strong in current account surplus economies, which naturally experience large capital inflows. Reduce FX Volatility: FX interventions can also be used to reduce exchange rate volatility that arises as a result of speculative behaviour or ‘overshooting’ effects (in both directions). Stock motive: Precautionary reserves: Large FX reserves reduce the likelihood of a ‘sudden-stop’ in capital inflows. Given the substantial economic costs associated with such 'sudden-stops', countries may seek to hold substantial foreign currency reserves and this could have been an important driver of the acceleration in FX accumulation from the mid-1990s. Goldman Sachs Global Investment Research 11 There are ‘fiscal’ costs associated with FX reserves… The costs have risen as the BoI has accumulated larger FX reserves Costs of FX reserves, per year, for different spreads Source: Goldman Sachs Global Investment Research Goldman Sachs Global Investment Research 12 …and the benefits diminish arguably after a certain point. 20 Gains, Costs 18 Costs (A: High carry) 16 Costs (B: Low carry) 14 12 Gains 10 "Marginal benefits equals marginal costs" 8 6 4 2 FX Reserves (% of short-term external debt) 0 0 100 Optimal FX reserves (A) ('High cost', e.g Turkey) 200 300 Optimal FX reserves (B) ('Low cost', e.g. Czech Rep) 400 Source: Goldman Sachs Global Investment Research Goldman Sachs Global Investment Research 13 Approach I: The ‘optimal’ FX reserves level (which balances the ‘costs’ and the precautionary benefits) depends on different factors The optimal level of FX reserves is inversely related to the ‘opportunity cost’ spread… Optimal FX reserves as a function of the opportunity costs …but depends positively on the degree of risk aversion. Optimal FX reserves as a function of the risk aversion Source: Goldman Sachs Global Investment Research, Jeanne and Ranciere (2006) CORRECT SOURCE Goldman Sachs Global Investment Research 14 The cost-benefit trade-off of FX interventions is less appealing today than it was back in 2008 The BoI’s FX reserves are above the optimal precautionary savings level. BoI’s FX reserves vs. optimal level Source: Goldman Sachs Global Investment Research Goldman Sachs Global Investment Research 15 Approach II: Quantifying the ‘precautionary’ benefits associated with FX reserves 1% Marginal effect on 'sudden-stop' probability* (following a 1pp increase in factor) 0% -1% -2% -3% 20pp increase in FX reserves (% of short-term external debt) -4% -5% CA surplus (% of GDP) FX reserves (% of short-term external debt) Currency overvaluation (in %) GDP growth (in %) Source: Goldman Sachs Global Investment Research Goldman Sachs Global Investment Research 16 Optimal level of CB FX reserves across EMs (note that the Czech National Bank recently introduced a ‘peg’ against the Euro) 500 450 400 FX reserves (% of short-term external debt) 'Optimal' level of precautionary reserves 350 300 250 200 150 100 50 0 Indonesia Malaysia Thailand India China Chile Mexico Colombia Brazil Peru Ukraine Turkey Poland Czech Republic Hungary South Africa Israel Russia Source: Goldman Sachs Global Investment Research, IMF Goldman Sachs Global Investment Research 17 Central banks in emerging markets have increased their FX reserves over the past decades 35 FX reserves (% of GDP) 30 Median 25 CEEMEA Avg AEJ Avg 20 LATAM Avg 15 10 5 0 1980 1984 1988 1992 1996 2000 2004 2008 2012 Source: Goldman Sachs Global Investment Research Goldman Sachs Global Investment Research 18 Shekel Outlook Goldman Sachs Global Investment Research 19 Shekel Outlook – where are we going from here? GS F’cast: $/ILS at 4.00 in 12 months. 4.1 $/ILS 4.00 4.0 Gas production from the Tamar field (March 2013) $/ILS 30 per. Mov. Avg. ($/ILS) 3.9 3.8 3.7 3.6 3.5 3.45 Nov-14 Aug-14 May-14 Feb-14 Nov-13 Aug-13 May-13 Feb-13 Nov-12 Aug-12 3.3 May-12 3.4 Source: Goldman Sachs Global Investment Research Goldman Sachs Global Investment Research 20 The Shekel continues to be overvalued according to our preferred valuation metrics 5.0 $/ILS $ILS > PPP: Israel price level is below the US USD/ILS PPP Exchange Rate GSDEER 4.0 $/ILS < PPP: Israel price level is above the US 3.0 96 98 00 02 04 06 08 10 12 14 Source: Goldman Sachs Global Investment Research, World Bank Goldman Sachs Global Investment Research 21 Institutional investors have bough large amounts of foreign assets in recent years (but since end-2012 they have been hedged). 25.0 % of total portf olio 20.0 21.9 22.8 12.6 12.8 21.0 20.5 17.6 15.9 15.0 13.6 11.4 10.0 9.9 10.9 11.4 8.6 7.3 7.6 10.8 12.4 12.6 12.5 8.8 8.4 5.0 D om es tic fi nancial investors foreign asset expos ure D om es tic fi nancial investors F X exposure 0.0 2006 2007 2008 2009 2010 2011 2012 2013 14Q1 14Q2 14Q3 Source: Bank of Israel Goldman Sachs Global Investment Research 22 Institutional investors' hedging demand weakened in August and, especially, in September. 2.0 1.5 Bn $ 1.4 Jan-Jul: Foreign as s et purc has es are f ully 'hedged' 1.0 1.2 1.6 0.5 0.9 0.5 0.0 0.2 0.5 0.0 0.8 0.6 -0.5 - 0.9 - 1.0 0.5 0.2 0.0 -0.4 -0.5 0.7 0.3 0.6 - 0.3 -0.3 - 0.2 -0.5 -1.4 -0.5 -1.8 -1.0 C hange i n FX derivati ve exposure -1.5 FX deriv ativ e ex pos ure ri ses in September T ransac tions in F X indexed ass ets T ransac tions in F X denom inated as sets -2.0 T otal FX transacti ons (i ncl. derivati ves) -2.5 Jan-14 F eb-14 M ar-14 Apr-14 M ay-14 Jun-14 Jul -14 Aug-14 Sep-14 Source: Bank of Israel Goldman Sachs Global Investment Research 23 Deflation risks have strengthened the BoI’s motive to weaken the currency… Goldman Sachs Global Investment Research 24 … and the BoI may hit the ‘zero lower bound’ and cut rates by 20bp (to 0.05%) in December or 2015Q1… Bn USD Bn USD / % 100 90 4 80 70 3 Jul 08 - Oct 09 Avg: $1.8bn 60 50 2 40 30 1 20 10 0 0 08 09 10 11 FX Interventions (bn US$), lhs Low cost' FX gas program (scheduled) BoI Policy Rate, lhs 12 13 14 'Low cost' FX gas program QE FX reserves (bn US$), rhs 15 Source: Bank of Israel, Goldman Sachs Global Investment Research Goldman Sachs Global Investment Research 25 … as the Shekel sell-off will not be strong enough to prevent headline inflation from moving into negative territory (due to fall in FX pass-through to inflation). 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