Israel - Life after Frenkel

Author: Nigel Dudley

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The local markets twitched nervously at the announcement in November of the resignation of Bank of Israel governor Jacob Frenkel, the man widely credited with curing the country's recalcitrant politicians of their addiction to inflation by insisting on an unbending monetary strategy. But, after an initial 1.2% drop, the shekel bounced back, even allowing the Bank of Israel to make a further 0.3% interest rate cut, and the stock market regained almost all of its losses within hours.

The sovereign bond, issued in June, and the recent $600 million issue for Israel Electricity are also performing strongly. These reactions are evidence that bankers and analysts are convinced that the legacy of Frenkel, who has dominated the economic landscape of the country through most of the decade, will live on long after he packs his briefcase for the last time on January 1.

Even though the temptation will remain for politicians to return to the old ways and reflate the economy in the run-up to elections - Frenkel's critics blame him for high unemployment - the majority view is that the culture has changed and there is an unshakeable consensus in favour of controlling inflation. This means that Israel is now better placed to deliver stable economic prosperity than for many years. Inflation is down to 2%, even though it will rise to nearer the top of the government's 3% to 4% range next year, the peace process has gained new momentum since the government of Ehud Barak took office earlier this year and the continued success of Israeli high-tech stocks on the Nasdaq index indicates the growing enthusiasm of international investors for purchasing Israeli paper.

But is it all held together by the narrow thread of Frenkel's anti-inflationary strategy? Israel's economy has long been plagued by price instability. Should interest rates fall too quickly or should the government pump too much money into the economy, investors would pull their money out of shekels and back into the dollar. Bankers fear the result would be a collapse in the value of the shekel, which would rapidly feed through into higher inflation.

"The test for the new governor will be his ability to allow some growth - we currently have negative GNP per capita - without letting inflation start to rise again," says one banker. That means the early months of the new governor's term will be subjected to close scrutiny to see if there is any evidence that the politicians are trying to wrest back the genuine independence that Frenkel won for the Bank of Israel. Any sign of a significant change of policy would undermine the country's recently established and hard-won reputation for fiscal and monetary prudence.

There will inevitably be some change of emphasis. "We will not get another Frenkel. He was like US Federal Reserve chairman Paul Volcker, except that he was much narrower in his view. We are inevitably going to get someone for whom inflation is a slightly lower focus," says one banker.

With unemployment at historically high levels of 8.7%, there is also pressure on the government to take a reflationary line. Chamber of commerce president Dan Gillerman says that Frenkel's "international stature and the importance he attributed to it led him to stubbornly and dogmatically pursue a destructive monetary policy that led the economy into a deep recession as well as the worst crisis in its history."

Not so long ago prime minister Barak would have been numbered among the critics, arguing during the election campaign that he would modify monetary policy. His finance minister, Abraham Baiga Shohat, had also clashed with Frenkel when he had held the post earlier in the decade. Barak has though pursued a cautious economic policy since his election and said, on Frenkel's resignation, that his successor would maintain monetarist policies.

Despite these reassurances, the reasons for Frenkel's surprise resignation after serving four years of his second five-year term are being subjected to close examination for any evidence that it had been provoked by a clash of political wills with the government. The consensus is that there is no hidden policy dispute.

Frenkel and his advisers insist that he was going because the "policy objectives he had set on taking office had been achieved in full". There is no doubt that the changes he has initiated have been considerable. Apart from the success in slashing inflation, Israel has abandoned its introverted isolation and become part of the global economy. Foreign exchange controls have been removed, the foreign currency market has been liberalized, the money and capital markets have been internationalized, the banking system has been partly privatized and made more robust and Israel has become an increasingly popular destination for foreign investors.

"While absorbing large-scale immigration, Israel has managed to integrate into the world economy with the utmost success, as is appropriate in the era of globalization. Israel is now poised for the renewal of sustainable growth, a process that is now under way," says Frenkel.

Israeli economists for the most part believe that Frenkel deserves his reputation for seeing off the coalition of businesspeople, politicians and voters, who had become inured to high inflation, and forcing them to accept that budgetary discipline, price stability, free markets and a smaller role for government should be the standards on which economic policy should be based.

Some analysts however point out that his success in reducing inflation can be exaggerated. According to Nadine Baudot-Trajtenberg, a senior manager at Bank Hapoalim: "The inflation figure for 1998 was artificially high because of the currency devaluation that year and this year it will be artificially low because of the revaluation early this year."

"Inflation next year will be more than 4%, which is at the top end of the government's targets. But his achievement has been to convince people that reducing inflation is an important target. He has changed the culture."

The main reason for Frenkel's departure, say bankers, is the government's plan to introduce a committee to oversee anti-inflationary policy in the central bank. Although this committee will carry greater weight because it will have members from different sectors of the economy and could be more effective in preserving the anti-inflationary gains, Frenkel is thought to have been reluctant to see a dilution of his power.

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Israel - Life after Frenkel

Author: Nigel Dudley

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