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Israel’s local markets are going through a rough period. During the past four months the Bank of Israel has had to intervene repeatedly in the market to support the price of government bonds. Research published by Bank Hapoalim on August 1 compared the central bank’s action to US Federal Reserve Bank intervention to preserve the financial system’s liquidity in the 1987 crash. Central bank interventions, under the government’s safety-net action, have already exceeded IS1 billion ($305.8 million). The stock market has also had a difficult ride. Since the beginning of this year the Mishtanin index of the 100 most liquid shares traded on the Tel Aviv Stock Exchange has fallen by 14.5%. Some Israeli investment funds have fallen by over 35%. But jitters over Binyamin Netanyahu’s recently formed coalition government and worries over a stalling Middle East peace process are not the only cause of the market’s retreat. And, although the Tel Aviv Stock Exchange has been a popular destination for emerging market funds since Morgan Stanley included Israel in its index of emerging markets in March 1995, neither is it a foreign investor withdrawal that is bringing the market down. The Israeli stock and bond markets are still driven largely by local forces and the underlying problems are structural. Israel’s capital market is dominated by a powerful banking sector. It lacks institutional investors. And liquidity on the Tel Aviv Stock Exchange is poor. Following a crisis in the country’s savings funds involving massive withdrawals, the government, worried by the prospect of a liquidity shortage, intervened in the bond markets in July to provide a safety net. The Bank of Israel announced that it would buy back between IS250 million and IS500 million of government bonds to meet fund redemptions. But by the end of July central bank governor Jacob Frenkel had announced that the bank would buy up to “IS15 billion if necessary”, in order to guarantee the liquidity of the financial system. In the wake of the crisis, the government is also considering how best to tackle wide-ranging reform of the capital markets. So far ideas have ranged from creating a single regulatory body to oversee the capital markets and a special economic court to adjudicate in cases of financial wrongdoing to the adoption of international accounting standards. Conversations about Israel’s capital markets in Tel Aviv, the headquarters of most of Israel’s private sector, and Jerusalem, where the government has its seat, generally start with the problem of the savings funds. Provident funds (essentially redeemable pension funds) have posted negative returns for the last two years. “For years the funds registered a guaranteed return thanks to heavy subsidies from the government,” says Shimon Ravid, chief financial officer of Bank Hapoalim, Israel’s largest bank. “But as the government gradually reduced subsidies to the provident funds, managers were forced to invest in the stock market. But when the market started edging downwards at the beginning of 1994, fund redemptions began to rise as savers, accustomed to guaranteed returns above inflation, saw their investments falling for the first time in decades.” The problem of provident fund redemptions has been exacerbated by the Bank of Israel’s aggressive stance on inflation, which has kept real interest rates at around 5%. Investors have simply switched out of their maturing provident funds and placed their money in high-yielding bank deposits. It’s raining redemptions What started as a trickle of redemptions in 1994 has become an unstoppable torrent. In April and June this year, monthly redemptions of provident funds topped IS1 billion for the first time. In August the provident funds were hit by a staggering IS2.2 billion in redemptions. Ravid describes the problem of provident fund redemptions as a “vicious circle”. Weakening bond prices undermined the performance of the provident funds, causing investors to redeem their policies. To meet these redemptions fund managers sold heavily in the government bond market, further weakening bond prices and accelerating the rate of redemptions. Union Bank of Switzerland (UBS) research describes the Bank of Israel’s intervention in the bond markets as “solely directed at patching up the symptoms rather than the causes”. Although government bond prices remained stable throughout September, the government is still worried that further provident fund redemptions could trigger another wave of government bond sales. The government’s announcement at the end of July that it would set up a committee to recommend structural changes to the Israeli capital markets was a step in the right direction. Headed by David Brodet, director general of the treasury, the committee’s main brief was to find ways to channel savings back into the local capital market. Israeli savers are sitting on more than $50 billion in liquid assets, equivalent to about 30% of the country’s domestic savings. To encourage them to reinvest in the capital markets the Brodet committee’s report recommends reweighting the tax structure to favour long-term investments and savings earmarked for retirement. But with real interest rates at around 5%, the proposals will offer little incentive to investors and fund managers to invest in a falling stock and bond market. Yoav Levy, managing director of Sahar Securities in Tel Aviv, says: “I had high hopes for the Brodet committee. But the 30-day timescale they gave for the report was unrealistic.” Rather than seriously rethinking the structure of the markets, the commission appears to be bogged down in a political row over the taxation of short-term savings. Fresh in the minds of the population was Netanyahu’s pre-election promise: “Read my lips. No new taxes.” Even though the reformers suggest that taxing short-term savings is reweighting rather than increasing the tax burden, the reforms quickly became a highly politicized issue. Although the reforms have stumbled on the tax question, this looks like a temporary setback. In an interview with Euromoney, Frenkel declared broad support for the proposals: “By and large I support the Brodet committee’s recommendations especially those that aim at increasing the flow of long-term institutional savings through the capital market. In the past a large proportion of long-term institutional savings did not go through the capital market because the government has been providing bonds directly to pension funds which secured a real return. This is one reason why our capital markets have become too narrow. There are some other recommendations involving the tax structure of savings, but the discussion is still not complete”. Part of the problem is the timing of the reforms. The government and leading bankers like Eitan Raff, chairman of Bank Leumi, Israel’s second-largest bank by equity, are worried that a combination of a volatile market and a tax on short-term deposits could drive liquid deposits outside the financial system, possibly into consumer goods. (A drive down Tel Aviv’s beach strip shows that it is no longer exports that are driving economic growth but consumer spending, largely on imports. “You can get any type of car here,” boasts a taxi driver, as he points out that most cars on the strip bear this year’s number plates.) Palliatives not panaceas But Tel Aviv’s brokers think the government is using a macroeconomic excuse to sidestep politically sensitive issues. Election promises and an increasingly tense political situation surrounding the peace process have led to scepticism about the coalition government’s ability to push through tough economic reforms. “Nobody cared about the structural problems in the markets until the provident fund crisis,” says Levy at Sahar Securities. “But now they are trying to cure a cancer with aspirin.” The Brodet committee has been criticized for ignoring the petition to bring in external management consultants. A Tel Aviv broker recalls a phone conversation with the committee in which he was asked: “What can McKinsey teach us about our own capital market?” Eventually the government must tackle the structural imbalances in the market. “The root of the problem lies in [government] bond supply,” says David McWilliams, an analyst at UBS in London. “Falling government revenues and increasing funding requirements have put huge pressure on the fragile bond market.” Israel’s government bond market overshadows all other instruments traded on the Tel Aviv Stock Exchange. Government domestic issues rose from IS9.3 billion in 1990 to IS23.2 billion in 1995. At the end of 1995 the market capital of the government bond market was IS103.8 billion, compared with a corporate bond market of just IS8.1 billion and an equity market of IS96.5 billion. This oversupply of government bonds has distorted the market’s pricing mechanism. “By issuing subsidized bonds the government has created a floor on the cost of funds of about 4.5% above inflation,” says McWilliams. As a result world-class Israeli companies have been unable to compete for funds in the domestic market. Not one private-sector company tapped the domestic bond market in the whole of 1995 (see chart). As the Brodet committee’s report puts it: “Arrangements that provide these players with subsidized, non-tradable government bonds … deprive the capital market of a crucially needed inflow of sources for business-sector investments.” Many Israeli companies have therefore chosen to list abroad and Israeli companies rank second, outdone only by Canadian companies, in foreign listings in New York. There are now over 80 Israeli companies listed abroad. The government, burdened by cost, wants to scale back its high-yield bond issues. But given that 95% of pension fund assets are invested in special high-yield bonds, any cuts will have to be explained carefully to the Israeli population. For the moment the markets are paying the price. Says one Tel Aviv broker: “It’s right that the government has supported the pension funds, but it should not have used the market to do it.” Radical changes are needed, but for the moment it’s a case of evolution, not revolution. “It took 40 years for the Israelites to get from Egypt to Israel,” quips a government official. “The question now is whether it’s going to take us as long to reform the pension funds.” The 30-day period given to Brodet’s committee to deliver its recommendations did not give it enough time to come up with long-term solutions. Although its report considered longer-term reforms such as the creation of a single body to regulate the capital markets, and the creation of a court for economic affairs to specialize in cases involving securities, banking and insurance, these recommendations appear to have been put on hold. The report states: “In view of its wish to complete its work by its stipulated deadline, the committee preferred to overlook the broad question of the financial structure of the financial-services sector within this timeframe.” The report suggests that another committee should be established to look at the crucial issue of “centralization” in the Israeli market. Tel Aviv’s non-bank brokers claim that the high level of centralization in the financial system has stifled competition in the markets. Says one brokerage director: “The banks used their capital to consolidate power. Their decision-making influence on companies is a real problem for the Israeli economy. I believe banks should own not 20% but 0% of non-financial companies.” In the words of the Brodet committee: “The bulk of market activity is controlled by the banks and their affiliated provident and mutual funds.” What the report does not point out is that the government is still the most powerful shareholder in Israel’s banks. Although the government has tried to curb the influence banks wield outside the financial sector, the Israeli bank lobby remains powerful. (Israel’s banks were set up along with the state of Israel to create a modern economy.) Bank Leumi was recently allowed to increase its stake in investment company Africa Israel to 56%, in a control battle, contrary to the government ruling that banks should reduce their stakes in non-financial companies below 20%. Although Leumi intends to sell the Africa Israel stake before the end of the year, the move was considered indicative of the continuing influence of Israeli banks. This concentration of ownership has made Israel’s market illiquid. “It’s a great market,” says McWilliams, “but it’s not traded enough.” Most of the exchange-traded companies are closely held by majority investors. Something between 70% and 75% of shares of listed companies are thought to be held by families, banks or institutional funds. And 65% are held by controlling interests. This makes it a hard market to get into. “Raising a 10% stake in a company is not always easy,” says Ronit Harel, vice-president of the Tel Aviv Stock Exchange. Tel Aviv bankers joke that their investors don’t sleep at night if they own less than 75% of the companies they invest in. Encouraging provident funds to become active in the stock market would help increase liquidity. At the moment, less than 15% of the provident funds’ assets are invested in equities. One problem is the size of the savings funds relative to equity market capitalization. Provident funds alone hold over IS90 billion in assets; the stock market has a capitalization of only IS96 billion. So the market is simply too shallow to accommodate the funds. Tzipi Samet, deputy commissioner of capital markets, insurance and savings says: “Every move the funds make affects the market.” The Knesset has approved the first stage of a bill to break up the funds into smaller units. The idea of putting the funds’ management contracts out to tender has also been discussed. Funds of a more manageable size would probably find it easier to invest in the local stock market. Samet is optimistic, arguing that “the reforms signal a move towards improving the structure of the market”. More foreign participation in the stock market would also help to create liquidity. US investment banks including Lehman Brothers, Salomon and Bankers Trust already have offices in Tel Aviv. According to UBS research, foreign investment makes up 10% of Israeli stock market investment. To encourage more foreign players, the Brodet committee recommends allowing foreign investors to become Tel Aviv Stock Exchange members. Getting the privatization programme back on track would also help bring foreign investors into the market. But in May the government cancelled a privatization issue for the third largest bank by assets, Mizrahi Bank, and it has been struggling to find buyers for Bank Hapoalim. First-half 1996 privatization receipts came to just $95 million, compared with $598 million for the whole of 1995 and $1.4 billion in 1992. One of Netanyahu’s first moves as prime minister was to bring the Government Companies Authority, previously under the finance ministry, under the direct control of the prime minister’s office. Tzipi Livni, the new head of the GCA and formerly a top Tel Aviv commercial lawyer, has been charged with rethinking the privatization programme. She has until the end of this month to come up with a new plan. Its successful relaunch could be just the fillip needed to restore confidence in Israel’s struggling markets. * Israel’s government bonds crowd out other paper new issues 1993 to June 1996Since 1991 professor Jacob Frenkel has been Israel’s central bank governor. But that is not his only role. He is also the government’s chief economic counsel, and an economist in his own right. Before 1991 he was director of research at the IMF. Commentators on the Israeli economy say his willingness to remain as governor gave Binyamin Netanyahu’s government the credibility it needed to survive the first few days following the election. Euromoney interviewed professor Frenkel in Jerusalem It is rumoured that you were offered the job of finance minister in the new government. Is this true? Yes. Why did you refuse it? I told the prime minister that I would prefer to stay in my position as governor [of the Bank of Israel]. I am not a political man and I prefer to be in a position where professionalism plays a greater role in daily decisions than it does in the role of minister of finance, who by the nature of his job has to make many more compromises. Does your current position as Bank of Israel governor and economic adviser to the government involve a conflict of interest? Not necessarily. The law of the Bank of Israel, which was drafted many years ago, contains this dual role for the governor. He is, on the one hand, the governor of the Bank of Israel, in charge of monetary policy and supervision. But he is also the chief economic adviser to the government. There is an apparent duality here because to maintain independence from the political framework, one probably would like to have a governor who deals only with monetary policy without acting as an adviser to the government. On the other hand, in order to maintain greater relevance and impact on economic policy, we want the governor to be able to influence the government’s policy decisions in the broader range of economic issues, particularly the budget. The art is in finding a balance between these two roles. Every governor has found his own balance. I think I have found my own satisfactory balance. One has to be clearly independent in the conduct of monetary policy, and, at times, ignore the role of government adviser. But when it comes to advising the government on cardinal issues I find it both challenging and useful to be able to express my views in the cabinet on the budget and on a broad range of economic issues, including structural reforms. Do you have more or less influence on economic policy than your predecessors? I can’t make this assessment. Every governor has found his own way. During the past five years I have served Mr Shamir, the late Mr Rabin, Mr Peres and now Mr Netanyahu. Each prime minister operates differently, but I found the balancing act between the two roles of the governor as challenging as possible under each of those four prime ministers. |
