SAVING THE PROVIDENT FUNDS AT THE EXPENSE OF INCREASING SHORT TERM
INTEREST RATES
(Article by Nehemia Strassler, "Ha'aretz", Feb 27, 1995, p. A1)
Yesterday, in the Cabinet meeting, the Bank of Israel Governor gave one of
his best speeches ever on the importance of the war against inflation.
Ministers who participated in the meeting said that his speech took the
wind out of his opponents' sails and was one of the reasons that Jacob
Frenkel won his main fight: interest rates will not fall, today.
Despite this, on the secondary front that of provident funds the
Governor sent up a white flag. He agreed that on this Tuesday, the Bank of
Israel will buy NIS 250 million in Short-Term Government Bonds on the
bourse. In other words, the Bank of Israel will intervene with a large
intervention in the bonds market.
What is the purpose of this intervention?
The purpose is to prevent a continuation of a fall in the price of bonds,
which are held for the long term by the provident funds. When an investor
in a provident fund sells part of his holdings in the fund, the fund is
forced to sell bonds on the bourse, in order to have available cash to pay
the investor. If a large number of investors sell their holdings in
provident funds, the price of bonds falls, and then the funds show losses
- - which forces other investors to sell their holdings in the funds, and
so forth and the funds' situation grows worse.
If so, what is bad about the Bank of Israel's intervention?
This intervention is extremely problematic. When the Bank of Israel buys
bonds from the bourse, this means that new money is interjected into the
economy. This act is a direct contradiction to the bank's policy of
fighting inflation, which is Frenkel's main point. Inflation is fought by
increasing interest rates and decreasing the amount of money in
circulation, and here, Frenkel himself, will be injecting new money into
the economy. And more than this, until now the market has proven itself
strong and stable enough to deal with the demand. In fact, all of the
excess demand was well absorbed last Wednesday and Thursday, and yesterday
(Sunday, 26.2.95) the demand for bonds was even greater all without the
intervention of the Bank of Israel. Thus, it is not clear why the Bank of
Israel hurried to announce its intervention.
How is the Bank of Israel settling the conflict?
The solution devised by the Bank of Israel is on one hand to inject money
to buy long-term bonds, yet on the other hand to absorb all of this new
money by offering a larger amount of short-term loans, which will be sold
to the public with high yields. In other words: the Bank of Israel wants
to lower long-term interest rates at the expense of short-term interest
rates.
What is the political advantage of this step?
The political advantage is that the Finance Minister and the Israeli
Government hope that the Bank of Israel's intervention in the bonds market
will calm the market, so that the public will stop selling provident funds
since the public-political pressure is coming from the direction of
pension fund holders.
But intervention by the Bank of Israel will exact a heavy economic price.
It will bring about an increase in short-term interest rates, an injection
of dollars by speculators from abroad at a faster pace, and severe
fluctuations and general instability in the financial and capital markets.