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Fears of constitutional crisis drive shekel to three-year low

The shekel fell to the lowest level in more than three years as hopes for a judicial overhaul compromise to prevent a constitutional crisis dissipate and amid growing tensions ahead of a high-profile High Court of Justice hearing next week.

The shekel depreciated more than 1% on Thursday to around 3.85 against the US dollar, trading around the weakest since March 2020. Political uncertainty around the government’s contentious judicial overhaul has seen the currency drop more than 9% against the greenback since the start of the year. The Tel Aviv Stock Exchange’s benchmark TA-125 index and the TA-35 index of blue-chip companies declined 0.7%, while the TA index of the five largest banks was down 1.4%.

Local analysts and economists linked the sharp depreciation of the local currency over the past day to a combination of two factors: heightened domestic political turmoil and a decline in world stock indexes.

“People are losing faith in compromise efforts on the judicial overhaul and are investing more abroad, while local institutional investors are increasing their exposure to foreign assets and foreign currency as they factor in a higher risk premium for the country,” Jonathan Katz, chief economist at Leader Capital Markets, told The Times of Israel. “In addition, global stock markets are down which means that local institutions see their foreign currency exposure to overseas markets fall and so technically they need to sell shekels and buy dollars to balance their exposure ratio.”

Earlier this week, President Isaac Herzog put together a framework proposal to act as the basis for talks between the coalition and opposition over the former’s controversial plan to drastically overhaul the judiciary. The proposal was met with pessimistic responses from coalition and opposition lawmakers with both sides accusing each other of not being prepared to resolve the political crisis. On Wednesday, Herzog urged political leaders to engage in dialogue to end what he called an “acute constitutional” crisis roiling society.

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The overhaul plan has faced months of weekly mass protests alongside warnings about the economic damage. The main concern among the business and tech community is that the proposed judicial overhaul will erode democracy and weaken checks and balances, which in turn will make venture capitalists and other money makers leery of investing their money in the country, triggering an outflow of funds. Foreign investment in Israel has already dived by 60% in the first quarter of this year, according to a report published by the Finance Ministry on Wednesday.

Workers from the high-tech sector protest against the proposed changes to the legal system, in Tel Aviv, on February 7, 2023. (Tomer Neuberg/Flash90)

The shekel is also losing ground ahead of a September 12 High Court hearing on petitions against the reasonableness law — part of the government’s controversial judicial overhaul — which bars courts from intervening in government and ministerial decisions based on their “reasonableness.” Should the court accept the petition and strike down the legislation — an amendment to a quasi-constitutional Basic Law — but the government then rejected the ruling, it would create an unprecedented constitutional crisis.

Later, on September 28, a separate hearing will be held on petitions against a law shielding prime ministers from forced recusal.

Fears of a constitutional crisis and continued internal tension in Israel could lead to further depreciation in the coming days and weeks, said Leader’s Katz, raising the odds of interference in the foreign exchange market by the Bank of Israel to stabilize the shekel.

“Until now the Bank of Israel has been adamantly opposed to interfering in the market through the sale of dollars, despite sitting on huge foreign currency reserves,” said Katz. “Nuances have changed in recent statements with the central bank saying it has ammunition in its arsenal suggesting that they are not ruling it out, but I don’t think that they are there yet.”

On Monday, the Bank of Israel left interest rates unchanged indicating that borrowing costs are high enough to cool down consumer prices. At the same time, the central bank warned about high volatility in the shekel exchange rate since the start of the year, adding that the local currency has remained one of the weakest currencies in the world, fueling inflation pressure. A weaker currency makes imports of goods to Israel more expensive.

“The depreciation of the shekel in recent months is contributing to an increase in the pace of inflation, and the path of the exchange rate in the coming months will have an impact on inflation dynamics,” the central bank said.

Bank of Israel Governor Amir Yaron attends a cabinet meeting at the Prime Minister’s Office in Jerusalem, on February 23, 2023. (Ronen Zvulun/Pool/AFP)

In recent months, Bank of Israel governor Amir Yaron cautioned that local political uncertainty has led to excess depreciation of over 10% in the local currency translating into excess inflation of at least 1% to 1.5%, while indicating that if the trend continued the central bank would need to raise borrowing costs to rein in price growth. Since interest rates hit a record low of 0.1% in April 2022, the central bank has hiked borrowing costs to 4.75% in May to bring down rising inflation.

“Even if the Bank of Israel will decide to intervene, which makes a lot of sense, we are still likely to see another interest rate hike in October as it becomes increasingly more challenging for the central bank to bring inflation back to its target range,” said Katz.

Adding to the political turmoil and weakness in the currency is speculation in recent days whether Yaron, who is due to end his term at the end of 2023, will ask to extend his tenure and whether lawmakers would want to reappoint him. Yaron has been critical of the advancement of the judicial overhaul in its proposed format, warning about its economic repercussions.

Prime Minister Benjamin Netanyahu met with a delegation from Moody’s Investors Service on Wednesday, ahead of the rating agency’s update on Israel’s sovereign country rating expected next month, Channel 12 reported.

Back in July, Moody’s warned about “negative consequences” and “significant risk” for Israel’s economy and security situation following the passage of the first bill of the judicial overhaul. Earlier this year, the agency lowered Israel’s credit outlook from “positive” to “stable,” citing a “deterioration of Israel’s governance” and upheaval over the government’s bid to dramatically overhaul the judiciary.