Judicial crisis – what the IMF and Greece can teach Israel

Israelis and foreigners are reportedly pulling spare cash out of Israel due to uncertainty about the proposed judicial reform in Israel. Consequently, the Shekel exchange rate is devaluing.
The International Monetary Fund has just published a report on what happened when another nearby country, Greece, experienced a heavy outflow of currency not so long ago, in 2015. In a nutshell, trade to and from Greece was severely affected (Guaranteeing Trade in a Severe Crisis: Cash Collateral over Bank Guarantees, WP/23/28 of February 24, 2023).

The Greek experience:
Banks guarantee international trade through letters of credit. This is critical for the flow of imports and exports. The IMF report estimates the impact on trade when the trade guarantor role is wholly disabled. The IMF focused on Greece, which imposed capital outflow controls to stabilize the banking system in July 2015. This drastic response, while ensuring the solvency of domestic banks, was associated with a significant disruption in trade. Capital outflow controls triggered an increase in the cost of trade for importers via the need for additional documentation for external payments and the need for full cash collateral for letters of credit. Following the imposition of capital controls, there was a risk Greece would be forced to exit the Euro and introduce its own weaker currency, which would hurt bank balance sheets. Consequently, foreign banks required full cash collateral to accept letters of credit from Greek banks – that is, Greek banks could no longer function as guarantors of trade on their own.

The IMF report shows that cash-constrained firms (start-ups?) suffered a 63% decline in their imports and, subsequently, exports. On average, Greek imports declined by 15%, exports declined by 8%.

What can countries like Greece do? The IMF report shows that EU support for banks via letter of credit guarantees helped imports recover while capital control policies existed.

Is Israel entering a period of economic difficulty similar to Greece, but without EU support? Will it affect not only trade but also investment? If so, Israeli corporate growth, profits and employment may be curtailed and tax revenues may be impacted. On the other hand, the Shekel may be partly cushioned thanks to the enormous gas finds in the Israeli part of the Mediterranean, So the Israeli government may be hoping to ride out the stormy political waters. Time will tell.

The Israeli experience:
Just in case anyone thinks the Greek experience cannot happen in Israel, it already has happened several times. Here’s our take.
First, Israel suffered hyper-inflation in the 1970s and 1980s, which affected all corners of the Israeli economy. The Israeli government’s solution of linking salaries, etc. to the consumer price index caused the inflation rate to further accelerate.

Second, the Israeli government’s alternative solution in 1984-1985 of moving over to the US dollar caused consternation and was stopped in its tracks (some say by US Secretary of State George Schultz, who was also an economist).

Third, exchange control stayed in force in Israel until Israel’s 50th independence anniversary in 1998. Israel’s Prime Minister then was Mr Netanyahu.

Fourth, in 2003-2004 Israel faced another big economic crisis when foreign venture capital (VC) funds refused to invest in Israeli tech companies for tax reasons. The Israeli Tax Authority argued that upon any exit (takeover) deal, US and other passive investors in VC funds were actually in the business of investing and should pay Israeli income tax at full rates (say 50%). This was out of step with the rest of the world which thought passive investors should only pay capital gains tax in their home country of residence, not income tax in Israel.

The potential outcome was double taxation approaching 80%. Not surprisingly, billions of VC dollars went into newly formed American holding companies that also acted as marketing companies. So Israeli tech, trade and investment were hit hard and the Finance Minister (Mr Netanyahu) had to relent.

A small country with enemies can’t stay out of step with the rest of the world for very long. You’ll never walk alone, to quote Liverpool football fans.

What next for Israel?
Things look frozen, but spring is approaching. The first signs of a thaw could be emerging with signs of compromise from the Israeli government. This author’s opinion is Israel could use a written constitution like the USA. President Herzog has proposed a 5-point plan which includes a new basic law to act as a constitution and help achieve separation of powers plus checks and balances.

Nobody seems to favor the Greek experience.

As always, consult experienced advisors in each country at an early stage in specific cases.
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(c) 27.2.23 Leon Harris

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