INFORMATION NOTE I
Israel: Targets and Instruments of Monetary Policy and of Official Transactions
A. Targets and Main Instruments
Short and intermediate targets
25. The short-term target for monetary policy is reflected in a daily auction of a fixed quantity of net credit to commercial banks (which can be positive or negative) to ensure that domestic monetary conditions are consistent with the preannounced monthly official interest rate.
26. The intermediate target is to meet the inflation target while keeping the exchange rate (a basket heavily weighted toward the U.S. dollar) trading within a band. Israel has had an inflation targeting regime since December 1991. Each fall, the government sets a target for the increase in the overall CPI for the 12-month-to-December of the following year, and the Bank of Israel (BoI) is to conduct monetary policy so as to meet this target. Between 1992–94, a point estimate was announced; between 1995–98 a range of width 2–3 percentage points was announced. For 1999, a point estimate set at 4 percent has been announced. The medium-term target is to achieve an annual inflation rate around the OECD average by 2001. Since 1998, a biannual Inflation Report is published by the BoI. Starting from 1999, the BoI is required to report quarterly to cabinet on any projected deviation in inflation by more than 1 percentage point from the target, and how monetary policy will be adjusted accordingly.
27. Israel has had a crawling band exchange rate system since 1991. As of June 7, 1997, the currency basket rate fluctuated within a 28 percent band without a central rate; the depreciated limit increased at 6 percent per annum, while the appreciated limit increased by 4 percent per annum. On August 6, 1998, the rate of change in the appreciated limit was slowed to 2 percent in recognition of the narrowing inflation differential between Israel and its major trading partners.
Main monetary policy instruments
28. Main effective instrument is changes in the monetary and the bank deposit rates as described below. Changes in official interest rates are considered monthly after examination of actual CPI data, private sector inflation expectations (derived from the differential between one-year nominal and CPI-indexed government securities), growth of Ml, changes in asset prices, fiscal policy, and real sector developments. The Governor has the authority to change official rates and does so after consultation with BoI staff; there is no central bank board.
29. For open market operations, the BoI uses 3-, 6-, and 12-month zero-coupon, nonindexed treasury bills (termed Makam). These securities are provided to the BoI by the Ministry of Finance (MoF) and are subject to a legal ceiling (currently a par value around NIS 25 billion). The proceeds can not be used to finance the budget deficit. The ceiling is raised twice per year at a rate equal to the growth of the overall CPI or of M1, whichever is larger. Due to the need to mop up liquidity in the face of strong capital inflows in 1996–97, virtually all of these bills have been sold by the BoI into the market (NIS 22.1 billion at end-November 1998). Daily trade in Makam occurs and its yield serves as a benchmark for pricing longer-term, variable rate, nonindexed securities as well as for determining inflation expectations; individuals are exempt from tax on earnings from T-bills.
30. The discount window loan rate (which also serves as the main indicative rate of the stance of monetary policy) is actually a ladder of windows, with a limited amount of credit available at each window (there is no formal discounting of bills and bonds). Each window carries a progressively higher interest rate (the lowest window is set at 0.7 percentage points below the announced official interest rate, with steps of 0.1 percent thereafter), with perfectly elastic supply at the highest rate which is set at a punitive level (around 48 percent). The amount of credit outstanding through the discount window is determined by commercial banks. Treasury bills and bonds of any maturity may be placed at the window. At end-November 1998, total loans through the (lower) window totaled NIS 0.8 billion; commercial banks tend to use these windows as a source of liquidity which they can rely on independent of the outcome of their bids at the monetary auction. In principle, each bank's eligibility to access a given step is determined by its share in total banking system assets, but interbank trading in practice renders this allocation issue irrelevant for system operating characteristics.
31. The monetary loan auction (introduced in 1987) functions as a repo-like facility; when in operation, it is a daily auction of overnight and week loans to commercial banks collateralized by government bills and bonds. The quantity offered is fixed by the BoI, and the interest rate is determined through the auction by the bidding commercial banks. The BoI attempts to maintain domestic liquidity conditions so that on average the (geometric average) auction yields are close to the (simple) monthly announced official rate. In 1998, the daily and weekly monetary auctions were suspended since the banking system was experiencing excess liquidity.
32. In June 1996, to augment its sterilization facilities, the BoI introduced a bank deposit facility, under which liquidity is absorbed through auctions among commercial banks for the right to deposit for one day, one week, one month, and three months funds with the BoI. All bids are accepted subject to the predefined quantity—which again is set so as on average to meet the monthly announced official (simple) interest rate—and the average bid rate is published. In general, either the monetary loan auction or the deposit auction facility is open at any one time. The outstanding balance of this facility at end-November 1998 was NIS 35.5 billion.
33. The BoI also has a shekel/dollar swap facility to augment its sterilization facilities (introduced in August 1995). Each week the BoI offers to commercial banks in a discriminatory tender a fixed quantity of dollars for shekels with an advance agreement to repurchase the dollars one month later. The conversion in both directions is made at a fixed predetermined exchange rate. Since the transaction involves no risk of a change in the exchange rate, the BoI pays a return equal to the difference between the tender-determined shekel yield and dollar interest rates. The outstanding stock at end-November 1998 was around US$1.4 billion.
B. Direct Instruments
34. During the 1980s and 1990s, the extensive direct controls on credit were virtually removed. A limited amount (NIS 20 billion) of direct subsidized lending for housing and export promotion is still outstanding. It is financed from a stock of government funded earmarked deposits.
C. Reserve Requirements
35. Reserve requirements are set uniformly on all banks. Current rates are 6 percent on demand deposits and time deposits of 1–6 days, 3 percent on time deposits of 7–365 days, and zero on longer time deposits. There is no distinction between domestic and foreign deposits (reserve requirements for foreign deposits are made in shekels as of January 1, 1998); there are no reserve requirements on nonresident foreign currency deposits held in Israel. The Governor has the authority to change reserve requirements for up to three months; after that time, the change has to be approved by legislation.
36. Banks are required to meet the reserve requirement ratio on an average basis over a reserve month, which is either four or five weeks long (Thursday to Wednesday) corresponding as closely as possible to a calendar month. Weekly reserve deficiencies of up to 12.5 percent are averaged with surpluses in other weeks within the reserve month. Weekly deficiencies in excess of 12.5 percent are fined at the highest discount loan rate. Cash deposits at the BoI are the only eligible asset for reserve requirement purposes. No interest is paid on such reserves.
D. Central Bank's Standing Facilities
37. Short-term credit of up to one month is available through the discount window and monetary auction facility as described above.
E. Other Instruments Primary market operations
38. As the fiscal agent of the government, the BoI sells all government securities on the government's behalf at weekly auctions with the quantity determined by the government. Each accepted bidder (a bank, stock exchange member, mutual fund, insurance company, provident fund, or pension fund) pays the price it offered. The BoI advises the government on types of securities and maturities to issue.
39. There are three types of government bonds offered. Indexed bonds include the Sagi (fixed coupon real interest that can not exceed 8 percent and which is paid yearly for a period of 5–6 years, with principal and interest indexed to the CPI), Galil (as for the Sagi but for periods of 7–20 years), and the Kfir (interest paid twice a year based on net daily yield set by the stock exchange for CPI-indexed bonds of between 3–5 years; these bonds are issued for a period of 4–25 years). Unindexed bonds include the Shahar (fixed interest paid yearly for a period of 1–20 years) and the Gilon (variable interest paid twice a year based on net daily yield, set in the secondary market on Makam treasury bills of between 3–12 months; these bonds are issued for a period of 1–10 years). Dollar-indexed bonds include just the Gilboa (variable interest paid twice a year depending on movements in LIBOR on 6-month dollar deposits and movements in the NIS/dollar exchange rate; issued for periods of 3–20 years). Individuals and mutual funds pay tax of 35 percent for the coupon payments of indexed and dollar-indexed bonds, and zero tax on the coupon for unindexed bonds. Foreigner's holdings amount to only ½ percent of total value. Finally, the government also issues special nontradable indexed bonds to pension funds and life insurance companies (the latter of which is being phased out), which pay a preferential interest rate (representing almost half of the stock of all government securities).
Secondary market operations
40. While in principle the BoI can buy and sell bonds freely, it has agreed with the Ministry of Finance that it will not do so, subject to a few exceptions. The BoI does act as a market maker in the secondary treasury bill (Makam) market which is traded on the stock exchange, though daily turnover is fairly low (around NIS 100 million, about equal to the average daily trading of shares on the stock exchange). Trading in the bill market became continuous in December 1998 and is to be extended to the government bond market in early 1999; until then the market acted as an auction where one rate was set daily.
41. As a general rule, the BoI does not act as a market maker in the secondary bond market; daily turnover on the stock exchange is also fairly low (around NIS 170 million). In 1995, a new outright purchase facility (the “purchase offer” facility) was introduced whereby the BoI purchases a fixed quantity of 3–15 year bonds at an auction. At present, the BoI purchases around NIS 40 million per week through this facility. The purpose of introducing the facility was to enable the BoI to inject liquidity due to the growth in economic activity; in practice, the facility has not been used extensively due to the strong capital inflows of 1996–97. The only major purchases under this facility were in mid-1996 when the BoI purchased CPI-indexed bonds worth NIS 1.5 billion to counteract a crisis in the provident funds (and sold an equivalent amount of Makam T-bills to sterilize this monetary injection). At end-November 1998, total holdings of government non-Makam securities was NIS 5.4 billion.
Transfer of government deposits
42. Since 1985, the BoI is not allowed to extend loans to the MoF and transfers of government deposits are not used as a monetary policy vehicle. The MoF keeps several accounts at the BoI, apart from its regular budgetary current account. The foreign currency accounts are primarily used for receipts of U.S. government grants and loans and for foreign borrowing under U.S. guarantees which can be used to finance any type of budget expenditure; these deposits are transferred to the regular budgetary accounts on an as needed basis. The Makam account represents the proceeds of special treasury bills issued by the MoF to the BoI for use of the latter in its monetary operations; these deposits can not be used for budgetary operations. The “frozen”account is the depository of any BoI profits over and above the agreed repayment schedule to clear the government's outstanding long-term indexed debt (carrying an interest rate of 8 percent) to the BoI (which stood at NIS 7.1 billion at end-November 1998). In 1992, the MoF and BoI agreed to transfer that part of the latter excess profit that represented realized profits on the BoI's foreign loans and deposits to the budget (which was placed as a revenue item in the budget's accounts). In 1994, the budget exceptionally withdrew NIS 4.2 billion from its frozen account to finance part of the deficit in that year which has since been repaid.
Foreign exchange options
43. The BoI offers 3- and 6-month shekel/dollar European call options. These options are not negotiable. The options are of two kinds: at and out of the money. For 3-month at-the-money options, US$4 million is auctioned twice a week; for 3-month out-of-the-money options, US$6 million is auctioned twice a week (i.e., a total of US$20 million per week). In addition, once a week a 6-month auction is offered out-of-the-money for US$5 million. From late December 1998, the 3 month at-the-money options have been replaced with a 3-month put option.
44. In addition to the foreign exchange option, the BoI offers two other derivative facilities. Each week, the BoI offers to deliver 3 and 12 month Makam treasury bills in three months time, with the yield determined by auction. This facility therefore functions as a forward interest rate derivative market. Around NIS 40 million is offered weekly (NIS 20 million for each type of auction). The forward contracts are not tradable.
45. The BoI also provides a swap facility between indexed government bonds with an average maturity of up to one year for T-bills of 12 months. The yield to maturity of the T-bills is set by auction. The weekly amount is around NIS 20 million.
F. Market Information and Procedures
46. Finally, the BoI provides its clearing services as a way to encourage an efficient interbank market and, as a byproduct, knows which banks are selling to whom, how much, and at what rate.