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WEEKLY NEWSLETTER
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Israel
Index
Worker assembling electronic equipment
Courtesy Embassy of Israel, Washington
In the late 1980s, Israel's financial system consisted of
various financial intermediaries providing a range of services from
short-term overdraft privileges to the financing of long-term
investments in construction, industry, agriculture, and research
and development. This financial system was concentrated among a
limited number of large banking groups under the supervision and
control of the Bank of Israel.
The government-owned Bank of Israel is Israel's central bank.
Its legal powers and functions allow it to determine policies and
regulate activities in all fiscal areas, including interest rates,
money supply, foreign currency, and export financing and control.
As part of its duties, the Bank of Israel seeks to create
institutions specializing in defined sectors of business or
customers. Consequently, banking corporations have been divided
into two main groups: ordinary banking institutions, such as banks,
foreign banks, and merchant banks--all of which are subject to
liquidity regulations on both assets and liabilities--and
specialized banking institutions, such as mortgage banks,
investment finance banks, financial institutions, and joint
services companies.
The financial system in 1988 consisted of five major bank
groups: Bank HaPoalim, Bank Leumi Le Israel, Israel Discount Bank,
United Mizrahi Bank, and the First International Bank of Israel.
Given the high degree of concentration (the three largest bank
groups accounted for more than 80 percent of total bank assets),
banks operated in an oligopolistic environment, with little
competition in determining lending and borrowing rates.
The financial system provided three types of credit
instruments: short-term, nondirected credit financing; short-term,
directed credit financing, and long-term and medium-term credit
financing. The granting of directed credit was the responsibility
of the Bank of Israel. This credit, however, actually was provided
by joint funds of the Bank of Israel and the commercial banks, and
it was primarily intended to meet the working capital requirements
of export enterprises. Seventy-five percent of these funds were in
foreign currency, with interest charges calculated on the basis of
United States dollar credits.
Apart from directed credit, the other major form of short-term
capital was nondirected credit, which was composed of overdraft
facilities. This credit facility provided the customer with great
flexibility at a nonindexed fee, which adjusted with inflation on
a periodic basis. The other loans that were denominated in new
Israeli shekels
(NIS--see Glossary) were
either indexed to the
consumer price index or, if nonindexed, were fixed-term credits.
Medium-term and long-term loans (exceeding eighteen months)
were primarily directed government loans. These credit flows were
supervised by investment finance banks such as the Industrial
Development Bank of Israel. The government generally determined how
medium-term and long-term investment was encouraged and how it was
financed. In an economy with a need for short-term capital, longterm financing was also used for financial activities other than
investment.
Government intervention in investment financing has taken forms
such as direct budget credits, development loans, and investment
grants (under the Law for the Encouragement of Capital Investment).
Since 1974 development loans--whose interest rates were not
adjusted for changes in the rate of inflation--have contained a
subsidy element that arises from the differential between the low
interest rate paid by the borrower on the one hand and a reasonable
market rate of interest plus the expected rate of inflation on the
other. Beginning in 1979, the government linked development loans,
thus reducing this subsidization. Despite this linkage, the
persistent high rate of inflation had kept the effective real
interest on these linked loans negative.
Although Israel had a well-developed banking system, it did not
have a well-developed stock market in 1988. The Tel Aviv Stock
Exchange (TASE), founded in 1953, had never developed properly
because of the government's domination of activities relating to
the raising and allocation of capital. TASE thus remained a shallow
market, poorly regulated and dominated by the major banks, who
assumed all stock market roles--brokers, underwriters, issuers,
fund managers, counselors, and investors.
Between 1975 and 1983, private corporations increasingly raised
more of their capital on the stock exchange. Most of the shares
sold were highly overvalued and carried little or no voting rights.
By the end of 1982, the total value of the shares registered on the
TASE reached more than US$17 billion; in real terms, the value had
more than doubled in a year and had multiplied five-fold since
1979. This development stood in sharp contrast to Israel's stagnant
GNP growth and the worsening trade and debt position of the
economy. In January 1983, however, the market sharply declined. In
a matter of days, most speculators lost 50 to 70 percent of the
value of their stocks. Mutual funds, which had been responsible for
much of the market manipulation, became nearly valueless.
In October 1983, the shares of the banks (which up to that
point had been unaffected by the market malaise) finally collapsed.
Their crash precipitated a dramatic change in the development of
Israel's banking system.
The banking industry had expanded spectacularly in the 1970s,
both at home and abroad. This process had forced the banks to
increase their capital base rapidly. The gradual advance of
inflation in the economy, and its distorting effect on financial
statements drawn up under historic accounting rules, only added to
this thirst for capital. But in a capital market dominated by the
government, which was able and willing to issue endless quantities
of index-linked bonds, the banks found this capital difficult to
raise.
The banks' solution was to transform their shares into indexlinked paper by creating a system that ensured that the price of
their shares would keep pushing upward, irrespective of the
underlying market forces. Over the years, bank shares were
perceived as a riskless investment. By 1983 the price of bank
shares was steadily becoming more detached from their true value.
When it became obvious in 1983 that the government would have to
devalue its currency, many people began to liquidate their holdings
of shekel-denominated assets in favor of foreign currency. The
assets most widely held and most easily liquidated were bank
shares. The selling wave began in the summer of 1983 and peaked in
October, forcing the government to intervene. In 1988 the
government undertook to secure the US$7 billion obligation (equal
to the public's holding of bank shares) at the United States dollar
value before the crash. The closing of the TASE, on October 6,
1983, became known as the "economic day of atonement" and
represented the end of the speculators' paradise created and
supported by leading Israeli banks.
Data as of December 1988
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