​Summary:
 
Israel's financial stability (FS) improved in external and forex activity in 2004 due to the more amenable financial environment in which the market operated and to a certain improvement in financial standing. An FS analysis is based on index monitoring and on an analysis of internal and external events and processes in Israel that have a potential effect on FS. 

The financial conditions under which the market operated in 2004 were more amenable than those of 2003: the indices show that the underlying conditions for global financial stability as well as that of Israel had improved. This was further bolstered primarily by global and domestic growth. A potential challenge to stability from the narrowed interest gap did not materialize. The external financial climate was responsive as a result of international investors' evident readiness to invest and the low cost of capital and debt financing. The economy operated in a climate of lower yields and risks than formerly and this contributed to economic activity. Trading on the NIS-forex market remained buoyant and heterogeneous in character. A further contribution to this stability resulted from reinforced credibility of monetary and fiscal policy. In 2004, no signs were discerned of any potential challenge to fiscal stability. Changes in the stability indices were minor compared to the previous year and changes during the year were more moderate than in 2002 and 2003. 

An analysis of Israel's external and internal resistance that derives from its balances and their components1 demonstrates the financial robustness of the economy in 2004 but a counter-development was also noted. On the one hand, Israel recorded a significant improvement in foreign currency activity as the business sector was no longer exposed to changes in the exchange rate. Furthermore, on the side of external liabilities, Israel was more resistant to a relative reduction in the extent of these obligations and an improvement in the short-term liquidity ratios. The continued upward trend of the net external debt assets improves Israel's standing in the eyes of foreign investors but exposes it to the risks of overseas investments. On the other hand, a deterioration was recorded in the economy on the liabilities and gross assets side because of their increase and a less favorable composition on the assets side. Furthermore, households hold a significant surplus of assets in forex and have a marked exposure to an increase in the value of the NIS. Non-residents short NIS position increased after it had closed during the year. 
A number of developments in 2004 had a significant impact on FS. After the last quarter of 2003 and during the first quarter of the year under review, considerable activity was discerned on the part of households to adjust their asset portfolios to changes in the relative external yields. This activity was inhibited by market forces. FS is sensitive to the households' activities because of potential of "herd" behavior patterns. Significant activity of non-residents was observed in two periods: in the months of April to June 2004 and September to December 2004. In the former period, an outward movement on the part of non-resident investors was noted. This corresponded to the capital outflow from emerging economies and a reduction in their short-term speculative positions. In the latter period, an increase in the in-flow of capital from non-residents was discerned against the backdrop of similar trends in other global economies. The heterogenic character of non-residents' activities in shares and derivatives was constant for most of the year but lessened in these two periods. The increased heterogeneity and spread of their activity will contribute to more robust FS. FS is sensitive to non-residents' behavior because of their financial strength and their behavior that is, at times, influenced by global trends. 

Global financial trends had an impact this year on the Israeli economy. The global volatility of financial assets lessened and credit gaps were reduced. Similar phenomena were noted also in Israel. The standard deviation inherent in options (the implied standard deviation) of the NIS-dollar exchange rate fell to a historically low level, but this was appreciably lower than the standard deviation inherent in other currencies; the exchange rate of the dollar-NIS was impacted by the weakening global trend of the dollar; the extent of the forex conversions recorded this year in Israel remained below record levels. However as a general rule, the increase in the extent of forex trading in recent years and its moderation this year are consistent similar trends in global money markets. A number of long-term processes were also noted this year that reinforce Israel's FS: reduced involvement of the public sector in economic and financial activity, increased activity of non-residents in the economy, the development of the NIS-forex market including the increased trading volume in recent years. 

Nevertheless, at the end of the period, Israel faced a lack of global balances externally and a low interest environment internally. The lack of global balances that derives mainly from difficulties in the US economy, contributed to financial stability denoted by Israel's interest reduction process but it embodies a potential for diverse exogenous crises in the absence of controlled and gradual regulation of the equilibration. The low level of interest in Israel was, from the aspect of the financial environment, unknown and increased Israel's vulnerability to crises. However the improvement in the financial strength of the economy in recent years and its characteristically low risk level do not necessitate maintaining a higher interest level than is required by considerations of monetary policy.  
 

Part III, External Financial Stability - Complete text - PDF file