I NVEST I NG | 4/29/2014 @ 1:11PM | 11,581 views

Why Israel's Boom Is Actually ABubble Destined To PopIn the past few years, Israel’s economy has been praised for its stability and

strong performance during and after the Global Financial Crisis. Israel’s

booming tech industry has earned it the nickname “The Startup Nation” and

international tech companies from Google to Facebook are clamoring to

acquire the country’s startups. Investors the world over have been vying to

add Israeli investments to their portfolios. Rather than experiencing a

property slump like the U.S. and many countries did, Israel’s property prices

are soaring and making speculators rich. Sadly, Israel’s economic boom is not

the miracle that it appears to be, but is actually another bubble that is similar

to those that caused the financial crisis.

Though it can be argued that Israel is no longer an emerging economy, Israel’s

economic bubble has been following a similar pattern to the overall emerging

markets bubble that I have been warning about. The emerging markets

bubble began in 2009 after China embarked on an ambitious credit-driven,

infrastructure-based growth plan to boost its economy during the Global

Financial Crisis. China’s economy immediately rebounded due to the surge of

construction activity, which drove a global raw materials boom that benefited

commodities exporting countries such as Australia and emerging markets.

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Jesse Colombo, Contributor

I'm an economic analyst who is warning of dangerous post-2009 bubbles

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Emerging markets’ improving fortunes attracted the attention of international

investors who were looking to diversify away from the heavily-indebted

Western economies that were at the heart of the financial crisis. Eventually,

even countries that were not significant commodities exporters (such as

Israel) began to benefit from the growing interest in this investment theme.

Record low interest rates in the U.S., Europe, and Japan, along with the U.S.

Federal Reserve’s multi-trillion dollar quantitative easing programs, caused

$4 trillion of speculative “hot money” to flow into emerging market

investments over the last several years. A global carry trade arose in which

investors borrowed cheaply from the U.S. and Japan, invested the funds in

high-yielding emerging market assets, and earned the interest rate differential

or spread. Soaring demand for emerging market investments led to a bond

bubble and ultra-low borrowing costs, which resulted in government-driven

infrastructure booms, dangerously rapid credit growth, and property bubbles

in countless developing nations across the globe.

Capital inflows into Israel immediately increased after the financial crisis and

hit a record high of $7.22 billion in the fourth quarter of 2013:

Source: Trading Economics

Strong capital inflows are the reason why Israel has been able to maintain a

current account surplus despite the country’s growing trade deficit over the

past decade.

Foreign “hot money” inflows into Israel contributed to a 23 percent increase

in the shekel currency’s strength against the U.S. dollar since the financial

crisis:

To stem Israel’s export-harming currency strength and support economic

growth, the country’s benchmark interest rate, prime rate, and effective

interbank rate were cut to all-time lows:

Source: Trading Economics

Source: Trading Economics

Source: Trading Economics

The global bond bubble and safe-haven demand helped to push 10 year Israel

government bond yields down to a record low of just 3.34 percent after the

financial crisis:

Source: Trading Economics

Exports account for approximately 40 percent of Israel’s GDP, which means

that the country’s economy is adversely affected by appreciation of the shekel

currency. For the past six years, Bank of Israel has been waging a war against

the strong shekel – the world’s best performing major currency in 2013 – with

a combination of ultra-low interest rates and aggressive currency

interventions.

Since 2008, Bank of Israel has purchased over $50 billion worth of foreign

currencies with newly created or “printed” shekels in an attempt to weaken

the currency. As a result, Israel’s M1 money supply, which includes physical

cash and demand deposits (typically checking accounts), surged by 150

percent even though the country’s real GDP grew by only 22 percent:

Source: Trading Economics

Unsurprisingly, Israel’s low interest rate, surging money supply environment

of the past half-decade has resulted in inflation and asset bubbles. The

quadrupling of the Israeli Consumer Price Index between June 2007 and

June 2011 led to massive street protests in 2011 and 2012 that drew hundreds

of thousands of participants.

Israel’s inflation protests started in July 2011 when Daphni Leef, a 25-year-old

video editor, pitched a tent on Tel Aviv’s tony Rothschild Boulevard after

being given a notice to vacate her apartment for renovations, only to find that

the rents of comparable apartments had doubled since 2006. Leef started a

Facebook page that she used to encourage other Israelis to pitch tents to

protest the country’s inflation epidemic.

Daphni Leef protests against housing costs in Israel (Photo credit: Wikipedia)

Israel’s inflation protests fixated particularly on the rising cost of food, energy,

and housing, which is partly due to the housing bubble that will be discussed

in greater detail in this report. While Israel’s inflationary pressure abated

somewhat after Bank of Israel hiked interest rates from late-2009 to late-

2011, inflation may rear its ugly head again now that interest rates have been

reduced to record lows for the second time since the global financial crisis.

Israel’s M1 money supply growth stabilized in 2010 and 2011 thanks to rising

interest rates and the weakening shekel, but has grown by nearly a third since

the start of 2012 after Bank of Israel cut rates and intervened as the shekel

began to strengthen again.

Israel Has A Property Bubble

Israel’s record low interest rates and rapid money supply growth after the

financial crisis has created a property bubble in which prices have soared by

80 percent since 2007 and 67 percent since 2009:

Since 2006, Israel has experienced the largest property price increase among

OECD nations. Israel’s property price increases have far outpaced the

country’s average nominal income gains of 23 percent since 2007 and 12.5

percent since 2009, which has contributed to the public’s growing discontent

over the rising cost of living. In the year ended Q3 2013, Haifa, Gush Dan, and

Tel Aviv saw the largest price increases with respective gains of 25.2 percent,

15.2 percent, and 12.7 percent. Tel Aviv, Sharon, and Jerusalem are Israel’s

most expensive housing markets with average prices of owner-occupied

dwellings of ILS2,250,900 (US$642,870), ILS1,535,900 (US$438,662), and

ILS1,497,200 (US$427,609) in Q3 2013 respectively.

Several affordability and valuation ratios show that Israel’s housing market

has become overvalued and far less affordable in the past half-decade as the

bubble inflated. From 1996 to 2008, Israel’s average apartment price-to-

average monthly salary ratio remained stable at 100, but has surged to 130 in

recent years. A recent IMF study showed that Israel’s home prices are now 25

percent above their equilibrium value as measured by price-to-income and

price-to-rent ratios that are 26 percent and 22 percent above their long-term

levels. Israel’s low average gross rental yield of 3.45 percent is also indicative

of an overvalued property market.

Israel’s price-to-rent ratio understates the true extent of the country’s housing

bubble because rents themselves have been experiencing what can be

considered a type of bubble. Since 2008, the average rent in Israel has risen

by 49 percent, with larger increases of 61 percent and 53 percent in Tel Aviv

and Sharon. The average rent rose from 30 percent of the average salary in

2007 to 38 percent in 2013, with rent consuming an alarming 56 percent of

the average salary in Tel Aviv.

Israel’s Ministry of Construction and Housing (MOCH) claims that the

country’s soaring rents are primarily driven by demand for investment

properties, which has increased as a result of the ultra-low interest rate

environment. A 2013 Bank of Israel study showed that the percentage of

households that own at least one home for investment purposes increased by

nearly 150 percent from 2003 to 2013. In Tel Aviv, which is Israel’s most

inflated housing market, investors account for 29 percent of all home

purchases. While foreign investors are often blamed for Israel’s soaring

property prices, they account for a small and declining proportion of the

country’s overall property sales. Foreign purchases of Israeli homes dropped

from 6 percent of all home purchases in 2005-06 to 3 percent in 2009 and 4.1

percent in 2011.

Israel’s property market has inflated on the back of a mortgage bubble that

has grown as a result of mortgage interest rates that have dramatically

decreased in the past decade:

According to Bank of Israel, total outstanding household mortgage debt

increased 78 percent from NIS136 billion at the end of 2007 to NIS242 billion

at the end of 2012. Israel’s banks are exposed to the country’s housing bubble

because mortgages and loans to real estate businesses account for

approximately 40 percent of their assets. Even more worrisome is the fact that

approximately 90 percent of new mortgages originated during the peak of the

bubble have adjustable interest rates, which is evidence that Israel is making

one of the key mistakes that the U.S. made during last decade’s housing

bubble. When Israel’s artificially low interest rates eventually rise again,

monthly payments on adjustable rate mortgages will rise and put

homeowners and banks in jeopardy.

Israel’s entire economy is exposed to the housing and mortgage bubble

because banking is one of the country’s key industries. Banking and real

estate companies account for a combined one-third of the benchmark Tel

Aviv-25 stock index’s capitalization:

Source: Tel-Aviv Stock Exchange

Israel’s growing economic bubble has helped the banking and real estate-

heavy Tel Aviv-25 stock index to triple in the past decade:

Source: Trading Economics

Like many nations outside of the hard-hit U.S. and Europe, Israel’s inflating

housing bubble helped to boost the country’s consumer spending in the wake

of the global financial crisis. Unfortunately, this wealth effect is not

sustainable and will actually reverse when Israel’s housing bubble pops.

Why Israel Has a Tech Bubble

Housing is not the only sector in Israel that is experiencing a bubble; the

country’s tech sector has been riding the wave of what I call “Tech Bubble

2.0,” which is primarily centered around companies and startups that are

involved with social media, apps, and, to a lesser extent, cloud computing.

While many of the technological trends of the past few years are genuine in

their own right, I believe that the bubble lies in the frenzied startup and

acquisition activity as well as the valuations of companies that operate in the

aforementioned arenas.

The overvalued U.S. stock market is acting as a benchmark that is helping to

set the tone for the valuations of tech companies and startups. Profitable

publicly-traded social media companies such as Facebook and LinkedIn are

currently carrying very high valuations, while many others such as Twitter,

Pandora, and Yelp have multi-billion dollar market capitalizations without any

earnings whatsoever. Recent acquisitions in the technology startup space

have also occurred at jaw-dropping valuations such as Facebook’s $19 billion

acquisition of mobile messaging company WhatsApp and $2 billion

acquisition of virtual reality company Oculus.

Azorim High-Tech park in Petah-Tikva, Israel. (Photo credit: Wikipedia)

While California’s Silicon Valley is the epicenter of Tech Bubble 2.0, the

bubble has recently spread to other tech centers around the world, including

Israel. As the world’s second-most important startup center after Silicon

Valley, Israel has been given the nickname “The Startup Nation” and its tech

corridor is nicknamed “Silicon Wadi,” which means “Silicon Valley” in Arabic

and colloquial Hebrew. There are currently over 4,800 startups in Israel,

including 15 to 20 companies that are likely to launch IPOs in 2014 in New

York, London, or Tel Aviv. Israel had 13 companies IPO in the U.S. in 2013,

after only 1 U.S. IPO in 2012. Israel’s increasingly frothy startup scene led to a

52 percent surge in demand for web developers last year.

Foreign companies including Facebook, Google, Apple, Intel, IBM, and Cisco,

which have been emboldened by their soaring stock prices, have acquired

nearly $14 billion worth of Israeli tech companies and startups since 2012.

Total foreign acquisitions of Israeli companies increased by over 50 percent in

value from $5.5 billion in 2012 to $8.4 billion in 2013. International tech

companies are making the same mistakes in their acquisitions of startups in

Israel that they are making in Silicon Valley, namely overpaying for

speculative startups with little to no earnings and valuing these startups based

on their number of users – a throwback to the practices of the late-1990s Dot-

com bubble.

In June 2013, Google acquired Israeli GPS app company Waze for $1.3 billion,

even though it generated only a nominal amount of revenue from advertising

and data licensing. Two months later, IBM acquired financial fraud-

prevention software company Trusteer for an estimated $1 billion despite its

comparatively anemic $40 million revenues in 2012. In November 2013,

website building company Wix went public on the U.S. Nasdaq stock

exchange with a lofty $750 million market capitalization against $55.5 million

in revenue and $17.8 million in losses in the first nine months of 2013.

In February 2014, Japanese online retailer Rakuten Inc. acquired Israeli

internet messaging and calling service Viber for $900 million, even though

the company posted just $1.52 million in revenue and a net loss of $29.51

million in 2013. Total Israeli tech VC exits via IPOs or M&A deals hit a ten year

high in 2013, with the average deal value of $146 million more than doubling

the $67 million average deal value of the past decade. Foreign acquisitions of

Israeli tech companies have contributed to the shekel’s appreciation in the

past couple of years.

The popping of the Israeli tech bubble is likely to coincide with the popping of

the tech and stock market bubbles in the United States. Israel has experienced

a tech wreck once before when the collapse of the late-1990s Dot-com bubble

(combined with the 2001 Israeli/Palestinian Conflict) helped to push the

country’s tech-heavy economy into the worst recession since 1953

Why Israel’s Offshore Gas Boom May Be Overhyped

The discoveries of the Tamar and Leviathan natural gas fields in the

Mediterranean Sea off the coast of Israel has become a source of optimism in

recent years as it promises to reduce the country’s energy costs and allow it to

eventually become a net energy exporter. While Israel is undoubtedly

fortunate to have discovered this natural bounty, there is reason to believe

that its potential economic impact is being overstated by the media, the

government, and the business community.

According to a recent Ernst and Young study, the Tamar and Leviathan gas

fields are worth $52 billion in total capitalization value to Israel’s economy

over the next 28 years, with domestic energy cost savings accounting for $42

billion of this figure and royalties and taxes on gas suppliers’ profits

accounting for $10 billion. When spread across 28 years, offshore natural gas

resources are expected to provide $1.86 billion in annual value to Israel’s

economy. A $1.86 billion annual windfall is certainly nothing to sneer at, but

what is overlooked is the fact that its expected contribution to Israel’s $242.9

billion GDP is a “drop in the bucket” of .76 percent – hardly the economic

game-changer that it is being hyped up to be.

In addition, the estimated value of Israel’s offshore natural gas may be overly

optimistic because it assumes that the country will be able to export its excess

gas to neighboring countries including Turkey, Jordan, and Egypt within the

next several years. Unfortunately, volatile relations between Israel and its

potential gas export partners are likely to hamper the cooperation that is

required for Israel’s goal of being a net energy exporter to become a reality.

The difficulties of finding reliable export partners for the region’s natural gas

are the reason why a recent piece in The Economist magazine claimed that

Israel and other Eastern Mediterranean countries may be “fooling their

people with false promises of an offshore gas bonanza.” The Economist piece

also quotes energy analysts who state that Israel is “unlikely … to start

exporting large amounts by 2020, as it hopes.”

On Stanley Fischer: Don’t Mistake a Bubble For Talent

No proper analysis of Israel’s economic bubble should neglect discussing the

role played by Stanley Fischer, the governor of the Bank of Israel from 2005

to 2013. Fischer, a New Keynesian economist, has been widely lauded by the

international economics community for his management of Israel’s economy

during and after the Global Financial Crisis. In 2009, 2010, 2011 and 2012,

Fischer received an “A” rating on Global Finance magazine’s Central Banker

Report Card, and in 2010, Bank of Israel was ranked the world’s most

efficiently functioning central bank. So highly respected is Stanley Fischer