As inflation rears its head around the world, Israel is no different from many other countries that have seen prices spike as of late.  Where Israel differs from the rest of the world is not in experiencing inflation, but how the economy is leveraged to it.

Let me explain: Israel suffered from bouts of hyperinflation during its 60 years of existence.  Most salient was the 1970s which saw double digit inflation throught the decade, culminating in 100+% inflation in 1979.  The beginning of the 1980s introduced stagflation and saw even higher inflation rates.

Here’s where the history impacts today’s Israel: in an effort to combat hyperinflation, Israel created an economy-wide phenomenon of CPI-linked debt.  This debt is not specific to a specific sector and according to a report produced last week by UBS’s Israel analysts, may compose over 50% of corporate debt, over 60% of the government’s shekel debt, and 60% of mortgages.

After the last couple of boom years 2005-2006, most of the corporate debt raised by Israeli firms is also linked to the CPI.  Merrill Lynch is out this morning as well with a study on the effects of higher CPI on Israeli firms.

The money line from the UBS report: However the spike in CPI in Q2 could affect the bottom lines of many Israeli corporates and we are concerned that a continued high inflation could continue to weigh on the profitability of many Israeli companies.

So, what’s an investor in Israeli firms traded in the U.S. to do?  UBS suggests underweighting those institutions with high CPI exposure.  The storm feared by analysts would play out with consumers being hit with rising prices in the market also being compounded with resets in adjustable rate mortgages that are linked to the CPI.  In turn, this could curb consumer spending which is playing a bigger and bigger role in GDP growth.

While Olmert clings to a feeble position in a government beset by scandal, UBS suggests that “the rise in CPI will also have fiscal implications as the Government could be squeezed by paying more on its CPI linked debts as well as collecting less corporate taxes.”