UPDATE 2-Israel fights shekel strength with debt tax plan

* Foreigners were exempt from 15 pct tax on short-term debt

* Measure needs approval of government, parliament

* Shekel weakens 1.1 pct vs dollar on news

(Adds economist's quotes, details, background)

By Tova Cohen

TEL AVIV, Jan 27 (Reuters) - Israel unveiled yet another measure on Thursday aimed at combating speculative money flows that have strengthened its currency, announcing a proposal to tax profits on foreigners' investment in short-term debt.

The Finance Ministry said it would act to annul a tax exemption for foreigners on profit from investments in short-term government bonds and short-term Bank of Israel bills called makams. Foreigners until now have been exempt from paying a 15 percent tax on makams and bonds to encourage them to invest in Israel's capital market.

The shekel ILS= lost 1.1 percent against the dollar shortly after the announcement and its official rate was set at 3.656. It was trading at 3.6158 prior to the announcement.

Last week the Bank of Israel imposed a reserve requirement on some foreign exchange derivative deals and said it will require Israelis and foreigners to report on transactions in foreign exchange swaps and forwards of more than $10 million in one day.

The tax measure is being examined by a government panel led by Haim Shani, director general of the Finance Ministry.

The ministry said the proposed change follows the increased flow of foreign currency into Israel due to the higher returns offered compared with low interest rates in major developed economies.

The Bank of Israel on Monday raised its key short-term lending rate by a quarter point to 2.25 percent to try and bring inflation back within target and analysts see further tightening in coming months.

The rate increase to 2.25 percent was the first since September and came as rising housing prices and strong economic growth add to inflation pressure.

"The strengthening of the shekel in recent years is due mainly to the strength of the Israeli economy and its resilience to the global economic crisis," the Finance Ministry said in a statement.

"Recently, in addition to welcome foreign investments in the Israeli economy, we are witnessing a substantial rise in the inflow of foreign currency aimed entirely at creating short-term financial profits due to the spread in interest rates between Israel and abroad, as well as other reasons."

This results in shekel appreciation that can hurt the economy's long-term competitiveness, the ministry said, adding that the panel led by Shani is examining other tools to deal with the situation.

SHORT-TERM GAINS

The ministry said it is concerned the tax exemption is being taken advantage of for short-term gains.

"Cancellation of the exemption, which requires legislative procedures, is expected to decrease somewhat the attractiveness of foreign purchases of makams and short-term bonds and reduce shekel buying, thereby weakening the currency," it said.

According to Bank of Israel data, in the first 11 months of 2010 nonresidents invested $9.2 billion in makam and government bonds, bringing the balance of their holdings of makam to about $10 billion and of government bonds to $2.6 billion.

Michael Sarel, chief economist at Harel Finance, said the measure was not unexpected, but he is not certain how effective it will be.

"Israel has tax treaties with certain countries so I'm not sure it will be able to impose a tax on investors from these countries, though it can increase bureaucracy," he said.

Sarel also believes foreign investors will find ways to avoid the tax by using other instruments to take positions in bonds without directly investing in them.

While the tax might weaken the shekel in the short term, in the long run it won't have an impact because it does not change economic fundamentals such as strong growth and a current account surplus that are driving the shekel's rally, he said.

The ministry's tax authority is drawing up a bill that will be submitted to the government and then parliament for approval. A ministry spokesman said he expects parliament to pass the bill during its current session, which ends in late March.

Analysts have said that Israel, like other countries, is trying to help exports and growth.

Brazil, Chile, Peru, Taiwan, South Korea, Turkey, South Africa and others have taken measures to keep their currencies from strengthening or control the flow of money into their economies as investors pour money into higher-yielding markets.

The shekel reached a 27-month high of 3.528 shekels per dollar earlier this month and the Bank of Israel has intervened repeatedly to contain the currency's rally. It bought $2.3 billion of foreign currency in December, bringing its forex reserves to a record $70.9 billion.

(Editing by Ruth Pitchford)