Journal Issue


International Monetary Fund
Published Date:
April 2012
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External and domestic strains cloud the outlook

1. Israel emerged from the 2008–09 global crisis with strong economic growth, a resilient banking system, and unemployment at historic lows. In this context, policies were gradually tightened through mid 2011 (Table and Figures 1 and 2).

Figure 1.Israel: The Long-Term View, 1996–2011

Sources: Haver Analytics; Bank of Israel; and IMF staff calculations.

Figure 2.Israel: Recent Economic Developments, 2007–11

Sources: Bank Hapoalim/Israeli Purchasing and Logistics Managers Association; Bureau of Economic Analysis; Central Bureau of Statistics; and Statistical Office of the European Communities.

2. But the external outlook has again deteriorated. Although the world economy is expected to avoid recession?assuming the euro area crisis is resolved?growth projections for 2012 and 2013 have been marked down substantially. And regional tensions have also risen (Annex I).

3. In addition, extensive peaceful social protests?in part reflecting a decade of stagnant real wages and concentration of economic power?took place in 2011 and could resurface.

World Economic Outlook(January 2012 update, annual percent change)
CurrentChange from Fall 2011CurrentChange from Fall 2011
Real GDP
Advanced economies1.2-0.71.9-0.5
Emerging and developing economies5.4-0.75.9-0.6
Trade volume (imports)
Advanced economies2.0-2.03.9-0.8
Emerging and developing economies7.1-1.07.7-1.0
Source: IMF World Economic Outlook Update, January 2012.
Source: IMF World Economic Outlook Update, January 2012.

4. And inequality and poverty—both already high—are set to rise further reflecting low participation and rapid growth of the Arab-Israeli and Haredi communities (see SIP Chapter I).

What are the channels through which these factors will affect Israel?

5. Exports, at 40 percent of GDP, depend on global demand for high-technology products, such as electronics and pharmaceuticals, and communications. One third of exports go directly to Europe, with more routed there indirectly. But if global weakness is reflected in international oil prices, this will help as Israel is a large net energy importer.

Israel’s GDP and Global Demand

(Annual percent change)

Source: IMF World Economic Outlook Update, January 2012.

Israel: Manufacturing Exports (excluding diamonds) by Technological Intensity

(SA, January 2007 = 100)

Source: Haver Analytics.

1/ Parentheses indicate shares in total manufacturing exports.

Israel: high-tech exports and US IT Industry

(Y/Ypercent change)

Source: Haver Analytics.

1/ Coincident indicators of activity in the US IT sector, including IT investment, consumption, employment, production, and shipments.

6. Links through the financial sector are limited. Banks’ cross border activities are moderate: their total foreign assets and liabilities amount to 10 percent and 14 percent of GDP, respectively, with negligible direct exposures to peripheral advanced European countries. And, operations of foreign-owned financial institutions in Israel are negligible. Likewise, wholesale funding of banks is low, but stress will likely appear from the domestic corporate bond market (Figure 3).

Figure 3.Israel: Selected Financial Market Indicators, 2008–12

Sources: Bloomberg; Datastream;Moody’s KMV; and Tel Aviv Stock Exchange.

7. Given the country’s weak direct trade linkages to the region, regional tensions mainly affect Israel through security, investor and consumer confidence, and via the public finances.

Israel: Exports Destination in 2011

Source: Haver Analytics.

8. Similarly, social pressures mainly affect fiscal choices, on taxation and spending. The “Trajtenberg Committee” (Box 1), set up to help the government plan a response to the social protests, has made a range of proposals for taxation and spending adjustments, most of which have been approved by the Knesset.

9. If continued, participation and demographic trends in minority communities will soon significantly lower the potential growth of the economy, with implications for overall income growth, inequality, and fiscal sustainability.

Israel: Banks Foreign Assets and Liabilities

(Percent of GDP)

Source: Haver Analytics.


Israel has strong fundamentals

10. Externally, foreign exchange reserves have increased steadily since 2008 to reach $77 billion, some 10 months of total imports, and above 130 percent of short-term external debt. For the first time over the last two decades, the net international investment position has turned to a surplus (6 percent of GDP, Tables 2 and 3).

11. Institutional frameworks are also strong.

Table 1.Israel: Selected Economic Indicators, 2007–13(Percent change; unless otherwise indicated)
20072008200920102011 Est.20122013
Real economy
Real GDP5.
Domestic demand6.
Private consumption6.
Public consumption3.
Gross capital formation11.70.9-
Foreign demand (contribution to real GDP growth)-
Unemployment rate (percent)
Overall CPI (end period)
Saving and investment balance
Gross national saving (percent of GDP)23.119.620.318.118.118.719.7
Foreign saving (percent of GDP)-2.7-0.9-3.6-
Gross domestic investment (percent of GDP)20.318.716.715.218.719.719.9
Money and credit (period average)
Interest rates (percent)
Bank of Israel policy rate (end year)4.002.501.002.002.75
10-year government bond yield (average)5.555.925.064.684.98
Public finance (percent of GDP)
Central government
Revenues and grants34.031.428.028.829.629.830.8
Total expenditure34.033.733.332.632.933.233.1
Overall balance0.0-2.3-5.3-3.7-3.3-3.4-2.3
General government
Overall balance-1.3-3.3-6.0-4.6-4.0-3.5-2.6
Of which: foreign currency external debt17.214.914.412.712.811.210.9
Balance of payments (percent of GDP)
Exports of goods and services42.440.334.736.936.933.633.8
Real growth rate (percent)9.26.6-12.613.44.9-4.46.0
Imports of goods and services43.941.632.334.937.835.134.4
Real growth rate (percent)11.72.3-14.012.610.6-3.73.7
Trade balance-1.5-
Oil Imports (billions of U.S. dollars)8.912.88.110.413.614.214.3
Current account2.
Foreign reserves (end period, billions of U.S. dollars)284361717577 2/77
Exchange rate
Exchange rate regimeFree floating
NIS per U.S. dollar4.
Nominal effective exchange rate (2005=100)103.6115.1109.8115.1
Real effective exchange rate (2005=100)100.6112.1109.9115.4
Social Indicators (reference year)
GDP per capita (current U.S. dollars, 2009): 27,656; Population density (2009): 343.9 inhabitants per square kilometer; Poverty rate (2008)1/: 19.9 percent; Fertility rate (2009): 3.0 per woman; Life expectancy at birth (2009): 79.7 (male) and 83.5 (female); Infant mortality rate (2009): 3.4 per 1,000 births; Physicians (2007): 3.6 per 1,000 people; CO2 emissions (tons per capita, 2007): 9.3.
Sources: Haver Analytics; Bank of Israel, Central Bureau of Statistics; World Bank; and IMF staff estimates and projections.

Poverty rate from National Insurance Institute of Israel.

As at end-February 2012.

Sources: Haver Analytics; Bank of Israel, Central Bureau of Statistics; World Bank; and IMF staff estimates and projections.

Poverty rate from National Insurance Institute of Israel.

As at end-February 2012.

Table 2.Israel: Balance of Payments Accounts, 2007–17(In billions of U.S. dollars; unless otherwise indicated)
20072008200920102011 Est.201220132014201520162017
IMF staff projections
Current account balance4.
Exports, f.o.b.50.857.746.356.165.761.064.068.973.679.185.4
Imports, f.o.b.-56.0-64.4-46.0-58.0-73.0-69.1-70.9-75.2-79.9-85.3-91.6
Civilian imports-53.6-61.9-44.1-56.0-71.1-67.2-69.0-73.3-78.0-83.4-90.7
Military imports-2.4-2.5-1.9-2.1-1.9-1.9-1.9-1.9-1.9-1.9-0.9
Factor Income-0.3-4.1-5.1-6.3-6.0-6.0-6.0-6.0-6.0-6.0-6.0
Net transfers7.
Capital and financial account balance 1/-3.613.
Capital account0.
Financial account 2/-4.412.
Direct investment, net0.23.72.7-
Foreign direct investment abroad-8.6-7.2-1.7-8.0-4.2-3.0-4.5-5.0-5.0-5.5-5.7
Foreign direct investment in Israel8.810.
Portfolio investment, net-1.5-0.6-
Other investment-
Change in reserves 3/1.7-14.2-16.6-11.8-4.0-
Errors and omissions-2.7-
Memorandum items:
Current account balance (percent of GDP)
Gross external debt (percent of GDP)54.443.847.948.744.244.944.443.943.643.342.5
Foreign reserves (billions of US dollars) 4/2843617175777777777777
GDP (billions of U.S. dollars)167202195218243248259271284299315
Sources: Central Bureau of Statistics.

IMF staff estimates and projections.

Excludes reserve assets.

Negative (positive) sign denotes increase (decrease) in reserves.

Data for 2012 is as at end-February 2012.

Sources: Central Bureau of Statistics.

IMF staff estimates and projections.

Excludes reserve assets.

Negative (positive) sign denotes increase (decrease) in reserves.

Data for 2012 is as at end-February 2012.

Table 3.Israel: International Investment Position, 2003–11
200320042005200620072008200920102011 Sept.
(In billions of US dollars)
Israeli assets abroad91.1107.8125.2163.7190.6187.9220.3250.3257.0
Of which: reserve assets26.226.927.929.028.442.560.670.976.3
Israeli liabilities abroad121.6135.7153.2177.2207.7191.8226.9251.2241.7
Net international investment position-30.5-27.9-28.0-13.5-17.1-3.8-6.6-0.915.3
(In percent of GDP)
Israeli assets abroad76.785.293.5112.5114.093.2113.1114.9106.0
Direct investment11.014.617.227.029.827.029.430.428.6
Portfolio investment12.614.719.824.325.216.625.428.423.6
Equity securities3.
Bonds and notes9.710.713.415.
Other investment30.934.635.541.242.028.627.223.622.5
Net financial derivatives0.
Reserve assets22.021.320.819.917.
Israeli liabilities abroad102.4107.2114.3121.8124.395.1116.4115.499.7
Direct investment22.523.427.336.136.230.935.535.732.9
Portfolio investment36.742.648.647.852.135.448.849.538.2
Equity securities19.824.131.027.935.722.335.232.723.5
Bonds and notes17.018.517.619.916.413.113.616.814.7
Other investment43.141.338.537.935.928.832.130.128.6
Net international investment position-25.7-22.0-20.9-9.3-10.2-1.9-3.4-0.46.3
(In percent of GDP)
Memorandum items:
Gross external debts62.362.058.460.154.443.847.948.744.9
Of which: short-term debts25.423.920.021.725.0
Net external debts-3.9-8.3-15.1-20.9-24.1-20.2-27.6-25.3-24.2
Source: Haver Analytics.
Source: Haver Analytics.

12. In particular, Israel’s new fiscal rule, embedded in the 2010 Deficit Reduction and Budgetary Expenditure Limitation Law, and reflected in the 2011-12 “two year” budget, comprises two disciplinary elements:

  • The expenditure rule adjusts the cap on real expenditure growth as public debt approaches 60 percent of GDP.

  • The headline budget deficit is targeted to fall to 2, 1½, and 1 percent of GDP in 2012, 2013, and 2014 respectively.

13. Furthermore, Central Bank legislation has been reinforced. The 2010 Bank of Israel (BoI) Law now stipulates price stability as the primary objective of monetary policy, and has strengthened the BoI’s autonomy, transparency, and governance.

14. The FSAP Update, conducted as part of this consultation, concludes that the financial system is stable, with the BoI maintaining strongly proactive supervisory practices, which have preempted the systemic risks seen elsewhere (Figure 4 and Tables 4 and 5).

Figure 4.Israel: Performance of Banks, 2005–11

Source: The Bank of Israel; and SNL database.

1/ Israeli banks are colored in red; the comparator samples consist of major banks in Europe, US, and Canada.

Table 4.Israel: Financial System Structure, 2005–10
Number ofTotal assetsNumber ofTotal assetsNumber ofTotal assetsNumber ofTotal assets
Institutions/ fundsIn billions of NISPercent of GDPInstitutions/ fundsIn billions of NISPercent of GDPInstitutions/ fundsIn billions of NISPercent of GDPInstitutions/ fundsBranchesEmployeesIn billions of NISPercent of GDP
A. Banks
Five major banks, consolidated5859.2142.951,012.8140.051,042.2136.051,20847,6901,068.8131.5
Bank Leumi Le Israel1272.845.41310.843.01321.842.0132213,339328.240.4
Bank Hapoalim1273.345.51306.842.41309.640.4129513,875320.939.5
Israel Discount Bank1154.825.71182.225.21187.824.5125210,219185.822.9
Mizrahi Tefahot Bank186.314.41114.015.81118.415.511635,170133.316.4
First International Bank of Israel171.912.0198.913.71104.613.611765,087100.712.4
Other banks342.17.0349.06.8346.26.03511,66652.86.5
B. Non-bank financial institutions667.7111.1765.2105.8959.8125.31,068.0131.4
Provident and severance pay funds104165.627.587145.420.166187.124.466194.123.9
Advanced study funds72.012.072.610.098.112.8112.013.8
Old pension funds18142.523.718237.232.818267.034.818287.235.3
New pension funds1844.77.41371.09.81093.512.210111.313.7
Mutual funds918124.620.71,18598.113.6133.217.41,247156.619.3
Assured yield life insurance plans47.37.954.97.660.77.966.18.1
Profit sharing life insurance plans71.111.886.111.9120.115.7140.717.3
Total financial system (A+B)1,526.9254.01,778.0245.72,002.0261.32,136.8262.8
Memorandum items:
GDP (NIS billions)601724766813
Sources: Bank of Israel, Ministry of Finance, and Israel Securities Authority.
Sources: Bank of Israel, Ministry of Finance, and Israel Securities Authority.
Table 5.Israel: Financial Soundness Indicators?Five Major Banks, 2005–11(In percent; unless otherwise indicated)
2005200620072008200920102011 Q2
Capital Adequacy
Regulatory capital to risk-weighted assets 1/10.610.711.111.313.613.913.6
Highest bank minus lowest bank2.
Regulatory Tier I capital to risk-weighted assets 2/
Highest bank minus lowest bank1.
Capital as percent of assets (leverage ratio)
Highest bank minus lowest bank1.
Asset quality and exposure
Nonperforming loans to total gross loans3.12.5
Highest bank minus lowest bank3.02.4
Nonperforming loans net of loan-loss provisions to capital23.320.4
Highest bank minus lowest bank22.719.5
Sectoral distribution of bank credit (percent)
Construction and real estate15.715.215.816.916.816.716.5
Finance services12.413.015.812.511.811.710.6
Of which: mortgages19.320.518.719.822.824.225.3
Earnings and profitability
Return on average assets (after tax)
Highest bank minus lowest bank0.
Return on average equity (after tax)
Highest bank minus lowest bank11.88.43.315.
Net interest income as percent of gross income62.561.961.
Highest bank minus lowest bank3.43.97.528.
Trading and fee income as percent of gross income30.232.034.640.038.535.334.6
Highest bank minus lowest bank3.13.74.928.
Noninterest expenses as percent of gross income62.561.961.
Highest bank minus lowest bank19.822.716.141.810.016.215.4
Personnel expenses as percent of noninterest expenses60.062.359.658.057.157.460.6
Highest bank minus lowest bank4.
Liquid assets as percent of total assets30.132.428.959.6
Highest bank minus lowest bank4.
Liquid assets as percent of short-term liabilities63.665.628.830.4
Highest bank minus lowest bank22.319.08.711.4
Customer deposits as a percent of total (non-interbank) loans129.2125.7119.5113.8117.6111.0110.0
Highest bank minus lowest bank45.040.426.315.822.715.918.0
Interbank assets to total assets10.611.
Highest bank minus lowest bank1.
Interbank liabilities to total assets2.
Highest bank minus lowest bank2.
Foreign exchange risk
Foreign currency-denominated loans as percent of total loans18.116.714.112.5
Foreign currency-indexed loans as percent of total loans1.
Foreign currency-denominated deposits as percent of total loans31.228.126.924.4
Of which: non-residents12.411.010.28.5
Foreign currency-indexed deposits as percent of total loans0.
Liquid foreign currency assets to short-term foreign currency liabilities64.644.044.444.7
Sources: Bank of Israel, and IMF staff estimates.

The market share of five major banks (in assets) is about 95 percent of the whole banking system.

From 2009, the calculation of capital base follows rules under Basel II.

Sources: Bank of Israel, and IMF staff estimates.

The market share of five major banks (in assets) is about 95 percent of the whole banking system.

From 2009, the calculation of capital base follows rules under Basel II.

15. Israel also enjoys the option to issue sovereign bonds under Section 502(7) of the US Federal Credit Reform Act of 1990. While only some 7½ percent of Israeli public debt is currently covered by these guarantees—some 40 percent is untapped—, and further use of the scheme is subject to key formal limits, the guarantees provide contingent reassurance.

16. Moreover, following recent discoveries of new natural gas fields, the total estimated value of which is some 50 percent of 2011 GDP, Israel will become a net energy exporter in coming years. Looking ahead, the taxation of natural resources has been rationalized, and provisions are being made to place the proceeds in a sovereign wealth fund.

17. This overall assessment of fundamentals is reflected in Standard & Poor’s rating upgrade from A to A+ on long-term foreign currency credit rating in September 2011. CDS spreads on the sovereigns have risen somewhat recently, but remain far below those of the stressed European countries.

And economic performance was strong in 2010 and into 2011

18. Output rebounded quickly from the global downturn as early as 2009 Q2, with growth of ¾ percent in 2009 and 4¾ percent in 2010. This was initially led by a pick-up in exports and private consumption, with a strong recovery in investment.

Israel: Recent Developments, 2009-11(Percent change from the previous period, SAAR; unless otherwise indicated)
Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4 Prel.
Private consumption-
Public consumption3.15.9-
Gross fixed capital formation-17.3-17.2-1.3-34.882.3-13.24.529.272.70.523.73.2
Net exports 1/0.8-1.1-0.22.3-0.60.7-0.1-0.5-1.5-0.20.3-0.8
Exports of goods and services-32.4-5.516.647.15.814.
Imports of goods and services-
CPI (end period, NSA, year on year)
Output gap (percent of potential)-1.4-1.9-2.0-1.6-1.2-0.7-
Source: Haver Analytics; IMF staff estimates and projections.

Contributions of GDP growth.

Source: Haver Analytics; IMF staff estimates and projections.

Contributions of GDP growth.

19. This was also quickly reflected in a return of employment to pre global crisis levels. The unemployment rate fell to a historical-low of 5½ percent, and wage pressures remained moderate, in part reflecting the increased entry of lower-wage earners. Unit labor cost growth was flat in 2011. But participation rates remain very low around 56–58 percent.

Israel: Labor Costs

(Y/Y percent change)

Source: Haver Analytics.

Macroeconomic policies were adjusted appropriately given the resumption of growth during 2009

20. On the fiscal side, the 2010 overall balance strengthened by 1½ percentage points of GDP (Table 6).

Table 6.Israel: Central Government Accounts, 2007–14(In percent of GDP; unless otherwise indicated)
2007 Act.2008 Act.200920102011201220132014
Revenues and grants34.031.428.828.029.128.830.329.630.829.830.830.9
Tax revenues27.825.323.223.223.524.024.924.325.524.824.624.7
Income Tax revenues13.511.49.69.810.010.510.410.4
Taxes on Goods and services11.911.811.612.
Value Added Tax7.
Other revenue 2/
Loans from NII2.
Assumed Adjustment1.01.0
Total Expenditure34.033.734.733.334.632.633.332.932.833.233.132.9
Compensation of employees5.
Use of goods & services6.
Consumption of fixed capital (CFC)
Social benefits3.
of which: Social security benefits0.
Net acquisition of nonfinancial assets-0.1-0.1-0.1-0.1-0.1-0.1-0.1-0.1
Required cumulative adjustment0.
Overall balance0.0-2.3-5.9-5.3-5.5-3.7-2.9-3.3-2.0-3.4-2.3-2.0
Net acquisition of financial assets1.81.30.3-
Net incurrence of liabilities-
Memorandum items:
Primary spending29.
Defence spending7.
Primary civilian spending21.621.823.422.022.921.822.721.722.522.722.622.5
Primary balance4.41.9-1.2-1.2-
General government balance-1.3-3.3-6.0-4.6-4.0-3.5-2.6-2.3
Cyclically adjusted primary balance3.10.5-0.6-0.2-
Deficit limit6.
Ceiling on the real expenditure growth2.
Public debt to GDP78.177.079.476.174.373.472.170.5
GDP growth rate (in percent)5.54.0-
Inflation (in percent)
Exchange rate (NIS per US$)
GDP (in billions of NIS)6877247467667808138648699199079581,013
Real spending growth-
Nominal growth in public spending4.396.
Public consumption15.915.915.715.516.717.617.717.8
Public savings (Rev-Expense)0.0-2.4-5.3-3.9-3.4-4.1-3.1-3.1
Public Saving-Investment balance-0.1-0.1-0.1-0.1-0.1-0.7-0.8-1.1
Sources: Data provided by the Israeli authorities; and Fund staff estimates.

Data as per the national defintion, cash basis, covers the budgetary sector and NII, excluding net credit.

Excludes the ILA profits from land sales, which have been recorded in financial transactions since 2009.

Sources: Data provided by the Israeli authorities; and Fund staff estimates.

Data as per the national defintion, cash basis, covers the budgetary sector and NII, excluding net credit.

Excludes the ILA profits from land sales, which have been recorded in financial transactions since 2009.

21. As domestic demand recovered and inflationary pressures and regional tensions began rising, the BoI began a tightening cycle in September 2009, raising the policy interest rate from 0.5 percent to 3.25 percent by June 2011 (Figure 5). These steps were supported by the adoption of macroprudential actions targeted at the housing market (Box 2). Though the CPI inflation was above its target band for much of 2011, the tightening helped bring it back within the target range later in the year.

Figure 5.Israel: Inflation and Monetary Policy, 2007–11

Sources: Bank of Israel; Bloomberg; DataInsight; and Haver Analytics.

1/ Defined by the Bank of Is rael as policy rate minus inflation expectations.

22. However, widening interest rate differentials vis-à-vis the United States and the euro zone alongside a resumption of “safe haven” flows led to large short-term capital inflows and significant shekel appreciation. In response, the BoI resumed intervention in foreign exchange markets, accompanied by capital control and macroprudential policy measures, such as the introduction of reserve requirements on banks’ derivative transactions with non-residents, new reporting requirements on foreign exchange swaps and derivatives, and the abolition of tax exemption for non-residents’ investments in BoI securities and treasuries.

Israel: Real Private Consumption Growth

(3 mo nth moving average, SAAR, q/q, percent)

Source: Haver Analytics.

But growth has slowed again

23. As external demand weakened again later in 2011, export volumes started dropping, with private consumption following suit, in part reflecting the negative wealth effect of falling asset prices and deteriorating consumer confidence.

Israel: Business Sector Borrowing

(Contribution to total growth, percent)

Sources: Bank o f Israel; and IMF staff calculations.

24. With downside risks to the global economy mounting, the BoI began monetary easing cycle from September 2011, which alongside the macroprudential steps noted in paragraph 22, relieved appreciation pressures on the shekel. The BoI has intervened only twice since July 2011 (Figure 5 and Box 3).

Israel: Exchange Rate and Change in Foreign Reserves

Sources: Bank of Israel; Haver Analytics; and IMF staff calculations.

25. Throughout, the shekel was slightly on the strong side, before easing more recently to around equilibrium (Box 4).

26. While the two-year 2011–12 budget was prepared on the basis of further fiscal consolidation, the slowdown in the latter half of 2011 resulted in lower than anticipated revenue collections, as the automatic stabilizers came into effect, leading to a smaller than anticipated headline consolidation.

And poverty remains elevated

27. The poverty rate, among the highest in OECD countries, has remained near 20 percent. Income inequality has also risen as measured by the Gini coefficient (0.37 in recent years).

Israel - Poverty Incidence and Gini Coefficients

(Index, total population)

source: OECD.

1/ Poverty threshold is 50 percent of the current median income.

And key concerns with preparedness for an adverse global environment remain

28. On the fiscal front, public debt is high, at some 75 percent of GDP. And security-related expenditure—typically running at some 7 percent of GDP—constrains room for maneuver (Table 4).

29. Revenue shortfalls are anticipated to continue into 2012. The authorities now project the deficit to be 3.4 percent of GDP (in line with staff forecasts), exceeding the 2 percent deficit target.

30. Furthermore, the housing market remains vulnerable (Figure 6). Though prices have recently plateaued after over a 50 percent increase since 2007—it is unclear if this heralds a soft landing. Risks in both directions remain high.

Figure 6.Israel: Housing Markets, 2007–11

Sources: Bank of Israel; Central Bureau of Statistics; and Haver Analytics.

31. In this context, Israeli share prices have fallen faster than in advanced countries, and volatility in foreign exchange markets has again risen.

32. These strains are most apparent in the Israeli corporate bond market—that seized up in 2009. Spreads have risen, particularly in real estate and holding companies, and bond financing has dropped again in recent quarters.

On balance, however, Israel is unlikely to experience a severe downturn in the near term

33. As a baseline scenario, given the external slowdown projected, staff expect real GDP growth to fall to 2.9 percent in 2012 and rebound to 3.8 percent in 2013, its staff-estimated potential rate. Exports will be the main channel, weakening and then leading the subsequent recovery?albeit recovering more slowly than after the 2008 downturn. Absent a major global crisis, private consumption and investment are projected to be resilient throughout, reflecting capacity constraints, low unemployment, and supportive macrofinancial policies.

34. The baseline scenario implies that the output gap will turn slightly negative in 2012, and will gradually close as the economy rebounds. CPI inflation will remain within the target band, reflecting soft domestic demand alongside stable global energy and commodity prices.

Israel: Short-term Projections, 2012–13(Percent change from the previous period, SAAR; unless otherwise indicated)
201220132011 Prel.20122013
Private consumption2.
Public consumption2.
Gross fixed capital formation5.
Net exports 1/-
Exports of goods and services-3.5-
Imports of goods and services-3.0-
CPI (end period, NSA, year on year)
Output gap (percent of potential)-0.1-0.2-
Source: Haver Analytics; IMF staff estimates and projections.

Contributions of GDP growth.

Source: Haver Analytics; IMF staff estimates and projections.

Contributions of GDP growth.

But risks—notably to the downside—remain significant

35. Early resolution of the Euro area crisis and stronger-than expected global growth would buoy prospects. But persistent Euro strains and the associated drag on global output represent more likely downside risks to the Israeli outlook, with regional tensions, a resumption of domestic social protests, and the possibility of early national elections all compounding these challenges to growth and to delivery of strong macroeconomic policies.


With global strains rising, the key task is to maintain growth momentum while strengthening resilience to downside external shocks. With the output gap opening slightly and automatic stabilizers given free rein, fiscal policy should remain focused on debt reduction over the medium term and on strengthening social inclusion. In this context, monetary policy has room for maneuver, and is thus in a position to alleviate the impact on growth of steady fiscal withdrawal. The FSAP update proposed various steps to strengthen the financial sector.

A. Fiscal Policy and Framework

The 2012 budget deficit is expected to overshoot the original target significantly

36. Revenue for 2011 is below budget estimates. This reflects shortfalls relative to projections of:

  • VAT (due to the deceleration in private consumption);

  • capital gains receipts (due to sharp falls i stock prices);

  • real estate taxes (due to lower transactions); and

  • fuel and energy excise hikes (due to cancellation of planned rises).

37. Thus, although expenditure was slightly lower than the budget in 2011, the budget deficit was 3.3 percent of GDP, somewhat above the 3 percent target.

38. These revenue shortfalls relative to official projections appear largely to reflect overoptimistic estimates. In particular, the outturns imply revenue ratios close to those 2009 and 2010. Thus hoped for revenue increases did not materialize. But overall, wit the possible exception of the yield from corporate taxation—where strong economic growth does not seem to be reflected in 201 receipts—there is no evidence that the 2011 shortfalls are rooted in major structural problems with the revenue base.

39. Thus, the outlook for overall revenue ratios in 2012 is similar to that for 2011, implying an additional shortfall in 2012 of revenue relative to the two-year budget projections.

Israel: VAT Revenues and Private Consumption

(billions of NIS)

Sources: Haver Analytics; and Bank of Israel.

40. With expenditure ceilings for 2012 already set out in the approved two-year 2011–12 budget, and given staff growth and associated revenue projections, the deficit outturn for 2012 is projected at around 3.4 percent of GDP, exceeding the target by almost 1½ percentage points of GDP.

The top priority of fiscal policy is to keep public debt on a downward track over the medium-term

41. This will maintain confidence in Israel despite strained international markets, and so allow some flexibility in the deficit path in the short term (Box 5).

42. This critical task has become considerably more difficult. Near-term global and Israeli growth projections have been marked down, and so the 2012 budget is set to overshoot its deficit projection. Furthermore, a surge in retirements in coming years will reduce the growth of Israeli productive capacity to below the norms of the past decade. Social concern with prices will constrain options to raise indirect taxation. Calls for added public spending—including for social needs and security—have mounted.1 Unfunded fiscal commitments of some ¾ of a percentage point of GDP for 2012 have to be resolved within the 2012 budget framework.

43. Accordingly, the authorities’ commitment to maintain the total spending limits in the 2012 budget is welcome, as is the Trajtenberg committee’s determination to observe these and the medium-term spending limits. Alongside the decision to withdraw plans for phased reductions in direct tax rates, these actions have helped to underpin continued investor confidence in the Israeli sovereign in a difficult global environment. And they allow scope to let the automatic stabilizers operate on the revenue side in 2012.

44. But more is needed—in particular, a decisive effort to approach the 2013 budget deficit ceiling should be made. This will require contributions from all sides—from expenditure restraint including defense to keep total spending within the ceiling, new initiatives to raise revenues, and efforts to strengthen the productive potential of the economy.

45. Even so, unless the outlook for activity and revenues improves markedly in coming months, a full return to the headline target for 2013 would be unduly contractionary. Final determination of the appropriate 2013-14 targets for the fiscal balance should be made before mid-2012 reflecting domestic and global developments at that time.

46. This change in the 2013 deficit target will need to be accompanied by a further strengthening of the fiscal rules and frameworks. Given commitment to the expenditure rule, there will likely need to be a reset of the path of targets for the deficit ceiling. Options for that include clarification that the path will be adjusted for automatic stabilizers. Alongside, and in response to the mounting difficulty of securing medium-term debt reduction, the establishment of a permanent and independent Fiscal Council to assess whether overall fiscal policies are consistent with debt reduction may help to secure that goal.

47. Following the approval of the Knesset of the arrangements for taxation of natural resources, as recommended by the Sheshinski committee, the authorities are finalizing arrangements for the sovereign wealth fund. This should follow international best practice, including assigning all relevant proceeds to the fund, and in regard to the management arrangements it will follow and the size of transfers back to general revenues.

48. In this context, even with expenditure restraint fully playing its appropriate role, there is a good case for deficit-reducing discretionary fiscal policy actions to focus on taxation, over the near and medium terms. Key non-security spending items?such as health and education?are around levels of moderate-spending OECD peers (see SIP Chapter II). And in some areas, there is need for increases, notably in education and public investment, including in the Arab-Israeli communities. So scope for additional overall spending compression on a significant scale is not apparent. On the other hand, with the VAT rate at only 16 percent—albeit with few exemptions—and given the priority attached to strengthening environmental and housing taxation, revenue increases in these areas alongside curbs to tax expenditures could reinforce the credibility of plans to lower public debt.

49. Although Israel has not exercised its option to issue debt under the longstanding US government guarantee scheme over recent years, it has provided additional reassurance in an environment of heightened sovereign risk. There is a good case to seek extension of this scheme when it expires in September 2012, and given heightened global risks, to seek to raise its limits.

Strengthening medium-term expenditure planning will add credibility

50. Continued expenditure restraint will be required—on both the civilian and defense sides, notably because government-approved undertakings exceed the ceilings implied by the fiscal rule. This perennial gap reflects longstanding shortfalls in medium-term expenditure planning mechanisms. As recommended in the 2010 Article IV consultation, and as is best practice in the OECD, a comprehensive institutional framework—including fiscal responsibility laws, a medium-term macro-fiscal framework, and a medium-term expenditure framework—is needed.

Israel: Medium-term Fiscal Outlook, 2010-15
BudgetEst.BudgetStaff proj.Staff projections
(Billions of NIS)
Central Government 1/
o/w Taxes196215212234225236250265
o/w Defense5259595656596266
Budget balance-30-25-29-18-31-22-21-20
(Percent of GDP)
Central Government 1/
o/w Taxes24.024.924.325.524.824.624.724.8
o/w Defense6.
Budget balance 2/-3.7-2.9-3.3-2.0-3.4-2.3-2.0-1.9
General Government
Overall balance-4.6-4.0-3.5-2.6-2.3-2.1
Cyclically adjusted primary balance-0.2-
Gross public debt76.174.373.472.170.569.0
Memorandum items:
Nominal GDP grow th (percent)
Inflation (annual average)
Real GDP grow th (percent)
New real expenditure grow th rule (percent)
Nominal GDP, NIS billion8138648699199079581,0131,068
Sources: Israeli authorities; and IMF staff estimates.

Data as per the national definition, covers the budgetary sector and NII, excluding net credit.

The deficit ceiling rule is applied to central government balances.

Sources: Israeli authorities; and IMF staff estimates.

Data as per the national definition, covers the budgetary sector and NII, excluding net credit.

The deficit ceiling rule is applied to central government balances.

B. Monetary and Exchange Rate Policies and Frameworks

The monetary policy stance is broadly appropriate under baseline projections, but policy can be relaxed further if fiscal and financial sector policies are strengthened or output prospects weaken.

51. Headline CPI, which exceeded the 1–3 percent target range during the first half of 2011, has returned within the target range. While longer-term inflation expectations have remained stable and on target, near-term inflation expectations have dropped sharply towards the mid-point of the range since Fall 2011.

52. This reflects various opposing forces: upward pressure due to a narrowing output gap; and downward pressures reflecting a sharp decline in global food prices, reduced retail mark-ups following the summer social protests, and (until recently) a strong exchange rate.

Israel: Inflation

(y/y percent change)

Source: Haver Analytics.

53. On balance, the outlook is for further disinflation, with output projected to decelerate and global food and energy prices to stabilize or recede. Inflation is on track to ease towards and even beyond the mid-point of the inflation target range.

54. But three factors warrant close attention.

  • First, wage pressures. While unit labor costs have been stable—with wage growth matching a productivity surge after the 2009 downturn—pressures could mount. In particular, following increases of 2 1/2 percent in the minimum wage in early 2011, rises of 8.9 percent are anticipated for October 2012. And if fiscal adjustment measures include increases in indirect tax rates, this could trigger wage pressures, with implications for inflation. Cooperation by wage setters to maintain stability will be essential to avoid this.

  • Second, house prices. While it is unclear if house prices are misaligned, abrupt corrections would pose limited risks to financial stability but could destabilize domestic demand. Conversely, monetary relaxation could also reignite the market, although the transmission between the discount and mortgage rates has been attenuated by recent macro prudential measures aimed at reducing the proportion of new variable-rate secured loans to total loans. Measures to smooth the supply of land for housing over time, and steps to increase the taxation of second properties, backed up by additional macro prudential steps if necessary, would help de-link further changes in the policy rate from house price inflation.

  • Third, phased anticipated increases in the required minima for banks’ core Tier 1 capital, possibly compounded by strains in the corporate bond market, and the recommended strong fiscal stance could slow both credit growth and activity. Thus, given lags, monetary policy should anticipate and offset these effects, once they are adopted. And if global tail risks materialize, there would be scope for more aggressive interest rate reductions.

The monetary and exchange rate frameworks have been strengthened

55. The adoption of a new BoI Law in 2012 has more formally entrenched inflation targeting as the monetary regime in Israel. However, there are a number of ways in which implementation might be strengthened. Options include emphasizing the mid-point of the inflation target range as the goal for policy; lengthening the horizon of published inflation and GDP forecasts; and providing more and more systematic public information on the Bank’s forecasting technology. And, the arrangements for remuneration of Bank of Israel staff should be reviewed making this the Bank’s remit alone to guarantee full budgetary autonomy—as in other inflation-targeting central banks—to secure the independence of the central bank (see SIP Chapter III).

56. The floating exchange rate regime remains appropriate. Though the switch from freely floating to floating which occurred in 2008 marked a break with a decade of practice, it proved an effective response to the disturbed global environment—notably because the new regime was mainly aimed at addressing disorder in the foreign exchange market rather than at affecting the trend. As inflation pressures have eased and markets have begun anticipating interest rate cuts, upward pressures on the shekel have eased and discretionary intervention has not occurred in recent months. This leaves foreign exchange reserves at a comfortable level by most standard measures (Text Table).

Foreign Reserves(End period)
In billions of US dollars60.670.974.977.1
In months of imports of goods and services9.69.110.0
In percent of short-term external debt143.5130.5
In percent of total external debt65.066.9
In percent of broad money53.757.058.9
Sources: Haver Analytics.
Sources: Haver Analytics.

57. Looking ahead, the monetary regime should continue to emphasize the policy rate instrument, with intervention playing a secondary role. In the case that strong safe-haven inflows resume, a mix of expansionary monetary policy and tighter fiscal policy will be appropriate. Should these measures not suffice to maintain orderly markets, intervention and additional administrative controls on foreign currency transactions can be considered, but if so, exit strategies from use of all these instruments should be prepared.

58. The introduction of a reserve requirement on derivative contracts and information requirements on foreign investments in the short government bond market have signaled efforts to maintain orderly condition in foreign exchange markets, The measures remain appropriate.

C. Financial Stability

The FSAP Update assures on financial system soundness, but the global environment is highly uncertain

59. Israel’s financial system appears robust in the context of a global and Israel slowdown, and even, to a significant extent, in the context of a global downside tail scenario (Tables 57 and Figures 68).

60. Various factors underpin that assessment:

  • Households’ balance sheets appear strong: despite the housing boom, household leverage has not increased even as their financial assets appreciated in recent years (Figure 7). Recourse-style mortgages, banks’ close customer relationships, and proactive BOI regulations on LTV ratios and variable rate loans all kept loan losses low. Corporate borrowing from abroad is also modest (about 15 percent of GDP).

  • Commercial banks’ largest borrowers, typically conglomerates groups, have diversified business activities, and the BOI has strengthened supervision of concentration risk. Banks have negligible direct exposure to European sovereign, bank, and nonfinancial sector credit risks.

  • Policy to secure bank stability has long emphasized highly proactive supervision as the core instrument, a practice now being adopted more widely internationally. And banks are overwhelmingly deposit funded, backed by strong implicit public deposit guarantees, minimizing liquidity risks. Overall risk weighted bank capital ratios are comfortable—which in parts reflect the use of conservative standardized approach in measuring asset risk weights—although the quality of capital is not as high as in many comparable countries.

  • Regulation of nonbanks and financial products has been strengthened (Figure 8 and Table 7). In insurance, the policy making and supervision capacity of the CMISD has been substantially upgraded since 2008. And in securities markets, following the Hodek Committee’s recommendations of early 2011, the Companies Law was amended in August 2011 to improve the quality and timeliness of disclosure, and corporate governance requirements.

Figure 7.Israel: Corporate and Household Sectors, 2004-11

Sources: Bank of Israel; Israel Central Bureau of Statistics, and Haver Analytics.

Figure 8.Israel: Performance of Non-Bank Financial Sector, 2005-11

Sources: Bank of Israel; Israeli Ministry o f Finance’s Capital Mark ets, Insurance, and Savings Dep artment; and Ha ver Analytics.

Table 7.Israel: Financial Soundness Indicators—Non Banks, 2005–11(In percent; unless otherwise indicated)
Insurance sector
Return on equity282329-193619-3 1/
Net premiums as percent of capital261261252303204193167 1/
Capital as percent of technical reserves7776777 1/
Surplus capital as percent of required solvency 1 capital2527141252915 1/
Liquid assets as percent of total assets42444641495250 1/
Household assets as percent of disposable income615577650541626
Of which: residential buildings155152150150140
Household debt as percent of disposable income62585961606262
Corporate sector
Business sector borrowing (in percent of GDP)9797104103969489 1/
From residents79798685797874 1/
From non residents18191817171615 1/
Debt to equity ratio
All nonfinancial corporate197188221265226230235 2/
Of which: Manufacturing sector124118118130111112112 2/
Construction corporate299275278411374296289 2/
Net income to equity ratio
All nonfinancial corporate121214-1912
Of which: Manufacturing sector11101391213
Construction corporate151925-41-215
Earning before interest and tax to equity ratio
All nonfinancial corporate211923111421
Of which: Manufacturing sector201917141417
Construction corporate241844-91332
Equity markets
Tel Aviv Stock Exchange Index 75 (annual percent change)19196-6815016-26
Equity prices of financial institutions (annual percent change)3680-561279-34
Equity prices of real estate firms (annual percent change)41681-8012515-23
Equity prices of banks (annual percent change)5546-561147-35
Market capitalization in percent of GDP9410513256939969
Corporate bond markets
Corporate bond yields over government bond yields (in basis points)
Real estate and construction1.91.83.517. 1/
Manufacturing2. 1/
Corporate bond outstanding (in billions of NIS)73.3109.0188.3202.3234.7255.7276.0 1/
Average daily turnover (in millons of NIS)214.6274.4672.8923.8899.4882.2892.0 1/
Real estate markets (prices; annual percent change)
Average prices of owner occupied dwelling11.3-
Tel Aviv14.5-7.914.910.734.116.9-8.1
Sources: Bank of Israel, and IMF staff estimates.

2011 Q3.

2011 Q2.

Sources: Bank of Israel, and IMF staff estimates.

2011 Q3.

2011 Q2.

61. With this background, the stress tests conducted under the FSAP Update suggest that the effect on financial institutions of a major shock would be considerable but manageable.2 A scenario more severe than that seen in 2008-09 would erode some banks’ capital significantly, but could recover quickly if earnings are retained. Liquidity stress tests likewise are broadly comforting. Stress tests for insurance and long-term savings funds also confirm that institutions and policy holders have sufficient buffers to cope with strong shocks.

62. But some concerns should be highlighted:

  • A major crisis associated with a contraction in trade and more difficult funding conditions could squeeze corporates’ market borrowing and have rapid and complex knock-on effects elsewhere in the economy.

  • Concentration risk is significant A failure of each bank’s largest borrower group would lead to credit losses equivalent to 9-13 percent of Tier 1 capital. Furthermore, some companies face rising risk premia and large roll-over needs in the coming period.

  • While households’ indebtedness is relatively stable and low, tails of LTV ratios are high. Banks have also significantly increased their exposures to construction sector. Thus, if a housing correction were to result in a drop in construction, banks would be exposed to credit risk through direct (increased nonperforming loans) and indirect channels (weaker economic growth).

63. The “Concentration Committee” has recommend that Israel’s corporate pyramid structures should be reformed. Notably, controlling shareholders will be prohibited from holding or controlling both financial institutions and real business companies of a significant size. The implications of the transition for stability are not clear. Some groups are already beginning to adjust by selling assets, and careful attention is warranted.

Summary of Performance of Israel Five Bajor Banks(In percent; unless otherwise indicated)
Bank LeumiBank HapoalimIsrael Discount BankMizrahi Tefahot BankFirst International Bank
200920102011 Q3200920102011 Q3200920102011 Q3200920102011 Q3200920102011 Q3
Total capital to RWAs 1/
Tier 1 capital to RWA8.
Equity to total assets6.
Asset quality
NPLs to credit 2/
Loan loss provision to credit0.
Earning and profitability
Return on equity10.
Deposits to loans122.4111.4112.6107.5103.999.3123.9116.3125.980.899.099.0137.4126.3123.1
Source: Bank of Israel.

Risk weight assets (RWAs) under Basel II standardized approaches.

Non performing loans (NPLs).

Source: Bank of Israel.

Risk weight assets (RWAs) under Basel II standardized approaches.

Non performing loans (NPLs).

In light of the FSAP assessment and the downside tail scenario, several steps are recommended.

Bank capital requirements

64. As the banking sector develops, proactive supervision needs to be reinforced by higher quality capital. Tail risks associated with large borrower groups and the concentrated structure of the banking sector reinforce this case. Focus should be on raising core Tier 1 capital, with some dilution of controlling shareholders if that is necessary to secure equity increases. The authorities are considering plans to do this.

Liquidity requirements

65. The BOI has already moved to tighten its regulation on liquidity management, but this is an area where international practice is fast evolving in the aftermath of the global crisis; the BOI will need to keep its regulations and practice up to date.

Non-bank financial sector supervision

66. Improving cross-border oversight, and the supervision of groups connected to insurance companies—in particular related holding companies—are among the priorities. For securities markets, enforcing high standards of due diligence in the underwriting of securities issues and closing the gap by bringing all unregulated broker dealers into regulatory periphery.

Supervisory coordination and macroprudential oversight

67. The institutional framework for cooperation among supervisory agencies has not been fully developed. While ex post, in mid 2008–09 crisis, cooperation between all the relevant agencies was frequent and substantive, ex ante it was considerably less so, greatly hampering preparedness. A Financial Stability Group consisting of representatives from the BoI, the CMISD, and the Israel Securities Authority, was set up in the mid-2011. But key operational issues remain, including those arising from the diverse mandates of the agencies involved, which complicate the sharing of information, the coordination of diagnostic analysis, and policy actions—including macro-prudential policies.

68. Thus, the FSAP suggested the establishment of a more formal standing Financial Stability Committee (FSC). If the FSC does not resolve apparent impediments for ex ante cooperation among the supervisory agencies, current architectural arrangements may need to change to secure that goal.

Crisis management

69. A comprehensive review of crisis management framework should be conducted, before a major disturbance occurs. Several elements need to be integrated:

  • The BOI’s emergency liquidity assistance framework should be more fully articulated so as to facilitate quick action when needed, but also protecting the BOI from taking on undue risks.

  • The legal framework for BOI’s early intervention powers and instruments should be strengthened, and a special bank resolution framework should be established.

  • A financial support mechanism for resolution is needed. Several possibilities are available (such as several versions of a resolution fund and deposit guarantee scheme), but in any case there needs to be some government rather than central bank back-stop for what is an essentially fiscal issue.

  • A study of the implications of Israel “pyramid corporate” structures for the origination and transmission of stress in markets is needed. The results should guide supervision policies, and the implementation of proposals from the “Concentration Committee” on reform of corporate structures.

D. Macrosocial Challenges and Sustainability

Long-standing problems in the labor market should be tackled soon

70. Labor force participation rates are among the lowest in the OECD, largely reflecting Arab-Israeli women and Haredi (Ultra Orthodox) men. The wage levels of overall Arab and Haredi workers are lower than other Israeli groups, and both communities consequently experience high incidence of poverty. If the employment and wage in their communities were on a par with others, Israel output would be some 15 percent higher than it is, and annual fiscal revenues would also be higher than they are by some 5 percent of GDP. These participation issues are macroeconomic in scale.

71. Both communities want work, and both should be facilitated to realize that goal. Necessary steps include provision of basic child care and transportation in the Arab areas, arrangements for inclusion of Haredi males in the armed forces in ways that support their employment and productive potential, and action to remove impediments to business establishment in both communities. Both groups also need their particular education requirements to be addressed, notably equalization of education provision at all levels in Arab-Israeli communities with that elsewhere, and focused provision of adult education to address Haredi needs. And social benefits to both groups, including child care, should be increasingly tied to employment.

72. A number of official initiatives to address the needs of these “currently” minority populations are underway—alongside the many ongoing private initiatives. These include targets for participation, extension of the earned income tax credit, establishment of a proactive unit for Arab affairs in the Prime Minister’s office, and expansion of Haredi units in the defense forces. And the recent Supreme Court ruling against Haredi exemption from military service has made a decisive resolution of these issues even more urgent. Accordingly, as well as upgraded enforcement of anti discrimination legislation and basic labor regulations, much more is needed. This has implications, as noted, for additional spending, particularly education and public investment. Early and substantive progress will require strong leadership from all sides—and great political dexterity.


73. The authorities agreed with the overall assessment of economic developments and the implications for policy including in the financial sector. They underscored need for maintenance of the 2012 expenditure ceiling and commitment to the expenditure rule for the 2013–14 budget. They recognized that while the deficit targets for 2012 and 2013 could be missed, this in large part reflected automatic stabilizers appropriately operating. This, and the recent relaxation of monetary policy would support near term growth, with macroprudential measures in place to stabilize the housing market. Policymakers stand ready to adjust fiscal and monetary policy settings in the event of a major global shock. And the authorities agreed on the need to raise labor participation rates.

74. Within that overall agreement, however, some differences of emphasis were noted.

Fiscal Policy and Framework

75. The authorities have decided not to increase the rate of VAT further at this stage. This reflects in part the concerns over the increase in the cost of living, and that the VAT, unlike many elsewhere, has few exemptions, but all options remain on the table.

76. Furthermore, in February 2012 the government approved the general framework of principles for the sovereign wealth fund, under which withdrawals from the fund will be restricted to the regular annual transfer to the budget based on long term yields.

77. The authorities indicated that they would explore the option of extending the existing US guarantee scheme as one element of their broader efforts to reassure markets of their commitment to fiscal stability. However, they did not see need at this stage to seek to raise the limits under the scheme.

78. The authorities also do not see a compelling case to establish a Fiscal Council. They regard the scrutiny by international agencies, the BoI, local experts, rating agencies, and investment banks as providing a sufficient degree of oversight. However, the idea would remain under review.

Monetary Policy and Framework

79. The authorities emphasized that they regard the current stance of policy as appropriately weighing upside and downside risks, while maintaining “sufficient firepower in reserve” to respond to possible adverse shocks. However, they agreed that their assessments would adjust in light of fiscal and supervisory initiatives, once these were adopted. They noted that the decrease in intervention over time essentially had constituted an exit strategy. It remains an option in line with the announced policy in cases of disorderly markets or significant departure from economic fundamentals.

80. They noted that while a number of developments to the inflation targeting framework could be considered, any change should be gradual and reflect local circumstances, given no ‘first best” model of inflation targeting.

81. The BoI noted concerns with the current arrangement, regarding the remuneration and contractual conditions for its staff. However, the fiscal authorities emphasized need for those arrangements to be consistent not only with private sector but also with public sector arrangements. Accordingly, the current arrangement for the BoI would remain in place.

Financial policy

82. The authorities are considering a number of options for the operation of the proposed FSC. Their inclination, rather than to move directly to formalizing the arrangement, is to “learn by doing” first, and to design a formal arrangement in light of lessons learned. At present, cooperation between the regulators has improved notably, in terms of both consultation and information flows: however, the need to prepare for effective crisis management (even given the relative safety and soundness of Israel’s financial system) requires an improvement in the pace and intensity of this cooperation, especially regarding the development of micro-based information flows on institutional interconnectedness (network diagrams) and related stress tests that include contagion risks.3 The BoI noted the lack of emphasis on these important points in the FSAP and the Article IV papers.

Labor participation

83. While agreeing that this matter is essential, the authorities also emphasized that cultural issues and low job market skills restrict participation in the labor market. They noted early signs that these matters are responding to an adjustment in incentives, and that dialogue with all communities would continue. And as part of the need for flexibility on all sides, the authorities emphasized need for the adoption of more of the core curriculum across all schools, and increased enforcement of anti-discrimination legislation.


84. Israel’s economy remains strong. Growth has been robust with fixed investment rising more recently, unemployment is at a historic low, while inflation and inflation expectations are squarely inside the 1–3 percent target range. The shekel is now broadly consistent with fundamentals and international reserves are appropriate by most measures. These successes reflect strong policy frameworks.

85. But vulnerabilities remain and growth is slowing. Public debt and security expenditures are high, house prices have surged by over 50 percent in recent years, and poverty is elevated. And risk premia in the corporate bond market have risen significantly.

86. Given the prompt accommodative policy response to signs of slowdown, a severe downturn is unlikely. The Bank of Israel reversed its tightening cycle from September 2011, and automatic stabilizers are operating fully. Accordingly, GDP growth is projected to decline to a little below 3 percent before returning to trend at 3¾ percent in 2013, with both sides of this cycle led by exports.

87. Nevertheless, policies and policy frameworks should all be adjusted further to better anticipate the risks, as elaborated below.

88. On the fiscal side, medium-term debt reduction remains the top priority. This requires firm adherence to the total spending limits in the 2012 budget and a decisive effort to approach the 2013 budget deficit ceiling. Discretionary fiscal actions to this end should focus on taxation, given limited scope for overall compression of spending

89. But a full return to the headline target for 2013 would be unduly contractionary. The target should be adjusted, as part of a broader suite of reforms to the fiscal framework, including specification that the deficit path will be adjusted for automatic stabilizers, confirmation that natural resource revenues will be placed in a well-managed sovereign wealth fund, and establishment of an independent Fiscal Council.

90. The monetary stance is broadly appropriate under the baseline projections, but the recommended fiscal and financial stability policies would create scope for further relaxation. In particular, phased increases in the required minima for core tier 1 bank capital, and the strong fiscal stance recommended could slow activity—which monetary policy should anticipate. Any remaining concerns with renewed housing inflation should be addressed with macroprudential tools.

91. Alongside, the monetary framework should continue to be enhanced. Options include lengthening the horizon of published inflation and GDP forecasts, and increased emphasis on the mid-point of the inflation target range as the goal for policy. In this connection, the arrangements for remuneration of Bank of Israel staff should be reviewed as they raise concerns with effective independence of monetary and supervisory policy.

92. Furthermore, with the shekel broadly at its equilibrium, a de facto free floating exchange rate regime should be maintained. But the option to intervene to sustain orderly conditions, if necessary, is appropriately warranted.

93. On the financial stability side, “normal” risks appear contained. Banks and other financial institutions would likely be able to withstand even a severe downturn including a domestic housing crash, and heightened credit risk in the corporate sector.

94. Nevertheless further steps are warranted, including plans to raise bank capital ratios and to strengthen liquidity requirements in accord with Basle III. A stronger financial crisis management framework and preparations for shocks outside of historical experience should be implemented. The use of the BoI’s emergency liquidity facilities and the legal framework for early intervention and resolution powers should both be reviewed urgently. The risks arising from the bankruptcy of one or more of the large corporate groups should be studied. And finally, the establishment of an FSC—comprising all the main supervisors—could help substantially in facilitating a more systemic approach to financial sector policy. But if this FSC does not succeed in addressing coordination challenges amongst supervisors, the architectural layout of financial sector supervisors may need to be recast.

95. But even with all this, stability in Israel in the long run will not be assured unless labor participation rates—notably the Arab-Israeli and Haredi communities—are raised. These exact a heavy toll on output, fiscal revenues, and inequality, and this toll is set to rise as the share of these populations rises towards half in coming decades. Actions needed include provision of basic child care and transportation, accommodation for both groups in the defense/civic services, business establishment in both communities, and imaginative reform of education. And social benefits to both groups, including child care, should be increasingly tied to employment. Steps are underway in this direction, but much more is needed to secure the long-term sustainability of the Israeli economy, and with it, the welfare of all of its citizens.

96. Staff recommends that Israel should remain on the standard 12-month consultation cycle.

Box 1.2011 Social Protest and the Trajtenberg Committee Recommendations

In July 2011, a nationwide protest movement happened, initially focused on rising house prices, but subsequently encompassing broader social issues and the cost of living. Protestors, pitching tents in main streets in large cities such as Tel Aviv, demanded lower indirect and higher direct taxes, free education and childcare, suspension of privatization, and investment in social housing and public transport. Though initially small, their numbers swelled to some 400,000 (five percent of the population) and they stayed through September.

The Trajtenberg committee, which the government established to address issues raised recommended several measures that have budgetary implications. On December 6, 2011, the Knesset passed legislative amendments to change taxation.

Key measuresAnnual Budgetary Impact (billions of NIS)Approved by the Knesset
Cancellation of scheduled income tax rate reductions
The corporate tax was due to fall from 24 to 18 percent, and the top rate of personal income tax from 45 to 39 percent, both by 2016.1.8yes
Increases in corporate income and capital gains taxes
Increase in the corporate income tax from 24 to 25 percent, and possibly later to 26 percent.0.7yes
Increase in investment income taxes on dividends, interest, loan discount, capital gains and land appreciation.1.4yes
Increase in tax on dividend payments to major shareholders from 25 to 30 percent.n.a.yes
Changes in personal income tax rates
Increase in the top rate from 45 to 48 perc en t on ann u al in c om e ov er NIS489, 480.0.8yes
Reduction of the medium rate from 23 to 21 percent on annual income NIS103,929 - NIS168,840-0.8yes
Imposition of an additional 2 percent tax on those with income over NIS1 million per year0.4no
Changes to social security contributions
Reduction of the ceiling on employee social-security contributions to five times the average wage (following a temporary increase in the ceiling to eight times the average wage in 2008).-0.8yes
Increase in employers’ national insurance contribution rate for those earning above 60 percent of the average wage f rom 5. 68 to 7. 5 percent.2.5No
Changes to indirect tax
Cancellation of the scheduled increase in excise on gasoline and diesel-2.5yes
Commitment to a scheduled cut in import duties, except on cars and agricultural products.-0.75yes
Cancellation of the scheduled cut in the VAT rate from 16 to 15.5 percent2yes
Additional tax breaks for families
Extension of child tax credits to fathers-1yes
50 percent increase in the earned income tax credit for mothers-0.8yes
Total revenue impact (excluding those approved by the Knesset)0.1
Expansion of child care and early childhood education
Increase in public spending on day care services for ages up to three years old; intorduction of free compulsory education from age 3 to 5; reduction in school fees.4Yes
Targeted schemes for minorities
A number of schemes are proposed, all of which aim to encourage the integration of minorities into the workforce, particularly Arab-Israeli females and ultra-orthodox men.n.a.yes
Additional measure to lower housing costs
Several schemes are proposed, for instance affordable long-term rental housing units, increased rent subsidies, increae in property tax on empty apartments0.2partly
Overall the Trajtenberg committee recommended additional spending of NIS30 billion over 5 years. Not approved by the Knesset6No
Reduction of defense spending by NIS2.5 billion per year over 5 years.-2.5No
Total expenditure impact (excluding those not approvedby the Knesset)4.2
Overall budetary Impact-4.2

Box 2.Measures to Stabilize the Real Estate Sector

  • August 2009: A regulatory alert for caution in extending adjustable rate housing loans. Intended to reduce potential losses in case of borrower’s payback difficulties as a result of an increase in interest rate.

  • March 2010: New treatment for credit to a “purchasing group"—individuals who organize themselves for the joint purchase of land rights in part to get tax benefits. Credit allocated to purchasing groups must be classified as “construction and real estate” credits that embed higher risk. Intended to reflect the true risk inherent in the business.

  • July 2010: Supplemental reserve for high leveraged housing loans. Additional reserve of at least 0.75 percent for new loans with loan-to-value (LTV) ratio exceeding 60 percent-intended to increase bank reserves to absorb losses when adverse developments in the housing market and real economy occurs.

  • October 2010: higher capital requirements for high leveraged housing loans. Applying a risk-weighted factor of 100 percent for housing loans where the amount indexed to a floating interest rate is over 25 percent & LTV of at least 60 percent. This regulation does not apply to loans less than NIS 800,000.

  • May 2011: limiting the adjustable-interest-rate component of housing loans to 1/3 of the total loan. Intended to reduce the likelihood that borrowers’ repayment ability would impaired as interest rates rise.

  • Detailed reporting requirement on residential mortgage loans including: loan-to-value, payment-to-income etc.

  • Collecting and analyzing stress tests results conducted by banks on residential mortgage portfolio; enhancing supervision of banks practices (off-site and on-site) and a monthly monitoring of developments in consumer market and residential mortgage loans’ market; and enhancing BOI cooperation with the Ministry of Finance and the Ministry of Construction & Housing concerning the residential housing market and its potential impact on financial stability.

  • Increasing the supply of land by Israel Land Authority, and raising taxation of the second property.

Box 3.BoI Foreign Exchange Policy 2010–11

After a long period without intervention, the BoI resumed the purchase of foreign currency from March 2008, in an effort to moderate the pace of currency appreciation and maintain orderly conditions in markets. However, no purchases have been made since August 2011. Over this period, the shekel has weakened against the dollar, sliding by more than 9 percent.

At the beginning of 2011 the Bank of Israel introduced additional measures in the foreign currency market:

  • It imposed reporting requirements on swaps and NIS/foreign currency forwards, and on nonresidents’ transactions in makam and short-term government bonds.

  • The Bank also announced the imposition of a 10 percent reserve requirement on nonresidents’ NIS/foreign currency swap transactions and foreign currency forwards. This was done to reduce the profitability of nonresidents’ short-term capital inflow into Israel, and thereby to moderate the appreciation caused by such inflows.

  • At the same time, the Ministry of Finance announced that it intended to abolish the tax exemption of nonresidents’ profits from investments in makam and short-term government bonds—thus bringing this taxation in line with that on Israeli residents—with the intention of making such investments less attractive.

Box 4.Exchange Rate Assessment

In 2011 the shekel experienced moderate volatility relative to peers amid strong capital inflows. Israel’s real effective exchange rate (REER) appreciated throughout 2010 and the first half of 2011, apart from a temporary weakening in January 2011 that resulted from heightened geopolitical uncertainty in the region. Currency interventions and the introduction of macro prudential measures to limit short-term capital inflows helped stabilize the exchange rate in the rest of 2011. Overall, the shekel weakened by 31/2 percent in real effective terms from December 2011 to October 2011.

The real exchange rate is broadly in line with its 1987-2010 average, but its equilibrium value has depreciated further below the historical mean due to worsened terms of trade. The equilibrium exchange rate approach based on staff’s panel-data CGER estimates indicates that the exchange rate is overvalued 18 percent, largely reflecting the expectation of a significant decrease in public consumption relative to GDP in the staff’s forecast—which pushes up the long-run current account norm as this is expected to reduce the price of non-tradables relative to tradables over time. Given hefty spending on defense relative to non-defense as well as the high share of tradables in defense spending in Israel, the CGER-ERER based estimates may be overstating the effect of public consumption on the real exchange rate and thus this misalignment should be interpreted with care. On the other hand, the projected medium-term CA balance is broadly in line with the CA balance norm and is larger than the NFA-stabilizing CA balance, implying a broadly balanced MB estimate and a moderate undervaluation according to the ES approach.

Real Exchange Rate CGER Assessment
Approach2010 AIV (Fall)2012 AIV
Equilibrium Exchange Rate10 pc18 pc
Macro Balance-10 pc-7 pc
External Stability-15 pc-1 pc

Staff’s view is that the shekel is around the rate suggested by fundamentals. Although the formal CGER indicators of competitiveness remain dispersed as they have been since 2009, the gap between the various measures is closing, with two out of three measures now indicating that the shekel is at or above fundamentals. Besides, both the macro balance and external stability indicators latter measures may exaggerate competitiveness in Israel, notably as both reflect an assumption that the impact on savings rates of the continued phased pension reforms has ended, even though the phasing itself has many years to run.

Box 5.Medium Term Fiscal Projections and the Fiscal Rules

In 2010 Israel adopted a new a new framework of fiscal rules, with the implicit aim of reducing the ratio of public debt to 60 percent GDP by 2020. These rules are:

  • An expenditure rule, which limits real expenditure growth to average real GDP growth over the past 10 years adjusted downwards for the gap between public debt and the desired target of 60 per cent. Thus, with public debt at 75 percent of GDP compared to the target of 60 per cent, the average real GDP growth of 4 percent is adjusted down by one-third to provide the 2.6 percent real expenditure growth limit for 2010.

  • A deficit ceiling rule, with the central government deficit limited to 3 percent of GDP in 2011, 2 percent in 2012, 1½ percent of GDP in 2013 and 1 percent thereafter.

Given the revenue outlook, the latter rule binds on the determination of the deficit target in practice. But deficit outturns in 2011 breached the ceiling because with expenditures as appropriated, revenue shortfalls have occurred. These are expected to continue in 2012. Accordingly, securing the deficit target for 2013 would require a significant fiscal adjustment - 2 percentage points of GDP equivalent to a 4 percentage point increase in the VAT rate.

If this fiscal adjustment was implemented, the ratio of public debt to GDP would continue to fall as the authorities originally projected, with debt ratios eventually falling to the implicit 60 percent target (Box 5Figures 1 and 2). However, such a fiscal adjustment could hurt growth in the context of global slowdown—a pro-cyclical fiscal action. Given Israel’s relatively sound fiscal outcomes over the past few years and the degree of market confidence, a procyclical policy of this magnitude does not seem warranted. If instead, the authorities simply focused on meeting the expenditure rule in 2013 and beyond, while keeping revenue ratios at the 2012 levels, debt would still remain on a downward trajectory, but deficits would remain elevated for some time, with a much shallower trajectory of debt reduction (Box 5Figures 2 and 3).

However, the downside risks to potential growth over the medium-term from demographic factors (SIP Chapter I), can cause major problems on the fiscal side. If potential growth fell to 3.2 percent (as the Bank of Israel currently assumes), deficits would remain above 3 percent for another 5 years before the real expenditure growth rule began to bite, and public debt would remain largely unchanged (Chart 4). If trend growth was reduced further to 2.6 per cent, due for instance to demographic issues, debt would actually resume an upward trajectory.

A middle path is suggested. Staff projections are based on the continuation of the real expenditure growth rule, combined with an assumed 1 percent of GDP revenue adjustment in 2013–still a significant adjustment. A fiscal adjustment of this magnitude would be sufficient to bring medium-term deficits within the 1-2 percent of GDP range that results in public debt falling to the 60 percent target within the decade (Charts 1 and 2).

The evolution of public debt under a no-policy change scenario (where the assumed revenue adjustment does not occur), as well as a range of other standard fiscal shocks, including interest rate, exchange rate, GDP growth and contingent liability shocks are presented in Figure 9 and Table 8. These shocks demonstrate that while debt to GDP is fairly robust to shocks in Israel (particularly if the expenditure rule is implemented, which requires any increase in interest expenditure to be offset by savings elsewhere), there is considerable sensitivity to lower GDP growth, as well as from any realization of contingent liabilities (as of end 2009, direct government guarantees were equivalent to around ½ a percent of GDP).

Figure 1.Budget Balance Under Alternative Rules

(Percent o f GDP)

Figure 2.Debt Trajectory Under Each Rule

(Percent of G DP)

Figure 3.Real Expenditure Growth Limit


Figure 4.Debt Trajectory with Expenditure Rule Alone Under Different Growth Assumptions

(percent o f GDP)

Figure 9.Israel: Public Sector Debt Sustainability Analysis, Bound Test 1/

(In percent of GDP; unless otherwise indicated)

Source: IMF staff estimates.

1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.

2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance.

3/ One-time real depreciation of 30 p ercent and 10 percent of GDP shock to contingent liabilities occur in 2009, with real depreciation defined as nominal depreciation (measured by percent age fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

Table 8.Israel: Public Debt Sustainability Framework, 2006–17(In percent of GDP; unless otherwise indicated)
200620072008200920102011201220132014201520162017Debt-stabilizing primary balance 9/
Baseline: Public sector debt 1/84.778.177.079.476.174.373.472.170.569.067.465.70.0
Of which: foreign-currency denominated21.517.214.914.412.712.811.210.810.510.29.89.5
Change in public sector debt-9.0-6.6-1.22.4-3.4-1.7-0.9-1.3-1.6-1.5-1.6-1.7
Identified debt-creating flows (4+7+12)-4.2-4.7-3.42.5-0.8-1.7-1.3-1.8-2.1-2.1-2.1-2.1
Primary deficit-3.8-4.6-1.91.0-0.4-0.8-0.7-1.7-1.9-2.1-2.1-2.1
Revenue and grants44.944.842.
Primary (noninterest) expenditure41.
Automatic debt dynamics 2/-0.6-0.5-0.92.2-0.4-
Contribution from interest rate/growth differential 3/-
Of which: contribution from real interest rate4.
Of which: contribution from real GDP growth-4.9-4.4-3.0-0.6-3.6-3.3-2.0-2.7-2.5-2.4-2.4-2.3
Contribution from exchange rate depreciation 4/-0.2-1.7-2.21.4-0.7-0.5
Other identified debt-creating flows0.20.4-0.6-0.60.0-0.3-1.8-0.5-0.5-0.4-0.4-0.4
Privatization receipts (negative)
Recognition of implicit or contingent liabilities0.
Other (specify, e.g., bank recapitalization)0.0-0.5-0.9-0.8-0.5-1.1-2.0-0.5-0.5-0.4-0.4-0.4
Residual, including asset changes (2–3) 5/-4.8-1.92.3-0.1-
Public sector debt-to-revenue ratio 1/188.5174.6183.0203.3189.3184.3181.0174.0169.7165.7161.3156.8
Gross financing need 6/20.919.721.522.223.120.720.218.617.715.715.114.6
In billions of U.S. dollars30.532.943.543.350.350.450.
Scenario with key variables at their historical averages 7/73.473.373.473.573.673.61.3
Scenario with no policy change (constant primary balance) in 2009–201473.473.272.972.772.572.20.1
Key macroeconomic and fiscal assumptions underlying baseline
Real GDP growth (in percent)
Average nominal interest rate on public debt (in percent) 8/
Average real interest rate (nominal rate minus change in GDP deflator, in percent)
Nominal appreciation (increase in U.S. dollar value of local currency, in percent)0.78.514.5-
Inflation rate (GDP deflator, in percent)
Growth of real primary spending (deflated by GDP deflator, in percent)
Primary deficit-3.8-4.6-1.91.0-0.4-0.8-0.7-1.7-1.9-2.1-2.1-2.1

Indicate coverage of public sector, e.g., general government or nonfinancial public sector. Also whether net or gross debt is used.

Derived as [(r - π(1+g) - g + αε(1+r)]/(1+g+π+gπ)) times previous period debt ratio, with r = interest rate; π= growth rate of GDP deflator; g = real GDP growth rate; α = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/ as r - π (1+g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/ as αε(l+r).

For projections, this line includes exchange rate changes.

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

Derived as nominal interest expenditure divided by previous period debt stock.

Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.

Indicate coverage of public sector, e.g., general government or nonfinancial public sector. Also whether net or gross debt is used.

Derived as [(r - π(1+g) - g + αε(1+r)]/(1+g+π+gπ)) times previous period debt ratio, with r = interest rate; π= growth rate of GDP deflator; g = real GDP growth rate; α = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/ as r - π (1+g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/ as αε(l+r).

For projections, this line includes exchange rate changes.

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

Derived as nominal interest expenditure divided by previous period debt stock.

Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.


(Scale—low, medium, or high)

Nature/Source of Main ThreatsLikelihood of Severe Realization in the Next Three YearsExpected Impact if Threat is RealizedIsrael’s Preparedness
1. Sharp global growth slowdown and intensification of the Euro zone crisisHigh

  • Global growth momentum, notably in the United States and the euro area, could deteriorate sharply, leading to a decline in global trade.

  • Activity in the United States might suffer a further blow from a political impasse over fiscal consolidation and a weak housing market. The financial turmoil in the currently most vulnerable European countries could spread to larger euro area countries.


  • As a small open economy, with substantial integration into global financial and goods markets, Israel’s growth is highly dependent on the performance of the global economy, although its performance during the global crisis was reassuring.

  • Highly-leveraged large conglomerates dominate a large share of Israeli economic activities. The multiple failures of these conglomerates would distract supply chains, adversely affecting growth, and would also hit the banking system hard.


  • Israel has strong fundamentals with foreign exchange reserves amounting to $76 billion (equivalent to 120 percent of short-term external debts) and a positive net international investment position.

  • Israel’s institutional framework has been strengthened, with a new fiscal rule, and a new central bank law.

  • Israel has ample space to ease monetary policy, [with use of discretionary foreign exchange intervention.]

2. Failure of an systemically important financial institutionsBanks


  • Major banks proved to be resilient through the global crisis. However, sudden failure of one bank for idiosyncratic reasons cannot be ruled out.


  • 2011 FSAP Update found that the banking system is robust. However, the banking system is concentrated, and bankruptcies of large borrowers would erode bank capital significantly.


  • The BoI has signaled its intention to raise the minimum capital requirements at a faster pace than Basel III timeline.

  • The institutional framework for cooperation among supervisory agencies remains weak. In particular, a formal macroprudential oversight mechanism does not exist.

  • There also remains ambiguity in crisis management framework, including the BoI’s emergency liquidity assistance framework and a financial support mechanism in crisis prevention and resolution.

Non-bank financial institutions


  • Insurers and pension funds experienced losses during the crisis. Their performance remains sensitive to financial market developments and insurance risks.


  • Insurers and pension funds are not prone to acute liquidity crises, and solvency requirements for insurers are being tightened.

Corporate bond markets


  • Corporate bonds markets, which froze in late 2008, have not fully recovered.


  • Many firms, which relied heavily on bond financing, would face credit crunch.

3. Sharp reversal of a housing boomLow/Medium

  • House prices have risen sharply, while construction has boomed.

  • Evidence of a housing bubble is mixed. A Bank of Israel study suggests that the level of prices reflect fundamentals, such as the policy interest rate, population growth, and a supply shortage.


  • A sharp fall in house prices would dampen real estate demand, leading to financial difficulty in the construction sector.

  • Banks’ loan losses would increase and their profitability will fall through: (i) the direct impact of an increase in nonperforming loans to households and construction sectors; and (ii) an indirect impact through weaker economic growth.

  • On the contrary, expected monetary easing could risk a further increase in house prices.


  • If house prices fall sharply, reversing macroprudential policies that the BoI implemented in recent years could help support housing markets.

  • If house prices continue to rise, a further tightening in macroprudential policies would be required.

4. Severe escalation in regional geopolitical security concerns
  • The political and security situation in the Middle East and North Africa region remains highly uncertain.


  • The Israeli economy has proven resilient to past episodes of heightened regional tensions.

  • Severe escalation in regional security concerns could hit the Israeli tourism sector, consumer confidence, and possibly capital inflows. In the extreme, banks could face deposit withdrawals.

5. Re-escalation in social protestsMedium

  • In the summer of 2011, a nationwide protest movement erupted. Protestors also demanded for lower indirect taxes and higher direct taxes, free education and childcare, suspension of privatization, and investment in social housing and public transport.


  • The government is formulating a package of new fiscal measures to address part of protestors’ demand, although it remains committed to the fiscal rule.

  • Were social protests to re-escalate, the government would expand fiscal policy. The government could abandon the existing fiscal rules, undermining fiscal credibility.


  • Were social protests to re-escalate, the government would expand fiscal policy. The government could abandon the existing fiscal rules, undermining fiscal credibility.

Annex II. Authorities’ Response to Past IMF Policy Recommendations

(Scale—fully consistent, broadly consistent, or marginally consistent)

IMF 2010 Article IV Policy RecommendationsAuthorities’ Response

Inflation expectations have risen towards the upper end of the target band, nominal house prices have boomed, and the shekel has appreciated significantly. Against this background, the 2010 Article IV called for additional policy tightening to keep them under control.
Fiscal policy

Fiscal policy should carry the burden of the additional policy tightening, so a stronger than planned structural fiscal consolidation is recommended for 2011 and 2012.
Not consistent

The budget outturn underperformed in 2011, in part reflecting optimistic revenue projections.
Monetary policy

The policy interest rate should be raised.
Fully consistent

The BoI continued to raise the policy through June 2011. Since 2011, the BoI has turned to a monetary easing cycle.
Foreign exchange policy

Foreign exchange intervention can play a supportive role, but intervention should be symmetric over a long time horizon
Fully consistent

The BoI has stopped intervention since June 2011.
Financial sector policy

The development of stress testing procedures focusing on systemic risk, and the enhancement of the collaboration between and within supervisory institutions is strongly encouraged. Supervision of non-banks might be further strengthened by locating it outside the Ministry of Finance.
Broadly consistent

For the FSAP Update, stress tests were conducted jointly with IMF staff. An inter-agency Financial Stability Group has been established, although further work is needed to strengthen a cooperation framework. There is no consensus about where to locate the non-bank supervision function.
Structural reform

Further strengthening of structural reforms, including in education, research, the business environment, and infrastructure, effective management of natural gas resources will also be necessary.
Marginally consistent

The authorities have decided to set up a Sovereign Wealth Fund and review natural resource tax regime.

According to OECD, there has not been much progress in education and labor market reform.

Defense spending may also rise further following the recent Supreme Court ruling that the exemption of Haredi men from military service is unconstitutional. This could lead to an unbudgeted surge in recruits, although the pace and scale of such developments will be determined in due course as part of a broader response by the authorities to the ruling.

See the accompanying Financial System Stability Assessment.

See Moretti, M., et al, “Stress Testing at the IMF,” IMF WP 08/206.

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