We would like to thank staff participating in both the FSAP and Article IV missions for their professional and candid assessments and their constructive recommendations.
Macroeconomic performance and outlook
The Israeli economy grew by 4.7 percent in 2011, which is substantially higher than the average in other advanced economies. A mild recession in 2009, followed by high growth rates in 2010 and 2011, resulted in a near-potential level of economic activity. The rate of unemployment fell to 5.4 percent in the fourth quarter, the lowest level since the early 1980s.
The relatively good performance in recent years is the result of many factors, including successful economic policies before and during the crisis. Fiscal discipline, a responsive monetary policy, a conservative banking sector, and a strong external position had positioned the economy at a strong starting point as the global crisis unfolded, and these factors also supported the rapid recovery.
The local and international trust in the Israeli economy was reflected in the relatively low CDS spreads throughout 2011 and in a substantial increase in the level of Foreign Direct Investment. The credit rating upgrade to A+ by S&P in September, in a period when credit ratings in many countries were downgraded, stands out.
However, as the slowdown in global markets intensified, export growth stopped and even turned negative in the last quarter of 2011, and growth slowed. The growth rates decreased monotonically throughout the year to 3.2 percent in 2011Q4. The current account, which had been in surplus since 2003, turned slightly negative in the fourth quarter.
The sentiment at the Tel-Aviv Stock Exchange deteriorated during the year. Geopolitical developments and the inability of some large borrowers to service their debt led to a series of debt restructurings, which resulted in higher spreads in the corporate bond market. Share prices declined by about 20 percent relative to the levels in early 2011.
Although the unemployment rate fell to a 30-year low, and although the economy was at that point growing at nearly 4 percent, a surge of social unrest swept the country during the summer. The protest focused on rising housing costs and food prices. Mass peaceful demonstrations led to the establishment of the Trajtenberg committee – a public committee that recommended a comprehensive set of policy measures to respond to the demands of the protestors. The government announced its intention to implement the proposals of the Trajtenberg committee, and has begun to do so.
Following the negative local and international developments during the year, the Israeli authorities have revised the outlook for 2012 downward, and it currently ranges between 3.2 percent (MOF) and 2.8 percent (BOI), which bracket the Fund’s 2.9 percent outlook. As these rates are lower than potential growth, unemployment is expected to increase. Additional risks to the forecast include geo-political risks, possible further increases in oil prices, and an intensifying recession in Europe, as Israel is an export-led economy.
Fiscal consolidation in 2011 was broadly on track, as the budget deficit in 2011declined to 3.3 percent of GDP, after reaching 5.1 percent in 2009. Although the deficit was reduced substantially, lower than expected tax revenues led to a slightly higher deficit than the originally planned 3 percent target. Public debt fell to 74.2 percent of GDP, lower than the OECD average.
The robustness of the fiscal position was well reflected in the bond issuance of US$1.5 billion for 10.5 years at yield as low as 4.1 percent, in January 2012 in New York. This yield spread, at 205 bp spread over 10-year US treasury bonds, is the lowest-ever pricing achieved by Israel in issues of dollar-denominated bonds.
Fiscal policy in Israel is currently implemented through a two-year budget framework. This mechanism, first adopted in 2009-2010, has proven to be an important instrument to restore market confidence during the economic crisis, while at the same time allowing governmental units, as well as the parliament, to focus on longer-term issues.
Thus, fiscal expenditure in 2012 is executed according to the 2011-2012 budget, which was approved in late 2010. As tax revenue projections today are lower than originally envisaged and automatic stabilizers are fully at work, the deficit for 2012 is expected to be higher than the 2 percent ceiling. The current projection is that it will reach 3.4 percent.
The deficit targets for 2013 and 2014 pose a complicated challenge. It seems that the deficit targets for these years, previously set at 1.5 and 1 percent, respectively, may be too contractionary, given the lower growth outlook. The new targets, which balance the need to consolidate, support economic activity, and comply with previous obligations, will be set in place in the next few months.
Although a decrease in the pace of consolidation is expected, the authorities are fully aware of the importance of continued consolidation, and have reiterated that reducing the public debt-to-GDP ratio remains a major goal of the government’s economic agenda. This commitment is backed-up by an effective fiscal toolkit that includes an expenditure cap along with a deficit target. The expenditure rule, introduced in 2010, sets the increase in real government spending to be lower than potential growth, which is calculated as 10-year average growth, as long as the debt-to-GDP ratio is above its target. This rule is designed to reduce the debt-to-GDP ratio to 60 percent by 2020.
As noted above, in response to the social unrest that emerged last summer, the government established the Trajtenberg committee. Following its recommendations, the tax cut program, according to which tax rates were to have been further reduced from 2012 on, was cancelled. This, along with other measures, will allow financing a series of steps that will address social demands, at least partially. However, the authorities do not envisage at this stage increasing the VAT.
Large natural gas fields were discovered in recent years. In 2011, a new ‘superprofit’ tax was legislated, and in February 2012, the government approved the general framework for establishing a sovereign wealth fund, which is expected to begin to accumulate revenues by the end of the decade. This fund, which will be invested in international capital markets, will restrain the possible “Dutch disease’ effects and strengthen the fiscal position.
Monetary policy changed course in 2011. In the first half of the year, the Bank of Israel continued its policy of restoring the nominal interest rate to “normal” levels, which had begun in 2009. The increases were justified by the relatively high - above target - actual and expected inflation rates and a near-potential level of economic activity. In addition, the housing market was showing signs of overheating. By June, the Bank of Israel interest rate had reached the level of 3.25 percent.
However, as the severity of the European debt crisis intensified, the market sentiment in global and local markets turned negative, and economic activity showed signs of weakness, the BOI has gradually reduced its key rate to 2.5 percent. The inflation rate decreased from 4 percent in early 2011 to 1.7 percent today, below the midpoint of the inflation target range. Expected inflation for the next 12 months, as derived from capital markets, is now 2.5 percent, implying that the real interest rate is about zero. The Bank of Israel (BOI) assesses that given the evident slowdown in growth, the current interest rate, which is expansionary, is consistent with inflation being around the midpoint of the target range, while at the same time leaving ample ‘firepower’ in case further risks materialize.
In order to curb capital inflows, the BOI and the Ministry of Finance (MOF) took a few coordinated measures in 2011. In January, the BOI imposed a 10 percent reserve requirement on banks, when engaging in currency swaps and forward foreign exchange transactions with non-Israeli residents. In March, the MOF canceled the tax arbitrage between local and foreign investors in the makam - a short-term zero-coupon debt instrument issued by the BOI, targeted by the carry-trade foreign investors who were tax exempt. In July, the BOI imposed a regulation, according to which forward foreign exchange transactions above a threshold have to be reported. These policy measures contributed to lowering the pressure on the new Israeli shekel (the NIS), which has eased further as the BOI reduced its key rate and a ‘risk-off’ mood started to take over markets. Consequently, foreign exchange purchases, which were used to restrain overvaluation forces in recent years, have stopped, and since August 2011, the NIS has been freely floating.
A new and modern Bank of Israel Law was legislated by the Knesset In March 2010. The new law, which formally defines the de-facto independence of the BOI, states that price stability is the prime goal of the central bank. Based on the new law, a Monetary Policy Committee (MPC), which includes the Governor of the BOI as chairmen, two additional BOI members and three external members, began operating in October 2011. The BOI will carefully study the staff’s suggestions regarding possible improvements in the practices and procedures of the MPC’s work. On the subject of emphasizing the midpoint of the inflation target band of 1 to 3 percent, given the high volatility of inflation, the band allows the BOI to credibly balance between its objectives.
Financial Sector Stability Assessment
The financial sector was assessed thoroughly by the FSAP team, after more than a decade since the previous (and first) FSAP was conducted. At the outset, the Israeli authorities would like to express their appreciation to staff for their dedicated work, and to the Fund for devoting resources to this task, given the current condition of the global economy.
The Israeli supervising authorities – the MOF, the BOI and the Israeli Securities Authority (ISA) – have all found the process useful and effective. The worldwide experience of the IMF and the use of common methodologies have delivered important insight into the current state of financial markets and supervision.
The authorities generally share the overall assessment. The results indicate a high level of observance of the international standards of supervision. The stress tests that were jointly conducted by the authorities and the FSAP team reaffirm the robustness of the financial system, banks and nonbanks alike, and confirm that the current buffers can shield the system even from severe shocks. However, the risks facing the financial system are exceptionally high.
Market Structure and Concentration
The financial system has changed considerably since the previous FSAP assessment. The Bachar reform of 2005 – which required the banks to divest their asset management activities – triggered a structural change, which led to the rapid growth of the non-bank sector. At the same time, a flourishing corporate bond market has evolved.
The soundness of the new structure and institutes was stress-tested during the economic crisis. The stability of the major financial players – banks, insurance companies, and institutional investors – was maintained. Some weaknesses in the corporate bond market emerged, as the primary market dried up in late 2008 and the spreads rose dramatically. Following the crisis, the Treasury in 2010 established a committee (the Hodak committee) to suggest measures to strengthen the robustness of the market. These measures were implemented and increased the degree of transparency in the market and the quality of issuers. In addition, the supervisor of Capital Markets Insurance and Savings Division (CMISD), located in the Treasury, issued tougher regulations regarding the investment of institutional investors in corporate bonds.
The banking industry, the nonbank financial sector, and the nonfinancial sector are all relatively concentrated. Therefore, many financial institutions, and even nonfinancial business groups, can have systemic importance. The supervisors are well aware of risks that stem from this market structure, and apply “hands-on", stringent and sometimes intrusive policies to offset the excess risk. The CMISD will strengthen group supervision as part of the adoption of the Solvency II regulatory paradigm, following the publication of global supervisory standards in this matter.
The Concentration Committee, an ad-hoc public committee that has recently finalized its report, has recommended that no individual can be a controlling shareholder in both a financial and a real company, and has in addition recommended steps to limit the extent of pyramidical structures that in the past have enabled shareholders to in effect operate with extremely high leverage in controlling companies.
The adoption of the committee’s recommendations will lead to a reduction of excess concentration in the future, and to a flattening of pyramidal ownership structures. However, given clear evidence of economics of scale in many industries, some degree of concentration is almost inevitable in a small economy. Excessive market fragmentation could eventually lead to an even less efficient industrial structure.
The new Bank of Israel Law (2010) strengthened the institutional framework by defining financial stability as a major objective of the BOI, and by giving it the authority to act as lender of last resort to non-bank financial institutions if it should judge that to be necessary for financial stability.
Following the previous FSAP recommendations, the BOI has set up a real time gross settlement (RTGS) payment system, which is now operational. This has enabled the BOI to strengthen its control over the payment systems, and to join the CLS system, turning the NIS into a fully convertible currency.
As part of a strategic plan to strengthen the supervision of nonbanks, the CMISD has tightened its regulation, monitoring, and oversight. Manpower and budget increased, and two new departments, Solvency II implementation and enforcement, were established.
The authorities realize the importance of strengthening the framework for conducting coordinated macroprudential policy. The Banking Supervision Department (BSD), CMISD and ISA are currently examining possible ways to implement the Fund’s recommendation to institutionalize their cooperation, which has improved since the crisis, by establishing an FSC in a way that will add real value to the supervisory frameworks while adhering to the existing legal structure of three separate supervisory bodies.
The BOI concurs that the framework for early intervention and orderly resolution of problem banks, including the legal basis, should be overhauled. The overhauled framework for dealing with problem banks, which should include early intervention, going-concern resolution, and gone-concern resolution, would allow the BOI to deal effectively with emerging problems and to address major problems promptly and decisively.
The ISA has proposed to amend the securities law so that underwriters will be subject to broader scrutiny at the time of registration, and that underwriters acting as distributors in the offering process will be subject to liability for misleading or defective statements in a prospectus. In addition, ISA has established an internal working group dedicated to examine and propose a legislative framework to regulate the broker-dealer activity in Israel.
Banking System Stability and Basel III implementation
Israel’s banking system is conservative, tightly regulated and closely monitored, all of which helped the system remain sound and resilient throughout the global financial crisis. The banks are well capitalized and profitable, especially when taking into account that Israeli banks use the conservative standardized approach to calculating CAR’s; their asset portfolios are of high quality; and their operation consists mostly of traditional banking. As the Israeli banks are net lenders to foreign banks abroad, the opening of spreads and difficulties in attracting wholesale funding did not much affect them in the global crisis.
The banks’ buffers have increased following the crisis. In June 2010, the Supervisor of Banks issued a directive ordering banks to increase core capital to at least 7.5 percent by the end of 2011, and prohibiting dividend distribution before this target is met. By the end of September 2010, all five of the largest banking groups achieved the target.
As of 2011Q3, the total capital ratio was 13.5 percent, Tier 1 core capital was 7.8 percent and ROE was 10 percent, similar to the long-term average. Banking credit grew by 7 percent in the first 3 quarters of 2011. The banks’ credit portfolio quality is high, as indicated by the low, 2.0 percent, non-performing loans ratio and by the low provision expense for credit losses, 0.4 percent of total loans. The total exposure to the Euro zone is 1.6 percent, and to the most vulnerable countries only 0.2 percent.
The new draft rules for implementation of Basel III were published on March 14, 2012. The minimum core capital requirement will be raised to 9 percent by January 1st, 2015. For banks holding more than 20 percent of total banking sector assets, it will be further raised to 10 percent as of January 1st, 2017. This differential treatment, which is driven by macroprudential considerations, is expected to affect the two largest banks in Israel, which currently each hold about 30 percent of the assets in the banking system.
The gradual increase in core capital is designed to balance the need to strengthen the banking system with minimizing the negative macroeconomic effects of deleveraging. According to the BSD’s assessment, banks will be able to meet the new capital requirements while expanding their credit portfolios at a rate that is similar to or slightly below potential growth.
The Housing Market
The BOI assesses that the risk related to elevated house prices is contained. House prices have risen considerably during the past few years; this can be attributed in part to initial levels in 2007, when house prices relative to wages or rent prices were exceptionally low, and to the very low interest rates in place during and after the global crisis. The current price-rent ratio implies a rate of return of 4 percent.
That said, the BOI took active macro-prudential measures to contain the risks of price correction, the Ministry of Housing and Construction has taken steps to increase the supply of land, and the MOF has increased the purchase tax on second properties. These policies seem to have been effective in easing the pressure in the housing market, as house prices leveled off since April 2011 and the share of second-property transactions fell sharply.
In March 2011, the BSD limited the floating interest rate component of housing loans to 1/3 of the total loan. Competition among the banks in supplying this type of mortgage, linked to the Bank of Israel rate, had led to the spread over the BOI rate falling to only 60 bp. The constraint on the share of this type of loan in the total financing package for a house was imposed to reduce the risks attendant with this type of financing when the Bank of Israel rate would rise. The issuance of this directive was immediately followed by on-site supervisory actions that ensured that it is fully implemented.
This step has slowed the growth of mortgages, decreased the share of non-indexed floating rate loans, and decreased LTVs to previous levels. Since it was implemented, 58 percent of new residential loans are at an LTV of up to 60 percent, and only 7.1 percent of loans are at an LTV of over 75 percent. High-risk mortgages, with high LTV combined with high payment-to-income ratio, amount to 0.5 percent of the outstanding balance. Thus, the tails of LTV ratios are not significant.
Limited lending on floating interest rates, combined with low LTVs, implies that the banking sector most likely will remain unscathed in the event of a price correction in the housing market.
Long-run issues: Participation of minorities in the Labor Force
In this report, staff has expanded the review to one of the most difficult socio-economic challenges that Israel is likely to face in the years to come – how to integrate minority groups, which are becoming relatively larger over time, into the labor market. Staff has done a service to Israeli society by adding its considerable weight to the discussion and analysis of the issues, and by emphasizing the urgency of accelerating the pace of reforms.
The Israeli authorities as well as the Israeli public – including the minority groups – fully understand that the current rates of participation of the ultraorthodox men and Arab women in the labor force are unsustainable.
The low participation rate of ultraorthodox men is a complicated phenomenon. A combination of the strong desire to ring-fence themselves from the influences of the Jewish secular society – including through not doing military service – and economic incentives, have resulted in a full-time entrenchment to religious studies – for life. As this starts from a very young age, ultraorthodox boys do not acquire basic knowledge and skills that are necessary in the modern labor market.
Although political difficulties and a feeling that the issue could be put off to a future date resulted in slow progress, recent evidence suggests that employment rates of ultraorthodox men have increased from 39 percent in 2009 to 45 percent in 2011.
In order to speed up this process, and to achieve the 63 percent by 2020, a target that was set by the government in 2008, the incentives for the community have to change. The community also has to take responsibility by introducing core secular subjects, including science, mathematics and English into its school curricula and by signaling to its members that participating in the labor market is not inferior to being a full-time student of religion.
A Supreme Court ruling in February 2012 that the law under which ultraorthodox men can work while being exempted from military service (the ‘Tal law’) does not comply with Israeli Fundamental laws, which have a constitutional status, has given the political system six months to come up with a solution. This also creates an opportunity to better incentivize the community to speed up the pace of reform.
In addition, the Ministry of Education intends to acknowledge the special external exams in ultraorthodox girls’ high schools, where the curriculum covers also general studies, as eligible for credit towards completing either the matriculation exams or professional exams in the public education system. This will allow ultraorthodox women to apply for tertiary education.
A number of policy steps were taken recently in order to encourage the participation of Arab women in the labor force. The Prime Minister’s Office and the Ministry of Transportation added public transportation lines within major Arab towns, and between Arab towns and central cities. Following the Trajtenberg committee recommendations, the government decided that mandatory and free education will be gradually provided from age 3 on (vs. 5 today) and to expand the public provision of subsidized and regulated daycare services for younger children, especially from low-income families. These steps will increase female labor supply in general, and will be particularly beneficial to Arab women, who have more children, and whose participation rates are found to be substantially affected by childcare support.