Frameworks for Monetary Stability

22 Financial Deregulation in Israel: Policy and Results

Carlo Cottarelli, and Tomás Baliño
Published Date:
December 1994
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On July 1, 1985, the Government of Israel decided on a stabilization program, the central aim of which was to reduce inflation from a monthly rate of 15-20 percent to practically zero.1 Almost nine years later nobody doubts that the program was highly successful, even though the inflation rate is still some three to five times higher than that of Israel’s trading partners in the Western world. The program also incorporated a few elements that had the nature of financial reform. This paper attempts to evaluate them and tell how they led Israel forward on the path of reform.

From the middle of 1985 until the end of 1987, not much was done to change Israel’s financial landscape, and some of the steps that were taken were even retrogressive. From 1988 through 1991, however, there was a significant change that placed the policy of deregulating Israel’s financial markets high on the Bank of Israel’s agenda. The second part of this paper reviews the components of that policy and the underlying conceptual framework.

The paper concludes by suggesting a few indicators of the progress made in the deregulatory effort and the impact of the policy on the structure of interest rates in Israel. Finally, it looks ahead and briefly sketches an agenda for completing the reform of Israel’s financial markets.

Financial Elements of the Stabilization Program

Segmented Markets

The financial landscape in 1985 was anything but a level playing field. The government and the central bank did their best to crisscross the terrain with special arrangements, each one surrounded by thick artificial walls built to restrict entry; as listed below:

1. Firms that were entitled to get short-term low-interest credit from domestic banks in order to finance exports were treated differently from those that received permission to take long-term credit from foreign banks in order to finance imports of equipment.

2. Certain investors who received favorable tax treatment so that they could raise capital from the public to invest in government bonds were treated differently from firms, which had to obtain specific approval from the treasury each time they wanted to sell securities to the same public in order to finance their investment in real assets.

3. Some of those who were obliged by the government to buy its bonds were lucky and got high-interest bonds, although nontraded ones, while others were not so fortunate and had to buy those bonds in the market, irrespective of their price.

4. Firms that wanted to borrow foreign currency but were not exporters had to pay prohibitive rates because the central bank limited such borrowing to a small quota. On the other hand, firms that sought loans indexed to the cost of living had to take them for at least two years, because the central bank regarded such a constraint as an instrument in the fight against inflation.

5. Liquidity requirements were extremely high if the deposit was indexed to the exchange rate, but relatively low if it was not, even if the period to maturity of the two deposits was identical and the unindexed interest turned out to be very high in real terms.

6. A commercial bank had to get the approval of the central bank if it wanted to change a given commission and if it wanted to change the prime rate.

7. Foreign exchange control was tight, serving as a major policy instrument, and the cost of foreign currency (the exchange rate) was controlled and occasionally adjusted upward by a government decision.

Although this is not an exhaustive list, it suffices to characterize a market with large-scale administrative involvement by the government and the central bank. This state of affairs substantiates the claim that the deep segmentation of the market created interest rate spreads that could not be tolerated by a competitive market. Thus, for example, in 1987: (1) the total cost of foreign-currency borrowing by residents in the domestic market was more than twice the cost of borrowing abroad; (2) the real cost of short-term local-currency borrowing was more than three times the cost of long-term local-currency borrowing; and (3) the rate paid by short-term local-currency borrowers was almost four times the rate paid to local-currency depositors.

The Program’s Financial Elements

The 1985 program did not attempt to bring about a structural transformation of Israel’s financial system. Nevertheless, a reform of the financial markets was very much on the minds of the policymakers in the first half of the 1980s, although no coherent and comprehensive approach was formulated. As a result, changes were introduced from time to time, but the lack of an agreed concept sometimes caused new distortions. This occurred in the case of exchange-rate-indexed deposits, which were dealt with in the framework of the 1985 stabilization package. Another major example was the decision to send the provident funds to the market to buy government bonds, instead of providing them (as had been the case until then) with special, non-traded bonds. These two items—the exchange-rate-indexed deposits and the provident funds’ portfolio—accounted for 30 percent of the public’s total financial assets in mid-1985. Examining the way they were handled in the context of the stabilization program might be a good starting point for presenting Israel’s policy for the deregulation of financial markets, which had been implemented since 1988.

Exchange-Rate-Indexed Deposits

These deposits, called PATAM (an abbreviation for foreign exchange deposits of Israeli residents), were naturally very popular among Israelis in the years preceding the 1985 program, when devaluations and inflation were racing forward at an ever-increasing pace. These were, however, very peculiar bank deposits. To start with, the reserve requirements on them amounted to 100 percent since the central bank rigorously opposed foreign exchange lending to Israeli residents by domestic banks.2 As a result, the Bank of Israel provided the public with a deluxe hedge against devaluation that was immune to the impact of the market forces that otherwise determine the cost of such options or a future contract, and it did so within the framework of a fixed exchange rate policy, where the external value of local currency can move in only one direction—i.e., downward.

Furthermore, these were not really foreign-currency deposits. It was not that, in order to open such an account, the customer did not have to buy foreign currency; he did, and he paid the bank an appropriate commission for that, and for many years he also paid a 1 percent tax on the amount bought. However, the rules specified that the depositor could use only the local-currency equivalent of his balance in the account, and when he did that he again paid a commission for converting the balance into local currency.

These features remained unchanged by the stabilization program. What the program did was to limit the liquidity of the deposits by ruling that such current deposits could no longer be created by using local currency to buy foreign currency, and that time deposits could be opened only for a period of at least one year, instead of 3, 6, or 12 months. These rules drove a new wedge between local-currency and foreign-currency transactions, thus segmenting (instead of opening) the markets.

Managing the Portfolio of the Provident Funds

Provident funds were established in Israel to provide the government with an additional channel of funds for financing the budget and in order to promote long-term savings. Those were the days when government officials knew better than the market and therefore decided everything. They ordained who could save through provident funds, how much, for what period of time, what tax benefits would be given, what the funds should do with the money, and what tax benefits they would receive. All this came with a more or less complete government guarantee—free of explicit charge, of course—against the erosion of the savings because of inflation.

The stabilization program changed only one of these features: instead of providing the funds with special high-interest, nontraded, cost-of-living-indexed bonds, the funds were told to buy government bonds in the market. The new rule had an important effect on the development of the bond market in Israel. However, since the funds still had no choice but to invest in government bonds, the change helped the government reduce the cost of financing the deficit—also an important result—but could not alter the funds’ investment strategy. It certainly could not have much of an effect on the behavior of savers, because nothing had changed for them. The tax advantages of saving through the funds were apparently still significant, so they swallowed the decline in the yield and stayed with the funds.

Deregulating Financial Markets, 1988–91

The policy led by the central bank during this period aimed at: (1) minimizing and, if possible, abolishing government involvement in the functioning of financial markets; and (2) to the extent that this involvement was originally devised in order to conduct monetary policy, to replace these administrative policy instruments with market-based ones.

The government intervened in the domestic financial markets in various ways, and the object of the policy was to deal with all of them, sometimes sequentially and sometimes simultaneously.

Abolishing Quantitative Ceilings

Two of these were still in place at the beginning of 1988: (1) a ceiling on overall domestic foreign-currency credit to Israeli residents; and (2) a ceiling on guarantees that banks could issue on nonbank loans. The two ceilings were raised gradually, and then abolished after they proved to be ineffective.

Shortening Maturity Constraints

For many years policymakers believed that inflation could be eradicated by forbidding short-term-indexed (either to the cost of living or to the exchange rate) financial transactions, deposits, and loans. Hence, (1) deposits indexed to the cost of living were permitted only if they were for at least two and a half years; (2) deposits indexed to the exchange rate (like the PATAM mentioned earlier) were permitted only if they were for at least one year; (3) loans indexed to the cost of living were permitted only if extended for at least two years; and (4) loans indexed to the exchange rate were completely forbidden.

This policy apparently stemmed from the time when the government was the major provider of indexed financial instruments. Therefore, whenever the government wanted to implement an anti-inflationary program, whether by cutting subsidies, increasing indirect taxes, or devaluing the currency, the restraining impact of the initial increase in prices could be mitigated by the increased value of the public’s indexed wealth. Hence, it was considered desirable to curtail the extent to which the public’s wealth was immune to a policy whose aim was to erode the real value of income and wealth.

However, this reasoning is valid only when the government is the seller of indexed debt, thus taking it upon itself to pay inflation and devaluation differentials. If the debtor is not the government but the private sector, the argument is not relevant. The initial inflationary impact of the government’s stabilization policy does indeed increase the nominal value of the public’s assets but at the same time it also raises the nominal value of its liabilities.

Furthermore, when it is left to the market to decide how to price indexed assets and liabilities, expectations regarding future changes in inflation and the exchange rate will be brought to bear on the pricing mechanism. When the government is the debtor, it does not set out to charge more (i.e., by reducing the interest rate) when it offers exchange-rate-indexed instruments (like the PATAM) if devaluation is around the corner. The rate remains linked to world rates, regardless of changes in economic conditions and government policy in Israel.

It took time to understand this distinction. The government ought, indeed, to reduce the indexed component of its debt. On the other hand, it should not intervene in the decisions of the private sector regarding the nature of its assets and liabilities. Hence, by a slow process Israel abolished all maturity constraints on loans and almost all on deposits. The result was to increase the substitutability of different loans and different deposits, especially at the short end of the yield curve. The impact on interest rate spreads followed suit.

Reducing Reserve Requirements

Another way the government interfered with the working of market forces was through high reserve requirements—sometimes as much as 100 percent. As is well known, such requirements result in a monetary tax or in a larger than usual spread between the interest rates on deposits and loans. By the end of 1987 the average reserve requirement in Israel’s banking system amounted to 63 percent.

The government therefore started implementing a policy aimed at reducing requirements to their normal business level—i.e., a few percentage points. It will take a few more years to reach the goal, but the government has already taken and published all the decisions that will lead to that end. Thus, for example, two years ago it was announced that reserve requirements on a certain kind of foreign exchange account would decline each month by 1 percentage point from 90 percent, the requirement at the starting point, until it reached 4 percent; and it was recently announced that the pace would be accelerated to 1.5 percentage points a month. The reserve requirement on that particular account stood at around 60 percent by the end of 1993.

A different strategy was adopted toward savings accounts. In this case reserve requirements started at 83-100 percent. Since these are long-term deposits, the policy of reducing reserve requirements was applied only to new savings. At the beginning of 1993 the point was reached where the requirements on new savings accounts stood at 4 percent. The old savings accounts will continue to carry the previous reserve requirements until they mature. Hence, there is a continuously declining average reserve requirement on savings accounts, both old and new. This had already declined to some 40 percent by the end of 1993.

Yet another strategy was applied to the PATAM foreign exchange account mentioned above, the reserve requirement on which is 100 percent. In this case the reserve requirement was reduced in an indirect way. The banks could offer the public a local-currency deposit indexed to the exchange rate, the reserve requirement on which was set at 4 percent. Simultaneously, the government started to reduce the interest rate paid on the reserves required to be deposited by the banks as a cover for the PATAM. As a result, banks started to reduce the interest rates that they paid to the depositors on PATAM accounts. Not surprisingly, the public started to shift deposits from the PATAM, with its 100 percent reserve requirement, to the new exchange-rate-indexed deposit, with its reserve requirement of 4 percent. The average combined requirement of the two accounts started to decline, and by the end of 1993 it amounted to 30 percent. The process will end when there are no more PATAM deposits, and it seems that this point is not far away.

Eliminating Special Credit Arrangements

Government involvement in the functioning of financial markets was not limited to credit ceilings, constraints on the maturity of loans and deposits, and high reserve requirements. The government also intervened by arranging credit facilities, through commercial banks, for specific purposes. The latter included short-term export financing, long-term import financing, long-term development loans, and various bail-out programs for industrial corporations, agricultural settlements, and municipalities. To get an idea of the importance of these facilities, suffice it to point out that by the end of 1987 some 55 percent of all bank credit to the public was extended through such programs.

The programs were arranged by the treasury, with the cooperation of the Bank of Israel. It was the government, not the market, that decided who the borrower would be, how much he would pay for credit and other terms relating to repayment, what the spread of the bank would be (which almost always did not cover the credit risk and operational expenditures as it should), what the reserve requirements, if any, on the financial sources of the program would be, and to what extent the rules of foreign exchange control would apply.

The large-scale distortions introduced into the financial markets by all the special facilities were widely evident. The easy credit terms supported projects and industries that eventually went bankrupt, raising the level of unemployment and causing a significant increase in commercial banks’ loan-loss provision. Between 1989 and 1993 there was a gradual end to all the special credit facilities. Some old arrangements are still in place and will hopefully expire on schedule. Nevertheless, it takes a cultural change to eradicate the government’s tendency to get involved in extending credit, and nobody can be sure that the point of no return is past.

Determining Prices of Financial Services

In February 1981 the central bank introduced a system whereby it had to approve any change in bank commissions. This policy was introduced at a time when the government believed that it was possible to hold back inflation by controlling prices. It is obvious now, as many economists could tell in advance, that price controls lead to a variety of distortions but do not reduce inflation. Nevertheless, the policy of controlling bank commissions lasted for seven years, and only in 1988 did deregulation start to affect this area. It took an additional three years, as well as endless public and internal debates, before the central bank ended its interference in the process of determining bank commissions.

The damage that the policy of controlling bank commissions inflicted on financial services was significant. For many years the cost of a given bank service could not be reflected in its price. The surging demand for ever cheaper services forced banks to invest heavily in equipment, mainly computer hardware and software and buildings. Banks compensated themselves with higher interest rate spreads and an increasing number of “new” bank services, for which new commissions had to be set.

Between 1984 and 1987, the central bank also engaged in interest rate control. It established a system whereby banks had to get the approval of the central bank before changing the prime rate, whether upward or downward. The result, as could have been expected, was that the markets invented substitutes for the prime rate under different names. Hence, even though this special mechanism for changing the prime rate was terminated in 1987, its impact on the structure of lending rates lingered until recently, since the official prime rate was not the one known from other countries. This had distorting repercussions on the pricing of deposits, fixed-term loans, and the spread.

Easing Foreign Exchange Control

By 1987 Israel had reached a position in which foreign exchange control affected mainly the capital account, although individuals could not buy services freely abroad. The rule was, and still is, that foreign-currency transactions are forbidden, unless explicitly permitted. Israel needs foreign exchange control, so the argument goes, because the exchange rate is the main policy instrument for restraining inflation.3 Control is believed to be necessary for protecting the foreign exchange reserves, which are the means of maintaining central bank control over the exchange rate. This is not the place to elaborate on the implications of such an approach for the conduct of monetary policy, or on its effectiveness in attaining the target of price stability, but the slow pace of removing exchange controls in Israel cannot be fully understood without appreciation of the role of the exchange rate as a nominal anchor. The importance attached to this required an adequate level of foreign exchange reserves and that, in turn, made it difficult to give up foreign exchange control.

There is, of course, the option of keeping the exchange rate as a nominal anchor, and taking care of foreign exchange reserves by relying on the market-based exchange rate and interest rate policy rather than on foreign exchange control. Israel has started to move in this direction, as will be described later, and as a result the capital account could gradually be liberalized. The main changes that were introduced between 1988 and 1991 are set forth below.

Israeli Residents

In the beginning of the program Israeli residents, whether corporations or individuals, were allowed to keep foreign exchange that they had earned, or unilaterally obtained, in foreign-currency accounts in domestic banks. This does not mean that they may use the balance for purposes that are not permitted by law, but it enables people to manage their assets and liabilities, or their liquidity, more efficiently. All constraints on borrowing abroad were removed.

In addition, two new channels were opened for investment abroad. Corporations can invest up to 40 percent of their capital in real assets abroad. For most companies in Israel, the change in effect removed the constraint on their ability to operate abroad. On average, the Israeli corporate sector invests 17 percent of its capital abroad. By the end of 1993, the value of this real investment amounted to 3 billion. It is interesting to note that not all of this capital was exported from Israel. Israeli corporations have been successful in raising capital on foreign, especially American, exchanges. The amounts raised in 1991–93 totaled approximately 0.8 billion.

Also, mutual funds may invest up to 10 percent of their portfolio in foreign financial assets. Also permitted was the establishment of special mutual funds specializing in foreign securities, which could invest up to 50 percent of their assets abroad. By the end of 1993, the value of the foreign financial portfolio held by Israeli mutual funds amounted to 0.7 billion.

Foreign Residents

Foreign residents were gradually allowed to invest in all types of domestically traded securities in Israel. This, of course, implies freedom of movement, both into and out of the country, of the initial investment and whatever was added to it in terms of interest, dividends, and capital gains.

By the end of 1993, foreign residents held a portfolio of domestic securities, mainly shares, worth around 1 billion. In addition, it is estimated that they also held a controlling interest in Israeli companies, in terms of traded shares, to the tune of 3 billion. However, the main financial asset of foreign residents in Israel consists of foreign exchange deposits in domestic banks, and this amounted to almost 11 billion by the end of 1993.

Market-Based Monetary Policy Instruments

Since some of the past regulations served as monetary policy instruments, there was a need to devise new ones if they were to be given up in the deregulatory process.

Toward the end of 1987, the government started to build a portfolio of market-based instruments that basically continues to this day. That system is based on the following components:

1. Banks are required to maintain their deposit balances with the Bank of Israel on an average monthly basis, with a ceiling on the average maximum weekly deficit. The fine for not meeting these weekly and monthly requirements is very high, so that banks violate them only rarely.

2. On that basis, monetary auctions were offered to commercial banks—in effect, extending them short-term loans. The interest rate was determined through the auction, which was based on the (then) American discriminatory model; namely, to the extent that a participant obtained a given part of the loan auctioned, he was charged with the interest rate he offered at the auction. At the beginning there were weekly auctions, with monthly auctions added after two and a half years, with an additional daily auction six months later. This last step was taken at the beginning of 1991, and the daily auction has proved to be the major policy instrument.

3. Besides the monetary auctions, right from the beginning discount windows were opened. Commercial banks could borrow limited quantities of money, at their initiative (allocated to each bank according to its size) at rising interest rates. The “ladder” starts at interest rates somewhat lower than the monetary auction average rate, and ends a great deal above it. These discount windows enable each bank to adjust its daily liquidity position, and they serve as a basis for an active interbank market for buying and selling liquid assets.

4. The government also uses a short-term note for very rudimentary open market operations. This is a traded government security, the maturity of which is up to 12 months, and (according to a special law) can be used only in the framework of monetary policy and not, for example, to finance the budget deficit. The rudimentary—and not full-scale—use of this instrument is due to the fact that there is a legal ceiling on the quantity of short-term notes that can be issued. Hence, the market is not broad enough to tolerate the significant quantitative changes that are required from time to time.

5. Finally, much-needed flexibility was introduced into our exchange rate regime. The first step in what proved to be a rather long process was taken in January 1989. At that time there was installed a band of ±3 percent around a central rate, which meant that the exchange rate could change from one day to the next without a formal decision by the government. This was bad news for speculators. A year later the band was expanded to ±5 percent. The next major step was taken in December 1991, when it was decided to adopt a diagonal band, the slope of which is equal to the difference between the target for domestic inflation and the inflation rate of Israel’s trading partners. The crucial innovation here, in my opinion, was not the diagonal band but rather the fact that a domestic inflation target was set. This had not existed previously, but had been created as a by-product of the diagonal band. This innovation, which dramatically changed the nature of monetary policy, merits a separate discussion.

Apart from the traditional central bank role of employing instruments to attain intermediate monetary policy targets (usually domestic interest rates) the Bank of Israel has contributed to developing a market for financial derivatives. In this context, it offers a limited amount of call options on the U.S. dollar against the shekel and interest rate futures through a short-term note. Thus, it creates a reasonable primary market in both cases, and it is now expected that such instruments will be traded in the secondary market.

Policy Results

To obtain some perspective on the progress the Bank of Israel has made in removing administrative regulations on the working of the market, it is desirable to present a few indicators. In addition, since it is plausible to expect that a policy of deregulation and liberalization will narrow interest rate spreads, some evidence is presented to show that this has indeed happened.

Indicators of Progress

Let us examine some measures of the progress made in deregulating financial markets.

Bank Credit Allocation

Bank balance sheet data allow division of total credit to the public into two categories: one in which the terms of the loan are decided by the government, whether the loan is financed from government sources or not (“directed” credit), and one in which the terms of the loan are negotiated between the bank and the borrower (“non-directed” credit).

Data for the last six years (Chart 1) clearly indicate that the share of “directed” credit is on the decline. This share decreased from 55 percent of total credit to the public by the end of 1987 to 13 percent by the end of 1993. The trend is backed by a declared government and Bank of Israel policy to end their involvement in financial intermediation. By doing this, the government steadily increases the role of the market in allocating resources and determining interest rates.

Chart 1.Government Directed and Nondirected Credit to the Public

(In percent)

Reserve Requirements

This outcome is enhanced by a policy of reducing reserve requirements to their business level—namely, a few percentage points. Data for the last six years (Chart 2) reflect the progress made in this area, too. The average requirements went down from 63 percent at the end of 1987 to 29 percent by the end of 1993. The continued decline toward the goal of a few percentage points has been announced and the necessary legislation has been introduced, and it is now only a matter of time and automatic process until the goal is reached. No further decisions are required. The implication of this trend is clear. High reserve requirements mean a high monetary tax—i.e., a greater spread between borrowing and lending rates. Reducing requirements means lowering the burden of this particular tax and introducing a more efficient process of promoting savings and allocating investment.

Chart 2.Average Reserve Requirements on Bank Deposits

(In percent)

By-Product: A Bond Portfolio

An interesting by-product of lower government involvement in credit allocation and declining reserve requirements is the emergence of a bond portfolio held by commercial banks. This portfolio consists of government and private, and foreign and domestic bonds, and it serves two purposes: (1) it is an alternative to extending loans, and as such brings the yield on bonds closer to lending rates, adjusted for risk; and (2) it makes it easier for banks to develop an over-the-counter market for financial derivatives, offering such products as exchange rate options and domestic interest rate futures that can be covered by their bond portfolio.

At the end of 1987 the size of the bond portfolio was negligible. Six years later it was almost equal in value to the stock of capital of the commercial banks (Chart 3).

Chart 3.Portfolio of Bonds Held by Commercial Banks

(In percent of own capital)

Impact on Interest Rate Spreads

To show the impact of deregulation on the interest rate spread, four pairs of interest rates are used.

Foreign Exchange Borrowing: Domestic Spread over LIBOR

Since world financial markets were opened up completely and without any reservations to Israeli borrowers, and all restrictions preventing Israeli banks from extending foreign-currency loans were removed, two results were obtained (Chart 4): (1) the spread between the domestic borrowing rate, in foreign currency, and the London interbank offered rate (LIBOR) narrowed from 11.8 percentage points (for U.S. dollar loans) at the end of 1987 to 3.5 percentage points by the end of 1993; and (2) the trend of interest rates on domestic foreign-currency loans mirrors that of the LIBOR.

Chart 4.Dollar Borrowing Rate: Domestic vs. LIBOR

(In percent; quarterly data)

Fixed-Term Lending Rate: Sheqel/Dollar

The impact of international rates did not stop there. Since borrowing in foreign currency became a reasonable substitute for borrowing in local currency, trends in international rates started to affect local-currency interest rates as well. And, indeed, the spread between interest rates on local-currency and foreign-currency domestic loans declined from 16.4 percentage points at the end of 1987 to 6.8 percentage points by the end of 1993 (Chart 5).

Chart 5.Fixed-Term Lending Rate: Sheqalim vs. U.S. Dollars

(In percent; quarterly data)

This spread presumably reflects expectations regarding the devaluation of the sheqel against the dollar. This can be verified by examining the premium customers are willing to pay to purchase a call option on the U.S. dollar. Purchasing such an option nails down the cost of borrowing foreign currency in terms of domestic interest rates. By doing this the gap between the two interest rates does indeed approximate devaluation expectations.

Long and Short Real Interest Rates

Short-term local currency rates were extremely high in Israel following the stabilization program of the mid-1980s. By the end of 1987, real short-term bank credit rates still stood at an average level of 25 percent. At the same time the real yield on medium-term and long-term government bonds averaged some 5 percent.

The gap declined rapidly in the subsequent two years, and by the end of 1993 there was not much difference between the two rates (Chart 6). Furthermore, because of deregulation, institutional investors were given a freer hand to manage their growing financial portfolios. Shifts along the yield curve became more common and, as a result, changes at the short end of the curve, initiated by monetary policy, were more readily transmitted to the medium and long end.

Chart 6.Real Interest Rates on Loans: Short vs. Long

(In percent; quarterly data)

Is it noteworthy that all medium-term and long-term bonds in Israel, issued by the government and the private sector, are indexed—mostly to consumer prices. The government is nevertheless implementing a policy designed to gradually increase the share of unindexed nominal debt. Naturally, the progress that can be made is related to the government’s ability to reign in inflation and eradicate inflationary expectations. This seems to be a relatively slow process, and the share of unindexed debt in the significant domestic public debt was still a meager 1.5 percent by the end of 1993.

Spread Between Deposits and Lending Rates

The final pair of interest rates relates to financial transactions (deposits and loans) in unindexed local currency. This segment attracted the attention of bankers, policymakers and the public because it was the least regulated area of banking activity in Israel. At the end of 1987, the proportion of credit that was unindexed was only 29 percent. As a result of deregulation and the changing inflationary environment, that share had increased to 45 percent by the end of 1993.

What is more important, however, is that this unindexed segment has been a major source of profit for Israel’s commercial banks, traditionally contributing more than half of total bank profits. This situation is gradually changing because other profit sources (additional financial services) are emerging, and controls over bank commissions have been removed. Since the proper pricing of banking services has been feasible for some time, income from commissions has replaced interest income. This trend is reflected in a declining spread on unindexed credit. All of these phenomena result from the impact of deregulation on the extent of competition in the financial services industry.

At the end of 1987 the spread between the deposits and lending rates was huge indeed: a whopping 34 percentage points between an average rate of 13 percent paid on deposits and an average lending rate of 47 percent. By the end of 1993 the spread had narrowed dramatically, to 7.1 percentage points, largely because of the reduction in the average lending rate to 14.6 percent (Chart 7).

Chart 7.Nonlinked Interest Rate Spread: Debit vs. Credit

(In percent; quarterly data)

Concluding Remarks

Israel as a Regional Financial Center

The changing political environment in the world and the Middle East is likely to have repercussions on the economic prospects of the Middle Eastern region. Among other things there seems to be particular scope for expanding financial services and, if it prepares itself, Israel can serve as a regional financial center. This involves providing an open and stable economic environment, and completing the reform of the financial markets.

A Stable Economic Environment

A stable environment involves at least two elements: (1) fiscal discipline that is reflected by a ratio of budget deficit to gross national product (GNP) that is not larger than 2 to 3 percent, and (2) a declining public debt/GNP ratio. The former has been enacted by law, and the latter should be an annual policy concern. The public debt/GNP ratio in Israel was 117 percent in 1993, and a steady effort should be made to cut it by half. This should not be done by increasing tax rates, but by reducing spending rates.

The goal is not as ambitious as it seems. Fiscal discipline is one of the most important legacies of the stabilization program of 1985. Declining public debt ratios have also existed since then. An additional aspect of these trends, with important ramifications for financial markets, is the declining share of government domestic debt in the public’s portfolio of financial assets (Chart 8). The public now holds fewer government bonds (40 percent of total financial assets in 1993, compared to 68 percent ten years earlier) not because of lack of demand but because of lack of supply. The evidence for this is the trend of declining yields on government bonds.

Chart 8.Government Domestic Debt in the Portfolio of Financial Assets of the Public

(In percent)

The other element of a stable environment is monetary control. This kind of control becomes easier if there is fiscal discipline. However, and not less important, is the fact that starting from December 1991, annual targets for inflation have been publicly announced. Given the relatively high annual inflation rates (16–21 percent from 1986 to 1991), it is also significant that the ultimate goal is to reach price stability. The latter is defined as not exceeding the average inflation rate of Israel’s principal trading partners—namely, the United States, Western Europe, and Japan.

In this context it is pertinent to look again at the public’s portfolio of financial assets, and to note the declining share in it of bank deposits. That share, which was not very high ten years ago (42 percent in 1983), declined further, reaching 27 percent toward the end of 1993 (Chart 9). The decline occurred even though Israel does not yet have a commercial paper market. Such a trend is familiar from the experience of other countries, but for Israel it has particular implications. The main one is that the instruments employed in Israel turn out to be gradually less optimal. As described earlier in this paper, Israel’s monetary instruments consist of monetary auctions to the banking system. Israel should start employing instruments that will allow direct access to the capital market.

Chart 9.Bank Deposits in the Portfolio of Financial Assets of the Public

(In percent)

Completion of Financial Market Reform

To complete the reform in the financial markets involves continuing along two roads: (1) giving the capital market wider scope and depth by securitizing the assets of pension funds, removing the nonprudential government rules still governing the management of the portfolio of institutional investors, and equalizing the tax rules for all players in the market; this is a very ambitious target, and a subject that concerns most of the Israeli population; and (2) a much easier road—to turn the sheqel into a convertible currency; this means abolishing foreign exchange control, with perhaps a few explicit exceptions—not unlike ones that still exist, under different names, in some developed economies.

Other Requirements

A stable economic environment and the completion of financial market reforms are not sufficient for turning Israel into a regional financial center. However, the other building blocks are already in place, and can be upgraded if the challenge exists. Israel has a modern financial infrastructure, professional labor force, and advanced technology and communication systems. All this takes the form of commercial banks, with subsidiaries and branches in all the financial centers of the world; a hectic and efficient 40-year-old stock exchange; as well as many brokers and other financial firms managing a whole array of mutual funds, long-term savings funds, venture-capital funds, and private portfolios. Israel also has an experienced regulatory system in the central bank, the Ministry of Finance, and the Securities Authority. With more coordination, these can form a very efficient system. Excellence in financial services is not beyond Israel’s reach. If the government continues to lead, the market will do the rest.

The author is Senior Director for Monetary Operations and Exchange control, Bank of Israel.


A thorough discussion of the program, including the background and subsequent events, is included in Michael Bruno, Crisis, Stabilization and Economic Reform (Oxford: Clarendon Press, 1993). Professor Bruno was Governor of the Bank of Israel from 1986 through 1991. The policy of deregulating financial markets, described in this paper, was carried out during his term of office, with the full support of the then Minister of Finance, Yitzhak Modai.


This attitude was revealed again in 1987 when the central bank advocated a 3 percent surcharge on foreign exchange borrowing, which was abolished three years later. Another episode occurred in 1987, when some of the commercial banks started to offer exchange-rate-indexed loans. The central bank rushed to crack down on this “startling” innovation, Instructing that these loans should be included in the small quota of foreign exchange lending that was in force at the time.


In December 1988 the Research Department of the Bank of Israel prepared a program for renewing growth and reducing the pace of inflation, which was submitted by the Governor to the government. In the list of measures required to restrain inflation, the first item was government commitment to use the exchange rate as an anchor to attain price stability. “This does not mean,” the text explains, “that the exchange rate will never change, but that changes will be infrequent, the intention being to gradually reduce the rate of devaluation until the exchange rate is fully stabilized. In particular the public ought to know that the government will not change the exchange rate to compensate for unjustified price and wage increases, or to deal with current problems of exports and imports.”

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