Israel: Selected Issues and Statistical Appendix
Author: International Monetary Fund
Publication Date:
13 Feb 1997
eISBN:
9781451819434
Language:
English
Keywords:
ISCR; CR; deficit; firm; budget deficit; GDP growth; current account sustainability; debt service; consumer goods; Current account deficits; Current account balance; Migration
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Contents include: Budget deficit - concepts, measurements, and developments; definition, accounting basis, scope, and coverage. Structural reform issues: privatization; capital market reform; exchange and trade liberalization; other government intervention - investment subsidies and price controls; labor market reform; and land reform. Current account sustainability in Israel: overview of the Israeli economy and its transformation in the 1990s; a model of the current account applied to Israel; and sustainability indicators. Statistical tables.

Abstract

Contents include: Budget deficit - concepts, measurements, and developments; definition, accounting basis, scope, and coverage. Structural reform issues: privatization; capital market reform; exchange and trade liberalization; other government intervention - investment subsidies and price controls; labor market reform; and land reform. Current account sustainability in Israel: overview of the Israeli economy and its transformation in the 1990s; a model of the current account applied to Israel; and sustainability indicators. Statistical tables.

III. Current Account Sustainability in Israel39

The topic of current account sustainability has been long debated among economists, but little consensus has been reached on how to analyze the issue using a formal methodology. In addition to technical difficulties, opinions diverge as to what constitutes an unsustainable current account. Indeed a vast literature is devoted to explaining—ex post—the causes of balance of payments crises, but few studies have attempted to predict a crisis. Lack of confidence in the predictive power of formal economic models is understandable: evidence shows that some countries have maintained current account deficits in excess of 5 percent of GDP (a level many economists believe to be alarming) for extended periods without encountering serious difficulties.

This paper presents a study of external sector developments in Israel and the sustainability of the current account deficit along two lines: (1) a theoretical analysis of some of the causes that have led to a widening external deficit and (2) an assessment of the risks that the current situation poses. The paper is divided into four sections: the first describing the impact of immigration from the former Soviet Union; the second developing a simple consumption-smoothing model and using it to examine the Israeli experience; the third examining the dynamics of a number of sustainability indicators that have recently been discussed in the literature and comparing them with analogous figures from other countries; and, the fourth summarizing the major points.

A. An Overview of the Israeli Economy and its Transformation in the 1990s

In late 1989 a wave of Jewish immigrants began to arrive in Israel, mainly from the former Soviet Union: about 750,000 individuals have arrived over the past 6 years and the flow is expected to continue at a rate of about 70,000 per year. The total population increased over this period on average by 3.5 percent per year, from 4.52 million in 1989 to 5.54 million in 1995. This massive inflow caused not only an extraordinary demand push, but radically transformed the economy.

Average annual GDP growth jumped up from 3.5 percent during the 1980s, to over 6 percent during 1990-95. The expansion was fueled mainly by investment which grew at an annual average rate of 16.2 percent over the period 1990-95, compared to 0.1 percent during the 1980s. Private consumption was also stimulated by demand coming from the new immigrants: over the 1980s private consumption had increased on average by 5 percent a year, while in the last 6 years this rate was 7.1 percent.

The immigrant absorption program, although exacting a large amount of resources, did not itself put undue strain on the fiscal position: indeed although the domestic budget deficit increased from 3.2 percent of GDP in 1989 to 5.3 percent in 1991, it decreased steadily to 2.0 percent of GDP in 1994, thanks in part to strict controls on budget execution. However, starting in that year large wage increases were granted to civil servants while revenues were underestimated in both 1995 and 1996. In 1995, the domestic budget deficit reached 3.3 percent of GDP against a 2.75 percent target. Likewise in 1996, the domestic budget is expected to be above 4 percent of GDP, instead of the targeted 2.5 percent.

Perhaps most significantly, unemployment, which peaked at over 11 percent in 1992, was absorbed quickly, so that the rate now stands at around 6.2 percent, while the number of employed has increased from less than 1.5 million in 1989 to almost 2.0 million in mid-1996. More than 60 percent of the new jobs have been created in the business sector.

In the context of these developments, the current account position relative to national income deteriorated from 0.3 percent in 1992 to -4.2 percent in 1995 (Table 1).

Table 1.

Israel: National Saving, Investment, and the Current Account, 1986-95 1/

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Source: Bank of Israel Annual Report 1996

Total income is GNP less unilateral transfers from abroad (converted to NIS at official exchange rate).

B. A Model of the Current Account Applied to Israel

In Israel the current balance of payments deficit stems from a combination of several ingredients. One factor frequently cited is the surge in investment and consumption stemming from the need to provide the new immigrants with an adequate level of both human and non-human capital and cater to their necessities. In addition, however, there are several other explanations: the increase in government spending in the last three years; the effects of a long-term trade liberalization program exposing domestic producers to international competition; the opportunities created by the peace process in terms of access to new markets and foreign investors’ interest; a real effective appreciation of the shekel caused by high domestic interest rates; and a worsening of the terms of trade over the last two years.

This section focuses on the first element by developing a formal model to investigate current account developments and then examines how the stylized facts of the recent Israeli experience compare with its qualitative predictions.

The consumption smoothing approach: a basic formulation

A formal model that could explain all the factors influencing the current account balance, their interactions and their relative importance would be extremely complex. For this reason economic theory has focused on specific elements that can provide an insight about particular stylized facts or episodes. Economists in recent years have developed a framework, usually referred to as the consumption smoothing approach, to investigate—among other issues—current account sustainability. The advantage of this framework can be found in its solid microeconomic foundations and in its versatility to incorporate a wide array of features, while its main drawback consists of the difficulty in testing its predictions statistically, unless rather strong—and to some extent arbitrary—assumptions are made. In this section a simple consumption smoothing model is presented which appears to fit the Israeli experience. Because of limitations in the data, and to avoid the imposition of arbitrary assumptions, no attempt is made to estimate the model.

The starting point is an identity linking changes in net foreign liabilities to the investment-savings gap

CAt=At+1−At=rtAt+Yt−Ct−Gt−It(1)

where: At are net foreign liabilities at time t; rt is the real interest rate between time t-1 and t; Yt is GDP; Ct is consumption; Gt is public expenditure; I, is investment, and CAt is the current account balance.

By iterating identity (1) over an infinite period one obtains

(1+rt)At=Σs=t∞Rt,s(Cs+Gs+Is−Ys)+lim⁡s→∞Rt,sAs

where Rt, s is the market discount factor at time t for consumption at future date s, defined as

Rt,s=1Πv=t+1s.

The assumption that foreign lenders will not finance a growing debt indefinitely can be formalized by imposing a transversality condition

lim⁡s→∞Rt,sAs=0

so that the intertemporal budget constraint of the economy can be written as

Σs=t∞Rt,s(Cs+Gs+Is)=(1+rt)At+Σs=t∞Rt,sYs(1.a)

It must be noted that the transversality condition is rather weak and in reality a large external debt might create problems even if the transversality condition is satisfied. In this regard economists make a distinction between the notions of solvency, unsustainability and illiquidity. A country is solvent if the intertemporal budget constraint is not violated, a condition weak enough to accomodate a wide range of current account patterns, but virtually untestable in practice. Sustainability describes a situation that does not require a sharp shift in the current policy stance in order to prevent a crisis. Finally, illiquidity is defined as the impossibility of servicing the external debt for an extended period. The present section is devoted to an analysis of the effects of immigration on Israel’s external borrowing needs and therefore its intertemporal solvency, while the next section focuses on the more general sustainability problem.

The solution to a representative consumer’s intertemporal utility maximization problem subject to the constraint (la) allows the current account balance to be described by the following equation40

CAt=(rt−r˜t)At+(Yt−Y˜t)−(Gt−G˜t)−(It−I˜t)+[1−1(β˜/R˜)σ](r˜tAt+Y˜t−G˜t−I˜t)(2)

where a tilde indicates the permanent level of a variable41.

Equation (2), in essence states that the current account balance is influenced by two factors: on one hand are the deviations of the key variables from their “permanent” levels, on the other the discrepancy between the world market discount rate R and residents’ rate of intertemporal preference P, in other words their “impatience” relative to the international interest rate. It is argued below that in the case of Israel the immigration likely produced a sizable effect on both factors.

A change in intertemporal preferences. When residents are more impatient than the rest of the world, they are willing to borrow because p is lower than the future world interest rates, so

βR˜<1.(3)

Substituting condition (3) into equation (2), it can be seen that the country will tend to have a higher current account deficit (or lower surplus).

The flow of new immigrants into Israel likely changed the parameter p, in the sense of increasing the impatience, because the new comers brought virtually no assets with them and therefore had to be supplied all essentials until they could be productive. As well, the sense of increased security at the onset of the peace process could have induced the public to be more confident in the future.

Shifts in the permanent levels of the variables. The immigration wave was a unexpected phenomenon, which can be modeled as a one time jump in the permanent level of the variables due to a change in economic fundamentals. Indicating by Ŷ, and Ît the new permanent levels after the immigration, where Ŷt > Yt and Ît > Ĩt, one can argue that Yt - Ŷt would be negative, while It - Ît would be positive until the capital stock is fully adjusted to the increase in the quantity and quality of the new labor force, a process that will take several years to complete. During this time the current account balance would be subject to downward pressures. The permanent level of public expenditures was likely pushed up by the immigration inflow, so <t > Gt, but the sign of Gt - <t is unclear. Thus in the present framework, the immigration itself would not have caused a deterioration in the current account deficit through the channel of higher government spending unless the Government made an explicit decision to move current spending above its “permanent level”. In any case, it is clear that in this framework an expansionary fiscal policy, defined as Gt > Ĝt, would lead to such a deterioration.

Investment and consumption: some extensions of the model

Production function. Equation (2) neglects the interrelations between the variables on the right hand side. To understand the relationships between investment, the capital stock, output and the current account the model can be extended to incorporate a production function with capital installation costs. Assuming that the technology can be represented by a homogenous and concave production function Y = θ F(K, L), where K indicates capital, L labor and θ total factor productivity, the economy can be modeled as a firm maximizing an intertemporal discounted profit function

Σs=t∞Rt,s[θsF(Ks,Ls)−wsLs−Is−aIs22Ks](4)

where w denotes the real wage and the term a It2/2Kt represents the fixed cost of installing new capital. The solution to the intertemporal constrained maximization problem of adjusting the capital stock to the post immigration level of employment L yields an equation for the current account in the form

CAt=([θF(KtL¯)−aIt22Kt]−r1+rΣs=t∞(11+r)s−t[θF(KsL¯)−aIs22Ks])(5)−[qt−1aKt−r1+rΣs=t∞(11+r)s−tqs−1aKs]

where qt can be interpreted as the shadow cost of capital, also known as Tobin’s q.

By noticing that the term

YN,t≡θF(KtL¯)−aIt22Kt(6)

represents net output, and that profit maximization requires

It=qt−1aKt(7)

equation (5) can be simplified as

CAt=[YN,t−Y˜N,t]−[It−I˜t](8)

Equation (5), or its simpler version (8)—abstracting from public expenditure—is analogous to equation (2), but shows more clearly the links between capital and output. The jump in the labor force to the new level L produces an increase in the stream of Ks (to the indefinite future) which has a twofold negative effect on the current account balance: first it raises permanent net output, so that until current net output fully adjusts, the first term in the right hand side of equation (8) is negative. Second because investment at time t must climb up above its permanent level, the second (negative) term in equation (8) increases. Moreover the shadow cost of capital qt grows more than proportionally to the ratio It+1/Kt+1, amplifying the effect on investment. In other words, the higher cost of installing the new capital puts additional pressure on the current account.

Consumption and savings. Table 1 displays the changes in the savings rate, investment and current account in Israel as a percentage of disposable income. Since 1991 private savings have declined in conjunction with the deterioration of the current account, while investment has remained relatively constant after an initial jump in 1991.

How can this be explained in terms of the model presented here? For the sake of simplicity assume that 1+r is fixed and equal to 1/β, thereby omitting the “impatience” element, it can be shown that the current account is

CAt=[wtLt−w˜tL¯t]−(Gt−G˜t)−It(9)

By taking It to the left hand side one can write equation (9) in terms of savings St

St=[wtLt−w˜tL¯t]−(Gt−G˜t)(10)

Equations (9) and (10), in addition to the role of public expenditures already delineated in equation (2), highlight the role of wages, productivity and employment on the current account.

In this framework the absorption of the new immigrants can affect the current account for two reasons. First because Lt is initially below its post-immigration level (although now that the unemployment rate is approaching its lowest level in many years this effect should dissipate). Second, because real wages in the private sector have been constant during the 1990s, reflecting a more flexible labor market (the immigrants were not unionized and willing to accept a lower wage) and sluggish productivity gains (because of lags in the adjustment of the capital/labor ratio).

So far it has been shown that in a simple consumption-smoothing model, the increased immigration into Israel could have led to a deterioration in the current account because of increased demand for consumer goods as well as higher demand for the investment goods needed to increase the capital stock up to its new equilibrium level. How do these predictions of the model compare with the Israeli experience? Consumer goods imports grew by 179 percent over the period 1989-95 (Table 2). At the same time, imports of production goods (excluding diamonds) rose by 115 percent and investment goods by 300 percent. However, in spite of the high rate of investment during these years (Table 1), the capital/GDP ratio in the business sector fell from an average of 2 in 1986-89 to 1.75 in 1995. Thus the stylized facts of the Israeli experience would seem to match the predictions of the simple model developed here.

Table 2.

Israel: Commodity Imports by Main Economic Destination

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Source: Central Bureau of Statistics.

Clearly there are many important factors that have influenced recent current account developments in Israel beyond the wave of immigration. The role of fiscal policy has only been briefly touched on in the above analysis. As well, movements in the real effective exchange rate and the terms of trade certainly also played a role but these effects are beyond the scope of this paper.

C. Sustainability Indicators

Having examined some of the factors behind the deterioration of the current account balance, attention will now be turned to the risks that such a situation might entail. This section pursues two main lines of analysis: a historic perspective and a comparison with other countries.

Israel’s external debt dynamics can be described by rearranging (1) as follows:

ft−ft−1=tbt+1(1+γt)(1+∈t)ft−1(rt−∈t−γt−γt∈t)(11)

where the rate of GDP growth is denoted by γt, the ratio of net external liabilities to GDP by ft, the rate of real appreciation of the domestic currency by εt, and the ratio of trade deficit to GDP by tbt.

Equation (11) states that the growth in the ratio of net foreign liabilities to GDP is driven by the increase in the trade deficit as a percent of GDP and the burden of the previous period’s external debt. The latter moves inversely to the growth rate increase and the exchange rate, but one should note that, as an appreciation of the exchange rate is likely to affect the trade deficit, the overall effect of εt on the growth of ft is ambiguous.

Equation (11) can help to explain how the Israeli economy in the past has absorbed a surge in the external deficit due to mass immigration. Between 1949 and 1952 the Jewish population of the State of Israel doubled from 0.76 million to 1.45 million. During that period the current account deficit swelled from US$ 220 million to US$ 306 million and the import surplus that in 1950 amounted to 25 percent of GDP rose to almost 29 percent of GDP in 1952. As the flow of immigrants stabilized at a relatively high rate (the population of Israel reached 2.6 million in 1965) the import surplus as a percent of GDP declined to a low of 18 percent in 1960, to raise again towards 20 percent in 1965. Despite this unusually high use of external resources, Israel did not experience any current account crisis thanks to remarkably strong growth: between 1950 and 1965, GDP grew at an annual average rate of 11.4 percent (6.3 percent in per capita terms).

In reality, the sustainability of current account must be analyzed in a broader context than the simple model examined here. In two papers Milesi-Ferretti and Razin (1996a,b) examine episodes of large external imbalances in a number of economies, three of which (Chile 1981, Mexico 1981, and Mexico 1994) led to a balance of payments crisis, i.e., a large devaluation accompanied by a renegotiation of the external debt. Table 3 reproduces the results by Milesi-Ferretti and Razin summarizing data on variables they identify as critical for the sustainability of the current account position. Although it is difficult to pinpoint the elements that unequivocally signal an impending emergency, one observes that balance of payments crises occurred when the current account deficit was higher than 5 percent of GDP, the exchange rate was overvalued, and the ratios of both exports42 and investments to GDP were low.

Table 3.

Macroeconomic Sustainability Indicators in Selected Countries 1/

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Source: Milesi-Ferretti and Razin (1996, a, b).

Current account balance, savings, investment, exports of goods and services, fiscal balance are average ratios of GDP during the period. The growth rate and the CPI-based Real Effective Exchange Rate are period averages (REER: average 1970-1995= 100). Interest payments and gross external debt are ratios to GDP for the last year of the period and based on data from IMF, International Financial Statistics; World Bank, World Debt Tables and national sources.

Persistent current account deficit led to a crisis, defined as a devaluation followed by a rescheduling of the debt service.

For Australia and Israel: net external debt.

Even if Table 3 might not provide a formal framework to predict the timing of a crisis, it, nevertheless, indicates quite clearly what kind of action is required to avoid one. All countries in the sample that averted a crisis implemented a major fiscal consolidation. In most cases this led to a downward correction in the level of the real exchange rate which produced an export boom. Despite the fiscal contraction and a lower investment share, GDP growth in the post-adjustment period picked up vigorously. This contrasts sharply with the three episodes where a balance of payments crisis developed and where growth was undermined by the fiscal contraction to the extent that negative growth rates prevailed afterwards.

Table 4 presents indicators for Israel over the last six years. The data in general do not seem to suggest that a crisis is looming: although the current account has reached a high level, Table 2 shows that the bulk of imports are production inputs or investment goods while the share of consumer goods—although increasing rapidly, especially in the first three quarters of 1996—remains relatively low.

Table 4.

Israel: Sustainability Indicators

(In percent of GDP unless otherwise indicated)

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

The official data on net external liabilities do not raise significant concerns, since net debt as a percentage of GDP is shrinking, as are debt service indicators.43 Moreover, figures on debt maturity provided by the authorities (not reported here) show that short term liabilities are relatively small. Public sector liabilities, which represent 77 percent of total liabilities, are all medium and long term. Even when the private sector and banking sector debts are added, long term liabilities constitute 75 percent of the total. The Bank of Israel forecasts that debt amortization during 1997-2000 will entail annual payments in the order of US$ 2-2.5 billion, a relatively low amount considering the size of the Bank of Israel’s foreign currency reserves (some US$ 10 billion at end-September 1996).

However, despite the generally favorable outlook some risks do exist. A reversal of the recent real appreciation of the shekel would cause the debt indicators to worsen and some borrowers could experience liquidity problems even if there were no real issue of solvency. Second, loan guarantees from the US Government will expire in 1998. Although Israel has so far been able to borrow at quite favorable spreads even without the guarantees, there is no assurance this will continue. Finally, so far Israel has received large unilateral transfers, particularly from the United States. Nothing can be said about the outlook for the continuation of these flows with any certainty.

D. Conclusions

This paper has presented a simple model which can be used to investigate the effect of the large wave of immigration on the Israeli current account. The model suggests that both consumption and investment would have increased due to the immigration; both factors tending to worsen the current account. The stylized facts of the Israeli experience are consistent with the model’s predictions.

In the second part of the paper, some cross-country comparisons of current account sustainability indicators are made which suggest that although the Israeli current account deficit is very high, the situation should be manageable assuming an appropriately tight fiscal stance. In particular, international experience shows that countries with large current account deficits were able to avoid balance of payments crises by pursuing tight fiscal policies.

STATISTICAL APPENDIX

Table A1.

Israel: Industrial Production, 1991-95 1/

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Source: Central Bureau of Statistics, Monthly Bulletin of Statistics.

According to the CBS new classification.

Table A2.

Israel: Investment, 1992-95

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Sources: Central Bureau of Statistics, Monthly Bulletin of Statistics; and data provided by the Bank of Israel.
Table A3.

Israel: Consumption, 1992-95

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Sources: Central Bureau of Statistics, Monthly Bulletin of Statistics, and data provided by the Bank of Israel.

This column gives rates of change, taking into consideration the fact that the government has undertaken to pay the Health Funds directly (in the framework of the National Health Law). This represents a volume decline in private consumption and an equivalent increase in public consumption.

Table A4.

Israel: Gross Private Income and Savings, 1990-95

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Sources: Central Bureau of Statistics, Monthly Bulletin of Statistics and data provided by the Bank of Israel.
Table A5.

Israel: Labor Market Indicators, 1977-95 1/

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Sources: Bank of Israel, Annual Reports, Central Bureau of Statistics, Monthly Bulletin of Statistics; and data provided by the Bank of Israel.

Beginning in 1985, the data are based on the 1983 census and correspond to the population aged 15 and over. Prior to 1985, the data correspond to the population aged 14 and over.

For Israeli population.

Table A6.

Israel: Business Sector Employment and Labor Input by Industry, 1989-95 1/

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Source: Bank of Israel.

Employment figures are annual averages; labor input figures are weekly averages.

The data does not sum up because of the “unknown” category.

Includes other employees from the administered areas except for those employed in public services.

Table A7.

Israel: Real Wages, Labor Costs, and Productivity, 1988-95

(Percentage change)

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Sources: Bank of Israel, Annual Reports, Institute for Research on Output and Productivity; and data provided by the Bank of Israel.

Real wages in the public sector and real consumption wages in the business sector are deflated by the consumer price index; real production wages are deflated by the implicit price index of business sector net domestic product at factor cost.

Measured on an hourly basis; deflated by the implicit price index of business sector net domestic product at factor cost.

Business sector net domestic product per man-hour estimated from the expenditure side.

Ratio of real labor cost per man-hour to labor productivity.

Table A8.

Israel: Real Wages, 1980-95 1/

(Average 1989-100)

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Source: Data provided by the Bank of Israel.

Average monthly wage per employee post at constant prices: Central Bureau of Statistics data based on employers’ contributions to the National Insurance Institute, deflated by consumer price index.

Table A9.

Israel: Consumer Price Index and its Main Components, 1993-95

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Source: Central Bureau of Statistics.
Table A10.

Israel: Selected Price Indexes, 1991-95

(Percent increase during the period, at annual rates)

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Sources: Central Bureau of Statistics, Monthly Bulletin of Statistics’, IFS; and data provided by the Bank of Israel.

Twelve-month rate through July.

The index of controlled prices comprises the following items: public transport, communication services, education, medical services, municipal taxes, electricity, fuel and water, meat.

The index of uncontrolled prices comprises items not listed in the preceding footnote.

Excluding fruit, vegetables, and controlled prices.

Table A11.

Israel: Bank of Israel Accounts, 1992-96

(In millions of new sheqalim, end of period)

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Sources: IMF; and Bank of Israel.
Table A12.

Israel: Monetary Survey, 1991-95

(In millions of new shekels at end of period)

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Source: Bank of Israel Research Department.

From December 1992 data are based on the New Reporting System.

Quasi-money consists of time and savings deposits, CDs, and other deposits.