Israel: Staff Report for the 2003 Article IV Consultation

This 2003 Article IV Consultation highlights that Israel’s economy has entered a modest recovery path, after almost three years of recession. Led by external demand, real GDP is estimated to have grown 1.3 percent in 2003, despite anemic investment. Furthermore, high frequency indicators suggest that output is recovering, private consumption is growing, and tourism is rebounding. The external current account deficit continues to fall and is now close to balance. The sizable capital outflow of the last quarter of 2002 and the first quarter of 2003 has been reversed, and foreign direct investment has rebounded.

Abstract

This 2003 Article IV Consultation highlights that Israel’s economy has entered a modest recovery path, after almost three years of recession. Led by external demand, real GDP is estimated to have grown 1.3 percent in 2003, despite anemic investment. Furthermore, high frequency indicators suggest that output is recovering, private consumption is growing, and tourism is rebounding. The external current account deficit continues to fall and is now close to balance. The sizable capital outflow of the last quarter of 2002 and the first quarter of 2003 has been reversed, and foreign direct investment has rebounded.

I. Background

1. The strong and sustained growth experienced by the Israeli economy since the mid-1980s came to a halt in late 2000 as a result of the burst of the high-tech bubble, the global slowdown, and the deterioration in the security situation. Waning exports and investment, combined with declining private consumption led to a deep recession, with negative GDP growth in both 2001 and 2002 (Figure 1). There is a consensus that most of the shortfall in GDP growth in 2001–02 is of a quasi permanent rather than cyclical nature. The authorities estimate that the deterioration in the security situation accounted for a loss of 6–8 percent of GDP, and the burst of the high-tech bubble amounted to a loss of about 3 percent of GDP.

Figure 1.
Figure 1.

Israel: Real Demand and Output, 1985–2003

(year-on-year change)

Citation: IMF Staff Country Reports 2004, 158; 10.5089/9781451819533.002.A001

Sources: Central Bureau of Statistics; Bank of Israel; and Fund staff projections.

2. Throughout the downturn, the authorities struggled to maintain macroeconomic stability and re-establish the basis for a resumption of growth, but fiscal policy faltered and monetary policy remained tight. The government deficit, under the mounting pressure of rising defense expenditures and falling revenues, swelled from an average of 1.5 percent of GDP in 1999–2000 to 3.8 percent in 2002 (Figure 2). To regain credibility prior to the elections, the government presented the 2003 budget with a deficit target of 3 percent of GDP. This budget, however, was based on unrealistic revenue projections and a major fiscal gap emerged very early in the year. Monetary policy during most of 2002–03 was tight in view of the large fiscal deficits and in an effort to regain credibility after a large interest rate cut in late 2001 led to a sharp depreciation of the sheqel and a bout of inflation. After raising it in June 2002, the Bank of Israel (BoI) maintained its policy rate around 9 percent through the first half of 2003.

Figure 2.
Figure 2.

Israel: Selected Fiscal Indicators, 1992–2003

(In percent of GDP; unless otherwise stated)

Citation: IMF Staff Country Reports 2004, 158; 10.5089/9781451819533.002.A001

Sources: Israeli authorities; Ministry of Finance; and Fund staff estimates.
uA01fig01

Israel: Central Government Deficit, 1992-2003

(in percent of GDP)

Citation: IMF Staff Country Reports 2004, 158; 10.5089/9781451819533.002.A001

Source: Data from Israeli authorities.

3. The extended recession worsened the already burdened labor market and welfare system. The unemployment rate rose from 8.5 percent in early 2001 to 10.7 percent in November 2003, while the share of long-term unemployed (jobless for more than six months) in total unemployment reached 35 percent (Figure 3). The participation rate is low,1 partly because of social or religious values and partly because of disincentives to work created by the relatively generous welfare system. In some cases, the loss of welfare benefits from accepting employment implies an effective tax rate that exceeds 100 percent. Reflecting the frail economy and the high unemployment rate, real wages dropped some 3 percent during 2003, while poverty increased,2 in part because of a reduction in welfare benefits (see below). The decline in income was more pronounced among poor families, resulting in a widening of income inequality. The average income of the poor relative to the poverty line fell 10 percent, and the Gini coefficient for income inequality has climbed to about 0.37 (Figure 4).

Figure 3.
Figure 3.

Israel: Labor Market Indicators, 1993–2003

Citation: IMF Staff Country Reports 2004, 158; 10.5089/9781451819533.002.A001

Source: Central Bureau of Statistics.
Figure 4.
Figure 4.

Israel: Poverty Incidence among Families in Specific Population Groups, 2002

Citation: IMF Staff Country Reports 2004, 158; 10.5089/9781451819533.002.A001

Source: National Insurance Institute.1/ Defined as income below 50 percent of median income adjusted for family size.

4. With the advent of a new coalition government in February 2003, fiscal and structural policies shifted to a more decisive course. On the fiscal front, the new government’s emergency economic program included a temporary public sector wage reduction of 4 percent on average (14.5 percent wage reduction to high wage earners and executives) and a postponement of cost of living adjustments and bonuses until June 2005; a uniform 12 percent cut in government ministry budgets; a reduction in transfers to local authorities; a sharp cut in welfare benefits;3 an increase in taxes on the employment of foreign workers;4 and a broadening of the tax base by reducing geographic exemptions. In addition, to foster private consumption, investment and growth, the planned reduction of taxes on labor income was accelerated by one year.5 Overall, the adjustments amounted to about 2 percent of GDP in 2003, of which about ½ percent of GDP was transferred to the Ministry of Defense. Nevertheless, the budget deficit reached a worrying 5.6 percent of GDP in 2003, compared to a target of 3 percent in the budget, and public debt rose to about 106 percent of GDP by the end of the year.

5. The economic program also featured a number of key structural reforms. These include streamlining the public sector by reducing the number of employees, merging units and outsourcing activities; modifying child allowances, by reducing benefits and eliminating gradually the progressivity of benefits linked to the number of children; reforming the pension system by raising the retirement age and lowering benefits, providing funds to rescue insolvent funds, and increasing pension fund participation in the capital market (Box 1).6

6. In tandem with the improvement in global conditions, these policies have led to a return of confidence. The formulation of the economic program, the ending of the major conflict in Iraq, some progress in the security situation, the rebound in world stock markets (particularly the NASDAQ), and the decision by the United States to extend US$1 billion in additional grants and nearly US$9 billion in loan guarantees (spread over three years) led to buoyant financial markets. The stock market surged close to 60 percent during 2003, longterm real rates on indexed bonds declined from 5.9 percent to 4.2 percent during this period, the sheqel recovered, and inflation expectations fell to within the inflation target range of 1-3 percent. At the same time, in response to the improved outlook and the authorities’ regained credibility, the implied volatility of the NIS/US$ exchange rate declined, and Israel’s risk premium fell from 200 to 70 basis points.

uA01fig02

Stock Market Index (TA 100)

Citation: IMF Staff Country Reports 2004, 158; 10.5089/9781451819533.002.A001

uA01fig03

Exchange Rate

Citation: IMF Staff Country Reports 2004, 158; 10.5089/9781451819533.002.A001

Pension Reform in Israel

The government’s last major reform was in 1995. An important objective of the reform was to shift participants from a defined benefit to a defined contribution system. As part of the reform, any participant who entered the system after 1995 became a member of the “new” pension funds, which were characterized by defined contributions and more investment possibilities. Those who were already in the system prior to the 1995 reforms remained in the “old” pension funds. At the end of 2002, about 1.2 million workers and pensioners were covered by the “old” funds, approximately 52 percent of the workforce. The “old” pension funds continued to accumulate actuarial deficits, reaching about NIS 110 billion (23 percent of GDP) at the end of 2002. To bring these funds to an actuarial balance, the government implemented in 2003–04 the following changes:

  • the government will provide up to NIS 73 billion to the “old funds” over the next 35 years.

  • starting in 2004, employers will contribute an additional 1.5 percent of their salary (to 13.5 percent), while employees will contribute an additional 1.5 percent (to 7.0 percent).

  • starting in 2004, benefit payments to current pensioners were reduced 2 percent.

  • the retirement age will increase from 65 to 67 for men and from 60 to 64 for women. These changes will be phased in gradually, with a four months increase in the retirement age every year.

  • all benefits will be calculated according to the career-average salary rather than the salary during the last three years, and the annual increase in real terms of the pensionable salary will be limited to 2 percent.

  • pension funds will be allowed to invest only up to 30 percent in non-traded government bonds with an assured real return of 4.8 percent yield, compared with 5.5 percent previously. To lower the risk affecting individual pension accounts, an insurance scheme will be implemented and the government will set a reserve of NIS 15 billion to hedge against investment risk.

  • management of funds will be carried out by professional managers, with approval of investment strategies by a 3–5 person investment committee and supervision by the state controller.

7. Inflation turned negative in 2003, owing to the tight monetary policy, the appreciation of the sheqel against the U.S. dollar, and the weakness in economic activity (Figure 5). The CPI declined 1.9 percent during 2003, compared with a 6.5 percent increase during 2002. The decline was not uniform during the year—after rising 0.8 percent in the first quarter prices fell sharply in the second and third quarter, and leveled off toward the end of the year. The bulk of the decline can be attributed to a drop in housing rental prices of 5.7 percent—mainly due to the 9 percent nominal appreciation of the sheqel against the U.S. dollar during 2003.7 Excluding housing, inflation decelerated from 6.1 percent to -0.5 percent between 2002 and 2003. Twelve months ahead inflation expectations—derived from capital markets and forecasters’ surveys—have diminished since April 2003 and reached 0.7 percent in December, while two to three years ahead expectations fell to around the middle of the inflation target range of 1–3 percent.

Figure 5.
Figure 5.

Israel: Inflation, 1991–2003

Citation: IMF Staff Country Reports 2004, 158; 10.5089/9781451819533.002.A001

Sources: Central Bureau of Statistics; and Bank of Israel.1/ Percentage change from the corresponding period one year earlier.
uA01fig04

Israel: Monthly Inflation, 2003 1/

Citation: IMF Staff Country Reports 2004, 158; 10.5089/9781451819533.002.A001

Source: Central Bureau of Statistics.1/ Month on month percent change.

8. The drop in inflation and in inflationary expectations, the enhanced fiscal commitment and the strengthening of financial markets prompted the BoI to cut interest rates. Starting in mid-2003, the BoI lowered its policy rate in successive steps to 4.5 percent by February of 2004. Nevertheless, real interest rates remained high as the drop in inflation and inflation expectations outpaced the decline in interest rates. The high interest rates, the negative inflation, and the still weak economic activity led to marked reductions in the growth of monetary and credit aggregates Table 1).

Table 1.

Israel: Selected Economic and Financial Indicators, 1999-2003

article image
Sources: Bank of Israel, Annual Report; Central Bureau of Statistics; IMF, International Financial Statistics; and Fund staff estimates and projections.

Fund staff estimates and projections.

The Bank of Israel set the policy rate at 4.5 percent in February 2004.

As of November 2003.

uA01fig05

Interest Rates and Inflation Expectations

(In percent)

Citation: IMF Staff Country Reports 2004, 158; 10.5089/9781451819533.002.A001

Source: Bank of Israel.
uA01fig06

Monetary Aggregates

(y-o-y change)

Citation: IMF Staff Country Reports 2004, 158; 10.5089/9781451819533.002.A001

Source: Bank of Israel.

9. Against this background, the protracted decline in economic activity has given way to a mild rebound in 2003, led by a surge in external demand. The Central Bureau of Statistics estimates that real GDP grew by 1.3 percent in 2003, despite anemic investment (Figure 1). This estimate reflects a boost in external demand with exports growing 6.2 percent. Furthermore, high frequency indicators, such as industrial production, retail trade, and tourist arrivals, suggest that output is recovering, private consumption is growing, and tourism is rebounding from its trough prior to the war in Iraq (Figure 6).

Figure 6.
Figure 6.

Israel: Recent Developments, 1998–2003

Citation: IMF Staff Country Reports 2004, 158; 10.5089/9781451819533.002.A001

Sources: Bank of Israel; Ministry of Finance; and Central Bureau of Statistics.
uA01fig07

Real GDP Growth, 1995-2003

Citation: IMF Staff Country Reports 2004, 158; 10.5089/9781451819533.002.A001

Source: Central Bureau of Statistics; and Fund staff projections.

II. Policy Discussions

10. The staff very much welcomed the authorities’ shift to public expenditure and structural reform, and the discussions concentrated on the policies needed to support the budding recovery and enhance long-term potential growth. There was agreement that the fiscal-cum-structural reform policies were the right, even if somewhat delayed, response to the quasi-permanent loss in potential output occasioned by the security situation and the bursting of the high tech bubble. These policies had contributed to confidence and helped instill a moderate if potentially fragile recovery. Against this background, staff viewed fiscal policy as broadly on the right track, and providing some room for monetary easing. To be credible, however, this approach would need to be sustained by steadfast implementation of the envisaged structural reforms and faster progress on debt reduction.

11. The authorities and staff concurred that the economic recovery is likely to gain some strength in 2004, assuming no deterioration in the security situation. The real GDP growth rate projection in the budget of 2.5 percent appears realistic and is in accordance with the BoI and staff forecasts. There was agreement, however, that a swift recovery is unlikely, and that downside risks—a deterioration of the security situation, a weaker than envisioned global demand, or a decline of the high-tech sector—are significant.

A. Fiscal Affairs

12. The authorities stressed their determination to pursue the announced economic program, which aims at reducing the tax burden and the hefty public sector as well as the budget deficit and public debt as a share of GDP. The commitment to across-the-board medium-term fiscal discipline is embodied in the recently enacted law, which limits real annual expenditure growth to 1 percent and the deficit to less than 3 percent of GDP during 2005–10. Assuming that the authorities will target deficit of about 3 percent of GDP through this period, staff projects that the public debt ratio to GDP would rise slightly in 2004 before beginning to decline in 2005, and falling to about 100 percent in 2010 as a result of the projected growth of income. However, if real GDP continues to grow by one percent or the budget deficit remains at about the 2003 level, staff projects that public debt would reach more than 115 percent of GDP by 2010 (Table 6).

Table 2.

Israel: Balance of Payments, 2000-08 1/

(in billions of U.S. dollars)

article image
Sources: Central Bureau of Statistics, Monthly Bulletin of Statistics;

Fund staff estimates and projections.

Revised: tourism expenditures excludes outlays by Israeli citizens that reside overseas.

Excludes reserve assets.

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

Gross external debt minus the foreign reserve asset holdings of the Bank of Israel and commercial banks.

Table 3.

Isreal: Indicators of External and Banking Sesctor Vulnerability, 1998-2003

(In percent of GDP, unless otherwise indicated)

article image
Sources: Bank of Israel; Central Bureau of Statistics; International Monetary Fund; Fund staff estimates and projections.

According to WEO GEE trade deflators.

Exposure of the business sector, measured by the difference between the capitalized flow of foreign currency receipts and payments (including all receipts and payments in or formally indexed to foreign currency at the time of measurement. Data for 2000 refer to end-July.

Table 4.

Israel: State Budget, 1998-2004

(In percent of GDP)

article image
Sources: Data provided by the Israeli authorities; and Fund staff estimates.
Table 5.

Israel: Medium Term Scenario, 1998-2007

article image
Source: Fund staff estimates and projections.
Table 6.

Israel: Public Sector Debt Sustainability Framework, 1998-2010

(In percent of GDP, unless otherwise indicated)

article image

General government gross debt.

Derived as [(r - ÷5] Γg÷ - g + ÷5] Γr÷]/(1+g+÷+g÷)) times previous period debt ratio, with r = interest rate; ÷ = growth rate of GDP deflator; g = real GDP growth rate; ÷ = share of foreign-currency denominated debt; and ÷ = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

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

The exchange rate contribution is derived from the numerator in footnote 2/ as ÷ 5(1+r).

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

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

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

Real depreciation is defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

Assumes that key variables (real GDP growth, real interest rate, and primary balance) remain at the level in percent of GDP/growth rate of the last projection year.

13. The 2004 budget aims to hold the deficit to 4 percent of GDP because of the full year effect of the measures adopted in mid-2003 and further across-the-board and defense expenditure cuts. As a result, overall expenditure as share of GDP is projected to decline by 2 percentage points. Capital outlays in infrastructure—highways, rapid rail system, desalination plants, and a rail link from the Red Sea to the Mediterranean—are to increase marginally, but with about ½ percent of GDP financed off-budget: the railway has been converted into a public corporation and the usual capital transfers are now recorded as equity investment and not as expenditures. Staff took the view that the planned deficit of 4 percent of GDP in 2004 budget, given the medium-term fiscal framework and the wideranging reform program, represents an appropriate step toward fiscal consolidation, while providing support to the incipient recovery. Yet, staff stressed that adhering to this target is crucial to maintaining credibility and to allying concerns about sustainability. With regard to the capital transfer to the railway, the mission recognized that this recording procedure is consistent with Eurostat guidelines, but noted that government debt would increase irrespective of how this transaction was recorded.8

14. The authorities expressed confidence in the revenue projections. Domestic revenue as a share of GDP is projected to grow by about ½ percent, while foreign grants are projected to decline by a similar amount. The bulk of the increase in domestic revenue is due to one-off transfers of surpluses from government insurance companies to the budget and an increase in the surplus of the National Insurance Institute. In contrast to past years, when revenue projections were based mainly on assumptions about nominal GDP growth, the projections for 2004 are based on a vector of quantities and prices (e.g., business GDP, private consumption, and imports). The authorities added that revenue collections had strengthened in recent months, suggesting that revenue may actually exceed budget projections in 2004. In this respect, staff encouraged the authorities to use any additional tax revenue to lower the deficit and the debt—as this would enhance credibility in the authorities’ commitment to fiscal consolidation—rather than raise expenditures or lower taxes. Correspondingly, if growth in 2004 appears to be lower than expected and a return to potential growth in 2005–08 remains realistic, the mission suggested that a limited deviation from the deficit target—say, up to ½ percent of GDP—to moderate the downturn could be considered.9

15. The Minister of Finance welcomed the flexibility in the event of revenue shortfalls,10 but thought that part of any revenue windfalls ought to be used to lower taxes and thus enhance growth prospects. The mission suggested that tax cuts at this stage could be perceived as too hasty and could undermine the credibility of the authorities’ commitment to fiscal discipline, which would hamper growth prospects and financial stability. The mission proposed that before considering any such cuts, the government prepare and make public a realistic and detailed medium-term expenditure plan that fulfills the government commitments to keep the deficit below 3 percent of GDP and to limit real expenditure growth to 1 percent starting in 2005. However, in early February, the Ministry of Finance announced a reduction in taxation amounting to ½ percent of GDP,11 based on the expectation of continued higher revenue collection than budgeted.

16. Following the mission, the Knesset approved the budget, but it became increasingly apparent that some ministries—mainly the defense ministry and local authorities—were facing unexpectedly difficult budgetary situations. The authorities have said that adjustments to the budget totaling close to 1 percent of GDP are needed to raise the allocations to defense and local authorities, but have vowed to reduce other expenditures in order to keep the budget envelope intact.12

B. Monetary Policy

17. The BoI emphasized that the goal of monetary policy is price stability—an annual inflation rate of 1–3 percent over the next 12–24 months. They did not seek to achieve a particular target over short periods. In particular, the sharp interest rate reduction that would have been needed to bring inflation within the target range during 2003 would have been inappropriate. It would have called for a major subsequent reversal, introducing undue volatility in output, the exchange rate, and prices. In fact, inflation expectations throughout most of 2003 were within the target range, indicating that market participants considered monetary policy to be consistent with the price stability target. While agreeing that policies should not overreact to shocks, the staff argued that with the benefit of hindsight, inflationary risks had been overestimated. As a result, monetary policy was excessively conservative and contributed to a marked undershooting of the inflation target.

18. Looking forward, there was general agreement that inflationary pressures are limited. Output remains subdued, inflation over the last 12 months has been negative, longterm interest rates have declined in both real and nominal terms, the foreign exchange market has remained calm following recent reductions in interest rates, and most importantly, inflationary expectations over the next 12 months are below the lower bound of the inflation target range. Moreover, upside inflationary risks appear modest and take primarily the form of a depreciation of the sheqel. In this regard, the decline in the country and currency risks is an encouraging sign. Furthermore, staff noted that compared with other emerging markets with inflation targeting regimes, Israel’s monetary policy appeared tight.

19. The authorities agreed that there was room to continue with monetary easing. The BoI, however, stressed the importance of maintaining financial stability, which called for moving gradually and cautiously with interest rate reductions. Indeed, since the mission, the BoI has gradually lowered its policy rate from 5.6 percent to 4.5 percent.

20. Discussions also covered several aspects of the inflation targeting framework.

  • The roles of inflation forecasts and expectations. The BoI currently places a great deal of emphasis on measures of real interest rates and inflation expectations that are derived from capital markets rather than its own forecasts. This approach could inherently contribute to price instability since market measures may be biased and inefficient as they reflect the authorities’ credibility and risk premium. Moreover, there is a certain degree of circularity in the approach: while the central bank relies on market-derived measures, markets look to central bank actions to assess inflationary prospects. The mission argued, therefore, that in addition to the use of market expectations, mainly to gauge the bank’s credibility, more emphasis could be placed on the Bank’s forecast models that do not rely on market expectations as a framework for policy decisions. BoI staff welcomed the suggestions.

  • Anchoring expectations through greater transparency. Because of the lags between policy actions and their impact on inflation, the public has difficulty monitoring policy commitment to inflation targets on an ongoing basis. This difficulty is particularly marked in emerging market countries with a history of high and volatile inflation. To help assure that short-term deviations from inflation targets do not unhinge expectations, the mission suggested adopting procedures used in other inflation targeting frameworks, e.g. by supplementing the semi-annual Inflation Reports with interim quarterly updates and by giving more attention in those reports to the dynamics of future inflation (Box 2). The BoI agreed with the call for more transparency while expressing concerns that markets may misinterpret the added information, particularly, the assessment of risks and possible policy response, and react in an unwarranted manner.

  • The establishment of a monetary policy committee. The mission noted that Israel is the only emerging market country with an inflation targeting regime that does not have a monetary policy committee. Such a committee would broaden the range of perspectives in the decision-making process and increase the delegation of authority within the central bank. The authorities agreed on the need to amend the BoI Law to reflect international best practices, along the lines of the recommendations of the Levin Committee (appropriately updated).13

C. Other Policy Issues

21. The structural reforms in the fiscal dimension of the economic program are complemented by equally broad-based reforms in product and labor markets. As regards the former, the reforms aim at (a) increasing competition of the business sector through breaking up of monopolies in the ports, oil refineries, electricity, water, milk distribution, and mail, and pushing forward with privatization of Bezeq Telecom, Discount Bank, Bank Leumi, Zim Shipping14, Bazan Oil Refineries and the defense industry companies (privatization would be carried out mainly via the stock exchange, as with the recently successful privatization of El-Al (airline)); (b) streamlining bureaucracy and reducing the public sector, while improving its efficiency and accessibility through enhancing computerization and services available through the internet; (c) assisting impoverished families by increasing employment opportunities, fighting welfare fraud, improving the quality of education, and reducing the number of illegal foreign workers. The mission welcomed this reform agenda, and underscored the benefits of close consultation and cooperation with all parties involved.

A Comparison of IT Regimes Among Emerging Market Countries

Successful inflation targeting requires that central banks undertake extensive analysis and forecasting of inflation, operate transparently, and be held accountable for their actions. These goals have been particularly challenging for emerging market economies given their histories with price and financial market instability, and their tradition of stricter controls and regulations and reluctance to communicate their intentions and economic outlooks. To overcome these difficulties, many countries have taken the following important steps. First, to improve their governance structure many countries incorporated a broader range of perspectives into their decision-making process and increasing the delegation of authority. Second, to enhance transparency and accountability, countries issue regular press releases and inflation outlook reports, carry out an ongoing dialogue with the private sector and media, and, in some cases, publish inflation forecasting models.

The table below presents a snapshot of current practices among emerging market economies. While there are a number of commonalities, Israel differs in two important aspects. First, all of these countries have set up monetary policy committees, and most of these committees include non-central bank members. Second, most central banks issue quarterly inflation reports. The inflation reports differ in their content, although the trend is toward issuing model-based inflation forecasts with highly analytical discussions of the inflation outlook.

Selected Countries: Characteristics of Inflation-Targeting Regimes Among Emerging Market Economies

article image
Sources: Schaechter and others (2000) and central bank websites.

Requires either indicating a time frame for returning to within target range or establishing a new target.

22. Quite aside from their fiscal implications, the authorities viewed the cuts in benefits and the welfare to work program as essential to improving the functioning of the labor market. They stressed that cuts in income support to those capable of work was key to enticing people back to the labor market and improving the social structure. The mission agreed, in principle, but underscored the importance of protecting the poor. It also cautioned that the pace of the recovery may not permit absorbing many workers quickly, and suggested facilitating mobility and increasing job training opportunities and education. The authorities thought that the soon to be established employment centers, based on the Wisconsin model for welfare reform, would ease the transition. The mission noted that the scope of the welfare to work program is very limited and suggested that the authorities consider temporary tax incentives linked to job creation and training.

23. The authorities are also taking steps to develop the financial markets and reduce the dominance of the two largest banks. These steps include revamping regulations and enforcement practices that hinder capital market development, limiting banks’ exposures to large corporate borrowers, and increasing pension funds’ involvement in the capital market. These efforts would be buttressed by the introduction by the BoI of a state-of-the-art payment and settlement system. Staff noted that these steps—which are in line with the FSAP recommendations—together with the necessary legislation to increase the number of market players and instruments, should improve the agility and resiliency of the Israeli financial markets.

24. The banking system strengthened in 2003. The economic downturn had a significant impact on the banking system, sharply reducing bank profitability and borrower repayment ability. Against this background, the Supervisor of Banks took important regulatory steps to strengthen banks’ monitoring and risk-management systems in order to improve banks’ ability to assess and manage operational, liquidity, and credit risks. While problem loans continue to grow, albeit at a reduced pace, and loan concentration is high (although significantly reduced from a year ago), positive signs have emerged: profitability has increased, capital adequacy ratios have improved, and provisions relative to nonperforming loans have risen substantially.

Israel: Banking Soundness Indicators—Five Largest Banking Groups, 1997—2003

(in percent)

article image
Sources: Bank of Israel and Fund staff estimates.

Annualized based on the first nine months of the year.

25. There have been no major developments recently in the area of trade policy. Israel’s trade policy aims at expanding its network of bilateral trade agreements and enhancing the process of trade liberalization at the multilateral level. After completing free trade agreements with the European Union and the United States during the 1980s, Israel has expanded its free trade agreements to many other countries. Presently, more than 75 percent of Israel’s trade is covered by free trade agreements. Except for security considerations and in a few cases involving antidumping rules and agricultural products, Israel maintains a trade system free of non-tariff barriers.

26. External vulnerability appears to have declined significantly. The current account deficit continues to fall and is now close to balance. The sizeable capital outflow of the last quarter of 2002 and the first quarter of 2003—prior to the war in Iraq—has been reversed, and foreign direct investment rebounded. Total gross external debt is about 60 percent of GDP, but net external debt remains negligible.15 Of the external debt, 80 percent is backed by U.S. guarantees or is held by the Jewish Diaspora, the average maturity is about 6.5 years, and the new U.S. guarantees cover most of the government external debt maturing in the next 3 years. Staff noted that given that the BoI follows a de facto fully floating exchange rate system (as the exchange rate band is not actually binding (Figure 7)) and that international reserves (amounting to US$25 billion at end-2003) cover most of short-term debt, the level of reserves appears adequate. There are also no apparent problems of external competitiveness. Exports to all major markets are recovering markedly as a result of the global upturn and the depreciation of the sheqel in real effective terms (about 20 percent in 2002–03).

Figure 7.
Figure 7.

Israel: Exchange Rates, 1998–2004

Citation: IMF Staff Country Reports 2004, 158; 10.5089/9781451819533.002.A001

Sources: Bank of Israel; and IMF, Information Notice System.1/ Weekly average of daily rates. Updated to February 13, 2004.2/ A decrease represents depreciation.

27. A fiscal ROSC mission concluded (its draft report is being reviewed by the authorities) that Israel meets the requirements of the fiscal transparency code in many areas, including internal and external audit and fiscal accounting. The greatest scope for improvement lies in the way the budget is prepared and presented. In particular, the budget documents should include a more systematic analysis of the sensitivity of the budget to economic and financial shocks, and additional information on budget execution (including a revised projection for the year in course). In addition, the expenditure classification should be revised to conform more closely to international standards. This reform would facilitate assessments of the effectiveness and efficiency of the government’s expenditure programs.

III. Staff Appraisal

28. The policies of consolidation and reform put in place over the past year have set the stage for a more balanced policy mix, but they need to be sustained and complemented with a stronger commitment to debt reduction. The structural reforms in both the fiscal area and labor and product markets are the right response to the tougher economic environment that Israel has been and is facing. It has already led to an improvement in confidence and allowed a needed rebalancing of the policy mix. This, together with the rebound in the global economy and the considerable improvement of the financial and foreign exchange markets, has laid the foundation for a gradual recovery of activity after almost three years of recession, assuming no deterioration in the security situation.

29. The 2004 budget, with a deficit target of 4 percent of GDP, is a key element of the necessary change of course. The budget strikes an appropriate balance between fiscal consolidation and sustainability, on the one hand, and the need to support the budding economic recovery on the other. Upward deviations from this target may raise concerns about the government’s commitment and ability to rein in its deficit and debt. In this regard, recent cabinet consideration of expenditure cuts in several ministries and the use of part of the contingency reserves to accommodate increases in defense and local authorities so soon after the budget was approved is troublesome.

30. Given the high level of public debt the scope for allowing automatic stabilizers to play a role is limited. Only if the recovery in 2004 is weaker than expected but a return to potential growth in 2005–08 appears realistic, should a limited deviation from the deficit target be considered. However, if the recovery is stronger than expected, the likely additional revenues should be used to lower the deficit and curb the substantial public debt. In this context, the authorities’ decision in early February to reduce taxes is disappointing insofar as it portends a slower pace of debt reduction than would be desirable given its still very high level.

31. The adoption of a limit of one percent on expenditure growth in real terms and a ceiling of 3 percent of GDP on the overall deficit for 2005–10 is welcome. It is important that the authorities adhere strictly to this framework, as this would help the government achieve its goals of gradually reducing the public debt as a share of GDP and the size of the public sector, allowing for a reduction of the tax burden. The frequent amendments of the deficit targets during downturns and the inability to limit expenditures during upturns have eroded the government’s credibility, making it essential to introduce a new credible medium-term beacon to navigate by.

32. To further raise credibility and facilitate the implementation of the fiscal adjustment, the preparation and publication of a more detailed spending plan with medium-term expenditure targets would be critical. This could be supplemented by semiannual detailed reports on progress in achieving the government’s public finance goals and the implementation of the various measures and reforms.

33. The authorities’ efforts to undertake structural reforms, including the pension and welfare systems, and the push forward with privatization and infrastructure investment are commended. These steps are overdue, and their steadfast implementation will help improve the efficiency of the economy and the structure of the public finances.

34. A further relaxation of monetary policy seems warranted, and the recent reductions in the BoI policy rate are welcome. Several factors suggest that inflationary pressures are limited: the CPI has fallen nearly 2 percent over the last 12 months, long-term real and nominal interest rates have declined markedly. Most importantly, as a result of the BoI efforts inflationary expectations over the next 12 months are below the lower bound of the inflation target range, and upside inflationary risks appear modest and stem primarily from a depreciation of the sheqel. In this respect, the declines in country and currency risks are encouraging signs. These factors, together with the subdued state of economic activity, suggest that further interest rate reductions are unlikely to push future inflation above the upper bound of the price stability target. Accordingly, there is still some room for the BoI to continue lowering its policy interest rate gradually, while closely watching developments in the foreign exchange and financial markets.

35. It would be important to support the implementation of monetary policy by strengthening BoI efforts to communicate more clearly its policy and its views regarding the inflationary environment in order to continue anchoring expectations within the inflation target range. To this end, supplementing the semi-annual Inflation Report with interim quarterly updates and rebalancing the focus of the Report by giving more attention to the dynamics of future inflation would be advisable.

36. There is a need to amend the BoI law to reflect international best practice regarding monetary policy objectives and procedures, along the lines of the recommendations of the Levin Committee. This would help monetary policy become more transparent and accountable to ensure financial market stability and to minimize the risks that temporary breaches of inflation targets unhinge expectations.

37. The situation in the labor market is worrisome. High social benefits relative to the minimum wage and high penalties for joining the labor market at the lower end, combined with steady inflows of foreign workers, have induced many to exit the labor market. Therefore, cuts in social benefits to those capable of work are an essential part of any policy that aims to entice people back to the labor market and improve the social structure. Staff lauds the authorities for implementing these necessary changes in such difficult times, while stressing the importance of protecting the disabled and the truly needy.

38. Eliminating these distortions may lead to temporary social hardship, as the current frail labor market may be unable to absorb quickly most of those affected by these reforms. There is a need to complement the reduction in benefits with additional steps, such as facilitating mobility and increasing job training opportunities and education, in order to assist the rapid absorption of unemployed and income support recipients in the labor market. In this regard, the “Welfare-to-Work” pilot project, based on the so-called Wisconsin Program, is promising, but its scope is limited and should be expanded over time. Consideration could be given to establishing temporary tax incentives linked to job creation and training.

39. Israel has subscribed to the Special Data Dissemination Standard. The periodicity, timeliness, coverage, and quality of Israel’s economic data are generally adequate for surveillance.

40. It is recommended that the next Article IV consultation be held on the standard 12-month cycle.

Table 7.

Israel: External Debt Sustainability Framework, 1998-2010

(In percent of GDP, unless otherwise indicated)

article image

Derived as [r - g - g) + (1+r)]/(1+g+ +g) times previous period debt stock, with r = nomina