Israel: Staff Report for the 2005 Article IV Consultation

International Monetary Fund

doi:10.5089/9781451819595.002.A001

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Israel: Staff Report for the 2005 Article IV Consultation

Author: International Monetary Fund

Publication Date:: 23 Mar 2006

eISBN:: 9781451819595

Language:: English

Keywords:: ISCR; CR; balance of payments data; interest rate; authority; February CPI; current account; output gap; banking system; poverty rate; central bank; Central bank policy rate; Global

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This 2005 Article IV Consultation highlights that following a strong performance in 2004, Israel’s economic expansion accelerated in 2005, supported by a relatively favorable global economic environment, an improvement in the security situation, and prudent policies. Real GDP grew at an estimated 5.2 percent in 2005. Inflation is slightly higher than a year ago, but remains in check. The unemployment rate continues to fall, but remains high. The macroeconomic policies and structural reforms of recent years have opened up the economy, increased its competitiveness, and attracted foreign investment.

Abstract

I. Overview

1. Following a strong performance in 2004, the economic expansion accelerated in 2005, supported by a relatively favorable global economic environment, an improvement in the security situation, and prudent policies. The Article IV consultation occurred against the backdrop of robust output growth, low inflation, falling unemployment—albeit from a high level—and a steady improvement in the external position. The current account is in a small surplus, the sheqel has remained broadly stable, and foreign investment has reached record levels.

2. The macroeconomic outlook is positive, but there is further scope to enhance growth and reduce vulnerabilities. The macroeconomic policies and structural reforms of recent years have opened up the economy, increased its competitiveness, and attracted foreign investment. However, more can be done to improve the framework for fiscal and monetary policies, reduce vulnerabilities in the financial system, and increase the economy’s flexibility. A key challenge is to sustain the ongoing fiscal retrenchment and thereby reduce the large stock of public debt relative to GDP. While banking system indicators have strengthened recently, credit risks remain high and the development of capital markets has created new regulatory and supervisory challenges. Poverty alleviation has become a top priority in the political agenda and may require some reallocation of resources within the fiscal envelope.

Box 1.

Israel: Key Policy Recommendations and Implementation

Fiscal policy: The Fund has considered the fiscal stance over the past several years as appropriate and welcomed the introduction of expenditure and deficit ceilings. At the same time, the public debt as a share of GDP remains very high and the Fund has emphasized the importance of accelerating debt reduction by abstaining from further tax cuts. In this regard, the passage of the 2005 legislation of multi-year tax cuts may risk slowing the path of debt reduction.

Structural Fiscal Reform: The Fund has urged the authorities to adopt a multi-year budget framework to help ensure that future budgets are better insulated from political pressures and reflect long-term priorities. The authorities are concerned about loss of budget flexibility, but have agreed in principle to explore this recommendation further.

Monetary policy: In line with the Fund’s recommendation, the authorities are working to enhance their policy tools and procedures for implementing inflation targeting. The authorities have also continued to take steps to increase the transparency of the Inflation Report, including by giving more attention to the dynamics of the inflation forecast. Key parameters of the proposed new Bank of Israel Law are consistent with previous Fund recommendations.

Capital Market Reforms: During the 2004 Article IV consultation, Executive Directors welcomed the authorities’ commitment to strengthen competition in the financial sector and the steps being taken to remove obstacles to capital market development. Banks’ divestiture of their mutual and provident funds has so far increased competition in these instruments. Directors also noted, however, that the capital market reforms would require the supervisory and regulatory functions to be enhanced to mitigate systemic risk that could arise from the transfer of mutual and provident funds to the non-bank sector. The authorities have recognized the risks posed by these reforms and are taking action to address them, in particular, by introducing new laws and regulations and developing new proactive approaches to enforcement.

3. The fallout from the Gaza disengagement, which included the resignation of the finance minister and the creation of a new centrist party, has significantly altered the political landscape. Prime Minister Sharon’s illness has added to the political turmoil. Deputy Prime Minister and Minister of Finance Ehud Olmert has been serving as Acting Prime Minister in the run-up to the March 28 elections. Because the Knesset was dissolved prior to approving the 2006 budget, the government has been operating using the (relatively tight) 2005 budget framework, which allows 1/12 of that budget to be spent each month until a new 2006 budget is approved. The staff suggested a follow-up staff visit to assess the proposed new budget following the elections. This suggestion was welcomed by the authorities. The new political landscape is not expected to adversely affect economic policy in the near term, but may well have implications over the longer term.

II. Macroeconomic Background and Outlook

4. After three years of depressed activity, real GDP growth recovered strongly in 2004 and increased further in 2005. The strong and sustained growth experienced since the mid-1980s came to a halt in 2001–02 as a result of the high-tech slump, the global slowdown, and the deterioration in the Israeli security situation (Figure 1). The economy has since recovered; real GDP grew by 4.4 percent in 2004, and by an estimated 5.2 percent in 2005. The expansion is being driven by exports, which rose by an average of 10 percent annually over the past three years, and private consumption (Table 1). Staff analysis suggests that investment has lagged other indicators in recent years partly because of high corporate leverage.¹ However, as the financial health of the corporate sector improved, investment began to rise in 2005. Inflation is slightly higher than a year ago, but remains contained, while unemployment continues to fall, although from a high level (Figure 2, Table 1).

Table 1.

Israel: Selected Economic and Financial Indicators, 2000–06

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

^{^1/}CAI World Fact Book. Includes Israeli settlers in the West Bank, Gaza Strip and Israeli-occupied Golan Heights

^{^2/}As of October 2005.

^{^3/}The Bank of Israel set the policy rate at 4.75 percent for February 2006.

^{^4/}As of November 2005.

^{^5/}National accounts indicators reflect preliminary estimates.

^{^6/}Public finance figures based on proposed 2006 budget.

^{^7/}Fund staff projections.

^{^8/}As of September 2005.

5. There is broad agreement that economic growth will remain strong in the short term. In line with the authorities’ views, the staff projects output to expand by slightly more than 4 percent in 2006–07, driven by private consumption, in turn supported by strong employment and income growth, and a favorable external environment. The staff expects the recovery of business investment to strengthen, reflecting increased profitability and liquidity as well as lower debt ratios; while residential investment will likely still lag given the continued high leverage in the real estate sector. Export growth is projected to remain strong, while imports should rise in line with the recovery in investment. As the output gap closes, inflation is expected to pick up, albeit moderately. The main risks to the outlook are related to weakness abroad, especially in the United States and Europe, a sustained rise in oil prices, political volatility, and a deterioration in the security situation.²

6. Improved confidence in the macroeconomic outlook has been helped by the authorities’ fiscal consolidation efforts, which are critical to putting the public debt to GDP ratio on a firm downward path. After a prolonged period of fiscal laxity, the authorities have embarked on fiscal consolidation over the past two years. Legislation in 2004 limiting the central government’s fiscal deficit to no more than 3 percent of GDP and real expenditure growth to no more than 1 percent a year was key to this retrenchment.³ To allow for Gaza disengagement costs, the 2005 fiscal deficit target was raised to 3.4 percent of GDP. In the event, lower than projected expenditure and stronger than expected revenue helped bring down the deficit to an estimated 1.9 percent of GDP (Figure 3, Table 2). Of the estimated 1.5 percent of GDP improvement in the fiscal deficit relative to the budget target, about 1.2 percent of GDP was attributed to lower expenditure while 0.3 percent of GDP to higher revenue. The lower than expected expenditure was mostly reflected in reduced interest costs, while the larger-than-anticipated revenue reflected the higher-than-projected GDP growth. This is a welcome development, although the low deficit achieved in 2005 will be difficult to repeat in an election year.⁴

Table 2.

Israel: Central Government Accounts, 2001–06

(In percent of GDP)

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

^{^1/}Based on preliminary estimates from the authorities.

^{^2/}This is a proposed budget that was approved by the previous government prior to dissolvent of the Knesset.

^{^3/}These revenues were not classified as a separate item before 2002.

Table 2.

Israel: Central Government Accounts, 2001–06

(In percent of GDP)

					2001	2002	2003	2004	2005 Budget	2005 Estimate ^1/	2006 Budget ^2/
Revenue (excluding repayment of credit)					37.1	39.2	37.1	37.0	37.0	37.3	36.8
	Domestic				34.7	34.2	33.2	34.0	33.9	34.1	34.4
		Tax			30.6	29.8	28.6	28.9	29.2	29.1	29.4
			Of which: On income and profits		17.8	16.2	15.2	15.2	15.2	15.7	15.4
				On domestic goods and services	12.8	13.6	13.5	13.7	13.9	13.4	14.0
		Nontax domestic			4.2	4.4	4.6	5.0	4.7	4.9	5.0
			Of which: Loans from the National Insurance Institute		0.9	1.6	1.8	2.1	2.1	2.2	2.2
			Other		3.3	2.8	2.8	3.0	2.6	2.7	2.8
	Foreign				2.5	5.0	3.9	3.0	3.1	3.2	2.4
		Of which: Grants			2.0	3.0	2.1	2.0	2.1	2.1	2.0
		Vat on defense imports			0.3	0.4	0.3	0.2	0.2	0.3	0.2
		Interest foreign currency			0.1	0.1	0.1	0.0	0.0	0.1	0.0
		Other revenues abroad ^3/			0.0	1.5	1.4	0.7	0.7	0.7	0.1
Expenditure (excluding lending and expenditure by public hospitals)					41.5	43.0	42.7	40.8	40.4	39.2	39.8
	Current expenditure				39.8	41.1	40.6	38.4	36.7	…	…
			Wages		8.6	8.8	8.7	8.6	8.2	…	8.2
			Subsidies & transfers		14.8	14.4	14.5	13.9	13.1	…	13.1
			Interest		5.8	5.6	6.5	6.1	6.6	5.9	6.2
			Other		10.6	12.4	11.0	9.8	12.5	…	12.3
	Capital expenditure				1.7	1.8	2.1	2.4	3.7	…	…
Budget deficit					4.4	3.8	5.6	3.8	3.4	1.9	3.0
Financing					4.3	3.4	5.3	3.3	2.7	1.5	2.5
	Domestic (net)				1.4	-1.2	-0.5	2.3	1.5	-0.4	1.7
	Foreign (net)				3.5	4.9	4.4	1.5	0.5	-0.3	0.5
	Sale of assets (net)				0.0	0.1	0.1	0.2	0.7	1.5	0.3
	Change in cash balances and other financing (net)				-0.6	-0.4	1.3	-0.7	0.0	0.6	0.0
Memorandum item:
	Defense expenditure				9.8	11.8	10.8	9.6	8.4	…	8.2
	Primary balance				1.4	1.8	0.8	2.3	3.2	4.0	3.2

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

^{^1/}Based on preliminary estimates from the authorities.

^{^2/}This is a proposed budget that was approved by the previous government prior to dissolvent of the Knesset.

^{^3/}These revenues were not classified as a separate item before 2002.

Table 2.

Israel: Central Government Accounts, 2001–06

(In percent of GDP)

					2001	2002	2003	2004	2005 Budget	2005 Estimate ^1/	2006 Budget ^2/
Revenue (excluding repayment of credit)					37.1	39.2	37.1	37.0	37.0	37.3	36.8
	Domestic				34.7	34.2	33.2	34.0	33.9	34.1	34.4
		Tax			30.6	29.8	28.6	28.9	29.2	29.1	29.4
			Of which: On income and profits		17.8	16.2	15.2	15.2	15.2	15.7	15.4
				On domestic goods and services	12.8	13.6	13.5	13.7	13.9	13.4	14.0
		Nontax domestic			4.2	4.4	4.6	5.0	4.7	4.9	5.0
			Of which: Loans from the National Insurance Institute		0.9	1.6	1.8	2.1	2.1	2.2	2.2
			Other		3.3	2.8	2.8	3.0	2.6	2.7	2.8
	Foreign				2.5	5.0	3.9	3.0	3.1	3.2	2.4
		Of which: Grants			2.0	3.0	2.1	2.0	2.1	2.1	2.0
		Vat on defense imports			0.3	0.4	0.3	0.2	0.2	0.3	0.2
		Interest foreign currency			0.1	0.1	0.1	0.0	0.0	0.1	0.0
		Other revenues abroad ^3/			0.0	1.5	1.4	0.7	0.7	0.7	0.1
Expenditure (excluding lending and expenditure by public hospitals)					41.5	43.0	42.7	40.8	40.4	39.2	39.8
	Current expenditure				39.8	41.1	40.6	38.4	36.7	…	…
			Wages		8.6	8.8	8.7	8.6	8.2	…	8.2
			Subsidies & transfers		14.8	14.4	14.5	13.9	13.1	…	13.1
			Interest		5.8	5.6	6.5	6.1	6.6	5.9	6.2
			Other		10.6	12.4	11.0	9.8	12.5	…	12.3
	Capital expenditure				1.7	1.8	2.1	2.4	3.7	…	…
Budget deficit					4.4	3.8	5.6	3.8	3.4	1.9	3.0
Financing					4.3	3.4	5.3	3.3	2.7	1.5	2.5
	Domestic (net)				1.4	-1.2	-0.5	2.3	1.5	-0.4	1.7
	Foreign (net)				3.5	4.9	4.4	1.5	0.5	-0.3	0.5
	Sale of assets (net)				0.0	0.1	0.1	0.2	0.7	1.5	0.3
	Change in cash balances and other financing (net)				-0.6	-0.4	1.3	-0.7	0.0	0.6	0.0
Memorandum item:
	Defense expenditure				9.8	11.8	10.8	9.6	8.4	…	8.2
	Primary balance				1.4	1.8	0.8	2.3	3.2	4.0	3.2

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

^{^1/}Based on preliminary estimates from the authorities.

^{^2/}This is a proposed budget that was approved by the previous government prior to dissolvent of the Knesset.

^{^3/}These revenues were not classified as a separate item before 2002.

7. Given the renewed emphasis on fiscal consolidation, and inflation within the Bank of Israel’s (BoI) target range of 1–3 percent, monetary policy has been appropriately accommodative, notwithstanding recent increases in the policy rate (Figure 5). Interest rates were lowered in 2004, as inflationary pressures eased amid sheqel appreciation against the U.S. dollar. For most of 2005, the BoI kept its policy rate unchanged at 3.5 percent, as inflation remained subdued. In September, and again in October, the BoI raised the rate by 25 basis points to 4 percent, and by a further 50 basis points in November, citing increasing signs of upward pressure on prices, including those emanating from global oil prices, and a rise in inflation expectations. By the end of the year, the December-over-December inflation rate reached 2.4 percent—twice the rate in 2004—but only slightly above the mid-point of the target range (Table 1). The 4.5 percent policy rate was not changed in December but was increased by 25 basis points in January as the Bank of Israel became concerned about the closing of the output gap and the narrowing interest rate differential with the United States.

8. The Israeli sheqel, a freely floating currency, has remained broadly stable over the past year, balanced by strong economic activity on the one hand and relatively low interest rates on the other. The improved economic outlook helped attract strong foreign capital inflows in 2005 amounting to a record US$9.7 billion of direct and portfolio investment, an increase of 66 percent over the 2004 level. The US$5.7 billion of foreign direct investment, in particular, has helped mitigate downward pressure on the sheqel stemming from the historically low interest rate differential with the U.S. Owing largely to the continued low inflation, Israel’s competitive position has remained relatively strong, as evidenced by the depreciation of the real effective exchange rate (REER) in recent years (Figures 1, 4). The improved competitiveness can also be seen in the strength of private sector productivity growth, which averaged 2 percent in the period 1993–2004, compared to the growth in real wages, which averaged 1.3 percent over the same period. This is confirmed by the depreciation in recent years in the unit labor cost (ULC) based REER.

Looking ahead, staff expects capital inflows to remain strong, although below the record levels reached last year, provided the security situation remains relatively calm, productivity continues to strengthen, and the economy expands further. In the event that these favorable conditions fail to materialize, there is the risk that capital inflows would reverse, as happened in 2001–02, and the sheqel could come under pressure.

9. The current account continued to show a small surplus in 2005, further enhancing confidence and mitigating external risks. After ten consecutive years of current account deficits, Israel has run surpluses for the past three years, largely reflecting the strong recovery in exports (Figure 4, Table 3). The staff expects the improvement in the current account to continue over the medium term, reflecting past gains in productivity and competitiveness. The improved balance of payments position is also reflected in the country’s net external asset position (on debt instruments), which is close to US$23 billion as of end-2005. Moreover, foreign reserves, totaling about US$27 billion (22 percent of GDP), cover roughly 90 percent of total gross short-term external debt or about 5 months of imports. Rollover risks of public-sector external debt—currently at about 25 percent of GDP—are mitigated by two key factors; about 80 percent of this debt is held by the Jewish Diaspora or backed by U.S. government guarantees,⁵ while short-term external public debt remains low, at around 2 percent of GDP. Indeed, the relatively low level of sovereign risk is reflected in the low risk premium of about 80 basis points over U.S. treasuries on 10-year foreign-currency denominated sovereign bonds (Figure 5). This risk premium compression and the sharp rise in the equity market over the past two years (Figure 5) were in part driven by foreign investors’ appetite for emerging market assets generally and Israeli assets in particular.

Table 3.

Israel: Balance of Payments, 2002–10 ^1/

(In billions of U.S. dollars)

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

^{^1/}Fund staff estimates and projections.

^{^2/}Excludes reserve assets.

^{^3/}Negative (positive) sign denotes increase (decrease) in reserves.

^{^4/}Gross external debt minus the foreign reserve asset holdings of the Bank of Israel, commercial banks, and the non-financial corporates.

^{^5/}As of September 2005.

Table 3.

Israel: Balance of Payments, 2002–10 ^1/

(In billions of U.S. dollars)

							Projections
				2002	2003	2004	2005	2006	2007	2008	2009	2010
Current account balance				-1.3	0.8	1.5	1.0	0.2	1.3	2.1	3.1	4.4
Merchandise				-3.7	-2.2	-1.9	-3.8	-3.9	-2.9	-1.7	-1.1	-0.1
	Exports, f.o.b.			27.5	30.1	36.6	39.3	42.9	43.6	45.1	46.8	49.0
	Imports, f.o.b.			31.2	32.3	38.5	43.1	46.8	46.5	46.9	47.8	49.1
		Civilian imports		28.8	30.3	36.6	41.0	44.5	44.0	44.2	44.9	46.0
		Military imports		2.4	2.1	1.9	2.1	2.3	2.5	2.7	2.9	3.1
Services				-0.3	0.7	1.3	1.9	2.5	3.0	3.6	4.3	5.1
	Exports			11.3	12.7	14.9	16.9	18.7	20.5	22.4	24.5	26.9
	Imports			11.6	12.0	13.6	15.0	16.2	17.5	18.8	20.2	21.8
Factor Income				-4.0	-4.0	-4.2	-3.7	-5.0	-5.3	-6.2	-6.5	-7.0
	Receipts			2.4	2.7	2.3	3.1	3.0	3.2	2.8	3.0	3.0
	Payments			6.4	6.7	6.5	6.8	8.0	8.5	9.0	9.5	10.0
Net transfers				6.8	6.4	6.2	6.6	6.6	6.4	6.4	6.4	6.4
Capital and financial account balance ^2/				-1.2	-0.7	-1.8	2.4	1.2	1.2	1.2	1.0	1.0
	Capital account			0.2	0.5	0.5	0.3	0.3	0.3	0.3	0.3	0.3
	Financial account			-1.3	-1.2	-2.3	2.1	0.9	0.9	0.9	0.7	0.7
		Direct investment, net		0.8	1.8	-1.5	4.5	3.0	3.0	3.0	3.0	3.0
			Foreign direct investment (in Israel)	1.8	3.9	1.7	5.7	4.2	4.2	4.2	4.2	4.2
		Portfolio investment, net		-2.0	-0.8	3.6	0.0	-0.2	-0.2	-0.2	-0.2	-0.2
		Other investment		-0.1	-2.2	-4.4	-2.4	-1.9	-1.9	-1.9	-2.1	-2.1
Errors and omissions				1.8	1.3	0.6	0.0	0.0	0.0	0.0	0.0	0.0
Change in reserves ^3/				0.6	-1.3	-0.3	-3.4	-1.3	-2.4	-3.2	-4.1	-5.4
Memorandum items (percentage of GDP):
Current account balance				-1.2	0.7	1.3	0.8	0.1	0.9	1.4	2.0	2.6
Civilian trade balance				-1.2	-0.2	0.0	-1.4	-1.2	-0.3	0.6	1.2	1.8
Gross external debt ^5/				65.1	64.6	63.5	60.8	57.3	54.0	54.1	53.8	53.5
Net external debt ^4/^5/				-2.0	-5.6	-9.7	-16.8	-16.4	-15.2	-13.6	-11.7	-9.1
Gross external debt (in billions of U.S. dollars)				67.8	71.3	74.2	75.2	75.2	75.4	80.1	84.7	89.5
Net external debt (in billions of U.S. dollars)				-2.1	-6.2	-11.3	-20.7	-21.5	-21.2	-20.1	-18.4	-15.3
GDP (in billions of U.S. dollars)				104.2	110.4	116.9	123.7	131.3	139.6	148.1	157.4	167.4

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

^{^1/}Fund staff estimates and projections.

^{^2/}Excludes reserve assets.

^{^3/}Negative (positive) sign denotes increase (decrease) in reserves.

^{^4/}Gross external debt minus the foreign reserve asset holdings of the Bank of Israel, commercial banks, and the non-financial corporates.

^{^5/}As of September 2005.

Table 3.

Israel: Balance of Payments, 2002–10 ^1/

(In billions of U.S. dollars)

							Projections
				2002	2003	2004	2005	2006	2007	2008	2009	2010
Current account balance				-1.3	0.8	1.5	1.0	0.2	1.3	2.1	3.1	4.4
Merchandise				-3.7	-2.2	-1.9	-3.8	-3.9	-2.9	-1.7	-1.1	-0.1
	Exports, f.o.b.			27.5	30.1	36.6	39.3	42.9	43.6	45.1	46.8	49.0
	Imports, f.o.b.			31.2	32.3	38.5	43.1	46.8	46.5	46.9	47.8	49.1
		Civilian imports		28.8	30.3	36.6	41.0	44.5	44.0	44.2	44.9	46.0
		Military imports		2.4	2.1	1.9	2.1	2.3	2.5	2.7	2.9	3.1
Services				-0.3	0.7	1.3	1.9	2.5	3.0	3.6	4.3	5.1
	Exports			11.3	12.7	14.9	16.9	18.7	20.5	22.4	24.5	26.9
	Imports			11.6	12.0	13.6	15.0	16.2	17.5	18.8	20.2	21.8
Factor Income				-4.0	-4.0	-4.2	-3.7	-5.0	-5.3	-6.2	-6.5	-7.0
	Receipts			2.4	2.7	2.3	3.1	3.0	3.2	2.8	3.0	3.0
	Payments			6.4	6.7	6.5	6.8	8.0	8.5	9.0	9.5	10.0
Net transfers				6.8	6.4	6.2	6.6	6.6	6.4	6.4	6.4	6.4
Capital and financial account balance ^2/				-1.2	-0.7	-1.8	2.4	1.2	1.2	1.2	1.0	1.0
	Capital account			0.2	0.5	0.5	0.3	0.3	0.3	0.3	0.3	0.3
	Financial account			-1.3	-1.2	-2.3	2.1	0.9	0.9	0.9	0.7	0.7
		Direct investment, net		0.8	1.8	-1.5	4.5	3.0	3.0	3.0	3.0	3.0
			Foreign direct investment (in Israel)	1.8	3.9	1.7	5.7	4.2	4.2	4.2	4.2	4.2
		Portfolio investment, net		-2.0	-0.8	3.6	0.0	-0.2	-0.2	-0.2	-0.2	-0.2
		Other investment		-0.1	-2.2	-4.4	-2.4	-1.9	-1.9	-1.9	-2.1	-2.1
Errors and omissions				1.8	1.3	0.6	0.0	0.0	0.0	0.0	0.0	0.0
Change in reserves ^3/				0.6	-1.3	-0.3	-3.4	-1.3	-2.4	-3.2	-4.1	-5.4
Memorandum items (percentage of GDP):
Current account balance				-1.2	0.7	1.3	0.8	0.1	0.9	1.4	2.0	2.6
Civilian trade balance				-1.2	-0.2	0.0	-1.4	-1.2	-0.3	0.6	1.2	1.8
Gross external debt ^5/				65.1	64.6	63.5	60.8	57.3	54.0	54.1	53.8	53.5
Net external debt ^4/^5/				-2.0	-5.6	-9.7	-16.8	-16.4	-15.2	-13.6	-11.7	-9.1
Gross external debt (in billions of U.S. dollars)				67.8	71.3	74.2	75.2	75.2	75.4	80.1	84.7	89.5
Net external debt (in billions of U.S. dollars)				-2.1	-6.2	-11.3	-20.7	-21.5	-21.2	-20.1	-18.4	-15.3
GDP (in billions of U.S. dollars)				104.2	110.4	116.9	123.7	131.3	139.6	148.1	157.4	167.4

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

^{^1/}Fund staff estimates and projections.

^{^2/}Excludes reserve assets.

^{^3/}Negative (positive) sign denotes increase (decrease) in reserves.

^{^4/}Gross external debt minus the foreign reserve asset holdings of the Bank of Israel, commercial banks, and the non-financial corporates.

^{^5/}As of September 2005.

10. While the economic recovery has led to a strengthening of the financial system, the banking system continues to hold a stubbornly high level of problem loans.⁶ Despite the growing economy, problem loans as a percentage of total loans averages about 10 percent for the banking system. The construction and real-estate sectors, which have been in a persistent slump since the beginning of the 2001–02 recession, account for a significant share of the banks’ problem loan exposure. Risk-based capital adequacy ratios for the five largest banks range from 9.7 to 12.2 percent.

11. Post recession bank earnings have improved, but remain low despite a strong economy. Through end-September 2005, the banking system reported net income of NIS5.3 billion or a 0.8 percent annualized return on assets compared to a 0.6 percent rate for 2004. The banks expect to realize one-time gains from the divestiture of their funds management businesses, which temporarily will augment income. The banking system enjoys ample liquidity provided primarily through deposit funding, including from the foreign offices of Israeli banks. Foreign currency funding averaged 43 percent of liabilities for the five largest banks.

Israel: Financial Soundness Indicators

(In percent)

Source: Bank of Israel.

^{^1/}As of end-June.

Israel: Financial Soundness Indicators

(In percent)

	2000	2001	2002	2003	2004	2005 ^1/
Regulatory capital to risk weighted assets	9.2	9.4	9.9	10.3	10.8	10.9
Problem loans to total gross loans	6.9	8.2	9.8	10.5	10.5	10.3
Return on assets	0.5	0.2	0.1	0.4	0.6	0.8

Source: Bank of Israel.

^{^1/}As of end-June.

Israel: Financial Soundness Indicators

(In percent)

	2000	2001	2002	2003	2004	2005 ^1/
Regulatory capital to risk weighted assets	9.2	9.4	9.9	10.3	10.8	10.9
Problem loans to total gross loans	6.9	8.2	9.8	10.5	10.5	10.3
Return on assets	0.5	0.2	0.1	0.4	0.6	0.8

Source: Bank of Israel.

^{^1/}As of end-June.

12. The recent passage of new capital market reforms has led to rapid changes in the structure of the capital market. The Knesset approved the capital market reforms in mid-2005 with the objective of fostering a stable, competitive financial system with well-developed capital markets. The main reform measures included the requirement that banks divest themselves of their mutual and provident fund business, regulations on banks’ securities-related activities to reduce potential conflicts of interest, and restrictions on the maximum market share of individual firms. Contrary to expectations, the sale of the mutual and provident funds proceeded rapidly, with banks selling most of the funds, primarily to insurance companies, within three months of the passage of legislation. Separately, the authorities have also taken actions that have led to an expansion in the corporate bond market and in capital markets more generally. This has provided further opportunities for businesses to obtain credit and more choice for investors.

III. Policy Discussions

13. Discussions focused on four main areas: fiscal policy, monetary policy, financial stability, and poverty alleviation. There was broad agreement on the key issues, particularly on the need to continue fiscal consolidation.

A. Fiscal Policy

14. The authorities instituted in 2004 a new budgetary framework intended to ensure medium-term fiscal consolidation. This framework, which, provides a welcome sign of increased commitment to fiscal consolidation, is based on two rules: a cap on the growth rate of budgeted real expenditures of 1 percent a year and a ceiling on the deficit of 3 percent of GDP. When growth is weak, as was the case when the framework was adopted, the framework is binding. However, when growth is strong, the deficit ceiling becomes non-binding and scope emerges to use revenue over-performance to either reduce the stock of public debt or cut taxes. This possibility arose early in 2005, and a 5-year tax reduction package was enacted (Box 2). Staff had urged that the revenue over-performance be used to reduce the deficit and debt. In the event, both happened because of unexpected favorable one-off shocks to expenditure late in the year.

15. Turning to prospects for 2006, the authorities reiterated their commitment to fiscal consolidation.⁷ In particular, they noted that the budget adhered to the 1 percent ceiling on the growth in real expenditure as well as the 3 percent of GDP ceiling on the deficit. The staff noted that a 3 percent of GDP deficit outturn in 2006 would be expansionary relative to the estimated 1.9 percent deficit in 2005. The authorities observed that the 2005 fiscal over-performance reflected a number of one-off factors that amounted to expenditure reduction estimated at 1.2 percent of GDP.⁸ More generally, they noted the importance of keeping the framework during a political transition. The staff agreed and welcomed the broad parameters of the proposed 2006 budget and shared the authorities’ view that, once a new government is formed, a budget which adheres to the expenditure and deficit ceilings should be approved without delay.

16. Maintaining a deficit of 3 percent of GDP in the years ahead, however, implies only a modest decline in public debt as a share of GDP, and the staff recommended more ambitious consolidation. The staff argued that the 1 percent real expenditure growth ceiling ought to be the binding constraint, and the authorities should allow any unanticipated increase in revenues to bring the fiscal deficit below the ceiling of 3 percent of GDP. The authorities reiterated that the expenditure and deficit targets should be seen as ceilings, and thus lower-than-targeted deficits are indeed possible. The debt sustainability analysis illustrated in Figure 6 shows that, under the baseline scenario of 3 percent of GDP deficit and 4 percent real GDP growth, the public debt to GDP ratio would fall only slightly, from about 101 percent today to about 95 percent by 2010.⁹ Furthermore, the debt ratio is vulnerable to interest rate and growth shocks. For example, if growth were to average only 2.8 percent,¹⁰ the debt ratio would rise to 111 percent of GDP in five years. Alternatively, given a reasonable assumption about revenue growth (e.g., a revenue/GDP elasticity of one), no new tax cuts, combined with the binding limit on real expenditure growth, would imply a fall in the stock of public debt by about 20 percent of GDP over five years, compared to the baseline scenario.¹¹ There is a strong case for more ambitious fiscal consolidation—e.g., to achieve and maintain fiscal balance over the medium term—in order to achieve a meaningful reduction in the debt-to-GDP ratio.

17. The staff, therefore, stressed that the authorities should resist taking additional measures, such as the tax cut measures introduced in the middle of last year, that would impede lowering the public debt to GDP ratio. The authorities argued that these multiyear tax rate reductions need not hinder the pace of debt reduction, since stronger growth is expected to compensate for any revenue shortfall resulting from the tax cuts. The staff was unconvinced and noted that possible offsetting measures should be identified. As regards 2006, the authorities indicated that currently there are no plans for any additional tax reductions. Turning to the expenditure side, while there is broad agreement among the authorities on the need for sustained fiscal consolidation, there is less agreement about the best rule for the medium term. Some officials have the view that the real expenditure growth target should be closer to Israel’s population growth rate, currently at about 1.7 percent. The staff acknowledged the potential difficulties in meeting the 1 percent expenditure rule, but stressed the importance of adhering to the original ceiling over the medium term, so as to further cement policy credibility.

Box 2.

Israel: Multi-Year Tax Plan

On July 25, 2005, the Knesset approved a multi-year tax plan covering the next five years. The plan expands some of the measures introduced in the 2003 tax reform,¹ and its stated goal is to stimulate private sector growth. The key measures are:

Lowering the top marginal income tax rate, from 49 percent to 44 percent by 2010.
Cutting the corporate tax rate, from 34 percent to 25 percent by 2010.
Reducing the VAT rate from 17 percent to 16.5 percent.
Establishing a uniform 20 percent capital gains tax rate.
Widening the tax base and strengthening enforcement through a proposal for taxation of trusts.

Schedule of Tax Cuts

The fiscal cost of the tax plan is estimated at NIS 11.2 billion (or 0.4 percent of GDP annually over the five-year period). The authorities are very confident that the plan will be financed through the increase in tax receipts stemming from stronger economic growth and the progressiveness of the tax brackets.

Annual Cost Relative to Current Trajectory

(NIS billions, 2005 prices)

Source: Ministry of Finance.

Annual Cost Relative to Current Trajectory

(NIS billions, 2005 prices)

	2006	2007	2008	2009	2010	Total (% GDP)
Personal income tax	-0.8	-1.8	-4.0	-5.6	-8.1	-1.5
Cutting VAT to 16.5%	-1.2	-1.2	-1.2	-1.2	-1.2	-0.2
Cutting corporate tax to 25%	-0.4	-0.4	-1.3	-1.8	-2.3	-0.4
Capital: unification of rates at 20%	0.6	0.6	0.6	0.6	0.4	0.1

Source: Ministry of Finance.

Annual Cost Relative to Current Trajectory

(NIS billions, 2005 prices)

	2006	2007	2008	2009	2010	Total (% GDP)
Personal income tax	-0.8	-1.8	-4.0	-5.6	-8.1	-1.5
Cutting VAT to 16.5%	-1.2	-1.2	-1.2	-1.2	-1.2	-0.2
Cutting corporate tax to 25%	-0.4	-0.4	-1.3	-1.8	-2.3	-0.4
Capital: unification of rates at 20%	0.6	0.6	0.6	0.6	0.4	0.1

Source: Ministry of Finance.

^1/ See IMF Country Report No. 03/75.

18. The introduction of a medium-term budget framework, with a detailed expenditure breakdown consistent with the overall expenditure ceiling, is unlikely to be implemented in the near-term. The staff noted that international experience has shown that multi-year budget plans reinforce fiscal consolidation, minimize expenditure growth, and strengthen adjustment. The staff pointed out that the government already has a medium-term tax plan as well as a plan for capital expenditures over several years and that broadening this approach to current expenditures would provide additional benefits by raising the government’s credibility and lessening political pressures to deviate from the expenditure ceiling. The authorities agreed, in principle, with multi-year budgeting, but were concerned that it would reduce budget flexibility. The staff also stressed the importance of presenting mid-year reports covering the execution of the budget and progress in achieving the rest of the economic agenda.

B. Monetary Policy

19. The policy rate has risen, in line with higher inflation, but remains accommodative. Over the past two years, both the headline and core CPIs have increased, although at a gradual pace, while inflation expectations have remained within the target range. The rise in oil prices has yet to result in appreciably higher consumer prices, but the authorities agreed that it will be important to monitor closely the degree of pass-through from oil prices to wages and core inflation. There was also broad agreement that, in light of the historically strong pass-through from the sheqel/dollar exchange rate to inflation, exchange rate developments and their impact on prices should also be closely monitored. The staff noted that other factors, such as high unemployment and excess capacity in the construction sector, argued against aggressive tightening.

20. The policy rate was agreed to be broadly appropriate, but below the long-run neutral rate, and would need to be raised as the employment and output gaps close (Box 3). At present, the staff’s view is that the neutral policy rate is around 5.25 percent and the policy rate will have to rise over time as the excess capacity, currently estimated at around 1 percent of GDP, is gradually eliminated. The authorities broadly shared this assessment, but there was no agreement about the estimated value of the output gap. Indeed, experience has shown in many countries that there is considerable uncertainty in such estimates so it will be important to monitor measures of core inflation and inflation expectations as well as other indicators of slack so that these estimates are updated in a timely manner.

21. Israel has a well-established inflation-targeting framework—and the fully floating exchange rate that it requires—but there is scope for improving the analytical framework used to formulate policy and to communicate with the public. In the past, the BoI largely relied on measures of market-based inflation expectations to adjust the policy rate, rather than developing a forecast based on the BoI’s own views about the fundamentals driving the inflation process. It is widely recognized that over-reliance on market expectations can give rise to an indeterminacy problem as market participants look to the central bank to provide an anchor for inflation and inflation expectations. For this reason, increased emphasis has recently been given to communicating the BoI’s views about future inflation developments and how the BoI will likely respond to new information. The development of a model-based framework will greatly facilitate the process of developing baseline forecasts and risk assessments as well as communicating the logic of current and possible future policy actions to the public. The development of a model-based framework has recently become an important priority at the BoI.

22. As part of a more general effort to improve surveillance of inflation targeting countries, the staff developed a small model of the Israeli economy and received feedback on its structure and properties from the authorities.¹² This model was used to organize monetary policy discussions with the authorities and to construct a baseline forecasts and undertake risk assessments. The authorities welcomed this initiative, as well as the discussions that took place concerning state-of-the-art modeling techniques and how they are being used in other central banks that face similar sorts of challenges with short data samples.¹³

Box 3.

Israel: Inflation Targeting, Modeling, and Risk Assessment

The mission developed a small simulation model to construct baseline forecasts of key macroeconomic variables and undertake risk assessments. The model is based on a conventional view of the transmission of monetary policy which focuses on the output gap as the major driving force of underlying inflation, but allows for exchange rate pass-through to play a significant role in the shorter term. The model enforces consistency on the largely judgmental baseline forecast and allows for risk assessment under uncertainty.

The baseline is predicated on the assumption of an output gap of 0.7 percent of GDP in the first quarter of 2006 that closes by 2007. Under these circumstances, the current policy rate of 4.75 percent is below the neutral rate of 5.25 percent and will thus have to rise as the output gap closes. This, in turn, implies that headline inflation will gradually fall to the mid-point of the target range-2 percent-by the end of the year and remain there in 2007. As in all inflation targeting countries, it will be important to monitor economic and financial developments and update the baseline in response to new information.

There are three major sources of uncertainty underlying the baseline: the size of the risk premium and thus the level of the neutral rate; the size of the output gap; and the future price of oil. The tables below show how the baseline forecast would be altered if the risk premium and thus the neutral rate were 50 basis points higher (table 2a), if the output gap were 1 percent larger (table 2b), and if the price of oil were to be permanently 50 percent higher than in the baseline.

Baseline Forecast on February 14, 2006

Weaker Sheqel and Higher Neutral Rate Deviation from Baseline

Effects of More Excess Capacity Deviation from Baseline

Effects of 50% Hike in Oil Prices Deviation from Baseline

23. A proposed new Bank of Israel Law should strengthen the independence of the central bank. After years of futile attempts, a proposed new Bank of Israel Law was finally approved by the government in 2005. However parliamentary approval is still required and is not expected until after the March elections. Key principles of the proposed new law include the creation of a monetary committee responsible for interest rate decisions;¹⁴ the formation of a management board responsible for oversight of administrative matters; and the establishment of price stability as a primary policy objective. The staff agreed that other policy goals, for example growth, should be considered only in so far as they do not undermine the primacy of price stability.

C. Financial Sector Stability

24. Israel has a large and highly concentrated banking system, with the five largest banking groups accounting for 95 percent of system assets. Banking assets were NIS 875 billion at end-September 2005 (1.7 times 2004 GDP). Against the background of the ongoing economic recovery, the banking system has shown some positive signs: capital ratios have increased and system profitability has recovered to pre-recession levels, though remaining weak. Problem loans have remained elevated, however, particularly in the construction and real estate sectors, which have not yet fully felt the impact of the recovery. The authorities have taken some steps, such as increased bank provisioning, but further action is needed to encourage banks to be more proactive in lowering problem loan levels, including through the greater use of charge-offs and loan sales.

25. The staff encouraged the authorities to refine their supervisory and regulatory activities focusing more on key risks in the changing financial system. Additionally, the staff noted that undertaking self assessments against key internationally recognized regulatory standards would help the authorities address the new challenges more effectively. The staff agreed with the decision by the BoI to gradually move towards the more sophisticated risk-based approach within the framework of Basel II. However, the staff cautioned that implementation of Basel II will require a significant resource commitment of staff over a number of years and more extensive dialogue with industry. There is also scope for the BoI to enhance its oversight of group-wide activities of Israeli banks, particularly following actions taken by foreign regulators that have identified deficiencies in the AML programs in foreign offices of Israeli banks. The BoI agreed with the staff that given the significance of foreign currency funding of Israeli banks, this is an area where weak controls in banks’ overseas operations pose an AML/CFT vulnerability and that greater coordination with host supervisors should take place.

26. The ongoing reforms in the capital markets have gone well to date.¹⁵ In particular, forcing banks to divest themselves of mutual and provident funds has contributed to increased competition and market efficiency, as sought by the authorities. The relatively rapid changes in the capital markets have resulted in new participants selling new products to investors under new rules, with financial advisors operating under a new regime.¹⁶ The faster-than-expected sale of mutual and provident funds was welcomed, and was seen, in part, as a by-product of the buoyant financial market environment in Israel during the second half of 2005.¹⁷ There is a particular risk, however, that arises because of the radically changed risk profile of provident funds, as a result of a shift in their asset portfolio away from “risk-free” government bonds to newer capital market instruments. The staff stressed that investors may not be fully aware of the changed risk profile and thus need to be properly advised and protected.

27. The authorities recognize that these capital market developments pose risks, and agreed that there is a need to strengthen supervision, regulation, and enforcement.. The introduction of new laws and regulations designed to increase competition in the financial services market and the development of new, proactive approaches to enforcement are welcome. But more remains to be done. In many cases, the legislation proposed by the authorities has yet to be enacted. And new regulations for non-bank financial institutions—and the budgets of their regulators—require prior approval of the Knesset Finance Committee. Most importantly, the regulatory infrastructure, although strengthened by recent legislation, needs further attention, particularly in the form of greater independence and additional resources. In particular, the supervisors of insurance companies, provident funds, pension funds and mutual funds require additional resources to undertake the necessary research into the effect of the new developments, collect and analyze the information received from regulated institutions, and conduct on-site inspections.

D. Poverty and Social Issues

28. Despite the strong economic recovery, the incidence of poverty increased in 2005 due, in part, to cuts in social spending. Notwithstanding improvements in employment and income, the poverty rate among families increased to 20.5 percent in 2005, while child poverty rose to 34.1 percent.¹⁸ Moreover, the poverty gap and income inequality have increased over the past five years. The poverty rate in Israel is also high when compared to OECD countries. The rise in the scope of poverty can be partly attributed to the erosion of welfare benefits, particularly those paid to the working-age population (child allowances, unemployment benefits and income support).¹⁹ Poverty alleviation has now become a top priority in the Israeli policy agenda, and the authorities are working on developing new initiatives.

29. Against this background, an advisory group headed by Director General of the Ministry of Finance is examining policy options to reduce the poverty rate. In mid-December, the Primer Minister, Minister of Finance, and the Central Bank Governor approved a seven year initiative to combat poverty with a total budget of about NIS 14 billion (2.5 percent of GDP) to be spread over the seven years. The authorities are considering a broad range of measures, including the introduction of a negative income tax (NIT).²⁰ The exact timetable and budget allocation for each measure are still under discussion. In general, it was recognized that a NIT can be a useful mechanism in promoting employment and/or ensuring adequate income for low income earners. However, its effectiveness depends on a variety of factors, and the authorities had some concerns about implementation given its potential high cost and difficulties in its administration. The staff concurred and stressed that any poverty alleviation measures should be within the current fiscal envelope, be targeted, provide the right incentives to work, and be consistent with growth-promoting policies. The staff also noted the importance of an appropriate safety net to protect children, the elderly, and the disabled, particularly given the recent cuts in welfare benefits.

E. Other Issues

30. The economic reform agenda for 2006 reiterates the government’s continued dedication to structural reforms. The authorities highlighted the privatization of the second largest bank, Bank Leumi, in 2005 as a key accomplishment fundamental to enhancing competition in the financial sector. Looking ahead, in addition to completing the ongoing efforts to streamline the public sector and increase competition in the electricity and water distribution networks, the authorities intend to implement restructuring measures with the objective to privatize the oil refineries. The staff supported the authorities’ reform efforts and commended the achievements to-date. Streamlining the public sector and strengthening its efficiency are crucial to fostering growth. However, the staff noted that, given the natural monopoly nature of many of these sectors, care must be taken to ensure that a proper, independent regulatory mechanism is in place.

31. A recent Data ROSC mission concluded that Israel has a well-developed macroeconomic statistical system, but some shortcomings may impede the accurate and timely analysis of macroeconomic and financial developments.²¹ Foremost among these are deficiencies in the timeliness, methodology, and classification of monetary statistics. There is also room to enhance source data for national accounts, producer prices, and government finance statistics. In this regard, the staff noted the need, especially at the Central Bureau of Statistics, for adequate and sustained resources to improve the scope and timeliness of data compiled under its mandate.

IV. Staff Appraisal

32. The Israeli economy is strong and the outlook favorable, but challenges—primarily reducing the public debt stock, strengthening financial supervision, and alleviating poverty—lie ahead. Growth has largely been driven by high technology exports and private consumption and has been supported by prudent policies, a favorable global environment, and an improvement in the security situation. Inflation remains in check, while unemployment continues to fall. The sheqel has been relatively stable over the past year, and the level of the REER reflects underlying economic fundamentals. Development of the capital market has accelerated bringing with it new challenges to the supervisory and regulatory agencies. Banking system indicators have strengthened, but credit risks remain high. While the macroeconomic outlook is positive, there is further scope to enhance growth and reduce vulnerabilities, especially to external shocks.

33. Fiscal consolidation and an appropriately accommodative monetary policy have underpinned this strong performance. Limiting the growth of public expenditures to one percent a year is a strategy that has served Israel well and should be continued. Fiscal retrenchment is crucial in putting debt on a firm downward path and thereby reducing vulnerabilities and allowing future spending to be directed at priority items. Given the renewed emphasis on fiscal consolidation, and with inflation within the Bank of Israel’s (BoI) target range, monetary policy has been appropriate. Developing a detailed medium-term budget plan would also enhance credibility and ensure that future budgets are allocated according to long-term priorities. The presentation of mid-year reports covering the execution of the budget and progress in achieving it would strengthen transparency and budget planning.

34. The authorities should seize the opportunity provided by the strong fiscal outturns in 2005 and strong growth to sustainably reduce the deficit to well below the 3 percent of GDP ceiling and thereby achieve a meaningful decline in the large stock of outstanding public debt. It is important that, once a new government is formed, the 2006 budget should maintain the expenditure and deficit ceilings and additional tax cut be avoided. Failure to do so would increase uncertainty in the market, lead to a loss of confidence, and increase the country’s risk premium. The authorities have made important progress in keeping expenditure under control and strict adherence to the current expenditure ceiling in future budgets will cement the credibility of fiscal policy. As shown in the debt sustainability exercise, this approach would lead to a reduction in the public debt-to-income level of about 20 percent over the next 5 years when compared to a strategy of holding the fiscal deficit to 3 percent of GDP. More ambitious fiscal consolidation would underpin lower interest rates, greater private investment, lower future taxes, and stronger medium-term growth.

35. Inflation targeting, and the associated floating exchange rate regime, have served Israel well, but there is scope for enhancing the analytical framework used to formulate policy and communicate it to the public. In particular, the increased emphasis on the development of macroeconomic models at the BoI is welcome. Once this work is completed, practices at the BoI will be among the best of inflation targeting countries. The development of these models is central to implementing a forward-looking approach to monetary policy and will serve to enhance policy deliberations and the communication of policy actions in speeches, press releases, and the Inflation Report.

36. The proposed new Bank of Israel law will strengthen the independence of the central bank. Updating the current Bank of Israel Law to reflect international best practices will help reinforce central bank independence, enhance transparency and accountability, and aid in achieving price stability. The proposed creation of a Monetary Committee responsible for interest rate decisions and the formation of a Management Board to oversee the administration of the central bank should aid in meeting these objectives. Adoption of the Law by the Knesset is overdue.

37. The banking system has strengthened but the level of problem loans remains high, notwithstanding the improving indicators, such as profitability and capital adequacy. The measures taken by the supervisor to reduce the banks’ exposure to credit risk, including by increasing required provisions, are thus welcome. Nevertheless, continued supervisory vigilance of the systemically important financial institutions is essential to maintain financial stability. In light of the recent developments in the capital market, the authorities could benefit from undertaking self assessments against the key internationally recognized regulatory standards. The staff cautioned that actual implementation of Basel II will require a significant resource commitment. There is also scope for the BoI to enhance its oversight by cooperating and coordinating with its foreign counterparts, especially in the area of anti-money laundering. The authorities should undertake a self assessment against the revised Financial Action Task Force (FATF) Recommendations using the assessment methodology.

38. Efforts to alleviate poverty are welcome. Notwithstanding improvements in employment and income, the poverty rate among children and families increased last year, and both poverty and income inequality have increased over the past five years. From this perspective, the work of the advisory group headed by director general of the ministry of finance on measures to reduce the poverty rate is welcome. In broad terms, any such measures should be within the current fiscal envelope, be targeted, provide the right incentives to work, and be consistent with growth-promoting policies. The cuts in some welfare benefits have contributed to social hardship, and it is therefore important to ensure that there is a safety net to protect children, the elderly, and the disabled.

39. Israel has subscribed to the Special Data Dissemination Standards and its macroeconomic statistical system is generally adequate for Fund surveillance. Nonetheless, there are some shortcomings that may impede the accurate and timely analysis of macroeconomic and financial developments, which need to be addressed.

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

Table 4.

Israel: Indicators of External and Financial Sector Vulnerability, 2001–06

(In percent of GDP, unless otherwise indicated)

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

^{^1/}According to WEO GEE trade deflators.

^{^2/}On foreign currency long-term debt, Moody’s upgrade in July 2000.

Table 4.

Israel: Indicators of External and Financial Sector Vulnerability, 2001–06

(In percent of GDP, unless otherwise indicated)

									Latest Data
					2001	2002	2003	2004	2005	Date
Financial indicators
		Broad money (percent change, 12-month basis)			15.5	6.1	2.2	4.6	8.7	Oct. 2005
		Private sector credit (percent change, 12 month basis)			13.1	7.2	-5.5	4.9	10.1	Oct. 2005
External Indicators
		Terms of trade (percent change, average) ^1/			-2.1	0.1	-1.4	-1.9	2.7	Jun. 2005
		Current account balance			-1.4	-1.2	0.7	1.3	0.8	Dec. 2005
		Capital and financial account balance			1.1	-0.5	-1.9	-1.8	-1.0	Sept. 2005
			Of which: Inward portfolio investment (debt securities etc.)		-1.4	-1.9	-0.7	3.1	-2.2	Sept. 2005
				Other investment (loans, trade credits etc.)	-1.4	-2.6	-2.6	-1.7	-2.1	Sept. 2005
				Inward foreign direct investment	3.2	1.7	3.5	1.4	0.3	Sept. 2005
		Gross official reserves (in US$ billions; e.o.p.)			23.5	24.2	26.5	27.2	27.5	Dec. 2005
		Official reserves in months of imports GNFS			6.5	6.8	7.2	6.3	5.4	Sept. 2005
		Ratio of foreign reserves to Broad Money			0.35	0.37	0.36	0.35	0.36	Oct. 2005
		Total gross external debt/GDP (in percent)			57.2	65.1	64.6	63.5	60.8	Sept. 2005
		Total net external debt/GDP (in percent)			0.1	-2.0	-5.6	-9.7	-16.8	Sept. 2005
		Country risk ratings (S. & P./Moody’s) ^2/			A-/A2	A-/A2	A-/A2	A-/A2	A-/A2
		Exchange rate (per US$, period average)			4.21	4.74	4.55	4.48	4.49	Dec. 2005
		REER appreciation (+) (period average)			-0.2	-10.0	-7.9	-7.1	-0.9	Oct. 2005
		Change in Stock Market Index (in percent)			-6.6	-19.9	55.4	17.6	32.8	Dec. 2005
	Share of foreign exchange credit in total credit to the public (e.o.p.)				36.0	36.7	34.9	30.2	26.5	Jun. 2005
	Share of foreign deposits in total deposits of the public (e.o.p.)				31.1	32.4	32.6	33.0	33.4	Jun. 2005
	Share of foreign currency liabilities in total liabilities (e.o.p.)				28.1	29.7	29.4	29.1	29.1	Jun. 2005

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

^{^1/}According to WEO GEE trade deflators.

^{^2/}On foreign currency long-term debt, Moody’s upgrade in July 2000.

Table 4.

Israel: Indicators of External and Financial Sector Vulnerability, 2001–06

(In percent of GDP, unless otherwise indicated)

									Latest Data
					2001	2002	2003	2004	2005	Date
Financial indicators
		Broad money (percent change, 12-month basis)			15.5	6.1	2.2	4.6	8.7	Oct. 2005
		Private sector credit (percent change, 12 month basis)			13.1	7.2	-5.5	4.9	10.1	Oct. 2005
External Indicators
		Terms of trade (percent change, average) ^1/			-2.1	0.1	-1.4	-1.9	2.7	Jun. 2005
		Current account balance			-1.4	-1.2	0.7	1.3	0.8	Dec. 2005
		Capital and financial account balance			1.1	-0.5	-1.9	-1.8	-1.0	Sept. 2005
			Of which: Inward portfolio investment (debt securities etc.)		-1.4	-1.9	-0.7	3.1	-2.2	Sept. 2005
				Other investment (loans, trade credits etc.)	-1.4	-2.6	-2.6	-1.7	-2.1	Sept. 2005
				Inward foreign direct investment	3.2	1.7	3.5	1.4	0.3	Sept. 2005
		Gross official reserves (in US$ billions; e.o.p.)			23.5	24.2	26.5	27.2	27.5	Dec. 2005
		Official reserves in months of imports GNFS			6.5	6.8	7.2	6.3	5.4	Sept. 2005
		Ratio of foreign reserves to Broad Money			0.35	0.37	0.36	0.35	0.36	Oct. 2005
		Total gross external debt/GDP (in percent)			57.2	65.1	64.6	63.5	60.8	Sept. 2005
		Total net external debt/GDP (in percent)			0.1	-2.0	-5.6	-9.7	-16.8	Sept. 2005
		Country risk ratings (S. & P./Moody’s) ^2/			A-/A2	A-/A2	A-/A2	A-/A2	A-/A2
		Exchange rate (per US$, period average)			4.21	4.74	4.55	4.48	4.49	Dec. 2005
		REER appreciation (+) (period average)			-0.2	-10.0	-7.9	-7.1	-0.9	Oct. 2005
		Change in Stock Market Index (in percent)			-6.6	-19.9	55.4	17.6	32.8	Dec. 2005
	Share of foreign exchange credit in total credit to the public (e.o.p.)				36.0	36.7	34.9	30.2	26.5	Jun. 2005
	Share of foreign deposits in total deposits of the public (e.o.p.)				31.1	32.4	32.6	33.0	33.4	Jun. 2005
	Share of foreign currency liabilities in total liabilities (e.o.p.)				28.1	29.7	29.4	29.1	29.1	Jun. 2005

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

^{^1/}According to WEO GEE trade deflators.

^{^2/}On foreign currency long-term debt, Moody’s upgrade in July 2000.

Table 5.

Israel: Medium-Term Scenarios, 2002–10

Source: Fund staff estimates and projections.

^{^1/}For the purpose of its budget deficit targets, the central government excludes net credit.

^{^2/}Baseline scenario (06’-10’) assumes real expenditure growth of 1 percent and a deficit of 3.0 percent of GDP, with revenue as the residual.

^{^3/}Illustrative alternative scenario (06’-10’) assumes real expenditure growth of 1 percent and a revenue/GDP elasticity of one, with the fiscal balance as the residual. If the central government budget is constrained to be in balance over 2008–10, the public debt/GDP would decline to 80.2 percent by 2010.

^{^4/}Applies to both baseline and alternative scenarios.

Table 5.

Israel: Medium-Term Scenarios, 2002–10

		2002	2003	2004	2005	2006	2007	2008	2009	2010
(In percent unless indicated otherwise)
GDP growth rate		-1.2	1.7	4.4	5.2	4.2	4.2	4.0	4.1	4.3
Inflation (average)		5.7	0.7	-0.4	1.3	2.4	2.0	2.0	2.0	2.0
Fiscal deficit/GDP ^1/
	Central government balance (baseline) ^2/	-3.8	-5.6	-3.8	-1.9	-3.0	-3.0	-3.0	-3.0	-3.0
	Central government balance (alternative) ^3/	-3.8	-5.6	-3.8	-1.9	-1.2	-0.2	0.8	1.8	2.8
Public debt/GDP (end of period) ^2/		104.5	106.4	105.4	101.8	100.4	98.8	97.5	96.2	94.9
Public debt/GDP (end of period) ^3/		104.5	106.4	105.4	101.8	98.6	93.9	88.6	82.2	74.7
Current account/GDP		-1.2	0.7	1.3	0.8	0.1	0.9	1.4	2.0	2.7
Foreign reserves (in billions of U.S. dollars)		24.2	26.5	27.2	27.5	27.6	28.1	29.0	30.1	32.0
(Percent changes)
Memorandum Items:
Aggregate domestic demand		-1.0	-1.7	2.8	4.0	3.7	3.3	3.3	3.3	3.3
	Private consumption	1.0	0.9	5.0	4.0	4.0	4.0	4.0	4.0	4.0
	Public consumption	5.0	-2.3	-2.4	2.7	2.0	2.0	2.0	2.0	2.0
	Gross capital formation	-14.6	-8.7	4.0	6.4	5.7	2.7	2.7	2.7	2.7
Exports of goods and services		-2.4	7.5	17.4	7.0	7.1	6.9	6.4	6.6	6.9
Imports of goods and services		-1.7	-1.7	11.8	4.4	5.3	4.8	4.7	4.7	4.7
Central Govt. expenditure/GDP (in percent) ^4/		43.0	42.7	40.3	39.2	39.2	38.2	37.2	36.2	35.2

Source: Fund staff estimates and projections.

^{^1/}For the purpose of its budget deficit targets, the central government excludes net credit.

^{^2/}Baseline scenario (06’-10’) assumes real expenditure growth of 1 percent and a deficit of 3.0 percent of GDP, with revenue as the residual.

^{^4/}Applies to both baseline and alternative scenarios.

Table 5.

Israel: Medium-Term Scenarios, 2002–10

		2002	2003	2004	2005	2006	2007	2008	2009	2010
(In percent unless indicated otherwise)
GDP growth rate		-1.2	1.7	4.4	5.2	4.2	4.2	4.0	4.1	4.3
Inflation (average)		5.7	0.7	-0.4	1.3	2.4	2.0	2.0	2.0	2.0
Fiscal deficit/GDP ^1/
	Central government balance (baseline) ^2/	-3.8	-5.6	-3.8	-1.9	-3.0	-3.0	-3.0	-3.0	-3.0
	Central government balance (alternative) ^3/	-3.8	-5.6	-3.8	-1.9	-1.2	-0.2	0.8	1.8	2.8
Public debt/GDP (end of period) ^2/		104.5	106.4	105.4	101.8	100.4	98.8	97.5	96.2	94.9
Public debt/GDP (end of period) ^3/		104.5	106.4	105.4	101.8	98.6	93.9	88.6	82.2	74.7
Current account/GDP		-1.2	0.7	1.3	0.8	0.1	0.9	1.4	2.0	2.7
Foreign reserves (in billions of U.S. dollars)		24.2	26.5	27.2	27.5	27.6	28.1	29.0	30.1	32.0
(Percent changes)
Memorandum Items:
Aggregate domestic demand		-1.0	-1.7	2.8	4.0	3.7	3.3	3.3	3.3	3.3
	Private consumption	1.0	0.9	5.0	4.0	4.0	4.0	4.0	4.0	4.0
	Public consumption	5.0	-2.3	-2.4	2.7	2.0	2.0	2.0	2.0	2.0
	Gross capital formation	-14.6	-8.7	4.0	6.4	5.7	2.7	2.7	2.7	2.7
Exports of goods and services		-2.4	7.5	17.4	7.0	7.1	6.9	6.4	6.6	6.9
Imports of goods and services		-1.7	-1.7	11.8	4.4	5.3	4.8	4.7	4.7	4.7
Central Govt. expenditure/GDP (in percent) ^4/		43.0	42.7	40.3	39.2	39.2	38.2	37.2	36.2	35.2

Source: Fund staff estimates and projections.

^{^1/}For the purpose of its budget deficit targets, the central government excludes net credit.

^{^2/}Baseline scenario (06’-10’) assumes real expenditure growth of 1 percent and a deficit of 3.0 percent of GDP, with revenue as the residual.

^{^4/}Applies to both baseline and alternative scenarios.

APPENDIX I Israel—Fund Relations

(As of December 31, 2005)

I. Membership Status: Israel became a member of the Fund on July 12, 1954, and accepted the obligations of Article VIII, Sections 2, 3, and 4 on September 21, 1993, and maintains an exchange system free of restrictions on the making of payments and transfers for current international transactions. Israel subscribes to the SDDS and is in full observance of the SDDS’s prescriptions for data coverage, periodicity and timeliness, and for the dissemination of advance release calendars.¹

II. General Resources Account:

III. SDR Department:

IV. Outstanding Purchases and Loans: None

V. Financial Arrangements: None

VI. Projected Payments to Fund:

VII. Implementation of HIPC Initiative: Not applicable

VIII. Safeguards Assessments: Not applicable

IX. Exchange Rate Arrangement:

As of June 9, 2005 Israel’s exchange rate regime is officially classified as floating. This step by the Government of Israel was taken to remove the last vestige of a policy in which the exchange rate of the NIS fluctuated within the limits of a crawling band. In practice, however, the NIS has been floating since 1997, when the Bank of Israel stopped intervening to protect the band.

X. Article IV consultation:

The last Article IV consultation was concluded on April 18, 2005. Israel is on the standard 12-month consultation cycle.

XI. ROSCs:

Financial System Stability Assessment was conducted in 2000, issued in August 2001.
Fiscal Transparency ROSC was conducted in 2003, issued in March 2004.
AML/CFT ROSC was conducted in 2003, issued in June 2005.
Data Module ROSC conducted in 2005, expected issuance in March 2006.

XII. Technical Assistance:

For purposes of Fund relations, the West Bank and Gaza are under Israeli authority within the terms of Article XXXI, Section 2(g) of the Articles of Agreement.

The IMF has provided technical assistance to the Palestinian Authority (PA) in the WBG, with a focus on assisting the PA in establishing economic and financial institutions, and in monitoring and reporting on fiscal developments and institution building. In particular, technical assistance has been provided in the areas of tax and customs administration, and expenditure management (Fiscal Affairs Department); in the areas of bank supervision and restructuring, payments systems, and central bank organization (Monetary and Financial Systems Department (MFD)); financial sector legislation (MFD together with Legal Department); and in the areas of national accounts and monetary statistics (Statistics Department).

XIII. Resident Representative:

A resident representative has been in the WBG since early 1996.

APPENDIX II Israel: Statistical Issues

Israel is a subscriber to the Special Data Dissemination Standard. The periodicity, timeliness, and coverage of economic data are generally adequate for surveillance. The methodology underlying the reported overall annual fiscal balance is not in conformity with internationally accepted practice as interest costs exclude the inflation component of such payments. The authorities are gradually moving toward the methodology that is standard in other countries. Data submitted for the 2004 Government Finance Statistics Yearbook now present cash and accrual data for revenue and expense, following the GFSM 2001 format. However, no data on transactions and stocks of financial assets and liabilities were submitted. Within-year monthly reports on central government operations cover only the main aggregates of budgetary accounts, without a breakdown by composition.

Israel: Table of Common Indicators Required for Surveillance

As of February 10, 2006

^¹Includes reserve assets pledged or otherwise encumbered as well as net derivative positions.

^²Both market-based and officially-determined, including discount rates, money market rates, rates on treasury bills, notes and bonds.

^³Foreign, domestic bank, and domestic nonbank financing.

^⁴The general government consists of the central government (budgetary funds, extra budgetary funds, and social security funds) and state and local governments.

^⁵Including currency and maturity composition.

^⁶Daily (D); Weekly (W); Monthly (M); Quarterly (Q); Annually (A); Irregular (I); Not Available (NA).

Israel: Table of Common Indicators Required for Surveillance

As of February 10, 2006

	Date of latest observation	Date received	Frequency of Data⁶	Frequency of Reporting⁶	Frequency of publication⁶
Exchange Rates	1/2006	2/06/06	D and M	D and M	D and M
International Reserve Assets and Reserve Liabilities of the Monetary Authorities¹
Reserve/Base Money	11/2005	12/15/05	M	M	M
Broad Money	11/2005	12/15/05	M	M	M
Central Bank Balance Sheet	11/2005	12/15/05	M	M	M
Consolidated Balance Sheet of the Banking System	10/2005	01/04/06	M	M	M
Interest Rates²	12/31/05	1/4/06	D and M	D and M	D and M
Consumer Price Index	Dec 2005	1/17/06	M	M	M
Revenue, Expenditure, Balance and Composition of Financing³ – General Government⁴
Revenue, Expenditure, Balance and Composition of Financing³ – Central Government
Stocks of Central Government and Central Government-Guaranteed Debt⁵
External Current Account Balance	Q2 2005	9/14/05	Q	Q	Q
Exports and Imports of Goods and Services	Q2 2005	9/14/05	Q	Q	Q
GDP/GNP	Q3 2005	11/16/05	Q	Q	Q
Gross External Debt	Q2 2005	9/16/05	Q	Q	Q

^¹Includes reserve assets pledged or otherwise encumbered as well as net derivative positions.

^²Both market-based and officially-determined, including discount rates, money market rates, rates on treasury bills, notes and bonds.

^³Foreign, domestic bank, and domestic nonbank financing.

^⁴The general government consists of the central government (budgetary funds, extra budgetary funds, and social security funds) and state and local governments.

^⁵Including currency and maturity composition.

^⁶Daily (D); Weekly (W); Monthly (M); Quarterly (Q); Annually (A); Irregular (I); Not Available (NA).

Israel: Table of Common Indicators Required for Surveillance

As of February 10, 2006

	Date of latest observation	Date received	Frequency of Data⁶	Frequency of Reporting⁶	Frequency of publication⁶
Exchange Rates	1/2006	2/06/06	D and M	D and M	D and M
International Reserve Assets and Reserve Liabilities of the Monetary Authorities¹
Reserve/Base Money	11/2005	12/15/05	M	M	M
Broad Money	11/2005	12/15/05	M	M	M
Central Bank Balance Sheet	11/2005	12/15/05	M	M	M
Consolidated Balance Sheet of the Banking System	10/2005	01/04/06	M	M	M
Interest Rates²	12/31/05	1/4/06	D and M	D and M	D and M
Consumer Price Index	Dec 2005	1/17/06	M	M	M
Revenue, Expenditure, Balance and Composition of Financing³ – General Government⁴
Revenue, Expenditure, Balance and Composition of Financing³ – Central Government
Stocks of Central Government and Central Government-Guaranteed Debt⁵
External Current Account Balance	Q2 2005	9/14/05	Q	Q	Q
Exports and Imports of Goods and Services	Q2 2005	9/14/05	Q	Q	Q
GDP/GNP	Q3 2005	11/16/05	Q	Q	Q
Gross External Debt	Q2 2005	9/16/05	Q	Q	Q

^¹Includes reserve assets pledged or otherwise encumbered as well as net derivative positions.

^²Both market-based and officially-determined, including discount rates, money market rates, rates on treasury bills, notes and bonds.

^³Foreign, domestic bank, and domestic nonbank financing.

^⁴The general government consists of the central government (budgetary funds, extra budgetary funds, and social security funds) and state and local governments.

^⁵Including currency and maturity composition.

^⁶Daily (D); Weekly (W); Monthly (M); Quarterly (Q); Annually (A); Irregular (I); Not Available (NA).

See Selected Issues paper – “Corporate Balance Sheets and Firm Investment: Empirical Estimates for Israel.”

Nevertheless, the Israeli economy has been relatively resilient to recent increases in oil prices, partly because of its low oil intensity.

The real expenditure ceiling refers to budget-to-budget growth rates.

The initially proposed 2006 budget projected a deficit of 3.0 percent of GDP.

Under the 2003 U.S. government’s guarantees program, Israel is eligible to issue US$9 billion of sovereign guaranteed debt spread between 2003 and 2007. As of end-October, 2005, the remaining balance was US$4.6 billion, of which US$2.6 billion is available immediately.

Problem loans are loans that are under special supervision, rescheduled, overdue or otherwise non-performing, or considered doubtful either in part or in total, and problem off-balance sheet exposures. The BoI does not deduct collateral from problem debts.

The budget that had been proposed to the cabinet was fully in line with the framework (Table 2).

Moreover, a 3 percent of GDP deficit in 2006 would be an improvement over the roughly 4 percent average deficit reached in the previous five years.

For more details on the debt sustainability and fiscal policy analyses, see the accompanying Selected Issues paper – “Fiscal Policy in Israel: Trends and Prospects.”

This would be a shock scenario, whereby real GDP is assumed to grow at the baseline level minus one-half standard deviation.

In this analysis, we assume that the subnational governments run a collective annual budget deficit of 0.5 percent of GDP, which is in line with the authorities’ projections. The DSA also reflects the tax cuts approved in 2005 to cover the period 2006–10.

For more details on the features and properties of the model, see the accompanying Selected Issues paper—“A Simple Forecasting and Policy Analysis System for Israel: Structure and Applications.”

BoI staff is planning to visit the Fund to continue the work that was started during the December mission.

According to the current draft of the law, the monetary committee will be made up of equal number of BoI members and outside public representatives. In the event of a tied vote, the Chairman (the governor) will have the casting vote. The minutes of the monetary committee’s meetings would be expected to be published after two weeks.

For more details on the development and reforms of the capital market, see the accompanying Selected Issues paper – “The Reform of the Capital Markets in Israel.”

The reduced number of non-tradable, guaranteed government bonds in the portfolios of institutions has encouraged the use of a wider range of financial instruments in order to secure yield and manage risks. The equalization of the tax treatment of overseas investments to match that for domestic investments has widened the investment opportunities. Barriers to the promotion of foreign mutual funds in Israel are being removed and the registration and approval requirements for new issues are being simplified. The corporate bond market is growing rapidly and activity on the stock exchange has increased. The development by the BoI of a real time gross settlement system, which will reduce banks’ settlement risks, has prompted an interbank market and proposals for repos.

Some of the regulators and banks believe that the price received by the banks was substantially higher (perhaps up to 50 percent higher) than might have been expected on the basis of the current fee income received by the banks.

Measured as households living below half the median disposable income, standardized by family size.

Welfare payments for children have declined from 4.7 percent of GDP in 2001 to 2.8 percent in 2004.

The advisory group is considering four different models for implementing negative income tax at a cost of NIS 1–2 billion per year but, as of yet, no specific details have been announced.

See Report on the Observance of Standards and Codes—Data Module.

For purposes of Fund relations, the West Bank and Gaza are under Israeli authority within the terms of Article XXXI, Section 2(g) of the Articles of Agreement. However, the mission focused on the Israeli economy and did not meet with representatives of the Palestinian Authority.

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Israel: Staff Report for the 2005 Article IV Consultation

Author: International Monetary Fund

Volume/Issue:: Volume 2006: Issue 120

Publisher:: International Monetary Fund

ISBN:: 9781451819595

ISSN:: 1934-7685

Pages:: 50

DOI:: https://doi.org/10.5089/9781451819595.002

	SDR Millions	% Quota
Quota	928.20	100.00
Fund holdings of currency	787.04	84.79
Reserve position in Fund	141.17	15.21

	SDR Millions	% Quota
Quota	928.20	100.00
Fund holdings of currency	787.04	84.79
Reserve position in Fund	141.17	15.21

	SDR Millions	% Allocation
Net cumulative allocation	106.36	100.0
Holdings	13.04	12.26

	SDR Millions	% Allocation
Net cumulative allocation	106.36	100.0
Holdings	13.04	12.26

Forthcoming
	2006	2007	2008	2009	2010
Principal
Charges/Interest	2.82	2.83	2.84	2.83	2.83
Total	2.82	2.83	2.84	2.83	2.83

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About

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Abstract

I. Overview

II. Macroeconomic Background and Outlook

III. Policy Discussions

A. Fiscal Policy

B. Monetary Policy

C. Financial Sector Stability

D. Poverty and Social Issues

E. Other Issues

IV. Staff Appraisal

APPENDIX I Israel—Fund Relations

APPENDIX II Israel: Statistical Issues

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