Statement by Jeroen Kremers, Executive Director for Israel and Nir Klein, Senior Advisor to Executive Director

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

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.

General remarks

On behalf of the Israeli authorities we thank the staff for an insightful set of papers, which provide a fair and balanced description of the consultation discussions and economic developments in Israel.

Following three years of a deep recession, in 2001-03, economic growth has since picked up, and the Israeli economy now shows a strong and consistent recovery. A relatively benign global economic environment and improvement in the security situation, together with a continued policy mix of fiscal tightening alongside accommodative monetary policy in 2005, provided favorable conditions for business sector activity. Fiscal policy was geared towards further consolidation with a lower tax burden and a substantial reduction in the relative size of the public sector. These policy measures together with considerable progress in implementing structural reforms, including much privatization, enabled the government to reduce its budget deficit and to renew progress in reducing the size of the public debt as a percentage of GDP. Monetary policy remained expansionary, yet in keeping with the authorities’ determination to meet inflation targets. In this respect, recent inflationary pressures brought about a policy of interest rate increases. In light of recent policies, and in view of recent macroeconomic outcomes, the authorities have succeeded in enhancing credibility and boosting confidence of market players.

The authorities are committed to pursuing prudent policies to support strong and sustainable economic growth alongside price and financial stability. In view of the challenges ahead, the authorities are determined to make every effort to reduce economic vulnerability by promoting development that increases the economy’s competitiveness and flexibility. As output is still below its potential, the authorities concurred with the staff’s projection that strong economic growth will continue in the medium term, albeit at a slightly slower pace.

GDP

Following GDP growth of 4.4 percent in 2004, economic activity further picked up in 2005, recording a remarkable growth of 5.2 percent. Economic expansion continued to reflect the rapid expansion of the business sector, while the public sector continued to decline (as a percentage of GDP). The robust growth was led by a confluence of external and internal favorable conditions, particularly the continued global growth and the improvement in the security situation, and was supported by prudent fiscal policy and an accommodative monetary stance. These policies helped restore market participants’ confidence and raise domestic demand. In 2005, private consumption increased by 3.9 percent and together with export growth, particularly in the high-tech sector, continued to be a major force of economic expansion. Investment in fixed capital grew by 2.4 percent after several years of continuous decline.

The external position continued to be positive. While export growth remained relatively strong at 5.6 percent—albeit slower than the remarkable increase in the previous year—imports recorded a more moderate growth of 4 percent. As a result, the 2005 current account balance ended with a surplus, for the third consecutive year after a decade of continuous deficits. The capital and financial accounts demonstrated great vigor in 2005. Notwithstanding the record-high level of foreign direct and portfolio investments, net capital exports increased in 2005 to 4.5 billion US dollars, a reflection of the removal of several restrictions on institutional investors’ investments abroad as well as the reduction of the tax rate differential on investments in Israel and abroad.

The fact that output level was still below its potential enabled a relatively quick response in supply with only a mild commensurate price increase. Higher oil prices continued to have an adverse effect on the supply side, though this was limited as the share of industry with heavy oil consumption in total production is relatively low. As part of the supply-side response, the labor market absorbed 93,000 new employees in 2005—a 3.9 percent increase—mainly in the trade and services sectors. The unemployment rate declined from 9.7 percent at the end of 2004 to 8.8 percent in the last quarter of 2005, while the labor participation rate increased.

Fiscal issues

In 2005, the authorities continued with ongoing efforts to downsize the public sector and further enhance the fiscal position. To promote transparency and credibility, fiscal policy was placed within a medium-term framework—for the years 2005-2010—anchored in 2004 legislation, and stipulating a budget deficit ceiling of 3 percent of GDP and real growth in public expenditure of no more than 1 percent a year. The budget deficit ceiling for 2005 was temporarily increased by 0.4 percent of GDP to allow for one-time spending related to the disengagement, but the contingency was unnecessary, as the 2005 budget balance recorded the lowest deficit in the past five years, amounting to only 1.9 percent of GDP compared to 3.9 percent in the previous year. This significant improvement in the fiscal balance can mainly be attributed to lower-than-budgeted government spending while revenues were broadly in line with earlier projections, despite the tax cuts that were introduced in the middle of the year. This is the third consecutive year that such underspending has taken place.

The low budget deficit and considerable revenues from privatization, together with rapid economic growth led to a sharp reduction in 2005 in the general government debt ratio—contracting by 3.8 percent of GDP to 102 percent of GDP—following a moderate decline in the previous year. The high level of public debt underlines the need for further reduction. The authorities reiterate their commitment to continue with a firm fiscal retrenchment, noting that the budget deficit rule of not exceeding 3 percent of GDP should be regarded as a ceiling and not a target. The proposed 2006 budget, which was approved by the government, adheres to the budget deficit and expenditure’s real growth restrictions, with the aim of continuing to reduce the debt to GDP ratio.

Given currently high tax rates, the authorities intend to continue with implementing an agreed multi-year tax reduction plan. However, the implementation of tax reform is conditional on a continuation of the downward-moving debt-to-GDP ratio, meaning that it could be postponed in the event of a sharp or unforeseen decline in revenues.

Monetary issues

The staff views the current monetary stance as accommodative and appropriate. In 2005, Israel continued to benefit from favorable external macroeconomic conditions, such as the relatively low foreign interest rates, a decline in emerging markets’ risk premium and a surge in capital inflows. These conditions, which supported foreign currency market stability despite the narrowing interest rate differentials, enabled the Bank of Israel (BoI) to reduce the policy rate to its historically lowest level—of 3.5 percent—and maintain this low rate for a consecutive eight months (February-September). Starting in October 2005, given the rise in global interest rates and the NIS depreciation against the US dollar, together with the rapid economic growth, the BoI gradually raised its interest rate cumulatively by 1.25 percentage points to 4.75 percent.

During 2005, the CPI rose by 2.4 percent, slightly more than during the previous year, yet still within the target range of price stability (1-3 percent). The increased inflationary pressures can be mainly attributed to the global increase in energy prices, the rapid growth in economic activity, which led to further contraction in the excess capacity of production, and to the depreciation of the NIS against the US dollar, particularly in the second half of the year as interest rate differentials narrowed. The CPI excluding housing, fruit and vegetables—a usual measure for core CPI1—rose during 2005 by 1.8 percent, 0.3 percentage points less than during the previous year. Continued price adjustments alongside the continued narrowing of Israel’s excess production capacity are also expected to exert upward pressure on prices in 2006. The BoI also noted that several factors, such as changes in foreign interest rates and the interest rate gap between the US and Israel, the geo-political uncertainty, possible reversal in capital flows to emerging markets, exchange rate developments, and the rapid economic growth, continue to pose upside inflation risks. The Bank of Israel will continue to closely monitor economic developments, with the intention of achieving the government’s price-stability target.

Within the framework of inflation targeting, the authorities use several forward-looking market indicators to formulate monetary policy. Efforts are being made to further improve existing macroeconomic statistical models in order to better understand the macroeconomic structure as well as the monetary policy transmission mechanism. In this regard, the authorities appreciate the recent cooperation between the BoI and the Fund’s staff, which has helped to enhance their analytical capacity.

Financial and banking sector

In 2005, significant progress was made in reducing the dominance of the banks in the financial markets as legislation forcing the divestiture of the banks’ holdings in mutual and provident funds was enacted and implemented. Within three months after the legislation, a significant part of the banks’ mutual and provident funds had been sold to domestic insurance companies or foreign investors. Despite these welcome developments, the new market configuration, which reflects a significant change in the financial and banking systems, demonstrates vulnerabilities that need to be reduced. In this regard, the authorities acknowledge the staff’s recommendations as described in the selected issues paper (Chapter IV, paragraphs 37-43).

The authorities express considerable satisfaction at their succeeding in raising the banking system’s capital ratio from 9.5 percent in 2000 to 11.5 percent in 2005 (during and despite the recent economic recession), although they are aware that the system has relatively low capital levels compared to its international peers. The banks’ recent higher earnings, which reflected favorable macroeconomic conditions, as well as one-time revenues from their divesture of mutual and provident funds, clearly provide an opportunity to further improve these rates.2 The authorities have taken several measures to reduce the risks of problem loans, including pursuing extensive series of on-site inspections and further enhancing the banks’ internal procedures for detecting, classifying and provisioning of problem loans. The authorities are quite confident that despite the considerable level of problem loans, there are no immediate risks to financial stability. In this regard, a recent stress testing performed on the problem loan portfolio showed endurance of the banking system despite heavy losses under extreme scenarios.

AML/CFT

In 2005, the AML/CFT regime was further strengthened as the “Prohibition of Financing Terrorism” was enacted and the Banking Supervision Directive was modified appropriately. The main modifications include the implementation of guidelines for customer identification to combat the financing of terrorism and for treating the risks embedded in check deposits. In addition, the criteria of countries bearing high risk have been elaborated and a list of countries that require heightened scrutiny of money transfers has been furnished. Action is also being taken to encompass credit card companies in the Directive on combating the financing of terrorism. The authorities share the staff’s view that more needs to be done to ensure appropriate compliance with legal and regulatory requirements for AML/CFT, particularly in the foreign offices of Israeli banks. Therefore, the Banking Supervision department recently undertook some measures to strengthen those foreign offices’ compliance with legal and regulatory requirements of the host country as well as with internal procedures and regulations of a banking group.

Structural reforms and poverty reduction

The authorities are continuing with their reform agenda to boost competition and efficiency in the markets. In the banking sector, following the privatization of Israel Discount Bank, the third largest bank in Israel, the authorities completed in 2005 the privatization of one of the country’s two largest banks and the last publicly-owned bank, Bank Leumi, to international institutional investors. In addition, an agreement was signed between the Ministry of Finance and Hahistadrut (the Israeli labor union) to separate the three seaports with an intention to privatize them in the future. The split of the Ports Authority into three separate companies is expected to enhance competition, raise productivity and significantly reduce labor costs. Furthermore, the authorities took measures to improve transportation infrastructure standards by transforming the public works department, Maatz, a unit of the Transportation Ministry, into a state-owned company. Ongoing efforts are also being made to privatize the Israel Military Industries (Taas) and the Oil Refineries company (Bazan).

Following extensive cuts in welfare payments in recent years, which led to a significant rise in measured poverty,3 there seems to be a consensus among political parties on the need for implementing—after the elections—policies targeted at reducing poverty, particularly among working, low-income families. In this regard, the government will consider adopting various policy measures that provide incentives for low wage individuals to participate in the labor market, and thus to allow their families to rely on a productive income source. Such considered measures include the “Earned Income Tax Credit” (EITC) plan, a subsidy to low wage working families.

1

Housing prices are highly sensitive to exchange rate movements as most rental contracts are denominated in US dollars.

2

The divesture of mutual and provident funds, although eliminating a potential source of income, may lead to higher revenues in the future, as banks are now allowed to widen their fee base by offering advisory and brokerage services in pension funds, an area in which banks were previously forbidden to operate.

3

Poverty in Israel is based on a relative measure and not on an absolute one.