Israel
2007 Article IV Consultation: Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Israel

The Israeli economy is performing exceptionally well, but still high public indebtedness calls for the continuation of strong economic policies. Monetary policy has successfully stabilized inflation expectations, but policy and communication challenges remain. The recent positive fiscal performance needs to be carried forward to improve international credibility. The government’s intention to stick with a rules-based approach to fiscal policy, solidly anchored in longer-term objectives, is commended. Enhanced fiscal transparency and governance are essential to improve the quality of policymaking.

Abstract

The Israeli economy is performing exceptionally well, but still high public indebtedness calls for the continuation of strong economic policies. Monetary policy has successfully stabilized inflation expectations, but policy and communication challenges remain. The recent positive fiscal performance needs to be carried forward to improve international credibility. The government’s intention to stick with a rules-based approach to fiscal policy, solidly anchored in longer-term objectives, is commended. Enhanced fiscal transparency and governance are essential to improve the quality of policymaking.

I. Report on the Discussions

1. Strong macroeconomic conditions and sound domestic policies have significantly improved Israel’s growth performance and prospects but vulnerabilities remain.1 Amid global financial market turmoil and heightened uncertainty about growth prospects, the discussions focused on external stability and the exchange rate; financial sector vulnerabilities and policy requirements; and fiscal policy, notably the need to reduce the high public debt.

uA01fig01

Productivity Growth of the Business Sector (Output per person, percent) 1/

Citation: IMF Staff Country Reports 2008, 062; 10.5089/9781451819649.002.A001

Sources: Bank of Israel; and IMF staff calculations.1/ Data for 2007 as of June.
uA01fig02

Real GDP, SA

(Semiannual growth; annualized)

Citation: IMF Staff Country Reports 2008, 062; 10.5089/9781451819649.002.A001

Sources: Central Bureau of Statistics; and IMF staff estimates.
uA01fig03

GDP Components Growth (Percent)

Citation: IMF Staff Country Reports 2008, 062; 10.5089/9781451819649.002.A001

Sources: Central Bureau of Statistics; and IMF staff estimates.

A. Macroeconomic prospects: strong but Less Buoyant Activity

2. The economy is entering the global slowdown with significant momentum. Notwithstanding the war in the north during 2006, real GDP growth averaged about 5¼ percent during 2006–07 (Table 1, Figure 1). Buoyant world trade propelled exports and investment, fostering strong employment growth—which was also supported by welfare reform—and private consumption.

Table 1.

Israel: Selected Economic and Financial Indicators, 2001–08

(Percent change, unless otherwise indicated)

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

IMF staff projections.

Capital expenditure of the central government.

Data for 2007 as of September.

Data for 2008 as of January.

Data for 2007 as of October.

Data for 2007 as of December.

Data for 2007 as of August.

National definition, cash basis.

International definition, accrual basis. On the difference between central and general government deficits during 2003–06: much of it is accounted for by the difference between accrual and cash bases accounting. On the latter, the key factor is the CPI indexation component that is paid on all NIS debt when it matures and is recorded below the line in the central government balance but above the line in the general government balance when it accrues.

Figure 1.
Figure 1.

Israel: The Long View, 1996–20071/

(Percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2008, 062; 10.5089/9781451819649.002.A001

Sources: IMF, World Economic Outlook; and IMF, Information Notice System.1/ Projections for 2007.2/ From 1999 onward, international definition, accrual basis.3/ Data for 2007 as of October.

3. The global financial turmoil has caused some increase in risk premia but has not prompted significant concerns thus far (Figures 23 Tables 24). Stock prices have been resilient in the face of recent financial turbulence; CDS spreads on government bonds are up somewhat from unusually-low pre-crisis levels; and corporate bond spreads have widened, reflecting also the bankruptcy of a local nonfinancial firm. Some banks have announced losses on mortgage-related US assets but the effect on profitability and capital has been small. Nor have banks been experiencing funding pressures, as they rely almost exclusively on deposits from the public. The authorities do not expect a fall-out of the financial turmoil on the Israeli banking system that could affect its ability to adequately support the domestic economy, provided losses on AAA-rated prime-mortgage- backed securities (ABS) remain limited.2

Figure 2.
Figure 2.

Israel: External Indicators, 2001–07

Citation: IMF Staff Country Reports 2008, 062; 10.5089/9781451819649.002.A001

Sources: Central Bureau of Statistics; Bank of Israel; and IMF staff projections.1/ Inclusive of goods and services; data for 2007 as of September.2/ Data for 2007 as of November.3/ Projection for 2007.4/ A decrease represents depreciation. Data for 2007 as of October.5/ Data for 2007 as of December.
Figure 3.
Figure 3.

Israel: Selected Monetary and Financial Indicators, 2006–07

Citation: IMF Staff Country Reports 2008, 062; 10.5089/9781451819649.002.A001

Sources: Bank of Israel; IMF, International Financial Statistics; and Bloomberg.1/ Data for 2008 as of January.2/ Defined as the Bank of Israel policy rate minus inflation expectations. Data for 2007 as of December.3/ Data for 2007 as of December.4/ Data for 2007 as of October.5/ Data for 2008 as of January 3.
Table 2.

Israel: Financial Soundness Indicators, 2001–07

(Percent)

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Source: Bank of Israel.
Table 3.

Israel: Balance of Payments, 2004–12

(Billions of U.S. dollars)

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

IMF staff estimates and projections.

Excludes reserve assets.

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

Table 4.

Israel: Indicators of External and Financial Sector Vulnerability, 2001–07

(Percent of GDP, unless otherwise indicated)

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

According to WEO GEE trade deflators.

On foreign currency long-term debt, Moody’s upgrade in July 2000.

uA01fig04

Risk Premium of Corporate Bonds over Government Bonds by Rating

(Percent)

Citation: IMF Staff Country Reports 2008, 062; 10.5089/9781451819649.002.A001

Sources: Bank of Israel.

4. Looking forward, activity is thus widely expected to remain strong, even if somewhat less buoyant than in the past. Domestic preconditions for continued output growth remain in place. Specifically, GDP growth is broad based; families’ real incomes are rising, including those of the poor; corporate profitability and balance sheets have improved; and the cooperation between employers and trade unions is good. Furthermore, the economy’s competitiveness is still solid (¶). However, capacity constraints are beginning to bind (Figure 4), notably in the market for highly skilled employees; and risk premia on corporate funding have risen. Also, external conditions are becoming less supportive. In particular, decelerating activity in the United States and Europe will weigh on exports and investment, although much hinges on the extent to which the external slowdown spreads beyond foreign real estate sectors; and oil prices are standing some 40 percent above 2007:Q1 levels. Accordingly, the Ministry of Finance (MoF) and Bank of Israel (BoI) foresee 4.2 percent and 4.4 percent real GDP growth, respectively, for 2008. Taking into account the latest developments and prospects, staff projects 3.8 percent real GDP growth, which is around potential, and an output gap that is estimated to be broadly closed.3

Figure 4.
Figure 4.

Israel: Labor Market, 1987–2008

Citation: IMF Staff Country Reports 2008, 062; 10.5089/9781451819649.002.A001

Sources: Bank of Israel; Central Bureau of Statistics; and IMF staff estimates and calculations.

5. Risks around the forecasts were seen to be broadly balanced. MoF staff felt that their forecast was prudent, considering repeated upside surprises to growth in the past. BoI staff explained that under an alternative scenario, with the United States experiencing a recession, growth would still reach 3.6 percent. The authorities concurred that external risks are tilted to the downside: partner demand might slow more than expected, global financial turmoil might worsen and begin to affect Israel significantly, oil prices could exceed projections further, and rising geopolitical uncertainty could adversely affect output. But domestic risks are to the upside. In particular, despite unemployment rates nearing record lows and wages accelerating gradually, capacity might be less constraining than estimated.

B. External Prospects: More Integration with the World Economy

6. The economy is integrating rapidly with the rest of the world. Flows of nonresident investment into Israel—spurred partly by privatization of public enterprises—and resident investment abroad together reached a record 40 percent of GDP in 2006, up from 22 percent of GDP in 2005, partly on account of some exceptionally large transactions. In 2007, gross flows are moderating toward 2006 levels. The increased flows have also pushed gross external debt to about 60 percent of GDP but this does not detract appreciably from robustness. While this raises vulnerability to exchange rate shocks (Figure 5, Table 5), this vulnerability is greatly diminished by the country’s net external debt asset position of about 25 percent of GDP. Only the public sector has net external debt liabilities, equivalent to some 3 percent of GDP.

Figure 5.
Figure 5.

Israel: External Debt Sustainability: Bound Tests 1/

(External debt in percent of GDP)

Citation: IMF Staff Country Reports 2008, 062; 10.5089/9781451819649.002.A001

Sources: International Monetary Fund, country desk data, and IMF staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.3/ One-time real depreciation of 30 percent occurs in 2008.
Table 5.

Israel: External Debt Sustainability Framework, 2002–12

(Percent of GDP, unless otherwise indicated)

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Derived as [r - g - ρ(1+g) + εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock, with r = nominal effective interest rate on external debt; ρ = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-ρ(1+g) + εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock. ρ increases with an appreciating domestic currency (ε > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

uA01fig05

International Investment Position

(Percent of GDP)

Citation: IMF Staff Country Reports 2008, 062; 10.5089/9781451819649.002.A001

Source: Bank of Israel.
uA01fig06

Current Account and Real Exchange Rate

(Distance from 1986-2006 average; percent)

Citation: IMF Staff Country Reports 2008, 062; 10.5089/9781451819649.002.A001

Sources: Bank of Israel; IMF, Information Notice System; and IMF staff calculations.

7. The current account surplus is falling but the exchange rate may still be moderately undervalued. The current account surplus reached 5½ percent of GDP in 2006, up from 3.3 percent in 2005. While domestic investment has been recovering strongly, public savings have been rebuilt. Concurrently, temporary factors are boosting private savings and the current account, notably the 2005 tax reform on investments abroad, which has fostered record capital outflows. At a constant real effective exchange rate and based on data available through end-November 2007, staff and BoI projections point to a decline in the current account surplus to 2½ percent of GDP by 2008. Staff sees the current account stabilizing at 2¼ percent of GDP over the medium run. Multilateral calculations point to an equilibrium current account (“norm”) of about 1 percent of GDP for Israel and suggest that the real exchange rate may be undervalued by 5–10 percent, although the “norm” and the underlying current account could be closer together.4 Consistent with such a view, the balance for goods and services has not moved much during 2004–06 and market shares for goods have moved broadly sideways.

uA01fig07

Change in Current Account Balance Components, 2003 to 2006

(Percent of GDP)

Citation: IMF Staff Country Reports 2008, 062; 10.5089/9781451819649.002.A001

Source: Bank of Israel; and IMF staff calculations.
uA01fig08

Market Share of Israel’s Goods Exports

(Percent)

Citation: IMF Staff Country Reports 2008, 062; 10.5089/9781451819649.002.A001

Source: IMF, Direction of Trade Statistics.

8. The authorities had no firm view on the valuation of the exchange rate. There was agreement that domestic policies are consistent with external stability. However, the authorities considered it difficult to determine the medium-run equilibrium current account balance and exchange rate with much confidence. BoI analysis suggests that the former is higher and the latter more appreciated than over the 1990s. Also, BoI representatives thought that talk about under or overvaluation could prompt calls for renewed intervention in exchange markets (BoI last intervened in 1997), which could complicate monetary policy. The flexible exchange rate regime was viewed to be appropriate for Israel. Also, any undervaluation would allow scope for nominal appreciation, which would help moderate inflationary pressure (¶10).

C. Monetary Policy: Staying on Target Amid Exchange Rate Volatility

9. Monetary policy has successfully stabilized inflation expectations, even though inflation has frequently been outside the 1–3 percent target range on account of exchange rate changes. Lately, inflation has been undershooting the 1–3 percent target, largely reflecting sheqel appreciation against the US dollar, but is rising again. By November, prices stood just under 3 percent above the end-2006 level (Figure 6), while the sheqel (NIS) appreciated by about 6.5 percent against the US dollar (US$), which may have lowered domestic prices by about 2 percent.5 As the exchange rate prompted CPI deflation earlier in the year, the BoI responded by cutting interest rates from a peak of 5.5 percent in October 2006, to 3.5 percent by June 2007. The rate cuts to below the U.S. federal funds rate (an unprecedented differential) contributed to weakening the shekel. With inflation reaccelerating, falling unemployment and rising wage pressure, and some evidence of slowing productivity growth, the BoI changed course in August, raising rates in three steps, to 4.25 percent by January 2008.

Figure 6.
Figure 6.

Israel: Recent Economic Indicators, 2001–07

(Percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2008, 062; 10.5089/9781451819649.002.A001

Sources: Central Bureau of Statistics; Bank of Israel; IMF, World Economic Outlook; and IMF staff calculations.1/ Projection for 2007.2/ Seasonally adjusted; data for 2007 as of September.3/ Data for 2007 as of September.4/ Data for 2007 as of November.5/ Percentage change from the corresponding period one year earlier.
uA01fig09

Volatility of Inflation Expectations

(Standard deviation/average)

Citation: IMF Staff Country Reports 2008, 062; 10.5089/9781451819649.002.A001

Sources: Bloomberg; and IMF staff calculations.

10. Further rate hikes will probably be needed for inflation to stay within the 1–3 percent target range, with the amount depending on exchange rate developments. Monetary policy will have to contend with rising domestic pressures on inflation and a volatile exchange rate. BoI econometric estimates suggest that the domestic component of consumer prices is rising over 4 percent, while the external component is declining, owing to the appreciation of the sheqel against the U.S. dollar. Judging by current developments and with prospects for rising capacity constraints, domestic inflationary pressure is unlikely to moderate in the context of a policy rate that is not firmly within neutral range. Also, global inflation is on the rise. Thus, much will hinge on the development of the NIS/US$ exchange rate. In this regard, there was agreement that, because the current account surplus would probably narrow fundamental pressures for sheqel appreciation would diminish. Furthermore, BoI officials expected capital inflows to moderate more than outflows, as diversification by institutional investors would continue. Market analysts foresee inflation of just over 2 percent over the medium run, with the policy rate rising to around 4.5 percent by 2008:Q4. Staff’s forecast based on the WEO and other tools is for inflation of around 2 percent in 2008–09, assuming interest rates rise gradually to about 5.0 percent by end-2009. However, the risks around this scenario, particularly on account of the potential for a further appreciation of the exchange rate, remain appreciable (Box 1). More importantly, there was agreement that growing uncertainty about external demand prospects and rising risk premia in capital markets argue for caution in raising rates.

uA01fig10

Policy Rates

(Percent)

Citation: IMF Staff Country Reports 2008, 062; 10.5089/9781451819649.002.A001

Sources: IMF, Information Notice System; and IMF staff calculations.
uA01fig11

Policy Rate: Actual and Expected, 2007

(Percent)

Citation: IMF Staff Country Reports 2008, 062; 10.5089/9781451819649.002.A001

Source: Bank of Israel.

11. Staff welcomed steps to strengthen the transparency of the monetary policy framework and discussed options for further improvements. The BoI is moving to publish inflation reports on a quarterly rather than semi-annual frequency to improve communication with markets. In addition, model-based fan charts of inflation and interest projections have been added to the report. Staff welcomed these steps, but suggested clarifying the role of the fan chart forecasts, which are not considered official BoI forecasts, in the BoI’s decision making; the relationship between these forecasts and those for other macroeconomic variables (notably the exchange rate); and the monetary policy horizon. BoI officials were open-minded, but also had concerns about publishing a formal, full-fledged inflation forecast. They thought that the volatility of the exchange rate and its high (although weakening) pass through to domestic prices would limit the informational content of such a forecast. Nonetheless, they stood ready to alter their communications, notably when restructuring the BoI following the adoption of the draft BoI law.6

Monetary Policy—Baseline Forecast and Risk Assessments

The central scenario assumes a small positive output gap that is expected to close by mid-2008. Under this scenario, and at an exchange rate of about 3.9 shekel/$, the policy rate would be expected to rise in order to maintain headline inflation within the 1–3 percent band over the next two years.

Baseline Forecast on December 17, 2007

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The baseline forecast is subject to a number of risks, the policy implications of which are illustrated below (IMF Country Report 06/121, Chapter III provides detailed explanation and properties of the model used to derive these assessments).

  • Unexpected slack, resulting in negative output gap, would alleviate the need to increase the policy rate in the near term, while keeping headline inflation within the targeting band.

  • Continued sheqel appreciation (against USD), coupled with compression in Israel’s risk premium, would also alleviate the need for higher policy rate in the near term.

  • A 25 percent increase in oil prices from current projected levels would require acceleration in the policy rate hikes, relative to baseline.

Negative Output Gap

(Deviation from baseline)

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Lower Risk Premium/Sheqel Appreciation

(Deviation from baseline)

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Higher Oil Prices

(Deviation from baseline)

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D. Fiscal Policy

12. The key challenge for fiscal policy is to keep the public debt ratio firmly on a downward path. Public debt, which exceeded 95 percent of GDP in 2005, is expected to fall to 82 percent of GDP by end-2007, still very high for one of the most vulnerable advanced economies. The 2001-03 downswing—which resulted from a confluence of global and security developments—is a stark reminder of this vulnerability, as the public debt ratio, which had been on a downward trend since the early 1990s, swung upward by 15 percentage points, to 102 percent of GDP. The Debt Sustainability Analysis (DSA) suggests that this vulnerability remains significant (Figure 7, Table 6).

Figure 7.
Figure 7.

Israel: Public Debt Sustainability: Bound Tests 1/

(Public debt in percent of GDP)

Citation: IMF Staff Country Reports 2008, 062; 10.5089/9781451819649.002.A001

Sources: International Monetary Fund, country desk data, and IMF staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance.3/ One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2008, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).
Table 6.

Israel: Public Sector Debt Sustainability Framework, 2002–12

(Percent of GDP, unless otherwise indicated)

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Indicate coverage of public sector, e.g., general government or nonfinancial public sector. Also whether net or gross debt is used.

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

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

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

For projections, this line includes exchange rate changes.

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

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

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

Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.