General

The Israeli authorities thank staff for the productive discussions in Jerusalem as well as for their well-written set of papers. They share staff’s appraisal on the challenges ahead and broadly agree with the report’s key recommendations.

Owing to global economic buoyancy and prudent economic policies, geared toward a free- market economy, the Israeli economy continued to thrive in 2007, growing at above 5 percent for the fourth year consecutively. The robust economic performance was supported by high corporate profitability, prosperous financial markets and an increasing household income, which boosted business confidence and spurred private consumption and investment, as well as by the benign external conditions that contributed to a strong export performance. The current account surplus – although somewhat declining - remained at a comfortable level, and together with the high level of the net external asset position, underpinned the economy’s external resilience. The positive developments in 2007 percolated to the labor market as the unemployment rate continued to decline, reaching the lowest level in decades, while the participation rate continued to grow. Fiscal policy remained responsible, keeping the central government budget at balance, and thus allowing a sharp reduction in the debt-to- GDP ratio. On the monetary front, while opposing inflationary pressures shifted the inflation rate from a negative level in early 2007 to above the upper limit of the inflation target at the end of the year, the policy’s high credibility kept inflationary expectations well anchored within the inflation target range, and thus continued to support price and financial stability.

The impressive momentum of Israel’s economic activity was acknowledged by Standard and Poor’s, which upgraded Israel’s risk rating in November, and earlier in 2007 (May) by the OECD, which invited Israel to begin membership negotiations.¹ That said, the authorities well recognize that Israel is not yet “out of the woods” as significant challenges remain, including the need to reduce the high debt-to-GDP ratio, closing social gaps and, in view of the recent structural change, further enhance the financial sector’s resilience. In this regard, they remain committed to continue with prudent policies and underscore their intention to forcefully progress with their ambitious reform agenda to ensure a sustainable and high growth path for the economy.

Macroeconomic developments and outlook

In 2007, the Israeli economy continued the strong cyclical upswing that was recorded in the past three years. Overall, economic activity expanded by 5.3 percent (preliminary estimate) while the performance of the business sector was even stronger (6.3 percent). Strong domestic demand,² which benefited from supportive macroeconomic policies and benign business environment, generated a significant increase in imported investment and consumption goods and contributed to the decline of the current account surplus to 3.6 percent of GDP, despite strong export performance (8.6 percent). On the supply side, while in previous years growth was largely based on high productivity growth, a significant increase in labor and capital inputs became apparent in 2007. Indeed, the unemployment rate declined by 0.9 percentage points to 7.5 percent, while the participation rate increased to 56.4 percent, and fixed capital formation increased by 10.4 percent. The deceleration of productivity indicates that excess capacity is narrowing, and that a future increase in demands may result in higher inflationary pressures. In this context, signs of price pressures from the labor market are beginning to emerge as real wages rose this year by 2.7 percent, which is significantly higher than in the previous two years.

Looking ahead, the authorities broadly share the staff’s assessment that the domestic fundamentals are solid and provide a firm platform for future expansion. They well recognize that growth performance is likely to be less strong than in previous years as capacity constraints are beginning to bind and external conditions are becoming less supportive. Accordingly, the authorities’ baseline scenario suggests that 2008 GDP growth will be in a 4.2-4.4 percent range, assuming a moderate slowdown in global economic activity and no significant change in the geo-political situation. A more conservative scenario (3.6 percent), which in view of the recent global developments is becoming more realistic, is also being considered. The authorities are closely monitoring current developments and intend to revise their growth projections should conditions warrant that.

Fiscal policy

In 2007, the authorities continued with prudent fiscal policy-making and further progressed with fiscal consolidation. Buoyant revenues and strong fiscal discipline, as reflected in a tight expenditure envelope, led to a balanced central government budget, despite the ongoing implementation of the tax reform, in which corporate and personal income tax rates are being reduced, and the significant increase in defense-related spending following the conflict in the north. The balanced budget, coupled with robust GDP growth, contributed to a sharp reduction in the debt-to-GDP ratio to the level of 81 percent of GDP in 2007. This decline sums up an accumulated decrease of more than 20 percent in 4 years. In the same vein, the ongoing fiscal retrenchment continued to support the business sector’s activity and was reflected in downsizing of the public sector to 46 percent of GDP, compared to 56 percent in 2002.

While being encouraged by the recent fast decline in debt-to-GDP ratio, the authorities recognize that its current level remains relatively high and needs to be further reduced to contain the remaining vulnerabilities. They agree with staff’s view that reducing debt to GDP to the level of 60 percent over the medium term is an ambitious yet achievable goal and reiterate their intention to make every effort to progress in this direction. In this context, the authorities are in the process of redefining their fiscal policy rules. Accordingly, they intend to revise the current fiscal rules to ensure the continuation of debt reduction (as a share of GDP) in both good and bad times, while allowing a more sustainable path for public expenditures. The expectation is that new fiscal rules will be introduced and adopted in the course of this year and will take effect in the 2009 budget onwards.

In late December, the Knesset adopted the 2008 budget, which envisages a deficit of 1.6 percent of GDP and expenditure real growth of 1.7 percent, in line with earlier commitments.³ The authorities, nevertheless, underscore that the envisaged fiscal deficit should be regarded as a ceiling, and in fact, expect to end the year with a smaller deficit, as in the past few years. The budget envisages a significant increase in the public civil consumption (nearly 7 percent), which under the current tight expenditure rule, was possible due to the considerable reduction of public debt and its associated interest rate payments. The budget aims at closing social gaps, inter alia, by encouraging labor participation, reforming the education system and increasing the support to weak population.

In an effort to streamline the budgetary process and allow a far-reaching public debate on the budget components, the government has agreed to bring forward the submission of the budget proposal to the Knesset. The proposed 2009 budget will be submitted no later than 30 September 2008 and the proposed 2010 budget and future budgets will be submitted no later than 31 August. To further increase transparency and improve fiscal management, the MoF positively considers, in line with staff’s recommendation, introducing a multi-year budgetary plan with an explicit analysis of potential risks.

Monetary issues

The opposing inflationary pressures, driven by both domestic and external factors, shifted, in 2007, the monetary stance from easing to tightening. In the first half of the year, the significant appreciation of the Sheqel, coupled with the decline in energy prices toward the end of 2006, exerted downward pressures on prices and brought the inflation rate in the last 12 months to a negative level. Consequently, the Bank of Israel (BoI) continued to maintain an accommodative monetary stance by gradually cutting the interest rate by 1 percent to 3.5 percent in June, thus allowing the US-Israel interest rate differential to reach its record-high level (1.75 percent). During this period, local components of the CPI continued to increase, yet their impact on the overall headline inflation was rather moderate. In the remainder of the year, the narrowing output gap and higher energy and food prices exerted greater inflationary pressures and pushed the inflation rate toward the upper limit of the inflation target range (1-3 percent). Accordingly, the BoI tightened the monetary stance and gradually raised the interest rate to 4 percent. In January 2008, the interest rate was raised again by additional 25bp following new indications about mounting inflationary pressures. The CPI recorded, during 2007, an overall increase of 3.4 percent. At present monetary policy has to take into account both the ongoing inflationary pressures from the closing of the output gap, and the impacts on future inflation of the slowdown in global demand growth and the strengthening of the Sheqel. This caused the authorities to leave the interest rate for February unchanged, and leaves the future course of interest rates uncertain.

While the high variability of inflation underscores the complexity of monetary policymaking in a small and open economy such as Israel where exchange rate movements largely affect the pattern of prices, it is worth noting that inflation expectations for one and two years ahead remained relatively stable and, for most of 2007, fluctuated within the inflation target range.⁴ This serves as a testimony to the high credibility of the current flexible inflation targeting framework and the public’s recognition that the BoI is committed to meet the inflation target at the medium term. The BoI is constantly making efforts to improve its communication and transparency. In this regard, it has started to publish its forecast about the interest rate path⁵ and intends, starting from 2008, to shift toward quarterly publication of Inflation Reports.

Following a protracted dispute over the wage structure at the BoI, an agreement was signed (December 2007) between the BoI and MoF and the labor union. It is expected that this agreement will pave the way for prompt adoption of the new BoI law as well as for the acceleration of the BoI’s restructuring process, which will enhance the BoI’s capacity and professional independence and place it in line with the best practice of central banks in advanced economies.

Financial sector issues

Israel’s financial system is undergoing rapid reform-driven change. Accelerated financial deepening has fostered economic growth and has been reflected in a continuous improvement in financial sector’s indicators. In this context, since 2004 there has been an improvement in banks’ earnings, capital ratios, levels of NPLs and in loan-loss reserves, and even under an extreme stress-test scenario, the banking system is resilient. By and large, the current financial turmoil has had so far a relatively moderate impact on financial institutions’ balance sheets due to their limited exposure and conservative investment approach. That said, the authorities are vigorously monitoring the banks and other financial institutions’ exposures to structured products, and have required enhanced transparency in their financial statements.

The staff rightly points out that the recent capital market reform has generated significant challenges for supervisors as risks have shifted from banks to institutional investors and households. While a new inter-institutional (Ariav) committee was recently established to address the emerging challenges, the authorities have taken several steps to secure financial stability, inter alia by increasing markets’ transparency and discipline as well as fostering greater competition and market sophistication. Among other measures, the authorities enacted a series of new regulations to facilitate switching between the supervised entities and choosing between different savings instruments and plans, and launched a website that enables comparison between provident funds and between pension funds. Additionally, following extensive discussions with commercial banks, the latter decided to exploit the benign macroeconomic conditions, and included in their business plans a gradual rise in capital ratios to the range of 12-13 percent (from 10-12 percent) within the next two years.

In May 2007, the authorities announced a Joint Work Plan for the Supervisor of Banks and Banks regarding implementation of Basel II. The plan has a twofold objective: enhancing the risk management, control systems and corporate governance of the banks as well as moving towards risk- and principles-based banking supervision. The authorities intend to devote substantial resources to this issue, including through hiring high-quality international experts, and they are conducting consultations with banks in order to implement Basel II by the end of 2009. In line with disclosure requirements of Basel II, the authorities published a new financial reporting directive on the measurement and disclosure of impaired loans and debt securities, credit risk and the allowance for credit risk. The directive improves the standards for measurement and disclosure of credit risks, in alignment with the advanced economies’ standards, as well as the banks’ ability to monitor and measure credit risks. The authorities share staff’s appraisal that more is needed to improve their capacity to manage and resolve financial stress. To this end, the BoI’s Governor established teams with the objective to prepare a manual on this issue.

Structural reforms and social policy

The authorities are continuing with their ambitious reform agenda to boost competitiveness and efficiency in the markets. In 2007, the government reduced its holding in the Pi-Glilot gas depot and completed the privatization process of the Israel Oil Refineries with the sale of the second oil refinery in Haifa. Further structural changes in the energy sector also include the government’s intention to split the monopolistic Electric Corporation into several separated companies (transmission, generation and distribution) in order to improve efficiency and induce price reduction. Additional planned privatizations, which are currently in the stage of evaluation and assessment, include the Postal Authority, the Israeli Military Industries (IMI), the Israel Aircraft Industry (IAI) and the seaport in Eilat.

As for the social developments, the authorities are encouraged by the fact that after a continuous increase in poverty, the extent of the population living below the poverty line, has recorded a moderate decline.^{6 7} Nevertheless, the poverty level remains high and income inequality continues to be among the highest in the world. The government, in this regard, adopted (April 2007) the “Social-Economic Agenda for 2008-10”, which sets explicit targets for poverty and the labor market participation rate.⁸ To achieve these targets the government intends to introduce in the course of 2008 an Earned Credit Income Tax (EITC), which subsidizes low wage working families, to expand vocational training in the context of ALMP, subsidize day-care centers (to encourage mothers to join the labor market), to strengthen enforcement of labor laws and to reduce the number of illegal foreign workers. The new agreement between the labor union and the manufacturers association on a mandatory pension is also expected to contribute to poverty reduction over the medium and longer term.