Abstract
The methodologies used in this paper suggest that Israel’s real exchange rate is moderately undervalued, while gains in external competitiveness appear to have been eroded in recent years. Market-based indicators provide a useful additional dimension to the analysis of financial stability in Israel. The Israeli government has made far-reaching reforms to financial markets in recent years. Banks’ performance and financial strength have been improving. This paper proposes two rules that are based on a debt-brake concept and an alternative error-correction-mechanism toward fiscal policy in Israel.
This Selected Issues paper offers further analysis of the key topics covered in the accompanying Staff Report. These include Israel’s equilibrium exchange rate, financial sector stability, and prudential policy challenges. The final chapter serves as an input into the ongoing policy debate on reforming fiscal rules.
The main findings are:
Israel’s real exchange rate is moderately undervalued (by about 5–10 percent), while gains in external competitiveness appear to have been eroded somewhat in recent years. For this and other reasons the undervaluation could be lower than the econometric estimates suggest.
Financial stability has been improving. Compared with the accounting ratios (capital/assets, ROE etc), market-based indicators paint a less improved picture of recent financial stability developments in Israel, possibly reflecting markets’ assessment of challenges and risks for banks associated with the recent financial sector reforms and concerns over the wider impact of global credit market events. Stress tests for banks, based on publicly available data, suggest that the banks have become more resilient to shocks over time. Credit risk remains the key source of risk.
Financial sector reforms are spurring rapid mostly positive change and much work to adapt the prudential framework and financial infrastructure is ongoing. For example, banks are expanding abroad, taking on new risks. However, data disclosed by the major banks suggest that exposures to US mortgage-related assets, though causing significant loss to one bank, do not present systemic risks. Insurance companies are developing into diversified groups. Regulators now need to (i) build the expertise necessary to support a more complex regulatory system; (ii) ensure consistency between the pace of regulatory change and high-quality implementation, ideally moving to a more principles-based approach; and (iii) strengthen their capacity to manage and resolve financial stress.
Israel’s performance against its fiscal rules over the past two decades has been mixed but improving noticeably as of late. A new fiscal rule should be anchored on the objective of lowering the public debt to 60 percent of GDP by 2015, with a view to rapidly diminishing the economy’s vulnerability to shocks.
I. Israel’s External Competitiveness: Assessing the Real Exchange rate1
A. Introduction
1. Israel’s real effective exchange rate (REER) has trended lower since 1998, while the current account moved from deficit into surplus.2 The REER depreciation ought to have made Israeli exports more competitive in world markets, and the improvement in the current account position in part reflects this. However, the recent transition to appreciable current account surpluses appears to have been driven more by factors associated with capital market developments rather than durable competitiveness gains in exports of goods and services.
Current Account and Real Exchange Rate
(Distance from 1987-2006 average; percent)
Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A001
Sources: Bank of Israel; IMF, Information Notice System; and IMF staff calculations.1/ Data for 2007 as of September.2/ Projection for 2007.Current Account and Real Exchange Rate
(Distance from 1987-2006 average; percent)
Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A001
Sources: Bank of Israel; IMF, Information Notice System; and IMF staff calculations.1/ Data for 2007 as of September.2/ Projection for 2007.Current Account and Real Exchange Rate
(Distance from 1987-2006 average; percent)
Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A001
Sources: Bank of Israel; IMF, Information Notice System; and IMF staff calculations.1/ Data for 2007 as of September.2/ Projection for 2007.2. This paper adopts an eclectic approach to assessing Israel’s external competitiveness.3 Particular attention is paid to measures of equilibrium real exchange rates. The paper is structured as follows: Section B reviews recent trends in the current account; Section C examines various measures of the real exchange rate; Section D analyzes Israel’s export performance; Section E concludes.
B. Current Account Trends
3. The current account balance has trended higher since the mid 1990’s. In order to assess the underlying factors behind this improvement, it is helpful to decompose the current account into its key sub-components over two broad periods.4
The late-1980’s-mid 1990’s featured high investment/low savings, and the current account position deteriorated from about balance in 1989 to a deficit of around 5 percent of GDP in 1994–96. This was primarily due to a substantial wave of immigration (equivalent to about 20 percent of Israel’s original population at the time), appreciable increases in government spending and deficits, and a reduction in current transfers. Transfers mainly comprise US government aid, compensation from Germany, and private transfers. All three sources are trending lower (as a share of GDP) and are expected to continue to do so.
However, starting in the second half of the 1990s the current account began to improve, in large part because of the unwinding absorption effects of the large immigration pool, gains in price competitiveness—helped by the downward trend in the real exchange rate, but also due to structural changes that increased savings.5 While public saving rose, private savings were supported by cutbacks in the welfare state.
Current Account Balance and Components
(Percent of GDP)
Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A001
Sources: Bank of Israel; and IMF staff estimates.Current Account Balance and Components
(Percent of GDP)
Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A001
Sources: Bank of Israel; and IMF staff estimates.Current Account Balance and Components
(Percent of GDP)
Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A001
Sources: Bank of Israel; and IMF staff estimates.4. Since 2003, the improvement in the current account mainly reflects an appreciable increase in the income balance. The current account rose from a surplus of 1 percent of GDP in 2003 to 5.6 percent in 2006. Over 70 percent of the gain is attributed to the income balance, which rose steadily from a deficit of 3.5 percent of GDP in 2003 to about zero percent in 2006. The rise in the income balance stems mainly from a steady increase in the holdings of foreign assets by Israeli residents, who have seeked to diversify their investment portfolios. Over the same period, the goods balance was trend-less, hovering around a deficit of 2–3 percent of GDP, while the services balance rose gradually to a surplus of about 3 percent of GDP. The surplus in net transfers slowly declined to around 4 percent of GDP. These recent developments suggest a possible disconnect between the improvement in the current account and the extent to which it has reflected sustained gains in external competitiveness.
Change in Current Account Balance Components, 2003 to 2006
(Percent of GDP)
Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A001
Sources: Bol; and IMF staff calculations.Change in Current Account Balance Components, 2003 to 2006
(Percent of GDP)
Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A001
Sources: Bol; and IMF staff calculations.Change in Current Account Balance Components, 2003 to 2006
(Percent of GDP)
Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A001
Sources: Bol; and IMF staff calculations.C. Measures of Real Exchange Rate Valuations
5. In comparison with long-run historical averages, Israel’s real exchange rate appears undervalued, albeit moderately. A secular uptrend in the CPI-based real effective exchange rate (REER) during the previous two decades reversed course in 1998 when the REER began to trend lower, and depreciated further as a result of the 2001–02 recession. At 2007Q2, the REER was more than 20 percent below its peak, but only 12 percent below its average level over the preceding 20-year period and 6 percent below the average level since 2001. On the basis of unit-labor-cost (ULC), the real exchange rate shows a similar trend.
6. More refined approaches to assessing real exchange rates rely on estimates of an equilibrium rate derived from underlying macroeconomic fundamentals. The premise here is that the real exchange rate is not stationary (confirmed by unit root tests) but rather changes slowly over time in response to fundamentals. The methodology developed by the IMF’s Consultative Group on the Exchange Rate (CGER) adopts three key approaches: Equilibrium Real Exchange Rate (ERER), Macro Balance (MB), and External Sustainability (ES).6
7. The ERER estimates the equilibrium relationship between the real exchange rate and a set of fundamentals. These are:net foreign assets (NFA), labor productivity, commodity terms of trade, government consumption, trade restrictiveness, and price controls, with an intercept for each country (equal to the average real exchange rate over the sample period).7 The equilibrium rate is assessed at “trend” values of the right-hand-side variables, and thus is calculated as a function of the projected medium-run (2012) values of these fundamentals. On this basis, Israel’s real exchange rate was found to be 9.5 percent below its estimated equilibrium level.8 However, a key assumption of the ERER methodology is that average misalignment over the sample period is zero. This may lead to an overestimation of Israel’s equilibrium real exchange rate at the end point of the sample period (2006), for the following reasons:
Current transfers receipts have been falling as a share of GDP.
Immigration, much of which occurred during 1989–95, may have temporarily boosted the real exchange rate, beyond what is captured by productivity and government consumption. Indeed, government consumption has trended down as of late, reflecting in part the end of immigration-related spending,.
ERER
(1995=100)
Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A001
Sources: IMF staff estimates.ERER
(1995=100)
Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A001
Sources: IMF staff estimates.ERER
(1995=100)
Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A001
Sources: IMF staff estimates.
Tradeable/Nontradeable Productivity vs. Trading Partners
(1986=100)
Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A001
Sources: IMF staff estimates.Tradeable/Nontradeable Productivity vs. Trading Partners
(1986=100)
Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A001
Sources: IMF staff estimates.Tradeable/Nontradeable Productivity vs. Trading Partners
(1986=100)
Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A001
Sources: IMF staff estimates.8. The MB methodology calculates the real exchange rate adjustment needed to bring the projected medium-run (underlying) current account into line with an estimate of the equilibrium or “norm” current account level.9 The approach entails two steps. First, the current account norm is estimated from a set of fundamentals: fiscal balance, output growth, relative income, demographics (old-age dependency ratio), NFA, and the oil trade balance.10 In the second step, the norm is compared with the underlying current account, and the magnitude of the required real exchange rate adjustment is derived by applying to the current account gap the elasticity of the current account to the real exchange rate.11 Thus, exchange rate misalignment under the MB approach is essentially a by-product of current account misalignment. Since the approach does not assume an average misalignment of zero, many of the ERER-related problems do not arise. For Israel, the estimated norm current account is a surplus of 0.8 percent of GDP.
9. Staff estimates put the underlying current account at a surplus of 2.2 percent of GDP, implying an estimated 6.1 percent RER undervaluation.12 However, the risks to staff’s estimate of the underlying current account are predominantly to the downside. The main reason is that there may well be more slack in the economy than medium-run output growth projections currently suggest, which would allow more domestic-demand driven growth to lower the current account and thus narrow the RER misalignment.13
10. The ES approach complements the ERER and MB methodologies by focusing on the relationship between the sustainability of a country’s NFA position and its flow current account and real exchange rate. Specifically, the ES method determines the current account balance that stabilizes NFA (in percent of GDP) at a benchmark value, which is then compared with the underlying current account. The benchmark value is determined by the most recently recorded NFA level (here end-2006). At end-2006, the NFA-stabilizing current account was estimated at minus 0.1 percent of GDP. Similar to the MB approach, the magnitude of the required real exchange rate adjustment is then derived using the aforementioned trade elasticity.
11. The ES approach pins the real exchange rate undervaluation at 9.9 percent14, but may also overstate the extent of undervaluation. One concern with the ES method is the choice of the benchmark NFA value at the last period’s level. For Israel, NFA have been trending higher and this may very well be appropriate with respect to future needs stemming from population aging, which is set to accelerate after 2010.15 A higher benchmark value would lower the degree of undervaluation.
Net Foreign Assets
(Percent of GDP)
Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A001
Sources: Lane and Milesi-Ferretti (2006)Net Foreign Assets
(Percent of GDP)
Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A001
Sources: Lane and Milesi-Ferretti (2006)Net Foreign Assets
(Percent of GDP)
Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A001
Sources: Lane and Milesi-Ferretti (2006)Summary of Estimated Real Exchange Rate Undervaluation Measures
Average measure of CPI-based and ULC-based REER deviations from their five-year and twenty-year avergaes.
Summary of Estimated Real Exchange Rate Undervaluation Measures
| Percent | |
|---|---|
| Real Effective Exchange Rate—Deviation from Trend 1/ | 9.6 |
| Equilibrium Real Exchange Rate, CGER | 9.5 |
| Macroeconomic Balance, CGER | 6.1 |
| External Sustainability, CGER | 9.9 |
Average measure of CPI-based and ULC-based REER deviations from their five-year and twenty-year avergaes.
Summary of Estimated Real Exchange Rate Undervaluation Measures
| Percent | |
|---|---|
| Real Effective Exchange Rate—Deviation from Trend 1/ | 9.6 |
| Equilibrium Real Exchange Rate, CGER | 9.5 |
| Macroeconomic Balance, CGER | 6.1 |
| External Sustainability, CGER | 9.9 |
Average measure of CPI-based and ULC-based REER deviations from their five-year and twenty-year avergaes.
12. These different approaches to assessing the appropriateness of Israel’s real exchange rate generate a range of estimates that are broadly suggestive of modest undervaluation. While these estimates are subject to uncertainty, taken as a whole, they point to a real exchange rate undervaluation on the order of about 5–10 percent, with some downside risk.
D. Export Performance
13. Market penetration of Israel’s exports increased significantly during the 1990’s, but has been falling recently.16 Israel’s share of world exports of goods increased by about 40 percent in value terms between 1990 and 2000. However, since then the market share has been on a decline, notwithstanding the about 20 percent depreciation of Israel’s REER (by about 20 percent between 2001 and 2006). This suggests that competitiveness gains have not been apparent, but it may also reflect the recent global boom in commodity prices, particularly energy prices, to which Israel’s exports are hardly exposed.
Market Share of Israel’s Goods Exports
(Percent)
Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A001
Source: IMF, Direction of Trade StatisticsMarket Share of Israel’s Goods Exports
(Percent)
Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A001
Source: IMF, Direction of Trade StatisticsMarket Share of Israel’s Goods Exports
(Percent)
Citation: IMF Staff Country Reports 2008, 063; 10.5089/9781451819656.002.A001
Source: IMF, Direction of Trade Statistics14. A constant market share (CMS) analysis is applied here to help identify factors underlying Israel’s goods export growth over the past couple of decades and more recently. A CMS decomposes the change in Israel’s exports into four effects—world trade, commodity composition, market distribution, and a residual—and can be expressed by the following equation and summary table below:
where
and
Xijt= the value of Israeli export of commodity i to market j at time t,
r = the rate of growth of world exports,
ri= the rate of growth of world exports of commodity i,
rij= the rate of growth of world exports of commodity i in market j.
Israel: CMS Analysis of Changes in Exports
(Billions of U.S. dollars, unless otherwise indicated)
Israel: CMS Analysis of Changes in Exports
(Billions of U.S. dollars, unless otherwise indicated)
| 1988–2006 | 2001–06 | 2004–06 | ||
|---|---|---|---|---|
| Change in exports | 37.1 | 17.7 | 8.2 | |
| Average annual growth rate (percent) | 9.1 | 10.0 | 10.1 | |
| Due to: | ||||
| World trade effect | 51.5 | 25.0 | 9.9 | |
| Commodity composition effect | -7.5 | -0.5 | -0.7 | |
| Market distribution effect | -21.4 | -11.2 | -3.9 | |
| Residual | 14.4 | 4.4 | 2.9 | |
Israel: CMS Analysis of Changes in Exports
(Billions of U.S. dollars, unless otherwise indicated)
| 1988–2006 | 2001–06 | 2004–06 | ||
|---|---|---|---|---|
| Change in exports | 37.1 | 17.7 | 8.2 | |
| Average annual growth rate (percent) | 9.1 | 10.0 | 10.1 | |
| Due to: | ||||
| World trade effect | 51.5 | 25.0 | 9.9 | |
| Commodity composition effect | -7.5 | -0.5 | -0.7 | |
| Market distribution effect | -21.4 | -11.2 | -3.9 | |
| Residual | 14.4 | 4.4 | 2.9 | |
The world trade effect measures the impact of expanding global trade on Israel’s exports. As an open economy, globalization should have a large effect. Indeed, during 1988–2006, the expansion in world trade is estimated to have contributed some US$51 billion to Israel’s merchandise exports, significantly higher than the total US$37 billion gain in these exports.
The commodity composition effect measures the contribution to exports from individual commodities. A negative value indicates that Israel’s merchandise exports are concentrated in products with lower-than-average growth rates. Due to this effect, exports were reduced by about US$7.5 billion, or around 20 percent of the total value of exports gained since 1988. However, in recent years the effect of this measure has become negligible, suggesting that merchandise goods exports are now more concentrated in products with about average growth rates.
The market distribution effect reflects the contribution from export-partners’ demand. A large negative value early in the period indicates that Israel’s exports went to countries where demand growth was slower than the global average. More recently, the measure has become relatively more negative. This might reflect the large share of export market to advanced countries rather than to emerging markets, which have been growing more rapidly recently.
The residual is a catch-all for other factors, including changes in competitiveness, and these have generally boosted exports.
E. Conclusion
15. The methodologies used in this paper suggest that Israel’s real exchange rate is moderately undervalued, while gains in external competitiveness appear to have been eroded somewhat in recent years. In some ways, regarding exports of goods, the depreciation of the REER has been largely offset by commodity composition and market distribution effects. At a constant REER, the current account is projected to settle at around 2 ¼ percent of GDP surplus over the medium-run. CGER estimations and other measures suggest that the real exchange rate may be undervalued by about 5–10 percent However, uncertainty with respect to the three CGER measures, notably the current account balance estimate for 2012, suggests the misalignment may well be somewhat narrower.
References
Bank of Israel, 2006 “The Balance of Payments” Annual Report, Chapter 7.
De Broeck, Mark and Torsten Slok, 2001, “Interpreting Real Exchange Rate Movements in Transition Countries,” IMF Working Paper 01/56 (Washington: International Monetary Fund).
Drummond, Paulo, 2007, “Italic: How Large is the External Competitiveness Gap?” Italy—Selected Issues IMF Country Report 07/65 (Washington: International Monetary Fund).
Drummond, Paulo, 2006, “Portugal: How Large is the External Competitiveness Gap?” Portugal—Selected Issues Country Report 06/386 (Washington: International Monetary Fund).
Epstein, Natan, 2007, “Assessing Latvia’s External Competitiveness,” in Latvia—Selected Issues—Additional Topics, IMF Country Report 07/xx (Washington: International Monetary Fund).
Gagales, Anastassios, 2007, “Greece’s Competitiveness Deficit: How Big is it and How could it be Unwound?” Greece—Selected Issues IMF Country Report 07/27 (Washington: International Monetary Fund).
Gutierrez, Eva, 2006. “Export Performance and External Competitiveness in the Former Yugoslav Republic of Macedonia.” IMF Working Paper 06/261 (Washington: International Monetary Fund).
International Monetary Fund, 2006, “Methodology for CGER Exchange Rate Assessments” (http://www.imf.org/external/np/pp/eng/2006/110806.pdf)
Lane, Philip R., and Gian Maria Milesi-Ferretti, “The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities, 1970-2004,” IMF Working Paper,06/69
McGrew, Wes, 2007, “How to assess the Valuation of the Lira—Different Approaches,” in Turkey—Selected Issues—Additional Topics, IMF Country Report 07/48 (Washington: International Monetary Fund).
Prepared by Natan Epstein, with research assistance from Jonathan Manning.
Israel’s exchange rate is floating; the Bank of Israel last intervened in the foreign exchange market in 1997.
See Drummond (2006, 2007), Epstein (2007), Gagales (2007), Gutierrez (2006), and McGrew (2007) for similar approach taken in recent assessments of Portugal, Italy, Latvia, Greece, Macedonia, and Turkey, respectively.
The analysis in this paper is confined to developments after the 1985 economic stabilization program for reasons of relevance and ease of analysis.
See Chapter 7 of the BoI Annual Report for 2006.
For a detailed discussion of CGER methodologies, including estimated panel coefficients, see IMF (2006)
Estimated by a panel cointegration, with data for 48 countries over 1980–2004.
The precise misalignment is 9.3 percent, but with a multilateral consistency adjustment the misalignment rises to 9.5. For all three methodologies once exchange rate misalignments are calculated for all the countries in the panel, a final correction is made to ensure they are mutually consistent. This multilateral consistency is required by the fact that there can only be n–1 independent exchange rate misalignments among n currencies.
The underlying CA is defined as the projected 2012 CA and assumes (i) a constant real effective exchange rate over 2008-12; and (ii) closed output gaps for all countries.
Panel estimation with data for 54 countries over 1973–2004, using 4-year averages to remove cyclical effects.
This elasticity is computed as: (export elasticity) x (export/GDP) – (import elasticity -1) x (import/GDP). In Israel’s case, the elasticity of the current account to the real exchange rate was estimated at 0.26, using common export and import elacticities derived from panel estimations (-0.71 and 0.92, respectively), and Israel’s own export and import shares of GDP.
On a multilateral consistency basis.
In staff’s latest WEO projections, domestic-demand growth averages 3.6 percent in 2008–12. for further details, see Staff Report
On a multilateral consistency basis.
Although the link between future demographic trends and estimated current account norms is found not to be robust across countries
The analysis in this section pertains to goods exports. It ignores exports of services due to data limitations.
