2008 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Israel.

The staff report for the 2008 Article IV Consultation of Israel on economic developments and policies is examined. Fiscal and monetary credentials have been established in markets. Banks and their supervisory arrangements have been robust, and growth has been strong, sustained, and balanced. Although public debt is much reduced, to about 80 percent of GDP, it remains vulnerable. Although domestic securities prices tracked those abroad downward, prompting outflows from provident funds, flows in domestic credit markets remained largely undisturbed.


The staff report for the 2008 Article IV Consultation of Israel on economic developments and policies is examined. Fiscal and monetary credentials have been established in markets. Banks and their supervisory arrangements have been robust, and growth has been strong, sustained, and balanced. Although public debt is much reduced, to about 80 percent of GDP, it remains vulnerable. Although domestic securities prices tracked those abroad downward, prompting outflows from provident funds, flows in domestic credit markets remained largely undisturbed.

I. Summary and Appraisal

Israel was well situated when the global financial turmoil began in the fall of 2007

1. Fiscal and monetary credentials were established in markets; banks and their supervisory arrangement were robust; and growth was strong, sustained, and balanced. Though public debt is much reduced, to around 80 percent of GDP, it remains a vulnerability.

2. That set the stage for a relatively strong performance into the third quarter of 2008. As conditions deteriorated abroad, economic growth continued. And although domestic securities prices tracked those abroad downwards, prompting outflows from provident funds, flows in domestic credit markets remained largely undisturbed. In this context, capital inflows and the Shekel strengthened.

Since the fall of 2008, challenges facing policymakers have deepened profoundly

3. With the intensification of financial strains internationally, global demand, prospects, and securities markets slumped, and the Israeli real sector showed the first signs of strain. Declines in commodities prices, inflationary pressures, policy interest rates and the Shekel provided some respite. With elections due in February, the 2009 budget will not be adopted until well into the new year.

4. There is little sign that global difficulties will ease soon. Recessions in the U.S. and Euro areas are anticipated through the first half of 2009, but their length and depth is highly uncertain

5. With Israeli investment and exports weak, the staff central scenario anticipates a decline in economic growth to ½ percent in 2009, with average inflation around 1½ percent. A modest recovery is projected for 2010. However, financial sector vulnerabilities abroad imply that risks are firmly to the downside, notwithstanding strong profiles for external amortization and short term external debt.

Despite the global origins of present challenges, strong domestic policy can help

6. Policy needs to be well coordinated, with steps to strengthen long-run credibility increasing scope for flexibility in addressing immediate exigencies. In summary, we recommend, in the central scenario context, key steps to support credit flows and stability, a flexible near term budget stance backed by enhanced commitments to public debt reduction in the medium-term, and further monetary relaxation. These recommendations are subject to review should significant downside risks materialize.

Progress—notably concerning stability and credit flows—has already begun

7. Policymakers’ immediate attention has rightly turned to the nexus of concerns regarding credit flows and financial stability.

8. The recently approved public-private fund to purchase corporate bonds is welcome. It should be established promptly and tasked primarily to support new credit flows for large solvent firms. Alongside, the initiative to streamline procedures to reorganize corporate bonds is welcome.

9. Given these steps to support credit flows, other financial sector initiatives should focus on further strengthening bulwarks against extreme strains on banks. This includes the proposed guarantee for bond issues by banks, which is an appropriately pre-emptive step to increase bank capital. Restrictions on dividend payments by participating banks would maximize its effect.

10. In addition, the technical review of legal provisions concerning troubled banks is welcome. The mandated rapid publication of lender-of-last-resort actions for publicly traded companies should also be reviewed to ensure that this policy instrument is fully effective in a crisis context.

11. The package of initiatives outlined above constitutes a first step. If downside risks materialize, abroad or domestically, more may be needed.

On the fiscal side, flexibility is required

12. There is a clear case to allow automatic stabilizers to operate fully given the degree of fiscal credibility. But the likely relatively moderate extent of the economic slowdown in 2009 and the still high debt ratio counsels against going much further than that.

13. Accordingly, the structural fiscal balance in 2009 should be unchanged from 2008, excluding the financial sector support initiatives described above and any already-committed investment and infrastructure projects which are brought forward. This stance leaves essential “fiscal firepower” in reserve should downside risks materialize, and it underscores commitment to fiscal sustainability. All these desiderata are implicit in the deficit outturns likely to emerge from implementation of the draft 2009 budget, which is therefore appropriate.

But flexibility requires enhanced credibility

14. The draft 2009 budget, the policy initiatives described above, and the fiscal outlook for 2010 could imply headline budget deficits for consolidated general government well in excess of 4 percent of GDP in 2009 and 2010. These are large numbers and public debt ratios will rise. This underscores need to reinforce confidence in long run fiscal sustainability. Adjustments to the framework of fiscal rules will help to address these concerns.

Credibility might best be secured through adjustments to the fiscal rules

15. The one-year ceiling on the deficit of 1 percent of GDP needs to adjust to allow the operation of automatic stabilizers in 2009. Building on recent proposals from the Ministry of Finance, one alternative could be to replace it with a formal commitment to reduce public debt to well below 60 percent of GDP during the middle years of the next decade. This objective would be backed by new budget procedures laying out annually and in detail how and when the ultimate debt objective would be realized.

16. This flexible framework would also allow an effective fiscal response in the event that significant output downside risks materialize immediately during 2009, which a monetary response cannot fully address.

17. And the other fiscal rule—the annual cap of 1.7 percent on real spending growth—may also need to be amended. Instead, adoption of caps for three years ahead on annual nominal spending, excluding emergency outlays, has merit. This framework would be highly transparent, would improve the operation of fiscal stabilizers, and would buttress monetary responses to inflation surprises.

In this context, monetary policy can take the lead

18. On the monetary side, the advantages of the inflation targeting and flexible exchange rate frameworks are now more apparent than ever. Furthermore, the credit-supporting and financial stability initiatives outlined above will help to maintain the effectiveness of the domestic monetary transmission mechanism, while the suggested fiscal policy and framework steps reduce need for the Bank of Israel (BoI) to weigh upside risks as it pursues the inflation target. Both will allow monetary policy to play its maximum role in addressing external weakness and uncertainties.

19. Even after the most recent monetary easing, inflation is still set to fall below the target range for much of 2009 with indicators of inflation expectations remaining very subdued. If the outlook for output continues to deteriorate, with policies as outlined above, scope therefore remains for further reductions in policy rates.

Strong reserves and planned adjustments in the BoI law will boost credibility further

20. Increased international reserves—now over 100 percent of short-term debt—have attenuated external vulnerabilities. Purchase modalities under the program appropriately avoided any discretionary intervention.

21. Preparations for a new BoI law are welcome. In particular, provision in the draft law for establishment of a monetary policy committee of well qualified experts to determine the policy rate is appropriate.

Nonetheless, the outlook remains uncertain

22. Even with policies thus calibrated to address the coming slowdown and downside risks, prospects are challenging. While much has been done, planning for contingencies needs to proceed further and urgently.

23. Israel should remain on the standard 12–month consultation cycle.

II. The Context—2004–081

Israel has enjoyed sustained balanced growth (Figure 1)

24. Real GDP growth rebounded strongly from the 2001–03 slump, averaging over 5 percent since then (Table 1, Figure 1). Export of goods and services supported employment and incomes, spurring private consumption and investment (Figures 2 & 3). Despite the deteriorating merchandise trade balance, strong transfers kept the current account in surplus. Inflation has been subdued and inflation expectations were well-anchored by the Inflation Targeting (IT) regime. These assessments are shared by the authorities (¶68).

Figure 1.
Figure 1.

Israel: The Long View, 1996−2008 1/

(Percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2009, 057; 10.5089/9781451819663.002.A001

Sources: IMF, World Economic Outlook; and IMF, Information Notice System.1/ Projections for 2008.2/ From 1999 onward, international definition, accrual basis.3/ Data for 2008 as of June.
Table 1.

Israel: Selected Economic and Social Indicators, 2001−08

(Percent change, unless otherwise indicated)

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Sources: Bank of Israel, Annual Report; Central Bureau of Statistics; IMF, World Economic Outlook; World Bank, World Development Indicators; and IMF staff estimates and projections.

IMF staff estimates and projections.

Data for 2008 as of October.

Data for 2008 as of September.

Data for 2008 as of November.

Data for 2008 as of October.

Poverty rate from National Insurance Institute of Israel.

Figure 2.
Figure 2.

Israel: External Indicators, 2001−08

Citation: IMF Staff Country Reports 2009, 057; 10.5089/9781451819663.002.A001

Sources: Central Bureau of Statistics; Bank of Israel; and IMF staff projections.1/ Inclusive of goods and services; data for 2008 as of April.2/ Projection for 2008.3/ A decrease represents depreciation. Data for 2008 as of October.
Figure 3.
Figure 3.

Israel: Recent Economic Indicators, 2001−08

(Percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2009, 057; 10.5089/9781451819663.002.A001

Sources: Central Bureau of Statistics; Bank of Israel; IMF, World Economic Outlook; and IMF staff calculations.1/ Seasonally adjusted; data for 2008 as of July.2/ Data for 2008 as of September.

This has reflected and supported strong fiscal and financial sector policies

25. In this context, public debt was lowered from 100 percent of GDP in 2003. This was secured by adoption and adherence to fiscal rules—a cap of 1.7 percent on annual real expenditure growth (excluding emergency security-related items) and deficit ceilings for central government. The general government structural primary balance strengthened steadily from 1½ percent of GDP in 2004 to 2¼ percent in 2007, and public debt fell to just under 80 percent of GDP in 2007.

26. Far reaching financial sector reforms proceeded alongside (Table 2, Attachment I). These have significantly diversified financial markets, reflected in a switch from bank towards nonbank credit—including corporate bond issuance—to the business sector.

Table 2.

Israel: Financial Soundness Indicators, 2001−08 1/


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Source: Bank of Israel.

Problem loans include non-performing loans, rescheduled loans, loans designated for rescheduling, loans in temporary arrears and loans under special supervision.

External vulnerabilities are contained, and competitiveness remains firm

27. Strong policies have supported resilience and competitiveness (Box 1). Accordingly, despite gross external debt of some 43 percent of GDP, the net International Investment Position (IIP) has also strengthened further, with overall liabilities only modestly exceeding assets currently, and gross debt liabilities less than gross debt assets in the short-term and overall. Alongside, although indicators are mixed, competitiveness appears comfortable. The recent Shekel appreciation provided an opportunity, in the authorities’ view, to implement a program of reserve accumulation to attenuate external vulnerability further (¶75).

Competitiveness and the Equilibrium Real Exchange Rate

After a six year period of weakness, the Shekel appreciated about 20 percent in real terms in 2007, returning to its long-term average (See Figure 4). The trend current account balance was the mirror image of this pattern—relatively strong in the period of six year shekel weakness, and deteriorating more recently (though remaining positive through the third quarter of 2008).

On balance, the Shekel appears to be around its equilibrium, in light of various indicators. Abstracting from the temporary boost from the bubble to Israel’s high tech exports and hence its overall export market share, penetration of global markets has remained broadly stable, Export growth remained firm until late 2008 when the weakening of the global economy began to be felt. Also, (i) some of the weakening in the merchandise trade balance reflects strong—and likely sustainable—income and net transfers from abroad (even if both weaken in the immediate period ahead); (ii) there are few signs of loss of labor competitiveness, either from relative unit labor cost measures or unemployment; (iii) and trade in services is still in surplus. These assessments are supported by the CGER estimates.

Figure 4.
Figure 4.

Indicators of Competitiveness

Citation: IMF Staff Country Reports 2009, 057; 10.5089/9781451819663.002.A001

Sources: Bank of Israel; Direction of Trade Statistics; Haver Analytics; IMF, Information Notice System; and IMF staff calculations.

28. Strong macroeconomic developments reflect policies consistent with past staff recommendations (Box 2).

Implementation of IMF Recommendations

Fiscal policy and framework. As recommended, a sustained program of fiscal consolidation and debt reduction has been implemented, secured in part by adoption and adherence to a home-grown medium-term fiscal deficit target framework. Recommendations to strengthen fiscal transparency and governance remain outstanding.

Monetary policy: In the context of a strong inflation targeting framework, the BoI has enhanced its communications with the markets, including through regular publication of fan-chart projections.

Financial sector: Given ambitious financial sector reforms, the authorities have been fostering their capacity to supervise the increasingly complex domestic financial firms and markets.

In 2008, however, external shocks brought new challenges

29. Soaring global food and fuel prices first raised inflation concerns. Thereafter, as global financial turmoil deepened, output prospects weakened even as global commodity prices fell back. In this context, S&P downgraded its rating for Israeli sovereign foreign currency credit one notch to stable in late October 2008.

Monetary policy adjusted swiftly

30. Under the IT regime, monetary policy adjusted nimbly to this shifting environment (Figure 5). When external price shocks—compounded by diminishing economic slack—pushed headline inflation substantially above target, policy rates were raised gradually by 75 bps in the five months to February 2008 to 4¼ percent. With inflation expectations apparently anchored, rates were then lowered in light of global and domestic output concerns, albeit with a temporary reversal in this trend when high CPI outturns from April suggested residual inflationary challenges. But as the global financial crisis deepened later in the year, interest rates have been reduced appropriately since 2008 September, in six steps to 1 percent (¶70). Indicators of medium-term inflation expectations slumped, albeit rising modestly in recent weeks. Inflation nevertheless remained above target at end–2008.

Figure 5.
Figure 5.

Israel: Selected Monetary and Financial Indicators, 2006–08

Citation: IMF Staff Country Reports 2009, 057; 10.5089/9781451819663.002.A001

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

And overt banking sector strains have been relatively few

31. Banking vulnerabilities appeared to have been contained, so far. Bank losses due to ABS exposures were minimized as they were sold early in 2008, leaving marginal remaining exposures.2 Banks remain profitable, largely deposit-funded, and strongly capitalized (significantly above the legally required ratio of 9 percent), despite some exposure to failed international institutions (See Text table and Table 2). There is little sign of stress in money markets, notwithstanding sharp falls in banks’ share prices and the associated distance-to-default measures—mirroring similar falls for other domestic and global financial firms (Figure 5). The only sign of a change is the increase in non performing loans (Box 3).

Summary of Banks Balance Sheet

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Source: Bank of Israel.

Why was Israel’s financial sector not more affected by the global financial crisis?

Although Israel is highly integrated in the global economy with free capital mobility and extensive international trade and financial flows, financial markets held up relatively well compared with other small open economies (Figure 6). The shekel has strengthened until recently despite foreign exchange purchases by the BoI, and has been less volatile than many other currencies. Although the drop in equity prices was similar to other markets, the volatility has been smaller. Furthermore, bank share price falls have been in line with non-bank declines, a much better performance than elsewhere. The drop in corporate bonds has been similar to the global drop in corporate bonds with similar volatility. Finally, while global money markets came under severe stress, the overnight inter bank market in Israel has continued to operate calmly, albeit that it comprises only inter bank overnight lending.

Figure 6.
Figure 6.

Indicators of Financial Market Stress

Citation: IMF Staff Country Reports 2009, 057; 10.5089/9781451819663.002.A001

Source: Bank of Israel, Bloomberg.1/ Israel: Tel Aviv Banks / Tel Aviv 100US: S&P Financials / S&P 500UK: FTSE 300 Financials / FTSE 100Sweden: OMX Nordic Banks / OMX Stockholm 30France: ENEXT CAC Financials / CAC 40

The relative strength of the financial sector is a result of conservative banking practices, transparency, and the longstanding implicit government guarantees that anchored confidence. Until the reforms of the last few years, banks benefited from strong market power, which provided little incentive to develop sophisticated financial instruments and move away from relatively conservative practices (See attachment I). The recent reforms increased competition and banks started to explore new markets abroad as well as new lines of businesses. However, for lack of time since reform was initiated, when the global crisis commenced, Israeli banks’ exposures remained limited.

In addition, transparency has been high. The small and intimate size of the banking system, and the enhanced regulations that required more detailed reporting helped maintain confidence in the integrity of available information. This was boosted further by enhanced transparency rules adopted over the past year.

Finally, confidence in the ability of banks to meet their obligations was enhanced by the implicit government guarantee to support the banks and guarantee deposits. Indeed, the Minister of Finance issued a statement supporting this presumption, and the government has a track record of intervening to save banks and guaranteeing deposits.

Yet, stability may have come at a price. While the implicit government guarantees may have successfully avoided overt stress, the implicit transfer of risk to the public sector may have been reflected in increased yields on government bonds.

Non bank financial institutions have suffered, however.

32. The value of provident funds declined by about 20 percent in 2008, while some mutual funds lost even more. More importantly, withdrawals from provident funds amounted to NIS 8 billion (or about 5 percent of their total assets) in 2008. The corporate bond market, which was the main source of new corporate credit in the previous year has de facto closed. Yields in the secondary market rose significantly and new bond issues have halted since September.

The overall banking sector resilience may have buoyed net capital inflows during 2008

33. The robustness of the banking sector and the supportive policies may also account for the strength of the currency during most of 2008. Israel has been something of a safe haven, with residents repatriating capital from more hostile global environments. In the context of the consequent upward pressure that the BoI in late March announced its intention to increase foreign exchange reserves by $10 billion during a two year period, taking reserves to between $35–40 billion. In July, the announced pace of accumulation was raised, reflecting the absorptive capacity of the market, and in November the target range was raised to $40–44 billion. By end–December the reserves had reached $41½ billion.

Signs of strains in the real sector and the budget have emerged, however

34. Since September, global financial conditions have deteriorated further. The unfavorable asset market and export developments have impaired private consumption and investment, with merchandise imports also reflecting the strong shekel. Activity thus cooled significantly in the second half of 2008, with consumer and business confidence weakening along with global prospects. This is expected to bring the overall 2008 growth to 4¼ percent.

35. In this context, notwithstanding an over performance in the first half of 2008 and tight expenditure control by the authorities, significant revenue shortfalls in recent months are expected to bring the full-year budget deficit for central government to 2 percent of GDP (Table 6), with the structural primary balance weakening to ¾ percent of GDP. Public debt stands at little below 80 percent of GDP at end-2008.

Table 3.

Israel: Balance of Payments, 2005−13

(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, 2001−08

(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

Table 5.

Israel: Medium-Term Scenarios, 2008−13

(Percent, unless indicated otherwise)

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Source: IMF staff estimates and projections.

For the purpose of its budget deficit targets, the central government excludes net credit.

Assumes the government adheres to the 1.7 percent growth in real expenditure, excluding emergency security spending.

End of period.

Macro projections for 2009 are based on staff recommended fiscal policy.

Table 6.

Israel: Central Government Accounts, 2003−09

(Percent of GDP)

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

Based on staff projection of 2008 GDP.

Set in 2006. of GDP to expenditures in 2006-08, respectively.

In percent. For 2008, staff projection. For 2009 “Draft budget” column, MoF growth assumption behind the draft budget.

And political and geopolitical uncertainties have recently mounted

36. General elections are now scheduled for early February 2009 after negotiations to reconstitute the coalition government broke down. With adoption of the 2009 budget therefore delayed until at least the Spring, spending will be capped each month until adoption of the full budget at 1/12 of the 2008 budgeted levels. Further, if the conflict in Gaza resumes, that would pose risks to real activity and public spending, though the economic and fiscal implications have been modest, so far.

III. Near Term Outlook and Risks

External factors continue to weigh on near term prospects

37. As the authorities envisage, assuming that the Gaza conflict does not resume, the outlook is likely to be dominated by the ongoing consequences of sustained global financial turmoil, with corresponding weakness in commodity prices only a partial offset (¶69). Growth in the imports of Israel’s trading partners, averaging 7 percent annually in recent years, is projected at -1½ percent in 2009. Activity is anticipated to recover only in 2010.

Spillovers from the U.S. seem particularly pronounced

38. Staff work indicates strong spillovers from the U.S. to Israel (see Attachment II). Possibly reflecting close trade linkages—including through exports of intermediate inputs through third countries—a 1 percentage point increase in the U.S. quarterly economic growth is statistically associated with as much as ½ percentage point rise in Israel’s GDP over two quarters. On the other hand, neither global stock markets nor oil prices appear to be major determinants of Israeli activity.

So Israeli output trends are set to follow those in the U.S. closely

39. In this light, domestic demand is projected to weaken further in 2009 reflecting the global slowdown, the impact on net trade of past shekel appreciation, and tight credit conditions. Activity weakness is cushioned however by past monetary easing and fiscal automatic stabilizers. Thus, in broad accord with the authorities, staff project growth to slow to ½ percent in 2009, before gradually regaining momentum in 2010 as the external environment turns (¶69) Declining commodity prices and slowing activity should rapidly bring inflation—now at 4½ percent—back to the 2 percent range by mid-2009.


Real Quarterly GDP Growth 2003 – 2010

Citation: IMF Staff Country Reports 2009, 057; 10.5089/9781451819663.002.A001

Various downside risks are associated with this outlook

  • Global risks are to the downside of the WEO central forecast, and the Gaza conflict could resume.

  • Israeli government debt is high, at some 80 percent of GDP and is associated with needs to finance significant roll-overs and current fiscal positions.

  • If major defaults in the domestic corporate bond market occur, this could compound constraints on access by healthy corporations to refinancing.

  • Though direct bank exposure to ABS is limited, economic slowdown could impair credit quality and prices of securities held by banks could continue to fall. Thus, although banks’ total risk-adjusted capital-asset ratio is relatively high at 11 ½ percent, raw equity is some 6 percent of assets and both major banks issued profits warnings for the latter part of 2008.

  • Furthermore, risk of disorderly withdrawals from nonbank financial institutions remains, and insurance companies have suffered losses on their assets as financial markets have fallen.

  • As elsewhere, tail risks, including in the financial sector, may materialize with little warning.

But these are mitigated by various factors

  • On the external side, banks’ short-term external debt is more than matched by deposits abroad; private sector short-term assets are more than twice the size of short-term debt; and only a small portion of public external debt matures within one year.

  • External public debt rollover needs are modest. US$3.4 billion (NIS 12 billion) of the total US$30 billion in external debt was due in one year from end-September, 2008.

  • Public financing for the next several months has largely been secured.

  • Almost half of all external public debt is guaranteed by the U.S. government. In 2003, the United States approved a new loan guarantee program for up to US$9 billion, subject to certain understandings and deductions. That program has been extended until 2011. Another third of the external debt is comprised of State of Israel Bonds, where the Diaspora constitute the major and hitherto stable source of demand.

  • The economy has shown a capacity for rapid adjustment, as in its resilience during the 2006 war and its sharp rebound from dotcom bubble, and as reflected in the rapid response of inflation expectations and monetary policy to global developments since October 2008.

  • Several stimulating policy measures—including advancing infrastructure investment, extending credits to small enterprises, establishing public-private corporate bond funds, and guaranteeing new capital raised by banks—have been approved (see Attachment I).

  • The economy was cyclically strongly placed to face these challenges.

  • Though banks’ expansion into new domestic and global markets—the fruit of earlier financial sector reform—has had, as yet, uncertain effects on their credit risk exposures, the fact that this expansion has been only recent may, fortuitously, have limited their direct exposure to the ongoing global turmoil.

IV. Implications for Policies and Policy Frameworks: 2009–10

40. The economy has proven comparatively resilient so far, even in the face of heightened global financial sector turmoil since September 2008. But a growth slowdown is underway and, following global trends, is set to continue through 2009 even if domestic banking sector stability continues. And continued economic stability is not certain, not least with external risks firmly to the downside.

41. In that context, the immediate priority is to ensure that the financial stability framework is ready to address downside tail risks should those materialize. Alongside, the medium-term focus of fiscal policy should strengthen so as to continue steady reduction in debt and the associated vulnerability. But this should not impede operation of automatic stabilizers during the downturn. In this fiscal context, with the monetary transmission mechanism relatively undisturbed by recent global financial turmoil and inflation pressures diminished, monetary rather than fiscal policy should remain the instrument of first recourse to support activity, with the interest rate remaining the primary instrument used to achieve that goal. This stance would leave fiscal resources available to cope with possible materializations of downside risks.

A. Financial Sector Policy and Framework

Downside tail risks should constitute the immediate focus for policy

42. Frameworks for crisis preparedness are needed for the support and resolution of both banks and non-banks. These should address liquidity and capital adequacy issues, and corresponding public interventions. As the authorities agreed, although the legal framework is in general adequate to address banking crisis and has worked formerly when banks failed, some aspects might need to be further reviewed. These include the framework for dealing with failures of large banks and non bank institution, notably the legal recourse for affected shareholders, and the mandated transparency of use of lender-of-last-resort facilities by publicly traded companies (see Box 4) (¶72).

Is Israel Ready to Address Financial Instability, if it occurs?

1. Market liquidity, and ELA facilities. The Governor appropriately enjoys wide discretion to determine the instruments, pricing, and collateral arrangements for emergency liquidity operations to support individual banks and the banking system. Thus, any shortfalls can be rapidly addressed. Nonetheless, a particular concern warranting review is the mandate under stock exchange listing requirements for financial firms to rapidly announce any LOLR facilities they receive.

2. Bank resolution framework. The banking ordinance gives the Governor the power to takeover a bank. In particular, if the Governor, after consultation with the Supervisor, is of the opinion that a particular banking corporation is unable to meet its obligations, he may with the approval of the Government, appoint, without delay, an administrator to manage the banking corporation. It will be key to ensure legal capacity to complete such operations speedily, should they become necessary. In this regard, it will be important to strengthen provision for preemptive bank resolution by the regulator, notably via restriction of legal recourse for affected stakeholders to financial compensation only.

3. Coordination amongst the authorities. Given the more complex financial system that has emerged due to recent reforms and the need for close cooperation between supervisors, the central bank, and the Government, strong technical capacity to manage and resolve financial stress is needed. A recent Memorandum of Understanding among the supervisors, as well as exercises that test responses to crisis scenarios are welcome.

4. Non-banks. Readiness to handle weakness in a large non-bank financial institution is unclear. While forms of appropriate support will vary from case to case, early consideration of options and risks that may arise is needed.

43. The corporate bond market has been under strain. Accordingly, the authorities have temporarily suspended mark-to-market rules for institutional investors, up to a maximum of 3 percent of their assets and only if the institutions commit to holding the bonds to maturity. This has brought a measure of relief to the corporate bond market, while retaining the principle of transparency for the bulk of institutions’ accounts. And the Israeli security authority has proposed a detailed and flexible blueprint for procedures to reorganize corporate bonds.

44. Furthermore, the authorities have approved the establishment of a NIS 10–20 billion fund to purchase corporate bonds (see Attachment I). NIS 5 billion of this will come from public sources which bear most of the risk. While the authorities preferred to consider the options for the specific objectives of this fund further, staff suggest that the prime functions of the fund would be to refinance bond installments as they fall due and to support new bond issues, because these directly support credit to firms (¶71). In this light, purchases by the fund on the secondary market would generally be avoided as these will not provide new credit, and they risk implicitly transferring accrued institutional investor or corporate losses to the budget. While plans should be prepared to address priorities in the corporate bond market other than credit flows, the tasks for this fund should not be extended lest its effectiveness and accountability is diluted. Given these terms of reference, the anticipated size of the fund is sufficient at least through 2009.

45. Against the backdrop of continuing initiatives to buttress supervision of all financial firms during 2008—enhancing capital, reporting, monitoring, transparency, and regulatory coordination—the steps above could help maintain orderly financial market conditions under conditions of duress.

Alongside, more deep-seated reforms should remain under review

46. The ongoing process of financial sector reform continues to require corresponding review of the supervisory regulations and structures. However, as noted by the authorities, given that the immediate priority is management of tail risks, implementation of organizational reforms which might cause a temporary loss of focus on tail risks should be avoided, even if those changes are aimed at better supervisory arrangements in the long run (¶72).

47. In particular, whatever the best long run allocation of bank and non-bank supervisory tasks between the Central Bank and other agencies, the immediate priority is to ensure that the flow of information from banks to the central bank remains uninterrupted.

48. Similarly, consideration of action to implement a deposit insurance scheme would best await the easing of global financial market tensions lest such action call into question the meaning of the authorities’ commitment to financial market stability. Eventual implementation of formal deposit insurance could provide an appropriate opportunity to exit from the current implicit deposit guarantee.3

B. Fiscal Policy and Framework

A strong medium-term budget framework would underpin fiscal credibility, and so facilitate accommodation of stabilizers in 2009

49. The ongoing progress towards debt reduction over the medium term needs to continue to reduce the associated vulnerability (See Figure 7 & Attachment III). Accordingly, staff have earlier suggested—and reiterate—that the government endorse the Minister of Finance’s proposal of an objective of debt of below 60 percent of GDP in the medium term. This goal reflects the EU ceiling as expressed in the Maastricht criteria. But it should be a minimum objective; Israel’s unique vulnerabilities—including those arising from geopolitical considerations—call for a more ambitious debt goal over the longer term than may be appropriate for EU countries.

Figure 7.
Figure 7.

Israel: Public Debt Sustainability: Bound Tests 1/

(Public debt in percent of GDP)

Citation: IMF Staff Country Reports 2009, 057; 10.5089/9781451819663.002.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 2009, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

50. But with a further growth slowdown in prospect, macroeconomic policies should provide appropriate support, while maintaining confidence.

51. Accordingly, adjustment of the fiscal framework needs to weigh two considerations.

  • On the one hand, there is need for a flexible framework given uncertainties about the economic outlook.

  • On the other hand, adjustment of the strong rules and procedures that have delivered strong fiscal outcomes in recent years, raises risks that budget discipline may be lost.

The revenue and deficit estimates in the draft 2009 budget have been overtaken by events

52. The draft 2009 budget envisages full implementation of the programmed tax cuts of about ½ percent of GDP, and observes the pre-set deficit target of 1 percent of GDP by anticipating a marked reduction in expenditure growth (Text Table). On the authorities’ fiscal projections, the structural primary surplus implied by the draft budget is roughly 1 percent of GDP, representing a modest improvement from 2008, and public debt is expected to fall to 77 percent of GDP.

Israel: Budget and Macroeconomic Outlook

(Percent of GDP)

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

Excludes net credit.

Assumes adherence to the annual real expenditure growth ceiling of 1.7 percent, excluding emergency security-related spending.

Excludes proposed govt initiatives to support the financial sector and infrastructure investment brought forward.

In percent. For 2009 Budget, it is the growth assumption by the Ministry of Finance.

In percent, period average.

53. Four factors are of concern, however.

  • First, the draft budget’s growth and therefore revenue estimates may prove optimistic as real GDP growth appears unlikely to reach the assumed 3½ percent for 2009. If growth is closer to ½ percent, fiscal revenue would likely be much weaker than projected by the draft budget—especially since the size of automatic stabilizers tends to be larger during downturns. In such scenarios, either the operation of automatic stabilizers will have to be constrained, or the headline 1 percent deficit ceiling would be breached.

  • Second, the structural primary surplus implied by the 2009 draft budget falls short of the steady-state structural surplus of 3¾ percent of GDP needed to lower debt to 60 percent of GDP within the next decade. While this stance may be appropriate given the cycle, it also underscores need for a strong medium-term framework to deliver the necessary primary balances to realize the debt objective.

  • Third, the technical estimation of the structural primary surplus should reflect a cautious assessment of the automatic stabilizers. In particular, past buoyancy in fiscal revenue in part reflected the excesses in the global financial markets before the outbreak of the current crisis. In that light, future tax collection ratios may be unlikely to return to the levels seen in recent years, even after the global crisis passes.

  • Fourth, ongoing political and geopolitical uncertainties are inevitably reflected in risks to budget prospects.

Accordingly the 2009 budget deficit target should be modified and the medium-term framework strengthened

54. In this context, as agreed with the authorities, the cap on the headline budget deficit ceiling for 2009 should be adjusted to accommodate full operations of automatic stabilizers (¶73). It should also accommodate, without offsets, the fiscal and financial-sector initiatives recently approved by parliament, and any already-planned investments which are brought forward investments as these leave the NPV of anticipated government spending over the medium-term unchanged. Implementation of the expenditure estimates in the planned 2009 budget would be consistent with these recommendations (see Text Table). Nevertheless, the headline deficit outturns will be large relative to the recent past, underscoring need to sustain confidence by elaborating a formal framework to deliver ambitious medium-term debt objectives.

Key characteristics of the current fiscal framework should be retained

55. The current targets, established in 2006, cap real expenditure growth at 1.7 percent beginning in 2007 and set ceilings on the headline deficit. Excluding emergency security spending, they have been adhered to, so far. The key elements of this framework that would best be retained include simplicity, robustness, and compliance.

A new framework could formally be anchored by debt reduction, with scope for appropriate fiscal flexibility

56. The authorities share the view that reforms to the current fiscal framework are needed. They recognize—and staff agree—that any new framework should reflect six principles:

  • Fiscal policy in Israel should be guided by rules

  • Those rules should have a medium-term focus, targeting debt reduction

  • Automatic stabilizers should be allowed to operate unimpeded

  • The key instrument to deliver the debt objective is expenditure caps

  • Spending caps should exclude emergency allocations for security.

  • In this context, the deficit target of 1 percent of GDP for 2009 should be relaxed

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57. In this light, the authorities have proposed a new framework that entails elements of an “error correction” mechanism. The proposed framework would automatically constrain (loosen) real expenditure should debt rise above (drop below) the envisaged adjustment path due to breaches.4 The explicit link between spending and debt is a clear advantage in the system.

58. There may be scope to increase the flexibility of the framework in three dimensions, however. First, establishment of a range of dates—e.g., the middle years of the next decade—rather than a single year for the debt target may improve the flexibility of policy in the face of a highly uncertain global outlook. Second, adoption of caps on spending in nominal rather than real terms may better accommodate automatic stabilizers—with cumulative errors in inflation projections corrected only after three years, rather than all inflation errors corrected after one year. This more extended correction mechanism would also help monetary policy to reduce inflation volatility. Third, rather than an automatic error correction mechanism tied to debt, a less formal link has merit to accommodate output surprises. It could be based on adoption of new budget procedures mandating publication of full medium-term budget projections as part of each budget, showing exactly how and when, and in accord with the predetermined caps on nominal spending, the debt objective was expected to be met. These projections would take into account, each year, new information on output prospects, allowing annual policy on fiscal deficits to respond flexibly to developments, while maintaining the credibility of the medium-term anchor. In the context of agreement with staff on the six principles outlined above, the authorities were inclined to a less flexible framework, notwithstanding global uncertainties (¶74).

C. Monetary Policy and Framework

Inflationary pressures have abruptly eased

59. Given global and domestic developments, inflationary pressures have eased markedly since the fall of 2008 and remain contained, even after the late January policy rate cut. Monthly inflation peaked in August with core inflation measures continuing subdued.

And an undershoot of the 2009 inflation target is now anticipated

60. Markets still anticipate a further modest reduction in the policy rate—some 25bp in coming months—and, associated with that, evidence from surveys and financial market instruments suggests that the inflation target will be undershot by end–2009. Given the expected policy rate, the recommended fiscal stance, and WEO projections for commodity prices and Israeli output in 2009 and beyond, such an undershoot indeed still appears likely.

On balance, the bank rate could be lowered further

61. In these circumstances, and in the context of the staff recommended fiscal policy, both for 2009 and beyond, several considerations should guide whether, and to what extent, the policy rate should be lowered further.

  • Even if indicators of inflation expectations understate likely outturns, falling commodity prices and activity, long-contained nominal wage behavior, and recent sharp reductions in international central bank interest rates underscore that the domestic and global inflationary concerns even of a few months ago have substantially dissipated.

  • In balancing risks, a case to err on the side of caution is not persuasive. Indicators of inflation expectations for 2009 and beyond are now below target, with liquidity-premia distortions to such indicators likely minimal (given similar liquidity for indexed and non-indexed Israel government bonds). With inflation expectations so low, output concerns remain considerable even with fiscal stabilizers operating (as recommended) and domestic financial sector strains continuing to be limited.

62. On balance, therefore, further early policy relaxation seems appropriate (¶76). Concerns not to surprise markets with large steps may be attenuated with prior guidance and by the increased market familiarity with large steps globally. And as policy rates approach zero, options for quantitive easing should be considered in case that is needed.

The IT framework serves well, and appropriate strengthening is anticipated

63. As the authorities noted, although inflation has frequently been outside the 1–3 percent target range, inflation, inflation expectations, and nominal wages remain contained, and indexation has declined (¶75).

64. In this broad context, the proposed new draft BoI Law appears appropriate. The proposal to increase the BoI independence, establish a committee with power to set monetary policy, and a separate management committee to manage the bank’s administration. However, provisions for BoI capital, staff remuneration, and legal protections for staff may need to be strengthened.

Foreign exchange intervention should play at most a limited role in the framework

65. As the authorities agreed, sizeable foreign currency reserves can provide a useful signal of resilience to markets (¶75). Accordingly, a level equal to short-term debt has merit. This ratio was realized by end-December as the reserves reached the target range of $40–44 billion. Such a target should, however, also be set in light of the associated sterilization costs (estimated at less than 0.1 percent of GDP so far).

66. However, the bank rate should remain clearly the central instrument in the inflation targeting regime. This requires, first, preannouncement of the schedule of purchases and the targets for foreign exchange purchases, as reflected in the authorities’ actions in 2008. Once the announced target has been reached, there may be a case to maintain the ratio relative to short term debt. If so, this objective and the schedule of purchases to realize it over time, should be preannounced. Second, maintenance of the pre-eminence of the bank rate also requires restriction of discretionary intervention to combat disorderly conditions. And if flows persist in either direction, the policy response should focus on the bank rate (¶75).

V. The Authorities’ Views5

67. There was broad agreement with staff that the recent intensification of global financial stresses required policy responses in various areas, with many still yet to be finalized. There was common ground on diagnosis and broad principles for the policy response, with fiscal rules a particular focus of debate with staff.

68. Sustained strong policies meant that Israel had been well prepared on the eve of global financial turmoil, with public debt falling, low inflation and stable monetary conditions, conservative and healthy banks, and a significantly improved international investment position.

The immediate outlook has weakened

69. Given global conditions, however, the near-term macroeconomic outlook was challenging, including significant downside risks. The BoI’s latest growth forecast for 2009—at -0.2 percent—is a little below that of staff, but the BoI and staff were in close agreement on the pace of recovery in 2010. And while the Ministry of Finance concurred broadly that real activity in 2009 would slow sharply, it had not updated its macroeconomic framework since submission of the draft 2009 budget. The macro assumptions underlying that draft would be substantially marked down (¶37).

70. Given the deteriorating outlook and associated declines in inflationary pressure, the first response to intensified turmoil had been significant reductions in the Bank of Israel rate. Thereafter, focus had turned to concerns with stabilization of the corporate bond market, securing continued credit supply, and fiscal support for activity (¶30 &41).

Financial sector stabilization policy has been strengthened

71. With the terms of reference for the proposed private investment fund with public capital for the corporate bond market still in development, its purpose was broadly to support liquidity, credit to solvent corporates whose main activity is in Israel and which face difficulties in recycling their credit, and restoration of confidence in the market. Potential conflicts of interest should be addressed and secondary market purchases may be warranted on some occasions, for example as part of broader debt workouts. The relative importance of raising capital ratios versus increased credit supply as the objective for the guarantee for bond issues by banks was similarly under consideration. But pre-emptive action was warranted in either case (¶44).

72. Extensive arrangements have been made to strengthen information-sharing and coordination amongst the regulatory authorities in the context of stresses in financial markets since the fall of 2007. In that context, the review of readiness for contingencies undertaken by the mission was welcome, and legal provisions guiding the resolution of troubled banks and transparency of lender-of-last-resort would both be considered further. And hitherto lively domestic debate on the appropriate organizational structures of financial regulation had been largely suspended while policymakers and regulators’ focus remained on the immediate challenges in markets (¶45–48).

Fiscal policy needs to be more flexible

73. Turning to budget matters, the authorities agreed that the essential issue was how to accommodate greater flexibility in the context of a downturn without losing momentum in debt reduction and fiscal sustainability. In striking this balance, they concurred with staff that to accommodate fiscal stabilizers, the 2009 deficit should exceed its ceiling under the prevailing fiscal rules. And they agreed that some framework of firm fiscal rules was needed nevertheless. While revenue would be lower than the estimates in the draft 2009 budget, the Ministry envisaged that total nominal spending in 2009 would conform to the draft budget ceilings. In this way, fiscal discipline would be maintained in 2009 and in the medium-term (¶52–54).

74. The Ministry of Finance’s preferred approach to reform of the fiscal rules was to target public debt below 60 percent of GDP by 2015, underpinned by a ceiling on real expenditure growth, adjusted downwards if debt overshoots its path towards the 2015 goal. This framework constrains automatic stabilizers but aids the credibility of the medium-term goal. And, in contrast to a ceiling on nominal spending, it implied lower volatility in annual real spending. Finally, a framework with caps on nominal spending might be susceptible to pressures to raise the ceilings should the inflation outturn be higher than expected (¶58).

Monetary policy options would remain under review

75. On the monetary side, the IT framework remained appropriate and the accumulation of reserves had been prudent according to a variety of metrics, and had been secured without disturbance to the market. Further reserve accumulation seemed warranted by the continuing buoyant market conditions, reflected in the strength of the Shekel, and by a desire to build up resilience to further shocks. Going forward, proactive financial sector and prudent fiscal policies would support monetary policies (¶27, 65 & 66).

76. Sizeable interest rate cuts had been necessary to avoid undershooting the 2009 target and strengthen the economy’s ability to cope with the effects of the global economic crisis. While indicators remained mixed, the case for further rate reductions would remain under review. However, reductions would have to be consistent with maintenance of market confidence (¶61–62).

Attachment I. Financial Sector Reform: Diversification and Credit Crunch1

1. The Israeli financial system has undergone a comprehensive transformation over the past few years. Reforms were significantly accelerated in 2005 with the introduction of various legislative measures and changes in regulatory coverage and taxation.2 Though these steps were contraversial and some mid course corrections were necessary, they led to a rapid diversification of the financial sector towards non-bank financial institutions and expanded the choice of financial products and providers. In the process, new challenges have emerged for managing risks.

2. The key pillar of the financial sector reform was the Bachar Legislation. Implemented in July 2005, the legislation’s main objective was to enhance the development of capital markets by

  • Increasing competition and reducing concentration of financial institutions: This was achieved mainly through decentralization of the financial system whereby banks were required to sell their holdings of mutual funds and provident funds.

  • Reducing conflicts of interest in the capital market: The Bachar legislation also stipulated separation between advice on financial assets and their marketing through changes in rules for employment in financial consultancy and marketing.

  • Increasing foreign participation: Foreign-owned firms were encouraged to acquire stakes in the fund management businesses being disposed by the banks. In addition, government bond market reforms allowed entry of foreign-owned banks in the capital markets.

3. Along with the Bachar legislation, reforms in taxation and regulatory coverage were also introduced in 2005–06. These reforms sought to increase market efficiency, encourage competition between players and enhance supervision of financial institutions and services. Specifically, reform measures were implemented to:

  • Widen investment choices of institutional investors: Tax provisions favoring domestic investment were removed for private and institutional investors, which encouraged foreign investment.

  • Strengthen investor’s choice and rights: Regulations governing long-term savings were revised, beginning in 2006, to ease mobility of savings between provident funds and insurance plans. In April 2005, institutional investors were also required to provide a more accurate fair value assessment of investor’s rights.

  • Improve supervision of institutional investors: In line with the change in the institutional structure, supervision of the activities of the provident funds were initiated, while regulatory coverage of insurance companies was expanded.

4. The authorities have continued to consolidate the reforms with the goal of deepening the capital markets and improving market infrastructure. To facilitate the development of competitive and liquid markets, market makers were introduced in the trading of government bonds in 2006. Repo auctions were introduced by the Bank of Israel at end-2007. Repo trading in te Tel Aviv Stock Exchange is expected to start by the end of 2009 Q1. A new underwriting law was implemented in July 2007 allowing allocation of securities at the underwriter’s discretion without an auction. Market infrastructure has been strengthened with the introduction in June 2007 of the RTGS system for settling intraday payments.

5. Mobilizing long term savings in an efficient manner remains a key priority. In December 2007, pension benefit coverage was expanded to employees without occupational pension plans. Effective 2008, changes in regulatory coverage were introduced that subjected a wide range of institutional investors to a uniform regulatory directive thereby equalizing the terms of savings on all forms of long-term savings, both domestic and foreign. It has also enabled banks to engage in pension advice and allowed a wide range of institutional investors to offer a basket of alternative products.


6. These reform measures have resulted in a fundamental restructuring of the financial sector towards non-bank institutions and non bank credit. A private long-term saving industry separate from the banking system emerged. By 2007, the dominance of the banks was significantly reduced in the areas of credit to businesses and management of long-term savings. The share of bank deposits to the public’s total assets declined from 46 percent at end-2002 to 30 percent at end-2007. Moreover, the control of banks over long term saving declined from 52 percent in 2003 to 11 percent at end-2007.

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Source: Bank of Israel.

7. The reforms also shifted the source of credit, in particular of new credit from banks toward non-bank financial institutions. By end 2007, non-bank financial institutions provided nearly 50 percent of the business sector’s outstanding credit, and most of new credit in 2007. In particular, corporate bonds issuance surged in recent years reaching about NIS 80 billion in 2007, and turnover in the financial market rose significantly. Most of the bonds issued during 2003–08 were by real-estate companies (32 percent), and holding companies (21 percent).

8. However, since the beginning of 2008, the capital market came under stress. Bond prices declined significantly, particularly since September of 2008 and withdrawals from provident funds amounted to about NIS 5 billion in 2008. The surge in yields on corporate bonds has been particularly high in bonds in the real estate sector, mainly in those companies that invested in real estate projects abroad. In light of these developments, concerns emerged that some bonds had been systematically over-valued and that investors, notably provident funds were substantially exposed.

9. Thus, overall credit—from banks and non-banks consolidated—declined since September 2008, while bank credit has continued to expand at a normal rate. Bank credit to the private sector expanded at an annual rate of about 10 percent, but the collapse of the non bank credit caused overall sources of new credit to falter, despite the expansionary monetary stance. Issuance of new bonds, which declined in the first half of 2008 compared with 2007, stopped altogether from September.

10. Looking ahead, credit conditions are likely to remain tight, with sizeable bond amortization due. In 2009, bond repayments and interest will amount to almost NIS 25 billion. Most of it is by companies and financial institutions with high ratings, but about NIS 3 billion is by real estate companies—many of which were downgraded recently.


Corporate bond yields

Citation: IMF Staff Country Reports 2009, 057; 10.5089/9781451819663.002.A001

11. On the other hand, although banks are sound and liquid, they are unable to meet the additional demand for credit. First, although banks are well capitalized, the capital ratio of most banks is still below the 12 percent ratio which the bank supervisor has encouraged them to achieve. Second, the slowdown in economic activity has raised credit risks and will raise non performing loans, reducing the banks appetite for additional risks. Finally, because banks’ role in overall credit has declined significantly, their influence on overall credit is constrained.

Policy response

12. The authorities have taken several specific steps to address strains in capital and financial markets (See Box 1). These are anticipated to take effect during 2009.

13. In addition, bank supervisors have intensified monitoring of banks exposures, enhanced regulatory requirements, required additional public disclosure, and have enhanced internal preparedness. In addition to increasing the frequency of reporting, monitoring was intensified particularly in the areas of large credit and sensitive exposures, provisioning for credit losses, exposures to foreign financial institutions, Nostro securities exposures, and liquidity positions.

14. At the same time the supervisor has issued various regulations. These include instructing banks to review their business strategy and risk management policies, improved reporting on exposure to foreign financial institutions, guidelines regarding effective control over foreign offices, instructing banks to map their material exposures according to relevant risk parameters, improving reporting on liquidity positions, and guidelines regarding fair value evaluations. They also required additional disclosure with regards to investments in complex instruments, enhanced risk disclosures in quarterly reports, and additional reporting on country risk.

15. Finally, the bank supervisor reviewed internal procedures regarding the handling of banks in difficulties, analyzed closely options to enhance financial stability (e.g. alternatives regarding capital injection, limiting capital distributions). And overall coordination and information sharing between regulators--BoI, the MoF and the ISA—was enhanced.

16. The ISA responded to the global financial crisis in several dimensions. They proposed establishment of new regulatory infrastructure to ease refinancing of bond obligation in the capital market, and disclosure and transparency requirements were increased. Examples of the latter include reporting on cash sources, value of collateral, and exposure to the exchange rate, commodity prices and complex financial products. In addition, it increased supervision of rating agencies and auditors.

Policies to support capital and financial markets

1. Purchasing of corporate bonds. The authorities plan to establish several funds to purchase corporate bonds, with the board objective to support liquidity and credit to solvent corporations whose main activity is in Israel and which face difficulties in recycling their debt. The government’s overall investment will be up to NIS 5 billion, matched by about NIS 5-15 billion from institutional investors. Each fund will be set for 7 years with an option to extend it for an additional 3 years. To encourage private-sector participation in the fund, the government will provide the following incentives. If at the termination of the fund, the average real return is below 4 percent, the government will pay the intuitional investors 90 percent of the amount needed to raise their return to 4 percent as long as the amount is below the government revenues from the fund. If, on the other hand, the average real return is above 4 percent, the government will pay the institutional investors half of its profits above 4 percent return.

2. Increasing banks’ capital. The government plans to provide guarantee of about NIS 6 billion for capital raised by banks to fortify banks’ capital and increase their lending.

3. Providing a safety net for long-term investors close to retirement. Savers who will retire within the next 10 years, and who have less then NIS 1.5 million in retirement saving at the time of retirement, can choose upon retirement whether to withdraw their retirement savings or receive an annuity according to the amount (up to NIS 750 thousands) they had at November 30, 2008.

4. Guaranteeing credit to small- and medium-sized firms. The government set up a fund of NIS 1.3 billion—NIS 260 million of public money and NIS 1 billion from three banks who won the tender to provide loans. To encourage banks’ participation, the government extends a 70 percent guarantee on the loans.

5. Reducing constraints on reaching agreements on the refinancing of payment obligations to corporate bondholders. According to new measures by Israel Security Authority, the trustees of bonds will be required in certain circumstances (or if demanded by a party holding substantial portion of bonds) to convene a forum of bond holders. Such a forum will require the presence of the three biggest holders of bond, who can delegate representatives to negotiate with the issuer. The bond issuer is allowed to withhold disclosure about the refinancing negotiation.

17. The supervisor of insurance, pension and providence funds at the Ministry of Finance responded to the crisis in the financial market mainly by increasing monitoring. It increased monitoring of the insurance companies’ exposures to structured financial instruments and investments abroad. It raised the monitoring of the institutions’ exposure to financial market and various instruments, their liquidity and withdrawal.


18. The financial market reform achieved the goal of developing the capital market and reducing the banks’ share in providing credit and managing long term saving. However, the pace of the reform may have led to increased exposure to risks—more than the risks that, ex ante, savers might have appreciated. It also raised significantly and rapidly the importance of non bank credit. The collapse of this source of credit is thus a significant blow to the economy—a clear instance of a “credit crunch.”

Attachment II. External spillovers to Israel1

1. As a small open economy, Israel is susceptible to spillovers from the global economy. Indeed, Israel’s latest economic cycle (since 2000) has to a large extent mirrored that globally. The burst of the dotcom bubble in the early 2000s—compounded by the intifada—pushed the Israeli economy into a recession.

Subsequently, notwithstanding security concerns in the mid-2000s, Israel enjoyed a period of strong economic performance alongside robust global growth and low risk aversion.


Synchronization of economic cycles: Annual real GDP growth

Citation: IMF Staff Country Reports 2009, 057; 10.5089/9781451819663.002.A001

Source: IMF.

Potential Channels

2. Trade linkages are likely to constitute the main channel transmitting external shocks to the Israeli economy. The share of exports in GDP rose rapidly—from 20 to 33 percent of GDP—between 1995 and 2007. The U.S. and EU together account for about 2/3 of these exports. While some diversification into the developing-country markets (especially Asia) has been taking place slowly, and many of these are intermediate goods ultimately shipped to the U.S. and EU.

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3. Meanwhile, Israel’s foreign assets have also grown rapidly, even though on net basis IIP remains modest at -10 percent of GDP. This followed the completion of capital account liberalization in 2003 and subsequent extensive financial sector reform—including the 2005 tax code change that reduced capital gains tax on foreign investment to the same level as on domestic investment. Consequently, foreign investment income has become an increasingly important element in the current account. The substantial increase in foreign portfolio (PI) and direct investment (DI) exposures has likely increased spillovers via the wealth and cash-flow effects.2


Increasing foreign assets: Gross IIP assets - excluding reserve assets

Citation: IMF Staff Country Reports 2009, 057; 10.5089/9781451819663.002.A001

Source: Bank of Israel.