1. The Economy and Economic Policy

The performance of the economy is solid. The Israeli economy is operating at a near-potential level, and growing at a moderate but stable pace of above 3 percent, which is high by advanced-economy standards, but is probably below its potential. The unemployment rate fell in the last quarter of 2013 to 5.7 percent, and the participation rate is high; the external position is robust, as illustrated by the current account surplus and the net investment position being in positive territory; the public deficit is down to 3.2 percent of GDP¹ and public debt fell to 66.7 percent of GDP. Inflation, at 1.8 percent, is fairly close to the midpoint of the inflation target band, the financial system is robust, and the financial markets are calm.

The policy mix is growth-friendly. The current policy mix, which includes expansionary monetary policy and moderately tight fiscal policy, is designed to support economic activity while facilitating the continuation of fiscal consolidation, as reducing the public deficit and the public debt-to-GDP ratios is a major goal of the government’s economic agenda. A set of housing-related macro-prudential policies geared to restrain excess demand and contain risks to financial stability, have been implemented by the BoI.

Not all is bright, however, and a mix of short-run and fundamental challenges looms. Growth is mostly driven by local demand, as weak global demand and exchange rate appreciation are a drag on export growth. Moreover, appreciation pressures persist. Growth is not inclusive, and does not trickle down to the middle class in full. The high cost of living, and especially elevated and still rising housing prices are a source of social tension. In the medium run and beyond, formidable challenges related to the inclusion of groups that are weakly attached to the labor market lie ahead. These issues keep policymakers and society alike occupied, and are at the heart of ongoing public debates.

2. Fiscal Policy

Fiscal policy is designed to reduce the levels of deficit and debt, which are still above the desirable levels, while keeping tax rates at competitive levels. The high deficit in 2012 led to a slowdown in the process of debt reduction. Following the formation of the new government in 2013, a biennial budget for 2013-2014 was adopted that includes a series of corrective actions to secure the consolidation process. The budgetary results so far are better than expected, and the deficit came down from 3.9 percent in 2012 to 3.2 percent of GDP in 2013². Furthermore, the deficit in 2014 is expected to be 3.0 percent of GDP, which is expected to yield an additional modest reduction in the ratio of debt to GDP. It is important to put the 2012 fiscal slippage, on which staff elaborates, in context. First, even in 2012, the debt to GDP ratio was reduced by 1.4 percent of GDP. Thus, the slippage was not so significant so as to jeopardize debt reduction. Secondly, the slippage was promptly dealt with, including by an initial, unpopular, VAT hike in late 2012 just before the elections.

The 2015 budget looks tight and the Ministry of Finance acknowledges the challenge. The deficit target for 2015 is 2.5 percent. A revised expenditure rule, which caps the growth of public expenditure by the rate of population growth, which is currently 1.7 percent, plus one percentage point at most, was approved by the government and sent to the parliament. This rule ensures that expenditures are lower than potential growth, and hence the increase in the tax burden in 2015 and onwards, required in order to meet the declining deficit targets, will be modest. With a broad-based VAT set at 18 percent, a CIT at 26.5 percent, and a marginal PIT rate at 50 percent, the MoF sees only limited scope for further tax rate hikes. Consequently, an effort to reduce exemptions will be made.

Fiscal policy is guided by well-defined fiscal rules. Fiscal policy is guided by two rules: an expenditure rule that caps the maximum growth of the real expenditure, and a deficit target expressed in percent of GDP. Every budget has to meet the terms of both. The forecasts on which the deficit targets are based are judged - by staff - to be conservative and unbiased, but as the deficit target is not cyclically adjusted, and there are no escape clauses that define when and how the deficit trajectory is modified, substantial unexpected revenue shortfalls tend to result in discretionary recalibration of the targets.

The current fiscal rules and institutions have proven to be useful. This two-rule framework, which has been in place since 2005, proved to be useful for conducting responsible yet flexible policies, and it was previously assessed by the Fund to have helped reduce public debt from very high levels.³ The results speak for themselves: since this framework is in place, debt went down from 89.8 percent of GDP to 66.7 percent of GDP. Yet, when the global financial crisis hit, the framework was flexible enough to let the automatic stabilizers operate in full. Thus, the MoF does not see a clear advantage in explicitly introducing the debt ratio into the fiscal rule, while the disadvantage is that the rule becomes more pro-cyclical, which is undesirable. The current framework, however, can be improved, and the MoF fully agrees with staff that strengthening the monitoring and analysis of the medium-term projections of expenditures is of the essence. Regarding the institutional setup, since the MoF tax revenue forecasts are unbiased and the BoI is providing a high-quality, independent assessment of the fiscal position, the authorities are not fully convinced that there is a case for an independent fiscal council, given the large costs involved in establishing and maintaining a high-quality council.

The strong fiscal position was demonstrated recently in the international financial markets. On January 22, 2014 Israel sold 1.5 billion euro worth of 10-year euro-denominated sovereign bonds in London, at an average yield of 2.93 percent and bid-to-cover ratio of 5.7. The low spread over comparable German bunds, 117 bp, reflects the strength of the fiscal position and the trust in the economy.

3. Monetary and Macroprudential Policies

The BoI’s policy is geared to support economic activity under an inflation targeting regime, while containing risks to financial stability and pressures on the currency. As economic activity slowed down, inflation pressures dissipated, and the appreciation pressures on the shekel intensified, the interest rate has been reduced gradually during 2013 from a rate of 2 percent to currently 1 percent. The lower spread between the policy rate and those of the major advanced economies takes off some of the appreciation pressures and the low rate provides additional support for private consumption and investment. Market-based inflation expectations remained close to the midpoint of the 1-to-3 percent inflation target band throughout the interest rate reduction process.

The exchange rate intervention policy is aimed at curbing overvaluation. Foreign exchange intervention policy is based on two pillars. The first pillar is a non-discretionary program designed to offset the effect on the current account of lower energy costs resulting from locally produced natural gas. The quantity of foreign currency purchases under this program is communicated to the public in advance, and in October 2013 the BoI announced that in 2014 the purchases will amount to US$ 3.5 billion. The purpose of this policy is to temporarily substitute for a lacking SWF, and to ease the Dutch disease symptoms that the Israeli economy seems to display. The second pillar of exchange rate intervention is discretionary and designed to curb excessive appreciation beyond that attributed to fundamental factors. The current level of the shekel - which is already affected by this policy - is assessed to be moderately overvalued, and the BoI occasionally acts whenever additional pressure on the shekel builds up.

A set of macroprudential measures is used to reduce the risks associated with the low level of the interest rate. In order to offset the undesirable effect of low interest rates on the risks associated with the elevated level of housing prices, a series of macroprudential measures were taken. These include direct measures such as capping the LTV to 70 percent and debt services to income to 50 percent, and limiting the mortgage repayment period to 30 years. In addition a series of indirect measures aimed at reducing the risks associated with mortgage lending, both to banks and to households, were implemented. As some of the MPs were implemented recently, and the full data on the housing market are available at a considerable lag, it is probably too early to assess the policy’s impact. The BoI is encouraged, however, by the initial evidence, as well as by staff’s assessment, that points to the effectiveness of direct measures, and it stands ready to tighten these measures if they prove to be insufficient.

4. Financial Stability Issues

The financial system is solid and conservative, and the banks are stable, liquid, and profitable. As part of a gradual adoption of Basel III starting in 2015, the core capital ratio further improved to 9.3 percent. The quality of the banks’ credit portfolio is high, with NPLs as low as 3.1 percent of total loans; deposits equal 89 percent of outstanding credit, and the direct exposure to international markets is low.

The financial system is robust and tightly supervised. The regulators, namely the Banking Supervision Department of the BoI, the Capital Markets, Insurance, and Savings Division of the MoF, and the Israel Securities Authority are exchanging information and analyses regularly through a joint working group that analyzes systemic risks. The authorities realize the necessity of establishing a formal Financial Stability Council. The report lays out two clear options to move ahead with the process, and the authorities are grateful for the constructive and thorough suggestions made by staff. A continued effort to resolve the outstanding impediments is currently taking place.

A new bank resolution framework is underway. The authorities would like to thank management for promptly accommodating their request for TA on this issue, and staff for providing a valuable contribution to finalizing the draft law for early intervention and resolution. The authorities expect to solve the remaining issues in the near future.

The authorities are grateful to the Article IV team for the excellent, analytical report they have written and for the open and constructive dialogue behind it.