Statement by Menno Snel, Executive Director for Israel and Yossi Yakhin, Senior Advisor to the Executive Director, September 4, 2015

Israel came through the crisis relatively well, and unemployment has continued to fall to multi-decade lows. But policy makers are confronted with several challenges. The fiscal deficit remains stubbornly high, leaving limited buffers to respond to shocks. Inflation is negative-well below the Bank of Israel's (BOI) target-but housing prices continue to rise, posing financial sector risks. Labor productivity is low and the gap relative to the US is widening. And income inequality is among the highest across all advanced countries.


Israel came through the crisis relatively well, and unemployment has continued to fall to multi-decade lows. But policy makers are confronted with several challenges. The fiscal deficit remains stubbornly high, leaving limited buffers to respond to shocks. Inflation is negative-well below the Bank of Israel's (BOI) target-but housing prices continue to rise, posing financial sector risks. Labor productivity is low and the gap relative to the US is widening. And income inequality is among the highest across all advanced countries.

On behalf of the Israeli authorities we would like to thank the Article IV mission team for an excellent report and for the candid, constructive and friendly dialogue. The authorities broadly agree with the analysis and recommendations in the report. They recognize that further reducing the debt-GDP ratio in the medium term in a slower potential growth environment, and raising labor productivity growth are among their main macroeconomic challenges. In the following comments we provide some details and updated data, and elaborate on the views of the authorities.

Economic Activity

The Israeli economy grew 2.6 percent in 2014 (latest estimate), 0.8 percentage points higher than the average growth in advanced economies. The economy weathered the global financial crisis relatively well and experienced only a short-lived slowdown in 2009. Nevertheless, after a strong rebound in 2010-11, the economy’s growth rate has been moderating to roughly 2 percentage points below its pre-crisis level of 2004-2008. The recent slowdown in growth is accompanied by a shift in the composition of aggregate demand, mainly from exports to private consumption. First estimates for the first half of 2015 point to a continuation of the weak growth at 2.6 percent SAAR (seasonally adjusted at annual rate) with additional weakness in the second quarter, although it is partly accounted for by temporary factors (work disruptions in the chemicals industry and a correction in durable consumption).

In 2014 a military conflict in the Gaza Strip had a temporary adverse effect on economic activity during the third quarter of the year. Overall, it is estimated that the conflict reduced growth by 0.3 percentage points in 2014. Learning from past conflicts, which since 2006 have unfortunately occurred every 2-3 years, the effect on economic activity typically concentrates on private consumption and tourism services. Private consumption is quick to rebound, but the recovery in tourism is sluggish and as of July 2015 tourist arrivals to Israel have not recovered to their pre-conflict level. The tourism sector accounts for 1.6 percent of GDP, but its share in employment is larger and it employs low-skilled, low-wage employees.

Medium-Term Fiscal Framework

The authorities broadly agree with staff’s assessment, and in particular they recognize the need to strengthen the medium-term fiscal framework. While budget execution in each current year typically meets the fiscal objectives, medium-term targets are revised too often. When consolidation measures are necessary for the current budget, expenditures are often postponed to future years; however, without a binding accountability mechanism, the result is a rise in future expenditure commitments without properly identifying the resources to finance them, and when the time comes fiscal targets are revised.

The debt-GDP ratio declined persistently in the past decade – from 93.8 percent in 2003 to 67.0 percent in 2014. Nevertheless, the authorities concur with staff that at current deficit levels and with potential growth around 3 percent, the debt-GDP ratio would inevitably start to rise. The decline in the ratio since 2003 was supported by high growth rates, but with potential growth moderating, a further reduction in the debt-GDP ratio is most challenging and requires reducing future deficits.

We note that in March the Ministry of Finance benefited from TA that focused on strengthening the medium-term budget framework, and first steps toward the implementation of its recommendations are already in progress. In early August the new government approved a biennial budget for 2015-2016 which incorporates some measures in that direction (the budget still requires the approval of the parliament). These measures require: adjusting the government’s medium-term expenditure commitments to the legislative constraints, upon the approval of each annual budget; publishing a semi-annual report of the government’s expenditure commitments and expected sources of revenue for the current year and for the following three years; concentrating government decisions that involve future budgetary commitments to designated bi-monthly meetings; and conducting a spending review that would help to systematically prioritize past programs and make space for new ones (expected to start in 2017). Ongoing deliberations also consider requiring the government to identify budgetary sources for new future expenditure commitments and revenue cuts whenever these commitments are expected to violate budgetary legislative constraints. In addition, for 2016 the budget incorporates cuts of 40 percent in the cost of the coalition agreements, and an across-the-board reduction of 4.5 percent in the budget of all offices.

As indicated above the authorities largely share staff’s assessment, but they do have a few reservations. First, they emphasize that although Israel’s deficit is high by international standards, Israel’s GDP growth rate is higher than in other advanced economies. This suggests that for equal long-term targets of the debt-GDP ratio, the benchmark deficit target in Israel should be higher. Second, they note that the recent discoveries of natural gas reservoirs in the Mediterranean and the expected accumulation of assets in a wealth fund would provide an additional buffer to the economy against future shocks. An evaluation of the appropriate debt level should factor in such assets. Finally, regarding staff’s recommendation to increase tax revenues through indirect taxes (paragraph 17), the authorities point out that the tax composition is already tilted toward indirect taxes and a further increase may adversely affect inequality as these taxes are typically regressive. Their preference is to raise tax revenues by cancelling ineffective tax exemptions.

Inflation, Exchange rate, and Monetary Policy

In the face of a slowdown in exports, a low inflation environment, a strong Shekel and low interest rates in the global economy, the monetary policy stance is very expansionary with the policy interest rate at a historic low of 0.1 percent. Monetary policy also uses foreign exchange interventions.

As of July, headline inflation over the previous 12 months has been –0.3 percent. However, the Bank of Israel’s decomposition of the CPI to its tradable and non-tradable components indicates that the negative inflation rate is mainly driven by the price of tradable goods, as over the same period tradable inflation was –1.5 percent, while non-tradable inflation was 0.5 percent. This is consistent with staff’s analysis, as presented in the selected issues paper, indicating that external factors, such as the fall in oil prices and the appreciation of the exchange rate were the main drivers of headline inflation recently. That said, domestic inflation, although positive, is also below desirable levels.

We note that while headline inflation deviates significantly from the official target range of 1-3 percent, inflation expectations for the next 12 months from the financial market and private sector forecasts have increased since the beginning of 2015, and until recently both hovered around the lower bound of the target range. However, weakness in economic activity during the second quarter (first National Accounts estimates were published in August) and a renewed decline in commodity prices have recently pushed inflation expectations and forecasts downward.

The Bank of Israel constantly monitors the developments in the markets and stands ready to use additional tools, if necessary, to lift inflation and boost demand. Such tools may include quantitative easing, further reduction of the policy rate and measures in the foreign currency market. However, with the current monetary stance already extremely expansionary, headline inflation driven mainly by external factors and expectations for a first rate hike in the US by the end of 2015, the authorities have not found additional expansionary measures to be appropriate so far.

The exchange rate has been under appreciation pressures for several years. The strengthening of the US dollar together with aggressive interest rate cuts reversed that trend only temporarily towards the end of 2014. The fundamental pressures for appreciation stem from a persistent basic current account surplus (i.e. the current account plus foreign direct investment), which partly originates from domestic gas production that has substituted for energy imports. The Bank of Israel counteracts the effect of gas production on the current account by purchasing foreign currency at the same amount, and this operation is expected to continue until a wealth fund will start to operate. Also, domestic institutional investors diversifying their portfolios abroad have typically hedged their positions against exchange rate risk in recent years, thereby neutralizing the potential offsetting effect their capital outflows could have had on the exchange rate.

Appreciation pressures, that are not always consistent with fundamentals, often originate in the financial markets, and as a small open economy they may have significant effect on the exchange rate. Since the beginning of 2015, for example, the Shekel appreciated against the US dollar while most currencies depreciated (see enclosed figure) and Israeli export was losing steam (8.6 percent SAAR contraction during the first half of 2015). The authorities estimated the Shekel to be overvalued during that period, and when such episodes occur, the Bank of Israel steps in and purchases foreign currency.


The appreciation rate of selected currencies against the US Dollar during 2015*

(July 2015 average rate vs the average of December 2014)

Citation: IMF Staff Country Reports 2015, 261; 10.5089/9781513536057.002.A005

* Adopted from the Bank of Israel Monetary Policy Report for the first half of 2015.

The Housing Market

Housing prices have nearly doubled since end 2007 (97 percent nominal, 69 percent real), though from a low base after a decade-long real price depreciation of nearly 25 percent. Staff assesses that housing prices are currently overvalued by 30 percent. We stress, however, that staff’s estimate is based on deviation from a long-run equilibrium and that to a large extent it is explained by supply-side shortages; therefore, staff’s estimate should NOT be interpreted as current price misalignment or as deviation from the fundamental value. The authorities would appreciate more careful and accurate communication on this point.

The recent rise in housing prices is driven both by low interest rates and by supply shortages. The pace of completion of dwellings has increased persistently since 2007; however, only since 2013 it has started to match household growth. This was mirrored in moderation in housing price inflation, although it is still quite high – around 4 percent annually. Improving housing affordability is among the highest priorities of the government, with some measures already being implemented and others underway on both demand and supply fronts. In addition the Bank of Israel has launched a series of macro-prudential measures to safeguard financial stability.

As stated above, the government has stepped up its efforts to reduce housing prices. In addition to the measures mentioned in the report (paragraph 34), aimed mainly at expediting the planning process, we also note the following: (1) State-owned land auctions are shifting from a highest bidder system to a system where the offer with the lowest marketing price of finished apartments wins the auction. (2) A purchase tax for owners of more than one apartment has recently increased, and the government also considers cancelling the exemption from betterment tax on apartments that were inherited. The latter would incentivize heirs to sell those apartments, thereby increasing supply. (3) Urban renewal projects receive tax benefits in order to increase density in urban areas. And (4) mobilization of large army bases from the center of the country to the periphery is expected to release valuable land for the development of adjacent cities.

The Financial Sector and Macroprudential Measures

The authorities share the staff’s concerns regarding the banks’ exposure to real estate and the construction industry, and since 2009 the Bank of Israel has launched a series of macro-prudential measures mainly targeting the mortgage market (see Annex III of the staff report for the list of measures). These measures are aimed at safeguarding financial stability rather than reducing housing prices by means of constraining demand as they mostly target the marginal mortgages with the riskiest profile, not the average mortgage. Risk indicators suggest that these efforts are fruitful; for example, following Banking Supervision directives the share of mortgages with payment-to-income ratio higher than 40 percent has fallen over the past four years from 23.8 percent to 0.9 percent, and the share of mortgages with loan-to-value ratio higher than 75 percent has fallen from 9.7 percent to 2.0 percent.

As for the construction industry, the authorities recognize its higher risk profile relative to other industries as the production process and financial exposure are longer and it has a legacy of realization of credit risks. Nevertheless, problematic credit risk in this industry has gone down from 6.1 percent in 2011 to 3.7 in 2014 and sectoral exposure regulations prevent banks’ exposure to the construction industry from exceeding 20 percent of their total credit. The authorities monitor this risk closely through both off-site and on-site examinations, and by attempting to identify areas of vulnerability prior to the realization of risks.

As staff indicates, the road to establishing a Financial Stability Committee (FSC) is indeed rocky. Nevertheless, some progress has been made recently, and on June 28 the government passed a resolution to circulate within 180 days a draft law for the establishment of a FSC. The authorities note, however, that regardless of the holdups in the establishment of the FSC, the three financial regulators (banking supervision, capital market supervision and the securities authority) meet regularly in an informal coordination committee.

The Labor Market and Productivity

The labor market is strong. Unemployment is at a multi-decade low while the participation rate is rising. These trends are supported by over a decade-long of measures incentivizing employment, e.g. earned income tax credit at low levels of income, and disincentivizing unemployment and labor market detachment, e.g. stricter eligibility criteria for unemployment benefits and reducing child allowances. However, they are accompanied by a prolonged sluggish productivity growth and a rise in inequality and poverty rates.

The authorities recognize the challenges of raising productivity growth and making growth more inclusive. They note, however, that to a large extent the weakness in labor productivity is driven by rising participation rates of groups that are loosely attached to the labor market, especially the Haredi (ultra orthodox Jews) population and Arab women. New workers from these groups typically have weaker labor market skills, thereby reducing average labor productivity. The challenge is therefore to keep raising their participation rate while equipping them with stronger skills for the labor market. This would help boosting labor productivity and support more inclusive growth. The authorities note that several programs are already in place to address these issues.1 Nevertheless, they recognize that this is one of the greatest long-term challenges for the economy as the growth rate of these population groups is higher than that of the general population.

The authorities agree with staff that increasing competition is key to raising Total Factor Productivity (TFP). They note that negative TFP gaps against OECD averages are particularly noticeable in industries with low export shares, where firms face weaker competition. A reform in cellular communication has increased competition significantly in that industry, and a reform in the food market is currently underway. As indicated by staff, boosting competition is a priority for the new government and several sectors are being targeted, but work on this front is still at its early stages and more has to be done.


For the Haredi population these include: full financing of academic education in selected fields (such as engineering, computer science and natural sciences), providing living allowances for the duration of the studies and assistance in job placement; operating placement centers and providing vocational training in accordance with Haredi customs and special needs; operating placement centers specific for Haredi women; and providing vocational training and gaining professional experience through a military service.

Programs for the Arab population include: subsidizing child care to incentivize Arab women to enter the labor force; supporting business and technological entrepreneurship; financial support and general guidance in gaining academic education; vocational training and help in job placement for academics in the high-tech industry; and vocational training targeting specifically the Bedouin population.

Israel: Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Israel
Author: International Monetary Fund. European Dept.