Statement by Mr. Anthony De Lannoy, Executive Director for Israel and Mr. Yossi Yakhin, Senior Advisor to the Executive Director, March 24, 2017

Israel is enjoying strong economic growth, estimated at 4 percent in 2016, supported by strong domestic demand-partly due to high vehicle sales ahead of a tax increase-and an export rebound. Unemployment declined to 4.4 percent in Q4 2016 and wage increases have picked up. Nonetheless, inflation remained below the 1-3 percent target range of the Bank of Israel (BOI), reflecting external factors and government measures to reduce the cost of living. The BOI has held the policy rate at 0.1 percent since February 2015 and stated that monetary policy in Israel will remain accommodative for a considerable time. Strong revenues contained the fiscal deficit to 2.1 percent of GDP in 2016 and the public debt ratio declined to 62 percent of GDP.


Israel is enjoying strong economic growth, estimated at 4 percent in 2016, supported by strong domestic demand-partly due to high vehicle sales ahead of a tax increase-and an export rebound. Unemployment declined to 4.4 percent in Q4 2016 and wage increases have picked up. Nonetheless, inflation remained below the 1-3 percent target range of the Bank of Israel (BOI), reflecting external factors and government measures to reduce the cost of living. The BOI has held the policy rate at 0.1 percent since February 2015 and stated that monetary policy in Israel will remain accommodative for a considerable time. Strong revenues contained the fiscal deficit to 2.1 percent of GDP in 2016 and the public debt ratio declined to 62 percent of GDP.

On behalf of the Israeli authorities, we 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. Overall, the macroeconomic performance of the economy is strong, especially compared to other advanced economies. Growth has accelerated in 2016, labor force participation is at an all-time high, the unemployment rate is at its lowest level since the 1970s, debt-GDP ratio has been on a declining path for over a decade and the financial system is strong. Nevertheless, the economy faces structural challenges, mainly demographic dynamics that weigh on labor productivity and rising house prices. The authorities acknowledge these challenges and are taking actions to confront them. In the following comments we elaborate on the authorities’ views and actions and provide additional perspectives to the staff report.

Economic Activity: Flying on One Engine

The Israeli economy grew by 4.0 percent in 2016. This performance is mainly a results of robust domestic demand, but recovery in export services and one-off factors also contributed their share.

Israel weathered the global financial crisis relatively well, but as a small and open economy it depends on strong trading partners and a vibrant global economy. In the aftermath of the crisis, external conditions have been challenging, export growth weakened and lost power as the main growth engine of the economy. From 2007 to 2016, the export share in GDP dropped 20 percent from 34.7 percent to 27.5 percent. With a weaker external sector, economic activity had to shift gears and rely more heavily on domestic demand. Since 2008, domestic absorption (private and public consumption and investment) has grown at an annual pace of 3.7 percent compared to export growth of 2.1 percent, while during the decade prior to the global financial crisis, exports was clearly the major growth engine with an annual growth rate of 7.2 percent compared to a growth rate of 3.1 percent of domestic absorption. Stable financial environment, robust labor market and civilian government expenditure supported domestic demand in the aftermath of the financial crisis.

In 2016 domestic demand accelerated and continued to grow strong, especially private consumption (6.3 percent) and investment in fixed assets (11.3 percent), on the back of a strong labor market with robust wage growth and acceleration in the construction sector. A one-off surge in vehicles purchase, due to changes in the tax policy, have also contributed to growth this year. Notably, exports have accelerated as well in 2016 and grew 3.0 percent. The recovery in exports, alongside the WEO projections for accelerated world trade and global growth, provide encouraging signs that Israel’s second growth engine may be reigniting.

Medium-Term Fiscal Framework

The authorities broadly agree with staff’s assessment, and in particular they recognize the need to establish a better record of medium-term fiscal management.

The debt-GDP ratio has declined persistently for over a decade – from 93.8 percent in 2003 to 62 percent in 2016. This decline was supported by strong growth rates, but with potential growth moderating, a further reduction in the debt-GDP ratio will become more challenging and will require maintaining lower deficits.

While the strong fiscal performance in 2016 is certainly a positive development, the more important one is the adoption of a robust medium-term budget management framework. In fact, following the recommendations of an IMF TA, 2016 was the first year during which a mechanism to control medium-term budget obligations was implemented. In the past, frequent government decisions regularly accumulated budgetary obligations for years to come and as a result the path of future deficit ceilings had to be revised upward every year. However, under the current framework, the government has to identify resources whenever it commits to new obligations, and it publishes semi-annual reports on its expenditure commitments and their expected sources of revenue. In addition, bi-annual expenditure reviews help prioritizing past programs and make space for new ones. It should be noted that the stock of past obligations has brought yet another upward revision for the 2017–18 deficit ceilings (2.9 percent of GDP in both 2017 and 2018, compared to the envisaged deficits at the time of approving the 2016 budget of 2.5 percent in 2017 and 2.25 percent in 2018). Nevertheless, the new fiscal framework has reduced substantially the pace at which the government accumulates new obligations, and while the legacy of previous budgetary commitments may still press on future deficit ceilings, their weight will decline going forward.

Monetary Policy, Inflation and the Exchange rate

In the face of low inflation environment, a strong Shekel and low interest rates in advanced economies, monetary policy has remained expansionary, employing both interest rate and foreign exchange interventions. The authorities concur with staff’s recommendation to maintain an accommodative policy stance until inflation and inflation expectations gain more solid ground.

Headline inflation has undershot the target range, 1–3 percent, persistently since mid-2014, reaching rates as low as -1.0 percent. Inflation has edged up in recent months, but it is still well below the target range with 0.4 percent for the 12 months ending in February 2017.

Nevertheless, decomposition of the CPI to its tradable and non-tradable components reveals that the low inflation rate is driven primarily by the price of tradable goods, with tradable inflation at -1.3 percent and non-tradable inflation at 1.3 percent. This result is consistent with staff’s appraisal, and indicates that mainly external factors, including exchange rate appreciation, are a drag on inflation. Recent analysis by the Bank of Israel suggests that a substantial rise in online retail trade has put pressure on prices due to increased competition and may have also lifted exchange rate pass-through to inflation. That said, non-tradable inflation, is also below desirable levels.

In the face of inflation undershooting the target, the Bank of Israel has appropriately maintained an accommodative policy stance, with the interest rate at 0.1 percent since early 2015.1 Nonetheless, with most of the weakness originating from the external sector and while facing persistent exchange rate appreciation pressures, partly generated by spillovers from extraordinary accommodative monetary policy in other advanced economies, it was considered appropriate to address further relaxation of the monetary stance through quantitative tools of purchasing foreign currency rather than further reducing the interest rate to uncharted negative territories. This consideration was reinforced by concerns of further fueling domestic house prices.

The Housing Market

House prices have risen 90 percent in real terms since end 2007, though from a low base after a decade-long real price depreciation of about 25 percent. The authorities agree that increasing supply is the key factor for effectively addressing housing affordability. We note that this is true for both house prices and rents, as the latter has also been rising rapidly, though at a slower pace than house prices.

The government is taking an array of measures to increase supply and expedite the planning process. These, among other measures, include: the establishment of the “Housing Cabinet” (under the Ministry of Finance) which brings all the authorities involved in the housing market under one roof, in order to improve coordination and reduce red-tape; bringing large housing projects to the approval of a special planning committee that is authorized to operate in an expedited schedule; the “Blanket Agreements” that provide municipalities with financing of necessary infrastructure to support new neighborhoods; and bringing foreign companies to introduce new technologies and improve the industry’s productivity.

These efforts start to bear fruits as is evident by the substantial rise of “planned units” available for issuing construction permits (100,000 units in 2016 alone) and by housing starts accelerating to an annual pace of over 50,000 units. To appreciate these figures we note that the last time housing starts exceeded the 50,000 bar was in 1997 in the aftermath of the massive immigration wave from the former Soviet Union. Staff rightly argues that there is still a long way to go and appropriately puts the figure on relevant bottlenecks. The authorities are well aware of the impediments and the necessary progress that still need to be made, they are highly committed to the goal of improving housing affordability, including by investing their own political capital, and it is high on the agenda of the Ministry of Finance.

As increasing supply is a slow process, demand-side measures such as the “buyer’s price” program and taxation of owners of more than one apartments, are invoked to provide a short-term relief. We note that the appropriateness and effectiveness of these measures are subject to ongoing public debate. That said, there is a broad consensus among the authorities that the key for resolving this issue lies in the supply side, and as described above, progress is being made in the right direction.

Financial Stability and Macroprudential Measures

As indicated by staff, the banking system is stable and healthy, and currently the main concerns are directed to improving its competitiveness while preserving financial stability. The main financial risks are associated with the high level of house prices, and this is appropriately reflected in the risk assessment matrix. Nevertheless, loan-to-value and payment-to-income ratios in the mortgages market are low in international comparison, and, since 2009, the Bank of Israel has launched a series of macro-prudential measures to contain these risks (see Annex IV of the staff report). We note that these measures are aimed at safeguarding financial stability rather than suppressing house prices by means of constraining demand as they mostly target the marginal mortgage with the riskiest profile, not the average one. 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 from 19.0 percent in 2012 to 0.5 percent in 2016, and the share of mortgages with loan-to-value ratio higher than 60 percent has fallen from 41.0 percent to 30.1 percent over the same period. Mortgages with leverage ratio higher than 75 percent have practically vanished.

The Labor Market, Productivity and the Demographic Challenge

The labor market is strong. Unemployment rate is at a multi-decade low and the participation rate is at a record high. This achievement is supported by protracted measures for over a decade aimed at incentivizing employment, e.g. through earned income tax credit, and disincentivizing unemployment and labor market detachment, e.g. by stricter eligibility criteria for unemployment benefits and reducing child allowances. The improvement in the labor market is however accompanied by sluggish productivity growth, which is at least partly driven by a benign factor—the increased labor market attachment of workers with weaker labor market skills. Nevertheless, the demographic composition of these workers, largely associated with the Haredi (ultra-orthodox Jews) and Arab populations, poses one of the greatest long-term macroeconomic challenges to the Israeli economy, as these groups are expected to become a majority in Israeli society within a few decades. Strengthening their labor market skills and keep improving on their labor market attachment will also address, at least partly, the inequality and poverty challenges as rightly emphasized by Staff.

Increasing labor force participation is probably one of the most effective mechanisms for improving growth inclusiveness. The Haredi society and Arab women have traditionally had the lowest participation rates in the Israeli labor market. Nevertheless, the participation rate of both populations have increased markedly over the past decade. In 2001–05 the participation rate of Haredi population in main working-age (25–64) averaged 46.4 percent while in 2015 it reached 63.7 percent, where most of the improvement was driven by the entry of Haredi women in the labor market. Over the same period and age group the participation rate of Arab women has increased from 25.1 percent to 34.6 percent.2 Clearly there is much room for further improvement in both populations, but the trend is robust and encouraging. That said, new workers from these groups typically have weaker labor market skills, thereby reducing average labor productivity. The challenge is therefore to keep increasing their participation rate while equipping them with stronger labor market skills. This would boost labor productivity and support more inclusive growth.

The macroeconomic importance of integrating Haredi and Arabs workers in the labor market in both extensive (participation) and intensive (skills) margins goes well beyond inclusiveness. The fertility rates of both groups, although declining, are higher than that of the rest of the population, and the demographic projection of the Israeli Central Bureau of Statistics envisages that within 40 years the Haredi and Arab communities combined will account for about 50 percent of the total population, compared to 32 percent in 2015. Putting projections aside, in 2015 Haredi and Arab children aged 0–9 have already accounted for 43 percent of that age group, compared to a share of 26 percent of these communities in the main working age population (25–64). The authorities recognize that with such demographic dynamics it is crucial to keep making progress with improving labor market participation and strengthening the skillsets in these communities.

The authorities see this issue as one of their greatest long-term macroeconomic challenges and have embarked numerous programs for promoting labor market attachment and improving productivity, in addition to providing better incentives through the tax system and social benefits. While some programs apply to the general population, many specifically target the Haredi and Arab communities. We list a few of them here to provide a general sense of the type of programs available: “One-Stop Career Centers” aim to enhance employment in the Haredi, Arab and Ethiopian immigrant communities, and they also target people with disabilities. These centers provide vocational training, help developing soft skills, provide guidance and assist with job placement. To better integrate Arabs in the high-tech industry, the government assists students and academics with job placement and subsidizes employee salaries through an “employment track” program for interns. Haredi students of high-tech professions at the Vocational Training System are entitled to scholarships. Other programs, through the Small and Medium Businesses Agency, support and guide entrepreneurship initiatives in both Arab and Haredi communities. Micro-finance loans are available to Arab women entrepreneurs. Special daycare subsidies also target Arab women.

The substantial rise in labor force participation over the past decade occurred on the back of such programs and other incentives. Staff rightly point the high poverty rate and inequality in Israel compared to other OECD countries, however these are on a persistent declining path, albeit a moderate one, since 2006 alongside improvement in labor market attachment. The authorities concur that pressing ahead with reforms to improve skills and increase labor market participation is the right way forward and they are crucial for the long-term outlook of the economy.


The macroeconomic performance of the Israeli economy is strong. Growth has accelerated in 2016, labor force participation is at an all-time high, the unemployment rate at its lowest level in decades, inflation is under check, debt-GDP ratio is on a declining path for over a decade and the financial system is strong. Challenges are mostly structural. High house prices driven by supply-side shortages are most pressing, and demographic dynamics weigh on long-term labor productivity. The authorities recognize these challenges and take actions to confront them. There is substantial progress on both fronts, but plenty remains to be done.

The authorities thank Mr. Beaumont and his team for the excellent discussions and report and look forward to future cooperation with the IMF.


It should be noted that while economic activity has firmed up during 2016, the early readings of the national accounts pointed to substantial weakness. At the time, they provided further support for maintaining an accommodative monetary position.


For comparison, the participation rate of the non-Haredi non-Arab population has improved as well but at much less impressive rates, from 79.8 percent to 87.4.