Public Information Notice: IMF Concludes Article IV Consultation with Israel

April 29, 2004

Public Information Notices (PINs) are issued, (i) at the request of a member country, following the conclusion of the Article IV consultation for countries seeking to make known the views of the IMF to the public. This action is intended to strengthen IMF surveillance over the economic policies of member countries by increasing the transparency of the IMF's assessment of these policies; and (ii) following policy discussions in the Executive Board at the decision of the Board.

On April 19, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the 2003 Article IV consultation with Israel.1


The economy has entered a modest recovery path, after almost three years of recession. Led by external demand, real GDP is estimated to have grown 1.3 percent in 2003, despite anemic investment. Furthermore, high frequency indicators suggest that output is recovering, private consumption is growing, and tourism is rebounding.

A major change of policy took place around mid year and contributed to a restoration of confidence and helped instill a moderate if potentially fragile recovery. A new coalition government took office in February 2003 and soon thereafter it presented a program designed to return to a path of declining deficits and public debt. In addition, key structural reforms were launched, including reforming the pension system, streamlining the public sector, reducing taxes, and speeding up privatization.

Notwithstanding the budgetary adjustments, the deficit reached 5.6 percent of GDP in 2003, compared to a target of 3 percent in the budget, and public debt rose to about 107 percent of GDP by the end of the year.

The formulation of an emergency economic program in March, the ending of the major conflict in Iraq, some progress in the security situation, the rebound in world stock markets (particularly the NASDAQ), and the decision by the United States to extend nearly US$9 billion in loan guarantees contributed to an upturn in financial markets since April 2003. A notable resurgence in financial markets also took place in 2003: the stock market surged, long-term rates declined, and the sheqel recovered.

Inflationary pressures have eased considerably. The Consumer Price Index declined 1.9 percent during 2003, compared with a 6.5 percent increase during 2002, and inflation expectations fell to below the lower inflation target bound of one percent. The drop in inflation and in its expectations to within the inflation target range, the enhanced fiscal commitment and the strengthening of financial markets prompted the Bank of Israel (BoI) to lower its policy interest rate from close to 9 percent during the first half of 2003 to 4.5 percent by February of 2004.

The recession worsened the already burdened labor market and welfare system. The unemployment rate rose from 8.5 percent in early 2001 to 10.7 percent in November 2003, while the share of long-term unemployed (jobless for more than six months) in total unemployment reached 40 percent.

The external current account deficit continues to fall and is now close to balance. The sizeable capital outflow of the last quarter of 2002 and the first quarter of 2003 has been reversed, and foreign direct investment rebounded. Total gross external debt is about 60 percent of GDP, but net external debt is negative and international reserves (amounting to nearly US$26 billion at end-2003) cover most short-term debt.

The banking system has strengthened in 2003. While problem loans continue to grow, albeit at a reduced pace, and loan concentration is high (although significantly reduced from a year ago), positive signs have emerged: profitability has increased, capital adequacy ratios have improved, and provisions relative to non-performing loans have risen substantially.

Executive Board Assessment

Executive Directors welcomed the economic program of consolidation and reform the Israeli authorities have put in place over the past year. This has allowed a needed rebalancing of the policy mix which, together with the rebound in the global economy and a return of market confidence, has laid the ground for a gradual economic recovery after three years of recession. At the same time, Directors cautioned that establishing the basis for stronger and more sustained medium-term economic growth remains a challenge going forward. Meeting this challenge will require a steady and consistent policy stance complemented with a steadfast implementation of structural reforms and a stronger commitment to debt reduction. Directors recognized that prospects for stronger and more durable economic recovery also depend on improved security conditions.

Directors welcomed the authorities' renewed commitment to fiscal discipline. They considered that the 2004 budget strikes an appropriate balance between fiscal consolidation, on the one hand, and the need to support the recovery, on the other. However, given that the public debt as a share of GDP and the budget deficit still remain high against the backdrop of an uncertain economic environment, most Directors recommended that any revenue windfall be used to lower the deficit and the public debt. In this regard, they expressed disappointment at the authorities' recent decision-based on higher-than-budgeted revenue collection-to reduce taxes, as this will not allow for a much-needed faster pace of debt reduction.

Directors welcomed the authorities' commitment to re-establish declining paths for the public debt, budget deficit, and expenditure ratios. They commended the authorities for adopting a limit of one percent on expenditure growth in real terms and a ceiling of 3 percent of GDP on the overall deficit for 2005-10. Directors called on the authorities to adhere strictly to this medium-term framework in order to help achieve their goals of gradually reducing the public debt as a share of GDP and the size of the public sector, while allowing for a reduction of the tax burden.

Directors recommended that the authorities take several structural measures that would enhance the credibility of the fiscal adjustment process and cushion market reaction to temporary setbacks. These include formulating a detailed medium-term spending plan consistent with the adopted expenditure limits, and preparing semi-annual reports on progress made in achieving the government's public finance goals and reform objectives.

Directors expressed concern about the high rate of unemployment, notwithstanding a labor market participation rate that is low relative to other developed economies. Reforms are needed to raise the incentive to work, and to better target welfare policy to the truly disadvantaged. In this vein, Directors welcomed the cuts in social benefits to those fully able to work. They urged the authorities to complement this reform with measures to enhance job training and education, in order to assist the unemployed and those affected by the social benefit cuts to adapt more quickly to the requirements of the job market. Directors noted that the broad-based reforms being pursued in the product markets, including measures to increase competition in the business sector by dismantling monopolies and streamlining bureaucracy, should also contribute to improving employment prospects in the medium term.

Directors welcomed the relaxation of monetary policy, as upside inflationary risks appear modest. Noting that real interest rates remain relatively high, most Directors encouraged the BoI to continue lowering its policy rate gradually, while closely watching developments in the exchange and financial markets. Directors supported the view that the BoI law should be amended to strengthen the central bank's independence and reflect international best practice regarding monetary policy objectives and procedures, so as to enhance confidence and minimize the risk that temporary breaches of inflation targets could unhinge expectations.

Directors welcomed the indications of a strengthening of the banking system in 2003, with improvements in banks' capital adequacy ratios, provisioning for nonperforming loans, and profitability. They also welcomed the enhancement in banks' monitoring and risk-management systems stemming from the initiative of the Supervisor of Banks. At the same time, they noted that problem loans continue to grow-albeit more slowly than in previous years-and loan concentration is high, suggesting a need for continued vigilance on the part of the bank regulatory authorities.

Directors agreed that Israel's external vulnerability has declined, with exports to all major markets recovering, the current account moving to close to balance, foreign direct investment rebounding, the level of foreign reserves adequate, and net external debt negative. They considered that the current floating exchange rate system remains appropriate, and external competitiveness appears to be sound.

Directors observed that Israel meets the Special Data Dissemination Standard specifications for coverage, periodicity, and timeliness of the data, and that the quality of the data is adequate for the purpose of surveillance.

Israel: Selected Economic Indicators







National account indicators (constant prices)


Real GDP






Private consumption






Public consumption






Gross capital formation






Exports of goods and services






Imports of goods and services






Labor market indicators


Unemployment rate (in percent)






Prices (end-period)


Overall CPI






Underlying CPI (excluding housing, fruits and vegetables)






Money and credit (period average)


Narrow money (M1)






Broad money (M3)






Domestic credit






Interest rates (average, in percent)


Bank of Israel policy rate





7.5 1/

Public finance (percent of GDP)


Central government balance






General government balance






Public debt






Balance of payments


Trade balance (percent of GDP)






Current account (percent of GDP)






Foreign reserves (end-of-period, in billions of U.S. dollars)






Exchange rate indices


Nominal effective exchange rate (period average; depreciation -)






Real effective exchange rate (period average; depreciation -)






Sources: Bank of Israel, Annual Report; Central Bureau of Statistics; IMF, International Financial Statistics; and IMF Staff estimates and projections.

1/ The Bank of Israel set the policy rate at 4.1 percent in April 2004.

1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. This PIN summarizes the views of the Executive Board as expressed during the Executive Board discussion based on the staff report.


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