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Israel-Article IV Consultation Discussions
Concluding Statement (Preliminary)
1. Since the last Article IV consultation discussions in December 1999, the Israeli economy experienced the best three quarters in recent memory-featuring both rapid growth and price stability-followed by a very sharp deceleration. The downturn arose primarily from a global turnaround of the high-tech boom (on which a considerable part of the preceding growth depended) and the security problem that particularly affected the tourism, construction, and agricultural sectors. The critical task confronting policy makers is to formulate economic policies so as to weather these shocks, maintaining stability and minimizing economic costs borne by the population, until global economic conditions rebound and the security situation improves.
2. Notably, although some economic indicators have fallen sharply since the fourth quarter of 2000, others have shown surprising resilience. In particular, the exchange rate, inflation, and market-based inflation expectations have exhibited remarkable stability, substantially attenuating the pain of adjustment. This is no doubt a reflection of the authorities' success in establishing credibility, on both the fiscal and monetary policy fronts, for which they should be highly commended. Looking forward, it is of the utmost importance that the overall macroeconomic policy mix be geared to maintaining stability of the economy. At the same time, within this requirement, any room to further ease the costs of the current downturn should not be left unexploited. This implies that the policy mix should be appropriately supportive of economic activity, through measured monetary loosening in the context of continued fiscal discipline. It is also important to make further, steady progress on the structural reform agenda, including on measures pertaining to financial sector stability, to create a more efficient and flexible economy, enhancing future growth prospects.
3. The mission considers that the growth rate this year will inevitably be subdued, at around 1.5-2 percent. It should be noted, however, that the strong influence of external or exogenous factors on the Israeli economy makes this and other forecasts subject to greater than usual uncertainty. Both domestic and external demand components will be adversely affected by these factors, with the result that the current account deficit will likely expand only moderately. Although capital inflows will decline substantially from the record level of last year, there should be no immediate concern about the balance of payments, partly because funds raised last year and held abroad by domestic firms are now being repatriated, supporting the sheqel's external value. Excess capacity will increase, and unemployment is set to rise from a level that was already high even at the peak of last year's rapid growth. Reflecting weaker demand conditions and excess capacity, inflation is expected to remain subdued, below the authorities' end-year target band of 2.5-3.5 percent and closer to the lower end of the target band at end-2003 and thereafter of 1-3 percent, even allowing for continued gradual easing of monetary policy this year.
Monetary and exchange rate policy
4. The moderate inflationary prospects and the need for prudent fiscal policy (see below) imply that monetary policy has an important role to play in providing support to economic activity without jeopardizing medium-term price stability. The Bank of Israel (BoI) has implemented a policy of cutting interest rates in small steps since late 1999, and the cumulative cut has become quite substantial. However, due to a sharp fall in inflation expectations that took place over the same period, the decline in real interest rates has been rather modest. In particular, since the beginning of the slowdown last October, short-term real rates have fallen only by about 70 basis points, in spite of a cumulative nominal rate cut of 170 basis points. As a result, current real rates are still high, at around 6 percent. Assuming that inflation expectations stop falling, future rate cuts will translate more directly into real rate declines. This should provide additional support to the economy over time, and the mission supports the easing of monetary policy consistent with inflation targeting.
5. The fall in inflation expectations to a level consistent with price stability is unprecedented in the history of Israel and is a major achievement of the BoI's prudent policy. This is a cornerstone of market stability, including exchange rate stability, and any future policy action by the BoI should be consistent with maintaining this non-inflationary environment. Important questions remain, however, about the extent to which such an environment has been firmly established in the economy, and hence about how much room exists for additional monetary loosening without undermining price stability. Israel's long battle against inflation compared to its relatively brief experience with price stability, as well as still-pervasive indexation practices inherited from high inflation periods, could be taken to imply that the current environment is still fragile.
6. However, the mission also emphasizes the remarkable ability of the economy to adjust to this new environment. For example, the share of CPI-indexed instruments in assets and liabilities is decreasing steadily. The resilience noted earlier in the face of a major exogenous shock last fall is an indication that the economy is much less prone to a depreciation/inflation spiral than in the past. The business sector's exposure to foreign exchange risk has declined, and the reaction in recent months of private capital flows to shocks that could potentially have destabilized the foreign exchange market has been remarkably different from that in October 1998, when another exogenous shock resulted in a major currency depreciation. Furthermore, the authorities in Israel have the advantage, not available in many other countries, that market participants' expectations of future inflation are directly observable in capital markets. The authorities are also using information derived from currency options to detect early on the probability-as perceived by market participants-that large exchange rate adjustments will take place. These facts should allow the BoI to take bolder steps in either direction in a forward-looking fashion.
7. The decline in inflation to a level comparable to that in major industrialized countries has clear implications for Israel's exchange rate regime. The current arrangement in essence implies that the exchange rate should depreciate by at least 2 percent, once it has hit its most appreciated level within the band. Over the medium term, productivity growth of the Israeli economy, led by the resumed buoyancy of the high-tech sector, will likely put upward pressure on the sheqel's real exchange rate. This would result in a nominal appreciation of the sheqel and/or a higher inflation rate in Israel than in other industrialized countries-the economy could not avoid both forever. If this real appreciation were to occur, the constraint imposed by the exchange rate band on nominal appreciation would become a perennial source of tension with inflation targeting. Hence, a process should be put in place leading to the abolition of the band. At a minimum, the band should be modified so that the lower boundary will not constrain the BoI's pursuit of price stability.
8. While the BoI's policy framework has evolved over time, the legal framework has not changed. The mission believes that the Levine Committee Report should be revisited and implemented.
9. The conduct of fiscal policy has improved markedly in recent years, enhancing the credibility of the overall policy environment. Despite this progress, however, ratios of general government expenditure and of public debt to GDP remain high relative to those of many other advanced economies, at about 53 and 95 percent of GDP, respectively, in 2000. Accordingly, the authorities have appropriately committed themselves to a path of fiscal consolidation up to 2003 that calls for continued progress in reducing deficit targets and with them the ratios of debt and spending to GDP. In line with this objective, the expenditure limits established in the 2001 budget should be maintained, with additional spending demands arising from the security situation or other factors being offset by cuts elsewhere in the budget. Aiming firmly at the original deficit target of 1¾ percent of GDP would send a clear signal to markets of the government's commitment to fiscal discipline, and the mission calls on economic and political decision makers to support this commitment by refraining from the introduction of private member bills and other measures that would put additional pressure on spending. However, if revenues fall short of the budgeted amount because of the growth slowdown, some deviation of the actual deficit from the target should be tolerated, in order not to accentuate the economic downturn. In the event that revenues exceed the budget forecast, for example due to a faster than expected rebound in growth, any revenue overperformance should be used to reduce the deficit, as occurred last year.
10. Looking beyond 2001, the achievement of the Maastricht criteria on debt and deficits-which the authorities have identified as a medium-term goal-would help illustrate the soundness of Israel's overall policy environment and would facilitate the country's continued integration into global capital markets. Progress toward these goals will release resources that can be better utilized by the private sector, enhancing the economy's growth potential. However, achieving this goal will require a combination of additional medium-term fiscal consolidation and macroeconomic policies that support strong output growth. The mission therefore urges the authorities to formulate a well-articulated medium-term fiscal program covering the next 5-10 years, so as to indicate clearly to the general public the size of fiscal adjustments likely to be needed and possible strategies for achieving them. In doing so, it is important to recognize those elements that might threaten the process of fiscal consolidation in the future, such as the public pension system and the health care system.
11. In recent years concern has mounted about the social and economic costs of income inequality in Israel. While the tax system and government transfers play a role in redistributing incomes, the need for future fiscal consolidation is likely to put increasing pressure on transfer payments, which account for about one-third of central government spending. In the mission's view, marrying continued progress in reducing the fiscal deficit with improved income equality over time can best be achieved by a rebalancing of spending, with an increasing emphasis on growth-enhancing investments in infrastructure, education, and training. Faster output growth to stimulate employment and better training and education to allow all Israelis to participate fully in an economy of increasing technological sophistication are in the long run likely to prove more effective than large transfer payments in reducing social and economic gaps.
12. The mission welcomes the authorities' ongoing commitment to tax reform, which is another key element to enhance growth in the medium term. Such a reform should address two major shortcomings of the current tax code, namely, the very high tax wedge at some income levels and the asymmetric tax treatment given to different forms of capital income that distorts investment flows and introduces substantial inequities into the tax system. More generally, the reform should seek to rebalance the overall tax burden, reducing the share of taxes on labor income and increasing that on capital. Such a reform should be structured so as to have limited impact on overall tax revenues, and should also ideally be introduced in phases, both to allow firms and individuals to adjust to potentially significant changes in the tax code and to allow the fiscal authorities to monitor its cost.
Other policy and structural reform issues
13. The mission reviewed a number of other policy and structural reform issues, including the minimum wage, privatization, and the trade regime. The linking of the minimum wage to the average wage may lead to a costly distortion in the labor market, pricing out unskilled labor. To mitigate this problem, the mission urges the authorities to reconsider the determination of the minimum wage, for example, linking it to the CPI or to the median wage. Privatization, appropriately planned and implemented, will enhance competition, and hence the efficiency, of the Israeli economy. In particular, privatization of government monopolies, such as in the telecommunication and energy sectors, should be accompanied by careful planning that ensures the creation and maintenance of a competitive environment before and after its implementation. The mission endorses the efforts in this direction being made by the Government Companies Authority and the Antitrust Authority, and encourages the authorities to move forward expeditiously with the privatization. With respect to the trade regime, the mission welcomes recent initiatives to simplify the tariff structure for textile products and to liberalize fully the dairy sector in accordance with World Trade Organization rules.
Financial sector stability
14. In September 2000, an IMF-led team conducted an in-depth assessment of the structure and stability of the Israeli financial system as part of its work on financial sector issues. The assessment concluded that the Israeli financial system has grown strongly, in the wake of the banking crisis of 1983-84 and then a twin process of disinflation and structural transformation that started in the mid-1980s and intensified in the last decade. Large banks were privatized, directed credit was phased out, and most restrictions on international capital mobility were lifted. Although this environment has contributed to financial sector development, it also has engendered new risks for financial intermediaries, and additional challenges for the various supervisory authorities.
15. Though financial services seem to be well provided for, the development of financial markets has been unbalanced. First, bank concentration and control of the financial sector is high and foreign bank presence is quite low. Second, capital market development is quite uneven: equity and derivative markets are well developed, whereas corporate bond and money markets are nearly nonexistent. Though banks are rather concentrated and dominate many financial services that might have developed elsewhere, the team recommends that policy should aim at a level playing field and removing barriers to the development of other financial products, rather than directly restricting banks.
16. The team found no major systemic weaknesses in the banking system. Israeli banks are conservative in their management of risks and banking supervision by the BoI is strong. Based on estimates of losses from hypothetical shocks (stress tests), banks seem to have enough capital to cover potential losses due to credit and market risks (i.e., inflation, currency and interest rate risks). This said, credit risk is, by far, the main source of risk for banks. Israeli banks are aware of this risk and have conservative credit exposures and risk management guidelines. Thus, even large external shocks, such as a large drop in capital inflows, would not be expected to result in widespread business failures and/or loan defaults sufficient to result in widespread bank failures. However, the squeezing of profit margins in recent years may force the consolidation or exit of some smaller, less efficient banks. The BoI will need efficient exit mechanisms, such as the introduction of procedures for the administrative resolution of failed banks based on a new Banking Law.
17. Payment systems are not adequately supervised and interbank payments are organized on the presumption that the BoI would cover the risk of any bank failing to settle. The BoI is considering the development of a Large Value Transfer System that would be able to eliminate the current risk to the BoI. The team urged the BoI to develop more systematic oversight of the payment system.
18. The insurance and pensions sectors are well developed, but they both now face significant transition issues as a more disciplined and market-oriented economy emerges. In particular, the private pension system was not fully funded until new plans were introduced in 1995. The pre-1995 plans are currently showing a very large actuarial deficit: at least one major fund is illiquid and suffering from negative cash flows. The public sector pension system is unfunded and has accumulated substantial liabilities. While economic and demographic factors are not currently a problem, there is a valid concern that pension increases can be too easily be traded off for wage increases and lead to generational inequity and future fiscal strains. A well planned program to move to a sustainable and funded second pillar pension arrangement, of which the 1995 reforms were first steps, will ensure that the long term cost of the pension system becomes more transparent. The insurance sector's transition requires the installation of an appropriate risk based supervisory capacity in concert with the removal of government oversight, subsidies and guarantees.
19. All key financial sector activities except payment systems are satisfactorily supervised, though coordination among sectors should be improved. The structure of supervision might be improved by consolidating the supervision of all collective investment schemes in the Israel Securities Authority (ISA), thus moving supervision of non-retirement related provident funds from the Ministry of Finance to the ISA. The most significant shortcoming and source of risk in the coordination of supervision arises from the inability of supervisors to share information on individual firms and financial conglomerates. Impediments in the law to appropriate information-sharing among domestic and foreign supervisors should be removed. The autonomy and authority of the BoI to supervision banks should also be strengthened in the appropriate laws. The team also recommended the establishment of a "Council of Financial Supervisors," comprising the BoI, ISA, and the Capital Markets, Insurance and Savings Division of the Ministry of Finance, to facilitate coordination of financial sector supervision.
20. In many ways, the contrasts between macroeconomic conditions at the time of the last Article IV consultation discussions and those at present could not be more striking. Dramatic and unfortunate changes in short-term prospects in response to largely external shocks, however, should not be allowed to obscure the fact that long-term growth prospects for the Israeli economy remain bright, particularly once a lasting solution to the security problem is reached. The authorities' record of skillful management of fiscal and monetary policies, and their commitment to continued structural reform, give cause for optimism that the Israeli economy will emerge from the current downturn with financial stability intact, and poised for a resumption of rapid, sustainable output growth.