Israel -- Interim IMF Staff Visit, Concluding Statement (Preliminary)
February 26, 2002
Israel -- Interim IMF Staff Visit
Concluding Statement (Preliminary) -- February 26, 2002
1. Since the last Article IV consultation in May 2001, the Israeli economy has continued to stagnate as a result of the global slowdown, especially the high-tech slump, and the security situation. Macroeconomic policies cannot fully offset these negative shocks. In fact, too vigorous policy reactions to these shocks could cause adverse consequences elsewhere, such as high inflation, a loss of fiscal discipline, and financial market instability. Rather, their main task is to attenuate the impact of these shocks by providing a stable, transparent, and supportive environment to economic activity, until the economy begins a solid recovery.
2. We argued in the past that, in order to achieve the policy objective stated above, the macroeconomic policy mix should be rebalanced in the direction of tighter fiscal and easier monetary policy. Such a policy mix should help the economy weather the global slowdown, while improving fiscal discipline and credibility. A rebalancing in this direction will be particularly appropriate when domestic inflationary pressures are subdued, providing room for monetary expansion without jeopardizing the inflation target over the medium term, and when public deficit and debt are at a high level.
3. The policy package announced on December 23, 2001 was consistent with the necessary rebalancing mentioned above. In this sense, the mission welcomes the direction of the policy steps taken by the authorities. The mission also welcomes several other structural measures included in the package, with respect to the exchange rate band, government short-term securities, and institutional investors' external investment. However, in light of the events that have unfolded subsequently, the macroeconomic policy part of the package requires a more cautious scrutiny, and the need for further policy adjustments has to be carefully examined.
4. First, on monetary policy. The two percentage point interest rate cut by the Bank of Israel (BoI) was a sudden departure from the gradualist approach previously advocated by the BoI. The rate cut clearly had a major impact on the view and behavior of market participants, as evidenced by the sharp depreciation of the sheqel. Part of this depreciation was intended by policy makers, and will have the desired effect of stimulating net exports. However, market participants seem to have been confused by the BoI's action, which may have led to an excessive weakening of the sheqel.
5. The pass-through of the depreciation will raise inflation substantially in the short run, as is evident from the recent release of the January consumer price index (CPI). A critical question is to what extent this initial rise will translate into a more persistent increase in the CPI over the medium term. Particularly important in this respect is whether upward price pressures will spread to those goods and services which are not exchange rate sensitive. It is still too early to make a definitive judgment on this; the generally weak economic conditions, including the recent rise in unemployment, will minimize such ripple effects, but alertness on the part of the BoI is clearly necessary. A related important question is whether the weakening of the sheqel has run its course. If the sheqel continues to weaken, the risk of broader-based inflation will inevitably rise.
6. Against this background, the BoI's decision to raise its policy rate by 60 bps sends a signal to financial markets that the BoI's commitment to medium-term price stability has unchanged, while still maintaining the desirable effect of policy rebalancing intended by the December 23 package. Once confidence is restored and the foreign exchange market stabilizes, the threat to price stability will be substantially alleviated. This will, in turn, create room for the BoI to ease its policy as appropriate, depending on the economic conditions in coming months.
7. Next, on fiscal policy. The mission commends the government's efforts to cut the planned deficit for 2002 to 3 percent of GDP. This is no small achievement in light of the current adverse environment, both economic and political, including the deepening recession and the tense security situation. However, not only has the deficit cut involved a significant amount of compromise, but also a considerable uncertainty still remains.
8. The 2002 budget has a number of important features. In order to contain the deficit, the government has taken steps to cut expenditures, including transfer payments, and has frozen most social benefits and the minimum wage. The government has also minimized the impact of expenditure cuts on infrastructure, a seed of sustainable growth in the future. These features notwithstanding, compromise had to be made to have the budget approved by the Knesset, which resulted, among others, in a failure to fully cancel populist private bills with considerable budgetary implications. The budget continues to deviate from the government's medium-term objective of reducing expenditure and debt as a share of GDP. Furthermore, in spite of the NIS 6 billion deficit cut, it is questionable whether the government can achieve its deficit target of 3 percent of GDP this year. Although no official estimate is available at present, private analysts expect that the deficit overrun could reach 1.5 to 3 percent of GDP due to a likely revenue shortfall.
9. As in the case of monetary policy, what is at stake now is the market's confidence in the authorities' will and ability to adhere to their stated medium-term objectives. In order to send a clear signal to the market that the government's determination has not been shaken, it is of utmost importance to present an up-to-date and transparent picture of this year's likely budget outcome as soon as possible, together with measures necessary to contain the possible deficit overrun. It is also important that the government's planning horizon should cover outer years as well; stop-gap measures for reducing the 2002 deficit would only increase the difficulty of achieving the targets in 2003 and beyond, and would do little to bolster market confidence. In this regard, it is imperative to revisit the thorny issue of transfers, tax exemptions, and private bills. Since the impact of these measures on growth is likely to be limited, and sometimes even negative, a permanent cutback on them would be less harmful than other measures from the cyclical point of view as well.
10. The mission welcomes the government's measures to encourage employment, such as those aimed at facilitating participation of welfare benefit recipients and the ultra-orthodox population in the labor market. The mission also welcomes a number of structural reform measures taken by the government, including in public transportation and OTC drugs, which will enhance competition and improve efficiency. Indeed, the limited availability of fiscal resources under the government's multi-year budget consolidation program makes it all the more attractive to implement structural reforms that invigorate the economy without expanding deficits. There are many remaining sectors of the economy in need of efficiency gains through reforms, including port service, public utility, and banking and finance. Tax reform continues to be high on the agenda, and the mission urges the newly formed committee on tax reform to present a reform program as broad-based as possible to maximize its benefits for the economy as a whole. Most important from the point of view of improving the budgetary process is limiting the scope of private bills with fiscal implications. Normalizing this practice, unique to Israel, will strengthen the government's control over the budget and improve its ability to conduct fiscal policy more efficiently.
11. The economic outlook this year depends very much on exogenous factors, notably the pace of global recovery and the security situation, and the policy rebalancing still in process. The mission considers that, provided that the foreign exchange market stabilizes obviating further monetary tightening, and the government expeditiously introduces growth-friendly measures that will contain deficits in 2002 and beyond, the overall macroeconomic policy will continue to support economic activity. The emerging global recovery and the resulting stronger exports will offer further support. Yet, since the economy starts from a very low level of activity recorded toward the fourth quarter of 2001, the mission expects the growth rate in 2002 to be subdued at slightly above 1 percent. Prices will continue to rise in the near future as a result of the sheqel's depreciation that has already taken place. However, so long as a further substantial depreciation does not occur, the mission expects that inflation in the rest of the year-measured from the level of CPI in February or March 2002-will be consistent with the medium-term target range of 1-3 percent.
12. The Israeli economy has withstood major exogenous shocks remarkably well so far. Once global demand begins to recover, there is a good chance that the economy will return to its high potential growth path relatively quickly. The authorities should facilitate, rather than hinder, this process. And for that purpose, it is important for monetary and fiscal policies to attain a right balance, while maintaining stability and transparency. The December 23 package was a step in this direction, but unfortunately, it came at a cost of loss of market confidence. What is required of the authorities now is to re-establish their medium-term orientation and demonstrate it convincingly to the market, without sacrificing the desirable rebalancing of the macroeconomic policy mix.