Israel -- Article IV Consultation Discussions, Concluding Statement (Preliminary) of the IMF Mission
December 9, 2002
1. Since the last staff visit in February 2002, macroeconomic conditions deteriorated with external demand stagnant and the security situation worsening. GDP growth this year is expected to be at around -1 percent, negative growth in two successive years. Furthermore, a temporary loss of confidence in macroeconomic policies that followed the December 2001 policy package caused a major disruption in financial and foreign exchange markets in the first half of 2002. The 2 percentage point interest cut, which was a clear departure from the previous gradualism, and the subsequent failure to reduce the fiscal deficit as planned, resulted in a sharp depreciation of the sheqel, a surge in inflation, and a threat to financial stability. The market disruption necessitated a substantial tightening of monetary policy in the end. Although the tightening was essential to avert a financial crisis and to restore market stability, it was unfortunate since the economy would have benefited more from a policy mix in the opposite direction—namely, tighter fiscal and easier monetary policy.
2. An important lesson to be learned from this experience is the need for macroeconomic policies to be consistent, transparent, credible, and geared toward maintaining stability. This is all the more important in light of the continuing uncertainties regarding the regional security situation and the global economy. The stability-oriented policy requires the government to adhere to fiscal prudence, and the Bank of Israel (BoI) to move gradually in loosening monetary policy not to disrupt foreign exchange and financial markets. This constrains the authorities' ability to support real economic activity in the midst of the deepest recession in the history of Israel. However, within this constraint, the authorities can, and should, explore ways to use macroeconomic policies to moderate the adverse impact of exogenous factors on growth and employment.
3. First, on fiscal policy. Given the high and rising public debt and concerns held by market participants about its sustainability, the basic requirement of stability-oriented fiscal policy is to convince the market that the government is able and willing to move the debt and deficit back to a declining path over the medium term. For this, the first step is to have the 2003 budget approved by the Knesset. We found it reassuring that the fiscal authorities are determined to achieve this without compromising on various expenditure-cutting measures included in the budget. Firmly adhering to this strategy will send a signal to the market that the government is committed to fiscal discipline.
4. The 2003 budget is based on a GDP growth forecast of 1 percent. While this was a conservative forecast when the budget proposal was first formulated, the subsequent developments have further clouded the growth prospects. We believe that 1 percent growth is still possible, although our current central forecast is somewhat lower at 0.5 percent. Nevertheless, we see considerable risk that revenue will fall short of the budgeted amount. The government that will emerge from the elections in January 2003 should be aware of the risk of a possible revenue shortfall, and take necessary steps to contain deficit expansion if it becomes clear that revenue is not coming in as expected. Failure to recognize and appropriately address the problem expeditiously would cast doubt on the government's resolve to maintain fiscal discipline.
5. The new government should also be aware that the process of fiscal consolidation continues beyond 2003. In this regard, we encourage the new government to formulate a multi-year budget program consistently with a declining deficit and expenditure path, in which future spending plans and commitments—including those stemming from public projects financed by private firms—and the expiration of any one-off deficit cutting measures are presented in a transparent way. Although the government need not be fully bound by this program in later years, any deviation should be explained to the public, together with proper justifications. To minimize deviations, the restriction on private member bills with budgetary implications should be maintained.
6. Within the tight deficit target, the government can improve its contribution to growth and employment. We commend the authorities' efforts to strengthen incentives of the unemployed to work, to streamline transfer payments, to increase infrastructure investment, and to re-align the tax system. These measures will lay the ground for future growth and job creation. However, it is imperative that the cuts in social benefits be complemented by measures that will facilitate the return of unemployed workers and welfare recipients to the labor force, including a decisive reduction in the number of foreign workers. In order to reduce foreign workers, it is essential to introduce measures that would bring the cost for employers of hiring foreign workers closer to that of hiring Israelis.
7. Next, on monetary policy. In our view, the BoI's task in maintaining stability is to strike the right balance between the risk of moving too fast and that of waiting too long in monetary easing. First, it should re-establish credibility to avoid repeating the market disruption over the past months, and for that purpose, should be cautious in cutting interest rates. This calls for gradualism in its policy action as well as close monitoring of market sentiment to choose the right timing to start easing. Second, it should also avoid becoming excessively conservative. This could result in an undershooting of the inflation target and put an extra burden on the economy, which would have various destabilizing effects, including on the fiscal deficit and banking and corporate sector profitability that has already been undermined due to a long and deep recession.
8. The BoI's quick and decisive action during last June, combined with the government's renewed efforts to contain the budget deficit, stopped the sheqel's depreciation. Once the sheqel's slide is halted, inflationary prospects become generally benign. The substantial output gap as indicated by high unemployment, the moderate wage settlements in 2002, a tighter fiscal policy, and a moderate recovery of external demand at best, all point to subdued inflation. The only upside risk to inflation stems from exchange rate instability if market confidence in the sheqel is somehow lost again. If this risk does not materialize, it is likely that inflation will fall to, or even below, the lower end of the target range of 1-3 percent over the next year. The BoI should definitely avoid this eventuality.
9. The BoI therefore needs to probe room for easing, seizing every opportunity provided by improvements in financial market conditions and a reduction in expected inflation, as various uncertainties are resolved one by one. One can see a number of events in the next few months which, if their outcomes are favorable, may improve market conditions; the approval of the 2003 budget by the Knesset without compromise; a stable and fiscally prudent government after the January 2003 elections; and the hopefully peaceful resolution of the Iraqi situation. If these events reduce concern of market participants and lead to a strengthening of the sheqel and/or a decline in inflationary expectations, the BoI should act without delay to cut its policy rate. If the BoI fell behind the curve, low inflation could raise real interest rates further, which would be counter-productive for maintaining stability. Indeed, in order for the BoI to keep to gradualism (i.e. to avoid the need to implement large interest rate cuts to catch up with a fall in inflation), not missing any opportunity to cut interest rates without disrupting financial markets is absolutely essential.
10. Turning to other policy issues, we found labor market conditions particularly worrisome. Generous income maintenance payments (inclusive of various supplementary benefits that income support recipients qualify to receive) relative to the minimum wage, combined with steady inflows of foreign workers, and inadequate vocational training and employment services, contributed to a low participation rate, high unemployment, and a sharp increase in the number of working-age population who receive income maintenance support. Although the economic slowdown has no doubt accentuated the deteriorating labor market conditions in recent years, the fact that income support recipients increased steadily even during an economic upturn indicates that the underlying cause is more structural than cyclical.
11. The government labor program incorporated into the 2003 budget is an attempt to address the problem by reducing workers' disincentives to work on the one hand, and decreasing the number of foreign workers on the other. This is a step in the right direction, but it should be accompanied by various measures that facilitate the job-search activity of the unemployed and income support recipients, such as an increase in, and improvement of, vocational training and employment services. In this regard, the recent Welfare to Work pilot project based on the so-called Wisconsin program is promising, and we support this initiative. However, given the limited scope of this project, further efforts may be needed to reallocate expenditures to areas conducive to job creation.
12. Credit quality of the corporate sector has declined significantly due to the continuing recession. Problem loans—excluding loans in the special mention category—have risen by 26 percent since December 2000.1 Bank supervisors reacted promptly by requiring banks to increase supplementary provisions in the fourth quarter of 2001. They have also conducted focused on-site examinations of major banks to assess their credit classification and to raise specific provisions so that their loan assessments better reflect underlying risks. The aggressive provisioning policy enabled banks to maintain the ratio of problem loans to total credit—excluding special mention loans and net of provisions—at around 3.5 percent during the period 2000-2002.2 However, it inevitably reduced bank profits substantially from the high levels that had prevailed before 2001, to such an extent that they turned negative in the case of some banks. Bank profits were also adversely affected by capital losses from the fall in tradable securities prices due to the sharp increase in interest rates.
13. Banks and supervisors reassured us that the additional provisions have brought the net book value of bank loans close to their true economic value. We therefore see at this point no imminent vulnerabilities in the banking sector that could pose a threat to financial stability. We commend the supervisors' timely preventive action. However, if economic conditions were to deteriorate further in 2003, or even remain stagnant, more provisions would become necessary and the capital base, which is fairly close to the regulatory minimum for some banks, might be eroded further. For this reason, we urge the authorities to remain vigilant, and take proactive measures to prevent financial sector instability. This consideration reinforces the importance of stability-oriented macroeconomic policies mentioned earlier, because macroeconomic and financial market instability, including those stemming from sharp policy reversals, is a major potential source of banking sector instability. We also encourage the authorities to develop stress tests to help gauge the impact of a further deepening of the recession or of major policy changes on the soundness of the banking sector.
14. We followed up on the findings of the Financial Sector Stability Assessment (FSAP) conducted in 2000-2001. We commend the authorities for the progress made toward the implementations of many FSAP recommendations. However, we also found that a number of recommendations are yet to be fully implemented such as; legislation that allows an adequate exchange of information among domestic supervisory agencies; the introduction of deposit insurance; further work towards reform of the payment and settlement systems; agreements for cooperation and information exchange between foreign and Israeli insurance supervisors; and enabling insurance supervisors to set, and implement, rules on corporate governance and internal controls in insurance companies. Work in these areas should continue, and efforts should be made to introduce the necessary changes that will bring the financial sector institutions and practices in Israel to full compliance with international standards.
15. A separate team of experts on anti-money laundering and combating financing of terrorism (AML/CFT) conducted an in-depth analysis of Israel's AML/CFT regime. The team found that Israel has made enormous progress in AML. The Prohibition on Money Laundering Law (PMLL) was enacted in August 2000 as comprehensive legislation for AML. In January 2002, the Israel Money Laundering Prohibition Authority (IMPA) became operational as the financial intelligence unit at the Ministry of Justice. On the basis of this legislative and organizational framework, the AML regime was implemented and IMPA started to receive unusual transaction reports in February 2002.
16. Although implementation of PMLL is still at an initial stage, the team noted a high level of the Israeli authorities' awareness of AML/CFT issues, as well as their considerable efforts to further enhance the AML/CFT regime, including the amendment to the PMLL in May 2002 and the IMPA's admission to the Egmont Group in June 2002. Nevertheless, the team's assessment of Israel's AML/CFT framework and implementation under the assessment methodology endorsed by the Financial Action Task Force and the IMF, identified a number of areas for further improvement. Some of these areas were already noted by the authorities before the assessment and concrete plans for improvements are in preparation. The team understands that the authorities will give consideration to the other issues and challenges as well, in order to enhance the AML/CFT regime further.
17. Both the Article IV and AML/CFT mission teams express their deep appreciation for the authorities' kind cooperation and hospitality.
1 Including special mention loans, problem loans have risen by 46 percent.
2 Including special mention loans, the ratio has risen from 6.9 percent as of end-2000 to 8.9 percent as of June 2002.