Israel -- Article IV Consultation Discussions, Preliminary Conclusions and Recommendations
December 15, 2003
The protracted decline in economic activity since October 2000 has given way to an incipient recovery led by external demand. Real GDP is expected to grow about 1 percent this year and around 2 percent in 2004, in line with the rebound in global markets and assuming no deterioration in the security situation.
The macroeconomic policy mix in 2003 was characterized by a considerable weakening in public finances and a gradual relaxation of monetary policy following a major tightening in 2002. Weakness in public finances intensified in early 2003, as government expenditures continued to grow, while revenues plummeted. As a result, the 2003 budget deficit is projected to reach 5½-6 percent of GDP,1 compared to a target of 3 percent in the budget, even after the emergency economic program of March 2003 and the special emergency aid from the United States. Public debt kept rising and will reach about 106 percent of GDP by the end of the year. In the aftermath of the turmoil in financial markets in 2002 and the notable deterioration in the public finances, monetary policy was conservative. With the benefit of hindsight, this policy was excessively conservative and led to a marked undershooting of the inflation target.
A welcome and essential shift in the policy mix began with the formulation of the economic program in March 2003. A stronger commitment to lowering the deficit and debt was a reassuring step toward fiscal consolidation. Optimism solidified with a rebound in the global economy, the decision by the United States to extend loan guarantees, and the ending of the major conflict in Iraq. Financial markets exhibited remarkable improvements, the stock market surged, the sheqel recovered, long-term rates on indexed bonds declined, and inflation expectations fell to within the inflation target. These notable developments propelled the Bank of Israel (BoI) to step up the pace of monetary policy easing.
The draft 2004 budget, with a deficit target of 4 percent of GDP, represents a necessary change of course. This budget strikes an appropriate balance between fiscal consolidation and sustainability, on the one hand, and the need to support the budding economic recovery on the other. Any upward deviation from this target may raise concerns about the government's commitment and ability to rein in its deficit and debt. Furthermore, given the high level of public debt and the frequent upward adjustments to the multi-year fiscal framework, the scope for allowing automatic stabilizers to play a role is limited. Only if the recovery in 2004 is weaker than expected and a return to potential growth in 2005-08 appears realistic, a limited deviation from the deficit target-say, up to ½ percent of GDP-to moderate a possible pro-cyclical policy may be considered. However, if the recovery is stronger than expected, the likely additional revenues should be used to lower the deficit and curb the substantial public debt.2
The mission commends the authorities for the adoption of a limit of one percent on expenditure growth in real terms for the next five years and a deficit ceiling of up to three percent of GDP starting in 2005. We urge the authorities to adhere strictly to this framework, as this would help the government achieve its goals of reducing gradually the public debt as a share of GDP and the size of the public sector, allowing for a reduction of the tax burden. The frequent amendments of the deficit reduction law during downturns and the inability of the law to limit expenditures during upturns have impaired the usefulness of the law as a planning tool and have eroded the government's credibility, making it essential to introduce a new credible medium-term beacon to navigate by.
To further raise credibility and facilitate the implementations of the fiscal adjustment, the mission recommends that the government present a more detailed spending plan with medium-term expenditure targets. This could be supplemented by semi-annual detailed reports on progress in achieving its public finance goals and the implementation of the various measures and reforms, including in the labor market.
The mission commends the authorities' efforts to undertake structural reforms, including the pension and welfare systems, and the push forward with privatization and infrastructure investment. These steps are overdue, and their steadfast implementation will improve the efficiency of the economy and the structure of the public finances. Close consultation and cooperation among all parties involved will help forge support for the successful implementation of these reforms and guarantee their sustainability, as suggested by international experience. The social and economic costs of continued impasse should not be underestimated.
The slump in economic activity worsened the already beset labor market and welfare system. High social benefits relative to the minimum wage and high penalties for joining the labor market at the lower end (in some cases the effective tax rate exceeded 100 percent because of lost welfare benefits), combined with steady inflows of foreign workers,3 have induced many to exit the labor market. Therefore, cuts in social benefits to those capable of work are an essential part of any policy that aims to entice people back to the labor market and improve the social structure. We laud the authorities for implementing these necessary changes in such difficult times, while we stress the importance of being mindful of the adverse social implications and of the need to protect the disabled and the truly needy.
Alas, eliminating these distortions may lead to temporary social hardship, as the current frail labor market may be unable to absorb quickly most of those affected by these reforms. There is a need to complement the reduction in benefits with additional steps, such as facilitating mobility and increasing job training opportunities and education, in order to assist the rapid absorption of unemployed and income support recipients in the labor market. In this regard, the Welfare to Work pilot project, based on the so-called Wisconsin Program, is promising, but its scope is very limited for the time being. In the meantime, consideration could be given to establishing temporary tax incentives linked to job creation and training.
A further relaxation of monetary policy seems warranted. Several factors suggest that inflationary pressures are limited: the CPI has fallen nearly 2 percent over the last 12 months, long-term real and nominal interest rates have declined, and the foreign exchange market has remained calm following recent reductions in interest rates. Most importantly, inflationary expectations over the next 12 months are near the lower bound of the inflation target range, indicating that there is room for further loosening monetary policy. Moreover, upside inflationary risks appear modest and stem primarily from a depreciation of the sheqel. In this respect, the declines in country and currency risks are encouraging signs.
As a result of the BoI efforts low-inflation expectations appear to be entrenched and this should allow the BoI to achieve lower interest rates. Given the current disinflationary pressures and subdued economic activity, further interest rate reductions are unlikely to push future inflation above the upper bound of the price stability target. We encourage the BoI to continue lowering its policy interest rate gradually, while closely watching developments in the foreign exchange and financial markets to avoid upsetting the stability of these markets. We suggest supporting these steps by strengthening BoI efforts to communicate more clearly its policy and its views regarding the inflationary environment in order to continue anchoring expectations within the inflation target range.
In this respect, we recommend supplementing the semi-annual Inflation Report with interim quarterly updates and rebalancing the focus of the Report by giving more attention to the dynamics of future inflation. The report could a) emphasize that the inflation target is operational for the next 12 to 24 months; b) explicitly compare the actual inflation outcome with the previous forecast, along with an explanation for the deviation and a discussion on the expected date when inflation would return to within the target; and c) provide a general assessment of the risks to achieving the target, along with the likely policy response under various scenarios.
It is important to amend the BoI law to reflect international best practices, along the lines (appropriately updated) of the recommendations of the Levin Committee. This would help monetary policy become more transparent and accountable to ensure financial market stability and to minimize the risks that temporary breaches of inflation targets unhinge expectations.
The banking system has strengthened in 2003. The downturn had a significant impact on the banking system, sharply reducing bank profitability and borrower repayment ability. Against this background, the Supervisor of Banks took important regulatory steps to strengthen banks' monitoring and risk-management systems in order to improve banks' ability to assess and manage operational, liquidity, and credit risks. Although problem loans continue to grow, albeit at a reduced pace, positive signs have emerged: profitability has increased, capital adequacy ratios have improved, and provisions relative to non-performing loans have risen substantially.
Israel has established a wide-ranging agenda to develop further its financial markets. The mission encourages the BoI to continue its efforts to implement a state-of-the-art payment and settlement system, the Israel Securities Authority to remove obstacles to capital market development-including revamping regulations and enforcement practices-and the Supervisor of Banks to continue to enforce the limits on banks' exposures to large corporate borrowers. All of these steps, together with the necessary legislation to increase the number of market players and instruments, would improve the agility and resiliency of the Israeli financial markets and would provide a favorable environment for the placement of assets by the reformed pension funds.
The mission team expresses its deep appreciation for the authorities' excellent cooperation and exceptional hospitality.
1 The higher figure reflects the possibility of a delay in the receipt of foreign grants expected in December 2003. Should these grants be disbursed next year, the deficit target for 2004 will need to be reduced accordingly.
2 Government debt is projected to rise more than implied by the deficit target, reflecting the way in which some transfers to the Railway Company and scoring of U.S. loan guarantees are recorded in the budget.
3 Available information suggests that the reduction in illegal foreign workers has led to an increase in employment of Israelis, particularly in the construction sector.