Israel-- 2004 IMF Article IV Consultation, Preliminary Conclusions and Recommendations
December 20, 2004
1. After nearly three years of depressed real activity, economic growth is underway supported by a favorable global environment, an improvement in the security situation, and appropriate policies. The Central Bureau of Statistics estimates that the economy will grow by 4 percent in 2004, led by external demand and private consumption. Looking ahead, we expect that the economy will continue to strengthen, although by a slightly lower growth rate than in 2004.
2. The recovery has proceeded hand in hand with a consolidation of the fiscal stance and a loosening of monetary policy. Israel's fiscal house is being put in order with the budget deficit being brought under control and with the government establishing credible commitments to maintain future deficits below three percent of GDP and to limit government expenditure growth, in real terms, to no more than one percent a year. At the same time, monetary policy has been appropriately relaxed during the first few months of 2004 and again more recently.
3. Furthermore, the policies of reform, and the government's commitment to boost competition and efficiency, have enhanced market confidence and lay the foundations for future growth. Welfare reform will improve the functioning of the labor market, tax reform will increase competitiveness, pension reform will aid the development of the capital market, and privatization will improve competition and efficiency in the market place.
4. Yet, many challenges lie ahead. The authorities face the task of adhering to the ambitious fiscal policy agenda of reducing the size of the government and public debt. There is further scope for enhancing the implementation of the inflation target regime. The capital market development has to be nurtured with sensitivity while strengthening the regulatory framework. The labor market situation and the extent of poverty continue to be troubling. Finally, improved consultation and cooperation among all interested parties is needed to ensure effective implementation of structural reforms and privatization.
5. It is essential that the budget be approved promptly without breaching the expenditure and deficit ceilings. Failure to do this could increase uncertainty in the market and lead to a loss of confidence. The planned 2005 budget, excluding the costs associated with the disengagement plan, adheres to the authorities' commitment to limit public spending. With regard to the costs associated with the disengagement plan, although it would have been preferable to contain them within the budget, in light of their temporary nature and the significance of the plan, we are of the view that a minor temporary—and capped—deviation of up to 0.4 percent of GDP should not raise undue concerns about the government's commitment to fiscal discipline. However, given the high level of public debt—and the absence of long established fiscal credibility—it is vital that the government resists any further deviations from its fiscal targets.
6. The notable commitment to limit the growth of public expenditure to one percent in real terms requires medium-term planning and a detailed spending plan. Such a limit on expenditure growth would reduce the government size, relative to GDP, by about one percentage point each year. To enhance credibility, and to ensure that future budgets are allocated according to long term priorities rather than dictated by short-term budget rigidity, the mission recommends that the government develop a detailed medium-term spending plan. In addition, to enhance transparency and planning, we also recommend the government present a semi-annual detailed report on progress in achieving its fiscal objectives as well as in implementing various structural reforms and measures, including those in the labor market.
7. The mission also recommends accelerating the path of debt reduction by abstaining from further unplanned tax cuts and by broadening the tax base through the elimination of various exemptions. Maintaining a deficit of 3 percent of GDP in the years ahead implies only a modest decline in public debt, relative to GDP, based on projected GDP growth. A more pronounced decrease in the stock of public debt would lead to lower interest rates, aid the development of the capital market, and give increased scope to countercyclical fiscal policy. For the same reason, we recommend that the automatic stabilizers be allowed to operate fully should revenues over perform, and should be reined in partially should revenues under perform.
8. We commend the Bank of Israel (BOI) in maintaining low inflation. The reduction in the interest rate during the first half of 2004 was warranted as was the recent reduction, given the limited inflationary pressures and calm and stable financial markets.
9. There is, however, scope for enhancing the tools and procedures for implementing inflation targeting. In the view of the mission, placing too much emphasis on measures of long-term real interest rates and inflation expectations derived from markets could inherently contribute to price instability if market measures are biased. Moreover, there is a degree of circularity in the approach: while the central bank relies on market-derived measures, markets look to central bank actions and statements to assess inflationary prospects. The mission argues, therefore, that the BOI should place more emphasis on statistical forecasting models in assessing the inflationary outlook.
10. The mission also suggests increasing the BoI's efforts to communicate more clearly its policy and its views regarding the inflationary environment. To help increase transparency and accountability, and to ensure that short-term deviations from inflation targets do not unhinge expectations, the mission recommends supplementing the semi-annual Inflation Reports with interim quarterly updates, explicitly comparing the actual inflation outcome with the previous forecast, along with an explanation for the deviation, and providing an explicit forecast of the inflation path over the longer term along with the general direction of interest rates consistent with the forecast.
11. It is important to update the current Bank of Israel Law to reflect international best practices. This would help reinforce BoI independence and enhance transparency and accountability, which are desirable in their own right, but would also aid in achieving price stability. The new law should clearly specify that the primary function of the central bank is to ensure price stability while supporting financial stability. The law should also provide for instrument independence and the establishment of a committee to set monetary policy.
The Capital Market
12. The mission shares the authorities' view that the level of concentration in the banking sector is high with potential conflicts of interest. The dominance of the two largest banks in deposit taking, underwriting, and managing mutual and provident funds is undesirable. However, we observe that many economies have a capital market dominated by a small number of banks. We further note that Israeli banks do not appear to earn monopoly profits (although this may well be because the banks' dominant position leads to inefficiencies and high costs), companies seem to be able to obtain finance on reasonable terms, and competition is effective in some sectors of the market.
13. We also share the authorities' view that the capital market is underdeveloped. The corporate bond market is thin (although growing) and a number of instruments that are available in other capital markets are largely absent from Israel. We share the authorities' view that the macroeconomic performance would be improved with a more developed capital market. The underdevelopment of capital markets is not surprising given that in the past the assets of the main non-bank financial institutions were held, almost exclusively, in the form of non-tradable, indexed government bonds that were effectively risk-free. Moreover, there were a series of tax, regulatory and accounting obstacles to the development of capital market instruments.
14. In this regard, the mission applauds the authorities for undertaking a number of steps to remove obstacles to capital market development. Reducing institutions' reliance on non-tradable government bonds will stimulate the demand for capital market instruments. Limiting banks' exposure to individual and connected lenders will promote the development of instruments in the capital market. In addition, the authorities are in the process of removing barriers to the development of capital market instruments such as real estate investment trusts, commercial paper, repos, funds of funds, asset backed securities, municipal bonds and exchange traded funds. These barriers include unequal tax treatment of different instruments, excessive stamp taxes, excessively onerous prospectus requirements on commercial paper and asset backed securities, inadequate rights for participants in repo markets, regulatory prohibition on funds of funds, and legal restrictions on the issue of municipal bonds. The removal of these barriers and the move towards the introduction of International Financial Reporting Standards will have a substantial beneficial effect on the development of the capital market.
15. With regard to bank concentration, the mission shares the authorities' view that it would be desirable if banks were not the dominant suppliers of mutual and provident funds. We are encouraged by the measures taken so far designed to increase competition and reduce conflicts of interest in the sale of these funds. These measures include the enhanced enforcement of the duty of banks to give impartial advice to investors in funds and the reform of the insurance commission structure so that insurance agents have an incentive to sell investment products other than life insurance. These measures, combined with others, including proposals to introduce deposit insurance and to make it easier for customers to switch accounts, will increase competition and minimize abuses of potential conflict of interests.
16. The authorities have thus already taken important measures that will promote the development of the capital market. Provided that they continue to implement those measures we consider that legislation to prevent banks from owning mutual and provident funds may be proven unnecessary. We believe the favorable trends are likely to accelerate as a result of the measures already taken and proposed as described in previous paragraphs. Intervention in financial markets, by imposing restrictions on banks that are being lifted elsewhere, may discourage potential market participants, in part by creating uncertainty about the authorities' future intentions. In addition, we believe that the banks' response to a ban on their management of funds will create substantial regulatory challenges and could, in practice, inhibit the achievement of the objectives of the ban. Although we agree that it would be preferable if banks were not the dominant suppliers of mutual and provident funds, we are aware that there is considerable uncertainty about the best route for achieving this outcome. We recognize that there is a risk that the reform measures already in train will not be sufficient. However, given the uncertain consequences of a forced divestiture of banks' interests in the management of mutual and provident funds, our assessment is that it would be preferable to give the current reform measures time to work.
17. The development of the capital market, already underway, will require stronger regulation. We support the introduction of an effective regulatory law for provident funds. Regulation of provident and pension funds does not, in practice, require suppliers to disclose their investment policies and the attendant risks with sufficient detail and clarity to allow the investor to make an informed choice. Enforcement of full disclosure is essential as the investor's previous expectations that these funds were essentially risk-free are no longer valid. Monitoring of the implementation of such investment policies by independent custodians is an international best practice and should be adopted in Israel.
18. We also support other measures designed to strengthen the enforcement of regulation in order to enhance competition and address conflicts of interest. The authorities are right to seek to enforce the regulation that banks, like other advisers, should offer their best impartial advice to customers and should sell their competitors' funds, and there should also be normal market incentives for them to do so. We support measures designed to enhance the independence of the regulatory bodies, to provide them with civil enforcement powers, to review the split of responsibilities and to improve coordination and free information exchange between them. Measures for resolving complaints, such as an Ombudsman, and a restitution power for the regulatory authorities should also be considered. We believe that it would be preferable if the regulatory authorities had independent rule making powers that did not require the separate consent of either the government or the Knesset.
19. The mission shares the authorities' concerns about the method of remuneration of investment advisers but believe a modified version of their proposals should be considered. We agree that commission-based remuneration creates the risk that advice will be driven by commission rather than the customers' best interests. However, commission payments are common practice internationally and the shock of an outright ban may discourage investors from using advisers or, indeed, from making investments. An alternative step—to require advisers and agents to make full disclosure of all remuneration and offer a choice of fee-based as well as commission-based advice—should be considered.
20. The government's efforts to boost employment by removing disincentives to join the labor market stemming from welfare benefits have yielded some encouraging results. The participation rate has increased, and employment has risen. At the same time, cuts in some welfare benefits have contributed to social hardship. It is important to ensure that, while reducing benefits to those capable of work, the protection of the needy, such as the elderly and the disabled, is preserved.
21. The welfare reforms of the past years should be complemented with expanded active labor market policies. The increasing numbers of job seekers and long-term unemployed suggest the need for steps to assist the absorption of new workers in the labor market and that an increase in the minimum wage may raise unemployment. The mission commends the refocused efforts by the Employment Service and the decision to continue the program for single mothers as well as to initiate the welfare-to-work program. The mission urges the authorities to improve the effectiveness of existing programs and broaden the range of active labor market policies, including carefully designed additional vocational training programs and wage subsidies.
The mission expresses its deep appreciation for the authorities' excellent cooperation and exceptional hospitality.