Israel -- 2005 Article IV Consultation, Concluding Statement of the IMF Mission
December 12, 2005
After a strong performance in 2004, economic expansion picked up pace in 2005 supported by high-technology exports, investment, and prudent policies. The relatively favorable global economic environment and an improvement in the security situation also contributed to this expansion. Inflation is slightly higher than a year ago, but remains in check, while unemployment continues to fall, albeit from a high level. The sheqel has remained broadly stable over the past year, balanced by strong economic activity on one hand, and relatively low interest rates on the other.
1. The authorities' fiscal consolidation and monetary policy stance have underpinned this growth. The mission welcomes the government's commitment to maintain future fiscal deficits below 3 percent of GDP and to limit government expenditure growth, in real terms, to no more than 1 percent a year. Fiscal retrenchment is critical to putting the public debt to income ratio on a firm downward path and thereby reduce vulnerabilities. Given the renewed emphasis on fiscal consolidation, and with inflation within the Bank of Israel's (BoI) target range, monetary policy has been appropriately accommodative, notwithstanding recent increases in the policy rate. The proposed new Bank of Israel Law should strengthen the independence of the central bank.
2. The authorities' commitment to increased competition and efficiency has enhanced market confidence and is crucial in fostering sustainable growth. The economic reform agenda for 2006 reiterates the government's dedication to structural reforms. In addition to completing the ongoing efforts to streamline the public sector and to strengthen competition in utilities, the recent privatizations in the banking system bode well for increased investor confidence. The economic recovery has created a benign environment for the financial sector, but credit risks remain and recent capital market developments will create new regulatory challenges.
3. The macroeconomic outlook is broadly positive, but there is further scope to enhance growth and reduce vulnerabilities. Macroeconomic policies and structural reforms of recent years have opened up the economy, increased its competitiveness, and attracted foreign investment. However, more can be done to improve the soundness of fiscal and monetary policies, reduce vulnerabilities in the financial system, and increase the economy's flexibility. The economy remains vulnerable to weakness abroad, especially in the United States and Europe, a sustained rise in oil prices, political volatility, and a deterioration in the security situation. Growth is expected to slow slightly in 2006, primarily due to lower projected growth in demand abroad.
4. It is critical that, once a new government is formed, the 2006 budget be approved without delay and without breaching the expenditure and deficit ceilings. Failure to do so would increase uncertainty in the market, lead to a loss of confidence, and increase the country's risk premium. The authorities have made important progress in keeping expenditure under control and strict adherence to the current expenditure ceiling in future budgets will cement the credibility of fiscal policy.
5. It is important that the new budget abstains from any further unplanned tax cuts in order to accelerate the path of public debt reduction. The authorities should seize the opportunity to consolidate the public finances while growth is strong and thereby achieve a meaningful decline in the large stock of outstanding public debt. Indeed, the government should aim at achieving a fiscal deficit well below the ceiling of 3 percent of GDP if growth is maintained at—or above—the 4 percent rate that they currently envision over the medium term. In this regard, the authorities should resist taking additional measures that would impede lowering the public debt to income ratio, and thus allow the automatic stabilizers to operate fully should revenues over perform. A pronounced and sustained decline in public debt, relative to income, would help lower future interest costs and thereby give greater scope to priority spending.
6. The mission also encourages the authorities to commit to a medium-term budget framework with a detailed expenditure breakdown consistent with the overall expenditure ceiling. International experience has shown that multi-year budget plans, properly done, reinforce fiscal consolidation, minimize expenditure growth, increase predictability, and reduce the likelihood of pro-cyclical bias. The authorities currently plan for capital expenditures over several years and the mission feels broadening this approach to current expenditures would provide additional benefits by raising the government's credibility and lessen political pressure to deviate from the expenditure ceiling. The presentation of mid-year reports covering the execution of the budget and progress in achieving it would also enhance transparency and budget planning.
Monetary Policy and Inflation Targeting Framework
7. The policy rate remains accommodative and is appropriate. Over the past year, inflation has been rising, albeit at a gradual pace, while inflation expectations have remained within the BoI target range. The rise in oil prices has yet to result in appreciably higher consumer prices, and, looking forward, it will be important that the authorities monitor closely the degree of pass-through from oil prices to wages and consumer prices. In light of the recent depreciation in the sheqel/U.S. dollar exchange rate, and its historically strong pass-through to inflation, the authorities should also continue to closely monitor exchange rate developments and their impact on prices. Other factors, however, such as high unemployment and excess capacity in key sectors, particularly housing and construction, argue against aggressive tightening over the near term. Moreover, the BoI also needs to assess the extent to which the structural reforms over the past decade have helped lower the natural rate of unemployment and have raised the potential growth rate of the economy. On balance, the mission's view is that the current policy stance is appropriately accommodative, but that the BoI needs to remain vigilant and will likely need to raise rates over time as the employment and output gaps close.
8. Israel has a well-established inflation-targeting framework, and the fully floating exchange rate that it requires, but there is scope for enhancing the analytical framework used to formulate and communicate policy. The mission welcomes the increased emphasis on the development of macroeconomic forecasting models. This has become an important priority at the BoI—as it has in other inflation targeting countries—and the mission looks forward to seeing this work completed. The development of these tools is an important priority in implementing a forward-looking approach to monetary policy and serves to enhance the Inflation Report.
9. The mission welcomes the government's approval of the proposed new Bank of Israel Law which should strengthen the independence of the central bank. Updating the current Bank of Israel Law to reflect international best practices will help reinforce central bank independence, enhance transparency and accountability, and aid in achieving price stability. There should be no ambiguity about the primary function of the BoI: it is to ensure price stability. The mission also supports the creation of a Monetary Committee, responsible for interest rate decisions, and the formation of a Management Board, responsible for the operational management of the central bank. Other goals, for example growth, should be considered only in so far as they do not undermine the primacy of price stability.
Financial Stability and Capital Markets
10. The banking system has strengthened but credit risks remain high. In the face of the ongoing economic recovery, the banking system has shown some positive signs: capital ratios have risen, profitability has recovered to pre-recession levels, and the adequacy of loan-loss provisions has improved. However, problem loans have continued to grow and unprovisioned, nonperforming loans have reached high levels. Credit risks remain high, particularly in the construction and real estate sectors, which have yet to fully feel the impact of the recovery. Against this background, the mission welcomes the measures taken by the supervisor to reduce the banks' exposure to credit risk, including by increasing required provisions, further limiting the concentration of banks' exposure to large corporate borrowers, and the reduction of the limit of total indebtedness of the six largest borrowers. Nevertheless, continued supervisory vigilance is essential to maintain financial stability. Looking forward, it is important that stress tests be conducted on a regular basis to assess the risks to the banking sector arising from changes in economic and financial conditions. The publication of the Financial Stability Report, which disseminates important information on the systemic health of the financial system, should be continued.
11. The authorities have taken—and continue to take—effective action to remove the barriers to the development of the capital markets. The reduced number of non-tradable guaranteed government bonds in the portfolios of institutions, such as insurance companies and pension funds, has encouraged the use of a wider range of financial instruments in order to secure yield and manage risks. The equalization of the tax treatment of overseas investments to match that for domestic investments has widened the investment opportunities for Israeli residents and has been matched by increasing interest from foreign investors in the expanding Israeli markets. Barriers to the promotion of foreign mutual funds in Israel are being removed and the registration and approval requirements for new issues are being simplified. The corporate bond market is growing rapidly, activity on the stock exchange has increased, and the selling by banks of their mutual and provident funds has resulted in a rapid transfer of ownership of such funds, largely to domestic insurance companies. The mission supports the development by the BoI of a real time gross settlement system which will reduce banks' settlement risks and has prompted an interbank market and proposals for repos.
12. While the development of the capital markets has been largely positive, it has created risks. The mission has supported the authorities' action to remove the tax, legal and regulatory barriers to the development of the capital markets. However, these changes will force participants in the capital markets to learn new skills. Insurance companies, provident funds and pension funds are having to acquire risk management skills applicable to a new range of instruments, domestic and foreign. Insofar as these institutions are engaged in direct lending to customers, they must also acquire credit evaluation skills. Moreover, while most investors will still rely on banks for financial advice, the advisors in banks will have to operate under a new regime governing the duties of advisors.
13. The regulatory authorities are aware of these risks and are taking action to address them, but more needs to be done. New legislation has given additional powers to the regulatory authorities and new regulations have been issued to deal with the new risks. But the supervisors of insurance companies, provident funds, pension funds and mutual funds do not have sufficient resources to undertake the necessary research into the effect of the new developments, collect and analyze the information received from regulated institutions, and conduct on-site inspections. Accordingly, the Insurance Commissioner should be given a sufficient budget to properly address this new challenge. Additionally, while outsourcing of some inspection work is not unreasonable, the mission feels it would be prudent for the Israel Securities Authority to be allocated sufficient resources to retain a substantial in-house capacity for inspections. Moreover, at present, new regulations for non-bank financial institutions and the budgets of the regulatory authorities require the prior approval of the Knesset Finance Committee. With the rapid development of capital markets, this arrangement creates the risk that the regulators will not be able to respond in a timely fashion. Greater independence over budget and technical rule-making is common internationally and would be of great value in Israel.
14. The authorities' efforts to increase employment by removing disincentives to join the labor market have continued to yield positive results. The participation rate has risen and employment has increased.
15. Poverty alleviation has become a top priority in the Israeli political agenda. Notwithstanding improvements in employment and income, the poverty rate among children and families increased last year, and the poverty gap and income inequality have become larger over the past five years. From this perspective, the work of the advisory group headed by Director General of the Ministry of Finance on measures to reduce the poverty rate is welcome. In broad terms, any such measures should be within the current fiscal envelope, be targeted, provide the right incentives to work, and be consistent with growth-promoting policies. The cuts in some welfare benefits have contributed to social hardship, and it is therefore important to ensure that there is a safety net to protect children, the elderly, and the disabled.
16. A recent IMF mission on data standards concluded that Israel has a well-developed macroeconomic statistical system, but some shortcomings may impede the accurate and timely analysis of macroeconomic and financial developments. In this regard, there is a need, especially at the Central Bureau of Statistics, for adequate and sustained resources to improve the scope and timeliness of data compiled under its mandate.
The mission wishes to express its deep appreciation for the authorities' excellent cooperation and exceptional hospitality.