Israel - Concluding Statement of the IMF Mission
December 15, 2008
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
1. Israel was well situated when the global financial turmoil began in the fall of 2007. Fiscal and monetary credentials were established in markets; banks and their supervisory arrangement were robust; and growth was strong, sustained, and balanced-with unemployment falling towards historical lows, a large current account surplus, and stable domestic real estate markets.
2. That set the stage for a relatively strong performance into the third quarter of 2008. As conditions deteriorated abroad, economic growth continued, buoyed by exports and consumption, unemployment fell further, and budget discipline was firmly maintained. Headline inflation and inflation expectations rose above target, but prices excluding food and fuels remained subdued. And although domestic securities prices tracked those abroad downwards, prompting outflows from provident funds, flows in domestic credit markets remained largely undisturbed. In this context, capital inflows and the Shekel strengthened.
3. Since then, challenges facing policymakers have deepened profoundly due to the intensification of global financial strains in the fall of 2008. As global demand, prospects, and securities markets slumped, Israeli exports and consumption slowed, economic growth and tax collections weakened alongside, and the flows in the corporate bond market dried up, with banks proving unwilling to fill the gap so far. Declines in commodities prices, inflationary pressures, policy interest rates and the Shekel provided some respite. But the outlook has deteriorated sharply. And with elections due in February, the 2009 budget will not be adopted until well into the new year.
4. In this context, external vulnerabilities remained contained. External assets exceed external debt including in the short-term, foreign exchange reserves are some 90 percent of short-term debt, and the current account continued in surplus. But with total external gross debt at around 50 percent of GDP and public debt close to 80 percent of GDP, some vulnerabilities remain.
5. Looking ahead, there is little sign that global difficulties will ease soon. Recessions in the US and Euro areas are anticipated through the first half of 2009, but their length and depth is highly uncertain As a small open economy which has prospered by integrating into the world, Israel is exposed-to slowdown in its key export markets, to the associated strains on its financial sector as domestic activity weakens, and to direct contagion from further financial disruptions abroad-with weak commodity prices providing at most a modest offset.
6. Thus, Israel faces a period of economic weakness with marked downside risks. With investment and exports weak, our central scenario anticipates a decline in economic growth to 1½ percent in 2009, with average inflation around 2 percent, all assuming implementation of policies recommended below. A modest recovery is projected for 2010. However, financial sector vulnerabilities abroad imply that risks are firmly to the downside, notwithstanding strong profiles for external amortization and short term external debt.
7. Despite the predominantly global sources of the downturn and risks, domestic policy can help if it is well coordinated across three spheres-financial stability, budgetary, and monetary. Within each sphere, steps to strengthen long-run credibility will increase scope for flexibility to address immediate exigencies. And specific initiatives should each have narrowly defined goals-maintaining a close correspondence between instruments and objectives-to ensure effectiveness and accountability.
8. In summary, we recommend, in the central scenario context, key steps to support credit flows and stability, a flexible near term budget stance backed by enhanced commitments to public debt reduction in the medium-term, and further monetary relaxation. These recommendations are subject to review should significant downside risks materialize.
9. Progress in this direction has already begun. Following the appropriately sizeable recent reductions in Bank of Israel (BoI) interest rates, policymakers' attention has rightly turned to the nexus of concerns regarding credit flows and financial stability.
10. In particular, the proposed public-private fund to purchase corporate bonds is welcome. It should be established promptly and tasked primarily to support new credit flows for large solvent firms. Thus, the fund should purchase new bond issues and refinance payments falling due for firms, at yields below those in the market now but well above those prevailing before the fall of 2007. These arrangements, and mechanisms to address conflict of interest issues for trustees, need to be reflected in the terms of reference for the fund.
11. In this light, purchases by the fund on the secondary market would generally be avoided. These will not provide new credit to firms, and they risk implicitly transferring accrued institutional investor or corporate losses to the budget. While plans should be prepared to address priorities in the corporate bond market other than credit flows, the tasks for this fund should not be extended lest its effectiveness and accountability is diluted. Given the terms of reference outlined here, the anticipated size of the fund-in the range of NIS 10-20 billion-is sufficient at least through 2009.
12. Alongside, the initiative to streamline procedures to reorganize corporate bonds is welcome. And any bureaucratic impediments to efficient and rapid disbursement of the NIS 230 million fund to support credit for small and medium size firms need to be removed.
13. Given these steps to support credit flows, other financial sector initiatives should focus on further strengthening bulwarks against extreme strains on banks. This includes the proposed guarantee of NIS 6 billion for bond issues by banks, which is an appropriately pre-emptive step to increase bank capital. Restrictions on dividend payments by participating banks would maximize its effect.
14. In addition, the technical review of legal provisions concerning troubled banks is welcome. Despite supervisory powers to replace managers and the implicit public guarantee on deposits, strengthened provision for preemptive bank resolution by regulators may be needed, notably via restriction of legal recourse for affected stakeholders to financial compensation only. The mandated transparency of lender-of-last-resort actions for publicly traded companies should also be reviewed.
15. Against the backdrop of continuing initiatives to buttress supervision of all financial firms during 2008-enhancing capital, reporting, monitoring, transparency, and regulatory coordination-additional steps as suggested above could help maintain orderly financial market conditions under conditions of duress.
16. While consideration of the merits of current financial regulatory organizational structures should continue, present arrangements would best remain as they are, for the time being, given the immediate challenges facing regulators. But suitable alternatives will ensure that information flows between banks and the BoI remain full, even under stressed circumstances.
17. The package of initiatives outlined above constitute a first step. If downside risks materialize, abroad or domestically, more may be needed. In this regard, developments in bank share prices and non-guaranteed bond yields may be monitored for signs of heightened stability concerns, and credit flows can be observed directly.
18. On the budget side, there is a clear case to allow automatic stabilizers to operate fully. Successful sustained tight budget control by the Ministry of Finance, and the associated reduction in public debt ratios to below 80 percent of GDP, has secured a considerable degree of fiscal credibility. Now is an appropriate time to deploy this credibility to cushion the domestic economy from some of the effects of the weak external environment.
19. But the likely moderate extent of the economic slowdown in 2009 and the still high debt ratio counsels against going much further than that. And, moreover, budgeting for 2009-10 should reflect cautious assessments of the portion of revenue declines that reflects automatic stabilizers. Tax collections in recent years likely reflected the excesses in financial markets that preceded the current global crisis-via wealth effects on spending, taxes on returns on foreign assets, and large profits in domestic non-banks. To this extent, aggregate tax collection ratios will not return to levels seen in recent years, even once global economic conditions normalize.
20. Accordingly, the structural fiscal balance in 2009 should be unchanged from 2008, excluding the financial sector support initiatives described above and any already-committed investment and infrastructure projects which are brought forward. This stance leaves essential "fiscal firepower" in reserve should downside risks materialize, and it underscores commitment to fiscal sustainability. All these desiderata are implicit in the deficit outturns likely to emerge from implementation of the draft 2009 budget, which we therefore endorse.
21. However, the draft 2009 budget and the policy initiatives described above are likely to deliver a headline budget deficit for consolidated general government in excess of 4 percent of GDP. And outturns of this order of magnitude could persist in 2010, even in the central case scenarios. These are large numbers. They will push public debt ratios up markedly again. Though this may well turn out to be in line with developments elsewhere, the possible extent, pace, and duration of the deterioration underscores need to reinforce confidence in long run fiscal sustainability now. If that confidence falters, far from cushioning external blows, the fiscal actions proposed could aggravate broader economic difficulties. Adjustments to the framework of fiscal rules will help to address these concerns.
22. The one-year ceiling on the deficit of 1 percent of GDP needs to adjust to allow the operation of automatic stabilizers in 2009. Building on recent proposals from the Ministry of Finance, one alternative could be to replace it with a formal commitment to reduce public debt to well below 60 percent of GDP during the middle years of the next decade. This objective would establish a buffer against shocks, including geopolitical developments. And it would need to be reflected in adoption of budget procedures which include publication with each budget of detailed medium-term fiscal projections and associated tax and spending policies. Each year, these would lay out how and when the ultimate debt objective would be realized.
23. This flexible framework would also allow an effective fiscal response in the event that significant output downside risks materialize immediately during 2009, which a monetary response cannot fully address. An immediate and full account to markets of how debt reduction would be secured in the medium-term would help to ensure that a weakening of the structural fiscal stance in 2009 can readily be financed. This would facilitate a significant budget adjustment should significant downside risks to output materialize.
24. And the other current fiscal rule-the annual cap of 1.7 percent on real spending growth-may also need to be amended. It permanently impedes efficient operation of fiscal stabilizers due to the accompanying "one-year lagged correction mechanism" for inflation surprises. And it may be inconsistent with consensus medium-term spending aspirations. Instead, adoption of caps for three years ahead on annual nominal spending, excluding emergency outlays, has merit. This framework would be highly transparent, would improve the operation of fiscal stabilizers and would buttress monetary responses to inflation surprises. With appropriate parameters-reflecting the inflation target and trend growth-such nominal caps would support the credibility of the flexible debt target objective.
25. On the monetary side, the advantages of the inflation targeting and flexible exchange rate frameworks are now more evident than ever. Furthermore, the credit-supporting and financial stability initiatives outlined above will help to maintain the effectiveness of the domestic monetary transmission mechanism, while the suggested fiscal policy and framework steps reduce need for the BoI to weigh upside risks as it pursues the inflation target. Both will allow monetary policy to play its maximum role in addressing external weakness and uncertainties now.
26. Inflation is set to fall below the target range for much of 2009. This is indicated by break-even measures derived from government bond yields-even allowing for possible liquidity distortions to these-and reflects weak output, muted nominal wage growth, and cordial and flexible labor relations. In the context of other policies as outlined above, scope therefore remains for further significant reductions in policy rates. Concerns not to surprise markets with large steps may be attenuated with prior guidance and by the increased market familiarity with large steps globally.
27. Increased international reserves have attenuated external vulnerabilities. They now approach 90 percent of short-term external debt. The purchase modalities appropriately avoid discretionary intervention, thereby respecting the primacy of the BoI interest rate in the inflation targeting framework. In that context, the fact of, timing, and specification of a target range for total reserve accumulation provides an appropriate broad signal to markets about the authorities' views on competitiveness.
28. Preparations for a new BoI law are welcome. In particular, provision in the draft law for establishment of a monetary policy committee of well qualified experts to determine the policy rate is appropriate. Additional provisions for BoI capital, staff remuneration, and legal protection for staff acting in good faith could also be included to ensure the BoI's soundness, independence, and operational effectiveness over the long term.
29. Even with policies thus calibrated to address the coming slowdown and downside risks, prospects are challenging given international conditions. But the economy has already made many of the necessary adjustments-to intercompany credit flows, export margins, and nominal wages-and policymakers have responded promptly, political constraints notwithstanding. While much has been done, planning for contingencies needs to proceed further and urgently. If policy credibility, effective coordination, and clarity of objectives remain the standard which further initiatives have to meet, Israel will pass through this turbulence successfully. We wish you well in your efforts to do so.