## _cr04158 - 2003. For purposes of Fund relations, the West Bank and Gaza Strip continue to fall under

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---

### Fund relations and mission
- For purposes of Fund relations, the West Bank and Gaza Strip continue to fall under Israeli jurisdiction in accordance with Article XXXI, Section 2(g) of the Articles of Agreement.
- Mission focus and staff:
  - Mission focused on the Israeli economy and did not meet with representatives of the Palestinian Authority.
  - Middle East and Central Asia Department undertaking Fund’s work on the West Bank and Gaza Strip.
  - Staff team: Messrs. Fajgenbaum (head), Brunner, and Mehrez (all EUR), and Ms. Polan (ICM); Mr. Litman (OED) participated in meetings.
  - Meetings held with: Minister of Finance Netanyahu; Ministers Olmert and Sheetrit; Bank of Israel Governor Klein; senior officials of the government and the Bank of Israel; representatives of private sector organizations including financial institutions, the manufacturing association, and a labor union organization.
- Exchange system and data:
  - Israel has accepted the obligations of Article VIII, Sections 2, 3, and 4 (Appendix I) and maintains an exchange system free of restrictions.
  - Israel subscribes to the Special Data Dissemination Standard and comprehensive economic data are available on a timely basis.
  - The last Article IV consultation was concluded on March 7, 2003.
  - The authorities have indicated their intention to publish this staff report.

### Macroeconomic background and causes of the downturn
- Growth reversal and causes:
  - Strong growth since mid-1980s halted in late 2000 due to the burst of the high-tech bubble, the global slowdown, and deterioration in the security situation.
  - GDP growth: negative in both 2001 and 2002.
- Authorities’ estimates of output losses:
  - deterioration in the security situation accounted for a loss of 6-8 percent of GDP;
  - the burst of the high-tech bubble amounted to a loss of about 3 percent of GDP.
- Consensus view: most of the shortfall in GDP growth in 2001–02 is of a quasi permanent rather than cyclical nature.

### Fiscal policy, deficits, and debt dynamics
- Fiscal deterioration and outcomes:
  - government deficit rose from an average of 1.5 percent of GDP in 1999–2000 to 3.8 percent in 2002.
  - 2003 budget target: deficit of 3 percent of GDP.
  - actual budget deficit reached 5.6 percent of GDP in 2003.
  - public debt rose to about 106 percent of GDP by end-2003.
- 2003 emergency program measures (fiscal adjustments):
  - temporary public sector wage reduction of 4 percent on average (14.5 percent wage reduction to high wage earners and executives);
  - postponement of cost of living adjustments and bonuses until June 2005;
  - a uniform 12 percent cut in government ministry budgets;
  - reduction in transfers to local authorities;
  - a sharp cut in welfare benefits;
  - an increase in taxes on the employment of foreign workers;
  - broadening of the tax base by reducing geographic exemptions;
  - planned reduction of taxes on labor income accelerated by one year.
- Fiscal impact and allocations:
  - overall adjustments amounted to about 2 percent of GDP in 2003;
  - about ½ percent of GDP was transferred to the Ministry of Defense.
- Fund/mission assessment and implementation:
  - Directors in the March 7, 2003 Article IV consultation agreed government should re-establish a declining path of public debt, deficit and expenditure ratios to GDP to strengthen market confidence.
  - Directors recommended cutting interest rates gradually as market conditions and inflation prospects eased.
  - Implementation: authorities generally agreed with Fund recommendations to re-establish fiscal discipline and ease monetary policy, but implementation fell short.

### Labor market and social indicators
- Unemployment and participation:
  - unemployment rate rose from 8.5 percent in early 2001 to 10.7 percent in November 2003;
  - share of long-term unemployed (jobless for more than six months) in total unemployment reached 35 percent (noted earlier) and 40 percent (in supplement).
  - Participation rates (ages 25–55): men 84 percent; women 68.5 percent; OECD averages: men 93 percent and women 71 percent.
- Wages, poverty, inequality:
  - Real wages: dropped some 3 percent during 2003.
  - Poverty incidence climbed from about 300,000 families in 2000 to 340,000 in 2003 (income below 50 percent of median income, adjusted for family size).
  - average income of the poor relative to the poverty line fell 10 percent;
  - Gini coefficient for income inequality climbed to about 0.37.
- Welfare reforms and labor composition:
  - unemployment benefits reduced by about one third; income support benefits slashed by 30 percent for most recipients.
  - foreign workers comprise 8 percent of the labor force, despite a considerable decline in 2003.

### Structural reforms and pension reform
- Structural reform measures:
  - streamlining the public sector by reducing employees, merging units and outsourcing activities;
  - modifying child allowances by reducing benefits and eliminating gradually the progressivity of benefits linked to number of children;
  - reforming the pension system by raising the retirement age and lowering benefits, providing funds to rescue insolvent funds, and increasing pension fund participation in the capital market.
- Pension system background and measures:
  - last major reform in 1995 shifted many participants from defined benefit to defined contribution funds;
  - at end-2002 about 1.2 million workers and pensioners covered by the “old” funds, approximately 52 percent of the workforce;
  - “old” pension funds had actuarial deficits reaching about NIS 110 billion (23 percent of GDP) at the end of 2002.
  - 2003–04 measures:
    - government will provide up to NIS 73 billion to the “old funds” over the next 35 years;
    - starting in 2004, employers will contribute an additional 1.5 percent of their salary (to 13.5 percent), while employees will contribute an additional 1.5 percent (to 7.0 percent);
    - starting in 2004, benefit payments to current pensioners were reduced 2 percent;
    - retirement age will increase from 65 to 67 for men and from 60 to 64 for women; phased in gradually with a four months increase in the retirement age every year;
    - all benefits will be calculated according to the career-average salary rather than the salary during the last three years, and the annual increase in real terms of the pensionable salary will be limited to 2 percent;
    - pension funds will be allowed to invest only up to 30 percent in non-traded government bonds with an assured real return of 4.8 percent yield, compared with 5.5 percent previously;
    - an insurance scheme and a government reserve of NIS 15 billion to hedge against investment risk;
    - management by professional managers with approval of investment strategies by a 3–5 person investment committee and supervision by the state controller.

### Monetary policy, inflation, and financial markets
- Inflation developments:
  - CPI declined 1.9 percent during 2003, compared with a 6.5 percent increase during 2002.
  - CPI movement during 2003: rose 0.8 percent in Q1; prices fell sharply in Q2 and Q3; leveled off toward end-2003.
  - housing rental prices dropped 5.7 percent in 2003—mainly due to a 9 percent nominal appreciation of the sheqel against the U.S. dollar during 2003.
  - excluding housing, inflation decelerated from 6.1 percent to -0.5 percent between 2002 and 2003.
  - twelve months ahead inflation expectations reached 0.7 percent in December; two to three years ahead expectations fell to around the middle of the inflation target range of 1–3 percent.
- Monetary stance and rates:
  - Bank of Israel maintained policy rate around 9 percent through the first half of 2003 after raising it in June 2002.
  - starting in mid-2003, the Bank of Israel lowered its policy rate in successive steps to 4.5 percent by February of 2004.
  - long-term real rates on indexed bonds declined from 5.9 percent to 4.2 percent during 2003.
  - despite cuts, real interest rates remained high as the drop in inflation and inflation expectations outpaced the decline in interest rates.
- Financial markets and confidence:
  - factors improving outlook: formulation of the economic program, ending of the major conflict in Iraq, some progress in the security situation, rebound in world stock markets (particularly the NASDAQ), and U.S. support in grants/loan guarantees.
  - U.S. assistance: extension of US$1 billion in additional grants and nearly US$9 billion in loan guarantees (spread over three years).
  - stock market: surged close to 60 percent during 2003.
  - Israel’s risk premium fell from 200 to 70 basis points.
  - monetary and credit aggregates: negative inflation, high interest rates, and weak activity led to marked reductions in growth of monetary and credit aggregates.

### Financial markets development and banking system
- Authorities' measures and expected impact:
  - Revamping regulations and enforcement practices that hinder capital market development.
  - Limiting banks’ exposures to large corporate borrowers.
  - Increasing pension funds’ involvement in the capital market.
  - Introduction by the BoI of a state-of-the-art payment and settlement system.
  - Expected to improve agility and resiliency of Israeli financial markets.
- Banking system 2003 developments:
  - downturn sharply reduced bank profitability and borrower repayment ability.
  - Supervisor of Banks strengthened monitoring and risk-management systems.
  - Problem loans continue to grow, albeit at a reduced pace; loan concentration remains high but significantly reduced from a year ago.
  - Profitability increased, capital adequacy ratios improved, and provisions relative to non-performing loans rose substantially.
- Banking soundness indicators for the five largest banking groups (1997–2003, in percent; 2003 figures annualized based on first nine months):
  - Asset growth: 1997: 6.1, 1998: 8.5, 1999: 10.9, 2000: 7.9, 2001: 7.5, 2002: -0.6, 2003 1/: -1.6
  - Credit growth: 1997: 7.3, 1998: 10.5, 1999: 12.0, 2000: 13.7, 2001: 12.7, 2002: 1.0, 2003 1/: -3.7
  - After-tax return on equity: 1997: 12.0, 1998: 9.9, 1999: 11.3, 2000: 11.7, 2001: 5.9, 2002: 2.5, 2003 1/: 7.6
  - After-tax return on assets: 1997: 0.6, 1998: 0.5, 1999: 0.5, 2000: 0.5, 2001: 0.3, 2002: 0.1, 2003 1/: 0.4
  - Problem loans to total loans ratio: 1997: 10.5, 1998: 9.9, 1999: 9.0, 2000: 6.7, 2001: 8.1, 2002: 9.9, 2003 1/: 10.3
  - Capital to risk-weighted assets ratio: 1997: 10.0, 1998: 9.2, 1999: 9.4, 2000: 9.2, 2001: 9.4, 2002: 9.9, 2003 1/: 10.4

### External sector and vulnerability
- Current account and capital flows:
  - Current account deficit continues to fall and is now close to balance.
  - The sizeable capital outflow of Q4 2002 and Q1 2003 has been reversed; foreign direct investment rebounded.
- External debt and guarantees:
  - Total gross external debt is about 60 percent of GDP, but net external debt remains negligible.
  - Of the external debt, 80 percent is backed by U.S. guarantees or is held by the Jewish Diaspora.
  - Average maturity of external debt is about 6.5 years.
  - New U.S. guarantees cover most of the government external debt maturing in the next 3 years.
- Reserves and exchange rate regime:
  - International reserves amount to US$25 billion at end-2003 and cover most short-term debt; level of reserves appears adequate.
  - BoI follows a de facto fully floating exchange rate system.
  - Real effective depreciation of about 20 percent in 2002–03 supported export recovery.

### Recent developments and outlook (supplement and staff projections)
- Growth and activity:
  - Real GDP growth in 2003: 1.3 percent (Central Bureau of Statistics estimate).
  - Exports growth in 2003: 6.2 percent.
  - High-frequency indicators suggest output is recovering; private consumption is growing; tourism is rebounding.
  - Staff and authorities view recovery in 2004 as likely to gain some strength, conditional on no deterioration in the security situation.
  - Real GDP growth projection in the 2004 budget: 2.5 percent.
- Fiscal framework and debt projections:
  - Recently enacted law limits real annual expenditure growth to 1 percent and the deficit to less than 3 percent of GDP during 2005–10.
  - Staff projection under assumed deficit of about 3 percent of GDP during 2005–10: public debt ratio to GDP would rise slightly in 2004 before beginning to decline in 2005; public debt falling to about 100 percent in 2010 as a result of projected growth of income.
  - Alternative staff projection: if real GDP continues to grow by one percent or the budget deficit remains at about the 2003 level, public debt would reach more than 115 percent of GDP by 2010.
- 2004 budget and revenue composition:
  - planned deficit for 2004: 4 percent of GDP;
  - overall expenditure as share of GDP is projected to decline by 2 percentage points;
  - capital outlays in infrastructure to increase marginally, with about ½ percent of GDP financed off-budget.
  - domestic revenue as a share of GDP is projected to grow by about ½ percent; foreign grants projected to decline by a similar amount.
  - Staff recommendation: use additional tax revenue to lower the deficit and the debt rather than raise expenditures or lower taxes.
  - Suggested limited fiscal flexibility: consider a limited deviation from the deficit target—say, up to ½ percent of GDP—if growth in 2004 is lower than expected.
- Monetary policy movements since mission and room for easing:
  - BoI policy rate gradually lowered from 5.6 percent to 4.5 percent (mission note); supplement notes BoI reduced policy rate to 4.1 percent by April 2004 after two 0.2 percentage point cuts in March and April.
  - Authorities agreed there was room to continue monetary easing but emphasized moving gradually and cautiously to maintain financial stability.
- Downside risks: deterioration of the security situation; weaker than envisioned global demand; decline of the high-tech sector.

### Monetary policy — assessment and recommended governance changes
- Assessment of 2003 policy:
  - With hindsight, staff argued inflationary risks had been overestimated and monetary policy was excessively conservative, contributing to undershooting of the inflation target.
- Inflation-targeting framework recommendations:
  - Place greater emphasis on the Bank’s forecast models rather than relying primarily on market measures of expectations.
  - Supplement semi-annual Inflation Reports with interim quarterly updates and give more attention to dynamics of future inflation.
  - Establish a monetary policy committee to broaden perspectives and increase delegation of authority within the central bank; authorities agreed on need to amend the BoI Law along lines of Levin Committee recommendations (appropriately updated).
- BoI communication and legislative recommendations:
  - Strengthen BoI communication of policy and views regarding the inflationary environment to anchor expectations.
  - Amend BoI law to reflect international best practice on monetary policy objectives and procedures to enhance transparency and accountability.

### Product-market, public sector, and social policy reforms
- Product-market reforms aim to increase competition by breaking up monopolies in ports, oil refineries, electricity, water, milk distribution, and mail.
- Privatization objectives include Bezeq Telecom, Discount Bank, Bank Leumi, Zim Shipping, Bazan Oil Refineries, and defense industry companies; Zim Shipping was privatized after the mission.
- Public sector and administrative reforms: streamline bureaucracy; reduce the public sector while improving efficiency and accessibility through enhanced computerization and internet services.
- Social and labor-market measures:
  - Cuts in benefits and welfare-to-work program seen by authorities as essential to entice people back to work.
  - Mission emphasized protecting the poor and cautioned that the pace of recovery may not permit absorbing many workers quickly.
  - Recommendations: facilitate mobility, increase job training opportunities and education; consider temporary tax incentives linked to job creation and training.
  - “Welfare-to-Work” pilot based on the Wisconsin model expected to ease transition.

### Fiscal transparency, ROSC findings, and public finance recommendations
- Fiscal ROSC (draft) findings:
  - Israel meets fiscal transparency code in many areas, including internal and external audit and fiscal accounting.
  - Greatest scope for improvement: budget preparation and presentation (budget sensitivity analysis, revised projections for the year in course, improved expenditure classification).
- Staff appraisal and recommendations:
  - Policies of consolidation and reform set the stage for a more balanced policy mix but need to be sustained with stronger commitment to debt reduction.
  - Upward deviations from the 4 percent 2004 target could raise concerns about commitment and ability to rein in deficit and debt.
  - Recommend preparation and publication of a more detailed spending plan with medium-term expenditure targets, supplemented by semi-annual detailed reports on progress in public finance goals and implementation of measures and reforms.
  - Commendation for structural reforms in pension and welfare systems, privatization, and infrastructure investment; steadfast implementation will improve efficiency and public finance structure.

### External vulnerability, reserves, and exchange rate framework
- External indicators:
  - Current account deficit close to balance; capital outflows reversed; foreign direct investment rebounded.
  - Total gross external debt about 60 percent of GDP; net external debt negligible; 80 percent of external debt backed by U.S. guarantees or held by Jewish Diaspora.
  - Average maturity of external debt about 6.5 years; new U.S. guarantees cover most government external debt maturing in next 3 years.
  - International reserves: US$25 billion at end-2003 (other sections note US$25.0 billion and nearly US$26 billion in supplements).
- Exchange rate arrangement:
  - New sheqel is managed against a basket within a crawling band; slope of upper limit: 6 percent annually since July 26, 1993; slope of lower limit: 2 percent since August 6, 1998; lower limit became flat on December 23, 2001.
  - On February 3, 2004, the width of the band, based on the average of the upper and lower limits, was 57.1 percent.
  - De facto fully floating exchange rate system.

### Data dissemination and statistical issues
- Israel has subscribed to the Special Data Dissemination Standard.
- Periodicity, timeliness, coverage, and quality of Israel’s economic data are generally adequate for surveillance.
- Methodological note: the reported overall annual fiscal balance excludes the inflation component of interest costs; authorities are gradually moving toward the standard methodology.
- Core statistical indicators (latest observation/data receipt dates included in source; e.g., Exchange rates latest observation 2/4/04; International Reserves Jan. 2004; CPI Dec. 2003).

### Executive Board assessment and recommendations (supplement)
- Executive Directors welcomed the economic program of consolidation and reform and the resulting gradual recovery after three years of recession.
- Fiscal policy: most Directors recommended any revenue windfall be used to lower the deficit and the public debt; expressed disappointment at recent tax reductions that slow debt reduction.
- Recommended structural measures: formulate a detailed medium-term spending plan, prepare semi-annual progress reports, and strictly adhere to the limit of one percent on expenditure growth and a ceiling of 3 percent of GDP on the overall deficit for 2005–10.
- Labor market: urged reforms to raise incentives to work and better target welfare to the truly disadvantaged; welcomed welfare cuts for those able to work but urged complementary training and education measures.
- Monetary and financial sector: welcomed relaxation of monetary policy and recommended gradual continued cuts while monitoring markets; supported amending BoI law to strengthen central bank independence.
- External sector: agreed external vulnerability has declined and current floating exchange rate system is appropriate.

### Key quantitative indicators and projections (selected, as presented)
- Real GDP growth: 1999: 2.6; 2000: 7.5; 2001: -0.9; 2002: -0.8; 2003: 1.3.
- Unemployment rate (percent): 1999: 8.9; 2000: 8.8; 2001: 9.3; 2002: 10.3; 2003: 10.7.
- CPI (end period): 1999: 1.3; 2000: 0.0; 2001: 1.4; 2002: 6.5; 2003: -1.9.
- Bank of Israel policy rate (average, percent): 1999: 12.1; 2000: 9.3; 2001: 6.8; 2002: 6.8; 2003: 7.5. (Note: BoI set the policy rate at 4.5 percent in February 2004; supplement notes 4.1 percent in April 2004.)
- Public debt (end-period, percent of GDP): 1999: 101.4 (other tables: 103.1), 2000: 91.4 (85.9 in other tables), 2001: 96.4 (92.8), 2002: 104.9 (101.2), 2003: 107.4 (106.5).
- Current account (percent of GDP): 1999: -1.5; 2000: -0.6; 2001: -1.6; 2002: -1.3; 2003: -0.2.
- Foreign reserves (end-period, US$ billions): 1999: 22.6; 2000: 23.3; 2001: 23.4; 2002: 24.1; 2003: 25.0 (25.8 and nearly US$26 billion noted elsewhere).

### Policy priorities and recommended sequencing (summarized)
- Fiscal: adhere to medium-term fiscal framework (limit real expenditure growth to 1 percent; deficit ceiling 3 percent of GDP for 2005–10); use windfalls to lower deficit and debt; prepare medium-term spending plan and semi-annual progress reports.
- Monetary: continue gradual policy rate reductions while closely monitoring exchange and financial markets; improve BoI transparency and governance (quarterly updates, monetary policy committee, amend BoI law).
- Structural and social policy: pursue product-market liberalization and privatization; protect the truly needy while using welfare reform to improve incentives to work; expand job training and employment services.
- Financial sector: continue regulatory vigilance, strengthen bank risk management, increase market instruments and players, and deepen capital market participation by pension funds.
- External: maintain floating exchange rate regime and monitor external debt and reserve adequacy; sustain policies that preserve competitiveness.

*Source: IMF staff report text contained in _cr04158 (IMF Article IV staff report and supplement).*

### 2003. For purposes of Fund relations, the West Bank and Gaza Strip continue to fall under

### _cr04158 - 2003. For purposes of Fund relations, the West Bank and Gaza Strip continue to fall under

### Fund relations and mission
- For purposes of Fund relations, the West Bank and Gaza Strip continue to fall under Israeli jurisdiction in accordance with Article XXXI, Section 2(g) of the Articles of Agreement.
- The mission focused on the Israeli economy and did not meet with representatives of the Palestinian Authority; the Middle East and Central Asia Department is undertaking the Fund’s work on the West Bank and Gaza Strip.
- Staff team: Messrs. Fajgenbaum (head), Brunner, and Mehrez (all EUR), and Ms. Polan (ICM); Mr. Litman (OED) participated in meetings.
- Meetings held with: Minister of Finance Netanyahu; Ministers Olmert and Sheetrit; Bank of Israel Governor Klein; senior officials of the government and the Bank of Israel; representatives of private sector organizations including financial institutions, the manufacturing association, and a labor union organization.
- Israel has accepted the obligations of Article VIII, Sections 2, 3, and 4 (Appendix I) and maintains an exchange system free of restrictions.
- Israel subscribes to the Special Data Dissemination Standard and comprehensive economic data are available on a timely basis.
- The last Article IV consultation was concluded on March 7, 2003.
- The authorities have indicated their intention to publish this staff report.

### Macroeconomic background and causes of the downturn
- Growth reversal: strong growth since mid-1980s came to a halt in late 2000 due to the burst of the high-tech bubble, the global slowdown, and deterioration in the security situation.
- GDP growth: negative in both 2001 and 2002.
- Authorities’ estimates of output losses:
  - deterioration in the security situation accounted for a loss of 6-8 percent of GDP;
  - the burst of the high-tech bubble amounted to a loss of about 3 percent of GDP.
- Consensus view: most of the shortfall in GDP growth in 2001–02 is of a quasi permanent rather than cyclical nature.

### Fiscal policy, deficits, and debt dynamics
- Fiscal deterioration during downturn:
  - government deficit rose from an average of 1.5 percent of GDP in 1999–2000 to 3.8 percent in 2002.
  - 2003 budget target: deficit of 3 percent of GDP (presented to regain credibility prior to elections), but based on unrealistic revenue projections.
  - actual budget deficit reached 5.6 percent of GDP in 2003.
  - public debt rose to about 106 percent of GDP by end-2003.
- Government emergency economic program adjustments in 2003:
  - temporary public sector wage reduction of 4 percent on average (14.5 percent wage reduction to high wage earners and executives);
  - postponement of cost of living adjustments and bonuses until June 2005;
  - a uniform 12 percent cut in government ministry budgets;
  - reduction in transfers to local authorities;
  - a sharp cut in welfare benefits;
  - an increase in taxes on the employment of foreign workers;
  - broadening of the tax base by reducing geographic exemptions;
  - planned reduction of taxes on labor income accelerated by one year.
- Fiscal impact and allocations:
  - overall adjustments amounted to about 2 percent of GDP in 2003;
  - about ½ percent of GDP was transferred to the Ministry of Defense.
- Fund/mission assessment:
  - Directors in the March 7, 2003 Article IV consultation agreed government should re-establish a declining path of public debt, deficit and expenditure ratios to GDP to strengthen market confidence.
  - Directors noted difficult trade-off for the Bank of Israel between maintaining financial market stability and easing the burden on the economy from high interest rates; recommended cutting interest rates gradually as market conditions and inflation prospects eased.
  - Directors welcomed the authorities’ request for fiscal transparency ROSC.
- Implementation: throughout the downturn the authorities agreed, in general, with the Fund recommendations to re-establish fiscal discipline and ease monetary policy, but implementation fell short.

### Labor market and social indicators
- Unemployment:
  - unemployment rate rose from 8.5 percent in early 2001 to 10.7 percent in November 2003;
  - share of long-term unemployed (jobless for more than six months) in total unemployment reached 35 percent.
- Participation rates (ages 25–55):
  - men: 84 percent;
  - women: 68.5 percent;
  - OECD averages: men 93 percent and women 71 percent.
- Real wages: dropped some 3 percent during 2003.
- Poverty and inequality:
  - National Insurance Institute estimates poverty incidence (income below 50 percent of median income, adjusted for family size) climbed from about 300,000 families in 2000 to 340,000 in 2003.
  - the average income of the poor relative to the poverty line fell 10 percent;
  - the Gini coefficient for income inequality climbed to about 0.37.
- Welfare reforms: unemployment benefits reduced by about one third (by restricting eligibility and shortening the eligibility period); income support benefits slashed by 30 percent for most recipients.
- Labor force composition: foreign workers comprise 8 percent of the labor force, despite a considerable decline in 2003.

### Structural reforms and pension reform (Box 1)
- Structural reform measures included:
  - streamlining the public sector by reducing employees, merging units and outsourcing activities;
  - modifying child allowances by reducing benefits and eliminating gradually the progressivity of benefits linked to number of children;
  - reforming the pension system by raising the retirement age and lowering benefits, providing funds to rescue insolvent funds, and increasing pension fund participation in the capital market.
- Pension system background:
  - last major reform was in 1995 shifting many participants from defined benefit to defined contribution funds;
  - at end-2002 about 1.2 million workers and pensioners covered by the “old” funds, approximately 52 percent of the workforce;
  - “old” pension funds had actuarial deficits reaching about NIS 110 billion (23 percent of GDP) at the end of 2002.
- 2003–04 pension measures to bring funds to actuarial balance:
  - the government will provide up to NIS 73 billion to the “old funds” over the next 35 years;
  - starting in 2004, employers will contribute an additional 1.5 percent of their salary (to 13.5 percent), while employees will contribute an additional 1.5 percent (to 7.0 percent);
  - starting in 2004, benefit payments to current pensioners were reduced 2 percent;
  - retirement age will increase from 65 to 67 for men and from 60 to 64 for women; phased in gradually with a four months increase in the retirement age every year;
  - all benefits will be calculated according to the career-average salary rather than the salary during the last three years, and the annual increase in real terms of the pensionable salary will be limited to 2 percent;
  - pension funds will be allowed to invest only up to 30 percent in non-traded government bonds with an assured real return of 4.8 percent yield, compared with 5.5 percent previously;
  - to lower risk affecting individual pension accounts, an insurance scheme will be implemented and the government will set a reserve of NIS 15 billion to hedge against investment risk;
  - management of funds will be carried out by professional managers, with approval of investment strategies by a 3–5 person investment committee and supervision by the state controller.

### Monetary policy, inflation, and financial markets
- Inflation developments:
  - CPI declined 1.9 percent during 2003, compared with a 6.5 percent increase during 2002.
  - CPI movement during 2003: rose 0.8 percent in the first quarter; prices fell sharply in the second and third quarter; leveled off toward end-2003.
  - housing rental prices dropped 5.7 percent in 2003—mainly due to a 9 percent nominal appreciation of the sheqel against the U.S. dollar during 2003.
  - excluding housing, inflation decelerated from 6.1 percent to -0.5 percent between 2002 and 2003.
  - twelve months ahead inflation expectations reached 0.7 percent in December; two to three years ahead expectations fell to around the middle of the inflation target range of 1–3 percent.
- Monetary policy stance and rates:
  - monetary policy during most of 2002–03 was tight; Bank of Israel maintained policy rate around 9 percent through the first half of 2003 after raising it in June 2002.
  - starting in mid-2003, the Bank of Israel lowered its policy rate in successive steps to 4.5 percent by February of 2004.
  - long-term real rates on indexed bonds declined from 5.9 percent to 4.2 percent during 2003.
  - despite cuts, real interest rates remained high as the drop in inflation and inflation expectations outpaced the decline in interest rates.
- Financial market outcomes and confidence:
  - factors improving outlook: formulation of the economic program, ending of the major conflict in Iraq, some progress in the security situation, rebound in world stock markets (particularly the NASDAQ), and U.S. support in grants/loan guarantees.
  - U.S. assistance: extension of US$1 billion in additional grants and nearly US$9 billion in loan guarantees (spread over three years).
  - stock market: surged close to 60 percent during 2003.
  - implied volatility of the NIS/US$ exchange rate declined; Israel’s risk premium fell from 200 to 70 basis points.
  - monetary and credit aggregates: the negative inflation, high interest rates, and weak activity led to marked reductions in growth of monetary and credit aggregates.

*Source: IMF staff report text contained in _cr04158 - 2003. For purposes of Fund relations, the West Bank and Gaza Strip continue to fall under (PDF).*

### 9.      Against this background, the protracted decline in economic activity has given

### _cr04158 - 9.      Against this background, the protracted decline in economic activity has given

### Recent developments and outlook
- Real GDP growth in 2003: 1.3 percent (Central Bureau of Statistics estimate).
- Exports growth in 2003: 6.2 percent.
- High-frequency indicators (industrial production, retail trade, tourist arrivals) suggest:
  - output is recovering;
  - private consumption is growing;
  - tourism is rebounding from its trough prior to the war in Iraq.
- Staff and authorities view recovery in 2004 as likely to gain some strength, conditional on no deterioration in the security situation.
- Real GDP growth projection in the 2004 budget: 2.5 percent (considered realistic and in accordance with BoI and staff forecasts).
- Downside risks highlighted: deterioration of the security situation; weaker than envisioned global demand; decline of the high-tech sector.

### Fiscal affairs — findings and projections
- Recently enacted law limits:
  - real annual expenditure growth to 1 percent;
  - the deficit to less than 3 percent of GDP during 2005–10.
- Staff projection under assumed deficit of about 3 percent of GDP during 2005–10:
  - public debt ratio to GDP would rise slightly in 2004 before beginning to decline in 2005;
  - public debt falling to about 100 percent in 2010 as a result of projected growth of income.
- Alternative staff projection: if real GDP continues to grow by one percent or the budget deficit remains at about the 2003 level, public debt would reach more than 115 percent of GDP by 2010 (Table 6).
- 2004 budget objectives and composition:
  - planned deficit for 2004: 4 percent of GDP;
  - overall expenditure as share of GDP is projected to decline by 2 percentage points;
  - capital outlays in infrastructure to increase marginally, with about ½ percent of GDP financed off-budget (railway converted into a public corporation; usual capital transfers recorded as equity investment and not as expenditures).
- Staff view: planned 4 percent of GDP deficit in 2004 is an appropriate step toward fiscal consolidation given the medium-term framework and reform program, but adherence is crucial for credibility and sustainability.
- Revenue projections and composition:
  - domestic revenue as a share of GDP is projected to grow by about ½ percent;
  - foreign grants projected to decline by a similar amount;
  - bulk of domestic revenue increase due to one-off transfers of surpluses from government insurance companies and an increase in the surplus of the National Insurance Institute.
- Staff recommendation on revenue windfalls: use additional tax revenue to lower the deficit and the debt rather than raise expenditures or lower taxes.
- Suggested limited fiscal flexibility: if growth in 2004 is lower than expected, consider a limited deviation from the deficit target—say, up to ½ percent of GDP—to moderate the downturn.
- Ministry of Finance action: announced a reduction in taxation amounting to ½ percent of GDP (reduction in VAT from 18 percent to 17 percent nine months earlier than planned; decline in taxes on consumer durables; decrease in customs duties on basic food items).
- Budgetary pressures noted post-approval:
  - adjustments to the budget totaling close to 1 percent of GDP are needed to raise allocations to defense and local authorities;
  - authorities intend to reduce other expenditures to keep the budget envelope intact.
- Footnote numeric reference: revenues amount to 40 percent of GDP (used in cyclical deficit sensitivity example).

### Monetary policy — stance, assessment, and recommendations
- BoI stated monetary policy goal: price stability—an annual inflation rate of 1–3 percent over the next 12–24 months.
- Assessment of 2003 policy:
  - sharp interest rate reduction to bring inflation within target during 2003 would have been inappropriate and could have induced major subsequent reversal and volatility;
  - with hindsight, staff argued inflationary risks had been overestimated and monetary policy was excessively conservative, contributing to a marked undershooting of the inflation target.
- Current inflationary environment and risks:
  - output remains subdued;
  - inflation over the last 12 months has been negative;
  - long-term interest rates have declined in both real and nominal terms;
  - foreign exchange market calm following recent reductions in interest rates;
  - inflationary expectations over the next 12 months are below the lower bound of the inflation target range;
  - upside inflationary risks appear modest and primarily take the form of a depreciation of the sheqel.
- Policy rate movement since the mission: BoI policy rate gradually lowered from 5.6 percent to 4.5 percent.
- Room for easing: authorities agreed there was room to continue with monetary easing but emphasized moving gradually and cautiously to maintain financial stability.
- Inflation-targeting framework discussions and suggestions:
  - Roles of inflation forecasts and expectations:
    - BoI places great emphasis on real interest rates and inflation expectations derived from capital markets rather than its own forecasts;
    - mission argued market measures can be biased and inefficient and recommended greater emphasis on the Bank’s forecast models that do not rely on market expectations.
  - Anchoring expectations through greater transparency:
    - mission suggested supplementing semi-annual Inflation Reports with interim quarterly updates and giving more attention to dynamics of future inflation (Box 2);
    - BoI agreed with increased transparency but expressed concerns about market misinterpretation of added information.
  - Establishment of a monetary policy committee:
    - mission noted Israel is the only emerging market with an inflation targeting regime that does not have a monetary policy committee;
    - such a committee would broaden perspectives in decision-making and increase delegation of authority within the central bank;
    - authorities agreed on the need to amend the BoI Law along the lines of Levin Committee recommendations (appropriately updated).

### Other policy issues and structural reforms
- Product-market reforms aim:
  - increase competition by breaking up monopolies in ports, oil refineries, electricity, water, milk distribution, and mail;
  - push privatization of Bezeq Telecom, Discount Bank, Bank Leumi, Zim Shipping, Bazan Oil Refineries, and defense industry companies (privatization mainly via the stock exchange; Zim Shipping was privatized after the mission; El-Al privatization cited as recently successful).
- Public sector and administrative reforms:
  - streamline bureaucracy;
  - reduce the public sector while improving efficiency and accessibility through enhanced computerization and internet services.
- Social and labor market reforms:
  - assist impoverished families by increasing employment opportunities, fighting welfare fraud, improving quality of education, and reducing number of illegal foreign workers;
  - cuts in benefits and welfare-to-work program seen by authorities as essential to improving labor market functioning by enticing people back to work;
  - mission underscored importance of protecting the poor and cautioned that the pace of recovery may not permit absorbing many workers quickly.
- Mission recommendations on labor-market transition:
  - facilitate mobility and increase job training opportunities and education;
  - consider temporary tax incentives linked to job creation and training;
  - note on implementation: soon-to-be-established employment centers based on the Wisconsin model for welfare reform expected to ease transition.
- Governance and transparency recommendation echoed in Box 2:
  - many emerging-market inflation-targeting countries use monetary policy committees and issue quarterly inflation reports; Israel differs by lacking a policy committee and issuing semi-annual inflation reports.

*Source: Excerpt from IMF staff report chapter: Central Bureau of Statistics; Bank of Israel; Ministry of Finance; and Fund staff projections.*

### 23.      The authorities are also taking steps to develop the financial markets and

### _cr04158 - 23.      The authorities are also taking steps to develop the financial markets and

### Financial markets development and banking system
- Authorities' measures:
  - Revamping regulations and enforcement practices that hinder capital market development.
  - Limiting banks’ exposures to large corporate borrowers.
  - Increasing pension funds’ involvement in the capital market.
  - Introduction by the BoI of a state-of-the-art payment and settlement system.
- Expected impact:
  - These steps, in line with the FSAP recommendations, together with necessary legislation to increase the number of market players and instruments, should improve the agility and resiliency of the Israeli financial markets.
- Banking system developments in 2003:
  - Economic downturn sharply reduced bank profitability and borrower repayment ability.
  - Supervisor of Banks strengthened banks’ monitoring and risk-management systems to improve assessment and management of operational, liquidity, and credit risks.
  - Problem loans continue to grow, albeit at a reduced pace; loan concentration remains high but significantly reduced from a year ago.
  - Positive signs: profitability has increased, capital adequacy ratios have improved, and provisions relative to non-performing loans have risen substantially.
- Israel: Banking Soundness Indicators—Five Largest Banking Groups, 1997—2003 (in percent) (Sources: Bank of Israel and Fund staff estimates; 1/ Annualized based on the first nine months of the year.)
  - Asset growth: 1997: 6.1, 1998: 8.5, 1999: 10.9, 2000: 7.9, 2001: 7.5, 2002: -0.6, 2003 1/: -1.6
  - Credit growth: 1997: 7.3, 1998: 10.5, 1999: 12.0, 2000: 13.7, 2001: 12.7, 2002: 1.0, 2003 1/: -3.7
  - After-tax return on equity: 1997: 12.0, 1998: 9.9, 1999: 11.3, 2000: 11.7, 2001: 5.9, 2002: 2.5, 2003 1/: 7.6
  - After-tax return on assets: 1997: 0.6, 1998: 0.5, 1999: 0.5, 2000: 0.5, 2001: 0.3, 2002: 0.1, 2003 1/: 0.4
  - Problem loans to total loans ratio: 1997: 10.5, 1998: 9.9, 1999: 9.0, 2000: 6.7, 2001: 8.1, 2002: 9.9, 2003 1/: 10.3
  - Capital to risk-weighted assets ratio: 1997: 10.0, 1998: 9.2, 1999: 9.4, 2000: 9.2, 2001: 9.4, 2002: 9.9, 2003 1/: 10.4

### Trade policy
- No major recent developments.
- Objectives:
  - Expanding network of bilateral trade agreements.
  - Enhancing trade liberalization at the multilateral level.
- Coverage and features:
  - After EU and US free trade agreements in the 1980s, Israel expanded FTAs to many other countries.
  - Presently, more than 75 percent of Israel’s trade is covered by free trade agreements.
  - Except for security considerations and a few cases involving antidumping rules and agricultural products, Israel maintains a trade system free of non-tariff barriers.

### External sector and vulnerability
- Current account and capital flows:
  - Current account deficit continues to fall and is now close to balance.
  - The sizeable capital outflow of Q4 2002 and Q1 2003 has been reversed; foreign direct investment rebounded.
- External debt and guarantees:
  - Total gross external debt is about 60 percent of GDP, but net external debt remains negligible.
  - Of the external debt, 80 percent is backed by U.S. guarantees or is held by the Jewish Diaspora.
  - Average maturity of external debt is about 6.5 years.
  - New U.S. guarantees cover most of the government external debt maturing in the next 3 years.
- Reserves and exchange rate regime:
  - BoI follows a de facto fully floating exchange rate system (exchange rate band is not actually binding).
  - International reserves amount to US$25 billion at end-2003 and cover most short-term debt; level of reserves appears adequate.
- Competitiveness and trade performance:
  - No apparent problems of external competitiveness.
  - Exports to all major markets are recovering markedly due to the global upturn and the depreciation of the sheqel in real effective terms (about 20 percent in 2002–03).

### Fiscal transparency and fiscal policy assessment
- Fiscal ROSC mission findings (draft report under authority review):
  - Israel meets requirements of the fiscal transparency code in many areas, including internal and external audit and fiscal accounting.
  - Greatest scope for improvement: budget preparation and presentation.
    - Budget documents should include a more systematic analysis of budget sensitivity to economic and financial shocks.
    - Additional information on budget execution should be included (including a revised projection for the year in course).
    - Expenditure classification should be revised to conform more closely to international standards to facilitate assessments of effectiveness and efficiency of expenditure programs.
- Staff appraisal on fiscal policy:
  - Policies of consolidation and reform over the past year set the stage for a more balanced policy mix but need to be sustained and complemented with a stronger commitment to debt reduction.
  - 2004 budget has a deficit target of 4 percent of GDP and strikes a balance between fiscal consolidation and supporting recovery.
  - Upward deviations from the 4 percent target could raise concerns about commitment and ability to rein in deficit and debt; recent cabinet moves to cut ministry expenditures and use contingency reserves soon after budget approval are troublesome.
  - Given high public debt, scope for allowing automatic stabilizers to operate is limited.
    - Only if 2004 recovery is weaker than expected but return to potential growth in 2005–08 appears realistic should a limited deviation from the deficit target be considered.
    - If the recovery is stronger than expected, additional revenues should be used to lower the deficit and curb substantial public debt.
  - Authorities’ decision in early February to reduce taxes is viewed as disappointing because it portends a slower pace of debt reduction.
  - Adoption of a limit of one percent on expenditure growth in real terms and a ceiling of 3 percent of GDP on the overall deficit for 2005–10 is welcome; strict adherence is important to reduce public debt and the size of the public sector.
  - Recommend preparation and publication of a more detailed spending plan with medium-term expenditure targets, supplemented by semi-annual detailed reports on progress in public finance goals and implementation of measures and reforms.
  - Commendation for structural reforms in pension and welfare systems, privatization, and infrastructure investment; steadfast implementation will improve efficiency and public finance structure.

### Monetary policy and BoI governance
- Monetary stance and inflation:
  - A further relaxation of monetary policy seems warranted; recent reductions in the BoI policy rate are welcome.
  - CPI has fallen nearly 2 percent over the last 12 months.
  - Long-term real and nominal interest rates have declined markedly.
  - Inflationary expectations over the next 12 months are below the lower bound of the inflation target range; upside risks are modest and stem primarily from depreciation of the sheqel.
  - Declines in country and currency risks are encouraging.
  - Subdued economic activity suggests further interest rate reductions are unlikely to push future inflation above the upper bound of the price stability target.
  - Recommendation: BoI has some room to continue lowering its policy interest rate gradually while closely monitoring foreign exchange and financial markets.
- Communication and legislation:
  - Support implementation of monetary policy by strengthening BoI communication of policy and views regarding the inflationary environment to anchor expectations.
    - Suggest supplementing the semi-annual Inflation Report with interim quarterly updates and giving more attention to dynamics of future inflation.
  - Need to amend the BoI law to reflect international best practice on monetary policy objectives and procedures, along the lines of Levin Committee recommendations, to enhance transparency and accountability and minimize risks from temporary breaches of inflation targets.

### Labor market and social policy
- Concerns:
  - High social benefits relative to the minimum wage and high penalties for joining the labor market at the lower end, together with steady inflows of foreign workers, have induced many to exit the labor market.
  - Cuts in social benefits to those capable of work are considered essential to entice people back to the labor market and improve social structure; authorities commended for implementing necessary changes, with emphasis on protecting the disabled and the truly needy.
- Complementary measures and risks:
  - Eliminating distortions may lead to temporary social hardship because the frail labor market may be unable to absorb quickly those affected.
  - Need to complement benefit reductions with steps to facilitate mobility, increase job training opportunities and education to assist rapid absorption of unemployed and income support recipients.
  - “Welfare-to-Work” pilot project (based on Wisconsin Program) is promising but limited in scope and should be expanded over time.
  - Consideration could be given to establishing temporary tax incentives linked to job creation and training.

### Data dissemination
- Israel has subscribed to the Special Data Dissemination Standard.
- Periodicity, timeliness, coverage, and quality of Israel’s economic data are generally adequate for surveillance.

*Source: IMF staff report (content unit: _cr04158 - 23. The authorities are also taking steps to develop the financial markets and).*

### 40.      It is recommended that the next Article IV consultation be held on the standard 12-

### _cr04158 - 40.      It is recommended that the next Article IV consultation be held on the standard 12-

### Recommendation on Article IV consultation
- It is recommended that the next Article IV consultation be held on the standard 12-month cycle.
- The last Article IV consultation was concluded on March 7, 2003. Israel is on the standard 12-month consultation cycle.

### Demographic and social indicators
- Population (2003): 6.7 million
- GDP per capita (2002): US$ 16,292
- Life expectancy at birth (2001):
  - Male (2001): 76.5
  - Female (2001): 80.6
- Infant mortality rate (2001): 6 per 1,000 live births
- Physicians per 1,000 people (1998): 3.85
- Population per sq. km. (2001): 308.6

### National accounts (shares and real growth, selected years)
- Expenditure shares (1993 and 2003, percent of GDP and U.S. dollar shares):
  - Private consumption: 41.0 (1993) / 64.2 (2003) — 61.0 percent of GDP (1993) / 59.0 percent of GDP (2003)
  - Public consumption: 18.9 (1993) / 33.0 (2003) — 28.1 percent of GDP (1993) / 30.4 percent of GDP (2003)
  - Gross capital formation: 15.0 (1993) / 17.2 (2003) — 22.3 percent of GDP (1993) / 15.8 percent of GDP (2003)
  - Exports of goods and services: 21.6 (1993) / 41.9 (2003) — 32.0 percent of GDP (1993) / 38.5 percent of GDP (2003)
  - Imports of goods and services: 31.7 (1993) / 48.9 (2003) — 47.1 percent of GDP (1993) / 44.9 percent of GDP (2003)
  - GDP: 67.3 (1993) / 108.8 (2003) — 100.0 percent of GDP (both years relative)
- National account indicators (real percent change, 1999-2003):
  - Private consumption: 4.2, 7.5, 3.2, 0.1, 1.8 (1999–2003)
  - Public consumption: 2.9, 2.2, 3.4, 5.7, -1.8 (1999–2003)
  - Fixed capital formation: -2.8, 3.9, -6.8, -7.5, -3.9 (1999–2003)
  - Exports of goods and services: 12.0, 24.0, -11.5, -3.0, 6.2 (1999–2003)
  - Imports of goods and services: 14.9, 12.2, -4.5, -2.3, -1.8 (1999–2003)
  - Real GDP: 2.6, 7.5, -0.9, -0.8, 1.3 (1999–2003)

### Labor market and prices
- Unemployment rate (in percent): 8.9, 8.8, 9.3, 10.3, 10.7 (1999–2003)
- Real wages: 2.5, 6.3, 3.0, -6.0, -3.4 (1999–2003)
- Overall CPI (end period): 1.3, 0.0, 1.4, 6.5, -1.9 (1999–2003)
- Underlying CPI (excluding housing, fruit and vegetables, end period): 1.7, 0.9, 0.2, 6.3, -0.6 (1999–2003)

### Interest rates and money
- BOI policy rate (average, in percent): 12.1, 9.3, 6.8, 6.8, 7.5 (1999–2003)
  - Note: The Bank of Israel set the policy rate at 4.5 percent in February 2004.
- Money and credit (period average):
  - Nondirect domestic credit 3/: 16.7, 13.1, 10.8, 10.5, 1.7 (1999–2003)
  - Narrow money (M1) 3/: 9.6, 11.0, 14.2, 15.6, 8.7 (1999–2003)
  - Broad money (M3) 3/: 21.2, 16.9, 15.5, 6.1, 2.2 (1999–2003)
  - (As of November 2003 for 3/)

### Public finance (percent of GDP, 1999-2003)
- Central government revenue: 37.5, 37.9, 35.8, 37.1, 35.3
- Central government expenditure: 39.3, 38.1, 40.1, 40.7, 40.5
- Central government balance: -1.8, -0.2, -4.3, -3.6, -5.2
- General government balance: -4.2, -2.1, -4.1, -4.5, -6.4
- Government debt: 96.7, 85.9, 92.8, 101.2, 106.5

### Balance of payments and reserves (selected)
- Current account (percent of GDP): -1.5, -0.6, -1.6, -1.3, -0.2 (1999–2003)
- Foreign reserves (e.o.p., in US$ billion): 22.6, 23.3, 23.4, 24.1, 25.0 (1999–2003)
- Reserve cover (in months of imports): 6.7, 6.0, 6.5, 6.8, 6.7 (1999–2003)

### Exchange rate and competitiveness
- NEER appreciation (period average) 3/: -7.7, 9.1, 0.7, -13.5, -6.3 (1999–2003)
- REER appreciation (period average) 3/: -3.8, 8.0, -0.3, -10.0, -9.4 (1999–2003)
- Terms of trade (1990=100; index level): 114.4, 116.3, 113.3, 113.4, 109.8 (1999–2003)

### Balance of Payments detailed flows and projections (2000–08, percent of GDP or US$ billions)
- Current account balance (percent of GDP): -0.7, -1.8, -1.4, -0.2, 0.0, -0.1, 0.2, 0.4, 0.3 (2000–08)
- Merchandise (percent of GDP): -2.9, -3.0, -3.7, -2.6, -2.2, -3.0, -2.2, -2.1, -1.8 (2000–08)
- Exports, f.o.b. (percent of GDP): 31.2, 28.0, 27.5, 29.8, 31.9, 35.0, 37.7, 40.2, 42.8 (2000–08)
- Imports, f.o.b. (percent of GDP): 34.0, 31.0, 31.2, 32.3, 34.1, 38.0, 39.9, 42.3, 44.6 (2000–08)
- Services (net, percent of GDP): 2.7, -0.6, -0.6, 0.5, 0.3, 0.4, 0.6, 0.9, 1.2 (2000–08)
- Factor income (net, percent of GDP): -6.9, -4.6, -3.6, -4.4, -4.5, -4.0, -4.6, -4.8, -5.5 (2000–08)
- Net transfers (percent of GDP): 6.5, 6.4, 6.5, 6.3, 6.4, 6.4, 6.4, 6.4, 6.4 (2000–08)
- Capital and financial account balance (excl. reserves) 3/: 4.5, 0.9, -1.6, 0.1, 0.0, 0.3, 0.1, -0.1, -0.2 (2000–08)
- Foreign direct investment (in Israel, percent of GDP): 5.0, 3.5, 1.6, 3.7, 3.9, 4.2, 4.3, 4.4, 4.4 (2000–08)
- Change in reserves (negative denotes increase in reserves): -0.8, 0.8, 0.7, -0.8, -0.1, -0.2, -0.3, -0.3, -0.2 (2000–08)
- Memorandum (percent of GDP): Gross external debt: 56.4, 57.7, 65.3, 64.5, 63.1, 61.9, 60.4, 58.9, 57.3 (2000–08 projections)
- GDP (in US$ billions): 114.8, 112.7, 103.7, 108.7, 110.2, 115.5, 121.9, 129.0, 136.9 (2000–08)

### Financial sector and external vulnerability indicators (1998–2003, selected)
- Broad money (percent change, 12-month basis): 15.9, 21.2, 16.9, 15.5, 6.1, 2.3 (1998–Oct. 2003)
- Private sector credit (percent change, 12-month basis): 17.7, 34.9, 16.4, 10.8, 10.5, -2.4 (1998–Oct. 2003)
- Exports of G&NFS (percent change): 6.1, 14.5, 24.3, -14.5, -3.7, 13.1 (1998–Sept. 2003)
- Imports of G&NFS (percent change): -1.5, 13.0, 19.0, -10.9, -3.6, 6.4 (1998–Sept. 2003)
- Gross official reserves (in US$ billions; e.o.p.): 22.7, 22.6, 23.3, 23.4, 24.1, 25.8 (1998–Dec. 2003)
- Official reserves in months of imports GNFS: 6.4, 5.6, 4.9, 5.5, 5.9, 6.4 (1998–Sept. 2003)
- Total net external debt/GDP (in percent): 10.9, 7.1, 3.2, 0.2, -2.9, -5.3 (1998–Sept. 2003)
- Total gross external debt/GDP (in percent): 56.2, 60.3, 56.4, 57.7, 65.2, 61.9 (1998–Sept. 2003)
- Exchange rate (per US$, period average): 3.80, 4.14, 4.08, 4.21, 4.74, 4.42 (1998–Jan. 2004)
- REER appreciation (+) (period average): -3.0, -3.8, 8.0, -0.3, -10.0, -7.7 (1998–Oct. 2003)
- Change in Stock Market Index (in percent): 0.6, 64.4, 0.3, -6.6, -19.9, 55.4 (1998–Dec. 2003)
- Country risk ratings (S. & P. / Moody's): A- / A3 (1998–Dec. 2002)

### State budget (1998–2004, percent of GDP)
- Revenue (1998–2004): 39.3, 38.3, 39.3, 37.5, 39.4, 40.6, 37.5, 37.7 (selected)
  - Domestic revenue: 34.9, 34.5, 36.5, 35.0, 34.4, 36.5, 33.4, 34.1
  - Tax revenue: 29.5, 29.6, 31.1, 30.8, 29.9, 31.2, 29.0, 28.9
  - Nontax domestic: 5.4, 5.0, 5.4, 4.2, 4.4, 5.4, 4.3, 5.1
  - Foreign revenue: 4.5, 3.8, 2.8, 2.5, 5.0, 4.1, 4.2, 3.6
- Expenditure (1998–2004): 41.6, 40.7, 40.0, 41.9, 43.2, 43.6, 43.1, 41.7
  - Domestic expenditure: 37.7, 37.3, 37.0, 38.6, 37.9, 38.8, 37.3, 37.4
  - Current expenditure (selected): 39.8, 39.1, 38.3, 40.2, 41.3, 41.5, ..., 39.8
  - Wages (percent of GDP): 8.4, 5.9, 8.8, 8.7, 8.8, 8.8, ..., 8.5
  - Interest (percent of GDP): 4.8, 4.5, 4.6, 4.6, 4.5, 4.9, 5.3, 5.4
  - Subsidies & transfers: 14.7, 15.0, 14.1, 14.9, 14.5, 14.6, ..., 13.3
- Budget balance (percent of GDP): 2.3, 2.4, 0.7, 4.4, 3.8, 5.6, 4.0 (selected)
- Financing (percent of GDP): 1.9, 2.1, 0.3, 4.3, 3.4, 3.0, 5.2, 4.1 (selected)
- Memorandum: Defense expenditure (percent of GDP): 9.7, 9.1, 9.4, 9.9, 11.9, 9.4, ..., 9.2
- Primary balance (percent of GDP): 4.0, 3.4, 5.2, 1.5, 1.8, 3.6, 0.9, 3.0 (1998–2004)

### Medium-term scenario and projections (1998–2007, selected)
- GDP growth rate (1998–2007): 3.3, 2.6, 7.5, -0.9, -0.8, 1.3, 2.5, 3.4, 3.5, 3.7
- Inflation (end of period): 8.6, 1.3, 0.0, 1.4, 6.5, -1.9, 1.1, 1.3, 1.3, 1.3
- Fiscal deficit/GDP Central government deficit (1998–2007, selected): -1.9, -1.8, -0.2, -4.3, -3.6, -5.2, -4.0, -3.0, -3.0, -2.5
- Public debt/GDP (end of period): 103.1, 96.7, 85.9, 92.8, 101.2, 106.5, 108.6, 107.8, 106.6, 104.7
- Current account/GDP (1998–2007): -1.3, -1.5, -0.6, -1.6, -1.3, -0.2, 0.0, -0.1, 0.2, 0.3
- Foreign reserves (in billions of U.S. dollars): 22.7, 22.6, 23.3, 23.4, 24.1, 25.0, 25.5, 25.6, 25.8, 26.0
- Memorandum items: Aggregate domestic demand (percent change): 1.8, 4.3, 3.9, 1.6, -0.7, -1.6, 1.9, 3.4, 2.8, 3.3

### Public sector debt sustainability framework (1998–2010, selected)
- Public sector debt (general government gross debt, percent of GDP): 103.1, 96.7, 85.9, 92.8, 101.2, 106.5, 108.6, 107.8, 106.6, 105.2, 103.7, 101.9, 100.1 (1998–2010)
- Debt-stabilizing primary balance (percent of GDP): 1
- Change in public sector debt (percent of GDP): 1.8, -6.4, -10.8, 6.9, 8.4, 5.3, 2.1, -0.8, -1.2, -1.4, -1.5, -1.8, -1.8 (1998–2010)
- Identified debt-creating flows (4+7+12): 6.1, 3.7, -5.4, 7.5, 10.1, 5.0, 3.2, -0.3, -0.7, -0.9, -1.1, -1.0, -1.0
- Primary deficit (percent of GDP): -2.7, -1.8, -3.8, -1.8, -0.9, -0.2, -1.7, -2.7, -2.7, -2.7, -2.7, -2.7, -2.7
- Automatic debt dynamics (percent of GDP): 6.7, 3.0, -1.6, 8.7, 7.6, 4.9, 5.4, 2.0, 1.2, 1.0, 0.9, 1.1, 1.1
- Contribution from interest rate/growth differential (percent of GDP): 2.4, 3.0, -0.9, 6.1, 5.7, 6.0, 5.4, 2.0, 1.2, 1.0, 0.9, 1.1, 1.1
- Contribution from real interest rate (percent of GDP): 5.4, 5.5, 5.8, 5.3, 4.9, 7.3, 8.0, 5.5, 4.8, 4.8, 4.8, 4.9, 4.9
- Contribution from real GDP growth (percent of GDP): -3.0, -2.5, -6.7, 0.8, 0.7, -1.3, -2.6, -3.5, -3.6, -3.8, -3.9, -3.8, -3.8
- Privatization receipts (negative, percent of GDP): -1.3, -0.5, -0.6, 0.0, -0.1, -0.1, -0.5, -0.5, -0.4, -0.4, -0.5, -0.5, -0.6
- Residual, including asset changes (2-3): -4.3, -10.1, -5.4, -0.7, -1.7, 0.3, -1.1, -0.5, -0.5, -0.5, -0.4, -0.8, -0.8

### Public debt stress tests — alternative scenarios (selected outcomes)
- A1. Key variables at historical averages in 2004-10: public sector debt remains around 106.5 down to 104.8 by end of scenario; debt-stabilizing primary balance: 2.8
- A2. Primary balance under no policy change in 2004-10: public sector debt rises to 115.6 by mid-projection; debt-stabilizing primary balance: 1.5
- A3. GDP growth 1 percent 2004-10: public sector debt rises to 119.3 by later years; debt-stabilizing primary balance: 5.3
- Bound tests (B1–B3) show higher debt paths under adverse shocks including real GDP shocks and a one-time 30 percent real depreciation.

### External debt sustainability framework (1998–2010, selected)
- External debt (percent of GDP): 56.2, 60.3, 56.4, 57.7, 65.2, 63.3, 64.5, 64.1, 63.1, 61.9, 60.4, 58.9, 57.3 (1998–2010)
- Change in external debt (percent of GDP): 2.8, 4.0, -3.9, 1.3, 7.5, -1.8, 1.2, -0.4, -1.0, -1.2, -1.5, -1.5, -1.5
- Identified external debt-creating flows (4+8+9): -3.3, -3.2, -11.3, 2.5, 5.7, -0.9, 0.6, 0.1, -0.3, -0.4, -0.5, -0.7, -0.7
- Current account deficit, excluding interest payments (percent of GDP): -2.1, -2.2, -3.1, -1.6, -1.9, -3.5, -3.3, -3.1, -3.3, -3.4, -3.2, -3.4, -3.3
- Exports (percent of GDP): 31.3, 36.1, 40.3, 35.4, 37.0, 38.9, 41.2, 43.0, 44.1, 44.8, 45.4, 46.0, 46.6
- Imports (percent of GDP): 34.7, 39.3, 40.5, 38.6, 41.2, 41.1, 42.8, 45.2, 45.4, 45.7, 45.8, 45.8, 45.9
- Net non-debt creating capital inflows (negative): -2.9, -3.2, -6.4, 0.4, 1.2, 0.2, 2.1, 2.0, 2.0, 2.1, 2.0, 2.1, 2.0
- Automatic debt dynamics (percent of GDP): 1.7, 2.1, -1.9, 3.7, 6.4, 2.4, 1.7, 1.1, 1.0, 0.9, 0.7, 0.6, 0.6
- External debt-to-exports ratio (in percent): 179.4, 166.8, 139.7, 162.9, 176.2, 163.0, 156.8, 149.2, 143.2, 138.2, 133.2, 127.9, 122.9
- Gross external financing need (in billions of US dollars): 29.7, 31.0, 32.8, 32.8, 33.6, 33.9, 35.0, 36.4, 37.5, 38.8, 40.3, 41.4, 42.9
- Alternative scenarios and bound tests show material increases in external debt ratios under adverse shocks (B1–B6), including a one-time 30 percent nominal depreciation raising external debt outcomes substantially.

### Fund relations and IMF operations (as of December 31, 2003)
- Membership: Israel became a member of the Fund on July 12, 1954, and accepted the obligations of Article VIII, Sections 2, 3, and 4 on September 21, 1993.
- Quota: 928.20 (SDR Millions), 100.00 percent of quota
  - Fund holdings of currency: 573.42 (61.78 percent)
  - Reserve position in Fund: 354.79 (38.22 percent)
- SDR Department:
  - Net cumulative allocation: 106.36 (100.0 percent)
  - Holdings: 6.39 (6.01 percent)
- Outstanding Purchases and Loans: None
- Financial Arrangements: None
- Projected payments to Fund (Charges/Interest): 1.58 each year for 2004–2008; Total 1.58 for each year 2004–2008 (Forthcoming)
- HIPC Initiative: Not applicable
- Safeguards Assessments: Not applicable
- Exchange rate arrangement:
  - The new sheqel is managed against a basket (dollar, euro, pound sterling, yen) within a crawling band.
  - Slope of upper limit: 6 percent on an annual basis since July 26, 1993.
  - Slope of lower limit: 2 percent since August 6, 1998; lower limit became flat on December 23, 2001.
  - On February 3, 2004, the width of the band, based on the average of the upper and lower limits, was 57.1 percent.
- Article IV consultation: Last concluded March 7, 2003; standard 12-month cycle.
- Technical assistance: IMF provided technical assistance to the Palestinian Authority (PA) in tax and customs administration, expenditure management, bank supervision, national accounts, and monetary statistics.
- Resident representative: A resident representative has been in the WBG since early 1996.

### Statistical issues and data dissemination
- Israel has subscribed to the Special Data Dissemination Standard.
- Periodicity, timeliness, coverage, and quality of Israel’s economic data are generally adequate for surveillance.
- Methodological note: The reported overall annual fiscal balance excludes the inflation component of interest costs; this is not in conformity with internationally accepted practice. Authorities are gradually moving toward the standard methodology.
- There is no within-year monthly report of expenditures broken down by composition.

### Core statistical indicators (as of February 4, 2004; latest observation dates noted)
- Exchange rates: Date of latest observation 2/4/04; Date received 2/4/04; Frequency: Daily; Source: Reuters; Mode: Electronic Mail/Publication; Confidentiality: Public
- International Reserves: Jan. 2004; Date received 2/2/04; Frequency: Monthly; Source: BoI; Mode: Electronic Mail/Publication; Confidentiality: Public
- Central Bank Balance Sheet: Jan. 2004; Date received 1/31/04; Frequency: Monthly; Source: BoI; Mode: Electronic Mail/Publication; Confidentiality: Public
- Reserve/Base Money: Oct. 2003; Date received Jan. 14, 2004; Frequency: Monthly; Source: BoI; Mode: Electronic Mail/Publication; Confidentiality: Public
- Broad Money: Oct. 2003; Date received 1/14/04; Frequency: Monthly; Source: BoI; Mode: Electronic Mail/Publication; Confidentiality: Public
- Interest Rates: 2/4/04; Date received 2/4/04; Frequency: Daily; Source: BoI; Mode: Electronic Mail/Publication; Confidentiality: Public
- Consumer Price Index: Dec. 2003; Date received 1/15/04; Frequency: Monthly; Source: Central Bureau of Statistics; Mode: Electronic Mail/Publication; Confidentiality: Public
- Exports/Imports: Dec. 2003; Date received 1/12/04; Frequency: Monthly; Source: Central Bureau of Statistics; Mode: Electronic Mail/Publication; Confidentiality: Public
- Current Account Balance: Q3 2003; Date received 12/16/03; Frequency: Quarterly; Source: Central Bureau of Statistics; Mode: Electronic Mail/Publication; Confidentiality: Public
- Overall Government Balance: Jan. 2004; Date received 2/3/04; Frequency: Monthly (on a cash basis); Source: MoF; Mode: Electronic Mail/Publication; Confidentiality: Public
- GDP/GNP: Q3 2003; Date received 1/4/04; Frequency: Quarterly; Source: Central Bureau of Statistics; Mode: Electronic Mail/Publication; Confidentiality: Public
- External Debt: Q3 2003; Date received 12/16/03; Frequency: Quarterly; Source: BoI/CBS; Mode: Electronic Mail/Publication; Confidentiality: Public
- Notes:
  - 1/ Market rates available daily through Reuters.
  - 2/ On a cash basis.
  - BoI = Bank of Israel; MoF = Ministry of Finance.

*Source: IMF staff report and appendices (data, estimates, and projections as presented in the source document).*

### 1. This supplement contains information on recent economic developments in Israel that

### _cr04158 - 1. This supplement contains information on recent economic developments in Israel that

### Recent information since staff report
- The supplement contains information on recent economic developments in Israel that has become available since the circulation of the staff report for the Article IV consultation. The information does not alter the thrust of the staff appraisal.

### Budget amendments and financing
- Amendments amount to almost NIS 5 billion (about 1 percent of GDP).
- Itemized supplements:
  - NIS 1.6 billion supplement to the defense budget.
  - NIS 1.3 billion to local municipalities.
- Financing of the supplements:
  - Reducing the contingency reserves by about NIS 2.8 billion.
  - Implementing a uniform 6% cut in all ministry procurement budgets.

### Monetary policy actions
- The Bank of Israel (BoI) reduced its policy rate by 0.2 percentage points in both March and April to 4.1 percent.
- The BoI stated the reduction was made possible by:
  - continued calm in financial markets,
  - the actual reduction in the Consumer Price Index last year,
  - continued moderate level of activity in the economy which is emerging from recession.

### Taxation plan announced by the Ministry of Finance
- In early April, the Ministry of Finance announced a plan to reduce taxation amounting to about ¼ percent of GDP in 2004.
- Expected effective timing: third quarter of 2004.
- Key elements of the plan:
  - Decreasing income taxes for middle and lower wage earners.
  - Lowering the corporate tax rate from its current level of 36 percent to 30 percent by 2007.
  - Reducing customs duties on various construction goods.

### Executive Board assessment and policy recommendations
- Assessment:
  - Executive Directors welcomed the economic program of consolidation and reform and the resulting gradual recovery after three years of recession.
  - Directors cautioned that establishing the basis for stronger and more sustained medium-term growth remains a challenge and depends on steady policy, structural reforms, debt reduction, and improved security conditions.
- Fiscal policy recommendations:
  - Most Directors recommended that any revenue windfall be used to lower the deficit and the public debt.
  - Directors expressed disappointment at the authorities’ recent decision—based on higher-than-budgeted revenue collection—to reduce taxes, as this will not allow for a much-needed faster pace of debt reduction.
  - Directors commended adoption of a limit of one percent on expenditure growth in real terms and a ceiling of 3 percent of GDP on the overall deficit for 2005-10, and urged strict adherence to the medium-term framework.
  - Recommended structural measures to enhance credibility of fiscal adjustment and cushion market reaction:
    - Formulate a detailed medium-term spending plan consistent with adopted expenditure limits.
    - Prepare semi-annual reports on progress toward public finance goals and reform objectives.
- Labor market and social policy recommendations:
  - Expressed concern about high unemployment and low labor market participation.
  - Recommended reforms to raise incentives to work and better target welfare policy to the truly disadvantaged.
  - Welcomed cuts in social benefits to those fully able to work and urged complementary measures for job training and education.
  - Noted that product market reforms (dismantling monopolies, streamlining bureaucracy) should contribute to improving employment prospects.
- Monetary and financial sector recommendations:
  - Welcomed the relaxation of monetary policy; most Directors encouraged the BoI to continue lowering its policy rate gradually while monitoring exchange and financial markets.
  - Supported amending the BoI law to strengthen central bank independence and reflect international best practice regarding monetary policy objectives and procedures.
  - Welcomed strengthening of the banking system (improved capital adequacy ratios, provisioning for nonperforming loans, profitability) and enhancements in banks’ monitoring and risk-management systems.
  - Noted continued growth in problem loans (albeit more slowly) and high loan concentration; urged continued regulatory vigilance.
- External sector and exchange rate:
  - Agreed that external vulnerability has declined: exports recovering, current account close to balance, foreign direct investment rebounding, foreign reserves adequate, and net external debt negative.
  - Considered the current floating exchange rate system appropriate and external competitiveness sound.
- Data dissemination:
  - Directors observed that Israel meets the Special Data Dissemination Standard specifications for coverage, periodicity, and timeliness, and that data quality is adequate for surveillance.

### Key macroeconomic findings and recent trends
- Recovery and activity:
  - Real GDP is estimated to have grown 1.3 percent in 2003, led by external demand, despite anemic investment.
  - High-frequency indicators suggest output is recovering, private consumption is growing, and tourism is rebounding.
- Fiscal outcomes:
  - Deficit reached 5.6 percent of GDP in 2003, compared to a target of 3 percent.
  - Public debt rose to about 107 percent of GDP by end-2003.
- Inflation:
  - Consumer Price Index declined 1.9 percent during 2003, compared with a 6.5 percent increase during 2002.
  - Inflation expectations fell to below the lower inflation target bound of one percent.
  - Drop in inflation and expectations, fiscal commitment, and stronger financial markets prompted the BoI to lower its policy interest rate from close to 9 percent during the first half of 2003 to 4.5 percent by February of 2004.
- Labor market:
  - Unemployment rate rose from 8.5 percent in early 2001 to 10.7 percent in November 2003.
  - Share of long-term unemployed (jobless for more than six months) in total unemployment reached 40 percent.
- External accounts and reserves:
  - Sizeable capital outflows in late 2002 and early 2003 reversed; foreign direct investment rebounded.
  - Total gross external debt is about 60 percent of GDP, net external debt is negative.
  - International reserves nearly US$26 billion at end-2003.

### Selected economic indicators (annual data)
- National account indicators (constant prices)
  - Real GDP: 1999: 2.6; 2000: 7.5; 2001: -0.9; 2002: -0.8; 2003: 1.3
  - Private consumption: 1999: 4.2; 2000: 7.6; 2001: 3.2; 2002: 0.1; 2003: 1.7
  - Public consumption: 1999: 2.9; 2000: 2.2; 2001: 3.4; 2002: 5.7; 2003: -1.8
  - Gross capital formation: 1999: 6.7; 2000: -2.9; 2001: -4.9; 2002: -12.4; 2003: -13.4
  - Exports of goods and services: 1999: 12.0; 2000: 24.0; 2001: -11.5; 2002: -3.0; 2003: 6.1
  - Imports of goods and services: 1999: 14.9; 2000: 12.2; 2001: -4.5; 2002: -2.3; 2003: -2.3
- Labor market indicators
  - Unemployment rate (in percent): 1999: 8.9; 2000: 8.8; 2001: 9.3; 2002: 10.3; 2003: 10.7
- Prices (end-period)
  - Overall CPI: 1999: 1.3; 2000: 0.0; 2001: 1.4; 2002: 6.5; 2003: -1.9
  - Underlying CPI (excluding housing, fruits and vegetables): 1999: 1.7; 2000: 0.9; 2001: 0.2; 2002: 6.3; 2003: -0.6
- Money and credit (period average)
  - Narrow money (M1): 1999: 9.6; 2000: 11.0; 2001: 14.2; 2002: 15.6; 2003: 0.5
  - Broad money (M3): 1999: 21.2; 2000: 16.9; 2001: 15.5; 2002: 6.1; 2003: 2.2
  - Domestic credit: 1999: 34.9; 2000: 16.4; 2001: 10.8; 2002: 10.5; 2003: 1.7
- Interest rates (average, in percent)
  - Bank of Israel policy rate: 1999: 12.1; 2000: 9.3; 2001: 6.8; 2002: 6.8; 2003: 7.5
  - Note: The Bank of Israel set the policy rate at 4.1 percent in April 2004.
- Public finance (percent of GDP)
  - Central government balance: 1999: -1.8; 2000: -0.2; 2001: -4.3; 2002: -3.6; 2003: -5.6
  - General government balance: 1999: -4.2; 2000: -2.1; 2001: -4.1; 2002: -4.5; 2003: -6.1
  - Public debt: 1999: 101.4 91.4 96.4 104.9 107.4
- Balance of payments
  - Trade balance (percent of GDP): 1999: -4.1; 2000: -2.5; 2001: `-2.7; 2002: -3.6; 2003: -2.4
  - Current account (percent of GDP): 1999: -1.5; 2000: -0.6; 2001: -1.6; 2002: -1.3; 2003: -0.2
  - Foreign reserves (end-of-period, in billions of U.S. dollars): 1999: 22.6; 2000: 23.3; 2001: 23.4; 2002: 24.1; 2003: 26.3
- Exchange rate indices
  - Nominal effective exchange rate (period average; depreciation -): 1999: -7.7; 2000: 9.1; 2001: 0.7; 2002: -13.5; 2003: -7.0
  - Real effective exchange rate (period average; depreciation -): 1999: -3.8; 2000: 8.0; 2001: -0.3; 2002: -10.0; 2003: -7.9

*IMF Public Information Notice (PIN) No. 04/48 — IMF Concludes 2003 Article IV Consultation with Israel (April 29, 2004).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2004/_cr04158.pdf_