## _cr05133 - Executive Summary and Supplement ## Source details **Canonical URL:** [_cr05133 - Executive Summary and Supplement](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05133.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05133.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05133.pdf.json) --- ### Overview and Outlook - Real GDP grew by an estimated 4.3 percent in 2004, led by exports and private consumption. - Growth supported by more favorable global conditions, improved security situation, and policies that combined tightening the fiscal stance and easing monetary policy. - Medium-term growth projected around 4 percent, described as insufficient to markedly reduce high unemployment and substantial public debt. - Labor market: participation rate cited at 54.5 percent; unemployment at 10 percent (monthly observations around 9.6–11.0 percent in 2004). Other series: participation rate in 2004 increased to 54.9 percent; employment rose by 3.0 percent. - Exchange rate stable and inflation low; CPI over last 12 months rose by 0.8 percent (supplement) and CPI inflation in 2004 was close to the lower bound of the 1–3 percent target range. ### Fiscal Policy — Findings and Recommendations - Key fiscal indicators: - 2004 budget deficit reached 3.9 percent of GDP (compared with 5.6 percent of GDP in 2003). - Public gross debt around 105 percent of GDP (general government debt 104.8 percent of GDP in 2004; staff projection 103.8 percent in 2005). - Government expenditures estimated to decline by 2.4 percent of GDP in 2004 (source statement). - Recommendations and targets: - Refrain from unplanned tax cuts should revenue over-perform. - Strictly observe the deficit target of 3 percent of GDP over the medium term. - Limit expenditure growth, in real terms, to no more than 1 percent a year. - Present a medium-term budget framework with detailed expenditure plans consistent with the expenditure ceiling and mid-year reports covering budget developments. - Accelerate debt reduction by broadening the tax base through elimination of tax exemptions and allowing automatic stabilizers to operate fully if revenues over-perform. - 2005 budget discussion: - Government plan proposed raising the deficit target to 3.4 percent of GDP and real expenditure growth to 2 percent in 2005 as a one-time adjustment for the Gaza disengagement plan—estimated cost about 1 percent of GDP, spread over 2005-2007. - Mission view: a temporary—and capped—deviation of up to 0.4 percent of GDP for an exceptional expense acceptable, but authorities need to adhere to budget framework and resist further deviations. - Debt dynamics and scenarios (public sector debt, percent of GDP): - Baseline projection: falls from 105 percent today to 97 percent in four years. - Planned central government deficits of 3 percent of GDP would result in a decline in public debt to GDP of only about 2 percentage points a year. - Alternative scenario A1 (key variables at historical averages, 2005-09) public sector debt rises: 2005 104.8; 2006 105.0; 2007 105.7; 2008 106.4; 2009 107.1; 2010 107.8. - Alternative scenario A2 (no policy change, constant primary balance, 2005-09): 2005 104.8; 2006 104.4; 2007 103.6; 2008 102.9; 2009 102.4; 2010 101.9. - Bound test B2 (real GDP growth at historical average minus two standard deviations in 2005 and 2006): 2005 104.8; 2006 114.3; 2007 128.0; 2008 133.3; 2009 139.1; 2010 145.0. - Debt-stabilizing primary balance (percent of GDP): 1.4 (from Table 6). ### Monetary Policy — Findings and Recommendations - Bank of Israel (BoI) policy rate evolution: - Lowered from 5.2 percent in December 2003 to 4.1 percent in April 2004. - Reduced by 20 basis points in December 2004 and again in January and February of 2005 to 3.5 percent. - BoI policy rate history cited: cut from 8.9 percent in March 2003 to 3.5 percent in February 2005. - Inflation and expectations: - CPI inflation in 2004 close to the lower bound of the 1–3 percent target range. - BoI argued inflation expectations were in the middle of the 1–3 percent target range when keeping the rate unchanged for six months. - Supplement: January CPI declined by 0.6 percent m/m; February CPI rose by 0.2 percent m/m; CPI over last 12 months rose by 0.8 percent, undershooting the lower bound. - Recommendations: - Easing of the monetary stance was judged appropriate. - Further scope to strengthen implementation of monetary policy within the inflation targeting regime. - Enhance transparency regarding BoI views about the inflationary environment; supplement semi-annual Inflation Reports with interim quarterly updates and consider publishing the authorities’ view of the inflation outlook. - Develop additional tools and improved forecast models that do not rely primarily on market expectations; avoid overreliance on market-derived measures which may be biased. - Update the Bank of Israel Law to reflect international best practices, including instrument independence and establishment of a monetary policy committee. ### Box 3 — Potential Difficulties with Inflation Targeting Rules (implementation issues) - Interest-rate rule specification: - Ti = rr + Tπ + λ(Eπ − Tπ) where Ti is the policy rate, rr the long-run real interest rate, Tπ the inflation target, Eπ expected inflation, λ the policy response parameter. - Two implementation issues: - Determining the long-run real interest rate. - Ascertaining expected inflation (future inflationary environment). - Measurement concerns: - BoI uses a CPI-indexed ten-year government bond as proxy for rr; this measure could misstate the actual real rate in a high public debt and past inflation environment. - Empirical observation: the real ten-year interest rate has fluctuated between 2 and 6 percent over the past ten years. - Expected inflation issues: - BoI relies heavily on private forecasts and capital markets expectations; limitations include bias from confidence in BoI policies and the Bernanke-Woodford (1997) problem. - Empirical observation: over the past decade, market participants have over-predicted inflation by 1 percentage point, on average. - Policy-objective implication: - Mission view: adding economic growth as a primary monetary objective could undermine BoI credibility and its ability to maintain stable prices. ### Capital Market Reform — Findings, Plans, and Cautions - Structural constraints and market structure: - Financial system dominated by banks: by end-2003 the largest three banks (Hapoalim, Leumi and Discount) had 78 percent of bank deposits, managed 80 percent of mutual fund assets and 85 percent of provident fund assets, and dominated underwriting. - Banking system provides 95 percent of all financing to the private sector. - Corporate bond market accounts for only 3 percent of GDP (2003). - Tel Aviv Stock Exchange market capitalization about 39 percent of GDP. - Factors inhibiting development: - Allocation of non-traded real indexed government bonds to institutional investors. - A 35 percent tax on investment in foreign securities (prior to change noted later). - Israeli prospectus requirements and legal/regulatory restrictions (e.g., municipal bonds not permitted; rights in REPOs not well defined; outdated bankruptcy law). - High issuance costs for corporate paper. - Authorities’ actions and measures: - Pension reform reducing proportion of pension funds held in non-tradable government bonds and establishing professional managers. - Sale of new pension funds to insurance companies and brokerage firms. - New law clarifying rules governing market makers for government bonds; TASE designated a bank as market maker in foreign currency derivative products. - Removing barriers to simplify and reduce costs of issuing corporate paper. - Amendments to banking regulation: limit on a bank’s credit to a single borrower; directive on liquidity risk management. - Reform of insurance commission structure, movement towards International Financial Reporting Standards, and determination to enforce regulatory regime and conflict-of-interest requirements. - Tax reform reducing and equalizing tax rates applied to securities traded abroad with those traded in Israel, which took effect in January 2005. - Proposed legislative and regulatory changes to encourage corporate bonds, short term commercial paper, foreign funds, funds of funds, REITs, ETFs and other instruments. - Specific policy debate: forced divestiture of mutual and provident funds from banks - Authorities plan to require banks to divest mutual and provident funds over a four-year period with limits on buyers’ market shares and other safeguards. - Mission cautions: - Divestiture could discourage potential new participants, create uncertainty, reduce banks’ fee-based income and diversification, and prompt circumvention attempts. - Regulatory and supervisory capacity for non-bank managers must be strengthened; ensure full disclosure and independent custodians. - Authorities view reform as essential and manageable; note evidence from prior reforms (1996 insurance sector opening) and recent foreign interest (sale of controlling share in Israel Discount Bank; sale of 6.5 percent of Bank Leumi). ### Banking Sector Soundness — Recent Indicators (Five Largest Banking Groups) - Selected indicators (unweighted or as in source) and values: - Asset growth (12-month percent change): 2001 = 6.9; 2002 = -0.3; 2003 = 1.3; Q2 2004 = 2.2 - Credit growth (12-month percent change) 2/: 2001 = 10.1; 2002 = 0.9; 2003 = -3.0; Q2 2004 = 1.0 - After-tax return on equity 3/: 2001 = 5.9; 2002 = 2.3; 2003 = 7.4; Q2 2004 = 12.4 - Problem loans to total loans ratio 3/: 2001 = 8.4; 2002 = 9.8; 2003 = 10.5; Q2 2004 = 10.6 - Capital to risk-weighted assets ratio 3/: 2001 = 9.4; 2002 = 9.8; 2003 = 10.2; Q2 2004 = 10.7 - Notes: 1/ Five largest according to assets (Hapoalim, Leumi Le, Discount, United Mizrah, First International). On a consolidated basis. 2/ Credit to the public. 3/ Unweighted average. ### External Position, Exchange Rate, and Trade Policy - Exchange rate regime and behavior: - In principle: crawling peg; in practice: wide bands effectively a float consistent with inflation targeting. - Since 1997, the BoI has not intervened to influence the exchange rate. - Implied volatility of the NIS/US$ exchange rate (from option pricing) has been low. - External indicators: - Current account remains near balance. - Net external asset position is $12 billion. - Foreign reserves total around US$26 billion (gross official reserves: 2004 26.3 US$ billions; other tables list 2004 26.2 US$ billions). - Reserves cover 91 percent of gross short-term external debt. - About 43 percent of total external public debt is held by the Jewish Diaspora (33 percent) or backed by U.S. government guarantees (10 percent). - Short-term external public debt roughly 2 percent of GDP. - Trade policy: - In 2004, some tariffs were cut and import licensing requirements were reduced; tariffs remain for certain goods (electronics, wood and agricultural products) and authorities plan further reductions. - Most trade covered by bilateral free trade agreements; additional agreements with neighboring countries under consideration. ### Structural Reforms, Privatization, and Welfare/Labor Market - Privatizations and market liberalization: - Privatization completed in 2004 for El–Al and Zim; sale of Bank Discount finalized early 2005; government sold 6.5 percent of Bank Leumi to institutional investors (remaining Leumi holdings about 28 percent). - Steps taken towards privatizing the telephone monopoly, ports, oil refineries, and water and electricity distribution; separation and privatization of the two ports launched. - Pension and welfare reforms: - Pension reform improved solvency and should aid capital market development; new pension funds sold to insurance companies and brokerage firms. - Welfare reform reduced expenditures and decreased distortions; authorities complement reductions with increased job training and education and pilot welfare-to-work centers, wage subsidies to single mothers, and enhanced employment services. - Active labor market spending remains small relative to OECD countries; recommendation to expand well-targeted vocational training and employment services. - Labor market indicators: - Unemployment series: 1999 8.9; 2000 8.7; 2001 9.3; 2002 10.3; 2003 10.8; 2004 10.4; 2005 9.8. - Participation and employment described as improving but unemployment remains high. ### Risks, Implementation Issues, and Political Context - Political uncertainty: - Gaza disengagement plan altered coalition make-up and delayed approval of the 2005 budget. - If the Knesset fails to pass the budget by March 31, new elections must be held within 3 months; government operating under 2004 budget framework allowing 1/12 of that budget to be spent each month. - Downside risks to outlook: - Worsening global environment (especially for high tech exports). - Political volatility in the region and deterioration of the security situation. - If real interest rates rise, the exchange rate depreciates rapidly, or real GDP growth slows substantially, public-debt-to-GDP ratio risks becoming entrenched at around 110 percent or higher. - Credit rating note: S&P raised Israel’s country outlook from negative to stable. ### Key Quantitative Indicators and Selected Time Series (exact figures as presented) - Population (2002): 6.3 million - GDP per capita (2002): US$ 16,675 - Real GDP growth (selected years): 1999 3.7; 2000 2.5; 2001 8.0; 2002 -0.9; 2003 -0.7; 2004 1.3; 2005 4.3; 2006 3.8; 2007 3.7 - Real GDP annual percent change (alternative IMF staff table): 1999 2.5; 2000 8.0; 2001 -0.9; 2002 -0.7; 2003 1.3; 2004 4.3; 2005 3.7 - Inflation (end period, selected years): 1999 8.6; 2000 1.3; 2001 0.0; 2002 1.4; 2003 6.5; 2004 -1.9; 2005 1.2 - Central government revenue (percent of GDP, selected years): 1999 38.3; 2000 39.1; 2001 37.2; 2002 39.2; 2003 37.1; 2004 36.5; 2005 37.0 (budget proposal) - Central government expenditure (percent of GDP, selected years): 1999 40.7; 2000 39.8; 2001 41.6; 2002 43.0; 2003 42.7; 2004 40.3; 2005 40.4 (budget proposal) - Central government balance (percent of GDP, selected years): 1999 -2.4; 2000 -0.7; 2001 -4.4; 2002 -3.8; 2003 -5.6; 2004 -3.8; 2005 -3.4 - General government debt (percent of GDP, selected years): 1999 101.4; 2000 91.4; 2001 96.4; 2002 104.9; 2003 107.4; 2004 104.8; 2005 103.8; 2006 101.8; 2007 100.0 - Gross official reserves (end of period, in US$ billions): 1999 22.7; 2000 22.6; 2001 23.3; 2002 23.3; 2003 24.1; 2004 26.3; 2005 26.2 - Public sector debt path (baseline projections, percent of GDP): 2004 104.8; 2005 103.8; 2006 101.8; 2007 100.0; 2008 98.3; 2009 96.7 - External debt (percent of GDP, baseline): 1999 59.7; 2000 55.8; 2001 57.5; 2002 65.0; 2003 64.8; 2004 63.3; 2005 61.2; 2006 59.0; 2007 56.7; 2008 55.2; 2009 53.9 - Selected external stress test (bound test B5 — one time 30 percent nominal depreciation in 2005) external debt path: 2005 63.3; 2006 80.6; 2007 77.4; 2008 74.4; 2009 72.4; 2010 70.9 ### Supplement — Recent Developments (since staff report circulation) - BoI kept its policy rate unchanged for the month of March at 3.5 percent; stated this level is consistent with the inflation targeting range of 1-3 percent a year. - As of March 17, 2005 the 2005 budget had yet to be approved by the Knesset; government operating under 2004 budget framework (1/12 rule). - Authorities initiated an investigation of Bank Hapoalim regarding suspected money laundering activity amounting to several hundred million dollars involving certain customers and employees of a branch. - After completion of negotiations with ports’ labor unions, authorities launched separation of the two ports with intention to privatize them in the future. - Directors’ assessment reiterated priorities: strengthen fiscal position and reduce public debt, implement structural reforms, update BoI Law, enhance inflation forecasting and transparency, and strengthen regulatory/supervisory framework should divestiture occur. *Source: IMF staff report content unit _cr05133 (Executive Summary, Section 9, Box 3, Supplement, and supporting tables and appendices).* ### Executive Summary....................................................................................................... ### _cr05133 - Executive Summary....................................................................................................... ### Overview and Outlook - Economic recovery is underway after a prolonged recession; Real GDP grew by an estimated 4.3 percent in 2004, with exports and private consumption leading the way. - Growth is supported by more favorable global economic conditions, an improvement in the security situation, and appropriate policies that combined tightening the fiscal stance and easing monetary policy. - Over the medium term, growth is projected to be around 4 percent, which is described as insufficient to significantly reduce high unemployment and substantial public debt. - Unemployment remained high but on a declining path; labor market participation rate cited at 54.5 percent and unemployment at 10 percent (text also cites monthly unemployment observations around 9.6–11.0 percent in 2004). - Exchange rate is stable and inflation is low. ### Fiscal Policy: Findings and Recommendations - Continued fiscal consolidation is essential to reduce the size of government and public debt. - Key fiscal indicators: - 2004 budget deficit reached 3.9 percent of GDP (compared with 5.6 percent of GDP in 2003). - Public gross debt around 105 percent of GDP. - Government expenditures were estimated to decline by 2.4 percent of GDP in 2004. - Recommendations and targets: - Refrain from unplanned tax cuts should revenue over-perform. - Strictly observe the deficit target of 3 percent of GDP over the medium term. - Limit expenditure growth, in real terms, to no more than 1 percent a year. - Past implementation note (Box 1): - During the 2003 Article IV consultation, Directors recommended using windfall revenues to lower the deficit and curb public debt, but authorities decided to reduce taxes based on higher revenue collection than budgeted. - The 2004 deficit would have been lower, perhaps by an estimated 0.5 percent of GDP, had the government not decided in early 2004 to use revenue-over-performance to lower taxes. - Authorities agreed in principle to explore adoption of a medium term spending plan and semi-annual reports on public finance goals. ### Monetary Policy: Findings and Recommendations - The easing of the monetary stance was judged appropriate. - Bank of Israel policy rate movements: - Lowered from 5.2 percent in December 2003 to 4.1 percent in April 2004. - Reduced by 20 basis points in December 2004 and again in January and February of 2005 to 3.5 percent. - Inflation and expectations: - CPI inflation in 2004 was close to the lower bound of the 1–3 percent target range. - The BoI argued inflation expectations were in the middle of the 1–3 percent target range when keeping the rate unchanged for six months. - Recommendations: - There is further scope for strengthening the implementation of monetary policy within the inflation targeting regime. - Authorities should continue to enhance transparency regarding their views about the inflationary environment. - The Bank of Israel law should be updated. ### Capital Market Reform: Findings and Recommendations - Development of the capital markets should be promoted by a wide range of measures; authorities are removing barriers to such development. - Structural constraints and market structure: - Financial system dominated by banks; by end-2003 the largest three banks (Hapoalim, Leumi and Discount) had 78 percent of bank deposits, managed 80 percent of mutual fund assets and 85 percent of provident fund assets, and dominated underwriting. - Banking system provides 95 percent of all financing to the private sector. - Corporate bond market accounts for only 3 percent of GDP (2003). - Tel Aviv Stock Exchange market capitalization about 39 percent of GDP. - Factors inhibiting capital market development include: - Allocation of non-traded real indexed government bonds to institutional investors. - A 35 percent tax on investment in foreign securities (prior to change noted later). - Israeli prospectus requirements and other legal/regulatory restrictions (e.g., municipal bonds not permitted; rights in REPOs not well defined; outdated bankruptcy law). - High costs associated with issuance of corporate paper. - Authorities’ actions to promote development: - Pension reform reducing proportion of pension funds held in non-tradable government bonds and establishing professional managers. - Sale of new pension funds to insurance companies and brokerage firms. - New law clarifying rules governing market makers for government bonds; TASE designated a bank as market maker in foreign currency derivative products. - Removing barriers to simplify and reduce costs of issuing corporate paper. - Amendments to banking regulation: limit on a bank’s credit to a single borrower; directive on liquidity risk management. - Reform of insurance commission structure to increase transparency and incentives to sell mutual and provident funds. - Proposed legislative and regulatory changes to encourage corporate bonds, short term commercial paper, foreign funds, funds of funds, REITs, ETFs and other instruments. - Measures to encourage customers to switch more readily between banks. - Movement towards introduction of International Financial Reporting Standards. - Determination by regulators to enforce regulatory regime and conflict-of-interest requirements. - Tax reform reducing and equalizing tax rates applied to securities traded abroad with those traded in Israel, which took effect in January 2005. - Specific policy debate: - Plan to require banks to divest themselves of mutual and provident funds could strengthen competition but is noted to go against trends toward universal banking and entails risks. - Improving the regulatory framework and strengthening supervisory enforcement will be an important part of the package. ### Banking Sector Soundness: Recent Indicators (Five Largest Banking Groups) - Selected indicators (unweighted or specified as in source) and values: - Asset growth (12-month percent change): 2001 = 6.9; 2002 = -0.3; 2003 = 1.3; Q2 2004 = 2.2 - Credit growth (12-month percent change) 2/: 2001 = 10.1; 2002 = 0.9; 2003 = -3.0; Q2 2004 = 1.0 - After-tax return on equity 3/: 2001 = 5.9; 2002 = 2.3; 2003 = 7.4; Q2 2004 = 12.4 - Problem loans to total loans ratio 3/: 2001 = 8.4; 2002 = 9.8; 2003 = 10.5; Q2 2004 = 10.6 - Capital to risk-weighted assets ratio 3/: 2001 = 9.4; 2002 = 9.8; 2003 = 10.2; Q2 2004 = 10.7 - Notes: 1/ Five largest according to assets (Hapoalim, Leumi Le, Discount, United Mizrah, First International). On a consolidated basis. 2/ Credit to the public. 3/ Unweighted average. ### Structural Reforms and Other Policy Areas - Privatization and market liberalization: - Privatization completed in 2004 for El–Al and Zim; sale of Bank Discount finalized early 2005. - Steps taken towards privatizing the telephone monopoly, ports, oil refineries, and water and electricity distribution. - Pension and welfare reforms: - Pension reform improved solvency and should aid capital market development. - Welfare reform reduced expenditures and decreased distortions in the labor market; authorities complement reductions in welfare benefits with increased job training and education to assist absorption of the unemployed and income support recipients. - Labor market: - Labor market reforms proceeding in line with previous recommendations. - Unemployment and participation remain key concerns: unemployment cited at 10 percent; participation rate 54.5 percent. - Box 3 (listed in contents) addresses potential difficulties with inflation targeting rules (referenced in Table of Contents). ### Risks, Implementation Issues, and Political Context - Political uncertainty surrounding the Gaza disengagement plan altered coalition make-up and delayed approval of the 2005 budget. - If the Knesset fails to pass the budget by March 31, new elections must be held within 3 months. - Meanwhile, the government is operating using the 2004 budget framework which allows 1/12 of that budget to be spent each month. - Implementation trade-offs: - Using revenue over-performance to lower taxes in early 2004 reduced the fiscal consolidation that would have otherwise been achieved. - Measures to reduce bank dominance (e.g., forced divestitures) could improve competition but carry risks and run counter to global trends toward universal banking, implying a need for strengthened regulation and supervision. *Source: Executive Summary, _cr05133 - Executive Summary.* ### 9. The sheqel has been relatively stable over the past year, balanced by the drop ### _cr05133 - 9. The sheqel has been relatively stable over the past year, balanced by the drop ### Exchange rate and external position - The sheqel has been relatively stable over the past year, balanced by the drop in interest rates and the rebound in economic activity. - Exchange rate regime: - In principle: crawling peg. - In practice: bands around the peg are sufficiently wide that the system is effectively a float consistent with the inflation targeting regime the BoI has adopted. - Since 1997, the BoI has not intervened in the foreign exchange market to influence the exchange rate. - Competitiveness and volatility: - Owing largely to the low inflation rate, competitiveness has improved somewhat as evidenced by a depreciation of the real effective exchange rate and has remained in line with economic fundamentals. - The implied volatility of the NIS/US$ exchange rate, based on the pricing of put and call options, has been low. - Israel’s risk premium, as measured by the yield spread on its 10 year foreign-currency denominated sovereign bonds, has remained low at about 75 basis points over U.S. treasuries. - External vulnerability indicators: - Current account remains near balance. - Net external asset position is $12 billion. - Foreign reserves total around US$26 billion. - Reserves cover 91 percent of gross short-term external debt. - About 43 percent of total external public debt is held by the Jewish Diaspora (33 percent) or backed by U.S. government guarantees (10 percent). - Short-term external public debt is very low at roughly 2 percent of GDP. ### Trade policy and liberalization - Tariff and non-tariff measures: - In 2004, some tariffs were cut and import licensing requirements were reduced. - Tariffs remain for certain goods, e.g., electronics, wood and agricultural products; authorities plan to further reduce them. - Free trade: - Most trade is already covered by bilateral free trade agreements. - Additional free trade agreements with neighboring countries are under consideration. ### Outlook and downside risks - Growth and inflation projections: - After the strong rebound in 2004, real GDP growth in 2005 is expected to decelerate somewhat to just under 4 percent. - In the medium-term, growth in the order of 4 percent is expected to be maintained as the labor market situation improves and productivity increases. - Barring external shocks, inflation is expected to remain in the target range, around 2 percent. - Fiscal outlook: - Fiscal consolidation in 2005, accompanied by an improvement in the current account, is expected to continue in 2006, consistent with the fiscal deficit target of 3 percent of GDP. - Downside risks noted: - Worsening global environment (especially for high tech exports). - Political volatility in the region and deterioration of the security situation. - Should real interest rates rise, the exchange rate depreciate rapidly, or real GDP growth slow substantially, the public-debt-to-GDP ratio risks becoming entrenched at around 110 percent or higher. - Credit rating note: - Recently, the rating agency S&P raised Israel’s country outlook from negative to stable. ### Policy discussions — overview - Four main areas discussed: fiscal policy, planned capital market reform, monetary policy, and the labor market. - Mission view: - Shared authorities’ view that fiscal consolidation is essential and supported the authorities’ ambitious structural reform agenda. - Staff more concerned than the authorities about the high level of public sector debt and suggested refraining from unplanned tax cuts. - On capital market development, staff emphasized strengthening regulation and improving enforcement if divestiture of mutual and provident funds from banks proceeds. - Staff welcomed easing of monetary policy and urged further development of inflation forecasting tools and greater transparency. - Both staff and authorities agreed welfare reform had contributed to labor market improvement and active labor market policies could help absorb some unemployed. ### Fiscal policy — details and recommendations - Authorities’ stance: - Determined to reduce the size of the public sector, the tax burden, and the welfare system. - Described Israel’s economy as trapped between high taxation, a generous welfare system, and strong state monopolies. - 2005 budget adjustments: - Initial commitments: limit real expenditure growth to 1 percent and the deficit to 3 percent of GDP. - Government plan: raise the deficit target to 3.4 percent of GDP and real expenditure growth to 2 percent in 2005 as a one-time adjustment to accommodate the cost of the Gaza disengagement plan—estimated at about one percent of GDP. - The cost of the disengagement plan is expected to be spread over 2005-2007. - Authorities aware of need to revert to original fiscal path in 2006. - Mission view: a temporary—and capped—deviation of up to 0.4 percent of GDP for an exceptional expense should not raise undue concerns, but given high public debt and absence of established fiscal credibility, authorities need to adhere to the budget framework and resist further deviations. - Mission recommendations: - Accelerate debt reduction by abstaining from further tax cuts, broadening the tax base through elimination of tax exemptions, and allowing automatic stabilizers to operate fully should revenues over-perform. - Present a medium-term budget framework with detailed expenditure plans consistent with the overall expenditure ceiling. - Present mid-year reports covering budget developments and progress in achieving the economic agenda. - Debt projections and scenarios: - Planned central government deficits of 3 percent of GDP would result in a decline in the public debt to GDP ratio of only about 2 percentage points a year, given current growth forecasts. - Baseline scenario: public debt to GDP ratio falls from 105 percent today to 97 percent in four years. - If real GDP growth, real interest rate, and the primary balance remain at their historical averages, public debt would rise to 108 percent of GDP by 2009. - Mission argued a more ambitious fiscal goal would help reduce interest rates, aid capital market development, and increase scope for countercyclical fiscal policy. ### Capital market reform — problems identified - Key deficiencies: - Underdeveloped capital markets, excessive concentration in financial markets, inadequate competition, and conflicts of interest. - Limited corporate bond issues, little securitization of bank assets, and absence of instruments common in developed markets (real estate investment trusts, municipal bonds, funds of funds, foreign based mutual funds). - Bank dominance: - Dominance of Bank Hapoalim and Bank Leumi cited as hindering capital market development and exacerbating conflicts of interest in universal banking. - Specific concerns listed in the source text about banks persuading customers to buy their funds, encouraging excessive borrowing to buy bank funds, channeling fund investments to bank-underwritten equity, and shifting corporate default risk to investors in bank funds. - Authorities’ planned measures to address deficiencies: - Prohibit banks from managing mutual and provident funds and oblige them to sell their interests in such funds over a four-year period; limits on the maximum share of the market any buyer could acquire at time of purchase. - Banks would not be permitted to act as pricing underwriters for public offerings of securities where the issuer (or entities it controls) owes the banks (or related parties) more than NIS 5 million or a sum equivalent to 10 per cent of its total financial liabilities. - Introduce a law to regulate provident funds and review the regulatory supervisory structure for consistency, better coordination, and greater effectiveness. - Measures to enhance liquidity using market makers in the secondary markets. - Measures to facilitate bank customers switching between banks. - An examination of deposit insurance. - Mission assessment and cautions: - Agreed with some measures but cautioned forced divestiture involves risks: - May discourage potential new participants and create uncertainty. - Could reduce banks’ diversification by lowering fee-based income and make profits more dependent on interest rate developments. - Risk of banks seeking to circumvent restrictions, creating regulatory challenges. - Regulation and supervision of provident funds currently inadequate; new managers must be well regulated to avoid increasing systemic risks. - Noted other obstacles to capital market development: - Persistently high fiscal deficits historically absorbed institutional savings by directing assets into special non-traded, index-linked government bonds. - A 35 per cent tax on investment in foreign securities makes foreign mutual funds relatively unattractive. - Israel requires foreign funds to register in Israel and bear restructuring/prospectus revision costs to meet local requirements. - Legislation does not permit municipal bonds or funds of funds. - Recommended strengthening regulatory powers of enforcement. - Authorities’ position: - Acknowledge risks but view them as manageable and consider the “one-time intervention” to change financial system structure essential. - Believe divestiture is crucial and see benefits as outweighing potential risks. - Noted some reforms already implemented are showing results; necessary legislation for divestiture has yet to be forwarded to the Knesset but is expected. ### Monetary policy — practice and recommendations - BoI main objectives and practice: - Primary objective: price stability with allowance for maintaining financial sector stability. - Price stability objective is ongoing and does not refer to a specific calendar period. - Subject to price stability, BoI takes into account real growth and employment when setting monetary policy. - Recent monetary policy decisions in 2004 were mostly based on market assessments of inflation because large forecast errors from econometric models prompted reliance on market expectations of low inflation. - Measures used included the yield spread between CPI-indexed and non-indexed bonds and inflation forecasts of professional private sector forecasters. - Mission views and recommendations: - Agreed recent interest rate reductions were appropriate given the subdued inflation environment. - Recommended developing additional tools to gauge inflation because market-derived measures may be biased and inefficient due to circularity between market expectations and central bank signals. - Suggested placing more emphasis on improved forecast models that do not rely primarily on market expectations as a framework for policy decisions. - Recommended supplementing BoI’s semiannual inflation report with interim quarterly updates reflecting BoI’s expectation of future inflation dynamics. - Noted inclusion of a ‘fan chart’ in BoI’s inflation reports was welcome, but observed it does not appear to be the forecast underlying BoI’s policy decisions. - BoI contended that the only forecast it can publish is the inflation target itself; other forecasts could be inconsistent and confuse the market. - Institutional recommendation: - Update BoI law to reflect international best practices. - Mission noted Israel is the only emerging market with an inflation targeting regime that does not have a monetary policy committee. - BoI supported the mission’s call to amend the Bank of Israel law and was already working on it. *Italic: IMF staff report content unit _cr05133, section 9 and following.* ### Box 3. Potential Difficulties with Inflation Targeting Rules ### Box 3. Potential Difficulties with Inflation Targeting Rules ### Interest-rate rule specification - Inflation targeting can be viewed as setting the policy interest rate as follows: - T i = rr + T π + λ(E π − T π) - where T i is the policy rate, rr is the long-run real interest rate, T π is the inflation target, E π is a measure of expected inflation, and λ is a parameter representing the degree to which the central bank addresses emerging inflationary or deflationary pressures. ### Implementation issues - Two implementation issues with this rule are identified: - Determining the long-run real interest rate. - Ascertaining the future inflationary environment (expected inflation). ### Long-run real interest rate: measurement concerns - The BoI relies on a CPI-indexed ten-year government bond as a proxy for the long-run real interest rate. - This measure could misstate the actual real rate, especially in a country with a high public debt and a history of past inflation. - Empirical observation: the real ten-year interest rate has fluctuated between 2 and 6 percent over the past ten years. ### Expected inflation: forecast and market-expectation issues - The BoI relies heavily on private forecasts and capital markets expectations for expected inflation. - Limitations of these measures: - They may be biased because they incorporate confidence in the BoI’s policies. - They face the Bernanke-Woodford (1997) problem: in a credible inflation targeting regime, market-based and professional inflation forecasts may simply reflect the target and thus not be informative. - The existence of a risk premium can distort market-based expectations. - Empirical observation: over the past decade, market participants have over-predicted inflation by 1 percentage point, on average, and their forecast errors are highly correlated with information that was available at the time of the forecast. ### Policy-objective discussion and implications - A ministerial query: whether monetary policy should have economic growth, in addition to price stability, as a primary objective. - Mission view: monetary policy cannot impact long-term economic growth and adding an economic growth target to the BoI’s objective might undermine the bank’s credibility and thus its ability to maintain stable prices. ### Related labor-market context (excerpted material in the source) - Welfare reform effects and labor-market indicators: - The participation rate in 2004 has increased by roughly one half a percentage point to 54.9 percent. - Employment has risen by 3.0 percent. - Concerns and responses: - The mission expressed concern that recent welfare reforms may have hurt some vulnerable groups, including the elderly and disabled. - Authorities signaled plans to increase support for the truly needy and to improve active labor market policies, including pilot welfare-to-work centers, wage subsidies to single mothers, and enhanced employment services. - Mission recommendation: additional steps to facilitate labor market absorption, such as improving effectiveness and scope of existing programs, expanding pilot programs, and carefully designed additional vocational training programs. *Source: IMF staff box text.* ### 33. Notable improvements in policies are prompting improved economic ### Notable improvements in policies are prompting improved economic performance in Israel ### Economic performance and policy actions - Economic growth has revived and prices and the exchange rate are stable. - Contributing factors: - Favorable external environment and improved security situation. - Rebalanced macro policies: ambitious fiscal consolidation and appropriately eased monetary policy. - Government reforms boosting competition and efficiency. - Structural reforms and expected effects: - Welfare reform: improve functioning of the labor market. - Privatization: improve competition and market efficiency. - Tax reform: increase competitiveness. - Pension reform: assure solvency of the system and aid development of the capital market. ### Fiscal policy, planning, and debt - Authorities committed to limit the growth of public expenditure to one percent in real terms; recommendation to develop a detailed medium-term spending plan to enhance credibility and align budgets with long-term priorities. - Recommendation: present a detailed semi-annual report on progress toward fiscal objectives and implementation of structural measures. - Debt reduction and fiscal stance: - Important to accelerate debt reduction by abstaining from further unplanned tax cuts and by broadening the tax base through elimination of various tax exemptions. - Maintaining a deficit of 3 percent of GDP in the years ahead implies but a modest decline in public debt, relative to GDP, and is insufficiently ambitious. - A smaller fiscal deficit would permit lower interest rates, increased private investment, lower taxes in the future, and higher medium-term growth. - Policy on automatic stabilizers: allow to operate fully if revenues over perform; partially rein in should revenues under perform. ### Monetary policy, Bank of Israel (BoI), and inflation targeting - BoI achievements: - Success in maintaining low inflation is commendable. - Reductions in interest rates over the past year were warranted. - Given subdued inflationary pressures and an inflation outlook well within the BoI target range, the policy rate appears appropriate provided the external environment remains stable. - Legal and institutional recommendations: - Update the Bank of Israel Law to reflect international best practices to reinforce central bank independence and enhance transparency and accountability. - New law should clearly specify that the primary function of the central bank is to ensure price stability. - Law should provide for instrument independence and establishment of a committee to set monetary policy. - Operational recommendations for inflation targeting: - Scope to enhance BoI tools and procedures for implementing inflation targeting. - Avoid placing too much emphasis on measures derived from markets of long-term real interest rates and inflation expectations which could contribute to price volatility. - Develop and improve statistical forecasting models for assessing the inflationary outlook. - Increase transparency and accountability by developing and presenting the authorities’ view of the inflation outlook and supplementing semi-annual Inflation Reports with interim quarterly updates explaining unexpected developments. ### Capital market development and banking sector issues - Concentration and underdeveloped capital market: many reforms underway are positive. - Measures that would stimulate capital market demand and development: - Reducing use of non-tradable, indexed government bonds. - Limiting banks’ exposure to individual and connected lenders. - Removing barriers: unequal tax treatment on different instruments; excessive stamp taxes; onerous prospectus requirements on commercial paper and asset backed securities; inadequate rights for repo market participants; regulatory prohibition on funds of funds; legal restrictions on municipal bonds. - Move toward International Financial Reporting Standards. - Proposed divestiture of mutual and provident funds from banks: - Could strengthen competition but goes against universal banking trends and involves risks. - If legislated, need to strengthen regulation and improve enforcement to avoid increased systemic risk. - Specific recommendations if divestiture occurs: - Vigorously enforce existing regulations. - Ensure supervisory and regulatory functions are sufficiently enhanced. - Introduce an effective regulatory law for provident funds. - Enforce full disclosure of investment policies and attendant risks. - Adopt independent custodians to monitor implementation of investment policies (international best practice). - Reassure market participants that measures are a “once and for all” event to encourage future market entry. - Proceed diligently with conventional capital market reform measures already underway; divestiture cannot substitute for these. ### Labor market and welfare reform - Welfare reform has started to bear fruit as indicated by: - Reduction in unemployment. - Increase in labor force participation. - Recommendations: - Support welfare reform with further active labor market policies. - Recent strengthening of active labor market programs and new pilot initiatives are encouraging. - Spending on active labor market policies, as a share of GDP, remains small compared to OECD countries. - Improve absorption of new job seekers by expanding vocational training and employment services in a carefully targeted way while enhancing effectiveness. ### Data, surveillance, and IMF relations - Israel has subscribed to the Special Data Dissemination Standard. - Periodicity, timeliness, coverage, and quality of Israel’s economic data are generally adequate for Fund surveillance. - Recommendation: hold the next Article IV consultation on the standard 12-month cycle. - Statistical methodology note: - Methodology underlying reported overall annual fiscal balance is not in conformity with internationally accepted practice as interest costs exclude the inflation component of such payments; authorities are gradually moving toward GFSM 2001 format. - Within-year monthly central government reports cover main aggregates but not broken down by composition. ### Key quantitative indicators and fiscal/financial snapshots (selected exact figures from source) - Population (2002): 6.3 million - GDP per capita (2002): US$ 16,675 - Life expectancy at birth (2002): Male 76.7; Female 80.7 - Infant mortality rate (2002): 6 per 1,000 live births - Physicians per 1,000 people (2001): 3.75 - Population per sq. km. (2002): 318.4 - Real GDP growth (selected years): 1999 3.7; 2000 2.5; 2001 8.0; 2002 -0.9; 2003 -0.7; 2004 1.3; 2005 4.3; 2006 3.8; 2007 3.7 - Inflation (end of period, selected years): 1999 8.6; 2000 1.3; 2001 0.0; 2002 1.4; 2003 6.5; 2004 -1.9; 2005 1.2 - Central government revenue (percent of GDP, selected years): 1999 38.3; 2000 39.1; 2001 37.2; 2002 39.2; 2003 37.1; 2004 36.5; 2005 37.0 (budget proposal) - Central government expenditure (percent of GDP, selected years): 1999 40.7; 2000 39.8; 2001 41.6; 2002 43.0; 2003 42.7; 2004 40.3; 2005 40.4 (budget proposal) - Central government balance (percent of GDP, selected years): 1999 -2.4; 2000 -0.7; 2001 -4.4; 2002 -3.8; 2003 -5.6; 2004 -3.8; 2005 -3.4 - General government debt (percent of GDP, selected years): 1999 101.4; 2000 91.4; 2001 96.4; 2002 104.9; 2003 107.4; 2004 104.8; 2005 103.8; 2006 101.8; 2007 100.0 - Current account (percent of GDP, selected years): 1999 -1.5; 2000 -1.9; 2001 -1.8; 2002 0.1; 2003 -0.1; 2004 0.3; 2005 -0.1 - Gross official reserves (end of period, in US$ billions): 1999 22.7; 2000 22.6; 2001 23.3; 2002 23.3; 2003 24.1; 2004 26.3; 2005 26.2 - Public sector debt path (baseline projections, percent of GDP): 2004 104.8; 2005 103.8; 2006 101.8; 2007 100.0; 2008 98.3; 2009 96.7 - Debt-stabilizing primary balance (percent of GDP): 1.4 (from Table 6) - Baseline primary deficit (percent of GDP, selected): 1999 -1.9; 2000 -3.9; 2001 -1.9; 2002 -0.9; 2003 -0.1; 2004 -2.5; 2005 -3.2; 2006 -3.6; 2007 -3.6 - External debt (percent of GDP, baseline): 1999 59.7; 2000 55.8; 2001 57.5; 2002 65.0; 2003 64.8; 2004 63.3; 2005 61.2; 2006 59.0; 2007 56.7; 2008 55.2; 2009 53.9 ### Debt sustainability and stress-test scenarios (selected outcomes from Public Sector Debt Framework) - Baseline public sector debt (percent of GDP): 2004 104.8; 2005 103.8; 2006 101.8; 2007 100.0; 2008 98.3; 2009 96.7. - Alternative scenario A1 (key variables at historical averages, 2005-09) public sector debt rise: 2005 104.8; 2006 105.0; 2007 105.7; 2008 106.4; 2009 107.1; 2010 107.8. - Alternative scenario A2 (no policy change, constant primary balance, 2005-09) public sector debt path: 2005 104.8; 2006 104.4; 2007 103.6; 2008 102.9; 2009 102.4; 2010 101.9. - Bound test B2 (real GDP growth at historical average minus two standard deviations in 2005 and 2006) public sector debt path: 2005 104.8; 2006 114.3; 2007 128.0; 2008 133.3; 2009 139.1; 2010 145.0. - Selected external debt baseline: 2004 63.3; 2005 61.2; 2006 59.0; 2007 56.7; 2008 55.2; 2009 53.9. - External debt bound test B5 (one time 30 percent nominal depreciation in 2005) external debt path: 2005 63.3; 2006 80.6; 2007 77.4; 2008 74.4; 2009 72.4; 2010 70.9. *Source: IMF staff report and supporting tables and appendices (staff projections and data as presented).* ### 1. This supplement contains information on recent economic developments in Israel that ### This 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 ### Recent developments (supplement highlights) - The Bank of Israel (BoI) kept its policy rate unchanged for the month of March at 3.5 percent. - The BoI stated the decision was based on the assessment that the current level of short-term interest is consistent with the inflation targeting range of 1-3 percent a year. - Consumer price index (CPI) monthly readings: January CPI declined by 0.6 percent m/m; February CPI rose by 0.2 percent m/m. - CPI over the last 12 months rose by 0.8 percent, undershooting the lower bound of the inflation targeting range. - As of March 17, the 2005 budget had yet to be approved by the Knesset; the government has operated using the 2004 budget framework which allows 1/12 of that budget to be spent each month. - If the Knesset fails to pass the budget by March 31, new elections must be held within 3 months. - Authorities initiated an investigation of Bank Hapoalim regarding money laundering activity amounting to several hundred million dollars involving certain customers and employees of a particular branch. - The government sold 6.5 percent of Bank Leumi to institutional investors; the government’s remaining holdings of Leumi stand at about 28 percent. - Following completion of negotiations between the government and the ports’ labor unions, the authorities launched the separation of the two ports with the intention to privatize them in the future. ### Macroeconomic performance and outlook - Real GDP grew by an estimated 4.3 percent in 2004; the economy is expected to continue to strengthen, albeit at a slightly lower growth rate in 2005. - Recovery drivers cited: more favorable global economic conditions, improvement in the security situation, and appropriate policies including tightening the fiscal stance and easing monetary policy. - Unemployment: described as remaining high but on a declining path. - Exchange rate: was stable throughout 2004, balanced by the drop in interest rates and the rebound in economic activity. - Current account: remained near balance in 2004. ### Fiscal policy, debt, and consolidation - Government commitment: maintain future deficits below 3 percent of GDP and limit government expenditure growth, in real terms, to no more than 1 percent a year. - Public sector debt: 105 percent of GDP (described as large public sector debt). - Fiscal outcomes and targets: - The fiscal effort realized almost 3 percent of GDP adjustment from 2002 to 2004. - Central government revenue and expenditure (percent of GDP): revenue 36.5 (2004), projected 37.0 (2005); expenditure 40.4 (2004), projected 40.4 (2005). - Central government balance: -3.9 (2004), projected -3.4 (2005). - General government balance: -4.3 (2004), projected -3.6 (2005). - General government debt: 104.8 (2004), projected 103.8 (2005). - Directors’ fiscal recommendations: - Adopt a multi-year budgetary framework and a detailed spending plan to enhance credibility and insulate budgets from political pressures. - Accelerate debt reduction by abstaining from further unplanned tax cuts and broadening the tax base through elimination of various tax exemptions. - Implement steadfastly the fiscal deficit target and respect the expenditure growth limit; some Directors recommended more ambitious deficit and expenditure rules. - Allow automatic stabilizers to operate fully if revenues overperform, and rein them in partially if revenues underperform. ### Monetary policy, inflation targeting, and central bank governance - Monetary easing: the BoI lowered its policy rate by 20 basis points in December 2004 and again in January and February 2005 to reach 3.5 percent. - BoI policy rate history cited: cut from 8.9 percent in March 2003 to 3.5 percent in February 2005; record low of 3.5 percent. - Directors’ assessment: - Commended BoI for maintaining low inflation and welcomed reductions in interest rates. - With inflationary pressures subdued and inflation outlook within the BoI target range, the current policy rate appears appropriate, provided the external environment remains stable. - Recommended updating the Bank of Israel Law to reflect international best practices: specify primary function to ensure price stability, provide for instrument independence, and establish a committee to set monetary policy. - Saw scope for enhancing inflation targeting tools and procedures; cautioned against overreliance on market expectations of long-term real interest rates and inflation. - Welcomed BoI’s intention to strengthen statistical forecasting models for assessing the inflationary outlook. - Staff observations on BoI forecasting and communication: - BoI uses simulations of two policy-oriented macro econometric models for briefing; simulation results do not always seem reasonable, leading to heavier reliance on market-based expectations and informed judgment. - BoI is actively seeking to produce an improved forecasting framework and devotes considerable resources to that task. - On publication of forecasts, logical consistency and credibility concerns were highlighted; the BoI published a general direction of interest rates in mid-2004 which turned out to be wrong. ### Financial sector soundness and structural reforms - Financial soundness: most indicators for the banking system have improved, albeit marginally; loan portfolio quality has yet to improve but is expected to strengthen as recovery takes hold. - Directors’ views on financial sector reform: - Welcomed authorities’ commitment to strengthen competition in the financial sector and steps to remove obstacles to capital market development. - Regarding the plan to require banks to divest mutual and provident funds, some Directors understood the preference given Israel’s highly concentrated financial system; other Directors cautioned about risks and noted the trend toward universal banking elsewhere. - If divestiture proceeds, regulators should vigorously enforce existing regulations and enhance supervisory and regulatory functions to mitigate systemic risk from transfer of mutual and provident funds to the non-bank sector. - Importance of proceeding rapidly with other capital market reform measures under way or planned. - Anti–money laundering: Directors welcomed strengthening of Israel’s regime to counter money laundering and the financing of terrorism to a level comparable to best international practices and noted heightened cross-border supervisory cooperation. - Privatization and structural measures: - Successful privatization in 2004: national airline and shipping entity. - Authorities plan privatization of ports, utilities, and oil refineries in the period ahead. - Following negotiations with ports’ labor unions, authorities launched separation of the two ports with the intention to privatize them in the future. - Labor market and welfare reform: - Welfare reform has started to bear fruit: reduction in unemployment and increase in labor force participation. - Authorities strengthened active labor market programs and introduced new pilot initiatives; Directors noted scope for increasing spending in this area, which remains low relative to OECD countries. - Recommended expanded and well-targeted vocational training and employment services to assist new job seekers. ### Key statistics and indicators (as presented) - Real GDP annual percent change: 1999 2.5; 2000 8.0; 2001 -0.9; 2002 -0.7; 2003 1.3; 2004 4.3; 2005 3.7 (IMF staff estimates and projections). - Private consumption (annual percent change): 1999 3.3; 2000 7.7; 2001 2.7; 2002 1.1; 2003 1.3; 2004 5.2; 2005 4.0. - Exports of goods and services (annual percent change): 1999 13.1; 2000 23.1; 2001 -11.2; 2002 -2.4; 2003 6.2; 2004 14.6; 2005 7.3. - Imports of goods and services (annual percent change): 1999 14.9; 2000 12.2; 2001 -4.7; 2002 -2.1; 2003 -1.8; 2004 12.3; 2005 5.5. - Unemployment rate (in percent): 1999 8.9; 2000 8.7; 2001 9.3; 2002 10.3; 2003 10.8; 2004 10.4; 2005 9.8. - Overall CPI (end period): 1999 1.3; 2000 0.0; 2001 1.4; 2002 6.5; 2003 -1.9; 2004 1.2; 2005 1.6. - BoI policy rate (average, in percent): 1999 12.1; 2000 9.3; 2001 6.8; 2002 6.8; 2003 7.5; 2004 4.2. (Note: As of December 2004. The Bank of Israel set the policy rate at 3.5 percent in February 2005.) - Non direct domestic credit (period average): 1999 8.9; 2000 -1.5; 2001 3.1; 2002 12.7; 2003 -4.0; 2004 2.4. (As of October 2004.) - Broad money (M3, period average): 1999 21.9; 2000 15.3; 2001 15.5; 2002 6.1; 2003 2.2; 2004 4.5. - Central government revenue (percent of GDP): 1999 38.3; 2000 39.1; 2001 37.2; 2002 39.2; 2003 37.1; 2004 36.5; 2005 37.0. - Central government expenditure (percent of GDP): 1999 40.7; 2000 39.8; 2001 41.6; 2002 43.0; 2003 42.7; 2004 40.4; 2005 40.4. - Central government balance (percent of GDP): 1999 -2.4; 2000 -0.7; 2001 -4.4; 2002 -3.8; 2003 -5.6; 2004 -3.9; 2005 -3.4. - General government balance (percent of GDP): 1999 -4.2; 2000 -2.1; 2001 -4.1; 2002 -4.5; 2003 -6.4; 2004 -4.3; 2005 -3.6. - General government debt (percent of GDP): 1999 101.4; 2000 91.4; 2001 96.4; 2003 104.9; 2004 107.4; 2004 (IMF staff estimate) 104.8; 2005 (IMF staff projection) 103.8. - Current account (percent of GDP): 1999 -1.5; 2000 -1.5; 2001 -1.9; 2002 -1.8; 2003 0.1; 2004 -0.1; 2005 0.3. - Foreign reserves (end of period, in US$ billion): 1999 22.6; 2000 23.3; 2001 23.4; 2002 24.1; 2003 26.3; 2004 26.2; 2005 26.4. - Reserve cover (in months of imports): 1999 6.7; 2000 6.0; 2001 6.5; 2002 6.8; 2003 7.1; 2004 6.1; 2005 5.7. - Nominal effective exchange rate (period average; depreciation -): 1999 -7.7; 2000 9.1; 2001 0.7; 2002 -13.5; 2003 -7.0; 2004 -3.4. (As of November 2004.) - Real effective exchange rate (period average; depreciation -): 1999 -3.8; 2000 8.1; 2001 -0.2; 2002 -10.0; 2003 -7.9; 2004 -4.8. ### Executive Board assessment and policy recommendations (summarized) - Directors welcomed improved policies that strengthened economic performance: resumed growth, stable prices and exchange rate, and increased competitiveness. - Priority areas recommended: - Continue strengthening the fiscal position and reducing the high level of public debt. - Implement key structural reforms to boost competition and efficiency. - Adopt a multi-year budgetary framework and detailed spending plan. - Abstain from unplanned tax cuts; broaden the tax base by eliminating tax exemptions. - Update the Bank of Israel Law to reinforce independence, transparency, and accountability; specify price stability as primary function; provide instrument independence; establish a monetary policy committee. - Enhance inflation targeting tools and forecasting models; avoid overreliance on market expectations. - Strengthen regulatory and supervisory framework if banks divest mutual and provident funds. - Proceed with privatizations (ports, utilities, oil refineries) and other capital market reforms. - Expand well-targeted vocational training and employment services; consider increasing spending on active labor market programs. *IMF Executive Board conclusion of the 2004 Article IV consultation with Israel and related staff estimates and projections as presented in the March 29, 2005 Public Information Notice (PIN) and accompanying supplement.* ### 106.5 percent of GDP in 2003 to 104.9 percent in 2004. Within the framework of the tax ### _cr05133 - 106.5 percent of GDP in 2003 to 104.9 percent in 2004. Within the framework of the tax ### Fiscal developments and tax reform - Government debt: 106.5 percent of GDP in 2003 to 104.9 percent in 2004. - Tax policy changes: - Maximum tax rate on wages cut from 60 to 49 percent. - Corporate tax to be gradually cut from 36 to 30 percent. - Fiscal balances: - 2004 fiscal deficit was 3.9 percent of GDP, lower than the target of 4 percent, compared to 5.6 percent in 2003. - 2005 fiscal deficit is targeted at 3 percent of GDP (excluding disengagement cost). - Cost of the disengagement plan, to be implemented in 2005 -07, amounts to 1 percent of GDP. ### Capital market reform - Market structure and concerns: - Israeli capital markets are highly concentrated and dominated by two large banks. - Israeli banks almost completely dominate the country's provident funds (providing management), which comprise a significant component of pension savings in Israel. - Non-bank intermediaries that provide a viable alternative to banking services are virtually absent in Israel. - Israeli banks do not face competitive “threats” from abroad, increasing adverse effects of concentration on competitiveness. - Authorities' reform rationale and measures: - Authorities believe divestiture of provident and mutual funds from the banks is a condition for other measures to be effective. - Authorities intend to legislate the divestiture of mutual and provident funds. - Implementation approach: controlled, cautious, gradual; strengthen regulation (including adoption of a new provident law) and improve enforcement. - Evidence and expected effects: - No evidence substantiating staff’s hesitation that reform may deter potential players; evidence supports view that reform will prompt new players to enter. - Historical precedent: 1996 decision restricting banks from holding substantial interests in insurance companies prompted foreign insurance companies to enter the insurance sector. - Following the proposed reform, there has been a rise in foreign interest in the Israeli financial markets, e.g. the recent sale of the controlling share in the Israel Discount Bank and of 6.5 percent of Bank Leumi’s shares to a foreign institutional investor. - Sale of provident and mutual funds by banks is expected to present opportunities for foreign financial institutions to compete in asset management. - Discussions with foreign financial institutions indicate they do not fear regulatory intervention if it is clear and consistent; once competition is established, restrictions will be lifted. - Impact on banking activity: - Reform will not “radically restrict” banking activity. - Banks will be allowed to continue to sell provident and mutual funds. - Banks will, for the first time, be allowed to sell pension and life insurance products in their branches. - Authorities believe the volume of banks’ activity may even broaden. ### Labor markets and structural reforms - Labor market context: - Economic growth not yet sufficient for substantially reducing unemployment. - Many new jobs were created in the high-tech sector; many other new jobs were part-time. - Active labor market policies: - Authorities improved existing and launched new active labor market policies. - New program to increase employment in the periphery subsidizes creation of new, better-paid jobs through one-stop employment centers operated by foreign companies. - The centers will cover 14,000 households in the first stage. - Employment placement rose 30 percent compared to 2003 following significant improvement in the existing employment service. - Competition and privatization agenda: - Privatizations completed: shipping company ZIM, national airline El-AL, the new pension funds, and the third largest bank, the Israel Discount Bank. - Gradual opening of mail services to competition launched. - Privatization of the refineries initiated. - Separation and privatization of the two sea ports launched. - Authorities sold 6.5 percent of shares of Bank Leumi, the last publicly owned bank, to an international institutional investor, and consider various ways to dispose of the remaining 28.5 percent of the shares. ### ALM/CFT (Anti-Money Laundering / Combating the Financing of Terrorism) - International standing and assessments: - In June 2002, Israel was removed from FATF’s list of “noncooperative countries”, and following further examination, also from its “monitoring list”. - Progress in strengthening ALM/CFT regime confirmed by the MFD-led mission which visited Israel at the end of 2002. - Regulatory and enforcement measures: - Implementation of mission’s recommendations, including cooperation among relevant supervisory authorities and information exchange between domestic and overseas supervisors. - Inspections carried out in recent years to ensure tools were in place to implement the Prohibition on Money Laundering Law. - Joint efforts of authorities and financial institutions brought Israeli AML/CFT regime to a level comparable to best international practice. - Enforcement authorities carry out investigations and inspections of specific centers of activity to identify breaches of the law, law-breakers and exceptional activities. - Recent investigations: - Widely publicized police investigation into one branch of Bank Hapoalim and Bank Hapoalim Trust Company uncovered findings appearing to constitute exceptional activity that bypassed the management team and controls. - It is suspected that the sums involved amounted to several hundred million dollars and involved certain customers and employees of the branch and the Trust Company. - Relevant overseas supervisors were notified. *Source: _cr05133 - 106.5 percent of GDP in 2003 to 104.9 percent in 2004. Within the framework of the tax* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05133.pdf_