## _cr0862

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### Executive Summary — A. Macroeconomic Prospects: Strong but Less Buoyant Activity
- Real GDP growth averaged about 5¼ percent during 2006–07.
- Domestic preconditions for continued output growth: broad-based GDP growth; rising real incomes (including for the poor); improved corporate profitability and balance sheets; good cooperation between employers and trade unions.
- Capacity constraints beginning to bind, notably in the market for highly skilled employees.
- External conditions weakening: decelerating activity in the United States and Europe and oil prices standing some 40 percent above 2007:Q1 levels.
- Official 2008 real GDP growth forecasts:
  - Ministry of Finance (MoF): 4.2 percent.
  - Bank of Israel (BoI): 4.4 percent.
  - IMF staff: 3.8 percent (around potential; output gap estimated to be broadly closed).
- Alternative staff scenario with a U.S. recession: 3.6 percent real GDP growth.
- Risks:
  - External downside: partner demand slowdown; worsening global financial turmoil; oil prices above projections; geopolitical uncertainty.
  - Domestic upside: capacity less constraining than estimated despite unemployment near record lows and accelerating wages.

### Executive Summary — B. External Prospects: More Integration with the World Economy
- Nonresident investment into Israel and resident investment abroad reached 40 percent of GDP in 2006 (record), up from 22 percent of GDP in 2005.
- Gross external debt rose to about 60 percent of GDP.
- Net external position: net external asset position of about 25 percent of GDP.
- Public sector: only the public sector has net external debt liabilities, equivalent to some 3 percent of GDP.
- Current account developments:
  - Current account surplus: 5½ percent of GDP in 2006 (up from 3.3 percent in 2005).
  - Staff and BoI projections: current account surplus decline to 2½ percent of GDP by 2008.
  - Staff medium-run stabilization: 2¼ percent of GDP.
  - Multilateral calculations: equilibrium current account (“norm”) about 1 percent of GDP; suggest real exchange rate may be undervalued by 5–10 percent.
- Authorities’ view: no firm view on exchange rate valuation; flexible exchange rate regime considered appropriate.

### Executive Summary — C. Monetary Policy: Staying on Target Amid Exchange Rate Volatility
- Inflation and exchange rate context:
  - Inflation frequently outside 1–3 percent target range due to exchange rate changes; lately undershooting but rising again.
  - By November, prices stood just under 3 percent above the end-2006 level.
  - Sheqel (NIS) appreciated by about 6.5 percent against the US dollar, which may have lowered domestic prices by about 2 percent.
  - A 10 percent appreciation against the US$ quickly reduces inflation by about 2 percent (housing and some services priced in US$ and account for roughly 20 percent of the CPI basket).
- Policy rate path:
  - BoI policy rate: cut from 5.5 percent in October 2006 to 3.5 percent by June 2007; then raised in three steps to 4.25 percent by January 2008.
  - Market analysts foresee policy rate around 4.5 percent by 2008:Q4.
  - Staff forecast assumes interest rates rise gradually to about 5.0 percent by end-2009.
- Staff inflation forecast: around 2 percent in 2008–09 (conditional on assumed interest path).
- Monetary policy challenges:
  - Rising domestic inflationary pressures (BoI estimates domestic component rising over 4 percent while external component declining).
  - Volatile exchange rate with significant pass-through.
  - Uncertainty about external demand and rising risk premia counsel caution in raising rates.
- Transparency and communications:
  - BoI moving to quarterly inflation reports; added model-based fan charts.
  - Staff recommended clarifying role of fan charts, relation to other macro forecasts (notably exchange rate), and monetary policy horizon.
  - BoI cautious about publishing a formal full-fledged inflation forecast given exchange rate volatility.

### Executive Summary — D. Fiscal Policy
- Section title preserved; substantive fiscal findings and numeric details appear in main report text beyond extracted executive-summary pages provided.

### Executive Summary — E. Managing the Transformation of the Financial System
- Financial stress and exposures:
  - Some banks announced losses on mortgage-related US assets; mark-to-market losses described as modest to date.
  - Banks rely almost exclusively on deposits and have not experienced funding pressures.
  - Banks instructed to disclose holdings of US mortgage-related assets by September 30, 2007.
  - Largest five banks disclosures: structured products holdings amounted to 0–12 percent of equity; ABS not guaranteed by US government-sponsored enterprises amounted to 3–11 percent of equity for four banks and 75 percent of equity for one bank (Hapoalim). Hapoalim reported 99 percent of its ABS holdings are AAA-rated.
  - Effect on profitability and capital described as small; authorities do not expect a fall-out that could impair banks’ ability to support the domestic economy provided losses on AAA-rated prime-mortgage-backed securities remain limited.
- Systemic integration and vulnerability:
  - Increased cross-border flows raise vulnerability to exchange rate shocks, but vulnerability diminished by net external asset position (~25 percent of GDP).
- Financial sector analysis:
  - Israel as case study for enhanced financial sector analysis; staff discussed banking sector stress tests.

### Executive Summary — F. Social Policy
- Section title preserved; substantive social-policy findings and recommendations appear in main report text beyond the extracted executive-summary pages provided.

### Cross-Cutting Risks and Policy Implications (summarized)
- Key downside risks: external slowdown, further financial market turmoil, higher oil prices, geopolitical risks.
- Domestic overheating risks from low unemployment and rising wages could require monetary tightening, but exchange rate volatility and external uncertainty counsel caution.
- Recommended: continued BoI transparency improvements and clarity around forecast products and policy horizons.
- Fiscal consolidation to reduce high public debt highlighted in discussions.

### Box 1. Monetary Policy — Baseline Forecast and Risk Assessments
- Baseline assumptions:
  - Small positive output gap expected to close by mid-2008.
  - Exchange rate of about 3.9 shekel/$.
  - Under these assumptions, policy rate expected to rise to maintain headline inflation within 1–3 percent over next two years.
- Risk scenarios and policy implications:
  - Unexpected slack (negative output gap): would alleviate need to increase policy rate in near term while keeping headline inflation within band.
  - Continued sheqel appreciation (against USD) coupled with compression in Israel’s risk premium: would also alleviate need for higher policy rate in near term.
  - A 25 percent increase in oil prices from current projected levels: would require acceleration in policy rate hikes relative to baseline.

### Insurance and Prudential Reforms (Section 22)
- Insurance-sector reforms:
  - Existing solvency requirements inadequate; proposals to strengthen regime.
  - Improvements to risk management and controls; development of risk-based supervision.
  - Dividends restricted to no more than 50 percent of income pending final solvency rules.
  - Supervisor needs: independence to set solvency standards; powers to enforce managerial changes and resolve failing institutions; powers to perform groupwide supervision.
- Prudential policy, banks, and crisis preparedness:
  - BoI has asked banks to increase capital ratios further ahead of Basel II implementation.
  - Regulators seeking to improve financial strength of banks and insurance companies to prepare for downturn and regulatory change.
  - Memorandum of Understanding among supervisors on crisis management welcomed; recommended crisis-response exercises.
  - Increased competition raises risk; strong capacity needed to manage and resolve financial stress.
- Regulatory capacity and implementation quality:
  - Need for regulatory expertise, recruitment flexibility, competitive pay scales.
  - Risk rapid regulatory change may be inconsistent with high-quality implementation.
  - Suggestion to rebalance from very rules-based to more principles-based approach.
  - Regulators at early stage of introducing risk-based supervision.
- AML/CFT:
  - Progress made; ROSC summarizing Moneyval assessment to be prepared during 2008.
  - Authorities committed to ensuring clearing function for West Bank/Gaza banks; addressing potential misuse concerns.

### Social Policy Priorities and Measures
- Government medium-run social targets:
  - Raise employment rate at ages 25–64 by about 3 percentage points to 71.7 percent by 2010.
  - Increase income of poorest fifth by 10 percent more than per capita GDP.
- Key 2007 measures:
  - Adoption (pilot) of an Earned Income Tax Credit.
  - Phased introduction of a compulsory employer-provided pension pillar.

### Staff Appraisal — Macroeconomic and Fiscal Context
- Economy performing exceptionally well but high public indebtedness calls for continuation of strong policies.
- Debt reduction remains key macroeconomic policy challenge.
- Economic activity likely to remain strong but less buoyant; domestic inflationary pressure elevated.
- Higher interest rates probably needed for inflation to stay on target over medium run, but external downside risks and heightened risk premia argue for caution.
- Monetary policy stabilized inflation expectations; communication challenges remain due to high pass-through of NIS/US$ exchange rate.
- Publication changes welcomed: quarterly inflation reports and model-based inflation/interest forecasts; greater clarity needed on role of these forecasts and policy horizon.
- Swift adoption of draft Bank of Israel law important to strengthen institutional foundation.

### Fiscal Policy Guidance and Transparency
- Central government budget needs to be kept close to balance.
- Budgeted 1.6 percent of GDP central government deficit is a ceiling and not a target.
- Maintain sound fiscal stance through:
  - strict compliance with 1.7 percent expenditure growth ceiling;
  - tight budget execution;
  - allocation of any revenue overperformance to debt reduction.
- Main objective of new fiscal rule: achieve 60 percent debt-to-GDP ratio by 2015.
- Debt reduction should be given precedence over tax cuts; scope exists to simplify tax system, including cutting tax exemptions.
- Budget documentation should include multiyear scenario analysis of risks and long-term fiscal sustainability analysis.
- Strengthen governance by instituting independent, nonpartisan fiscal evaluation.

### Financial System Soundness and Supervisory Resource Gaps
- Reforms fostered a more diversified financial system but increased complexity and new risks.
- Financial soundness indicators improving; risks of major losses in financial institutions appear low, although regulatory capital and solvency levels remain lower than in many advanced economies.
- Regulators’ resources not commensurate with challenges; key needs:
  - build regulatory expertise with recruitment flexibility and competitive pay;
  - ensure consistency between pace of regulatory change and implementation quality;
  - balance principles-based and rules-based supervision;
  - strengthen capacity to manage and resolve financial stress;
  - grant insurance supervisor formal independence and broader powers.

### Statistics and Data Dissemination
- Israel subscribed to the Special Data Dissemination Standards and macroeconomic statistical system generally adequate for Fund surveillance.

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

### Real Economy, External Sector, Monetary and Financial Indicators — Selected Exact Figures
- Real GDP growth:
  - 2006–07 average: about 5¼ percent.
  - Table 8: 2007 = 5.4 (percent); 2008 projection = 3.8; Supplementary update: staff lowered 2008 projection from 3.8 to 3.5 percent.
  - Supplementary staff latest projection snapshot: Real GDP: 3.8 3.5 (staff Latest).
- Output gap:
  - Table 1: 2007 = 0.6; 2008 projection = 0.4.
- Unemployment rate:
  - Table 1: 2007 = 6.8 (percent).
  - Text subgroup: unemployment rate decline in 2007 by 0.9 percentage points to 7.5 percent (source presents both series).
- Labor and wages:
  - Participation rate in 2007: 56.4 percent.
  - Real wages rose in 2007 by 2.7 percent.
- Inflation:
  - CPI (end period) Table 1: 2007 = 2.0; CPI (period average) 2007 = 2.7.
  - Supplementary: 2007 overall CPI increase: 3.4 percent; December monthly CPI rise: 0.6 percent.
- External and trade:
  - Current account balance 2007 = 3.6 (billions of U.S. dollars) and 3.6 (percent of GDP) reported in text.
  - Current account surplus 2006 = 5½ percent of GDP.
  - Exports, f.o.b. 2007 (Table 3 projection) = 62.7 (percent of GDP); Imports, f.o.b. 2007 = 67.5 (percent of GDP).
  - Foreign reserves (end period, billions of U.S. dollars) Dec-07 = 28.4.
  - Gross external debt (percent of GDP) 2007 projection = 53.3; Table 3 memorandum shows 2007 = 53.3.
  - Gross external debt rose to about 60 percent of GDP (text estimate).
- Monetary and financial:
  - Bank of Israel policy rate (average) 2007 = 4.3 (percent).
  - BoI policy rate path: peak 5.5 percent (Oct 2006) → 3.5 percent (June 2007) → 4.25 percent (Jan 2008).
  - Market-implied policy expectations: just under 0.5 percent hikes by end-2008.
  - Broad money (12-month change) Aug-07 = 16.2.
  - Private sector credit (12-month change) Oct-07 = 7.7.
  - Regulatory capital to risk-weighted assets 2007 = 11.1.
  - Regulatory Tier 1 capital to risk-weighted assets 2007 = 7.7.
  - Problem loans to total credit 2007 = 8.1 (percent).
  - Nonperforming loans net of provisions to capital 2007 = 18.7 (percent).
  - Return on assets 2007 = 1.2; Return on equity 2007 = 20.2.
  - Household debt to GDP 2007 = 30.1.
  - OFCs' assets to total financial system assets 2007 = 42.3 (percent); OFCs' assets to GDP 2007 = 101.5 (percent).
- Public finances and debt:
  - Central government revenue 2007 = 35.8 (percent of GDP); central government expenditure 2007 = 36.2 (percent of GDP).
  - Central government balance (Budget/Proj) 2007 = 0.0 (percent of GDP).
  - Knesset-adopted 2008 budget envisaged deficit: 1.6 percent of GDP.
  - Table 8 medium-term baseline central government balance: 2008 = -0.4; 2009 = 0.0; 2010 = 0.4; 2011 = 1.0; 2012 = 1.7.
  - Public sector debt (percent of GDP) 2007 = 81.4; projected end-2012 baseline = 62.2.
  - Change in public sector debt 2007 = -5.4 (percent of GDP).
  - Gross financing need 2007 = 10.0 (percent of GDP) and 15.8 (billions of U.S. dollars).
- Growth composition and 2007 performance:
  - 2007 preliminary real GDP growth: 5.3 percent.
  - 2007 business sector growth: 6.3 percent.
  - 2007 export performance: 8.6 percent.
  - Fixed capital formation increase in 2007: 10.4 percent.
  - Debt-to-GDP ratio in 2007: 81 percent of GDP (text summary).
  - Authorities’ target debt-to-GDP ratio: 60 percent by 2015.
- Financial sector adjustments:
  - Banks’ planned gradual rise in capital ratios to 12–13 percent (from 10–12 percent) within next two years.

### Debt Sustainability and Projections
- Public sector debt:
  - Baseline public sector debt 2007 = 81.4 (percent of GDP); projections to 2012 show decline to 62.2 (baseline).
- External debt and financing needs:
  - Baseline external debt 2007 = 53.3 (percent of GDP).
  - Gross external financing need 2007 = 35.3 (billions of U.S. dollars); percent of GDP 2007 = 22.4.
- Medium-term macro projections (Table 8, 2007−12):
  - GDP growth sequence: 2007 = 5.4 (percent); 2008 = 3.8; 2009 = 3.6; 2010 = 3.8; 2011 = 3.7; 2012 = 3.7.
  - Inflation (average) 2007 = 0.5; projections 2008−12 = 2.7, 2.0, 2.0, 2.0, 2.0.
  - Public debt/GDP (end period) baseline: 2007 = 81.4; 2008 = 77.7; 2009 = 74.4; 2010 = 70.8; 2011 = 66.7; 2012 = 62.2.

### Supplementary Information (February 8, 2008) — Updated Projections and Developments
- Staff lowered 2008 real GDP growth projection from 3.8 to 3.5 percent due to downward revisions for the United States and Europe; main reason: fall in projected export growth.
- Key staff projection comparisons (Staff Report Latest):
  - Real GDP: 3.8 3.5
  - Exports of goods and services: 5.4 4.8
    - Goods: 6.1 5.0
    - Service: 5.1 4.7
  - Private consumption: 4.5 4.2
  - Investment (gross fixed capital formation): 3.8 3.0
  - Current account balance (percent of GDP): 2.4 2.3
- Inflation developments:
  - December monthly CPI rose 0.6 percent; end-of-period inflation for 2007 = 3.4 percent (above 3 percent target upper limit).
  - Standard assumption: 10 percent appreciation of sheqel relative to US$ reduces prices by about 2 percent, but effect appears diminishing.
- Exchange rate and monetary signals:
  - Since staff report issuance the sheqel appreciated from 3.8 to close to 3.6 sheqel/US$, about 5 percent more appreciated than staff’s central scenario for 2008Q1.
  - Market-implied policy expectations: hikes of just under 0.5 percent by end-2008.
  - Inflation expectations around 2.5 percent.
  - Staff view: policy rate would likely need to be above current 4.25 percent once trading partner growth reaccelerates to keep inflation in 1–3 percent target range; near-term caution advised.

### Executive Board Assessment — Main Messages and Recommendations
- Directors welcomed exceptional economic performance but noted elevated public debt leaves economy vulnerable; debt reduction remains priority.
- Recommended improvements to financial sector framework to enhance resilience.
- Expected domestic inflationary pressure to mount; recent sheqel appreciation lowered external inflationary pressure.
- Recommended caution in raising interest rates over near term given external downside risks and heightened risk premia.
- Praised monetary policy for stabilizing inflation expectations; encouraged greater clarity on role of macroeconomic forecasts in decision-making and policy horizon.
- Recommended swift adoption of draft Bank of Israel law.
- Financial sector supervisory priorities:
  - Achieve consistency between pace of regulatory change and high-quality implementation.
  - Balance principles-based and rules-based approaches.
  - Strengthen regulators’ capacity to manage and resolve financial stress.
  - Grant insurance supervisory authority independence per international standards.
- Fiscal policy guidance reiterated: keep budget close to balance, comply with 1.7 percent expenditure growth ceiling, allocate revenue overperformance to debt reduction, and pursue rule to reach 60 percent debt-to-GDP by 2015.

### Structural Reforms and Social Policy Actions
- 2007 privatizations and structural changes: Pi-Glilot gas depot reductions, sale of second oil refinery in Haifa, planned split of Electric Corporation.
- Planned evaluations: Postal Authority, Israeli Military Industries (IMI), Israel Aircraft Industry (IAI), seaport in Eilat.
- Social-Economic Agenda for 2008–10 targets:
  - Gradually increase participation rate for ages 25–64 by 2.6 percent to OECD average (71.7 percent).
  - Increase income of lowest quintile by 10 percent higher than GDP per capita growth until 2010.
- Planned measures: introduce Earned Income Tax Credit (EITC) in 2008, expand vocational training in ALMP, subsidize day-care centers, strengthen labor law enforcement, reduce illegal foreign workers.
- NII 2007 poverty report: population below poverty line moderately declined by 0.6 to 20 percent (after welfare payments and taxes); poverty measure is relative (below half the median income).

### Appendix I — Israel: Fund Relations (AS OF NOVEMBER 30, 2007) — Selected Exact Facts
- Membership date: July 12, 1954.
- Accepted Article VIII obligations on September 21, 1993.
- Quota: 928.20 — 100.00.
- Fund holdings of currency: 867.56 — 93.47.
- Reserve position in Fund: 60.65 — 6.43.
- SDR net cumulative allocation: 106.36 — 100.00; holdings: 10.55 — 9.91.
- Outstanding Purchases and Loans: None.
- Financial Arrangements: None.
- Projected payments to Fund (Charges/Interest): 3.41 3.40 3.40 3.40 3.40 (2007 2008 2009 2010 2011 layout in source); Total: 3.41 3.40 3.40 3.40.
- Exchange rate arrangement: floating (official classification as of June 9, 2005).
- Last Article IV consultation concluded on January 19, 2007; Israel on standard 12-month consultation cycle.
- ROSCs listed with dates in source (Financial System Stability Assessment 2000/2001; Fiscal Transparency ROSC 2003/2004; AML/CFT ROSC 2003/2005; Data Module ROSC 2005/2006).
- Fund technical assistance and resident representation details as provided in source.

*IMF staff report — Executive Summary and selected annexes from the provided PDF chapter.*

### Executive Summary ......................................................................................................

### Executive Summary

### A. Macroeconomic Prospects: Strong but Less Buoyant Activity
- Real GDP growth averaged about 5¼ percent during 2006–07.
- Domestic preconditions for continued output growth cited: broad-based GDP growth; rising real incomes (including for the poor); improved corporate profitability and balance sheets; good cooperation between employers and trade unions.
- Capacity constraints beginning to bind, notably in the market for highly skilled employees.
- External conditions weakening: decelerating activity in the United States and Europe and oil prices standing some 40 percent above 2007:Q1 levels.
- Official growth forecasts for 2008:
  - Ministry of Finance (MoF): 4.2 percent real GDP growth.
  - Bank of Israel (BoI): 4.4 percent real GDP growth.
  - IMF staff: 3.8 percent real GDP growth (around potential; output gap estimated to be broadly closed).
- Alternative scenario: with the United States experiencing a recession, staff growth projection would be 3.6 percent.
- Risks:
  - External risks tilted to the downside: partner demand might slow more than expected; global financial turmoil might worsen; oil prices could exceed projections; geopolitical uncertainty.
  - Domestic risks to the upside: capacity may be less constraining than estimated despite unemployment near record lows and accelerating wages.

### B. External Prospects: More Integration with the World Economy
- Nonresident investment into Israel and resident investment abroad reached a record 40 percent of GDP in 2006, up from 22 percent of GDP in 2005.
- Gross external debt rose to about 60 percent of GDP.
- Net external position: country has a net external debt asset position of about 25 percent of GDP.
- Only the public sector has net external debt liabilities, equivalent to some 3 percent of GDP.
- Current account developments:
  - Current account surplus: 5½ percent of GDP in 2006 (up from 3.3 percent in 2005).
  - Staff and BoI projections point to a decline in the current account surplus to 2½ percent of GDP by 2008.
  - Staff sees the current account stabilizing at 2¼ percent of GDP over the medium run.
  - Multilateral calculations: equilibrium current account (“norm”) of about 1 percent of GDP; suggest the real exchange rate may be undervalued by 5–10 percent.
- Authorities’ view: no firm view on exchange rate valuation; flexible exchange rate regime considered appropriate; talk of under/overvaluation could prompt calls for intervention and complicate monetary policy.

### C. Monetary Policy: Staying on Target Amid Exchange Rate Volatility
- Inflation and exchange rate context:
  - Inflation frequently outside the 1–3 percent target range due to exchange rate changes; lately undershooting but rising again.
  - By November, prices stood just under 3 percent above the end-2006 level.
  - Sheqel (NIS) appreciated by about 6.5 percent against the US dollar (US$), which may have lowered domestic prices by about 2 percent.
  - A 10 percent appreciation against the US$ quickly reduces inflation by about 2 percent (housing and some services priced in US$ and account for roughly 20 percent of the CPI basket).
- Policy rate path:
  - BoI cut interest rates from a peak of 5.5 percent in October 2006 to 3.5 percent by June 2007.
  - BoI then raised rates in three steps to 4.25 percent by January 2008.
  - Market analysts foresee the policy rate rising to around 4.5 percent by 2008:Q4.
  - Staff’s forecast assumes interest rates rise gradually to about 5.0 percent by end-2009.
- Staff forecast for inflation: around 2 percent in 2008–09 (based on WEO and other tools, conditional on the assumed interest rate path).
- Monetary policy challenges:
  - Domestic inflationary pressures rising (domestic component of consumer prices estimated by BoI to be rising over 4 percent while the external component is declining due to sheqel appreciation).
  - Volatile exchange rate with significant pass-through to domestic prices.
  - Growing uncertainty about external demand and rising risk premia argue for caution in raising rates.
- Transparency and communications:
  - BoI moving to publish inflation reports quarterly rather than semi-annually; added model-based fan charts of inflation and interest projections.
  - Staff suggested clarifying the role of fan charts, their relation to other macro forecasts (notably the exchange rate), and the monetary policy horizon.
  - BoI officials open-minded but cautious about publishing a formal, full-fledged inflation forecast given exchange rate volatility.

### D. Fiscal Policy
- (Section title preserved; substantive fiscal findings, policy recommendations, and numeric details appear in the main report text beyond the extracted executive-summary pages provided.)

### E. Managing the Transformation of the Financial System
- Financial stress and exposures:
  - Some banks announced losses on mortgage-related US assets; mark-to-market losses to date described as modest.
  - Banks rely almost exclusively on deposits from the public and have not been experiencing funding pressures.
  - Banks were instructed to disclose holdings of US mortgage-related assets by September 30, 2007.
  - Disclosures by the largest five banks: holdings of structured products amounted to 0–12 percent of equity; holdings of ABS not guaranteed by US government-sponsored enterprises amounted to 3–11 percent of equity for four banks and 75 percent of equity for one bank (Hapoalim). Hapoalim reported that 99 percent of its holdings of ABS are AAA-rated.
  - Effect on profitability and capital described as small; authorities do not expect a fall-out that could impair banks’ ability to support the domestic economy provided losses on AAA-rated prime-mortgage-backed securities (ABS) remain limited.
- Systemic integration and vulnerability:
  - Increased cross-border flows raise vulnerability to exchange rate shocks, but vulnerability is diminished by the net external asset position (~25 percent of GDP).
- Financial sector analysis:
  - Israel noted as a case study for enhanced financial sector analysis.
  - Staff discussed banking sector stress tests (Box 2 referenced in report).

### F. Social Policy
- (Section title preserved; substantive social-policy findings and recommendations appear in the main report text beyond the extracted executive-summary pages provided.)

### Cross-Cutting Risks and Policy Implications (summarized)
- External slowdown, further financial market turmoil, higher oil prices, and geopolitical risks are key downside risks to growth.
- Domestic overheating risks from low unemployment and rising wages could require monetary tightening, but exchange rate volatility and external uncertainty counsel caution.
- Continued transparency improvements at the BoI and clarity around forecast products and policy horizons recommended.
- Fiscal consolidation to reduce high public debt highlighted in discussions (details in the main report).

*IMF staff report — Executive Summary*

### Box 1. Monetary Policy—Baseline Forecast and Risk Assessments

### Box 1. Monetary Policy—Baseline Forecast and Risk Assessments

### Baseline scenario and key assumptions
- Small positive output gap that is expected to close by mid-2008.  
- Exchange rate of about 3.9 shekel/$.  
- Under these assumptions, the policy rate would be expected to rise in order to maintain headline inflation within the 1–3 percent band over the next two years.

### Baseline forecast caveats and model reference
- The baseline forecast is subject to a number of risks; the policy implications are illustrated in the box.  
- IMF Country Report 06/121, Chapter III provides detailed explanation and properties of the model used to derive these assessments.

### Risk scenarios and policy implications
- Unexpected slack (resulting in negative output gap):
  - Would alleviate the need to increase the policy rate in the near term, while keeping headline inflation within the targeting band.
- Continued sheqel appreciation (against USD), coupled with compression in Israel’s risk premium:
  - Would also alleviate the need for higher policy rate in the near term.
- A 25 percent increase in oil prices from current projected levels:
  - Would require acceleration in the policy rate hikes, relative to baseline.

*Box 1. Monetary Policy—Baseline Forecast and Risk Assessments*

### 22.      The Ministry of Finance is reforming insurance regulation extensively in

### 22.      The Ministry of Finance is reforming insurance regulation extensively in

### Insurance-sector reforms and supervision
- The inadequacy of existing solvency requirements has been recognized and proposals made to strengthen the regime in the near future.
- Efforts are being made to improve the quality of the risk management and controls of insurance companies.
- Risk-based supervision is being developed.
- Insurance companies are being asked to restrict the payment of dividends to no more than 50 percent of income pending finalization of the new solvency requirements.
- In line with good international practice, the insurance supervisor needs:
  - independence to set solvency standards;
  - powers to enforce managerial changes in companies and resolve failing institutions, as necessary;
  - powers to perform groupwide supervision.
- The authorities agreed with these needs but indicated that the legal process to achieve them was complex and lengthy and preferred to await a clearer vision of how to adapt the structure of supervision to markets before proceeding.

### Prudential policy, banks, and crisis preparedness
- The Bank of Israel has asked banks to increase capital ratios further in advance of the implementation of Basel II, the impact of which on bank capital adequacy remains unclear.
- Regulators are seeking to improve the financial strength of banks and insurance companies further to prepare for a possible economic downturn and coming regulatory change.
- The mission welcomed a recent Memorandum of Understanding among the supervisors, which includes provisions on crisis management, and recommended further work such as exercises that test responses to crisis scenarios to identify remaining gaps.
- Staff highlighted that increased competition brings more risk and therefore a strong capacity is needed to manage and resolve financial stress if and when it emerges.

### Regulatory capacity, implementation quality, and approach
- Of critical importance is the ability of regulators to build the expertise necessary to support the more complex regulatory system now being put in place; this requires greater recruitment flexibility and competitive pay scales.
- Authorities had hired industry experts on a consultant basis but agreed this was not optimal.
- There is a risk that the rapid pace of regulatory change will prove inconsistent with high-quality implementation.
- All regulatory initiatives carry costs to consumers, firms, and regulators; major new initiatives should be submitted to cost-benefit analysis, though the authorities expressed concern about the resource implications.
- Staff suggested rebalancing from a very rules-based approach to a more principles-based approach could help alleviate resource constraints and has other advantages.
- Regulators are at an early stage of introducing risk-based supervision approaches.

### Anti–Money Laundering/Combating the Financing of Terrorism (AML/CFT)
- Progress has been made on AML/CFT.
- A ROSC summarizing the findings of a Moneyval assessment will be prepared during 2008.
- Authorities remain committed to ensuring a continuing clearing function for West Bank/Gaza banks; there are concerns about the vulnerability for potential misuse of the Israeli financial system that are in the process of being addressed.

### Social policy priorities and measures
- Social policy remains a priority given concerns about inequality.
- The government set two key medium-run social targets:
  - raising the employment rate at ages 25-64 by about 3 percentage points to 71.7 percent by 2010;
  - increasing the income of the poorest fifth of the population by 10 percent more than per capita GDP.
- Key measures during 2007 included:
  - adoption (presently on a pilot basis) of an Earned Income Tax Credit;
  - phased introduction of a compulsory employer-provided pension pillar.

### Staff appraisal — macroeconomic and fiscal context
- The economy is performing exceptionally well but still high public indebtedness calls for the continuation of the strong economic policies.
- Debt reduction remains the key macroeconomic policy challenge given public debt is not much lower than before the latest recession and the country is highly vulnerable to economic shocks.
- Economic activity is likely to remain strong, even if less buoyant than in recent years, and domestic inflationary pressure elevated.
- Higher interest rates are probably needed for inflation to stay on target over the medium run, but external downside risks and heightened risk premia argue for caution in raising rates.
- Monetary policy has stabilized inflation expectations, but policy and communication challenges remain because of the high pass-through of the NIS/US$ exchange rate to domestic prices.
- Publication changes welcomed: inflation reports on a quarterly rather than semi-annual basis and release of model-based inflation and interest rate forecasts; greater clarity is needed about the role of these forecasts in Bank of Israel decision making and the policy horizon.
- Swift adoption of the draft Bank of Israel law is particularly important to strengthen the economy’s institutional foundation.

### Fiscal policy guidance and transparency
- The central government budget needs to be kept close to balance.
- The budgeted 1.6 percent of GDP central government deficit is a ceiling and not a target.
- Maintaining a sound fiscal policy stance demands:
  - strict compliance with the 1.7 percent expenditure growth ceiling;
  - tight budget execution;
  - allocation of any revenue overperformance to debt reduction.
- The main objective of a new fiscal rule should be to achieve a 60 percent debt-to-GDP ratio by 2015.
- Debt reduction should be given precedence over tax cuts, although there is scope to simplify the relatively complex tax system, including through cutting tax exemptions.
- Budget documentation needs to include a multiyear scenario analysis of risks for public finance objectives and a long-term fiscal sustainability analysis.
- Governance of the fiscal framework should be strengthened by instituting independent, nonpartisan fiscal evaluation.

### Financial system soundness and supervisory resource gaps
- Reforms have fostered a more diversified financial system but have also increased complexity and new risks.
- Financial soundness indicators have been improving; risks of major losses in financial institutions appear low, although regulatory capital and solvency levels remain lower than in many advanced economies.
- Regulators’ resources are not commensurate with the challenges ahead.
- Key needs reiterated:
  - build regulatory expertise with recruitment flexibility and competitive pay;
  - ensure consistency between the pace of regulatory change and high-quality implementation;
  - achieve the right balance between principles-based and rules-based approaches to supervision;
  - strengthen capacity to manage and resolve financial stress;
  - grant the insurance supervisor formal independence and broader powers in line with international standards.

### Statistics and data dissemination
- Israel has subscribed to the Special Data Dissemination Standards and its macroeconomic statistical system is generally adequate for Fund surveillance.

*Source: IMF staff report content in the provided PDF chapter.*

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

### _cr0862 - 35.      It is recommended that the next Article IV consultation be held on the standard 12-month cycle.

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

### Real economy: growth, labor, prices
- Real GDP growth: projections for 2007 shown in Figure 1; Table 1 reports Real GDP for 2001−08 with values including 2007: 3.8 (2007) and 3.8 (2008 projection) in Table 8.
- Output gap: Table 1 shows Output Gap for 2001−08 with 2007 value 0.6 and 2008 projection 0.4.
- Employment and unemployment:
  - Unemployment rate (Table 1): 2001−08 listing includes 2007 value 6.8 (percent).
  - Labor force and employment: Table 1 lists Israeli civilian labor force 3.9 (2007) and Employment 3.1 (2007) (percent changes).
- Real wages and labor costs:
  - Private sector labor costs and real wage indices illustrated in Figure 4 (1987–2008); Table 1 reports Real wages 3/ with 2007 entry "..." indicating data for 2007 as of September.
- Inflation:
  - CPI (end period) in Table 1: 2007 value 2.0; CPI (period average) 2007 value 2.7.
  - CPI (excluding housing and energy, end period) reported with 2007 data noted as incomplete ("......").

### External sector and trade
- Trade and current account:
  - Trade Volume in Goods (Figure 2): exports often outpaced imports; export and import volume indices plotted 2001−07.
  - Current account (Table 3 and Figure 2): current account balance (percent of GDP) shows a surplus in 2006 and 2007; Table 3 lists Current account balance for 2004−12 with 2007 value 3.6 (billions of U.S. dollars) and Table 5 shows Current account balance (percent of GDP) 2007 value 3.6.
  - Table 3 (Billions of U.S. dollars): Current account balance 2007 = 3.6 (Proj. for 2007).
- Exports and imports (Table 3, percent of GDP):
  - Exports, f.o.b. 2007 = 62.7 (percent of GDP in projected series) in Table 3 projections (note different series across tables).
  - Imports, f.o.b. 2007 = 67.5 (projected in Table 3).
- Tourism and services: Figure 2 shows Tourist Arrivals recovery helped export services (seasonally adjusted; data for 2007 as of September).

### External financing and capital flows
- Financial account and capital inflows:
  - Financial Account (Figure 2): foreign capital inflows remain strong; FDI and portfolio investment series shown for 2001−07.
  - Table 3: Financial account (net) 2007 = -4.9 (billions of U.S. dollars, projected series) and Change in reserves 2007 = -1.1 (Table 3 line for 2007 projection).
- Gross external debt and reserves:
  - Table 3 memorandum: Gross external debt percent of GDP 2007 projection = 53.3.
  - Foreign reserves (end period, billions of U.S. dollars) Table 1 and Table 3: 2007 = 28.4 (Table 1 footnote 6; Table 3 Dec-07 = 28.4).

### Monetary and financial indicators
- Policy rate and interest:
  - Bank of Israel policy rate (Table 1 and Figure 3): Table 1 reports BOI policy rate (average) for 2007 = 4.3 (percent); Figure 3 notes the policy rate has moved up recently.
  - Implicit real interest and risk premium: Figure 3 shows implicit real interest and modest rise in risk premium in 2007; 10-year government bond spreads and 5-year CDS plotted (2006−07).
- Monetary aggregates and credit:
  - Monetary aggregates remain high: Figure 3 shows M1 and M2 year-on-year changes high in 2006−07.
  - Table 4 and Table 2: Broad money (percent change, 12-month basis) Aug-07 = 16.2; Private sector credit (percent change, 12 month basis) Oct-07 = 7.7.
- Financial market indicators:
  - Stock market: TA 100 index shown in Figure 3, with equities generally strong (Figure 3).
  - Country risk ratings (Table 4): 2007 rating A / A2 (S. & P. / Moody's).

### Financial soundness and vulnerabilities
- Banking sector indicators (Table 2, 2001−07):
  - Regulatory capital to risk-weighted assets: 2007 = 11.1.
  - Regulatory Tier 1 capital to risk-weighted assets: 2007 = 7.7.
  - Problem loans to total credit: 2007 = 8.1 (percent).
  - Nonperforming loans net of provisions to capital: 2007 = 18.7 (percent).
  - Return on assets 2007 = 1.2; Return on equity 2007 = 20.2.
  - Household debt to GDP 2007 = 30.1.
- Other financial corporations (OFCs):
  - OFCs' assets to total financial system assets 2007 = 42.3 (percent).
  - OFCs' assets to GDP 2007 = 101.5 (percent).

### Public debt and fiscal developments
- Fiscal consolidation and deficits:
  - Central government revenue and expenditure (Figure 8 and Table 7): revenue has been strong and expenditure curtailed; central government revenue 2007 = 35.8 (percent of GDP), central government expenditure 2007 = 36.2 (percent of GDP) in Table 1 and Table 7 summary.
  - Fiscal deficit: Central government balance (Table 7 Budget/Proj) shows Budget balance 2007 = 0.0 (percent of GDP) and Budget 2008 projection = -1.6 (percent of GDP) in Table 7 lines; Table 8 medium-term scenarios list Central government balance (baseline) 2008 = -0.4, 2009 = 0.0, 2010 = 0.4, 2011 = 1.0, 2012 = 1.7.
- Public debt dynamics and sustainability:
  - Public debt (percent of GDP) trends (Figure 7; Table 6): public sector debt 2007 = 81.4 (percent of GDP, Table 6 actual), projected end-2012 = 62.2 (Table 6 baseline).
  - Identified drivers (Table 6): Change in public sector debt 2002−07 and projections with identified debt-creating flows, automatic debt dynamics, and contribution from interest rate/growth differential provided; for example, Change in public sector debt 2007 = -5.4 (percent of GDP).
  - Gross financing need (Table 6): 2007 = 10.0 (percent of GDP) and in billions of U.S. dollars 2007 = 15.8.

### Debt sustainability (external and public): scenario and bound tests
- External debt sustainability (Figure 5 and Table 5):
  - Baseline external debt ratios and scenario shock results shown; baseline external debt 2007 = 53.3 (percent of GDP, Table 5).
  - Gross external financing need (Table 5): 2007 = 35.3 (billions of U.S. dollars); percent of GDP 2007 = 22.4.
  - Key assumptions underlying baseline (Table 5): Real GDP growth series include 2007 = 5.4 (percent for 2006 entry in sequence; Table 5 lists a sequence with 2007 = 3.8 as the 2008 projection under Key Macroeconomic Assumptions).
- Public debt sustainability (Figure 7 and Table 6):
  - Baseline public sector debt 2007 = 81.4 (percent of GDP); projections to 2012 show decline to 62.2 (baseline scenario).
  - Scenario with key variables at historical averages (Table 6) yields different debt paths; gross financing need 2007 = 10.0 (percent of GDP) and 2007 = 15.8 (billions of U.S. dollars).

### Balance of payments and projections
- Balance of payments (Table 3, 2004−12):
  - Current account balance (billions of U.S. dollars): 2007 = 3.6 (Proj.); projections for 2008−12 provided (e.g., 2008 = 4.0, 2009 = 3.8).
  - Exports and imports (billions of U.S. dollars, Table 3 projections): exports and imports series for 2007−12 with exports 2007 = 62.7 and imports 2007 = 67.5 (percent figures vary across tables and series).
  - Gross external debt (Table 3 memo): 2007 projection = 53.3 (percent of GDP).
- Medium-term macro projections (Table 8, 2007−12):
  - GDP growth: 2007 = 5.4 (percent) in Table 8 top line; Table 8 projection for 2008 = 3.8, 2009 = 3.6, 2010 = 3.8, 2011 = 3.7, 2012 = 3.7.
  - Inflation (average) 2007 = 0.5; projections 2008−12 = 2.7, 2.0, 2.0, 2.0, 2.0.
  - Public debt/GDP (end of period) baseline: 2007 = 81.4, projected 2008 = 77.7, 2009 = 74.4, 2010 = 70.8, 2011 = 66.7, 2012 = 62.2.

### Key numeric snapshots (selected exact figures preserved)
- Unemployment rate 2007: 6.8 (Table 1).
- Broad money (12-month change) Aug-07: 16.2 (Table 4 / Table 2).
- Private sector credit (12-month change) Oct-07: 7.7 (Table 4 / Table 2).
- Foreign reserves (end period, billions of U.S. dollars) Dec-07: 28.4 (Table 3 / Table 1 footnote).
- Gross external debt (percent of GDP) 2007 projection: 53.3 (Table 5).
- Public sector debt (percent of GDP) 2007: 81.4 (Table 6).
- Central government revenue (percent of GDP) 2007: 35.8; central government expenditure 2007: 36.2 (Table 7 / Figure 8).
- Gross financing need 2007: 10.0 (percent of GDP) and 15.8 (billions of U.S. dollars) (Table 6).

*International Monetary Fund, Staff Report for the 2007 Article IV Consultation — Informational Annex (January 22, 2008).*

### Appendix I. Israel: Fund Relations

### Appendix I. Israel: Fund Relations (AS OF NOVEMBER 30, 2007)

### Membership and Data Dissemination
- Israel became a member of the Fund on July 12, 1954.
- Accepted the obligations of Article VIII, Sections 2, 3, and 4 on September 21, 1993.
- Maintains, other than solely for national and international security reasons, an exchange system free of restrictions on the making of payments and transfers for current international transactions.
- Subscribes to the SDDS and is in full observance of the SDDS’s prescriptions for data coverage, periodicity and timeliness, and for the dissemination of advance release calendars.
- Note: For Fund relations, the West Bank and Gaza (WBG) fall under Israeli jurisdiction in accordance with Article XXXI, Section 2(g) of the Articles of Agreement.

### General Resources Account (SDR Millions and % Quota)
- Quota: 928.20 — 100.00
- Fund holdings of currency: 867.56 — 93.47
- Reserve position in Fund: 60.65 — 6.43

### SDR Department (SDR Millions and % Allocation)
- Net cumulative allocation: 106.36 — 100.00
- Holdings: 10.55 — 9.91

### Outstanding Purchases and Loans
- None

### Financial Arrangements
- None

### Projected Payments to Fund (Forthcoming)
- Charges/Interest: 3.41 3.40 3.40 3.40 (2007 2008 2009 2010 2011 layout in source)
- Total: 3.41 3.40 3.40 3.40

### Safeguards, HIPC, and Assessments
- Implementation of HIPC Initiative: Not applicable
- Safeguards Assessments: Not applicable

### Exchange Rate Arrangement
- As of June 9, 2005 Israel’s exchange rate regime is officially classified as floating.
- Government action intended to remove crawling band policy; in practice the NIS has been floating since 1997 when the Bank of Israel stopped intervening to protect the band.

### Article IV Consultation
- Last Article IV consultation concluded on January 19, 2007.
- Israel is on the standard 12-month consultation cycle.

### ROSCs (Reports on the Observance of Standards and Codes)
- Financial System Stability Assessment conducted in 2000, issued in August 2001.
- Fiscal Transparency ROSC conducted in 2003, issued in March 2004.
- AML/CFT ROSC conducted in 2003, issued in June 2005.
- Data Module ROSC conducted in 2005, issued as IMF Country Report No. 06/125 in March 2006.

### Technical Assistance and Resident Representation
- Fund has provided policy advice and technical assistance to the Palestinian Authority since the 1993 Oslo Accords; a senior resident representative is based in Jerusalem.
- Fund work in the WBG intensified with focus on macroeconomic, fiscal, and financial areas. Staff missions to the WBG took place during May-August and November 2007 to assist authorities in developing medium-term macroeconomic and fiscal framework underpinning the Palestinian Reform and Development Plan (PRDP) presented at the Paris donors’ conference in December 2007.
- Going forward: Fund will regularly report to donors on macroeconomic and fiscal situation and on implementation of public finance reforms; technical assistance will be stepped up in public expenditure management, banking supervision and regulation, and macroeconomic statistics.
- Resident representative has been in the WBG since early 1996.

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### Appendix II. Israel: Staff Research, 2006−08 — Key Findings and Policy-Relevant Analysis

### Monetary Policy Research
- "Endogenous Monetary Policy Credibility in a Small Macro Model of Israel" (2007, Working Paper)
  - Extends small linear model to include nonlinearities from convex Phillips curve and endogenous monetary policy credibility.
  - Extended model better matches dynamic responses from the 2001−03 recession, especially deterioration and recovery costs of monetary policy credibility.
- "A Simple Forecasting and Policy Analysis System for Israel: Structure and Applications" (2006, Selected Issues)
  - Develops FPAS model to support inflation-targeting regime analysis; captures linkages among policy rate, output, inflation, and exchange rate.
  - Conducts risk assessments for exchange rate, output gap, and oil prices; reviews model properties and performance.

### Fiscal Policy Research
- "Toward a New Fiscal Rule: What Might Work Well for Israel" (2008, Selected Issues)
  - Assesses fiscal performance vs. fiscal rules over two decades; reviews international experience; proposes anchoring a new fiscal rule on lowering public debt to 60 percent of GDP by 2015.
- "The Political Economy and Fiscal Institutions in Israel" (2007, Selected Issues)
  - Finds fragmented parliaments and short average government duration have boosted public debt and deficits.
  - Recommends strengthening fiscal governance via enhanced budgetary transparency and independent fiscal policy assessment.
- "Fiscal Consolidation in Israel: A Global Fiscal Model Perspective" (2006, Working Paper)
  - Uses IMF’s Global Fiscal Model to quantify costs of delaying fiscal consolidation.
  - Finds early consolidation through expenditure cuts would substantially increase Israel’s long-term output growth relative to delayed adjustment.
  - Finds delaying tax cuts would result in long-run cumulative real GDP that is five times larger than when tax cuts are immediately implemented (as presented in the study).

### Financial Sector Research
- "Financial Sector Stability Analysis for Israel" (2008, Selected Issues)
  - Examines market-based indicators and stress tests; market indicators show a more mixed picture than accounting ratios.
  - Preliminary stress tests using public data find banks have become more resilient; credit risk remains the key source of risk.
- "Financial Sector Developments" (2008, Selected Issues)
  - Documents ongoing reforms; banking performance improving, though one bank incurred significant losses on assets related to the US mortgage market.
  - Scope for further losses appears limited provided that AAA mortgage-backed securities other than sub-prime are not significantly impaired.
  - Insurance groups show greater diversification; reforms have led to more diverse financial markets but require further regulatory capacity building and consideration of principles-based vs. rules-based approaches.
- "Financial Sector Supervision Structures: Assessing the Alternatives for Israel" (2007, Selected Issues)
  - Reviews international supervisory structures; emphasizes need for more independent supervision, strong governance, adequate resources, strong regulatory capacity, and level playing field across industries.
- "Corporate Balance Sheets and Investment: Empirical Estimates for Israel" (2006, Selected Issues)
  - Finds weak balance sheets contributed to investment decline; leverage (debt-to-assets) has a large negative effect on investment.
- "The Reform of the Capital Markets in Israel" (2006, Selected Issues)
  - Reviews capital market reforms and forced divestiture of banks’ holdings of mutual and provident funds; notes rapid market development creates supervisory and regulatory challenges.
- "Banking Sector Developments and Issues" (2006, Selected Issues)
  - Banking system strengthened since 2001–02 recession, but problem loans remained stubbornly high, contributing to low profitability.
  - Bank of Israel supervisors are highly qualified; recommends increasing efficiency in supervisory operations.

### External Competitiveness
- "Israel’s External Competitiveness: Assessing the Real Exchange Rate" (2008, Selected Issues)
  - Finds Israel’s real exchange rate is moderately undervalued; various estimations suggest undervaluation of about 5–10 percent, though actual undervaluation may be lower for various reasons.

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### Supplementary Information for the 2007 Article IV Consultation — Staff Projections and Recent Developments (February 8, 2008)

### Updated 2008 Projections and Revisions
- Staff lowered its 2008 real GDP growth projection for Israel from 3.8 to 3.5 percent following downward revisions to growth forecasts for the United States and Europe.
- Main reason: fall in projected export growth, which would also slow investment and private consumption.
- Risks around the new projection are broadly balanced.

Key staff projection comparisons (Staff Report Latest)
- Real GDP: 3.8 3.5
- Exports of goods and services: 5.4 4.8
  - Goods: 6.1 5.0
  - Service: 5.1 4.7
- Private consumption: 4.5 4.2
- Investment (gross fixed capital formation): 3.8 3.0
- Current account balance (percent of GDP): 2.4 2.3
- Source: IMF staff projections.

### Inflation Developments
- Consumer price index rose 0.6 percent in December (monthly), bringing the end-of-period inflation rate for 2007 to 3.4 percent, above the 3 percent upper limit of the Bank of Israel target range and equal to the staff projection.
- One reason for upside surprise: recent sheqel appreciations appear to have had a less deflationary impact than staff and others had projected.
- Standard assumption noted in source: a 10 percent appreciation of the sheqel relative to the US dollar reduces prices by about 2 percent, but this appears to be diminishing.

### Exchange Rate and Monetary Policy Signals
- Since issuance of the staff report the sheqel appreciated from 3.8 to close to 3.6 sheqel/US dollar, about 5 percent more appreciated than in staff’s central scenario for 2008Q1 (Box 2).
- Market-implied policy expectations: markets foresee policy rate hikes of just under 0.5 percent by end-2008.
- Inflation expectations are around 2.5 percent.
- Staff view: policy rate would probably have to be above the current 4.25 percent level once growth in trading partner countries reaccelerates to keep inflation in the 1–3 percent target range.
- Near-term consideration: the latest sheqel appreciation, external downside risks to activity, and heightened risk premia argue for caution in raising rates over the near term.

### Macro Context and Fiscal Position (Excerpt from PIN No. 08/15, February 14, 2008)
- Economic momentum entering global slowdown: real GDP growth averaged about 5¼ percent during 2006–07 despite 2006 northern war.
- Drivers: buoyant world trade, strong exports and investment, strong employment growth supported by welfare reform, and private consumption.
- Inflation trajectory: undershot 1–3 percent target in 2006 and first half of 2007 due to sheqel appreciation, rose in second half of 2007 to 3.4 percent year-over-year in December 2007.
- Monetary policy stance: Bank of Israel cut policy rate from a peak of 5.5 percent in October 2006 to 3.5 percent by June 2007, then raised rates in three steps to 4.25 percent by January 2008 as inflation reaccelerated and unemployment fell and output gap closed.
- Fiscal outturns: central government deficit fell to 1 percent of GDP in 2006 and reached balance in 2007, below the 3 percent of GDP ceiling.
- Public debt remains at just over 80 percent of GDP.
- For 2008–09, the central government deficit ceilings are (text in source continues beyond provided excerpt).

*International Monetary Fund — Staff Report for the 2007 Article IV Consultation with Israel; Supplementary Information (February 8, 2008) and Appendix I. Israel: Fund Relations (AS OF NOVEMBER 30, 2007).*

### 1.6 percent and 1.0 percent of GDP, respectively.

### _cr0862 - 1.6 percent and 1.0 percent of GDP, respectively.

### Financial soundness and market developments
- Indicators for the financial soundness of corporations and households have generally been improving but the global financial turmoil has caused some increase in risk premia.
- There have been losses on mortgage-related US assets but the effect on bank profitability and capital has been small thus far.
- Banks have not been experiencing funding pressures.
- Credit default swap (CDS) spreads on government bonds are up from unusually-low pre-crisis levels.
- Spreads between the returns on corporate and government bonds have widened, testifying to a general increase in risk premia.

### Outlook and growth projections
- Slowing demand from Israel’s export partner countries is projected to reduce output growth in 2008 to around 3½ percent, with broadly balanced risks.
- The ongoing shift from external to domestic sources of economic growth would further reduce the external current account surplus.
- Authorities’ baseline scenario: 2008 GDP growth in a 4.2-4.4 percent range, assuming a moderate slowdown in global economic activity and no significant change in the geo-political situation.
- Authorities’ conservative scenario: 3.6 percent for 2008.

### Executive Board Assessment — main messages and recommendations
- Directors welcomed Israel’s exceptional economic performance and noted that while public debt has declined, its still elevated level leaves the economy vulnerable to shocks; debt reduction remains a priority.
- Directors considered that further improvements to the financial sector framework would enhance the economy’s resilience.
- Given continued solid growth and growing capacity constraints, Directors expected domestic inflationary pressure would probably mount, although the recent appreciation of the sheqel has lowered external inflationary pressure.
- Directors recommended caution in raising interest rates over the near term because external downside risks to activity and heightened risk premia argue for restraint.
- Directors praised monetary policy for successfully stabilizing inflation expectations and welcomed improvements in policymaking transparency; they encouraged greater clarity on the role of macroeconomic forecasts in decision-making and on the monetary policy horizon.
- Directors recommended swift adoption of the draft Bank of Israel law, noting it would strengthen institutional foundations.
- Directors agreed the flexible exchange rate regime is serving Israel well.

### Fiscal policy: assessment and guidance
- Directors welcomed strong fiscal policy performance that brought central government accounts into balance in 2007.
- With activity projected to remain strong, Directors advised the budget should be kept close to balance to further reduce the public debt ratio and the economy’s vulnerability to shocks.
- For 2008, Directors supported compliance with:
  - the 1.7 percent expenditure growth ceiling,
  - tight budget execution, and
  - allocation of revenue overperformance to debt reduction.
- Looking to 2009 and beyond, Directors welcomed the government’s intention to stick with a rules-based approach to fiscal policy; a reformed rule aiming at reaching a 60 percent debt-to-GDP ratio by 2015 was considered consistent with an upper-limit debt level in many less exposed advanced economies and could accommodate an increase in welfare spending.
- Directors agreed debt reduction should be given precedence over tax cuts and saw scope to simplify the relatively complex tax system, including through cutting tax exemptions.
- Directors recommended enhanced fiscal transparency and governance:
  - budget documentation to include multiyear scenario analysis of risks for public finance objectives,
  - long-term fiscal sustainability analysis,
  - consideration of instituting independent, nonpartisan fiscal evaluation.

### Financial sector policy and supervision
- Directors concurred that ambitious reforms fostering a more diversified financial system may raise new risks.
- They welcomed improvements in financial soundness indicators and ongoing work to adapt the prudential framework and financial infrastructure, while noting major challenges remain.
- Directors noted the importance of giving regulators more scope to build expertise to support an increasingly complex regulatory system.
- Key supervisory priorities identified:
  - Achieve consistency between the pace of regulatory change and high-quality implementation.
  - Balance principles-based and rules-based approaches to supervision.
  - Strengthen capacity of regulators to manage and resolve financial stress.
  - Grant the insurance supervisory authority independence in areas where it is currently constrained, in line with international standards.

### Selected quantitative findings and indicators (as reported)
- Projected 2008 GDP growth: around 3½ percent.
- Authorities’ baseline 2008 GDP growth projection: 4.2-4.4 percent.
- Authorities’ conservative 2008 GDP growth scenario: 3.6 percent.
- 2007 overall CPI increase: 3.4 percent.
- 2007 real GDP growth (preliminary estimate): 5.3 percent.
- 2007 business sector growth: 6.3 percent.
- 2007 export performance: 8.6 percent.
- 2007 current account surplus (reported in text): 3.6 percent of GDP.
- Knesset-adopted 2008 budget envisaged deficit: 1.6 percent of GDP.
- 2008 budget expenditure real growth ceiling: 1.7 percent.
- Unemployment rate decline in 2007: by 0.9 percentage points to 7.5 percent.
- Participation rate in 2007: 56.4 percent.
- Fixed capital formation increase in 2007: 10.4 percent.
- Real wages rose in 2007 by 2.7 percent.
- Debt-to-GDP ratio in 2007: 81 percent of GDP (sharp reduction; accumulated decrease of more than 20 percent in 4 years).
- Banks’ planned gradual rise in capital ratios to the range of 12-13 percent (from 10-12 percent) within the next two years.
- Authorities’ target debt-to-GDP ratio: 60 percent by 2015.

### Structural reforms and social policy actions
- Privatizations and structural changes in 2007 included reductions in government holdings (Pi-Glilot gas depot), completion of the privatization of Israel Oil Refineries (sale of the second oil refinery in Haifa), and plans to split the Electric Corporation into transmission, generation and distribution companies.
- Planned privatizations under evaluation: Postal Authority, Israeli Military Industries (IMI), Israel Aircraft Industry (IAI), and the seaport in Eilat.
- Social policy: government adopted (April 2007) the “Social-Economic Agenda for 2008-10” with targets to:
  - gradually increase the participation rate for ages 25-64 by 2.6 percent to the OECD average (71.7 percent),
  - increase the income of the lowest socio-economical quintile by 10 percent higher than the growth of GDP per capita until 2010.
- Planned measures to achieve social targets include introducing an Earned Credit Income Tax (EITC) in 2008, expanding vocational training in ALMP, subsidizing day-care centers, strengthening enforcement of labor laws, and reducing the number of illegal foreign workers.
- New agreement on a mandatory pension between the labor union and the manufacturers association expected to contribute to poverty reduction over the medium and longer term.
- NII 2007 poverty report noted the population below the poverty line moderately declined by 0.6 to 20 percent (after welfare payments and taxes); poverty measure in Israel is relative (below half the median income).

*Source: IMF staff report and Executive Board assessment contained in the provided PDF content.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2008/_cr0862.pdf_