## Competitiveness and the Equilibrium Real Exchange Rate

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### Summary assessment: current situation and risks
- Israel entered global financial turmoil with strong fiscal and monetary credentials, robust bank supervision, and sustained balanced growth.
- Public debt reduced to around 80 percent of GDP but remains a vulnerability.
- Into Q3 2008: growth continued despite international deterioration; domestic securities prices fell, prompting outflows from provident funds; domestic credit markets largely undisturbed; capital inflows and Shekel strengthened.
- Since fall 2008: global financial strains intensified, global demand and securities markets slumped, and the Israeli real sector showed first signs of strain.
- Declines in commodity prices, inflationary pressures, policy interest rates and the Shekel provided some respite.
- With elections due in February, the 2009 budget was not adopted until well into the new year.
- IMF staff central scenario projections:
  - Decline in economic growth to ½ percent in 2009.
  - Average inflation around 1½ percent in 2009.
  - A modest recovery projected for 2010.
- Risks are firmly to the downside given financial sector vulnerabilities abroad, despite strong profiles for external amortization and short term external debt.

### Monetary policy stance and recent actions
- Under the IT regime, monetary policy adjusted nimbly to shifting environment.
- When external price shocks pushed headline inflation above target, policy rates were raised gradually by 75 bps in five months to February 2008 to 4¼ percent.
- Rates were then lowered as global and domestic output concerns mounted, with temporary reversal when high CPI outturns in April suggested residual inflationary challenges.
- As the global financial crisis deepened, interest rates were reduced since 2008 September in six steps to 1 percent (¶70).
- Inflation indicators and expectations:
  - Inflation level noted as “now at 4½ percent” and projected to return “to the 2 percent range by mid-2009.”
  - Indicators of medium-term inflation expectations slumped, albeit rising modestly in recent weeks.
- Staff assessment: scope remains for further reductions in policy rates if output outlook deteriorates; further early policy relaxation seems appropriate (¶76).
- Consider quantitative easing options as policy rates approach zero.

### Financial markets, banks, and non-banks
- Money and equity markets:
  - Overnight interbank market continued to operate calmly despite global stress.
  - Equity markets plunged; bank share prices fell and distance-to-default measures mirrored similar falls.
  - Money market spreads and short-term interbank indicators exhibited limited but notable stress.
- Banking sector resilience and vulnerabilities:
  - Banks remain profitable, largely deposit-funded, and strongly capitalized (significantly above the legally required ratio of 9 percent).
  - Bank losses from ABS exposures were minimized as many were sold early in 2008; marginal remaining exposures.
  - Non performing loans increased.
  - Bank-specific balance sheet entries (as presented) include sequences for Credit/asset, Securities/asset, Deposit/liability, Equity/Assets, Equity/Risk Assets, Return on Equity, and Assets (million, NIS) that are preserved exactly in the source.
  - Bank Hapoalim: wrote off NIS 3 ½ billion in Q1 2008, leaving exposure of NIS 1½ billion, overall loss in quarter of some NIS 1½ billion, returned to profit in Q2.
  - Bank Leumi: ABS exposures of about NIS 6 billion, largely guaranteed by FNMA.
- Non-bank institutions and capital flows:
  - Value of provident funds declined by about 20 percent in 2008; some mutual funds lost even more.
  - Withdrawals from provident funds amounted to NIS 8 billion (or about 5 percent of their total assets) in 2008.
  - Corporate bond market effectively closed: secondary yields rose and new bond issues halted since September 2008.
  - Corporate bond amortization pressures in 2009: bond repayments and interest will amount to almost NIS 25 billion; about NIS 3 billion of this is by real estate companies.
- Policy responses for non-banks:
  - Temporary suspension of mark-to-market rules for institutional investors for up to a maximum of 3 percent of their assets, conditional on holding bonds to maturity.
  - Authorities approved establishment of a NIS 10–20 billion fund to purchase corporate bonds; NIS 5 billion from public sources bearing most risk.
  - Staff advise fund primary functions: refinance bond installments as they fall due and support new bond issues; generally avoid secondary market purchases to prevent transferring accrued losses to the budget.
  - Recommendation: prepare plans for other priorities in corporate bond market but avoid diluting fund’s tasks; anticipated size sufficient at least through 2009.

### Fiscal stance, framework reform, and contingencies
- Immediate fiscal guidance:
  - Allow automatic stabilizers to operate fully given fiscal credibility, but avoid going much further because slowdown likely relatively moderate and public debt remains high.
  - Structural fiscal balance in 2009 should be unchanged from 2008, excluding financial sector support initiatives and any already-committed investment and infrastructure projects brought forward.
  - Cap on headline deficit of 1 percent of GDP needs adjustment to allow stabilizers to operate in 2009.
- Medium-term fiscal framework recommendations:
  - Replace the 1 percent ceiling with a formal commitment to reduce public debt to well below 60 percent of GDP during the middle years of the next decade, backed by new budget procedures laying out annually how and when the debt objective will be realized.
  - The annual cap of 1.7 percent on real spending growth may need amendment; consider adopting caps for three years ahead on annual nominal spending, excluding emergency outlays.
  - Staff outline six principles for a new framework emphasizing rules, medium-term debt focus, unimpeded automatic stabilizers, expenditure caps as key instrument, exclusion of security emergency allocations, and relaxing the 1 percent deficit target for 2009.
  - Authorities proposed an “error correction” mechanism linking spending automatically to debt deviations; staff note alternatives such as ranges of target dates or nominal spending caps with multi-year correction.
- Fiscal risks and scenario impacts on debt (public debt in percent of GDP):
  - Baseline: 74 percent of GDP in 2013.
  - Growth shock scenario (½ standard deviation to growth): 93 percent of GDP in 2013.
  - Primary balance shock (½ standard deviation): 78 percent of GDP in 2013.
  - Interest rate shock (permanent ½ standard deviation; 1.4 percentage point increase): 80 percent of GDP in 2013.
  - One-time 30 percent REER depreciation (2009): 92¾ percent on impact; 86 percent in 2013.
  - One-time contingent liabilities shock (10 percent of GDP in 2009): 91 percent on impact; 85 percent in 2013.
  - Combined one-quarter standard deviation shocks: 83 percent of GDP in 2013.
- Policy implication: prepare contingency plans for tail events; ensure financing and legal procedures for interventions are ready.

### External position, reserves, and competitiveness
- External metrics and buffers:
  - Gross external debt described as over 40 percent of GDP in one section; memorandum items include gross external debt projection 31.1 (percent of GDP, projection for 2013 table).
  - Net International Investment Position at end-June 2008 about -4 percent of GDP, an improvement by more than 35 percentage points from beginning of decade.
  - Public external debt fairly modest at about 15 percent of GDP; only a small portion matures within one year.
  - Foreign exchange reserves increased, reaching $41½ billion by end–December (source mentions reserves reaching $41½ billion and elsewhere lists foreign reserves (end period, 2008, billions of U.S. dollars): 36.3).
  - Reserves correspond to over 100 percent of short-term debt.
  - BoI announced plans: increase reserves by $10 billion over two years to $35–40 billion; later target raised to $40–44 billion.
- Exchange rate and competitiveness:
  - Shekel appreciated about 20 percent in real terms in 2007 returning it to long-term average after six years of weakness.
  - Current account remained in surplus through Q3 2008; positive net transfers and services exports cushion.
  - Real effective exchange rate estimated close to its equilibrium.
  - Export market penetration broadly stable; export growth remained firm until late 2008.
- Policy guidance on FX intervention:
  - Preannounce schedule of purchases and targets for foreign exchange purchases; once announced target reached, consider maintaining ratio to short-term debt.
  - Restrict discretionary intervention to combat disorderly conditions; rely on bank rate if flows persist.
  - Sterilization costs estimated at less than 0.1 percent of GDP so far.

### Key macroeconomic and financial figures (selected exact values from source)
- Growth, inflation, labor:
  - Real GDP growth (2008 staff projection / 2008 figures appear in different tables): 4.3 (Real GDP (2008): 4.3; staff projection for 2008 GDP growth: 3.4 noted in memorandum).
  - IMF staff projection for 2009 growth: ½ percent.
  - Average inflation around 1½ percent in 2009; inflation noted as “now at 4½ percent” returning to “the 2 percent range by mid-2009.”
  - Unemployment rate (percent, 2008): 6.0.
- Public finances (percent of GDP, 2008 / staff projections):
  - Central government revenue (2008 staff projection): 30.0.
  - Central government expenditure (2008 staff projection): 32.1.
  - Central government balance (2008 staff projection): -2.1.
  - General government balance (2008 staff projection): -2.8.
  - General government debt (2008 staff projection): 77.6.
- External and monetary aggregates:
  - Exports of goods and services (2008): 41.9.
  - Current account (2008): 1.2 (percent of GDP, IMF staff estimate).
  - Foreign reserves (end period, 2008, billions of U.S. dollars): 36.3 (other text notes reserves reached $41½ billion by end–December).
  - Present exchange rate per U.S. dollar (January 26, 2009): 4.0.
  - Bank of Israel policy rate (average, 2008): 2.5.
  - Broad money (M3, period average, 2008): 5.3.
- Financial soundness indicators (selected):
  - Regulatory capital to risk-weighted assets (Deposit Takers, June): 11.6.
  - Regulatory Tier 1 capital to risk-weighted assets (Deposit Takers, June): 7.8.
  - Problem loans to total credit (Deposit Takers, June): 14.1.
  - Nonperforming loans to total gross loans (Deposit Takers, June): 1.3.
  - Return on assets (Deposit Takers, 2008): 0.7.
  - Return on equity (Deposit Takers, 2008): 10.7.
  - Household debt to GDP (2007): 39.5.
- Central government accounts (percent of GDP, selected):
  - Revenue (2007): 32.7; 2008 staff projection: 30.0.
  - Expenditure (2007): 34.3; 2008 staff projection: 32.1.
  - Budget balance (2007): -1.0; 2008 staff projection: -2.1.
- Balance of payments and GDP:
  - Current account balance (2008): 1.2 (percent of GDP, IMF staff estimate).
  - GDP (billions of U.S. dollars, 2008): 253.2.

### Financial sector reform, supervision, and preparedness
- Structural reforms since 2005:
  - Bachar Legislation (implemented July 2005): banks required to sell holdings of mutual funds and provident funds to increase competition and reduce concentration.
  - Tax and regulatory changes encouraged foreign participation and improved investor choice and rights.
  - By end-2007: shift toward non-bank institutions; share of bank deposits to public’s total assets fell from 46 percent at end-2002 to 30 percent at end-2007; control of banks over long-term saving declined from 52 percent in 2003 to 11 percent at end-2007.
  - Corporate bonds issuance reached about NIS 80 billion in 2007; most bonds in 2003–08 were by real-estate companies (32 percent) and holding companies (21 percent).
- Supervision and contingency preparedness:
  - Intensified monitoring of bank exposures, provisioning, disclosure, liquidity positions, and reporting frequency.
  - Review legal provisions concerning troubled banks and lender-of-last-resort transparency; consider legal capacity for speedy resolution and restriction of legal recourse to financial compensation only.
  - Enhance coordination among supervisors, central bank, and Government; recent Memorandum of Understanding and crisis-response exercises welcome.
  - Immediate priority: ensure uninterrupted flow of information from banks to central bank.
  - Consideration of deposit insurance implementation should await easing of global financial tensions.

### Recommended priorities and policy packages (near-term and medium-term)
- Near-term priorities:
  - Ensure financial stability framework ready for tail risks; establish and operationalize public-private corporate bond purchase fund (NIS 10–20 billion with NIS 5 billion public).
  - Streamline procedures to reorganize corporate bonds; implement proposed bank bond guarantees with dividend restrictions for participating banks.
  - Conduct technical legal review for troubled banks and review mandated rapid publication rules for lender-of-last-resort actions by publicly traded companies.
  - Allow automatic stabilizers to operate fully in 2009; adjust deficit ceiling to accommodate stabilizers and recently approved fiscal and financial initiatives.
  - Monetary policy to lead in addressing external weakness within IT/flexible FX framework; preserve monetary transmission via credit-supporting and financial stability measures.
- Medium-term priorities:
  - Strengthen medium-term fiscal framework anchored by a medium-term public debt goal (staff endorse proposal of debt below 60 percent of GDP) and associated spending caps (nominal caps over multi-year horizon suggested).
  - Maintain simplicity, robustness, and compliance of fiscal rules while increasing flexibility to accommodate stabilizers.
  - Strengthen Bank of Israel governance (monetary policy committee of well-qualified experts) and legal protections for staff; consider BoI capital and remuneration provisions.
  - Prepare frameworks for crisis preparedness covering support and resolution of banks and non-banks, including explicit scenarios for liquidity, capital adequacy, and public interventions.
  - Enhance information-sharing, supervisory capacity, and contingency planning across authorities.

*Italic: IMF staff report content unit _cr0957 — chapter "Competitiveness and the Equilibrium Real Exchange Rate" and related sections provided.*

### 1.     Competitiveness and the Equilibrium Real Exchange Rate ............................................10

### 1.     Competitiveness and the Equilibrium Real Exchange Rate

### I. Summary and appraisal: current situation and risks
- Israel entered the global financial turmoil with strong fiscal and monetary credentials, robust bank supervision, and sustained balanced growth.
- Public debt was reduced to around 80 percent of GDP, but remains a vulnerability.
- Into Q3 2008 growth continued despite international deterioration; domestic securities prices fell, prompting outflows from provident funds, but domestic credit markets largely undisturbed; capital inflows and the Shekel strengthened.
- Since fall 2008, global financial strains intensified, global demand and securities markets slumped, and the Israeli real sector showed first signs of strain.
- Declines in commodities prices, inflationary pressures, policy interest rates and the Shekel provided some respite.
- With elections due in February, the 2009 budget will not be adopted until well into the new year.
- Recessions in the U.S. and Euro areas are anticipated through the first half of 2009; their length and depth are highly uncertain.
- IMF staff central scenario projections:
  - Decline in economic growth to ½ percent in 2009.
  - Average inflation around 1½ percent in 2009.
  - A modest recovery projected for 2010.
- Risks are firmly to the downside given financial sector vulnerabilities abroad, despite strong profiles for external amortization and short term external debt.

### II. Policy guidance: immediate and medium-term priorities
- Core recommendation: well-coordinated policy combining steps that strengthen long-run credibility and provide near-term flexibility.
- Immediate financial sector measures (already begun and recommended):
  - Establish promptly the recently approved public-private fund to purchase corporate bonds, tasked primarily to support new credit flows for large solvent firms.
  - Streamline procedures to reorganize corporate bonds.
  - Implement the proposed guarantee for bond issues by banks to increase bank capital; restrict dividend payments by participating banks to maximize effect.
  - Conduct a technical review of legal provisions concerning troubled banks.
  - Review mandated rapid publication of lender-of-last-resort actions for publicly traded companies to ensure effectiveness in crisis context.
  - The above package is a first step; more may be needed if downside risks materialize.
- Fiscal stance and flexibility:
  - Allow automatic stabilizers to operate fully given fiscal credibility, but avoid going much further because slowdown is likely relatively moderate and public debt remains high.
  - Structural fiscal balance in 2009 should be unchanged from 2008, excluding financial sector support initiatives and any already-committed investment and infrastructure projects brought forward.
  - This stance preserves “fiscal firepower” and underscores commitment to fiscal sustainability.
- Credibility-enhancing adjustments to fiscal framework:
  - Current one-year ceiling on the deficit of 1 percent of GDP needs to adjust to allow operation of automatic stabilizers in 2009.
  - One alternative: replace the 1 percent ceiling with a formal commitment to reduce public debt to well below 60 percent of GDP during the middle years of the next decade, backed by new budget procedures laying out annually and in detail how and when the debt objective will be realized.
  - The annual cap of 1.7 percent on real spending growth may need amendment; consider adopting caps for three years ahead on annual nominal spending, excluding emergency outlays. This would be transparent, improve fiscal stabilizers, and buttress monetary responses.
- Monetary policy role:
  - Inflation targeting and flexible exchange rate frameworks permit monetary policy to take the lead in addressing external weakness.
  - Credit-supporting and financial stability initiatives will help preserve monetary transmission.
  - Even after recent easing, inflation is set to fall below target range for much of 2009 with subdued inflation expectations; scope remains for further reductions in policy rates if output outlook deteriorates.
- External position and reserves:
  - International reserves increased to now over 100 percent of short-term debt, attenuating external vulnerabilities.
  - Purchase modalities under the reserve accumulation program appropriately avoided discretionary intervention.
- Institutional reform:
  - Preparations for a new Bank of Israel (BoI) law are welcome, notably provision for establishment of a monetary policy committee of well qualified experts to determine the policy rate.
- Contingency planning:
  - Despite calibrated policies, prospects remain challenging; planning for contingencies needs to proceed further and urgently.
  - Israel should remain on the standard 12–month consultation cycle.

### III. Context—2004–08: macro performance and structural background
- Growth and labor market:
  - Real GDP growth rebounded strongly from 2001–03 slump, averaging over 5 percent since then.
  - Exports of goods and services supported employment and incomes, spurring private consumption and investment.
  - Unemployment has been declining; labor market conditions improving.
- Fiscal consolidation:
  - Public debt lowered from 100 percent of GDP in 2003 to just under 80 percent of GDP in 2007.
  - Fiscal rules adopted and adhered to: a cap of 1.7 percent on annual real expenditure growth (excluding emergency security-related items) and deficit ceilings for central government.
  - General government structural primary balance strengthened from 1½ percent of GDP in 2004 to 2¼ percent in 2007.
- Financial sector reforms:
  - Far reaching reforms diversified financial markets, with shift from bank toward nonbank credit, including corporate bond issuance to business sector.
- External position and competitiveness:
  - Gross external debt of some 43 percent of GDP; net IIP strengthened with overall liabilities only modestly exceeding assets.
  - Indicators of competitiveness mixed but comfortable overall.
  - Shekel appreciation about 20 percent in real terms in 2007 returned it to long-term average after six years of weakness.
  - Trend current account mirrored the Shekel movements: relatively strong during Shekel weakness and deteriorated more recently though remaining positive through Q3 2008.
  - Competitiveness assessment notes:
    - Export market penetration broadly stable (abstracting from dot.com bubble effects).
    - Export growth remained firm until late 2008.
    - Some weakening in merchandise trade balance reflects strong income and net transfers from abroad.
    - Few signs of loss of labor competitiveness from relative unit labor cost measures or unemployment.
    - Trade in services remains in surplus.
    - These assessments are supported by CGER estimates.
- External shocks in 2008:
  - Soaring global food and fuel prices raised inflation concerns; later global financial turmoil weakened output prospects as commodity prices fell back.
  - S&P downgraded Israeli sovereign foreign currency credit by one notch to stable in late October 2008.
- Monetary policy reaction:
  - Monetary policy adjusted swiftly in response to evolving conditions.

*Source: IMF staff report content provided in the chapter "Competitiveness and the Equilibrium Real Exchange Rate."*

### 30.      Under the IT regime, monetary policy adjusted nimbly to this shifting environment

### 30.      Under the IT regime, monetary policy adjusted nimbly to this shifting environment

### Monetary policy actions and inflation developments
- When external price shocks—compounded by diminishing economic slack—pushed headline inflation substantially above target, policy rates were raised gradually by 75 bps in the five months to February 2008 to 4¼ percent.
- With inflation expectations apparently anchored, rates were then lowered in light of global and domestic output concerns, with a temporary reversal when high CPI outturns from April suggested residual inflationary challenges.
- As the global financial crisis deepened later in the year, interest rates have been reduced appropriately since 2008 September, in six steps to 1 percent (¶70).
- Indicators of medium-term inflation expectations slumped, albeit rising modestly in recent weeks.
- Inflation nevertheless remained above target at end–2008.
- Inflation level noted: “now at 4½ percent” and projected to return “to the 2 percent range by mid-2009.”

### Financial market and money market conditions
- Recent money market strains have been limited; the overnight interbank market continued to operate calmly despite global stress.
- Equity markets plunged (Tel Aviv indices shown in Figure 5), with bank share prices falling and distance-to-default measures mirroring similar falls for other domestic and global financial firms.
- Money market spreads and short-term interbank indicators exhibited limited but notable stress (Figure 5 annotations).

### Banking sector resilience and vulnerabilities
- Banking vulnerabilities appeared to have been contained, so far.
- Bank losses due to ABS exposures were minimized as they were sold early in 2008, leaving marginal remaining exposures.
- Banks remain profitable, largely deposit-funded, and strongly capitalized (significantly above the legally required ratio of 9 percent), despite some exposure to failed international institutions.
- The only sign of a change is the increase in non performing loans (Box 3).
- Bank-specific data highlights (from Summary of Banks Balance Sheet):
  - Credit/asset entries include values such as 72.1, 67.7, 70.6, 65.7, 78.4, 78.0, 66.7, 60.4, 66.1, 60.1 (as presented).
  - Securities/asset entries include values such as 10.0, 15.9, 14.1, 15.6, 7.0, 6.4, 17.5, 22.1, 16.9, 23.2.
  - Deposit/liability entries include values such as 77.2, 81.8, 82.5, 84.3, 106.1, 83.9, 78.5, 81.9, 86.4, 87.4.
  - Equity/Assets entries include values such as 6.4, 6.2, 6.7, 6.5, 5.5, 5.8, 5.1, 5.5, 5.7, 5.9.
  - Equity/Risk Assets ratios include values such as 11.5, 10.3, 12.1, 11.5, 11.4, 11.3, 10.6, 10.9, 11.4, 11.4.
  - Return on Equity entries include values such as -3.8, 14.1, 8.5, 17.4, 12.1, 17.2, 5.3, 14.7, 5.8, 14.6.
  - Assets (million, NIS) sequence presented: 297854, 302991, 293811, 302151, 107015, 95317, 170573, 1687199, 697792, 516 (as presented).
- Bank Hapoalim specifics: wrote off NIS 3 ½ billion in Q1 2008, leaving exposure of NIS 1½ billion, yielding overall loss for the quarter of some NIS 1½ billion, returning to profit in Q2.
- Bank Leumi reported ABS exposures of about NIS 6 billion, largely guaranteed by FNMA.
- ABS exposures of other banks appear small.

### Non-bank financial institutions and capital flows
- The value of provident funds declined by about 20 percent in 2008; some mutual funds lost even more.
- Withdrawals from provident funds amounted to NIS 8 billion (or about 5 percent of their total assets) in 2008.
- The corporate bond market has de facto closed: yields in the secondary market rose significantly and new bond issues halted since September 2008.
- Robustness of the banking sector and supportive policies may explain strength of the shekel during most of 2008.
- Bank of Israel announced intention in late March to increase foreign exchange reserves by $10 billion during a two year period, taking reserves to between $35–40 billion; in July the pace was raised, and in November the target range was raised to $40–44 billion. By end–December the reserves had reached $41½ billion.

### Real economy, fiscal and political context
- Activity cooled significantly in the second half of 2008; overall 2008 growth expected to be 4¼ percent.
- Significant revenue shortfalls in recent months are expected to bring the full-year budget deficit for central government to 2 percent of GDP, with the structural primary balance weakening to ¾ percent of GDP.
- Public debt stands at little below 80 percent of GDP at end-2008.
- General elections scheduled for early February 2009; adoption of the 2009 budget delayed, with spending capped at 1/12 of the 2008 budgeted levels until full budget adoption.
- If the conflict in Gaza resumes, it would pose risks to real activity and public spending, though implications have been modest so far.

### Near-term outlook and risks (2009–10)
- External factors dominate near-term prospects; growth in imports of Israel’s trading partners (averaging 7 percent annually in recent years) is projected at -1½ percent in 2009.
- Staff project growth to slow to ½ percent in 2009, before gradually regaining momentum in 2010 (¶69).
- Declining commodity prices and slowing activity should rapidly bring inflation—“now at 4½ percent”—back to the 2 percent range by mid-2009.
- Spillovers from the U.S. are pronounced: a 1 percentage point increase in the U.S. quarterly economic growth is statistically associated with as much as ½ percentage point rise in Israel’s GDP over two quarters.
- Key downside risks:
  - Global risks to the downside of the WEO central forecast; Gaza conflict could resume.
  - High Israeli government debt around some 80 percent of GDP and financing/roll-over needs.
  - Potential major defaults in the domestic corporate bond market could constrain refinancing.
  - Economic slowdown could impair credit quality and push down prices of securities held by banks despite total risk-adjusted capital-asset ratio of 11 ½ percent and raw equity of some 6 percent of assets; both major banks issued profit warnings for late 2008.
  - Risk of disorderly withdrawals from nonbank financial institutions; insurance companies have suffered asset losses.
  - Tail risks in the financial sector could materialize with little warning.
- Mitigating factors:
  - Banks’ short-term external debt is more than matched by deposits abroad; private sector short-term assets are more than twice the size of short-term debt.
  - Only a small portion of public external debt matures within one year.
  - External public debt rollover needs: US$3.4 billion (NIS 12 billion) of the total US$30 billion in external debt was due in one year from end-September, 2008.
  - Public financing for the next several months has largely been secured.
  - Almost half of all external public debt is guaranteed by the U.S. government; a U.S. loan guarantee program for up to US$9 billion was approved in 2003 and extended until 2011.
  - Another third of external debt comprises State of Israel Bonds with Diaspora demand.
  - Economy has capacity for rapid adjustment, evidenced by resilience during the 2006 war and rebound from the dotcom bubble; rapid response of inflation expectations and monetary policy since October 2008.
  - Several stimulating policy measures approved: advancing infrastructure investment, extending credits to small enterprises, establishing public-private corporate bond funds, and guaranteeing new capital raised by banks.

### Policy implications and recommended priorities (2009–10)
- Immediate priority: ensure the financial stability framework is ready to address downside tail risks.
- Medium-term fiscal focus: strengthen policies to continue steady reduction in debt and associated vulnerability, while not impeding automatic stabilizers during the downturn.
- Monetary policy should remain the instrument of first recourse to support activity, with the interest rate remaining the primary instrument, leaving fiscal resources available for potential downside risks.
- Financial sector policy and framework actions:
  - Develop frameworks for crisis preparedness covering support and resolution of banks and non-banks, addressing liquidity and capital adequacy issues and public interventions.
  - Review aspects of legal framework for dealing with failures of large banks and non-bank institutions, including legal recourse for affected shareholders and mandated transparency of use of lender-of-last-resort facilities by publicly traded companies (see Box 4, ¶72).
  - Specific preparedness items (Box 4):
    - Market liquidity and ELA facilities: Governor has wide discretion for emergency liquidity operations; review concern regarding stock exchange listing rules requiring rapid announcement of LOLR facilities received by financial firms.
    - Bank resolution framework: Governor may take over a bank with Government approval and appoint an administrator; ensure legal capacity to complete such operations speedily and strengthen provision for preemptive bank resolution via restriction of legal recourse for affected stakeholders to financial compensation only.
    - Coordination among authorities: need strong technical capacity and close cooperation between supervisors, the central bank, and the Government; recent Memorandum of Understanding among supervisors and crisis-response exercises are welcome.

_Italic source attribution: IMF staff report content unit _cr0957 — section titled “Under the IT regime, monetary policy adjusted nimbly to this shifting environment.”_

### 4. Non-banks. Readiness to handle weakness in a large non-bank financial

### _cr0957 - 4. Non-banks. Readiness to handle weakness in a large non-bank financial institution is unclear. While forms of appropriate support will vary from case to case, early consideration of options and risks that may arise is needed.

### Non-banks: readiness and recommendations
- Readiness to handle weakness in a large non-bank financial institution is described as unclear.
- Early consideration of options and risks that may arise is needed.
- Forms of appropriate support will vary from case to case.

### Corporate bond market: measures and rationale
- The corporate bond market has been under strain.
- Authorities temporarily suspended mark-to-market rules for institutional investors:
  - Up to a maximum of 3 percent of their assets.
  - Suspension only if the institutions commit to holding the bonds to maturity.
- Effect: Brought a measure of relief to the corporate bond market while retaining transparency for the bulk of institutions’ accounts.
- The Israeli security authority has proposed a detailed and flexible blueprint for procedures to reorganize corporate bonds.

### Fund to purchase corporate bonds: design and staff advice
- Authorities approved establishment of a NIS 10–20 billion fund to purchase corporate bonds.
  - NIS 5 billion of this will come from public sources which bear most of the risk.
- Staff suggest prime functions of the fund would be:
  - To refinance bond installments as they fall due.
  - To support new bond issues, because these directly support credit to firms (¶71).
- Staff advise generally avoiding purchases by the fund on the secondary market because:
  - Secondary purchases will not provide new credit.
  - They risk implicitly transferring accrued institutional investor or corporate losses to the budget.
- Recommendation: Prepare plans to address other priorities in the corporate bond market, but do not extend the fund’s tasks so as to dilute effectiveness and accountability.
- Given the stated terms of reference, the anticipated size of the fund is sufficient at least through 2009.

### Supervision, reform sequencing, and information flow
- Continuing initiatives in 2008 aimed to buttress supervision of all financial firms by enhancing capital, reporting, monitoring, transparency, and regulatory coordination.
- While more deep-seated reforms should remain under review, implementation of organizational reforms that might cause a temporary loss of focus on tail risks should be avoided given the immediate priority is management of tail risks (¶72).
- Immediate priority: ensure the flow of information from banks to the central bank remains uninterrupted, regardless of long-run allocation of bank and non-bank supervisory tasks between the Central Bank and other agencies.
- Consideration of action to implement a deposit insurance scheme should await easing of global financial market tensions to avoid calling into question the authorities’ commitment to financial market stability.
  - Eventual implementation of formal deposit insurance could provide an appropriate opportunity to exit from the current implicit deposit guarantee.

### Fiscal policy and framework: medium-term objectives and 2009 budget context
- A strong medium-term budget framework would underpin fiscal credibility and facilitate accommodation of stabilizers in 2009.
- Staff reiterate endorsement of the Minister of Finance’s proposal of an objective of debt of below 60 percent of GDP in the medium term, noting it should be a minimum objective given Israel’s unique vulnerabilities.
- Draft 2009 budget envisages:
  - Full implementation of the programmed tax cuts of about ½ percent of GDP.
  - Pre-set deficit target of 1 percent of GDP by anticipating a marked reduction in expenditure growth.
- On the authorities’ fiscal projections:
  - The structural primary surplus implied by the draft budget is roughly 1 percent of GDP.
  - Public debt is expected to fall to 77 percent of GDP.
- Four factors of concern regarding the draft 2009 budget:
  - First: Draft budget’s growth and revenue estimates may prove optimistic; real GDP growth appears unlikely to reach the assumed 3½ percent for 2009. If growth is closer to ½ percent, fiscal revenue would likely be much weaker—automatic stabilizers tend to be larger during downturns. In such scenarios, either automatic stabilizers will have to be constrained, or the headline 1 percent deficit ceiling would be breached.
  - Second: The structural primary surplus implied by the 2009 draft budget falls short of the steady-state structural surplus of 3¾ percent of GDP needed to lower debt to 60 percent of GDP within the next decade.
  - Third: Technical estimation of the structural primary surplus should reflect a cautious assessment of automatic stabilizers; past revenue buoyancy partly reflected pre-crisis global financial market excesses, so future tax collection ratios may be unlikely to return to recent levels.
  - Fourth: Ongoing political and geopolitical uncertainties add risks to budget prospects.
- Recommendation: The 2009 budget deficit target should be modified and the medium-term framework strengthened.
  - As agreed with the authorities, the cap on the headline budget deficit ceiling for 2009 should be adjusted to accommodate full operations of automatic stabilizers (¶73).
  - It should also accommodate, without offsets, fiscal and financial-sector initiatives recently approved by parliament, and any already-planned investments brought forward as these leave the NPV of anticipated government spending over the medium-term unchanged.
- Key characteristics of the current fiscal framework to retain:
  - Simplicity, robustness, and compliance.
  - Current targets (established in 2006) cap real expenditure growth at 1.7 percent beginning in 2007 and set ceilings on the headline deficit (excluding emergency security spending).
- Authorities and staff view reforms needed; staff outline six principles for a new framework:
  - Fiscal policy in Israel should be guided by rules.
  - Those rules should have a medium-term focus, targeting debt reduction.
  - Automatic stabilizers should be allowed to operate unimpeded.
  - The key instrument to deliver the debt objective is expenditure caps.
  - Spending caps should exclude emergency allocations for security.
  - In this context, the deficit target of 1 percent of GDP for 2009 should be relaxed.
- Authorities proposed a new framework with elements of an “error correction” mechanism:
  - Would automatically constrain (loosen) real expenditure should debt rise above (drop below) the envisaged adjustment path due to breaches.
  - Explicit link between spending and debt is a clear advantage.
- Possible scope to increase framework flexibility:
  - Establish a range of dates (e.g., the middle years of the next decade) rather than a single year for the debt target.
  - Adopt caps on spending in nominal rather than real terms, with cumulative inflation projection errors corrected only after three years.
  - Use a less formal link to debt (rather than automatic error correction), based on mandatory publication of full medium-term budget projections each year showing how predetermined caps on nominal spending would meet the debt objective.

### Monetary policy and framework: inflation, rates, reserves, and recommendations
- Inflationary pressures have abruptly eased since fall 2008 and remain contained, even after the late January policy rate cut.
  - Monthly inflation peaked in August with core inflation measures continuing subdued.
- Markets anticipate a further modest reduction in the policy rate of some 25bp in coming months.
- Evidence from surveys and financial market instruments suggests the inflation target will be undershot by end–2009.
- Given expected policy rate, recommended fiscal stance, and WEO projections for commodity prices and Israeli output in 2009 and beyond, an undershoot appears likely.
- On balance, the bank rate could be lowered further.
- Considerations in favor of further policy relaxation:
  - Falling commodity prices and activity, long-contained nominal wage behavior, and recent sharp reductions in international central bank interest rates have dissipated prior inflationary concerns.
  - Indicators of inflation expectations for 2009 and beyond are now below target; liquidity-premia distortions likely minimal.
  - Output concerns remain considerable even with recommended fiscal stabilizers and limited domestic financial sector strains.
- Recommendation: Further early policy relaxation seems appropriate (¶76).
  - Concerns about surprising markets with large steps can be attenuated by prior guidance and market familiarity with large steps globally.
  - As policy rates approach zero, options for quantitative easing should be considered if needed.
- The inflation-targeting (IT) framework serves well; appropriate strengthening anticipated.
  - The proposed new draft BoI Law appears appropriate: increase BoI independence, establish a committee with power to set monetary policy, and a separate management committee for administration.
  - Provisions for BoI capital, staff remuneration, and legal protections for staff may need strengthening.
- Foreign exchange intervention guidance:
  - Sizeable foreign currency reserves can provide a useful signal of resilience; a level equal to short-term debt has merit.
  - This ratio was realized by end-December as the reserves reached the target range of $40–44 billion.
  - Sterilization costs estimated at less than 0.1 percent of GDP so far.
  - The bank rate should remain the central instrument in the inflation-targeting regime.
    - Requires preannouncement of the schedule of purchases and targets for foreign exchange purchases.
    - Once announced target has been reached, there may be a case to maintain the ratio relative to short-term debt; the objective and schedule of purchases should be preannounced.
    - Restrict discretionary intervention to combat disorderly conditions; if flows persist, policy response should focus on the bank rate (¶75).

### The authorities’ views and near-term outlook
- Broad agreement with staff that recent intensification of global financial stresses required policy responses in various areas, with many still to be finalized; fiscal rules were a particular focus of debate.
- Israel had been well prepared before global turmoil, with public debt falling, low inflation and stable monetary conditions, conservative and healthy banks, and a significantly improved international investment position.
- Near-term macroeconomic outlook had weakened:
  - The BoI’s latest growth forecast for 2009 is -0.2 percent, a little below staff.
  - BoI and staff were in close agreement on the pace of recovery in 2010.
  - The Ministry of Finance had not updated its macroeconomic framework since submission of the draft 2009 budget; the macro assumptions underlying that draft would be substantially marked down (¶37).

*Source: IMF staff report text (chapter 4 and related sections provided).*

### 70.      Given the deteriorating outlook and associated declines in inflationary pressure, the

### _cr0957 - 70.      Given the deteriorating outlook and associated declines in inflationary pressure, the

### Financial sector stabilization and policy response
- First response: significant reductions in the Bank of Israel rate in response to deteriorating outlook and declines in inflationary pressure (¶30 &41).
- Subsequent focus:
  - Stabilization of the corporate bond market.
  - Securing continued credit supply.
  - Fiscal support for activity (¶30 &41).
- Private investment fund (public capital) for corporate bond market:
  - Purpose: support liquidity, credit to solvent corporates whose main activity is in Israel and which face difficulties in recycling their credit, and restoration of confidence in the market (¶44).
  - Terms of reference still in development; potential for secondary market purchases on some occasions, for example as part of broader debt workouts (¶44).
  - Need to address potential conflicts of interest (¶44).
- Bank guarantees for bond issues by banks:
  - Consideration of relative importance of raising capital ratios versus increased credit supply as objectives for guarantees; pre-emptive action warranted in either case (¶44).
- Regulatory coordination and contingency readiness:
  - Extensive arrangements to strengthen information-sharing and coordination among regulatory authorities since fall 2007.
  - Review of readiness for contingencies welcomed.
  - Legal provisions guiding resolution of troubled banks and transparency of lender-of-last-resort would be considered further (¶45–48).
  - Domestic debate on organizational structures of financial regulation largely suspended while focus remained on immediate market challenges (¶45–48).

### Fiscal policy: flexibility within fiscal rules
- Authorities' agreement: need to accommodate greater flexibility in downturn without losing momentum in debt reduction and fiscal sustainability (¶52–54).
- Staff and authorities concurred: to accommodate fiscal stabilizers, the 2009 deficit should exceed its ceiling under prevailing fiscal rules (¶52–54).
- Ministry of Finance intended approach for 2009:
  - While revenue expected to be lower than draft 2009 budget estimates, the Ministry envisaged total nominal spending in 2009 would conform to draft budget ceilings, maintaining fiscal discipline in 2009 and medium-term (¶52–54).
- Proposed fiscal-rule reform:
  - Target public debt below 60 percent of GDP by 2015, underpinned by a ceiling on real expenditure growth, adjusted downwards if debt overshoots path toward 2015 goal (¶58).
  - Framework constrains automatic stabilizers but aids credibility of medium-term goal; implies lower volatility in annual real spending (¶58).
  - Concern: ceiling on nominal spending might be susceptible to pressures to raise ceilings if inflation outturn is higher than expected (¶58).

### Monetary policy stance and considerations
- Inflation targeting (IT) framework remained appropriate (¶27, 65 & 66).
- Reserve accumulation:
  - Described as prudent according to a variety of metrics and secured without market disturbance (¶27, 65 & 66).
  - Further reserve accumulation seemed warranted due to buoyant market conditions, strength of the Shekel, and desire to build resilience to shocks (¶27, 65 & 66).
- Interest rate policy:
  - Sizeable interest rate cuts had been necessary to avoid undershooting the 2009 target and to strengthen the economy’s ability to cope with global crisis effects (¶61–62).
  - Case for further rate reductions would remain under review; reductions must be consistent with maintenance of market confidence (¶61–62).

### Key macroeconomic and financial indicators (selected exact figures from source tables)
- Real economy (selected):
  - Real GDP (2008): 4.3
  - Private consumption (2008): 4.6
  - Unemployment rate (percent, 2008): 6.0
  - Overall CPI (end period, 2008): 4.8
- Monetary and financial aggregates:
  - Bank of Israel policy rate (average, 2008): 2.5
  - Broad money (M3, period average, 2008): 5.3
- Public finances (percent of GDP, 2008):
  - Central government revenue: 30.0
  - Central government expenditure: 32.1
  - Central government balance: -2.1
  - General government balance: -2.8
  - General government debt: 77.6
- External sector and reserves:
  - Exports of goods and services (2008): 41.9
  - Current account (2008): 1.2
  - Foreign reserves (end period, 2008, billions of U.S. dollars): 36.3
  - Present exchange rate per U.S. dollar (January 26, 2009): 4.0
- Financial soundness indicators (selected, various years and June 2008 where noted):
  - Regulatory capital to risk-weighted assets (Deposit Takers, June): 11.6
  - Regulatory Tier 1 capital to risk-weighted assets (Deposit Takers, June): 7.8
  - Problem loans to total credit (Deposit Takers, June): 14.1
  - Nonperforming loans to total gross loans (Deposit Takers, June): 1.3
  - Return on assets (Deposit Takers, 2008): 0.7
  - Return on equity (Deposit Takers, 2008): 10.7
  - Household debt to GDP (2007): 39.5
- Balance of payments and projections (selected):
  - Current account balance (2008): 1.2 (percent of GDP, IMF staff estimate)
  - Gross external debt (memorandum): 31.1 (percent of GDP, projection for 2013 table)
  - GDP (billions of U.S. dollars, 2008): 253.2

### Central government accounts and budget framework (selected exact figures)
- Revenue (excluding repayment of credit):
  - 2007: 32.7 (percent of GDP)
  - 2008 staff projection: 30.0 (percent of GDP)
- Expenditure (excluding lending and expenditure by public hospitals):
  - 2007: 34.3 (percent of GDP)
  - 2008 staff projection: 32.1 (percent of GDP)
- Budget balance (percent of GDP):
  - 2007: -1.0
  - 2008 staff projection: -2.1
- Financing (percent of GDP, selected):
  - Domestic (net) 2007: -0.7
  - Foreign (net) 2007: -0.3
- Memorandum: GDP growth (staff projection for 2008): 3.4

### Financial sector reform: diversification and credit risks (Attachment I)
- Reform drivers and timing:
  - Comprehensive transformation accelerated in 2005 with legislative, regulatory, and tax changes; led to rapid diversification toward non-bank financial institutions and expanded financial products and providers.
- Bachar Legislation (implemented July 2005) objectives and effects:
  - Increase competition and reduce concentration: banks required to sell holdings of mutual funds and provident funds.
  - Reduce conflicts of interest: separation between advice on financial assets and their marketing; changes in rules for employment in financial consultancy and marketing.
  - Increase foreign participation: encouraged foreign-owned firms to acquire stakes in fund management businesses sold by banks; government bond market reforms allowed entry of foreign-owned banks in capital markets.
- Accompanying reforms (2005–06):
  - Tax changes: removal of tax provisions favoring domestic investment for private and institutional investors to encourage foreign investment.
  - Strengthened investor choice and rights: revisions to long-term savings regulations beginning in 2006 to ease mobility of savings between provident funds and insurance plans; April 2005 requirement for institutional investors to provide more accurate fair value assessment of investor rights.
  - Improved supervision of institutional investors: initiation of supervision of provident funds activities and expansion of regulatory coverage of insurance companies.

*Source: _cr0957 - 70.      Given the deteriorating outlook and associated declines in inflationary pressure, the*

### 4.      The authorities have continued to consolidate the reforms with the goal of

### _cr0957 - 4.      The authorities have continued to consolidate the reforms with the goal of

### Financial market reforms and infrastructure
- Market-making and trading infrastructure:
  - Market makers introduced in the trading of government bonds in 2006.
  - Repo auctions introduced by the Bank of Israel at end-2007.
  - Repo trading in the Tel Aviv Stock Exchange expected to start by the end of 2009 Q1.
  - RTGS system for settling intraday payments introduced in June 2007.
- Regulatory changes:
  - New underwriting law implemented in July 2007 allowing allocation of securities at the underwriter’s discretion without an auction.

### Mobilizing long-term savings
- Coverage and regulatory uniformity:
  - In December 2007, pension benefit coverage expanded to employees without occupational pension plans.
  - Effective 2008, regulatory coverage changes subjected a wide range of institutional investors to a uniform regulatory directive, equalizing terms of savings on all forms of long-term savings, both domestic and foreign.
  - Changes enabled banks to engage in pension advice and allowed a wide range of institutional investors to offer a basket of alternative products.

### Outcomes: structural shift in the financial sector
- Shift toward non-bank institutions and non-bank credit:
  - By 2007, private long-term saving industry separate from the banking system emerged.
  - Share of bank deposits to the public’s total assets declined from 46 percent at end-2002 to 30 percent at end-2007.
  - Control of banks over long term saving declined from 52 percent in 2003 to 11 percent at end-2007.
- Non-bank credit and corporate bond issuance:
  - By end 2007, non-bank financial institutions provided nearly 50 percent of the business sector’s outstanding credit, and most of new credit in 2007.
  - Corporate bonds issuance reached about NIS 80 billion in 2007.
  - Most of the bonds issued during 2003–08 were by real-estate companies (32 percent) and holding companies (21 percent).

### Market stress since early 2008 and credit developments
- Market stress and investor withdrawals:
  - Bond prices declined significantly, particularly since September of 2008.
  - Withdrawals from provident funds amounted to about NIS 5 billion in 2008.
  - Surge in yields on corporate bonds especially pronounced in the real estate sector (companies with investments abroad).
  - Concerns that some bonds had been systematically over-valued and that investors, notably provident funds, were substantially exposed.
- Credit flows and bond issuance:
  - Overall credit—from banks and non-banks consolidated—declined since September 2008, while bank credit continued to expand at a normal rate.
  - Bank credit to the private sector expanded at an annual rate of about 10 percent.
  - Issuance of new bonds declined in the first half of 2008 compared with 2007 and stopped altogether from September 2008.
- Bond amortization pressures in 2009:
  - In 2009, bond repayments and interest will amount to almost NIS 25 billion.
  - About NIS 3 billion of this is by real estate companies—many of which were recently downgraded.

### Banks’ capacity to provide additional credit
- Capital and risk considerations:
  - Most banks’ capital ratios are still below the 12 percent ratio which the bank supervisor has encouraged them to achieve.
  - The slowdown in economic activity has raised credit risks and will raise non performing loans, reducing banks’ appetite for additional risks.
  - Banks’ diminished role in overall credit constrains their influence on overall credit availability.

### Policy response (anticipated effects during 2009) and supervisory measures
- General supervisory intensification:
  - Bank supervisors intensified monitoring of bank exposures, enhanced regulatory requirements, required additional public disclosure, and enhanced internal preparedness.
  - Monitoring intensified particularly in areas of large credit and sensitive exposures, provisioning for credit losses, exposures to foreign financial institutions, Nostro securities exposures, and liquidity positions.
  - Increased frequency of reporting and mapping of material exposures according to relevant risk parameters.
- Regulations and guidance issued by the bank supervisor:
  - Instructed banks to review their business strategy and risk management policies.
  - Improved reporting on exposure to foreign financial institutions and guidelines regarding effective control over foreign offices.
  - Guidelines regarding fair value evaluations, improved reporting on liquidity positions, additional disclosure on investments in complex instruments, enhanced risk disclosures in quarterly reports, and additional reporting on country risk.
  - Reviewed internal procedures for handling banks in difficulties and analyzed options to enhance financial stability (e.g., alternatives regarding capital injection, limiting capital distributions).
  - Enhanced overall coordination and information sharing between BoI, the MoF and the ISA.

### Israel Securities Authority (ISA) response
- Proposed regulatory infrastructure to ease refinancing of bond obligations in the capital market.
- Increased disclosure and transparency requirements, including reporting on cash sources, value of collateral, and exposure to the exchange rate, commodity prices and complex financial products.
- Increased supervision of rating agencies and auditors.

### Ministry of Finance (insurance, pension, and provident funds) response
- Increased monitoring of insurance companies’ exposures to structured financial instruments and investments abroad.
- Raised monitoring of institutions’ exposure to financial market instruments, liquidity and withdrawal risks.

### Box 1 — Policies to support capital and financial markets (summarized measures)
- Purchasing of corporate bonds:
  - Government’s overall investment up to NIS 5 billion, matched by about NIS 5-15 billion from institutional investors.
  - Each fund set for 7 years with an option to extend for an additional 3 years.
  - Government incentive: if at termination average real return is below 4 percent, government pays institutional investors 90 percent of the amount needed to raise their return to 4 percent as long as the amount is below the government revenues from the fund. If average real return is above 4 percent, government pays institutional investors half of its profits above 4 percent return.
- Increasing banks’ capital:
  - Government plans to provide guarantee of about NIS 6 billion for capital raised by banks.
- Safety net for long-term investors close to retirement:
  - Savers retiring within the next 10 years with less then NIS 1.5 million in retirement saving at the time of retirement can choose upon retirement whether to withdraw their retirement savings or receive an annuity according to the amount (up to NIS 750 thousands) they had at November 30, 2008.
- Guaranteeing credit to small- and medium-sized firms:
  - Government set up a fund of NIS 1.3 billion ─ NIS 260 million of public money and NIS 1 billion from three banks. Government extends a 70 percent guarantee on the loans.
- Reducing constraints on refinancing agreements with bondholders:
  - Trustees of bonds required in certain circumstances to convene a forum of bond holders; forum requires presence of the three biggest holders who can delegate representatives to negotiate with issuer; issuer allowed to withhold disclosure about the refinancing negotiation.

### Conclusion
- Reform achievements and unintended risk accumulation:
  - Financial market reform achieved the goal of developing the capital market and reducing banks’ share in providing credit and managing long term saving.
  - The pace of reform may have led to increased exposure to risks—more than the risks that, ex ante, savers might have appreciated.
  - The rapid rise in importance of non-bank credit means the collapse of this source of credit constitutes a significant blow to the economy—a clear instance of a “credit crunch.”

*Italic: IMF staff report content as provided in the source PDF.*

### 12.      Shocks to U.S. growth are found to stimulate both Israel’s private consumption

### 12.      Shocks to U.S. growth are found to stimulate both Israel’s private consumption

### Effects of U.S. growth shocks on Israel
- A 1 percentage point increase in U.S. quarterly growth implies a ¾ percentage point additional expansion in Israel’s private consumption in the second quarter.
- The same 1 percentage point increase implies a 1 percentage point rise in net trade’s growth contribution in the third quarter.
- Consumption shows little contemporaneous reaction to the shock, suggesting:
  - Rational anticipation of stronger net trade performance in the subsequent quarter could explain the second-quarter consumption increase.
  - Financial linkages and/or other sentiment effects are also likely important channels.
- Trade connection is one of multiple channels underlying U.S. spillovers to Israel.

### External vulnerability overview
- Despite sustained balanced growth, significant external vulnerabilities remain, amplified by the global financial turmoil.
- Non-bank financial sector has come under pressure.
- Public debt ratios remain elevated.
- Current market indicators:
  - The Shekel has mostly been on an appreciating trend vis-à-vis the dollar and other major currencies since early 2006, with recent depreciation against the dollar coinciding with significant reserves accumulation by the BoI.
  - The current account, seasonally adjusted, has remained in surplus through the third quarter of 2008, supported by continued positive net transfers and services exports, despite a deterioration of the goods trade balance.
  - Israel government CDS spreads are up, but the increase is much smaller than for many emerging European countries.
  - Israel’s sovereign credit ratings have not been significantly affected; one agency lowered the outlook from positive to stable.
  - The stock market is sharply down; the corporate bond market has fallen significantly.
  - Banks have appeared resilient but may not be willing to extend enough credit to offset corporate bond market shortfalls.

### Key exposures, external debt, and reserves
- Net International Investment Position:
  - At end-June 2008, it was about -4 percent of GDP, an improvement by more than 35 percentage points from the beginning of the decade.
- Total external gross debt:
  - Described as over 40 percent of GDP.
  - Mitigating factors noted: total external debt is less than the total holding of debt assets; private sector short-term debt assets are more than twice the size of its short-term debt; most banks’ external debt is short-term but more than matched by deposits abroad.
- Public external debt:
  - Fairly modest at about 15 percent of GDP; only a small portion matures in one year.
- Foreign exchange reserves of the BoI:
  - Described as quite large, corresponding to over 100 percent of short-term debt.
  - BoI announced intention in late March, 2008 to increase the level of foreign exchange reserves by $10 billion during a two year period to reach $35-40 billion.
  - Initially daily purchases were $25 million, later changed to $100 million.
  - On November 30, the bank announced the target level had been raised to $40-44 billion.

### Current account and public debt
- Current account:
  - No evidence of a fundamental imbalance; current account has been in surplus in recent years.
  - Real effective exchange rate estimated to be close to its equilibrium.
  - Positive net transfers constitute a cushion, though a drop in contributions from Jewish communities abroad may be expected due to the global financial crises.
- Overall government debt:
  - Around 80 percent of GDP, posing a vulnerability.
  - High public debt restricts countercyclical fiscal policy during downturns or crises and raises borrowing costs.
  - A significant part of near-term financing needs have already been secured, including via swap auctions.
- Sources of public external financing:
  - Almost half of all public external debt is guaranteed by the U.S. government.
  - Another third is State of Israel Bonds, historically a reliable financing source.

### Banks and other financial institutions
- Direct exposures of the banking system to the global financial crises reportedly small.
- Foreign currency credits accounted for 14 percent of bank credit to the public as of end-June 2008 (including foreign exchange indexed loans).
- Banks and other financial institutions are exposed via lending to Israeli corporations active abroad; export and investment abroad face significant challenges amid a severe global downturn.
- Corporate bond market weakness (problems abroad for some bond issuers and negative global sentiment) has sharply reduced corporate bond issuance and availability of credit for the business sector.
- Risk that bank credit will be similarly tight and unable to replace corporate bond financing in the near future.

### Policy credibility, financing, and lessons from past stress
- Macroeconomic policy credibility:
  - Strong track record dampens Israel’s sensitivity to external shocks and enhances policy flexibility.
  - Sovereign credit ratings are on a long-term upward trend and have held up during past downturns and exogenous shocks.
  - Yield spreads on government bonds (not guaranteed by the U.S.) have tended to be relatively stable around 1 percentage point; the increase during the last 1½ years has been less than in many emerging market economies.
  - Exchange rate has been strong and stable; inflation and inflation expectations have been contained and steady.
- Lessons from past economic stress:
  - Two notable periods of stress in the last 30 years show that appropriate policy responses are crucial, both when fundamental imbalances exist (early–mid 1980s) and when difficulties arise from a stronger starting point (early 2000s).
  - Good coordination of fiscal and monetary policies is crucial—misaligned expansionary fiscal and monetary stances can lead to loss of credibility and pressure on the exchange rate and financial stability (example: first half of 2002).
  - High and increasing public debt constrained policy options in both past stress periods; restoring confidence required policy adjustments and U.S. support (aid or debt guarantees) was also key.

*Source: IMF staff estimates and analysis in the cited chapter.*

### 20.      Israel’s external vulnerabilities and the continuation of the global economic

### Israel’s external vulnerabilities and the continuation of the global economic crises present major policy challenges.

### Major policy challenges
- How can fiscal policy flexibility and credibility be balanced?
  - In an economic downturn, a countercyclical policy stance is appropriate and there may be a need for extraordinary measures, e.g. to support the financial sector.
  - Fiscal policies must be credible in containing public debt over the medium-term.
- How large should foreign exchange reserves be – and when should they be used?
  - Sizeable foreign exchange reserves can instill confidence in the exchange rate market and provide liquidity for external financial transactions.
  - There are opportunity costs for holding and accumulating reserves, and they must be used appropriately.
- Should financial sector stress be addressed preemptively, or should the government resist intervention and then manage the consequences?
  - Government interventions are costly and likely to distort incentives.
  - In the absence of intervention the consequences of a financial crisis can be overwhelming.
- What is the right monetary policy stance?
  - Policy coordination is critical; monetary policy must be calibrated to be consistent with fiscal and financial sector policies, challenging in the current uncertain economic and political environment.

### Fiscal sustainability — baseline scenario and projections
- Baseline assumptions:
  - Adherence to the 1.7 percent ceiling on real expenditure growth.
  - Primary balance projected to continue strengthening.
- Projected outcomes under baseline:
  - Gross financing need drops from 13¾ percent of GDP in 2010 to 8¾ percent in 2013.
  - Public debt reduced to 74 percent of GDP in 2013.

### External risks and scenario impacts
- Risk aversion / global financial dislocation:
  - Permanent ½ standard-deviation shock to the interest rate (a 1.4 percentage point increase from the baseline) would bring public debt to 80 percent of GDP in 2013.
  - One-time 30 percent depreciation in the REER (in 2009) would immediately increase public debt to 92¾ percent of GDP upon impact; public debt would be 86 percent of GDP in 2013 under subsequent baseline-like reduction.
- Costly interventions from domestic financial stress:
  - One-time 10 percent of GDP shock to contingent liabilities (in 2009) would increase public debt to 91 percent of GDP; assuming baseline speed of debt reduction thereafter, public debt would be 85 percent of GDP in 2013.

### Domestic risks and scenario impacts
- Fiscal indiscipline:
  - A ½ standard deviation shock to the primary balance—lowering average primary balance to 0.7 percent of GDP during the forecast period—would increase debt by 4 percentage points of GDP (to 78 percent) in 2013 relative to the baseline.
- Growth slowdown:
  - A ½ standard deviation shock to growth would bring average projected annual growth down to 1.5 percent; even with no fiscal loosening, public debt would rise to 93 percent of GDP in 2013 due to adverse debt dynamics.
- Combined more realistic adverse scenario:
  - One-quarter standard deviation shocks to growth, real interest rate, and primary balance (lowering average annual growth to 2½ percent, raising real interest rate to 5¼ percent, and reducing the primary balance to 1¼ percent of GDP) would bring public debt to 83 percent of GDP in 2013—an increase of 9 percentage points of GDP from the baseline.

### Public debt sensitivity and historical context
- Historical episode: 2001–03 downturn saw public debt balloon by 15 percentage points to 100 percent of GDP, illustrating vulnerability to growth shocks.
- Bound tests and scenarios summarized (public debt in percent of GDP):
  - Baseline: 74 percent of GDP in 2013.
  - Growth shock scenario: 93 percent of GDP in 2013.
  - Primary balance shock: 78 percent of GDP in 2013.
  - Interest rate shock (permanent ½ standard deviation): 80 percent of GDP in 2013.
  - One-time 30 percent real depreciation (2009 impact): 92¾ percent on impact, 86 percent in 2013.
  - One-time 10 percent of GDP contingent liabilities shock (2009 impact): 91 percent on impact, 85 percent in 2013.
  - Combined one-quarter standard deviation shocks: 83 percent of GDP in 2013.

### Policy implications and recommendations (as presented)
- Near-term:
  - Allow automatic stabilizers to operate fully.
  - Support credit flows (e.g., public-private funds to purchase corporate bonds, guarantees for SME credit), focusing on refinancing and new issues from solvent firms.
  - Prepare contingency plans for tail events and review legal procedures governing public interventions in banks.
- Medium-term:
  - Strengthen the medium-term fiscal framework anchored by a medium-term public debt goal and associated expenditure ceilings.
  - Balance flexibility and credibility: a debt objective over the medium term supported by rolling multi-year ceilings on nominal annual spending could be appropriate; some Directors also saw merit in an automatic error correction mechanism and caps on real expenditures.
- Monetary policy:
  - Recent decisive reductions in policy rates were appropriate given expected low inflation; there remains some room for further monetary easing.
  - Maintain close monitoring of key indicators to ensure timely response and market confidence.
  - Reinforce inflation targeting and flexible exchange rate frameworks with effective communication; strengthen Bank of Israel governance.
- Financial sector:
  - Carefully review legal frameworks for interventions; consider supervisory reform and an explicit deposit insurance scheme once crisis conditions ease.
  - Enhance information-sharing and cooperation among regulatory agencies; strengthen supervision of the rapidly growing nonbank financial sector.

*International Monetary Fund — Staff Report for the 2008 Article IV Consultation with Israel (Informational Annex), January 27, 2009.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2009/_cr0957.pdf_