## 1. Banking Structure and Vulnerabilities

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---

### Staff appraisal — summary findings
- Israel experienced a relatively mild downturn in the global crisis: output was projected to have been no worse than flat overall in 2009, with output up in both Q2 and Q3 2009.
- Financial markets fell sharply in late 2008, but there was no local market meltdown; Israel acquired safe-haven status in early 2008 with sharp increases in net capital inflows and real exchange rate appreciation despite sustained foreign reserve accumulation.
- The Bank of Israel (BoI) was the first central bank globally to raise policy rates for over a year in September 2009.
- Key macro vulnerabilities identified:
  - Unemployment has edged up to some "8 percent".
  - The stock of bank credit to corporates has fallen through much of the year.
  - Inflation has been above target for much of the period.
  - Public debt is on an upward path, "heading towards 80 percent of GDP by end-2010."
  - External uncertainties: WEO central projection shows global growth of "3 percent in 2010" with 90 percent confidence margins ranging from "½ to 5½ percent"; corresponding range for projected growth in Israel in 2010 is "0 to 4 percent".
  - Medium-term potential growth likely to be lower by "some half a percentage point annually to 3–3½ percent".

### Why resilience occurred (drivers)
- Absence of prior housing or bank credit booms.
- High household savings rates.
- Investment goods and consumer durables are mostly imported (dampening the domestic investment contraction).
- Pre-crisis public debt reduction and structural reforms.
- Timely policy responses in 2008–09:
  - Decisive relaxation of monetary stance including "unconventional" measures.
  - Accommodation of automatic stabilizers in 2009 and adoption of a two year budget for "2009–10".
  - Focused measures to stabilize credit flows.

### Remaining weaknesses and risks
- Despite resilience, several components remain weak: exports, imports, and fixed investment are far from fully recovered.
- High public debt represents an enduring vulnerability; global increases in public deficits and debt aggravate this concern.
- In periods of international market stress, financing costs for high debt countries like Israel tend to rise sharply.
- The likely decline in potential output and loss of prior windfall fiscal revenues increase difficulty of reducing public debt.

### Policy recommendations — fiscal
- Core advice: strengthen policy frameworks to anchor long-run expectations and reinforce policy credibility; implications for fiscal, monetary, and financial stability areas.
- Reconcile aggregate spending caps with commitments on component parts to preserve credibility of fiscal rules.
- Review fiscal rules by Spring 2010 when outturns and global prospects are clearer.
- Move from deficit ceilings to a medium-term anchor targeted on public debt if central or upside global scenarios are realized:
  - Target of "60 percent of GDP by 2020", anticipating further reductions thereafter.
  - Interim ceiling of "70 percent of GDP by the middle of the coming decade".
  - Annual publication of three year ahead fiscal projections showing consistency with debt objectives.
  - Make debt objectives formally contingent on strength of global supply over the medium-term.
  - Policies should target debt ratios below these ceilings in "central case" scenarios to anticipate uncertainties.
- If downside global scenarios appear more likely in Spring 2010:
  - The same overall framework is appropriate but execution and parameters may be adjusted.
  - If investor demand for Israeli public debt remains resilient, full accommodation of fiscal stabilizers is appropriate even if that breaches 2010 and 2011 deficit ceilings.
  - If financing conditions prove challenging, a more ambitious consolidation path than in the upside scenario may be unavoidable.
- Public spending limits and tax policy:
  - Accompany a debt objective with ceilings on expenditures over the medium term, expressed as a cap on nominal spending rather than on real expenditure growth.
  - Adopt rolling three year ahead ceilings on nominal spending, abolish the automatic correction mechanism for inflation surprises, and strengthen medium-term planning procedures.
  - Tax reductions should follow demonstrated debt reductions consistent with the debt target and interim ceiling; precommitments to tax cuts that assume spending compression pose risks to debt reduction credibility.
- Immediate fiscal coordination:
  - Reconcile spending caps with component commitments as an immediate step.
- Specific numeric references:
  - Deficit close to "5 percent of GDP in 2009".
  - Achieving the interim objective implies a phased strengthening of the structural fiscal balance by "2¾ percentage points of GDP between 2009 and mid-2010" relative to the path implicit in current deficit ceilings.

### Policy recommendations — monetary and exchange rate
- Monetary policy actions taken were appropriate given the environment:
  - Headline inflation near the top end of the target band; no serious imminent deflation risks.
  - Policy rate hikes of "25bp each for September and December 2009 and again for January 2010" provide a measured anti-inflation signal.
- Exit from unconventional monetary measures (notably foreign exchange intervention) should be phased as policy rates rise above their effective floor.
- Shift from preprogrammed to discretionary FX intervention is an appropriate transitional step toward a free float, but:
  - Discretionary intervention could compromise clarity of BoI objectives if prolonged; discretionary intervention should be formally terminated when the policy rate is well above its effective floor on a sustained basis to restore a free floating regime.
- If capital inflows surge, discretionary intervention should not be the main policy response; consider:
  - Raising reserve requirements.
  - Strengthening consumer protection rules.
  - Achieving a stronger than currently planned budget balance.
- Capital controls and taxes on inflows are inadvisable alternatives.
- BoI and reserves actions (preserved figures):
  - BoI announced intention to systematically raise foreign exchange reserves by some "$10 billion over two years via preannounced daily purchases to $35–40 billion (later revised to $40–44 billion)".
  - Reserves rose to just above "$60 billion in November 2009".
  - BoI lowered interest rates sharply towards zero from "4¼ percent" during the crisis, then raised interest rates three times by "25bp each (September, December 2009, and January 2010) to 1.25 percent."

### Policy recommendations — financial sector supervision and prudential framework
- Banks proved resilient with limited support measures, due to:
  - Proactive supervision and conservative business practices.
  - Limited exposure to structured instruments.
  - Largely deposit-funded banking system backed by a strong comprehensive implicit government guarantee.
- Risk-weighted capital ratios and strong raw capital represent an adequate standard for bank capitalization in Israel; this should inform Basel II implementation.
- Recommended steps to strengthen prudential framework (actions in process and proposed):
  - Establishment of a financial stability unit within the BoI.
  - Adoption of the proposed draft BoI Law to strengthen BoI independence, create a monetary policy committee, and separate management committee.
  - Hodak committee and regulators’ proposals to strengthen due diligence practices, bond structures, remuneration arrangements, and investment portfolio guidelines.
  - Consider raising reserve requirements and strengthening consumer protection as tools if capital inflows surge.
- Caution to the public sector and wage policy:
  - Avoid early commitments to sizeable permanent remuneration increases; public sector wage settlements due in 2010 should be tightly restrained to signal wage moderation, keep inflation and interest rates low, and support continued good performance.
- Capital standards noted:
  - Risk-weighted capital ratios have risen to "over 12 percent".
  - Tier 1 capital has risen to "over 8 percent".
  - Adherence to the 12 percent risk-weighted standard—and the associated tier 1 ratio of "7 percent" and raw capital ratios of "5-7 percent"—proved effective.

### Macro-prudential upgrade and non-bank sector recommendations
- A significant upgrade of macro-prudential and financial stability analysis is needed.
- Priorities and recommended actions for the Bank of Israel (BoI):
  - Conduct comprehensive banking stress tests to provide regulators and banks with a better understanding of risks.
  - Stress test scenarios could include the lower bounds of staff’s 90 percent confidence intervals for the global and the associated Israeli projections.
  - Begin publication of a financial stability report, preferably semi-annually, with consideration to include stress test results.
  - Over the longer term, work with other regulators to broaden analysis to cover the entire financial system and its macroeconomic linkages.
  - Consider the introduction of an explicit deposit insurance scheme to provide additional options to deal with the resolution of non systemic banks.
  - Reinforce supervision of non-banks given their difficulties.
- Assessment of non-bank sector vulnerabilities and current initiatives:
  - Asset valuations have recovered significantly from mid-crisis troughs, reflecting global stabilization and Israel’s resilience.
  - Earlier asset price declines, closure of the corporate bond market, and fall of several insurance companies’ solvency ratios to below regulatory floors underscore vulnerability of non-bank financial institutions and related markets.
  - Various steps are underway to address difficulties, including the Hodak committee proposals and initiatives by the Israeli Securities Authority (ISA).
- Governance, autonomy, transparency, and moral hazard concerns for non-bank regulators:
  - The ISA should be given full operational independence.
  - The Capital Markets, Insurance and Savings Division (CMISD) of the Ministry of Finance should be given formal autonomy, in line with international best practice.
  - Changes should maintain full flow of information to other supervisors and to monetary and fiscal authorities; coordination of strategic priorities among regulators should be reinforced.
  - CMISD and ISA should significantly strengthen transparency through publication of timely analysis of developments, issues, and risks.
  - An assessment should be made whether emergency support measures for the nonbank sector have given rise to moral hazard; if so, reflect this in supervisory guidelines.

### Fiscal credibility and fiscal rules
- Adjustments to fiscal rules, however well motivated and timed, raise credibility issues. The increase in spending growth in 2009 is described as “temporary” (for 2009 only, with “corrections” to follow) and the deficit ceilings anticipate early consolidation, but the interrelated credibility of both sets of ceilings remains to be established.
- Concerns with the authorities’ approach:
  - The sum of detailed spending pledges in entitlement legislation and ministries’ medium-term plans remain well in excess (by a cumulative "2 to 3 percentage points of annual GDP by 2014") of the announced ceilings on the real growth of aggregate spending.
  - Lack of a formal medium-term fiscal anchor increases uncertainty about how conflicting expenditure commitments will be reconciled; if resolved at the expense of public debt, vulnerabilities will remain.
  - The implicit path in the deficit ceilings will deliver a debt ratio by 2015 of some "73 percent of GDP", putting a "60 percent of GDP" debt objective well beyond 2020.
- Box comparison — deficit and real spending growth caps vs. debt and nominal spending ceilings:
  - Advantages of a debt rule over a deficit cap include establishing debt reduction as the formal goal and minimizing false signals across the business cycle.
  - Advantages of rolling three year annual nominal spending caps over a real growth cap include countercyclicality, transparency, and practicality.
  - Design caveats include the need for an interim ceiling of "70 percent" if the headline goal is "60 percent of GDP by 2020", full annual three year ahead projections, and an exit clause if medium-term global supply deviates significantly.
- Specific budget table excerpts (selected rows preserved exactly as in source Text Table 2):
  - Deficit –Percent of GDP, New rule: 2009 "6"; 2010 "5½"; 2011 "3"; 2012 "2"; 2013 "1½"; 2014 "1".
  - Real expenditure growth, New rule: 2009 "3.0"; 2010 "1.7"; 2011 "0.4"; 2012 "1.7"; 2013 "1.7"; 2014 "1.7".
  - Top marginal income tax rates (Personal): 2009 "46"; 2010 "45"; 2011 "45"; 2012 "44"; 2013 "43"; 2014 "42".
  - Top marginal income tax rates (Corporate): 2009 "26"; 2010 "25"; 2011 "24"; 2012 "23"; 2013 "22"; 2014 "21".
  - Projected GDP growth: 2009 "0.1"; 2010 "2.5"; 2011 "4.0"; 2012 "4.1"; 2013 "3.9"; 2014 "3.8".

### Banking system concentration, culture, and crisis response
- Concentration and structure:
  - The top two banks account for nearly "60 percent" of banking system assets, and the top accounting for "95 percent".
  - By end-2007, assets of non-bank financial institutions amounted to around "110 percent of GDP" compared with banking system assets of around "140 percent of GDP".
  - There is no formal system of deposit insurance; an effective policy of treating almost all banks as too important to fail has led to very close supervision by the BoI.
- Conservative culture and supervisory intensity:
  - Conservative funding, lending, and supervision practices helped limit exposures and keep NPLs low.
  - Loan-to-deposit ratio at end-2007 was under "90 percent".
  - Banking supervision, including quantitative lending restrictions, helped avoid a property price bubble.
  - The 2005 Bachar reforms obliged banks to withdraw from long-term savings, pension and insurance activities, limiting exposure to non-bank sector risks.
- Crisis impacts and measures:
  - Tel-Aviv Stock Exchange capitalization fell "45 percent" from end-2007 to end-2008.
  - Prices of non-government bonds fell "14 percent" over the same period.
  - Real outstanding credit to Israeli firms from domestic non-banks, foreign creditors and households fell "5 percent in 2008" and remained flat in 2009.
  - Public interventions and support measures included:
    - "Manof" funds and guarantees to support corporate issues.
    - Guarantee for bank Tier II issuance initially "NIS 6 billion", later doubled to "NIS 12 billion".
    - Credit guarantees to SMEs expanded from "NIS 1.3 billion" to "NIS 2.6 billion" with a 70 percent guarantee; "NIS 0.7 billion" disbursed to date.

### Stress tests, accounting, deposit insurance, and supervisory capacity
- Upgrade and transparency:
  - Priorities for BoI: comprehensive banking stress tests; scenarios could include the lower bounds of staff’s 90 percent confidence intervals for global and Israeli projections.
  - BoI should begin publication of a financial stability report, preferably semi-annually, and consider including stress test results.
- Accounting and Basel II:
  - Work on moving from GAAP to IFRS accounting standards is underway and will provide increased transparency and international comparability.
  - Implementation of Basel II, using the standard approach, is in progress, with emphasis on Pillar II.
- Deposit insurance and resolution:
  - Further consideration should be given to introduction of an explicit deposit insurance scheme.
  - Any scheme would need to reflect that some banks are too large to be covered in a pre-funded or pooled insurance framework; special arrangements would be required for large, systemic institutions.
- Supervisory capacity:
  - The global financial difficulties have highlighted the importance of adequately qualified, resourced, and motivated supervisors.
  - High turnover reflects ongoing challenges; resource needs for accounting/Basel II reforms must be balanced against intensified supervision needs.

### Projections, scenarios, and key macro statistics
- Staff central case projections (selected series in percent):
  - Global GDP growth: 2007 "5.2"; 2008 "3.0"; 2009 "-1.1"; 2010 "3.1"; 2011 "4.2".
  - Israel GDP growth: 2007 "5.2"; 2008 "4.0"; 2009 "0.1"; 2010 "2.5"; 2011 "4.0".
  - CPI (period average): 2007 "0.5"; 2008 "4.6"; 2009 "3.6"; 2010 "2.3"; 2011 "1.8".
  - Central Government budget balance (percent of GDP): 2007 "0"; 2008 "-2.2"; 2009 "-5.1"; 2010 "-4.1"; 2011 "-3.4".
  - Current account (percent of GDP): 2007 "2.8"; 2008 "1.1"; 2009 "3.3"; 2010 "2.0"; 2011 "1.8".
- Public debt sustainability (figure highlights):
  - Baseline public debt averages: "Baseline 76"; Historical average: "Historical 72".
  - Individual scenario averages: "Growth shock 90", "PB shock 80", "Interest rate shock 80".
  - Combined shocks: "Combined shock 83".
  - Contingent liabilities and real depreciation scenario boxes show "88" and "86".
  - Baseline primary balance: "Baseline:1.5" (percent of GDP).
  - Baseline gross financing need: "Baseline:3.7"; scenario gross financing need: "Scenario:2.2"; historical gross financing need: "Historical:3.8".
- Selected national accounts and fiscal indicators (Table highlights):
  - Real GDP series: "Real GDP 1.5 5.0 5.1 5.3 5.2 4.0 0.1 2.5".
  - Unemployment rate series: "10.8 10.4 9.0 8.4 7.3 6.2 7.8 7.4".
  - Foreign reserves (end period, billions of U.S. dollars): "26.4 27.2 28.3 29.4 28.8 42.7 60.0 59.8".
  - General government debt series: "99.0 97.4 93.5 84.4 78.1 76.8 79.9 80.9".
  - Present rate per U.S. dollar (December 16, 2009): "3.8".

### Empirical findings on market stress and high-debt vulnerability
- Main empirical finding:
  - High-debt countries were particularly vulnerable when the market was stressed: the impact of market volatility on bond yields was greater for high-debt countries.
- Regression and robustness highlights (selected coefficients preserved):
  - Mid 2007 – Nov 2009: VIX * Debt: coeff "0.05" t value "2.79***".
  - Hi_VIX * VIX * Debt: coeff "0.025" t value "2.83***".
  - Hi_VIX * VIX * Hi_debt: coeff "0.014" t value "2.30**".
  - Quantitative illustration: two hypothetical countries with debt-to-GDP ratios "80 percent" and "60 percent" show yield differential reaches as high as "50 bps" at peak stress.
- Implications for Israel:
  - At the market stress peak in late October 2008, Israel’s bond yields were close to "100 bps" above predicted values from the panel regression.
  - As global conditions stabilized by mid-November 2009, Israel’s bond yields declined to around "100 bps" below predicted values.
  - Israel’s susceptibility to global financial conditions may be above what is typical for similarly indebted countries.

### Key recommendations and priorities (summary)
- Strengthen fiscal framework with an explicit medium-term debt anchor (staff recommends target of "60 percent of GDP by 2020" and interim ceiling "70 percent of GDP by the middle of the coming decade"), rolling three-year nominal spending ceilings, and annual medium-term projections.
- Phase exit from unconventional monetary measures; formally terminate discretionary FX intervention once policy rate is well above its effective floor, except in exceptional circumstances.
- Upgrade macro-prudential analysis: comprehensive stress testing, semi-annual financial stability reporting, and broadened system-wide macro-financial analysis.
- Strengthen non-bank regulation: increase autonomy, staffing, transparency of ISA and CMISD; assess moral hazard from emergency measures.
- Consider introduction of an explicit deposit insurance scheme with special arrangements for very large systemic banks.
- Restrain public sector wage settlements in 2010 to support inflation and interest rate objectives and to signal fiscal discipline.

*Source: IMF staff report — "1. Banking Structure and Vulnerabilities" section (content unit _cr1023).*

### 1. Banking Structure and Vulnerabilities .........................................................................11

### 1. Banking Structure and Vulnerabilities

### Staff appraisal — summary findings
- Israel experienced a relatively mild downturn in the global crisis: output was projected to have been no worse than flat overall in 2009, with output up in both Q2 and Q3 2009.
- Financial markets fell sharply in late 2008, but there was no local market meltdown; Israel acquired safe-haven status in early 2008 with sharp increases in net capital inflows and real exchange rate appreciation despite sustained foreign reserve accumulation.
- The Bank of Israel (BoI) was the first central bank globally to raise policy rates for over a year in September 2009.
- Key macro vulnerabilities identified:
  - Unemployment has edged up to some 8 percent.
  - The stock of bank credit to corporates has fallen through much of the year.
  - Inflation has been above target for much of the period.
  - Public debt is on an upward path, "heading towards 80 percent of GDP by end-2010."
  - External uncertainties: WEO central projection shows global growth of 3 percent in 2010 with 90 percent confidence margins ranging from ½ to 5½ percent; corresponding range for projected growth in Israel in 2010 is 0 to 4 percent.
  - Medium-term potential growth likely to be lower by some half a percentage point annually to 3–3½ percent.

### Why resilience occurred (drivers)
- Absence of prior housing or bank credit booms.
- High household savings rates.
- Investment goods and consumer durables are mostly imported (dampening the domestic investment contraction).
- Pre-crisis public debt reduction and structural reforms.
- Timely policy responses in 2008–09:
  - Decisive relaxation of monetary stance including "unconventional" measures.
  - Accommodation of automatic stabilizers in 2009 and adoption of a two year budget for 2009–10.
  - Focused measures to stabilize credit flows.

### Remaining weaknesses and risks
- Despite resilience, several components remain weak: exports, imports, and fixed investment are far from fully recovered.
- High public debt represents an enduring vulnerability; global increases in public deficits and debt aggravate this concern.
- In periods of international market stress, financing costs for high debt countries like Israel tend to rise sharply.
- The likely decline in potential output and loss of prior windfall fiscal revenues increase difficulty of reducing public debt.

### Policy recommendations — fiscal
- Core advice: strengthen policy frameworks to anchor long-run expectations and reinforce policy credibility; implications for fiscal, monetary, and financial stability areas.
- Reconcile aggregate spending caps with commitments on component parts to preserve credibility of fiscal rules.
- Review fiscal rules by Spring 2010 when outturns and global prospects are clearer.
- Move from deficit ceilings to a medium-term anchor targeted on public debt if central or upside global scenarios are realized:
  - Target of 60 percent of GDP by 2020, anticipating further reductions thereafter.
  - Interim ceiling of 70 percent of GDP by the middle of the coming decade.
  - Annual publication of three year ahead fiscal projections showing consistency with debt objectives.
  - Make debt objectives formally contingent on strength of global supply over the medium-term.
  - Policies should target debt ratios below these ceilings in "central case" scenarios to anticipate uncertainties.
- If downside global scenarios appear more likely in Spring 2010:
  - The same overall framework is appropriate but execution and parameters may be adjusted.
  - If investor demand for Israeli public debt remains resilient, full accommodation of fiscal stabilizers is appropriate even if that breaches 2010 and 2011 deficit ceilings.
  - If financing conditions prove challenging, a more ambitious consolidation path than in the upside scenario may be unavoidable.
- Public spending limits and tax policy:
  - Accompany a debt objective with ceilings on expenditures over the medium term, expressed as a cap on nominal spending rather than on real expenditure growth.
  - Adopt rolling three year ahead ceilings on nominal spending, abolish the automatic correction mechanism for inflation surprises, and strengthen medium-term planning procedures.
  - Tax reductions should follow demonstrated debt reductions consistent with the debt target and interim ceiling; precommitments to tax cuts that assume spending compression pose risks to debt reduction credibility.
- Immediate fiscal coordination:
  - Reconcile spending caps with component commitments as an immediate step.

### Policy recommendations — monetary and exchange rate
- Monetary policy actions taken were appropriate given the environment:
  - Headline inflation near the top end of the target band; no serious imminent deflation risks.
  - Policy rate hikes of 25bp each for September and December 2009 and again for January 2010 provide a measured anti-inflation signal.
- Exit from unconventional monetary measures (notably foreign exchange intervention) should be phased as policy rates rise above their effective floor.
- Shift from preprogrammed to discretionary FX intervention is an appropriate transitional step toward a free float, but:
  - Discretionary intervention could compromise clarity of BoI objectives if prolonged; discretionary intervention should be formally terminated when the policy rate is well above its effective floor on a sustained basis to restore a free floating regime.
- If capital inflows surge, discretionary intervention should not be the main policy response; consider:
  - Raising reserve requirements.
  - Strengthening consumer protection rules.
  - Achieving a stronger than currently planned budget balance.
- Capital controls and taxes on inflows are inadvisable alternatives.

### Policy recommendations — financial sector supervision and prudential framework
- Banks proved resilient with limited support measures, due to:
  - Proactive supervision and conservative business practices.
  - Limited exposure to structured instruments.
  - Largely deposit-funded banking system backed by a strong comprehensive implicit government guarantee.
- Risk-weighted capital ratios and strong raw capital represent an adequate standard for bank capitalization in Israel; this should inform Basel II implementation.
- Recommended steps to strengthen prudential framework (actions in process and proposed):
  - Establishment of a financial stability unit within the BoI.
  - Adoption of the proposed draft BoI Law to strengthen BoI independence, create a monetary policy committee, and separate management committee.
  - Hodak committee and regulators’ proposals to strengthen due diligence practices, bond structures, remuneration arrangements, and investment portfolio guidelines.
  - Consider raising reserve requirements and strengthening consumer protection as tools if capital inflows surge.
- Caution to the public sector and wage policy:
  - Avoid early commitments to sizeable permanent remuneration increases; public sector wage settlements due in 2010 should be tightly restrained to signal wage moderation, keep inflation and interest rates low, and support continued good performance.

### Specific numeric and programmatic references (preserved)
- Unemployment: "some 8 percent".
- Deficit close to "5 percent of GDP in 2009".
- Public debt "heading towards 80 percent of GDP by end-2010".
- WEO central projection: global growth of "3 percent in 2010" with 90 percent confidence margins ranging from "½ to 5½ percent".
- Projected growth in Israel in 2010: "0 to 4 percent".
- Medium-term potential growth lowered by "some half a percentage point annually to 3–3½ percent".
- Policy rate hikes: "25bp each for September and December 2009 and again for January 2010".
- Fiscal anchors proposed: "60 percent of GDP by 2020" with interim ceiling "70 percent of GDP by the middle of the coming decade".
- Two year budget for "2009–10" adopted; BoI Law proposed.

*Source: IMF staff report — "1. Banking Structure and Vulnerabilities" section.*

### 24.      A significant upgrade of macro-prudential and financial stability analysis is needed.

### 24.      A significant upgrade of macro-prudential and financial stability analysis is needed.

### Priorities and recommended actions for the Bank of Israel (BoI)
- Conduct comprehensive banking stress tests to provide regulators and banks with a better understanding of risks.
- Stress test scenarios could include the lower bounds of staff’s 90 percent confidence intervals for the global and the associated Israeli projections.
- Begin publication of a financial stability report, preferably semi-annually, with consideration to include stress test results.
- Over the longer term, work with other regulators to broaden analysis to cover the entire financial system and its macroeconomic linkages.
- Consider the introduction of an explicit deposit insurance scheme to provide additional options to deal with the resolution of non systemic banks.
- Reinforce supervision of non-banks given their difficulties.

### Assessment of non-bank sector vulnerabilities and current initiatives
- Asset valuations have recovered significantly from mid-crisis troughs, reflecting global stabilization and Israel’s resilience.
- However, the earlier asset price declines, closure of the corporate bond market, and the fall of several insurance companies’ solvency ratios to below regulatory floors underscore vulnerability of non-bank financial institutions and related markets.
- Various steps are underway to address difficulties, including the Hodak committee proposals and initiatives by the Israeli Securities Authority (ISA).

### Governance, autonomy, transparency, and moral hazard concerns for non-bank regulators
- A more fundamental strengthening of the budget, staffing, and autonomy of non-bank regulators is appropriate:
  - The ISA should be given full operational independence.
  - The Capital Markets, Insurance and Savings Division (CMISD) of the Ministry of Finance should be given formal autonomy, in line with international best practice.
- Such changes should maintain the full flow of information to other supervisors and to monetary and fiscal authorities; coordination of strategic priorities among regulators should be reinforced.
- CMISD and ISA should significantly strengthen transparency, going well beyond provision of data, through publication of timely analysis of developments, issues, and risks.
- An assessment should be made whether emergency support measures for the nonbank sector—even though relatively well targeted—have given rise to moral hazard; if so, this should be reflected in supervisory guidelines to be adopted.

### Institutional and consultative recommendation
- Staff recommends that Israel should remain on the standard 12–month consultation cycle.

### Key supporting facts and statistics from the text
- Banking sector capital and performance:
  - Risk-weighted capital ratios have risen to over 12 percent.
  - Tier 1 capital has risen to over 8 percent.
- Reserve accumulation and BoI actions:
  - The BoI announced intention to systematically raise foreign exchange reserves by some $10 billion over two years via preannounced daily purchases to $35–40 billion (later revised to $40–44 billion).
  - Reserves rose to just above $60 billion in November 2009.
  - The BoI lowered interest rates sharply towards zero from 4¼ percent during the crisis, then raised interest rates three times by 25bp each (September, December 2009, and January 2010) to 1.25 percent.
- Fiscal and policy measures:
  - Central government budget deficit for 2008 reached 2¼ percent of GDP (from balance in 2007).
  - The budget anticipates a 3 percent increase in real spending for 2009 (relaxing the 1.7 percent ceiling stipulated by the fiscal rule).
  - VAT rate temporarily raised by 1 percentage point to 16½ percent, to be reversed at end-2010.
  - The deficit was officially expected to reach close to 5 percent of GDP in 2009 and to fall in 2010.
- Text Table 2—Budget ceilings and income tax reductions (selected rows reproduced exactly as in source):
  - Deficit –Percent of GDP, New rule: 2009 6; 2010 5½; 2011 3; 2012 2; 2013 1½; 2014 1.
  - Real expenditure growth, New rule: 2009 3.0; 2010 1.7; 2011 0.4; 2012 1.7; 2013 1.7; 2014 1.7.
  - Top marginal income tax rates (Personal): 2009 46; 2010 45; 2011 45; 2012 44; 2013 43; 2014 42.
  - Top marginal income tax rates (Corporate): 2009 26; 2010 25; 2011 24; 2012 23; 2013 22; 2014 21.
  - Projected GDP growth: 2009 0.1; 2010 2.5; 2011 4.0; 2012 4.1; 2013 3.9; 2014 3.8.
- Market and non-bank sector impacts:
  - From end-2007 to end-2008, the capitalization of the Tel Aviv Stock Exchange fell 45 percent.
  - Prices of non-government bonds fell 14 percent over the same period.
  - Real outstanding credit to Israeli firms from domestic non-banks, foreign creditors and households fell 5 percent in 2008 and remained flat in 2009.

*Source: _cr1023 - 24.      A significant upgrade of macro-prudential and financial stability analysis is needed.*

### 1.5 percent.

### _cr1023 - 1.5 percent.

### Fiscal credibility and fiscal rules
- Adjustments to fiscal rules, however well motivated and timed, inevitably raise issues of credibility. The increase in spending growth in 2009 is described as “temporary” (for 2009 only, with “corrections” to follow) and the deficit ceilings anticipate early consolidation, but the interrelated credibility of both sets of ceilings remains to be established.
- Concerns with the authorities’ approach:
  - The sum of detailed spending pledges in entitlement legislation and ministries’ medium-term plans remain well in excess (by a cumulative 2 to 3 percentage points of annual GDP by 2014) of the announced ceilings on the real growth of aggregate spending.
  - Lack of a formal medium-term fiscal anchor increases uncertainty about how conflicting expenditure commitments will be reconciled; if resolved at the expense of public debt, vulnerabilities will remain.
  - Continued use of a path for the headline budget balance as the fiscal rule may:
    - Unduly constrain leeway to accommodate automatic stabilizers if downside global macrofinancial risks materialize.
    - Falsely signal scope for fiscal relaxation if a temporary boom in output in 2010 drives deficits down well below target.
  - The implicit path in the deficit ceilings will deliver a debt ratio by 2015 of some 73 percent of GDP, putting a 60 percent of GDP debt objective well beyond 2020.
- Recommended sequencing and reforms:
  - Immediate focused review of medium-term spending commitments to resolve inconsistencies (possible given the two-year budget adopted in July).
  - Review fiscal rules by Spring 2010; consider replacing deficit ceilings with rules incorporating an explicit public debt target formally contingent on the strength of global supply over the medium term.
  - If staff central or upside projections materialize, formally define a target to secure public debt below 60 percent of GDP by 2020 and an interim ceiling of 70 percent of GDP by the middle of the coming decade.
  - Achieving the interim objective implies a phased strengthening of the structural fiscal balance by 2¾ percentage points of GDP between 2009 and mid-2010 relative to the path implicit in current deficit ceilings.
  - Adopt expenditure ceilings as a cap on nominal spending rather than on real expenditure growth; pursue annually updated medium-term fiscal projections and rolling three-year nominal spending ceilings.
  - In adverse near-term global scenarios, accommodate automatic stabilizers (even if this breaches 2010–11 deficit ceilings) if investor demand for Israeli public debt remains resilient; if financing conditions are challenging, implement a more ambitious fiscal consolidation than currently planned.

### Economic vulnerabilities and macro context
- By various indicators, Israel’s vulnerabilities are modest:
  - Property has not boomed; contribution of construction and the financial sectors to growth is relatively small; returns on corporate assets are only slightly on the low side; external debt is low.
- Among more advanced countries, Israel exhibits:
  - Inflation on the high side.
  - General government deficit (for 2009) and public debt on the high side.
- Global prospects and implications:
  - “90 percent confidence interval for world GDP growth in 2010 ranges from ¼ to 5½ percent.”
  - Using standard trade elasticities, implied 90 percent confidence interval for Israeli exports in 2010 ranges from -2½ to 14 percent, and for Israeli output ranges from 0 to 4 percent.
  - WEO projected global output for 2013/14 is now some 9 percent lower than was projected in April 2008, with major trading partners (e.g., the US and Euro area) most heavily downgraded.
- Staff view: fallout from recession, vulnerabilities, and global uncertainties all cloud the outlook; the exit from emergency policies must strengthen policy frameworks to anchor long-run expectations and reinforce credibility.

### Projections, scenarios, and risks
- Staff central case projections (predicated on the WEO and authorities’ announced policy frameworks) — key series (in percent):
  - Global GDP growth: 2007 5.2; 2008 3.0; 2009 -1.1; 2010 3.1; 2011 4.2.
  - Israel GDP growth: 2007 5.2; 2008 4.0; 2009 0.1; 2010 2.5; 2011 4.0.
  - Private consumption growth: 2007 6.3; 2008 3.6; 2009 1.2; 2010 2.3; 2011 4.0.
  - Private fixed investment: 2007 16.1; 2008 5.2; 2009 -3.6; 2010 4.2; 2011 5.0.
  - CPI (period average): 2007 0.5; 2008 4.6; 2009 3.6; 2010 2.3; 2011 1.8.
  - Central Government budget balance (percent of GDP): 2007 0; 2008 -2.2; 2009 -5.1; 2010 -4.1; 2011 -3.4.
  - Current account (percent of GDP): 2007 2.8; 2008 1.1; 2009 3.3; 2010 2.0; 2011 1.8.
- Risk scenarios and assumptions:
  - Up- and downside scenarios use the WEO fan chart and assume automatic stabilizers operate unfettered with budgeted spending commitments unchanged.
  - Monetary risk scenarios assume inflation remains within the target band; inflation on the upper end in the upside scenario and vice versa.
  - While the downturn’s brevity and shallowness likely left Israel’s current potential output level intact, medium-term potential output growth may have been dented if potential growth in major global economies has been lowered by the crisis.

### Staff macro assessment and policy recommendations
- Core macrofinancial challenge: design and implement an exit from emergency policy settings with three distinctive aspects:
  - Exit strategy has to be designed largely from first principles due to lack of precedent.
  - As a small open economy, Israel’s outcomes are highly sensitive to global spillovers; strategy focuses on containing domestic downside risks.
  - Being in the vanguard of global exit may significantly affect capital inflows, with strong inflows likely until major economies catch up.
- Underlying advice: strengthen fiscal, monetary, and financial stability frameworks to anchor long-run expectations and reinforce credibility, securing flexibility for short-run shocks and supporting long-term growth.
- Two key staff recommendations:
  - Avoid actions now that might compound downside risks; specifically, public sector wage settlements due in 2010 should be tightly restrained to signal restraint to private sector wage setters, help keep inflation and interest rates low, and promote continued good performance.
  - High Israeli public debt is an enduring vulnerability; public debt needs to come down decisively. Given Israel’s exposure to global and geopolitical shocks, reducing public debt is a primary concern.
- Public spending and tax policy guidance:
  - Debt objective should be supported by ceilings on expenditure and annually updated medium-term fiscal projections to specify how policies will achieve medium-term debt objectives.
  - Given the premium on accommodating automatic stabilizers, nominal spending caps are preferable to deficit targets; pursue rolling multi-year nominal spending ceilings and use the two-year budgeting framework as a step toward this.

*Italic: Source — _cr1023 - 1.5 percent.*

### 16.      Both risks underscore difficulties with the planned reductions in headline income

### 16.      Both risks underscore difficulties with the planned reductions in headline income

### Tax policy, debt reduction, and implementation risks
- Planned reductions in headline income tax rates assume further spending compression; if tax cuts proceed without that compression, public debt reduction is put at risk.
- Alternative tax policy steps to make up shortfalls include:
  - expansion of the income tax bases,
  - increases in indirect taxation,
  - reductions in tax expenditures.
- The potential yield and feasibility of those alternative steps should be reviewed at an early stage, and their distributive impact should be taken fully into account.
- Policy sequencing recommendation: Given the centrality of debt reduction to reducing macroeconomic vulnerabilities, tax cuts should only follow once debt is firmly on a path consistent with its targets, rather than vice versa.

### Fiscal rules — Box 4: Deficit and Real Spending Growth Caps, or Debt and Nominal Spending Ceilings
- Recent rules: deficit and real spending growth ceilings helped lower public debt and government size through mid-2008, but both rules broke down during the global crisis.
- Advantages of a debt rule over a deficit cap:
  - Establishes debt reduction as the formal goal of deficit ceilings, aiding transparency.
  - Minimizes false signals across the business cycle (automatic stabilizers in downturns; temporary growth spurts).
  - Anticipates currently heightened global uncertainties.
- Advantages of rolling three year annual nominal spending caps over a real growth cap:
  - Countercyclical: automatically raises real spending when inflation falls short of the assumed rate; the real rule is procyclical.
  - Transparency: nominal ceiling is transparent; the real rule’s “correction” mechanism is little understood.
  - Practicality: nominal cap can be agreed quickly in annual budget negotiations, reflecting potential growth and the BoI inflation target of 2 percent; the real rule requires annual agreement of year-ahead inflation forecasts.
- Application caveats and design elements:
  - Debt target must be achievable over at most a medium term horizon—hence the need for an interim ceiling of 70 percent in five years if the headline goal is 60 percent of GDP by the decade’s end.
  - Full annual three year ahead budget projections consistent with this objective would be required to confirm policy remains on track.
  - An exit clause from the commitment if medium term global supply deviates significantly from expectations may be appropriate.
  - On spending ceilings, a new “third” year ceiling would be added annually and should “correct for any past persistent inflation over or undershoots to avoid unintended persistent changes in government size.”
  - Security emergencies should be allowed for; accountability via a fiscal council could assess classification or tax changes that distort comparisons of outturns relative to ceilings.
  - The nominal ceiling should be reflected in BoI interest rate decisions because it changes—strengthens—the economy’s automatic response to supply and demand shocks.
- Overall assessment:
  - The deficit rule could be too restrictive in the near term and flexible in the long run; the debt rule reverses these characteristics.
  - If medium term debt ceilings were accompanied by three year rolling nominal spending caps, the framework could be much more robust and flexible than current arrangements.
  - The two year budget framework is a key step—establishing nominal spending allocations and planning over a two year horizon—but it still lacks the medium-term debt anchor.
  - International precedent: Sweden’s “over the cycle” deficit rule has been the dual of the proposed debt ceiling for over 15 years; Israel could follow Sweden’s example.

### Monetary and exchange rate policies and frameworks
- Recent BoI actions and challenges:
  - The BoI ended its government bond purchase program and modified preprogrammed foreign exchange purchases to discretionary intervention.
  - Two interrelated challenges for Israel’s exit strategy:
    - The relative priority attached to avoiding inflation target under- versus overshoots.
    - Transitioning from unconventional to conventional instruments.
  - Context: domestic monetary and credit transmission mechanisms are essentially intact; banking system remains robust and the bond market has largely recovered, even if credit flows continue to be muted.
- Rationale for a balanced approach to inflation target under- and over-shoots:
  - A resumption of economic growth has become increasingly evident, with the moderation of the earlier downturn likely to imply a similarly moderated upswing.
  - Headline and core inflation measures are currently near the top end of the target band, and there are no serious imminent risks of deflation in any of the measures of inflation expectations or forecasts.
  - Israel’s relatively recent history of high inflation has engendered a strong aversion to risking a significant pickup in inflation.
  - Foreign exchange intervention could, if necessary in a downside scenario, effectively support the nominal interest rate instrument to ensure delivery of an appropriately accommodative stance.
- Recent BoI policy steps and guidance:
  - The BoI signaled intention to contain upside risks to inflation by being the first central bank to raise policy rates for over a year, by 25 bp each for September and December 2009, and January 2010 to the current level of 1.25 percent.
  - Looking ahead: further tightening should remain cautious given large uncertainties; if evidence emerges that growth has become self sustaining, policymakers should stand ready to move swiftly from the current accommodative stance to a neutral stance.
- Withdrawal from unconventional measures:
  - Transition should be phased; for Israel this largely concerns foreign exchange intervention.
  - Decision to shift from preprogrammed to discretionary intervention is appropriate: begins the exit while retaining the option for continued use for a transitional period.
  - Risks: discretionary intervention can compromise clarity of BoI objectives and credibility of a floating exchange rate regime.
  - Guidance on intervention:
    - Intervention must not target a particular exchange rate level; remain focused on delivering the appropriate stance of monetary policy.
    - Discretionary intervention should be formally terminated when the policy rate is well above its effective floor on a sustained basis, anticipating restoration of the free floating exchange rate regime.
    - Formal termination should not rule out the option to intervene in exceptional circumstances.
- Surges of capital inflows:
  - Israel has so far escaped the full brunt of inflow surges; cessation of preprogrammed intervention proceeded with relatively infrequent and modest discretionary interventions.
  - The Fund’s de facto classification will shift from “free floating” to “floating,” while authorities’ de jure classification remains “floating.”
  - If inflows surge, simply allowing the exchange rate to appreciate could be undesirable, particularly if inflows are temporary.
  - If capital inflows surge, discretionary intervention should not be the main policy response; consider:
    - raising reserve requirements for banks,
    - tightening consumer protection rules,
    - adopting a fiscal stance tighter than the staff central case.
  - Capital controls and/or taxes on inflows are not persuasive: effectiveness of capital controls is questionable given open and integrated financial markets; taxes on inflows would likely and unnecessarily compromise the signal of commitment to open and competitive markets.
- Institutional reform:
  - Proposed reforms to the BoI Law are welcome: increase independence, establish a committee with power to set monetary policy, and a separate management committee to manage the bank’s administration, following ECB and Bank of England precedents.

### Financial stability and banking system resilience
- Key observations:
  - The Israeli financial system weathered the storm better than many other countries: problem loans increased only moderately; the interbank market functioned throughout.
  - Slower bank credit growth primarily appears to reflect demand factors rather than supply constraints.
- Features of interest in Israel’s prudential framework:
  - Limited reliance of Israeli banks on wholesale funding or structured products.
  - Glass-Steagall-like restrictions on bank activities.
  - Banking supervision helped avoid a property price bubble and limit risk exposures.
  - Supervision practice when most or all banks are systemic.
  - Lack of deposit insurance but strong implicit comprehensive government guarantee.
- Box 5: readiness to address financial instability
  1. Market liquidity and ELA facilities: the Governor has wide discretion to determine instruments, pricing, and collateral for emergency liquidity operations; a concern is the stock exchange listing requirement mandate for financial firms to rapidly announce any LOLR facilities they receive.
  2. Bank resolution framework: the Governor, after consultation with the Supervisor and with Government approval, may appoint an administrator to manage a banking corporation unable to meet obligations; it is key to ensure legal capacity to complete such operations speedily and to strengthen provision for preemptive bank resolution, including restricting legal recourse for affected stakeholders to financial compensation only.
  3. Coordination among authorities: a recent Memorandum of Understanding among supervisors and crisis-response exercises are welcome; strong technical capacity for cooperation is needed.
  4. Non-banks: readiness to handle weakness in a large non-bank financial institution is unclear; early consideration of options and risks is needed.
- Banking system strengths prior to and during the crisis:
  - Israel did not experience a housing sector boom before the crisis; housing prices have risen through the crisis period, partly reflecting safe haven capital inflows.
  - Prudent lending practices and close BoI supervision, including quantitative lending restrictions, helped banks enter the crisis with generally strong lending portfolios, a low level of non-performing loans, and limited exposure to bond and equity markets.
  - The 2005 Bachar reforms obliged banks to withdraw from long-term savings, pension and insurance activities, limiting exposure to risks that hit the non-bank sector.
  - A strong deposit base and absence of wholesale funding reliance: at end-2007, the Israeli banking system had a loan-to-deposit ratio of under 90 percent.
  - Israeli banks strengthened capital buffers before and during the crisis in accordance with BoI requirements.
  - As a result, bank losses during the crisis stemmed primarily from losses on investments in domestic and foreign securities; for the banking system as a whole the return on equity in 2008 fell to close to zero, rather than well below it.
- Capital standards and supervisory enhancements:
  - Current capital standards have been effective: adherence to the 12 percent risk-weighted standard—and the associated tier 1 ratio of 7 percent and raw capital ratios of 5-7 percent—proved effective.
  - This should be reflected in determination of capital requirements as Basle II is brought in.
  - Strengthening needed: a significant upgrade of macro-prudential and financial stability analysis.
    - Priorities for the new BoI unit should include comprehensive banking stress tests; scenarios could include the lower bounds of staff’s 90 percent confidence intervals for the global and associated Israeli projections.
    - The BoI should begin publication of a financial stability report, preferably semi-annually, and consideration could be given to including stress test results.
    - Over the longer term, the BoI should work with other regulators to broaden analysis to cover the entire financial system and its macroeconomic linkages.

*IMF staff analysis as presented in the source content.*

### 49.      Work on moving from GAAP to IFRS accounting standards is underway, and will

### _cr1023 - 49.      Work on moving from GAAP to IFRS accounting standards is underway, and will

### Accounting standards and banking regulation
- Work on moving from GAAP to IFRS accounting standards is underway, and will provide increased transparency and international comparability.  
- Implementation of Basel II, using the standard approach, is in progress, with appropriate emphasis on Pillar II.  
- A particular challenge is to balance the resource needs for progress in these areas against the needs of intensified supervision in the current environment.

### Supervisory capacity and staffing
- The global financial difficulties have highlighted the importance of adequately qualified, resourced, and motivated supervisors.  
- High turnover reflects ongoing challenges on this front.  
- These issues have become more acute with the global financial crisis and, even in Israel, the increasing complexity of banking.

### Deposit insurance and resolution frameworks
- Further consideration should be given to introduction of an explicit deposit insurance scheme.  
- Any such scheme would need to reflect that some banks are too large to be covered in a pre-funded or pooled insurance framework. For the large institutions, special arrangements would be required, recognizing their systemic importance.  
- Even so, introducing an explicit framework could more readily facilitate consideration of other options to deal with the resolution of non-systemic banks.  
- Footnote example: The Netherlands deposit insurance framework offers a possible model, as it has been designed to deal with a banking system dominated by a few very large banks.

### Non-bank supervision and regulatory review
- Given the focus of difficulties in non-banks, a review of macro-prudential and regulatory frameworks should begin with non-banks.  
- The proposals from the “Hodak Committee” and initiatives by the Israeli Securities Authority (ISA)—including strengthening bond prospectuses and attaching contractual covenants and financial criteria to bonds—provide a good starting point.  
- Two broader issues remain:
  - The presumption behind the 2005 reforms was that investors in these sectors would face all risks, both upside and downside, with a correspondingly lighter regulatory framework than is applied to banks. Emergency measures provided some public assurance of returns but appropriately limited guarantees. With improving global market sentiment, there is a need to review whether that presumption remains valid—or if, in the event of sustained or renewed losses, obligations will de facto accrue to the public sector. If so, more robust regulatory arrangements to address consequent moral hazard concerns in non-banking operations will be required.
  - A more fundamental strengthening of the budget, staffing, resourcing and autonomy of the non-bank regulators is appropriate. Specific recommendations:
    - The ISA should be given full operational independence.  
    - The Capital Markets, Insurance and Savings Division (CMISD) of the Ministry of Finance should be given formal autonomy, in line with international best practice.  
    - Changes should maintain the full flow of information to other supervisors and to the monetary and fiscal authorities, and coordination of strategic priorities among the various regulators should be reinforced.  
    - CMISD and ISA should significantly strengthen their transparency, going well beyond the provision of data, through the publication of timely analysis of developments, issues, and risks.  
    - An assessment should be made of the risk that even the relatively well-targeted emergency support measures for the non-bank sector has given rise to moral hazard; if so, this should be reflected in the content of supervisory guidelines to be adopted.

### Financial stability observations from the crisis
- Given the ongoing stabilization of world markets and increased evidence that Israel has proven resilient to the recent global shock, asset valuations have recovered significantly from their mid-crisis troughs.  
- However, indicators of underlying fragility remain:
  - The particular severity of the declines in the peak of the financial crisis.  
  - The closure of the corporate bond market during the crisis.  
  - The decline of several insurance companies’ solvency ratios to below their regulatory floors.  

*Source: _cr1023 - 49.      Work on moving from GAAP to IFRS accounting standards is underway, and will*

### ConclusionApproach

### ConclusionApproach

### Vulnerability indicators and sectoral contributions
- House prices: "Average growth in house price over 5 years (percent)" shows Israel positioned without a boom in house prices relative to peers (chart context).
- Corporate profitability: "Return on assets in corporate sector (percent)" indicates corporate RoA/RoE have been adequate (chart context).
- Contribution to GDP growth:
  - Construction: "Contribution of construction to GDP growth (percent)" places Israel around positive contribution (chart context).
  - Financial sector: "Contribution of financial sector to GDP growth (percent)" shows a notable contribution from finance (chart context).
- External vulnerability:
  - "External Debt (percent of GDP)" places Israel relatively low compared with many peers (chart context).
  - Inflation: "Inflation rate (percent)" notes that Israel’s inflation has "exceeded the target level" (chart context).
  - Fiscal deficit: "Projected general Government Balance in 2009 (percent of 2009 GDP)" shows Israel among countries with a relatively high fiscal deficit, indicated as "a source of vulnerability."
  - Public debt: "Projected General Government Gross Debt in 2009 (percent of 2009 GDP)" indicates public sector debt has "stayed at high level."

### Public debt sustainability (Figure 9)
- Baseline and shocks:
  - Baseline public debt averages: "Baseline 76" (public debt in percent of GDP, average projection shown in figure boxes).
  - Historical average: "Historical 72".
  - Individual scenario averages shown: "Growth shock 90", "PB shock 80", "Interest rate shock 80".
  - Combined shocks: "Combined shock 83".
  - Real depreciation and contingent liabilities shocks: scenario with "30 % depreciation" and contingent liabilities shock shows "88" and "86" in figure boxes (average projections).
- Scenario details:
  - Individual shocks defined as "permanent one-half standard deviation shocks."
  - Combined shock uses "Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance."
  - Contingent liabilities scenario includes "One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2009."
- Gross financing need and primary balance scenarios:
  - Baseline primary balance: "Baseline:1.5" (percent of GDP).
  - Scenario primary balance: "Scenario: 0.7".
  - Historical primary balance: "Historical:1.9".
  - Baseline gross financing need: "Baseline:3.7".
  - Scenario gross financing need: "Scenario:2.2".
  - Historical gross financing need: "Historical:3.8".
  - Baseline gross financing need (alternate box): "Baseline:4.6".
  - Scenario gross financing need (alternate): "Scenario:5.6".
  - Historical gross financing need (alternate): "Historical:4.2".

### Selected economic and social indicators (Table 1 highlights)
- Real economy (selected growth and levels):
  - "Real GDP 1.5 5.0 5.1 5.3 5.2 4.0 0.1 2.5" (series shown across years 2003–2010).
  - "Unemployment rate (percent) 10.8 10.4 9.0 8.4 7.3 6.2 7.8 7.4".
- Prices:
  - "GDP deflator -0.4 0.0 0.8 2.4 0.3 1.6 3.4 2.2".
  - "Overall CPI (end period) -1.9 1.2 2.4 -0.1 3.4 3.8 2.6 2.1".
- Money and credit:
  - "Narrow money (M1) 2/ 0.5 18.0 17.5 13.7 15.3 414.1 57.8 ..." (values as listed).
  - "Broad money (M3) 3/ 2.2 4.6 7.9 7.4 12.9 8.0 15.2 ..." (values as listed).
- Public finance (percent of GDP):
  - "Central government revenue 35.1 34.8 35.1 35.2 35.4 31.6 29.1 29.8".
  - "Central government expenditure 40.5 38.4 37.0 36.2 35.4 33.8 34.2 33.9".
  - "Central government balance -5.3 -3.6 -1.9 -1.0 0.0 -2.2 -5.1 -4.1".
  - "General government balance -6.9 -4.2 -2.5 -1.4 -0.8 -2.8 -5.7 -4.7".
  - "General government debt 99.0 97.4 93.5 84.4 78.1 76.8 79.9 80.9".
- Balance of payments (percent of GDP):
  - "Exports of goods and services 36.7 41.3 42.6 42.9 42.8 40.2 29.2 30.8".
  - "Current account 0.5 1.7 3.1 5.0 2.8 1.0 3.3 2.0".
- Reserves and exchange rate:
  - "Foreign reserves (end period, billions of U.S. dollars) 26.4 27.2 28.3 29.4 28.8 42.7 60.0 59.8".
  - "Exchange rate regime Floating".
  - "Present rate per U.S. dollar (December 16, 2009) 3.8".
  - "NEER annual percent change (period average) -3.7 -3.4 -0.7 0.4 3.9 11.4 ......".
  - "REER annual percent change (period average) -5.3 -6.1 -2.0 0.0 1.8 12.3 ......".
- Social indicators (levels):
  - "GDP per capita (current U.S. dollars, 2005): 25,875".
  - "Life expectancy at birth (2005): 77.7 (male) and 81.8 (female)".
  - "Infant mortality rate (2005): 5 per 1,000 births".
  - "Poverty rate: 18.5 percent 4/."

### Balance of payments projections (Table 2 highlights)
- Current account and components (percent of GDP, 2006−14 projections):
  - "Current account balance 7.3 4.6 2.1 7.2 4.4 4.2 4.7 5.0 5.3" (series across years header).
  - "Exports, f.o.b. 43.3 50.3 57.2 42.2 47.2 51.8 56.3 61.0 65.8".
  - "Imports, f.o.b. 47.2 56.0 64.4 46.3 52.2 57.6 62.4 67.5 72.5".
- Capital and financial account:
  - "Capital and financial account balance 2/ -6.4 -2.8 -4.8 -7.2 -4.4 -4.2 -4.7 -5.0 -5.3".
  - "Foreign direct investment (in Israel) 14.8 9.0 9.6 5.0 5.0 7.0 7.0 7.0 7.0".
- Memorandum:
  - "Gross external debt 58.1 52.2 42.6 38.8 36.4 33.8 31.3 29.1 26.9".
  - "GDP (billions of U.S. dollars) 145.8 167.0 202.1 216.2 224.3 234.5 245.6 257.0 268.8".

### Financial soundness indicators (Table 3 highlights, 2001−mid-09)
- Banking sector capital and asset quality:
  - "Regulatory capital to risk-weighted assets 10.3 10.8 10.7 10.8 11.0 11.1 12.6".
  - "Regulatory Tier 1 capital to risk-weighted assets 6.9 7.3 7.1 7.4 7.6 7.5 8.0".
  - "Nonperforming loans to total gross loans 2.6 2.5 2.3 1.9 1.5 1.5 1.5".
  - "Nonperforming loans net of provisions to capital 33.3 31.0 27.2 21.2 15.8 17.8 17.3".
- Profitability and margins:
  - "Return on assets 0.7 1.0 1.1 1.0 1.2 0.0 0.2".
  - "Return on equity 14.1 17.9 19.4 17.6 20.0 0.2 4.1".
  - "Interest margin to gross income 64.1 63.1 62.6 61.9 61.0 58.8 59.3".
  - "Noninterest expenses to gross income 60.2 59.7 61.7 61.2 54.5 82.8 67.8".
- Sectoral loan distribution (percent of total loans):
  - "Nonfinancial corporations (NFCs) 48.1 44.7 43.4 41.9 41.5 41.8 41.1".
  - "Other domestic sectors 26.0 28.4 28.5 29.3 28.4 32.1 34.4".
  - "Nonresidents 15.4 16.2 16.9 17.8 17.9 14.3 14.0".
- Currency composition and household metrics:
  - "Foreign-currency-denominated loans to total loans 35.4 34.5 31.4 28.1 27.0 25.3 24.2".
  - "Foreign-currency-denominated liabilities to total liabilities 40.1 41.5 42.5 40.7 39.8 36.2 35.1".
  - "Household debt to GDP 40.6 40.1 40.1 38.2 39.0 39.9 39.5".
- Real estate:
  - "Residential real estate prices (annual percentage increase) -6.1 -1.3 4.4 -4.3 3.2 10.6 12.8".
  - "Residential real estate loans to total loans 11.9 12.4 13.1 13.9 12.5 13.2 14.2".
  - "Commercial real estate loans to total loans 17.9 16.6 16.1 16.0 16.4 16.6 16.5".

### Central government accounts (Table 4 highlights, percent of GDP)
- Revenue and expenditure:
  - "Revenue (excluding repayment of credit) 35.0 35.3 35.2 36.1 32.7 31.6 28.7 29.1 29.0 29.8".
  - "Expenditure (excluding lending and expenditure by public hospitals) 38.6 37.1 36.2 36.1 34.2 33.8 34.6 34.2 34.5 33.9".
  - "Current expenditure 36.3 35.1 34.3 34.1 32.5 32.1 32.6 32.6".
  - "Wages 8.1 8.1 8.0 7.7 7.3 7.3 7.7 7.9".
  - "Interest 5.8 5.6 5.5 5.2 4.8 4.6 4.8 4.9".
- Balances:
  - "Budget balance -3.6 -1.9 -1.0 0.0 -1.6 -2.2 -6.0 -5.1 -5.5 -4.1".
  - "Primary balance 2.1 3.8 4.6 5.0 3.2 2.4 -1.2 -0.6" (mem. item).
- Financing composition (percent of GDP):
  - "Financing 3.6 1.9 1.0 0.0 1.6 2.2 6.0 5.5".
  - "Domestic (net) 2.2 -0.4 -0.7 -0.7 0.9 2.8 4.4 4.4".
  - "Foreign (net) 1.4 -0.4 -0.3 0.9 0.7 -1.3 1.0 0.5".

### External and financial sector vulnerability indicators (Table 5 highlights)
- Broad money and credit (percent change, 12-month basis):
  - "Broad money (percent change, 12-month basis) 2.2 4.6 7.9 7.4 12.9 8.0 15.0 Sep-09".
  - "Private sector credit (percent change, 12-month basis) -3.1 3.9 7.1 4.3 6.7 9.2 -0.6 Sep-09".
- Reserves and external debt:
  - "Gross official reserves (end period, billions of U.S. dollars) 26.4 27.2 28.3 29.4 28.8 42.7 61.5 Nov-09".
  - "Official reserves in months of imports of goods and nonfactor services 7.1 6.2 5.9 5.7 4.7 6.1 11.9 Projected".
  - "Total gross external debt/GDP (percent) 60.5 60.6 56.6 58.1 52.2 42.6 38.9 Projected".
  - "Total net external debt/GDP (percent) -4.3 -8.0 -15.2 -22.7 -26.9 -23.3 -23.9 Jun-09".
- External indicators and market moves:
  - "Terms of trade (average, percent change) -1.4 -1.9 0.6 -1.4 -2.2 1.6 11.2 Jun-09".
  - "Change in Stock Market Index (end of period; 12 month percent change) 55.4 17.6 32.8 5.8 22.9 -46.4 75.3 12/14/09".
  - "Country risk ratings (S. & P. / Moody's) A- / A2 ... A / A1 Nov-09".

### Medium-term scenarios (Table 6 highlights)
- Scenario summary for 2009−14 (selected entries):
  - "GDP growth rate 0 2 1/24443 3/4" (table entries as listed).
  - "Inflation (average) 3 2/42 1/41 3/4222" (entries preserved as shown).
  - Fiscal metrics and debt:
    - "Central gov't balance -5 -4 -3 1/2 -2 3/4 -2 3/4 -1 1/2".
    - "General gov't structural primary balance 3/411 1/41 2/422 2/4" (entries as listed).
    - "Public debt/GDP (end of period) 79 3/48180 1/279 1/477 3/475 3/4".
  - Reserves:
    - "Foreign reserves (billions of U.S. dollars) 61 1/262 3/46465 1/466 1/468".

### Background study excerpt: resilience through the global crisis
- Key observation:
  - "The downturn in Israel was relatively mild and short during the global downturn compared to many other countries."
  - "The economy contracted in 2008 Q4 for two consecutive quarters for a total of 1.2 percent, and it has grown since then."
- Purpose of study:
  - "This note considers the reasons for this performance, and its implications for future output growth."

*Source: IMF staff compilation from _cr1023 - ConclusionApproach (figures, tables, and text excerpts provided).*

### 2.      The main conclusion is that like many others, Israel had strong economic

### 2.      The main conclusion is that like many others, Israel had strong economic fundamentals prior to the global downturn and responded to the crisis with timely and appropriate policies.

### Main conclusion and comparative performance
- Israel had strong economic fundamentals prior to the global downturn and responded to the crisis with timely and appropriate policies.
- Factors distinguishing Israel that may explain relative strength of output:
  - Absence of a housing bubble.
  - Bulk of investment goods and consumer durables are imported.
  - Resilience of the banking sector.
- These factors largely account for Israel’s relative strength of output in the face of the global shock.

### Aggregate demand, output dynamics, and exports
- Exports of goods and services fell by some 20 percent in real terms and had not recovered to pre-crisis levels at the time of the analysis.
- Total demand (consumption, investment, government, and exports) fell sharply in Israel as elsewhere, but the recession was relatively short and mild.
- The output gap deteriorated since second-half of 2008 and turned negative later that year.
- Contribution to Quarterly Real Output Growth (illustrative components cited):
  - Private consumption, Government consumption, Gross domestic investment, Exports of goods and services, Imports of goods and services, Real output.
- Cumulative Decline in Real Exports of Goods and Services (in percent) shows Israel among countries experiencing large declines (chart referenced).

### Selected economic indicators before the financial crisis (average 2003–2007 where available)
- Indicators (Israel / Euro-area 2/ / United States):
  - Real output growth: 4.4 / 2.0 / 2.8
  - Private credit growth: 4.2 / 5.9 / 9.4
  - Increase in real residential property price: -1.4 / 5.7 / 7.4
  - Household debt as percent of GDP: 35.4 / 87.4 / 132.5
  - Gross national saving rate: 20.7 / 18.5 / 13.9

### Timely and appropriate policy response (selected measures and commitments)
- Monetary policy measures:
  - Expansionary monetary stance with reduction of policy rates: Mar 2008, Oct 2008 - Aug 2009
  - Foreign exchange purchase program to increase reserves 1/: Mar 2008 - Aug 2009
  - Government bond purchase program 1/: Early 2009 - Aug 2009
  - Note: The foreign exchange purchase program was modified in August 2009. Amount purchased on government bonds was limited.
- Fiscal and government commitments (in NIS billions):
  - "Manof" funds in helping non-bank credit market 2/: 1.0 - 1.5
  - Guarantees extended to banks to increase capital ratio 3/: 6.0 - 12.0
  - Ashra (ECA): 3.8
  - Exporters and real estate guarantees: 6.2
  - Small and medium business fund 4/: 0.7
  - Notes on commitments:
    - Total commitments for "Manof" funds are about 4.5 NIS billion, of which about one-quarter are financed by government.
    - Guarantee 3/ had not been disbursed as of November 2009 and banks are not expected to use it.
    - Total commitments for small and medium business fund are about 2.6 NIS billion, of which one-fourth is financed by the government.

### Additional factors explaining Israel’s resilience
- Absence of a housing bubble:
  - Property prices remained subdued until the beginning of the crisis in 2008, largely unwinding the previous housing bubble in 2001–02.
  - Share of investment in residential property stayed flat for a long period preceding the global crisis.
  - Fixed capital investment in buildings and construction (about 40 percent of fixed investment; 7-8 percent of GDP) held steady throughout the crisis and helped sustain output.
- Bulk of investment goods and consumer durables are imported:
  - Imports fell more sharply than exports, reflecting contraction of imports of investment goods and production inputs.
  - Because a large bulk of these are imported, the collapse in global and Israeli demand for these items had a relatively modest impact on Israeli output.
  - When global demand recovered from mid-2009, Israeli import demand increased alongside, muting the beneficial impact on Israeli output.
- One-off positive factor:
  - The new Intel plant—with exports entirely in the high-technology sector—rapidly built up to full production during 2009 and drove the initial increase in Israel’s exports in 2009.
  - Since the Intel plant had already reached full capacity, its potential contribution to monthly export growth in 2010 may be limited.
- High private savings rate:
  - Private savings rates have long been high in Israel, providing scope for households to “consumption smooth” across the global shock.
  - Nondurable private consumption remained stable throughout the short recession.
- Resilience in the banking sector:
  - Banking system did not have significant foreign exposures in assets, wholesale funding, and domestic credit quality largely held up during the crisis.
  - Banks’ capital remained above the minimum regulatory requirements.
  - Selected indicators in deposit-taking institutions (in percent) cited:
    - Regulatory capital to risk-adjusted assets (LHS), Capital to assets (LHS), Nonperforming loans to total gross loans (RHS) with series spanning 2002–June 2009.

### Public debt and market distress
- High public debt increased sovereign yield vulnerability during market distress, but yields on Israeli government bonds, while increasing sharply, did not pose serious challenges to the real economy in this episode.
- Staff analysis indicates Israel was not directly exposed to the core of this global shock (which hit financial assets, construction sectors, and investment demand heavily); thus high public debt did not prove to be an immediate vulnerability in this case.
- Nonetheless, high public debt remains a key concern as Israel could be susceptible to different kinds of external demand shocks.

### Potential output, estimation methods, and results
- Three methodologies used to estimate Israel’s potential output growth:
  - Aggregate production function.
  - Univariate filters on actual real output (Hodrick-Prescott, Christiano-Fitzgerald random walk, Baxter-King, Butterworth).
  - Structural model that incorporates long-term inflation, capacity utilization, and unemployment rates (IRIS).
- Selected results (Potential output growth rate in percent; growth rates refer to year-on-year basis on quarterly data):
  - Selected period 1995Q1 - 2009Q2 estimates:
    - Hodrick-Prescott filter: 4.4
    - Christiano-Fitzgerald random walk filter: 4.2
    - Baxter-King filter: 4.1
    - Butterworth filter: 4.2
    - Aggregate production function and Structural model (IRIS) reported values clustered around 4.1
  - Medium term range (lower end / upper end) across methods:
    - Lower end: 3.4 / 3.1 / 3.4 / 2.9 / 3.0 / 3.2 (method order corresponds to table rows)
    - Upper end: 4.1 / 3.6 / 4.0 / 3.8 / 3.7 / 3.9
  - Estimations are subject to end point bias and large uncertainty with respect to global potential output growth; upper and lower end refer to 90 percent confidence bands of baseline estimates given current projections on U.S. and Euro-area growth.
- Real output expected to be below potential for 2009; all estimation methods suggest the estimated output gap deteriorated and turned negative over the past year in the sample.
- Various filtering techniques show comparable results except Baxter-King filter, which consistently underestimated the output gap because estimated potential output tracks closely to actual real output.

### Linkages between Israel’s potential output and major partners
- A vector autoregression (VAR) was used to correlate potential output growth in Israel with potential output growth in the United States and the Euro-area, and Israel’s unemployment rate (proxy for long-term production capacity).
- Christiano-Fitzgerald filtering technique used for consistency across countries.
- Findings:
  - Strong tie between Israel’s potential output growth and that in the U.S.
  - Variance decomposition suggests shocks to U.S. potential output account for over 15 percent of variation in Israel’s potential output, with smaller effects from the Euro-area.
  - Contemporaneous cross-correlation of Israel’s output gap with U.S. and Euro-area counterparts is over 70 percent, with stronger persistent effects from the U.S. output gap in lags.
- Population growth dynamics:
  - Average population growth exceeded 2 percent in the past 15-20 years due to large immigration flows in the 90s.
  - Population growth is expected to be 1.5 - 1.7 percent in near term, contributing to lower potential growth.

### Implications for Israel’s potential growth and public debt
- Given projected declines in global potential growth, Israel’s potential growth is likely to decline compared to historical long-term levels.
- Large uncertainty surrounding global recovery implies Israel’s potential growth would also be subject to a high degree of uncertainty.
- With a lower medium-term potential growth in Israel, the task of public debt reduction becomes both more important and more difficult.
- Robustness of fiscal rules and policies should be commensurate with the increased challenge of reducing public debt under lower potential growth.

### Policy implications and recommendations
- Israel’s resilience to this particular global shock was largely due to limited exposure in financial and construction sectors, but vulnerabilities remain:
  - Israel may remain vulnerable to other external shocks, including those focused on the “high tech” sector (as in 2001–02).
- Because part of the recovery reflected a significant one-off factor (the Intel plant), prospects for continued output growth are uncertain even if global conditions stabilize.
- Policy priorities:
  - Maintain and deepen the stability and strength of the banking sector.
  - Recognize that recent resilience does not imply long-term prospects are unaffected; prepare for lower medium-term potential growth.
  - Strengthen fiscal rules and policies to address the increased challenge of public debt reduction under lower potential growth.

*Prepared by W. Raphael Lam (EUR; wlam@imf.org)*

### 14.      Israel appeared to have only limited exposure to the global financial shock that

### _cr1023 - 14.      Israel appeared to have only limited exposure to the global financial shock that

### Exposure index and methodology
- An index (EX_i) is constructed to measure a country’s exposure to global financial shocks based on its sectoral composition on gross output.
- The index is calculated based on:
  - ∑ j ( (y_i,j / y_i) / (Y_w,j / Y_w) ) · (s_j / S_i ), where i and j denote country and sector, y_i,j / y_i is the percentage of country’s gross value-added on sector j, Y_w,j / Y_w is the sectoral share of gross value-added at world level, S is measured by the decline of S&P 500 in the U.S. stock market, and s_j is the sector shock measured by the change in the indexed stock returns on sectors in the U.S. market.
- Analysis covers the agricultural, manufacturing, wholesale & retail, construction, technology, services, and financial sectors.
- A higher index number implies the country is heavily exposed to the global financial shock.
- Note in text: “Using the U.S. equities data may not be a perfect measure of the global financial shock in general. However, the relative declines of different industries with respect to the overall equities in this particular crisis would arguably a good proxy. Substitution effect across countries in sectors that potentially bias the measure do not seem to be applicable given the short time frame in measuring and the synchronized declines across countries.”

### Empirical findings: exposure and output
- Israel scores at the lower end in the index relative to other advanced countries, indicating a narrow exposure to the global financial shock in 2008.
- Countries that score low in the index — less exposure to global financial shock in 2008 — tend to have less severe output contractions.
- Correlation and relationship:
  - Strong negative correlation between a country’s exposure to the global financial shock and its real output growth is about -0.5 at 5 percent significant level (figure).
  - Regression/figure caption: “Relationship between Declines in Real Output and Exposure to Global Financial Shock”
  - Illustrative points: Israel (2008) and Israel (2002) noted; Israel was more exposed in the high-tech sector linked to the 2002-03 shock when it had a sharper downturn.

### Regression results and determinants of output contraction
- Main explanatory variables found significant:
  - Country’s index on exposure to global financial shock (negative relation with output growth).
  - Percentage change in external trade (a higher decline in external trade could result in a higher decline in real output — positive coefficients on trade decline).
  - Vulnerabilities in the property sector, proxied by a cumulative housing price increase, also explain the magnitude of output declines (negative relation).
- Interactions and sectoral effects:
  - Countries with higher gross value-added in the high-tech sector (as in Israel) are about 40–50 percent less susceptible to external trade effect on output; the interacting term with external trade is negative and significant at 10 percent level.
- Credit growth to private sector prior to the crisis does not appear significant in contributing to declines in real output.
- The analysis is not fully conclusive on variables that explain Israel’s resilience but reflects the possibility that Israel could be less exposed under this particular global shock.

- Regression table (Dependent variable: Cumulative real output growth; White heteroskedasticity-consistent standard errors and covariance):
  - Columns labeled Regression 1 2 3 4
  - Constant:
    - 1: 1.20 (t-stat 2.82)
    - 2: 3.09 (t-stat 2.18)
    - 3: 0.33 (t-stat 3.14)
    - 4: 2.24 (t-stat 2.30)
  - Index on exposure to global shock:
    - 1: -5.87 ** (t-stat 2.69)
    - 2: -3.2 * (t-stat 1.93)
    - 3: -5.58 * (t-stat 2.92)
    - 4: -2.9 (t-stat 2.17)
  - Percentage change in external trade:
    - 1: 0.01 ** (t-stat 0.00)
    - 2: 0.002 (t-stat 0.00)
    - 3: 0.1 ** (t-stat 0.04)
    - 4: 0.11 ** (t-stat 0.03)
  - Percentage change in external trade * degree of high-tech exposure:
    - 3: -0.05 ** (t-stat 0.02)
    - 4: -0.06 ** (t-stat 0.02)
  - Nominal growth in residential property prices:
    - 1: -0.34 ** (t-stat 0.17)
    - 2: -0.38 ** (t-stat 0.16)
    - 3: 0.17 (t-stat 0.16)
  - Growth in bank credit to private sector:
    - 1: -0.02 (t-stat 0.08)
    - 2: 0.002 (t-stat 0.07)
    - 3: 0.08 (t-stat 0.07)
  - Adjusted R-squared:
    - 1: 0.24
    - 2: 0.44
    - 3: 0.28
    - 4: 0.52
  - F-statistics:
    - 1: 6.29
    - 2: 7.76
    - 3: 5.33
    - 4: 8.44
  - No. of observations: 35 across all regressions
  - Note: “'*' and '**' represent statistical significance at 10 percent and 5 percent, respectively.”

### Potential output estimation methodologies (Box 1)
- Three broad methodologies applied to estimate potential output and output gaps using quarterly data from 1995Q1 to 2009Q3:
  1. Aggregate production function
     - Production function: Z_t K_t^alpha L_t^beta = Y_t (presented in text as β α tttt LKZY =, with Y output, α and β denote capital and labor share).
     - Estimated capital and labor shares using data from 1995-2009Q2 are around 0.37 and 0.56, which do not reject constant returns to scale.
     - Estimated potential output captures below-trend output in recent global crisis but appears to overshoot for periods after the dot-com crisis.
  2. Univariate filtering
     - Four filtering techniques on quarterly output at constant prices, seasonally adjusted: Hodrick-Prescott filter (1997), Baxter-King filter (1999), Butterworth filter (Pollock (2000)), Christiano-Fitzgerald random walk filter (2003).
     - Filtering separates permanent and transitory movements to produce smoothed potential output.
  3. Structural model
     - Based on the IRIS project framework (Research Department).
     - Framework comprises four sets of equations on the output gap, inflation, unemployment, and capacity utilization; parameters on steady states set at long-term levels with some judgement applied to persistence and shock variations.
     - Uses same set of priors as in the cross-country studies.

### Israel’s public debt and market considerations (beginning of Section II)
- Key facts and findings:
  - “At near 80 percent of GDP and rising, Israel’s public debt ratio is expected to remain one of the highest among developed countries.”
  - High debt constrains fiscal options and may compromise investor confidence; credibility concerns over fiscal policy framework and the relaxation of expenditure and budget deficit rules for 2009-2010.
  - Despite concerns, current government financing strains are not pronounced:
    - Sovereign CDS spreads rose since the outbreak of the global crisis but the increase in spreads is relatively modest.
    - Strong inflows of capital occurred amid large-scale investment repatriation by domestic residents and recent tightening of monetary policy stance.
    - Israel’s sovereign credit ratings have been retained at A throughout the current crisis.
    - In March 2009, the government successfully issued US$1.5bn of external debt, the largest external bond offering ever for Israel.
  - Literature on high public debt shows mixed evidence on long-term implications; empirical relationship between debt and interest rates remains debatable.
  - During times of market stress, empirical analysis finds significant evidence that markets disproportionately penalize countries with high public debt:
    - “When the market is stressed, high-debt countries’ bond yields tend to rise by more, and be more susceptible to marginal increases in market anxiety.”
    - Results hold whether debt is expressed as a continuous or discrete variable.

### Empirical analysis setup for market stress and bond yields
- Data and variables:
  - Focus on countries with similar level of economic development as Israel (covered countries have per capita GDP above US$8,500 and US$10,000 in the two periods studied).
  - Dependent variable: government bond yields, taken from EMBIG and Bloomberg.
  - Key explanatory variable: market stress proxied by the VIX index.
  - Controls: US 10-year Treasury yields (from Bloomberg), public debt, net IIP, government budget balances (data sourced from WEO).
  - Daily data used for bond yields, VIX, and variables constructed using VIX to capture sudden shifts.
- Specification:
  - Interactive terms of interest: VIX*Debt and Hi_VIX*VIX*Debt, where Debt is public debt-to-GDP ratio and Hi_VIX is a dummy equal to one when VIX is high.
  - Coefficients interpret how impact of marginal change in market volatility on bond yields varies with debt, and how that effect behaves during periods of particularly high market stress.
  - Global risk-free rates, external position (net IIP as percent of GDP), financing need (fiscal balance as share of GDP), and country dummies included as controls.
- Periods analyzed:
  - mid-1997 to end-2002 (episodes: Russian default, collapse of LTCM, Asian financial crisis, burst of dotcom bubble).
  - mid-2007 onward (initial turbulence leading to global financial crisis).

*Italic source: IMF staff analysis in chapter titled “Israel appeared to have only limited exposure to the global financial shock that emerged in 2008” (content unit _cr1023 - 14).*

### 12.      The analysis indicates that high-debt countries were particularly vulnerable

### The analysis indicates that high-debt countries were particularly vulnerable

### Main empirical finding
- High-debt countries were particularly vulnerable when the market was stressed: the impact of market volatility on bond yields was greater for high-debt countries.
- The differential effect is not statistically significant when stressed and non-stressed periods are combined (Table 1, regression 1).
- Focusing only on periods when the market was stressed, the differential effect becomes strongly significant (Table 1, regression 2): at times of market unease, high debt-to-GDP countries face a particularly pronounced unfavorable impact of market fluctuation on risk premiums.

### Discrete debt-group results (robustness to non-linearities)
- Countries were discretely categorized into high-debt and low-debt groups using three debt cutoffs: 55 (sample median), 65, and 75 percent of GDP.
- With a 55 percent of GDP cutoff the coefficient of the interactive term is positive but statistically insignificant.
- With cutoffs raised to 65 or 75 percent of GDP, the coefficient becomes positive and significant (Table 1, regression 3 shows cutoff at 65 percent of GDP).
- Qualitatively: high-debt countries are disproportionately penalized by investors during times of market stress.

### Selected regression coefficient excerpts (mid 1997 - end 2002; dependent variable: Govt bond yields (percentage points); daily frequency; only countries with per capita GDP > US$8,500)
- VIX * Debt: coeff 0.014 t value 1.19
- Hi_VIX * VIX * Debt: coeff 0.009 t value 2.23**
- Hi_VIX * VIX * Hi_debt: coeff 0.0045 t value 2.26**
- US 10 yr Treasury yield: coeff 0.65 t value 12.86*** / 0.65 t value 12.83*** / 0.65 t value 12.79***
- VIX: coeff 0.006 t value 0.81 / coeff 0.018 t value 5.94*** / coeff 0.006 t value 4.26***
- Hi_VIX refers to VIX>24; Hi_debt refers to public debt > 65% of GDP
- Robust standard errors, clustered by country; *, **, and *** denote 10, 5, and 1 percent significant, respectively
- R sq: 0.91 0.91 0.91
- #Obs: 2473 1247 3124 731 (as shown)
- # countries: 20 20 20
- Table 1 period: Mid 1997 - end 2002 (Asia crisis, Russian default, LTCM, burst of dotcom bubble, etc.)

### Results for mid 2007 – October/Nov 2009 (global financial crisis)
- Market stress much higher in the current crisis; VIX rose to more than three times pre-crisis values and remained very heightened for over seven months after the collapse of Lehman Brothers.
- Key findings for this crisis (Table 2):
  - i) Debt amplifies the impact of market volatility on countries’ risk premiums (Table 2, regression 1).
  - ii) When the market is stressed, the impact of market volatility on risk premiums was particularly pronounced for high-debt countries (Table 2, regression 2).
  - iii) Finding (ii) remains valid when countries are discretely categorized into high- vs. low-debt groups (Table 2, regression 3).
- Definitions: Hi_VIX refers to VIX>35; Med_VIX refers to VIX> 25.5; Hi_debt refers to public debt > 70% of GDP
- Dependent variable: Govt bond yield (percentage points); daily frequency; includes only countries with per capita GDP > US$10,000

Selected regression coefficient excerpts (Mid 2007 - Nov 2009)
- VIX * Debt: coeff 0.05 t value 2.79***
- Hi_VIX * VIX * Debt: coeff 0.025 t value 2.83***
- Hi_VIX * VIX * Hi_debt: coeff 0.014 t value 2.30**
- US 10 yr Treasury yield: coeff 0.35 t value 4.84*** / 0.325 t value 5.44*** / 0.335 t value 5.51***
- VIX: coeff -0.02 t value -2.47** / coeff 0.011 t value 1.22 / coeff 0.006 t value 1.06
- Med_VIX * VIX: coeff -0.01 t value -3.84*** / -0.006 t value -4.14*** 
- Hi_VIX * VIX: coeff -0.01 t value -1.95* / -0.005 t value -1.01
- Table 2 R sq: 0.88 0.89 0.88
- #Obs: 10088 10088 10088
- # countries: 27 27 27
- Table 2 period: Mid 2007 - Nov 2009 (global financial crisis)

### Robustness checks — additional fiscal and economic risk controls
- Three interactive controls added as robustness checks:
  - Financial sector contingent liabilities: sizes taken from IMF (November 2009). Hi_contingent liabilities refers to countries with financial sector assistance > 30 percent of GDP (the 25th percentile of sample countries).
  - Depth of the economic downturn: measured as the difference between currently expected growth outturn for 2009 and the one-year ahead consensus growth forecast made before the crisis. Deep_downturn refers to countries with currently estimated 2009 growth at least 8 percentage points worse than pre-crisis expectations (the 25th percentile of sample countries).
  - Ageing-related fiscal costs: NPV of OECD estimates of ageing-related fiscal spending. A real growth rate of 2½ percent and a real discount rate of 4 percent are assumed in the NPV calculations. Ageing costs refers to NPV of the OECD estimates of ageing-related fiscal spending.
- Main result remains: risk premiums of high-debt countries are especially susceptible to global financial conditions when the market is stressed.

Selected regression coefficient excerpts (Table 3; Mid 2007 - Nov 2009)
- Hi_VIX * VIX * Debt: coeff 0.027 t value 2.99*** / coeff 0.025 t value 3.18*** / coeff 0.025 t value 2.77**
- Hi_VIX * VIX * Hi_contingent liabilities: coeff -0.007 t value -1.65
- Hi_VIX * VIX * Deep_downturn: coeff 0.008 t value 0.79
- Hi_VIX * VIX * Ageing costs: coeff 0 t value -0.11
- US 10 yr Treasury yield: coeff 0.335 t value 5.44*** / 0.335 t value 5.42*** / 0.325 t value 5.16***
- Med_VIX * VIX: coeff -0.009 t value -3.01*** / -0.01 t value -2.93*** / -0.01 t value -1.37
- Hi_VIX * VIX: coeff -0.014 t value -2.30** / -0.013 t value -2.03* / -0.012 t value -1.91*
- Robust standard errors, clustered by country; *, **, and *** denote 10, 5, and 1 percent significant, respectively
- Table 3 sample variations: #Obs 10088 / 9592 / 10088; # countries 27 / 25 / 27; R sq 0.89 / 0.89 / 0.89

### Quantitative illustration — two hypothetical country cases
- Two hypothetical countries with net IIP and fiscal balances equal to sample averages:
  - Country A: debt-to-GDP ratio 80 percent.
  - Country B: debt-to-GDP ratio 60 percent.
- Predicted bond yields since mid-2007 derived from panel regression estimates:
  - During relative market calm, bond yields of the two countries track closely.
  - During severe market strains (the 7½ months since September 2008 when VIX consistently hit above 35), yields diverge: the higher-debt country’s yields rise sharply while the lower-debt country’s yields remain relatively stable.
  - At the peak of the stress, the bond yield differential between these two hypothetical countries reaches as high as 50 bps.

### Considerations and findings for Israel
- Israel’s bond yields appear strongly susceptible to market stress, even after accounting for its high debt ratio.
- At the market stress peak in late October 2008, Israel’s bond yields were close to 100 bps above predicted values from the panel regression.
- As global conditions stabilized by mid-November 2009, Israel’s bond yields declined to around 100 bps below predicted values.
- A simple regression of Israel’s yield residuals on the US Treasury yields and VIX yields t-value on VIX of 13.78, indicating strong correlation between Israel’s yield residuals and market stress.
- Possible drivers of Israel’s particular susceptibility:
  - Coincident rise in expectations of a change in administration and lack of clarity about the new budget.
  - Concerns about Israel’s debt sustainability and geopolitical uncertainty amplified by rising global risk aversion.
  - Doubts about the Israeli economy amid the global downturn.
- Rapid fall in risk premiums in recent months likely driven by stronger-than-expected Israeli economic rebound and moderation of global risk pricing.

### Policy implications and recommendations (explicit and implied)
- For high-debt countries, market stress tends to disproportionately heighten bond yields.
- Israel’s susceptibility to global financial conditions may be above what is typical for similarly indebted countries.
- Renewed global shocks could sharply raise Israel’s risk premiums and expose fiscal weakness.
- Given limited potency of fiscal policy in high public debt contexts (WEO finding that fiscal stimulus may be attenuated or negated in high public debt contexts), steps to strengthen the potency of fiscal instruments are important.
- Policy priority: adopt credible and appropriately ambitious debt reduction plans to strengthen fiscal resilience and the effectiveness of fiscal policy against temporary exogenous shocks.

*Source: IMF staff analysis (excerpts from chapter "_cr1023 - 12.      The analysis indicates that high-debt countries were particularly vulnerable").*

### 5.      The Israeli banking system is highly concentrated, with the top two banks

### _cr1023 - 5.      The Israeli banking system is highly concentrated, with the top two banks

### Concentration and structure of the financial system
- The top two banks account for nearly 60 percent of banking system assets, and the top accounting for 95 percent.
- Until the mid-2005 Bachar reforms, banks dominated provident funds and mutual funds; the reforms forced banks to shed these activities.
- By end-2007, assets of non-bank financial institutions amounted to around 110 percent of GDP compared with banking system assets of around 140 percent of GDP.
- Banks are supervised by the Bank of Israel; insurance, pension and provident funds are supervised by the Ministry of Finance; mutual funds and equity markets are supervised by the Israel Securities Authority (ISA).
- There is no formal system of deposit insurance. Past government practice, notably during the banking crisis of 1983, implies an effective policy of treating almost all banks as too important to fail, which leads to very close supervision by the Bank of Israel.

### Shift of corporate funding and non-bank sector vulnerabilities
- Following the Bachar reforms, corporate borrowing shifted from banks to equity and especially the corporate bond market.
- The corporate debt-to-equity ratio and bond debt-to-GDP ratio rose rapidly to high levels by international standards.
- The increased risk from such leveraging is primarily borne by holders of corporate bonds, including pensions, insurers, and mutual funds in the non-bank sector.

### Pre-crisis comparative strengths of the banking system
- Israel’s banking system was relatively moderate in size, relative to GDP, compared with several peer group countries—implying:
  - Problems in the banking system were likely to have a smaller macroeconomic impact than in economies with larger financial systems.
  - Potential fiscal cost of banking problems was likely more manageable, making implicit government backing more credible.
- Israel did not experience a property boom in the run up to the crisis; household debt, especially mortgage debt, was much lower in relation to incomes than in peer countries, reducing banks’ exposure to household and housing market credit risk.
- On liabilities, Israeli banks had a very strong deposit base exceeding domestic lending, unlike many peers where domestic loans significantly exceeded deposits—reducing vulnerability to drying up of external or domestic funding.
  - The surplus of deposit funds led banks to invest funds in assets abroad.
- Non-performing loans (NPLs) declined to low levels relative to total loans during the pre-crisis growth period.
- Israeli banks built up capital buffers in the pre-crisis period, whereas in most peers capital ratios were allowed to decline.
- Comparable ratios of Tier I and total capital to risk-adjusted assets were more or less in line with peers.

### Selected financial sector statistics (as presented)
- By end-2007, NBFI assets/GDP amounted to around 110 percent of GDP; banking system assets around 140 percent of GDP.
- Table 2 (Financial sector characteristics, 2007) includes country comparisons and indicators such as:
  - Bank assets/GDP: entries include 1040.3, 476.1, 326.1, 147.4, 143.2 (as presented in the source).
  - NBFI assets/GDP: entries include 158.6, 228.8, 13.2, 111.7 (as presented).
  - Stockmarket/GDP and H/hold debt/disp. income entries and numerous other country-specific numeric indicators are reported in the table as presented in the source.
- NPL % of gross loans examples in the table include values such as 0.8, 1.1, 4.5, 0.5, 0.7, 0.3, 1.4 (as presented).
- Bank CAR (risk-weighted) entries include 12.1, 10.7, 11.2, 13.2, 11.2, 11.7, 12.3, 15.4, 11.0 (as presented).
- Return on Assets (ROA) entries in the table include 1.5, 0.7, 0.4, 0.6, 1.0, 0.8, 1.1, 1.2, 1.2 (as presented).
- Return on Equity (ROE) entries include 22.4, 16.4, 13.2, 18.7, 14.8, 17.0, 14.6, 14.3, 20.0 (as presented).

### Impact of the global financial crisis on Israel’s financial system
- The Israeli financial system weathered the crisis better than many peers, reflecting both resilience of the financial system and less severe transmission from global shocks.
- Key effects and developments:
  - Israel was less adversely affected by the global slump in export markets; country risk premium increased somewhat but less markedly than in most peers; downward pressure on the currency was less severe than in most peers.
  - Tel-Aviv market capitalization fell by over 40 percent from end-2007 to end-2008, in the same range as peer group countries; the real estate sector was especially hard hit.
  - Pension and provident funds, insurers and mutual funds suffered heavy portfolio losses and investor withdrawals; unlike many countries, there was a shift into real estate in Israel, and property prices rose rather than fell in the wake of the crisis.
  - Corporate bond issuance essentially ceased during the depths of the crisis and, although recovering, remained well below pre-crisis levels.
  - Bank lending growth slowed sharply, reflecting tightened credit conditions and weaker borrower demand; some re-intermediation occurred as large corporates returned to bank borrowing; aggregate lending was fairly flat rather than falling.
  - Israeli banks experienced a sharp fall in profits mainly from losses on foreign and domestic securities portfolios rather than lending; NPL rate remained almost unchanged despite some increase in overdue loans.
- Measures taken during the crisis aimed to bolster confidence, restore market liquidity, and ensure access to finance; since bank solvency was not an issue, public resource use was small, with benefits mainly in promoting market liquidity and reassuring the public about banking system safety.

### Financial sector and credit support measures 2008–09 (summarized from Box 1)
- Corporate bonds:
  - Government provided seed capital of NIS 1.1 billion, to be used in a 1:3 ratio with private funds, to support corporate issues for solvent firms facing debt rollover difficulties.
  - To date only 10 percent of the funds have been used.
  - Program expanded to include equity investments in corporates with market access problems.
- Increasing banks’ capital:
  - A guarantee was offered of some NIS 6 billion for bank issues of deferred notes classifiable as upper Tier II capital.
  - Conditions eased and the guarantee doubled to NIS 12 billion in April, but banks raised capital without using the guarantee.
- Credit guarantees to small- and medium-sized firms:
  - Initial NIS 1.3 billion scheme expanded to NIS 2.6 billion, with a 70 percent guarantee on the loans.
  - Funds are leveraged in a 1:5 ratio with private funds.
  - NIS 0.7 billion has been disbursed under the program to date.
- Easing out-of-court corporate bond rescheduling procedures:
  - The Israel Securities Authority provided that bond trustees will have to convene a forum of bondholders if requested by a party holding a substantial portion of bonds.
  - Some 50 companies are now subject to these procedures, accounting for total debt of US$3½ billion.

### Regulatory and supervisory features supporting resilience
- Conservative funding practices:
  - Heavy reliance on customer deposits insulated banks from cuts in external funding or local market disruptions; partly reflects stable, low-cost deposits from the Israeli diaspora and limited development of securities markets.
  - Legislation to enable securitization is only now being put in place.
  - Authorities should consider how to mitigate potential dangers of securitization through revised guidelines or practices for bank liquidity standards and lender of last resort arrangements.
- Prudent lending and asset allocation practices and rules:
  - Limits on exposures to single borrowers and to groups of closely associated borrowers.
  - A limit on equity investment in foreign subsidiaries or branches.
  - Sectoral lending limits.
  - A 20 percent limit on the share of lending to the housing sector constrained banking sector funding of a housing boom and limited vulnerability to a crash; the limit is not absolute and higher exposures are effectively discouraged by higher provisioning requirements for exposures above the 20 percent mark.
  - Industry limits on loan-to-value ratios commonly set at 70 percent.
  - An overhang of excess housing supply beginning in the early 2000s ended only in 2008; conservative rules may have dampened both booms and busts.
- Policy implications and interpretation:
  - Simple, across-the-board quantitative rules (e.g., sectoral lending limits) conflict with Basel II’s risk-sensitive approach but can act as robust safeguards when risk estimates are unreliable.
  - Robust quantitative limits can serve as a back-up against mis-estimated risks under Pillar I approaches.
  - Excessive caution could undermine banking intermediation efficiency, but Israeli banks’ rates of return on equity and assets comparable to peer countries suggest prudence has not significantly harmed efficiency.

*Source: IMF staff analysis in the provided chapter content.*

### 19.      Beyond the conservative rules used in bank funding and lending, the Israeli

### _cr1023 - 19.      Beyond the conservative rules used in bank funding and lending, the Israeli

### Conservative banking culture and capital adequacy
- Findings:
  - Israeli banks exhibit a conservative culture in funding, lending, and supervision, reflected in careful loan examination and borrower repayment assessment.
  - This conservatism is reflected in a low NPL rate and little change in the NPL rate during the crisis.
  - Origins of conservatism:
    - Past banking crises, including in 2001-03 and the 1980’s, whose lessons remain influential.
    - A significant proportion of senior bank management are former supervisors or government officials with conservative approaches.
- Policy questions raised:
  - How to ensure lessons from past crises are preserved over time.
  - How bank governance and senior management appointment/qualification requirements might be modified to embed prudent risk management in corporate culture.
- Capital adequacy observation:
  - Israeli banks’ capital ratios "appear to have been adequate in the current crisis."
  - Caution: outcomes could have differed if shocks were larger or longer, if the Bachar reforms had not occurred, or if there had been a housing bubble.

### Supervision intensity, transparency, and accountability
- Findings:
  - Israel has close supervision driven by:
    - The potential for public losses under an implicitly broad government guarantee (no explicit deposit insurance, but a common understanding government would act to prevent most bank failures).
    - Concentration of the banking system and separation of insurance, pension and capital market activities from traditional banking.
  - Concentration and simpler banking activities post-Bachar reforms facilitate in-depth supervisory knowledge.
- Potential risks:
  - Close supervision could lead supervisors to identify too closely with supervised entities (reversed Stockholm syndrome), particularly given personal connections between former supervisors and bank managers.
  - No evidence of this problem in Israel; possible mitigating factors include high transparency and a strong culture of personal accountability following the 1983 crisis (forced resignations of bank CEOs and the governor of the Bank of Israel).
- Recommendations:
  - Strengthen personal accountability of supervisors for their performance.
  - Apply transparency in the Bank of Israel’s financial stability framework analogous to its inflation targeting framework.
  - Begin publishing financial stability reports on a semi-annual basis to discipline supervisors and ensure defensible public assessments.

### Non-bank financial sector performance during 2007–09
- Key statistics and developments:
  - From end-2007 to end-2008:
    - Capitalization of the Tel Aviv Stock Exchange fell 45 percent.
    - Prices of non-government bonds fell 14 percent.
  - Capital raising on the Tel Aviv Stock Exchange largely ceased after Lehman Brothers in 2008Q4 and began recovering in 2009Q2.
  - Israeli pension funds fell by an average of only 11 percent in 2008.
- Findings:
  - Non-bank sector net worth was hit hard by equity and corporate bond declines and curtailment of new credit issuance.
  - Some insurers fell below minimum solvency requirements; sector solvency fell to just above minimum requirements.
  - Rapid recent development of the non-bank sector post-Bachar reforms left players and supervisors with limited experience, increasing vulnerability.
- Policy measures taken:
  - Public-private fund to purchase corporate bonds.
  - Cuts in interest rates.
  - Improvements in bond debt restructuring arrangements.
  - Supervisory remedial actions aimed at strengthening rights of shareholders and bondholders, and improving investor protection and disclosure.

### Supervisory framework, regulatory arbitrage, and Hodak recommendations
- Findings:
  - Three supervisory entities operate with responsibilities split along institutional rather than functional lines.
  - Pre-crisis supervision of banks contributed to resilience; non-bank supervision was less effective.
  - The Bachar reforms induced a rapid shift of corporate financing from banks to the non-bank sector, enabling regulatory arbitrage to less-experienced supervisors.
- Recommendations and actions:
  - CMISD and ISA should be given full operational autonomy to address prior under-resourcing and insufficient autonomy.
  - Strengthen coordination and information flows among supervisory authorities and to monetary and fiscal authorities, especially for macro-prudential supervision, which currently scarcely exists.
  - CMISD and ISA should significantly strengthen public transparency via timely analysis of developments, issues, and risks.
  - Assess moral hazard risk from targeted emergency support measures for the non-bank sector and reflect any risk in supervisory guidelines.
- Hodak Committee recommendations (bond market):
  - Make covenants commonly used in Europe and the US mandatory in Israel (e.g., negative pledges, right of bondholders to insist on immediate repayment in specified circumstances).
  - Require institutions purchasing bonds to establish meaningful processes for evaluating bond risks and to monitor such investments on an ongoing basis.
  - Require bond issuers to make necessary information available on a regular basis.

### Lessons from Israel’s experience
- Principal lessons:
  - Promote prudent behavior by financial institutions and a conservative approach by supervisors; without these, rules alone are insufficient.
  - Review governance to ensure senior officers have track records of prudent behavior and are held accountable.
  - High transparency and accountability reinforce supervisory conservatism.
  - Relatively simple quantitative guides and rules can be effective backstops for sophisticated risk management when risk parameter values are uncertain; efficiency costs may be modest.
  - Major financial-sector reforms should be accompanied by corresponding supervisory capacity and structural changes to avoid unsupervised activity or over-stretching supervisors.
  - Independent but accountable supervisory agencies and strong inter-agency cooperation help minimize risks.

### Authorities’ response; macroeconomic developments and policy responses 2007–09
- Authorities’ stance:
  - Agreed with much of the staff analysis and policy proposals, but reserved on the form of fiscal rules.
  - Emphasized commitment to phased reductions in income tax rates.
  - Intend to review international practice on non-bank supervision arrangements before final decisions.
  - Underscored intentions regarding exit from discretionary intervention on foreign exchange markets.
- Macroeconomic policy response highlights:
  - Progress in the prior decade had lowered public debt and budget deficit, strengthened banks, and increased flexibility through structural reforms.
  - Fall 2008 policy response included:
    - Bank of Israel policy rate cuts to ½ a percent.
    - Unconventional monetary measures, notably preprogrammed foreign exchange intervention.
    - Fiscal stabilizers accommodated; medium-term sustainability anchored on declining annual ceilings on deficits to 2014.
    - Targeted financial sector stabilization initiatives designed to minimize moral hazard.
  - As the crisis deepened, fixed investment and consumer durables spending fell sharply into early 2009; overall output impact was modest due to policy responses and high household savings.
  - Monetary stance tightened as inflation neared the upper end of the target band; some unconventional measures ceased and intervention shifted from preprogrammed to discretionary.
  - Fiscal developments:
    - A “two-year” budget adopted mid-2009 to end-2010.
    - Prior spending ceilings and the VAT rate were raised to meet immediate priorities; both to be reversed from end-2010.
    - Authorities place premium on deficit reduction via scheduled declining ceilings; cap on real spending growth set to decline in 2011 to just 0.4 percent.
    - No explicit medium-term debt objective, though a 60 percent of GDP objective is broadly understood as desirable.

*Italic: IMF staff report excerpt (content unit as provided).*

### 7.       The intent of preannounced income tax reductions is to clarify conditions for

### 7.       The intent of preannounced income tax reductions is to clarify conditions for 

### Preannounced income tax reductions: intent and implications
- The intent of preannounced income tax reductions is to clarify conditions for business and investors—and so encourage early new investment.
- As tax burdens are likely to rise internationally in coming years following the global crisis, the planned tax reductions may have a particularly beneficial impact on establishing Israel as an attractive investment destination.
- While the importance of public debt reduction is recognized, the commitment to announced tax reductions will remain in place, though assessments of their impact on investment, employment, and deficits will continue to be refined.

### Supervision of non-banks
- Best practice in the structure of supervisory bodies and the content of supervision remains unclear, with a variety of different models globally which will be reviewed before a determination is made of the appropriate arrangements for Israel.
- Effective supervision of non-banks is seen as a priority, not least given the risk of international and domestic aftershocks following the recent global crisis.
- A key benefit of housing the CMISD within the Ministry of Finance is that it facilitates the free flow of supervisory and market intelligence to policymakers there.
- Key steps to strengthen the content of nonbank supervision are underway, and the resourcing of those supervisors will be kept under review.

### Exit from discretionary intervention in foreign exchange markets
- Exit from discretionary intervention in foreign exchange markets

*Source: _cr1023 - 7.       The intent of preannounced income tax reductions is to clarify conditions for*

### 9.      Discretionary intervention is a transitional step towards a free floating exchange rate

### 9.      Discretionary intervention is a transitional step towards a free floating exchange rate

### Role and intention of discretionary exchange market intervention
- Discretionary intervention is described as a transitional step facilitating the exit from the preprogrammed USD purchases that began in March 2008.
- The transition is to a free floating exchange rate regime in the context of domestic and global exit from extraordinary measures taken during the crisis.
- When the transitional phase ends (envisaged when nominal policy rates return to “normal” levels), any formal announcement will note that the Bank of Israel (BoI) reserves the right to intervene in exceptional circumstances—i.e., a return to the situation prior to preprogrammed reserve accumulation.
- The BoI "does not target any specific rate" and “does not and will not target any specific rate.”
- With increasing integration into global capital markets, the need for such exceptional interventions to prevent disorderly conditions cannot be ruled out.

### IMF classification and timing
- Effective August 10, 2009, the Fund reclassified Israel’s de facto exchange rate regime from “free floating” to “floating,” because the authorities made discretionary interventions on more than three occasions since July 2009.
- The authorities’ de jure classification remains as “floating.”
- The BoI discontinued pre-announced FX interventions and government bond purchases in Summer 2009 and began raising policy rates for September 2009, to 1.25 percent for January 2010.

### Monetary policy actions and guidance
- BoI policy rate movements and targets:
  - Reduced from 4.25 percent in February 2008 to 0.5 percent in April 2009.
  - Began raising rates in September 2009; policy rate increased by a total of 75 basis points since it began increasing in September (timing of increases spans September through January 2010 context).
  - Policy rate was 1.25 percent for January 2010 (as stated).
- Unconventional measures during crisis:
  - Daily purchase of US$100 million (preannounced).
  - Preannounced daily amount of NIS 200 million of government bonds (stopped in August 2009 when preannounced target reached).
- Transition to discretionary intervention:
  - In August 2009 the preannounced daily purchase of foreign currency was replaced by discretionary intervention.
  - The BoI announced it would intervene only in the event of unusual movements in the exchange rate inconsistent with underlying economic conditions.
- Forward guidance on ending discretionary intervention:
  - Discretionary interventions should be formally terminated, for all but the most exceptional market circumstances, once the policy interest rate is well above its effective floor on a sustained basis.
  - Going forward, the pace of increases in the policy rate will be determined by growth (global and domestic), the inflation environment, and the rate at which major central banks increase their interest rates. Financial stability considerations, such as asset prices including housing prices, will also be taken into account.

### IMF Executive Board assessment and policy recommendations
- Directors’ observations:
  - Resilience during the global crisis reflected strong policy responses, robust fundamentals, prudent bank supervision, public debt reduction, and structural reforms.
  - Global outlook remains highly uncertain; slower medium-term global growth would adversely affect Israel’s potential growth.
- Recommended policy directions:
  - Strengthen long-term anchors in policy frameworks to allow flexible short-term responses and stimulate long-term supply.
  - Strengthen fiscal framework: reconcile aggregate spending ceilings with the sum of undertakings on specific programs; adopt fiscal rules anchored by explicit medium-term debt targets; adopt multi-year spending ceilings with appropriate countercyclical properties; strengthen medium-term budget planning.
  - Urged early completion of steps to adopt the Bank of Israel Law.
  - Monetary: discontinue discretionary interventions except in exceptional circumstances once policy rates are well above their effective floor; avoid targeting specific exchange rate levels.
  - Financial sector: conduct comprehensive banking stress tests; regularly publish a financial stability report by the BoI; improve coordination among regulators; consider a formal deposit insurance scheme (recommended by some Directors).
  - Non-bank sector: strengthen budget, staff, and autonomy of non-bank regulators; consider separation of the pension and insurance regulator from the Ministry of Finance; encourage regular publication of risk analyses by non-bank regulators.

### Contextual macroeconomic and policy developments (select figures and actions)
- Growth and external position:
  - Growth averaged over 5 percent in 2004–07.
  - Real GDP growth: 5.1 (2005), 5.3 (2006), 5.2 (2007), 4.0 (2008), 0.1 (2009 IMF staff projection), 2.5 (2010 IMF staff projection).
  - Current account (percent of GDP): 3.1 (2005), 5.0 (2006), 2.8 (2007), 1.0 (2008), 3.3 (2009), 2.0 (2010).
- Fiscal:
  - Central government balance: -1.9 (2005), -1.0 (2006), 0.0 (2007), -2.2 (2008), -5.1 (2009), -4.1 (2010).
  - General government debt: 93.5 (2005), 84.4 (2006), 78.1 (2007), 76.8 (2008), 79.9 (2009), 80.9 (2010).
  - Authorities’ program: temporary 1 percentage point rise in VAT programmed to be reversed at end-2010; at beginning of 2010 VAT reduced by 0.5 percentage points (bringing VAT to 16 percent).
  - Staff recommended interim target of 70 percent debt-to-GDP by the middle of the coming decade and 60 percent by 2020 (to be considered by authorities).
- Bank of Israel interventions and bond purchases:
  - Preprogrammed USD purchases began in March 2008.
  - Daily purchases of US$100 million continued as part of crisis response and were replaced by discretionary interventions in August 2009.
  - Preannounced daily purchases of NIS 200 million of government bonds stopped in August 2009 when target reached.
- Financial sector strength:
  - Banks ordered in 2007 to raise capital adequacy ratios (CAR) to 12 percent by end-2009; by September 2009 all banks achieved this goal without using government guarantees.
  - Problem loans to total loans rose by 1-2 percentage points in the five major banking groups since December 2007, amounting to 7-9 percent of total loans; loan-loss provision rose by 0.5 percentage point to 0.7 percent of total loans.
  - Long-term savings market investment returns (January 2008 to November 2009): life insurance policies 7.4 percent, provident funds 5.2 percent, new pension funds 11.9 percent.
- Foreign reserves (end period, billions of U.S. dollars): 28.3 (2005), 29.4 (2006), 28.8 (2007), 42.7 (2008), 61.5 (2009).

### Implementation and data classification notes
- The Fund reclassified Israel’s de facto exchange rate regime to “floating” effective August 10, 2009, due to discretionary interventions on more than three occasions since July 2009; authorities’ de jure classification remains “floating.”
- Statistical and reporting notes in Annex II highlight some shortcomings in monetary and government finance statistics (e.g., banking statistics not based on balance sheet reporting; interest expenditure excludes the inflation component in reported overall annual fiscal balance methodology) and ongoing moves to improve conformity with international standards.

*International Monetary Fund — Staff Report for the 2009 Article IV Consultation; Informational Annex (January 12, 2010) (as provided in the source content).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr1023.pdf_