## _cr1121

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---

### Financial sector structure and vulnerabilities — macroeconomic rebound and output
- Output fell mildly and for only 2 quarters from Q4 2008; growth was 0.8 percent in 2009 and is projected to rise to some 4 percent in 2010.
- Recovery drivers:
  - Consumer spending led the recovery from Q2 2009; strength mainly in non-durables while spending on durables fell sharply (by 6 percent in 2009) and recovered relatively slowly.
  - Exports recovered from H2 2009 and were back at pre-crisis levels by 2010, but Q3 2010 showed outright falls in export volumes and a sharp deceleration in private consumption.
- Housing: demand for housing construction picked up strongly from Q2 2009 as a delayed supply response to the housing market take-off that began a year earlier.

### Credit, employment, and real wages
- Credit patterns:
  - Credit from domestic and foreign sources to households: annual rates of some 8 percent in 2009 and 2010.
  - Credit to non-financial firms: all but stagnated; credit to firms remains weak.
- Employment and wages:
  - Jobs rose 4½ percent through Q2 2010; permanent jobs rose 2.8 percent through Q2 2010.
  - Unemployment: peak of 8 percent in early 2009; 6 percent in Q2 2010.
  - Participation rates leveled off at 56 percent in 2009–10.
  - Economy-wide real wage declines: 2½ percent in 2009.

### External sector, exchange rate, and inflation
- Current account and flows:
  - Current account balance strengthened by 3 percentage points of GDP in 2009 despite weakness in exports and net income receipts.
  - Short-term net inflows by residents surged from end-2007; short-term net flows by non-residents remained broadly stable; upward pressure on the shekel resumed after Spring 2010.
  - CDS spreads around 80 bps in 2010; no signs of sovereign debt stress.
- Exchange rate and inflation:
  - Real value of the shekel: some 15 percent above pre-crisis levels (soared back to mid-crisis peaks).
  - Headline CPI continuously slightly above the 1–3 percent target range since end-2007 (partly boosted by indirect tax hikes) and only recently fell back into the target range.
  - Inflation expectations one and three years ahead remain elevated.
  - Staff modeling: absent the strong shekel since mid-year, the CPI would be 1 percentage point higher in Fall 2010 than the outturn.

### Housing market and macrofinancial policy measures
- House prices:
  - Prices of owner-occupied dwellings rose steadily since fall 2007; house prices are now 40 percent above pre-crisis levels.
  - Evidence mixed on whether house prices were still rising as of the latest observations in the source.
- Bank of Israel (BoI) macroprudential measures:
  - Penalties increased on lending in excess of the 20 percent indicative limit on the share of banks’ lending.
  - Banks required to review risks in mortgage portfolios and raise loan-loss provisioning by at least 75 basis points for loans granted since April with LTV ratios above 60 percent.
  - Reserve requirement on such loans raised further from late October; the measures raise borrowing costs by some 50 basis points.
  - 1/3 of new mortgages extended during 2010 exceed the LTV threshold.
  - BoI described these measures as “warning shots” and indicated further actions if the housing market does not cool.

### Banking system and non-bank financial sector
- Banking sector:
  - Dominated by five banks.
  - Only one bank recorded outright losses in 2008; banks raised capital ratios during the crisis via retained profits, bond and equity issues.
  - Average risk-weighted capital ratios: 13.6 percent.
  - Tier 1 capital ratio: 8.5 percent.
  - NPLs declined; provisioning needs fell; returns on equity and assets increased though remain below pre-recession levels.
- Non-bank sector:
  - Insurance, pensions, mutual funds grew rapidly pre-crisis; share of financing via equity and bond markets rose to nearly half of corporate sector financing.
  - Capital markets suffered major losses in 2008–09; corporate bond market temporarily seized up at end-2008.
  - Insurers and pensions experienced large losses, but bond and equity market prices rose above pre-crisis levels since early 2009, boosting portfolios and solvency ratios.
  - Volume of bond and equity market issuance remains well off pre-crisis levels, especially in the non-financial corporate sector.

### Fiscal and monetary policy response (summary)
- Fiscal:
  - Budget set for two years (2009–10); central government nominal revenue overperformed despite VAT reduction to 16 percent from January 2010.
  - Nominal spending held well below budget in 2009 and partly in 2010; budget overperformance of 0.8 and 1½ percentage point of GDP in 2009 and 2010 respectively.
  - 2009–10 budget initiated credibility-building fiscal rules targeting phased near-term deficit reduction and capping spending growth.
- Monetary:
  - BoI tightened from September 2009, raising policy rates in 25 basis point steps from a floor of ½ percent to 2 percent by October 2010.
  - New Bank of Israel Law in 2010 formalized inflation targeting practices.
  - Despite rate increases, real interest rate remained negative and overall monetary stance remained expansionary.

### Key statistics and indicators (as reported)
- GDP growth: 0.8 percent in 2009; projected some 4 percent in 2010.
- Jobs: rose 4½ percent through Q2 2010; permanent jobs rose 2.8 percent through Q2 2010.
- Unemployment: 8 percent peak in early 2009; 6 percent in Q2 2010.
- Real wages: decline of 2½ percent in 2009.
- Household credit growth: annual rates of some 8 percent in 2009 and 2010.
- Current account: strengthened by 3 percentage points of GDP in 2009.
- Shekel real value: about 15 percent above pre-crisis levels.
- House prices: 40 percent above pre-crisis levels.
- Bank capital ratios: average risk-weighted capital ratio 13.6 percent; Tier 1 capital ratio 8.5 percent.
- Fiscal outperformance: 0.8 and 1½ percentage point of GDP in 2009 and 2010 respectively.
- Policy rate path: raised from ½ percent to 2 percent by October 2010.
- Mortgage measures: loan-loss provisioning raised by at least 75 basis points for loans since April with LTV above 60 percent; reserve requirement on such loans raised further; measures increase borrowing costs by some 50 basis points; 1/3 of new mortgages during 2010 exceed the LTV threshold.
- Public sector wage agreement: envisages rises of 6½ percent over three years.

---

### WEO projections and implications for Israel (central case and risks)
- WEO global projections (percent):
  - World GDP: 2010 4.6; 2011 4.3; 2012 4.6
  - Advanced Economies GDP: 2010 2.6; 2011 2.2; 2012 2.6
- Import volume growth (percent):
  - World: 2010 10.2; 2011 6.5; 2012 6.7
  - Advanced Economies: 2010 8.4; 2011 5.0; 2012 5.2
  - Good only excl. oil: Israel’s Partners: 2010 12.2; 2011 6.8; 2012 6.6
- Prices and Israel terms of trade (percent):
  - Oil price: 2010 23.3; 2011 3.3; 2012 4.4
  - Israel Export Prices: 2010 13.2; 2011 -2.1; 2012 -1.5
  - Israel Import Prices: 2010 12.2; 2011 0.0; 2012 0.0
- WEO uncertainty intervals:
  - WEO 90 percent confidence interval for global growth for 2011: 2–6 percent
  - WEO 70 percent confidence interval for global growth for 2011: 3–5 percent
  - Estimated 90 percent confidence interval for Israeli output (using elasticities): 2–5 percent

### Central staff macrofinancial projections (annual percent changes and levels)
- Real GDP: 2010 3.9; 2011 3.5; 2012 3.8
- Domestic demand: 2010 3.7; 2011 3.7; 2012 3.6
- Private consumption: 2010 4.9; 2011 4.0; 2012 4.3
- Public consumption: 2010 2.2; 2011 2.1; 2012 0.9
- Gross capital formation: 2010 2.2; 2011 5.0; 2012 4.7
- Fixed capital formation: 2010 8.2; 2011 6.5; 2012 6.0
- Exports of goods and services: 2010 11.8; 2011 2.4; 2012 7.5
- Imports of goods and services: 2010 10.6; 2011 2.8; 2012 7.1
- Current account (percent of GDP): 2010 2.2; 2011 1.2; 2012 1.5
- CPI: 2010 2.6; 2011 3.0; 2012 2.5
- Unemployment rate (percent): 2010 6.6; 2011 5.5; 2012 5.0

### Core diagnostic policy issues and staff judgments
- Five core issues for policy design:
  - Size of the output gap and inflationary restraint
  - House price developments and financial stability risks
  - Shekel competitiveness
  - Capital inflows: continuation or intensification
  - Sovereign risks
- Staff assessment on shekel:
  - ERER and CPI-REER indicate the shekel could be somewhat on the strong side (i.e., overvalued), though MB and ES estimates differ; significant uncertainty remains.
  - Recent discovery of offshore natural gas reserves: relatively modest—perhaps 30 percent of GDP in NPV terms—and authorities intend to apply proceeds to public debt reduction.
- Policy implication: further tightening of policies is warranted given contained inflation so far largely due to strong shekel.

---

### Fiscal policy: consolidation, budget mechanics, and recommendations
- Authorities’ budget path:
  - Ceilings on headline deficit under new fiscal rule: decline from 4 percent of GDP in 2010 to 3 percent of GDP in 2011 and 2 percent of GDP in 2012.
  - Budget anticipates a 0.8 percentage point of GDP strengthening in the structural primary balance in 2011 and a further 0.6 percentage point strengthening in 2012.
  - Nominal revenues net of tax policy changes grow some 4 percentage points higher than nominal GDP.
  - Within spending, switch from defense to higher education.
- Selected budget data (Central Government):
  - Revenue (Billions of NIS): 2010 238; 2011 262; 2012 258; 2015 333
  - Revenue (Percent of GDP): 2010 28.9; 2011 30.3; 2012 29.3; 2015 30.1
  - Expenditure (Percent of GDP): 2010 32.8; 2011 33.3; 2012 32.3; 2015 31.1
  - Budget balance (Percent of GDP): 2010 -3.9; 2011 -2.9; 2012 -3.0; 2015 -1.0
  - General Government overall balance: 2010 -4.1; 2012 -2.2; 2015 -1.1
  - Gross public debt: 2010 75.5; 2012 72.8; 2015 62.3
  - Memo: Nominal GDP, NIS billion: 2010 826; 2011 864; 2012 880; 2015 1109
- Staff recommendations:
  - Case for accelerating planned consolidation: strengthen planned fiscal stance for 2011 and beyond by some 1 percentage point of GDP in structural terms.
  - Practical measures: use budget operation mechanisms to hold spending below allocations (freeze reserves) without amending the approved budget; address revenue-side risks, possibly via indirect taxes if needed.
  - Rationale: dampen demand growth, lower inflation pressures, allow a slower rise in BoI rates, and ease upward pressure on the shekel.
  - Note: additional consolidation can be accomplished without amending the budget.

### Budget operation and revenue uncertainty
- Budget operation mechanisms and expenditure reserves allow scope to hold spending below allocations; operating the 2011–12 budget this way does not require amendment.
- Revenue uncertainty: difficulties accounting for outturns in 2009–10 (notably corporation tax) create uncertainties for 2011–12; corrective steps would be required early if receipts fall below target.
- If discretionary spending restraint already assigned, revenue shortfalls would likely need to be addressed on the revenue side; action on indirect taxes identified as an option.

---

### Monetary and exchange rate policies: dilemma, instruments, and staff view
- Macro context:
  - BoI policy rate expected to rise by 75–100 basis points over the coming year; real interest rates would then be just into a positive range.
  - Core inflation at the upper end of the target range; inflation expectations up to 5 years have risen to the top of the target range.
  - Output recovering; unemployment close to historical lows.
- Staff policy guidance:
  - Fiscal consolidation is first-best option; additional fiscal effort preferred.
  - FX intervention: discretionary intervention continues but should address disorderly conditions rather than become central; constraints include high reserves (US$ 65 billion, 15 months of 2007 imports) and BoI losses.
  - Macroprudential tools: reserve requirements and high LTV requirements for mortgage lending could be raised further; accelerate and apply anti-cyclical capital standards towards Basel III goals.
  - Capital controls: could play a role if affected flows are large and low substitutability, but effectiveness uncertain and signaling problematic; authorities view controls as “never-say-never” but not immediate.

---

### Financial stability, supervision, and strengthening resilience
- Banking system indicators:
  - Capital adequacy ratios and Tier 1 capital have risen; impaired and non-performing loan ratios have declined.
  - Household leveraging increased somewhat but overall level low; mortgage LTVs low by international standards.
  - Banks maintain high liquidity; interbank and direct FX exposures small.
- Non-bank sector:
  - Solvency ratios comfortably above pre-crisis levels; conservative portfolio allocations.
  - Vulnerability: close ties to domestic capital markets; corporate bond market size over 25 percent of GDP creates concentration risk.
- Basel III preparedness and stress testing:
  - Israeli banks well-positioned for higher capital requirements; BoI issued draft guidelines for core capital of at least 7.5 percent by end-2010.
  - Stress testing needs: detailed bank-by-bank data, corporate and household balance sheets, collaboration with CMISD and main banks, linkage to macro forecasting framework.
  - Recommendation: publish a Financial Stability Report regularly; strengthen BoI monitoring, resources, and institutional arrangements; review adequacy and autonomy of non-bank supervisors (ISA and CMISD), and consider structural options including shifting CMISD out of the MoF.
- Supervision governance:
  - Establish institutional arrangements to coordinate the three supervisory agencies on financial stability and macroprudential instruments, drawing on models in Europe and the United States.

---

### Sovereign risks and public debt outlook
- Baseline and vulnerabilities:
  - Israel’s public debt ratio well below the average for advanced countries, but exposed to external shocks and high macroeconomic volatility.
  - Public debt described elsewhere as "a little below 80 percent of Gross Domestic Product (GDP)."
- Stress-test findings (projected effects by 2015):
  - Negative permanent shock to growth of half a standard deviation: public debt ratio at 76 percent in 2015 (stalls consolidation).
  - Negative permanent shock to growth of one standard deviation (extreme tail): public debt ratio nearly 90 percent of GDP in 2015.
  - Fiscal contingent liabilities amounting to 10 percent of GDP could raise public sector debt to 72 percent of GDP by 2015.
  - Currency depreciation of 30 percent would raise the debt ratio to about 69 percent of GDP by 2015.
  - An increase in real interest rates would raise the public debt ratio to 66 percent by 2015.
- Monte Carlo/probabilistic assessment:
  - Under central scenario, new fiscal rules result in public debt reduction to slightly above 60 percent by 2015.
  - Monte Carlo simulations show significant uncertainty: there is a 97.5 percent chance that the maximum likely debt ratio will remain close to its 2009 level.
  - Policy tools that reduce variance (for example a fiscal reaction function) could lower uncertainty around the public debt path.

---

### Natural gas discoveries — fiscal impact, recommendations, and safeguards
- Medium-term impact:
  - Recent natural gas discoveries could have a positive impact on fiscal sustainability, but likely impact is highly uncertain.
  - Overall revenues will be modest on current estimates of the volume of gas.
- Policy recommendations:
  - Adopt international best practice in taxation of natural resources, including appropriate pricing arrangements and securing intergenerational distribution of proceeds.
  - First use of such tax receipts: reduce public debt, given modest revenue expectations.
  - Contingency if gas wealth proves much larger: place revenues in a sovereign wealth fund to ensure intergenerational equity and avert Dutch disease.
- Contextual debt indicators:
  - General government debt (percent of GDP): 77.7 (2007), 76.7 (2008), 77.6 (2009), 75.5 (2010), 72.8 (2011 projected).

---

### Staff recommendations and policy priorities (concise)
- Strengthen planned fiscal consolidation by some 1 percentage point of GDP in structural terms for 2011 and beyond.
- Use budget operation mechanisms (freeze reserves) to achieve additional consolidation without amending the budget.
- Prioritize fiscal consolidation as the primary tool to address inflationary pressures and competitiveness erosion from capital inflows and a strong shekel.
- Continue targeted macroprudential measures (higher provisioning, reserve requirements, LTV limits) and accelerate capital standard strengthening towards Basel III, complemented by better stress testing and institutional reforms in supervision.
- Reserve FX intervention for disorderly markets; do not rely on one-sided intervention as the main response to sustained inflows.
- Prepare contingency for capital controls as a targeted, last-resort option if other measures are exhausted and specific inflows are large and non-substitutable.
- First use of natural resource tax receipts: public debt reduction; consider a sovereign wealth fund if receipts are far larger than current estimates.

*Italic: IMF staff report chapter "1. Financial Sector Structure and Vulnerabilities" and related excerpts from the IMF staff report (_cr1121) as provided.*

### 1. Financial Sector Structure and Vulnerabilities ..............................................................6

### 1. Financial Sector Structure and Vulnerabilities

### Macroeconomic rebound and output
- Output fell mildly and for only 2 quarters from Q4 2008; growth was 0.8 percent in 2009 and is projected to rise to some 4 percent in 2010.
- The recovery was led by consumption and exports:
  - Consumer spending led the recovery from Q2 2009; strength was mainly in non-durables while spending on durables fell sharply (by 6 percent in 2009) and recovered relatively slowly.
  - Exports recovered from H2 2009 and were back at pre-crisis levels by 2010, but Q3 2010 showed outright falls in export volumes and a sharp deceleration in private consumption, signaling emerging limits to output strength.
- Demand for housing construction picked up strongly from Q2 2009 as a delayed supply response to the housing market take-off that began a year earlier.

### Credit, employment, and real wages
- Credit patterns:
  - Credit from domestic and foreign sources to households was buoyant—at annual rates of some 8 percent in 2009 and 2010.
  - Credit to non-financial firms has all but stagnated; credit to firms remains weak.
- Employment and wages:
  - After a modest decline in the first half of 2009, jobs rose 4½ percent through Q2 2010 (2.8 percent for permanent jobs).
  - Unemployment fell from its peak of 8 percent in early 2009 to 6 percent in Q2 2010.
  - Participation rates leveled off at 56 percent in 2009–10 after rising prior to that.
  - Economy-wide real wage declines were 2½ percent in 2009.

### External sector, exchange rate, and inflation
- External and capital flow dynamics:
  - Despite weakness in exports and net income receipts in 2009, the current account balance strengthened by 3 percentage points of GDP—reflecting sharp falls in durables and investment imports and falling international energy prices.
  - Short-term net inflows by residents surged from end-2007 while short-term net flows by non-residents remained broadly stable; upward pressure on the shekel resumed after Spring 2010.
  - The real value of the shekel soared back to its mid-crisis peaks—some 15 percent above pre-crisis levels—eroding competitiveness.
  - CDS spreads were in the neighborhood of 80 bps in 2010; there have been no signs of sovereign debt stress.
- Inflation dynamics:
  - The strong shekel has helped contain inflation; wholesale prices remained below their mid-2008 peaks and food prices were flat until recently.
  - Since end-2007, headline CPI was continuously slightly above the 1–3 percent target range (partly boosted by indirect tax hikes) and only recently fell back into the target range.
  - Inflation expectations one and three years ahead remain elevated (Figure references in source).

### Housing market and macrofinancial policies
- House prices:
  - After many years of stagnation in nominal terms, prices of owner-occupied dwellings rose steadily since fall 2007; house prices are now 40 percent above pre-crisis levels.
  - Evidence is mixed on whether house prices were still rising as of the latest observations in the source.
  - Rising house prices may have partly offset wealth effects from falling securities prices, supporting household consumption.
- Macroprudential and housing finance measures:
  - The Bank of Israel (BoI) tightened restrictions on housing sector financing:
    - Penalties increased on lending in excess of the 20 percent indicative limit on the share of banks’ lending.
    - Banks required to review risks in mortgage portfolios and to raise loan-loss provisioning by at least 75 basis points for loans granted since April with LTV ratios above 60 percent.
    - The reserve requirement on such loans was raised further from late October; the measures raise borrowing costs by some 50 basis points.
    - 1/3 of new mortgages extended during 2010 exceed the LTV threshold.
  - The BoI indicated these measures are “warning shots” and stated that further actions will be taken if the housing market does not cool.

### Banking system structure and non-bank financial sector (Box 1)
- Banking sector:
  - The Israeli banking system is dominated by five banks.
  - Although profits declined in 2008, only one bank recorded outright losses.
  - Banks continued to raise capital ratios during the crisis through retained profits, bond and equity issues.
  - Average risk-weighted capital ratios have risen to 13.6 percent.
  - The Tier 1 capital ratio has risen to 8.5 percent.
  - As NPLs declined, provisioning needs fell and returns on equity and assets increased for most banks, though returns remain below pre-recession levels.
- Non-bank financial sector:
  - The non-bank sector (insurance, pensions, mutual funds) grew rapidly prior to the crisis, with its share of lending via equity and bond markets rising to nearly half of total financing of the corporate sector.
  - Capital markets suffered major losses in 2008–09; the corporate bond market temporarily seized up at end-2008.
  - Insurers and pensions experienced large losses, but since early 2009 bond and equity market prices rose above pre-crisis levels, boosting insurance and pension portfolios and solvency ratios.
  - Volume of bond and equity market issuance remains well off pre-crisis levels, especially in the non-financial corporate sector.

### Fiscal and monetary policy response
- Fiscal stance and outcomes:
  - Policy tightening largely reflects automatic stabilizers following earlier loosening in 2008–09.
  - With the budget set for two years (2009–10) and growth higher than budgeted, central government nominal revenue overperformed—despite the earlier-than-anticipated reduction in the VAT to 16 percent from January 2010.
  - Nominal spending was held well below budget in 2009 and partly in 2010, yielding budget overperformance of 0.8 and 1½ percentage point of GDP in 2009 and 2010 respectively.
  - The 2009–10 budget represented first steps to establish credibility of fiscal rules targeting phased near-term deficit reduction and capping spending growth to support medium-term public debt reduction.
- Monetary policy:
  - The Bank of Israel commenced tightening from September 2009, raising policy rates in 25 basis point steps from a floor of ½ percent to 2 percent by October 2010.
  - A new Bank of Israel Law in 2010 formalized its established inflation targeting practices.
  - Despite rate increases, the real interest rate remained negative and the overall monetary stance remained expansionary, notwithstanding the appreciation of the shekel since mid-2008.

### Key statistics and indicators (as reported)
- GDP growth: 0.8 percent in 2009; projected some 4 percent in 2010.
- Recovery employment changes: jobs rose 4½ percent through Q2 2010; permanent jobs rose 2.8 percent through Q2 2010.
- Unemployment: peak of 8 percent in early 2009; 6 percent in Q2 2010.
- Real wages: decline of 2½ percent in 2009.
- Household credit growth: annual rates of some 8 percent in 2009 and 2010.
- Current account: strengthened by 3 percentage points of GDP in 2009.
- Exchange rate: real value of shekel about 15 percent above pre-crisis levels (as described).
- House prices: 40 percent above pre-crisis levels.
- Bank capital ratios: average risk-weighted capital ratio 13.6 percent; Tier 1 capital ratio 8.5 percent.
- Fiscal outperformance: 0.8 and 1½ percentage point of GDP budget overperformance in 2009 and 2010 respectively.
- Policy rate path: raised from ½ percent to 2 percent by October 2010.
- Mortgage measures: loan-loss provisioning raised by at least 75 basis points for loans since April with LTV above 60 percent; reserve requirement on such loans raised further; measures increase borrowing costs by some 50 basis points; 1/3 of new mortgages during 2010 exceed the LTV threshold.
- Public sector wage agreement: envisages rises of 6½ percent over three years (public sector).

*Source: IMF staff report chapter "1. Financial Sector Structure and Vulnerabilities" (excerpts provided).*

### 13.      The WEO projects a temporary slowdown of growth in advanced economies in 2011

### _cr1121 - 13.      The WEO projects a temporary slowdown of growth in advanced economies in 2011

### WEO projections and implications for Israel
- The WEO projects global and regional growth:
  - World GDP: 2010 4.6; 2011 4.3; 2012 4.6
  - Advanced Economies GDP: 2010 2.6; 2011 2.2; 2012 2.6
- Import growth: volume
  - World: 2010 10.2; 2011 6.5; 2012 6.7
  - Advanced Economies: 2010 8.4; 2011 5.0; 2012 5.2
  - Good only excl. oil: Israel’s Partners: 2010 12.2; 2011 6.8; 2012 6.6
- Prices and Israel terms of trade:
  - Oil price: 2010 23.3; 2011 3.3; 2012 4.4
  - Israel Export Prices: 2010 13.2; 2011 -2.1; 2012 -1.5
  - Israel Import Prices: 2010 12.2; 2011 0.0; 2012 0.0
- With the real price of oil projected broadly unchanged from current levels, further steady declines in Israel’s terms of trade are projected after the significant gains in 2009.
- WEO uncertainty:
  - WEO 90 percent confidence interval for global growth for 2011: 2–6 percent
  - WEO 70 percent confidence interval for global growth for 2011: 3–5 percent
  - Estimated 90 percent confidence interval for Israeli output (using elasticities): 2–5 percent

### Core diagnostic issues (overview)
- Five core issues for policy design:
  - Size of the output gap and inflationary restraint
  - House price developments and financial stability risks
  - Shekel competitiveness
  - Capital inflows: continuation or intensification
  - Sovereign risks

### A. Output gap and inflation
- Output gap assessment:
  - Israel was close to capacity in 2008, experienced a relatively mild and short passage through the great recession, and saw sharp falls in fixed investment.
  - HP filter (λ = 1600) on 1993Q1–2010Q3 data: output above capacity in 2007; falling below capacity in 2008–09; gap appears to be falling rapidly to below ½ of a percentage point of GDP at present.
  - Note: output was projected forward for 10 quarters prior to estimation to address end-point problems.
- Inflation dynamics:
  - Headline inflation has fallen back into range in 2010.
  - Private nominal wage growth has picked up; “break-even” inflation forecasts have risen to the upper limit of the inflation target over the medium term.
  - Staff modeling suggests that, absent the strong shekel since mid-year, the CPI would be 1 percentage point higher in Fall 2010 than the outturn.
- Policy implication: While the strong shekel has contained inflationary pressures so far, further tightening of policies is warranted.

### B. Housing markets and financial-stability considerations
- House price developments:
  - House prices are up over 40 percent since the great recession began.
  - Absence of a prior housing bubble; long-standing supply constraints; restrictive planning regulations; safe-haven inflows; low policy interest rates; uninterrupted bank lending to households contributed to the rise.
- Financial-stability indicators:
  - Private consumption behavior largely unaffected by the boom (possible exception Q2 2010).
  - No evidence the boom is related to weakening credit standards: mortgages are “full recourse”; almost all loans remain on original creditors’ books; none packaged into structured products.
  - Headline delinquency rates remain low and have declined over the past year.
  - Loan-to-values remain low (may reflect rising house prices).
- Affordability and supply:
  - Affordability is stretched relative to historical norms.
  - Residential building starts show a belated supply response easing pressures.
- Policy implication: Caution is appropriate; developments corroborate other signs that policies are accommodative.

### C. Shekel competitiveness
- Exchange rate and price indicators:
  - CPI-based REER is well above its trading range in the four years to end-2007.
  - Ratio of export prices to the GDP deflator is now well below ratios typical in those years.
- Historical equilibrium considerations:
  - The 2003–07 trading range may be near the equilibrium rate; that period had no BoI FX intervention, steady growth, unemployment falling toward 5 percent, and sustained low inflation.
  - Structural factors in 2007: fixed investment ratio 20 percent of GDP; high and rising private savings due to phased pension reform.
- Impact of recent developments:
  - Strong Israeli performance relative to core advanced countries may have raised the equilibrium rate somewhat.
  - Recent discovery of significant offshore natural gas reserves could further boost equilibrium, but the discoveries are relatively modest—perhaps 30 percent of GDP in NPV terms—and the authorities intend to apply proceeds to public debt reduction.
- CGER and valuation measures:
  - CGER estimates dispersed: ERER and CPI-REER suggest shekel significantly strong; Macro Balance (MB) and External Sustainability (ES) estimates suggest undervaluation.
  - MB and ES measures may exaggerate competitiveness by assuming the impact on savings of phased pension reforms has ended.
- Recent macro signs of overvaluation:
  - Export market share globally and in advanced countries fell in H1 2010, with outright export declines in Q3 2010.
  - Falling FDI inflows, weakness in non-housing fixed investment, and a small pickup in unemployment in Q3 2010.
- Assessment and policy sensitivity:
  - Emphasis on ERER and direct price measures leads to judgment that the shekel could be somewhat on the strong side (i.e., overvalued).
  - Significant margins of uncertainty; further significant and sustained appreciation beyond current rates would tilt the balance decisively.

### D. Capital inflows
- Inflow dynamics:
  - Relatively strong Israeli economic performance reflected in the policy interest rate differential and strong portfolio inflows in 2010.
  - On WEO projections showing advanced country deceleration in 2011, divergences in policy interest rates appear set to persist.
- Risk assessment:
  - Risk of significant and sustained exchange rate appreciation beyond current rates appears high.
- Policy stance:
  - Policy should be predicated centrally on inflow pressures being “enduring” rather than “short-lived.”
  - Purposeful policy response required to the extent inflows have eroded competitiveness and may do so further.

### E. Sovereign risks
- Sovereign financing and buffers:
  - Israeli sovereign financing and CDS spreads remained firm during the global recession.
  - Increases in headline debt ratios and contingent liabilities from the financial sector were limited; maturity structure of debt is long; growth outlook is strong.
  - Fiscal risks are not imminent.
- Risk drivers:
  - Spreads spiked after Lehman; global post-crisis strains compound perennial Israeli geopolitical risks.
- Policy implication: Strengthened macroeconomic buffers would be helpful, including further reductions in public debt.

### Macrofinancial policy settings — 2011–12 central case projections
- Staff central case: predicated on WEO and authorities’ announced policy frameworks.
- Fiscal rule and budget assumptions:
  - Ceilings on the headline deficit under the new fiscal rule: decline in the deficit from 4 percent of GDP in 2010 to 3 percent of GDP in 2011 and 2 percent of GDP in 2012.
  - Assumes growth of 4 percent in 2011 and 2012, with inflation on target.
  - Further moderate monetary policy tightening anticipated.
- Staff GDP projections (text table and Table 5 summary):
  - Annual projections (percent change):
    - Real GDP: 2010 3.9; 2011 3.5; 2012 3.8
    - Domestic demand: 2010 3.7; 2011 3.7; 2012 3.6
    - Private consumption: 2010 4.9; 2011 4.0; 2012 4.3
    - Public consumption: 2010 2.2; 2011 2.1; 2012 0.9
    - Gross capital formation: 2010 2.2; 2011 5.0; 2012 4.7
    - Fixed capital formation: 2010 8.2; 2011 6.5; 2012 6.0
    - Exports of goods and services: 2010 11.8; 2011 2.4; 2012 7.5
    - Imports of goods and services: 2010 10.6; 2011 2.8; 2012 7.1
  - Current account (percent of GDP): 2010 2.2; 2011 1.2; 2012 1.5
  - CPI: 2010 2.6; 2011 3.0; 2012 2.5
  - Unemployment rate (percent): 2010 6.6; 2011 5.5; 2012 5.0
- Outlook narrative:
  - With growth momentum checked by international deceleration and domestic fiscal consolidation, staff projections show GDP growth of some 4 percent in 2010, falling back to 3½ percent in 2011 before recovering in 2012.
  - Inflationary pressures expected to show up in 2011–12, partially checked by continued shekel strength.
  - Inflation projected to decline back to the mid-point of the target range and capital inflows pressures expected to ease thereafter; competitiveness and external performance are projected to suffer until then.

### Fiscal policy: consolidation and risks
- Authorities’ budget plans:
  - 2011–12 two-year budget anticipates decline in the deficit from 4 percent of GDP in 2010 to 3 percent in 2011 and 2 percent in 2012.
  - The 2011–12 budget anticipates a 0.8 percentage point of GDP strengthening in the structural primary balance in 2011 and a further 0.6 percentage point strengthening in 2012.
  - Nominal revenues net of tax policy changes grow some 4 percentage points higher than nominal GDP, allowing expenditure to rise in accordance with the new rule.
  - Within spending, the budget secures a switch in outlays from defense to higher education.
- Tax and expenditure measures:
  - Income tax rates fall as anticipated (see footnote on PIT and CIT schedule).
  - Additional revenue efforts: postponing a previously anticipated ½ a percentage point reduction in the VAT rate to 15½ percent from 2011 to 2013; increasing energy and other excise taxes in 2011; in 2012 additional energy tax increases offset planned tax cuts.
  - Outlays grow at 2.66 percent for 2011–12, adjusted with forecast average inflation, in line with ceilings under the new expenditure rule.
- Budget data excerpts (selected values preserved as in source):
  - Central Government (Billions of NIS): Revenue 2010 238; 2011 262; 2012 258; 2015 333
  - Central Government (Percent of GDP): Revenue 2010 28.9; 2011 30.3; 2012 29.3; 2015 30.1
  - Expenditure (Percent of GDP): 2010 32.8; 2011 33.3; 2012 32.3; 2015 31.1
  - Budget balance (Percent of GDP): 2010 -3.9; 2011 -2.9; 2012 -3.0; 2015 -1.0
  - General Government overall balance: 2010 -4.1; 2012 -2.2; 2015 -1.1
  - Gross public debt: 2010 75.5; 2012 72.8; 2015 62.3
  - Memo items: Nominal GDP, NIS billion: 2010 826; 2011 864; 2012 880; 2015 1109
- Assessment of sufficiency:
  - Even with structural deficit on a downward track, capital inflows and competitiveness concerns persist.
  - Tools to address those issues directly—intervention, macroprudential instruments, capital controls—have limited effectiveness and notable costs.
  - Case for accelerating planned consolidation to address competitiveness and inflow concerns.
  - Counter-argument that growth might falter and require fiscal support is attenuated by scope for monetary relaxation given Bank of Israel policy rates at 2 percent.
  - Planned structural consolidation should be regarded as the minimum; going further and faster would yield significant broader macroeconomic benefits.
- Practical note: Additional consolidation can be accomplished without amending the budget.

*Source: _cr1121 - 13.      The WEO projects a temporary slowdown of growth in advanced economies in 2011*

### 36.      As budget operation mechanisms and expenditure reserves allow considerable scope

### _cr1121 - 36.      As budget operation mechanisms and expenditure reserves allow considerable scope

### Fiscal policy: budget operation, revenue uncertainty, and natural resource taxation
- Budget operation mechanisms and expenditure reserves allow considerable scope to hold spending below allocations; one option is to operate the 2011–12 budget in this way by freezing reserves, which does not require amendment of the budget.
- Uncertainties in revenue outlook:
  - Difficulties in fully accounting for outturns in 2009–10, notably in respect of corporation tax, create uncertainties in revenue projections for 2011–12.
  - If during 2011 receipts appear to be falling below target, even with macro projections broadly on track or better than expected, corrective steps will be required at an early stage.
  - With discretionary spending restraint already devoted to securing structural over-performance, such revenue shortfalls would likely have to be addressed on the revenue side; action on indirect taxes—in line with OECD recommendations—was identified as one option.
- Natural gas tax policy:
  - Significant natural gas discoveries warrant a review of the current tax structure; the Ministry of Finance’s establishment of a commission to review current tax arrangements is welcomed.
  - The commission’s general intention to raise the “tax take” from these activities to advanced country norms is described as fully appropriate.
  - Reforms should adopt international best practice, including appropriate pricing arrangements in the tax and securing appropriate intergenerational distribution of the proceeds.
  - Recommended first use of such tax receipts: reduce public debt, given that overall revenues will be modest on current estimates of the volume of gas.
  - Contingency if large additional finds are made: place revenues in a sovereign wealth fund for intergenerational equity and to avert Dutch disease.

### Monetary and exchange rate policies: policy dilemma and instruments
- Macro context and dilemma:
  - Output recovering; BoI began withdrawal of stimulus early.
  - Cessation of preprogrammed forex intervention began process toward a freely floating exchange rate regime; intervention continues and Israel’s exchange rate regime remains classified as “floating.”
  - Unemployment close to historical lows; core inflation at the upper end of the target range; inflation expectations—even out to 5 years—have risen from the center to the top of the target range.
  - Markets are currently factoring an increase in the policy rate by 75–100 basis points over the coming year, which would bring real interest rates just into a positive range.
  - Even in that context, inflation expectations remain well above the middle of the target range through the medium-term.
  - Conclusion: further tightening is needed to avoid acceleration of inflation and associated need for subsequent disinflation.
- Policy instrument options and constraints:
  - Fiscal consolidation is the first best option; additional fiscal effort remains the option of choice.
  - Intervention:
    - Preprogrammed intervention ceased; discretionary intervention continues but would be one-sided and might need to be large.
    - Evidence of effectiveness given small market size; BoI research finds a consistent “unexplained residual” in exchange rate equations during the period of preprogrammed intervention.
    - Constraints: high level of reserves (US$ 65 billion, 15 months of 2007 imports) and associated BoI losses.
    - Sustained one-sided intervention risks signaling reduced commitment to allow exchange rate to broadly track fundamentals.
    - Recommendation: absent fiscal support, intervention should focus on addressing disorderly conditions rather than becoming central to resolving capital inflows, competitiveness and inflation concerns, even if this means allowing the exchange rate to appreciate.
  - Macroprudential instruments:
    - Existing tools: reserve requirements and high LTV additional requirements for mortgage lending; both could be raised further if needed.
    - Role for accelerated and anti-cyclical progress to raise bank capital standards towards goals under Basle III.
    - Caveat: such instruments cannot bear the full burden of policy restraint but can support conventional fiscal and monetary instruments.
  - Capital controls:
    - Controls on particular kinds of inflows could play a role if affected flows are large and have low substitutability.
    - Israel has little recent experience with controls (earlier occasions focused on curbing outflows).
    - Effectiveness is uncertain and signaling effects could be problematic.
    - Authorities view capital controls as a “never-say-never” option but not an immediate alternative.

### Financial stability: banking system, non-banks, and supervision
- Banking system resilience and indicators:
  - Capital adequacy ratios, notably Tier 1 capital relative to risk-weighted assets, have risen for most banks.
  - Impaired and non-performing loan ratios have declined.
  - Indicators of credit risk appear strong; household leveraging has increased somewhat but overall level is low.
  - Mortgage loan-to-value ratios are low by international standards.
  - Banks maintain high liquidity; interbank and direct exchange rate risk exposures are small.
- Non-bank financial sector:
  - Solvency ratios are comfortably above pre-crisis levels; conservative portfolio allocations noted.
  - Vulnerabilities: close tie to domestic capital markets, which are highly sensitive to external capital market developments.
  - Corporate credit quality concerns linger; corporate sector heavily dependent on bond financing with domestic bond issues currently over 25 percent of GDP—raising the risk that trouble at a large conglomerate could substantially impact institutional investor portfolios.
- Basel III preparedness:
  - Israeli banks are well-positioned to cope with higher capital requirements under Basel III; regulatory and Tier 1 capital levels are already high.
  - In June 2010 the BoI issued draft guidelines to achieve targets for core capital of at least 7.5 percent by the end of the year.
  - Adoption of higher capital requirements will have a countercyclical macroeconomic impact and could complement demand restraint and dampen upward pressure on the shekel; magnitude of effect is uncertain.
- Strengthening supervision and coordination:
  - Effective macroprudential use requires BoI to strengthen monitoring and analysis of financial vulnerabilities and transmission mechanisms.
  - Stress testing needs:
    - Draw on detailed, bank-by-bank data and corporate and household balance sheet data.
    - Be undertaken in collaboration with CMISD and main banks to capture cross-sectoral linkages.
    - Be closely linked to the macroeconomic forecasting framework to assess dynamic impacts.
  - Governance and reporting:
    - Stress-test analysis should feed into decisions on macroprudential tools and micro-prudential supervision.
    - BoI should begin publication of a Financial Stability Report on a regular basis to complement the Monetary Policy Report.
  - Capacity and institutional arrangements:
    - BoI needs adequate numbers of well-qualified staff and decision-making arrangements to ensure macro-prudential decisions are well-informed, systematic and accountable.
    - Adequacy of resources, capabilities, autonomy and accountability of non-bank supervisors—the Israeli Securities Authority (ISA) and the Capital Markets, Insurance and Savings Division (CMISD) of the Ministry of Finance—should be comprehensively reviewed.
    - Recent Article IV consultations recommended considering shifting CMISD out of the MoF to address resource and accountability issues and to minimize potential conflicts of interest arising from having the regulator within the MoF.
    - Need to separate roles of “supervisor” from that of “promoter of the sector”; placement of pension and insurance regulators varies across OECD countries.
    - Institutional arrangements should be established to coordinate a comprehensive approach by the three supervisory agencies on financial stability and macro-prudential instruments; models in Europe and the United States offer templates to be tailored to Israel.

### Views of the authorities
- General stance:
  - Authorities agreed with the overall assessment of developments and policy dilemmas, including housing market concern.
  - Agreed further withdrawal of stimulus is needed, planned via fiscal consolidation (deficit reduction law) and anticipated on the monetary side.
  - Welcomed staff endorsement to move taxation of natural gas towards international norms and role of macroprudential instruments for the housing market.
- Macroeconomic perspectives:
  - Authorities’ central view: the shekel is a little overvalued; emphasis on overvaluation risk “at the margin.”
  - Concern that further tightening could induce short-term capital inflows given policy interest rate differentials with the United States already at some 2 percentage points, contributing to overvaluation unless offsetting actions are taken.
  - Views on housing: monetary authorities more confident that house prices are not excessively detached from fundamentals, focusing on upward momentum; fiscal authorities consider house prices may have peaked or begun to fall.
- Fiscal authorities:
  - Committed to the path of budget consolidation and adherence to the framework of rules; wary that adjustments—even those securing strong performance—could raise doubts about the framework.
  - Noted constraints on expenditure and taxation sides; public expenditure of GDP is relatively low compared with the OECD (especially excluding security-related outlays).
  - Withholding expenditure reserves could be difficult if intended contingencies are realized.
  - Tax policy options constrained by administration’s priority of tax revenue reductions and recent compromises.
  - Acknowledge revenue projections are in doubt and will keep under close review and stand ready to act if shortfalls emerge.
- Monetary authorities and intervention:
  - Acknowledge concerns about inflation prospects and medium-term inflation expectations rising to the top of the target band, but note the indicator does not correct for risk premium.
  - Reluctant to tighten on basis of an unduly uncertain NAIRU estimate; structural changes and low participation and employment rates suggest a reservoir of unused resources.
  - Discretionary forex intervention retains a significant role; intervention has proven effective at curtailing daily noise and attenuating trends.
  - Intervention should be symmetric over a fairly long time horizon under a managed float; reflects commitment to the float.
  - Capital controls remain a “never-say-never” option but are not immediate due to reservations about effectiveness and signaling.
- Supervision of non-banks:
  - Optimal location and structure under review; fiscal authorities emphasize benefits of housing regulators in the Ministry, while monetary authorities see case to unify risk supervision within the central bank.
  - Neither authority sees a case for early action; debate should not distract from ongoing supervisory initiatives.
  - These issues could be discussed in the requested FSAP.

### Summary and staff appraisal: macro response and outcomes
- Preparedness and response:
  - Israel was well prepared for the global recession and responded decisively.
  - Low leverage and strong policy frameworks underpinned preparations.
  - Sharp cuts in policy interest rates to ½ a percent led the policy response, supported by pre-programmed foreign exchange intervention, accommodation of large automatic stabilizers, and steps to contain financial sector stress.
  - Policy frameworks were strengthened: a new Bank of Israel Law, increased bank capital requirements, entry into the OECD, and a new fiscal rule targeting debt reduction.
  - An innovative “two-year” budget framework was initiated.
- Economic outcomes:
  - Growth remained positive throughout: it was just under 1 percent in 2009, and is set to grow around 4 percent in 2010.
  - Unemployment is already back down to around 6 percent, close to its historic low.
- Current stance:
  - Withdrawal of policy stimulus has begun: BoI policy rate has been raised, forex intervention reduced and now discretionary, stabilizers have reduced the headline fiscal deficit.
  - Nevertheless, with real interest rates negative and the budget in structural deficit, the overall policy stance remains expansionary.

*Italic: IMF staff summary of chapter content.*

### 74.      But strains have emerged.  Buoyed by global capital movements, the shekel

### But strains have emerged. Buoyed by global capital movements, the shekel appreciated by some 15 percent in real terms relative to pre-crisis levels, and is still rising.

### Exchange rate, inflation, and asset prices
- Shekel appreciated by some 15 percent in real terms relative to pre-crisis levels, and is still rising.
- Inflation containment benefit noted, but:
  - Inflation expectations across the medium term have risen to the top of the target band.
  - Output gap has all but closed.
- Nominal house prices have risen over 40 percent in two years.

### Monetary policy dilemma
- Rising inflation would suggest a need to raise rates.
- Capital inflows and strengthening shekel, eroding competitiveness, argue against rate hikes.
- The dilemma can only be resolved by harnessing another policy instrument.

### Fiscal policy stance and recommendation
- Authorities plan headline deficit reductions to 3 and 2 percent of GDP in 2011 and 2012 respectively, implying structural consolidation of some 1½ percentage points of GDP over those two years.
- Further recommendation: strengthen the planned fiscal stance for 2011 and beyond by some 1 percentage point of GDP in structural terms.
  - Rationale: dampen demand growth, lower inflation pressures, allow a slower rise in BoI rates than would otherwise be needed, and ease upward pressure on the shekel.
- Suggested measures to achieve stronger consolidation:
  - Use budget operation mechanisms to hold spending below budgeted authorizations, including retention of all various reserves in the budget.
    - This avoids need to change the approved budget.
  - Address risks on the revenue side arising from generous official estimates.
  - With discretionary spending restraint already assigned, indirect taxes may need to be raised in line with OECD recommendations.

### Monetary policy actions and contingencies
- Further increases in the BoI policy rate of 75–100 basis points are anticipated during 2011.
- With output and employment buoyant and inflation expectations high, further progress towards a neutral stance is needed.
- If fiscal policy is tightened as recommended:
  - Policy rates could rise broadly as is now anticipated.
- If fiscal policy is not tightened:
  - A faster than anticipated rise in policy rates will be needed—albeit at the expense of competitiveness—to head off risk of higher inflation and the need to correct that later.
- Given nominal policy rates already well above the lower bound, monetary policy can also play a key role in responding to global uncertainty.
  - Policymakers should remain ready to act decisively—swiftly raising policy rates if upside global risks materialize, and vice versa.

### Other policy instruments and financial-sector measures
- Foreign exchange intervention:
  - Further intervention on both sides could help sustain orderly market conditions.
  - Constraints: reserves and central bank sterilization losses are already considerable.
  - Persistent one-sided use undermines credibility of the floating exchange rate regime; thus FX intervention is ill-suited as the main means of reconciling inflation and competitiveness objectives.
- Capital controls:
  - Could be considered after other policy options have been fully deployed.
  - Any use must be focused to ensure effectiveness in the face of sustained pressures.
- Banking regulatory capital:
  - Accelerated progress towards the eventual Basle III capital requirements for banks, especially if coupled with countercyclical buffers, could support restraint.

### Financial stability, supervision, and risk diagnosis
- Available indicators of financial stability are reassuring but limited in scope:
  - Capital adequacy and impaired loans have improved.
  - Non-bank financial institutions have advanced similarly.
- Concerns and gaps:
  - Stress testing still focused at sub-sector level and in early stages.
  - A number of indicators of risk not available.
  - Credit quality in the corporate bond market remains a lingering concern following its rapid expansion since 2004.
  - Latent threat to banking stability if rapid house price inflation continues.
- Recommended actions:
  - Strengthen diagnosis and management of risks.
  - Stress testing procedures should give added focus to systemic risk assessed over longer horizons.
  - Ensure full collaboration between and within supervisory institutions, with routine guidance from and feedback to all authorities responsible for stability, including the BoI and the MoF.
  - Promptly proceed with these steps to be reviewed in the requested FSAP.
  - Move non-bank supervision out of the MoF to establish its independence and address resource constraints; several good options exist including full independence as chosen by about half of OECD countries.

### Structural reforms and institutional guidance
- Continued structural reform remains essential, including progress in:
  - Education
  - Research
  - The business environment
  - Infrastructure
- Staff recommendation on consultation cycle:
  - Israel should remain on the standard 12–month consultation cycle.

### Key projections and fiscal figures (as stated)
- Headline deficit reductions: 3 percent of GDP in 2011 and 2 percent of GDP in 2012.
- Structural consolidation implied: some 1½ percentage points of GDP over 2011–2012.
- Recommended additional fiscal strengthening: some 1 percentage point of GDP in structural terms (for 2011 and beyond).
- Anticipated BoI policy rate increases during 2011: 75–100 basis points.
- Growth projection: slow to 3½ percent in 2011 before rising again in 2012.

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

### 3.      Israel’s public debt outlook is stronger than in many advanced economies,

### 3. Israel’s public debt outlook is stronger than in many advanced economies, but, this outlook is still exposed to shocks

### Summary of baseline position and vulnerabilities
- Israel’s public debt ratio is well below the average for advanced countries (Text chart).
- The Israeli economy has high sensitivity to external shocks, creating potential for high volatility in macroeconomic variables.
- The increase in global macro-financial risk, combined with high sensitivity to external shocks, could magnify macroeconomic volatility and increase uncertainty around projected public debt paths.
- Examples of plausible shock channels include sudden reversal of capital flows, spikes in borrowing costs, and high exchange rate volatility.
- Recent econometric evidence suggests that high debt refinancing needs and high debt levels are likely to be accompanied by higher long-term real interest rates, which could adversely affect global financing conditions and debt dynamics.

### Role of risk assessment and methods used
- Risk assessments are a critical input to a medium term fiscal strategy aiming at maintaining sustainability and managing risks.
- Because of high macroeconomic volatility and increased uncertainty around the public debt path, uncertainty must be incorporated into fiscal sustainability analysis.
- Two approaches used: stress tests focused on extreme events, and full Monte Carlo simulation to derive probability distributions ("fan charts") of future debt stocks based on stochastic properties of key risk variables.
- Stress tests are useful to demonstrate robustness under extreme events, which contributes importantly to credibility.
- Note: the risk assessment assumes that fiscal rules will be adhered to only ex-ante; ex-post adherence to a deficit rule would imply a very large fiscal adjustment in the presence of large economic shocks.

### Stress-test findings (key scenarios and outcomes)
- Adverse growth scenarios produce the most severe impact on public debt:
  - A negative permanent shock to growth of half a standard deviation is likely to completely stall the debt consolidation process, with public debt ratio at 76 percent in 2015.
  - An extreme tail risk of a negative permanent shock to growth of one standard deviation, similar to the impact of the 2009 global economic shock on Israel, is likely to reverse debt decline and to bring back public debt ratio to nearly 90 percent of GDP in 2015.
- Other shocks and their projected effects by 2015:
  - Fiscal contingent liabilities amounting to 10 percent of GDP could raise public sector debt to 72 percent of GDP by 2015.
  - Currency depreciation of 30 percent would raise the debt ratio to about 69 percent of GDP.
  - An increase in real interest rates would raise the public debt ratio to 66 percent by 2015.

### Monte Carlo / probabilistic assessment
- Under the central scenario, the new fiscal rules result in further public debt reduction to slightly above 60 percent by 2015.
- Monte Carlo simulations produce a probability distribution ("fan charts") of future debt stocks to assess the riskiness of the baseline projections.
- Despite the central scenario reduction, risks surrounding public debt dynamics remain relatively high:
  - There is 97.5 percent chance that the maximum likely debt ratio will remain close to its 2009 level.
- Policy tools that reduce variance, such as a fiscal reaction function, could be used to lower the uncertainty around the public debt path.

*Source: _cr1121 - 3.      Israel’s public debt outlook is stronger than in many advanced economies, https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr1121.pdf*

### 7.      In the medium-term, recent natural gas discoveries could have a positive

### _cr1121 - 7.      In the medium-term, recent natural gas discoveries could have a positive

### Medium-term fiscal impact and uncertainty
- "In the medium-term, recent natural gas discoveries could have a positive impact on fiscal sustainability."
- "While the likely impact of the natural gas is highly uncertain, reforms to adopt international best practice in taxation of natural resources, including appropriate pricing arrangements in the tax and in securing appropriate intergenerational distribution of the proceeds can help in ensuring a positive impact on fiscal sustainability."
- "Overall revenues will be modest on current estimates of the volume of gas."

### Policy recommendations for revenue management
- "Accordingly, the first use of such tax receipts should be to reduce public debt, given that overall revenues will be modest on current estimates of the volume of gas."
- "However, if the gas wealth proves to be much larger than anticipated, additional revenues could be placed in a sovereign wealth fund to ensure intergenerational equity and to safeguard against possible Dutch disease effects."
- Adopt "international best practice in taxation of natural resources," including:
  - appropriate pricing arrangements in the tax; and
  - securing appropriate intergenerational distribution of the proceeds.

### Risks to guard against
- Fiscal outcomes hinge on the uncertain volume of gas; therefore precautionary sequencing of uses of receipts is recommended (debt reduction first, sovereign wealth fund if revenues materially exceed expectations).
- Explicit objective to "safeguard against possible Dutch disease effects."

### Contextual fiscal indicators from the source document
- General government debt (percent of GDP): 77.7 (2007), 76.7 (2008), 77.6 (2009), 75.5 (2010), 72.8 (2011 projected).
- Public debt described elsewhere in the document as "a little below 80 percent of Gross Domestic Product (GDP)."

*Source: IMF staff report text as provided in the content unit.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr1121.pdf_