## ISRAEL — STAFF REPORT FOR THE 2015 ARTICLE IV CONSULTATION (_cr15261)

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### Fiscal position, debt, and fiscal policy
- Debt has declined to 67 percent of GDP from a peak of 94 percent of GDP in 2003 but is expected to increase for the first time since 2009 following upward revisions to deficit targets.
- Fiscal deficit remains stubbornly high, leaving limited buffers to respond to shocks.
- Key statistics:
  - Debt: 67.2 percent of GDP (2015, table); projected 67.2 percent of GDP in 2016 (table).
  - Overall balance (central government): -2.9 percent of GDP (2015, table); projected -3.0 percent of GDP (2016–2020).
  - Cyclically adjusted primary balance: 0.0 (2014), -0.1 (2015) (table).
  - Revenues and grants: 25.8 percent of GDP (2015, table).
  - Total expenditure: 28.7 percent of GDP (2015, table).
- Risks and projections:
  - Under baseline, debt would increase gradually to 69 percent of GDP by 2020 (Annex II).
  - Under a growth-shock or sharp housing correction scenario, debt could rise well above 75 percent of GDP by 2020 (Annex II).
- Required adjustment and options:
  - Under current law, deficit should be reduced to 2 percent of GDP next year and 1½ percent of GDP in 2019 (national standards).
  - Measures of around 1 percent of GDP needed to stick to the current expenditure ceiling.
  - Staff advocates an explicit revenue and expenditure plan for 2016–20 and strengthened commitment control of multi-year projects.
  - Preference for consolidation that minimizes growth impact: cut current over capital spending, favor indirect over direct taxes, and rationalize tax expenditures.
- Near-term guidance:
  - 2016 deficit should be brought down by at least ½ percent of GDP—the reduction envisaged in the Deficit Reduction Law.
- Authorities’ views:
  - Intend gradual deficit reduction but not at the pace in the Deficit Reduction Law.
  - Emphasize stronger fiscal position vs. a decade ago and argue for accommodating growth-enhancing spending; prefer canceling ineffective tax exemptions over raising indirect taxes.

### Monetary policy and exchange rate
- BOI policy rate reduced from 3.25 percent to 0.10 percent over the past 3 years (text).
- Key inflation statistics:
  - Overall CPI (end of period): 0.7 percent (2015, table); 2.2 percent (2016, table).
  - Overall CPI (average): -0.1 percent (2015, table).
- Staff view and rationale:
  - No further monetary easing needed at this stage; inflation expected to return to the target band next year.
  - Philips-curve analysis: growth pick-up, shekel depreciation, and tapering energy price declines will bring inflation back within the band.
  - Long-term inflation expectations remain well-anchored.
  - Output gap small; unemployment has fallen sharply.
- Exchange rate assessment:
  - Staff finds the shekel broadly in line with fundamentals; evidence mixed across models:
    - Modified EBA suggests shekel undervalued by about 9 percent in May 2015.
    - EBA-like REER regression suggests shekel 0.1 percent above fundamental value in 2014 (0.5 percent overvaluation as of May 2015).
    - CGER REER panel regression suggests medium-term overvaluation of 6.8 percent.
- Authorities’ stance:
  - Agree low inflation largely imported and view no additional easing necessary; BOI forecasts inflation will reach the lower end of target in 2016Q1.
  - BOI considers the shekel somewhat overvalued and notes sluggish exports despite weak world trade.
  - BOI ready to use additional tools (including quantitative easing) if necessary, but with current stance already extremely expansionary they have not found further measures appropriate so far.

### Housing market, household leverage, and macroprudential policy
- Housing prices:
  - Housing prices have nearly doubled since end 2007: 97 percent nominal increase since end 2007; 69 percent real increase since end 2007.
  - Housing price inflation around 4 percent annually.
  - Staff estimates housing prices currently some 30 percent overvalued (staff wording: overvaluation largely explained by supply-side shortages and should NOT be interpreted as current price misalignment).
- Household credit and balance sheets:
  - Household credit to GDP around 40 percent of GDP (text); household debt (percent of GDP, 2014Q4) series shows Israel relatively low versus peers.
  - Average LTV and PTI ratios of new loans declined to 52 and 26 percent, respectively (authorities’ analysis).
- Macroprudential measures and effects:
  - Since 2009 BOI introduced a wide range of macroprudential tools; these have contained the increase in household leverage.
  - Measures include LTV caps, PTI/DSI limits, capital surcharges, higher risk weights, and reserve requirements (Annex III timeline).
  - Policy recommendations: continue active use of macroprudential tools (including tightening LTV and PTI, and gradually increasing capital surcharges by 1 percent of outstanding mortgage lending).
- Supply-side housing recommendations:
  - Simplify planning procedures (time from initiation to completion ranges between 8 and 21 years).
  - Accelerate zoning and land release; consider eliminating restrictions to building in big cities and incentivize periphery investment.
  - Empower local governments to support high-density residential construction; consider higher intergovernmental transfers to finance infrastructure for new developments.
- Authorities’ actions:
  - Agreements with local governments and committees to identify land for development; decentralization of approval power; Israel Land Authority and Planning Committee placed under MoF command to improve coordination.

### Financial sector stability and policy
- Structural and market developments:
  - Non-bank financial sector assets now about half of all financial sector assets.
  - Outstanding corporate bonds grew from 5 percent of GDP in 2004 to 27 percent in 2013.
- Bank metrics and resilience:
  - Since early 2015, all banks met new minimum core Tier 1 capital ratio of 9 percent.
  - Leverage ratio around 7 percent (high compared with advanced countries).
  - Loan-to-deposit ratios well below 100 percent; limited wholesale funding exposure.
  - Guidelines for the liquidity coverage ratio enforced from beginning of 2015.
- Stress tests and concentration:
  - BOI stress test: return on equity would fall from around 7¼ percent to -4 percent, but all banks would maintain capital ratios above 6 percent (down from 9½ percent).
  - Five banking groups account for 95 percent of banking sector assets.
- Key vulnerabilities:
  - Mortgage loans account for 31 percent of bank credit; real estate/construction account for 13 percent of bank credit.
  - Non-banks and mutual funds exposed to corporate bond market correction; issuances concentrated in lower-rated real estate/construction borrowers.
- Policy and institutional recommendations:
  - Establish a formal Financial Stability Committee (FSC) with BOI Governor leading in normal times.
  - Complete legislative amendment to the Banking Ordinance to enhance crisis resolution; send draft legislation to the Knesset earliest possible.
  - Continue monitoring housing-related exposures across banks and nonbanks; enhance stress tests and sensitivity analyses.
  - Address delays and disagreements over FSC formation to avoid further postponement.

### Labor market, productivity, inequality, and structural reforms
- Labor market facts:
  - Unemployment has declined to multi-decade lows: 5.3 percent in 2015Q1 (text); unemployment rate series: 2015 (Prel): 5.4 percent; projections: 2016: 5.2 percent, 2017: 5.3 percent.
  - Employment-to-population ratio increased from 36 percent in 1990 to 48 percent now.
- Productivity and TFP:
  - Labor productivity fell from 70 percent of the US level in the early 1990s to 60 percent today.
  - Capital-to-labor ratio well below that in other advanced countries; TFP growth sluggish, reflecting lack of competition and restrictive product market regulation.
- Poverty and demographics:
  - Poverty rate near 20 percent.
  - Child allowances are now 60 percent lower than in 2002.
  - Share of Haredi and Arab-Israeli population projected to exceed 40 percent in twenty years—from 32 percent currently.
  - Haredi fertility: 6.8 children per woman; share doubles every 15 years.
- Policy priorities:
  - Boost competition (transportation, food, commodity imports, banking) and reduce product market restrictions.
  - Improve infrastructure (railroad, port, air transport) and education quality (PISA scores poor).
  - Increase labor force participation of Haredi and Arab-Israeli populations; expand targeted vocational programs, childcare subsidies, and placement services.
  - Consider comprehensive poverty reduction strategy addressing rural infrastructure, transportation, education, and civil/military service arrangements.
- Authorities’ actions:
  - Expansion of Haredi units in defense forces and opening public employment centers in Arab-Israeli towns; preliminary evidence suggests participation rising.

### Outlook, projections, and risks
- Growth and outlook:
  - Staff expects growth of 3 percent in 2015 (text); Selected Indicators table: Real GDP 2015: 2.5 percent (table), projected 2016: 3.3 percent, 2017: 3.2 percent.
  - Medium-term growth projected around 3–3¼ percent a year—in line with potential GDP growth.
  - Potential GDP growth: 2016: 3.0 percent (table); 2015 (Prel): 3.1 percent; projections: 2016: 3.1 percent, 2017: 3.0 percent.
  - Output gap near zero; table shows output gap 2015 (Prel): -0.1 percent of potential; 2016: 0.0 percent.
- Inflation and external:
  - CPI projections: overall CPI (end of period) 2015: 0.7 percent; 2016: 2.2 percent.
  - Current account balance (percent of GDP): 2015 (Prel): 3.7 percent; 2016 projection: 3.6 percent.
- Risks (Annex I and text):
  - External downside risks: disappointing trading-partner growth, geopolitical tensions, renewed shekel appreciation.
  - Domestic risks: housing price bust affecting growth and financial stability.
  - Upside risks: faster global recovery and increased natural gas investment.
  - Specific stress tests (Annex II):
    - Growth shock (1 s.d. for 2 years): debt-to-GDP above 73 percent by 2020.
    - Interest rate shock (+200 basis points): financing needs up marginally; debt impact <1 percent of GDP by 2020.
    - Combined macro-fiscal shock: financing needs above 14 percent of GDP; debt above 75 percent by 2019.
    - Tail risk (sharp housing correction + geopolitical shock): debt above 75 percent by 2018, around 77 percent by 2020; gross financing needs close to 15 percent of GDP by 2017.

### Cross-cutting policy recommendations (summary)
- Fiscal:
  - Reduce fiscal deficit to place debt on a downward path; produce explicit revenue and expenditure plan for 2016–20; strengthen commitment control of multi-year projects.
- Monetary:
  - Keep policy on hold; no additional easing while low inflation largely imported and expected to be temporary.
- Housing and macroprudential:
  - Prioritize supply-side measures to boost housing supply; continue macroprudential measures as first line of defense; consider tightening LTV/PTI and increase mortgage capital surcharges.
  - Establish an independent Financial Stability Committee to coordinate macroprudential policy; amend Banking Ordinance to enhance crisis resolution.
- Financial sector:
  - Monitor and limit exposures to real estate and construction; enhance stress tests; manage concentration risk from five banking groups holding 95 percent of assets.
- Structural reforms:
  - Boost competition, improve infrastructure and education, ease business constraints, raise labor force participation of Haredi and Arab-Israeli populations to raise productivity and reduce inequality.

*ISRAEL: STAFF REPORT FOR THE 2015 ARTICLE IV CONSULTATION (July 15, 2015).*

### 2.0 percent of GDP previously. Debt has declined to 67 percent of GDP from a peak of

### ISRAEL — STAFF REPORT FOR THE 2015 ARTICLE IV CONSULTATION

### Fiscal position and public debt
- Debt has declined to 67 percent of GDP from a peak of 94 percent of GDP in 2003 but is expected to increase for the first time since 2009, following the upward revisions to the deficit targets.
- The fiscal deficit remains stubbornly high, leaving limited buffers to respond to shocks.
- Key statistics (from tables/text):
  - Debt: 67.2 percent of GDP (2015, table) and projected to be 67.2 percent of GDP in 2016.
  - Overall balance (central government): -2.9 percent of GDP (2015, table); projected -3.0 percent of GDP (2016–2020).
  - Cyclically adjusted primary balance: 0.0 (2014), -0.1 (2015) (table).
  - Revenues and grants: 25.8 percent of GDP (2015, table).
  - Total expenditure: 28.7 percent of GDP (2015, table).
- Executive Board and Directors’ advice:
  - Strengthen the fiscal framework and sustain budgetary consolidation consistent with the Deficit Reduction Law to place the debt-to-GDP ratio on a downward path and broaden fiscal space.
  - Consider a path of fiscal adjustment not unduly frontloaded; use a mix of revenue and expenditure measures.
  - Emphasize stronger commitment control of multi-year projects to achieve deficit targets.

### Monetary policy and inflation
- The central bank kept interest rates on hold in August, as inflation is expected to return to the target band next year.
- Directors noted headline inflation is currently below the Bank of Israel’s target and that no monetary easing is needed at this point because low inflation is largely imported and likely to be temporary.
- Key statistics:
  - Bank of Israel policy rate reduced from 3.25 percent to 0.10 percent over the past 3 years (text).
  - Overall CPI (end of period): 0.7 percent (2015, table); 2.2 percent (2016, table).
  - Overall CPI (average): -0.1 percent (2015, table).
  - Staff projects inflation to recover to around 0.7 percent at the end of the year (outlook).

### Housing market and macroprudential policy
- Housing prices continue to increase by around 4 percent year-on-year, owing largely to supply constraints.
- Household credit to GDP has remained low at around 40 percent of GDP compared to other advanced economies.
- Policy recommendations and assessments:
  - Boost housing supply through a variety of initiatives; concerted efforts among relevant ministries and local governments are needed.
  - Macroprudential measures have been successful in containing the increase in household leverage and should remain the first line of defense against housing-related risks to financial stability.
  - Close monitoring of the financial sector’s exposure to the housing market is warranted.
  - Directors recommended prompt establishment of the Financial Stability Council to help coordinate macroprudential policies across sectors.
  - Timely adoption of the amendment to the Banking Ordinance to enhance the crisis resolution framework would be important.

### Financial sector stability
- The financial system appears sound, but risks emanating from exposure to real estate and construction should be carefully monitored.
- Directors welcomed macroprudential policy use and urged coordination (Financial Stability Council).
- Recommendation to monitor and limit financial-sector exposure to housing market risks.

### Labor market, productivity, and inequality
- Unemployment has continued to decline to multi-decade lows: 5.3 percent in 2015Q1.
- Labor productivity growth and levels are low, weighing on growth prospects; the gap relative to the United States is widening.
- Income inequality is among the highest in advanced countries; poverty is concentrated among the Israeli-Arab and Haredi populations.
- Policy recommendations:
  - Boost competition in several sectors.
  - Improve infrastructure and reform product markets.
  - Improve education and ease business constraints.
  - Increase labor force participation of the Haredi and Arab-Israeli populations to reduce poverty rates and safeguard long-run growth potential.
  - Banking sector reforms should be mindful of financial stability concerns.

### Outlook and risks
- Staff expects growth of 3 percent in 2015, driven by rapid employment growth, falling import prices, and near-zero interest rates boosting private consumption.
- Table of Selected Indicators shows Real GDP at 2.5 percent for 2015 (table) and projected Real GDP growth of 3.3 percent (2016) and 3.2 percent (2017) in the table.
- Medium-term growth is projected at around 3–3¼ percent a year—in line with potential GDP growth.
- Output gap is near zero; potential GDP growth projected at 3.0 percent (2016) and 2.9 percent thereafter (table).
- Risks to the outlook are balanced:
  - External downside risks: disappointing growth in trading partners, geopolitical tensions, renewed appreciation of the shekel.
  - Domestic risks: a housing price bust affecting growth and financial stability.
  - Upside risks: faster-than-expected global recovery and a further increase in natural gas investment.
- Specific risk notes:
  - Prospective US monetary tightening could diminish appreciation pressures on the shekel if it reflects stronger US growth.
  - Contagion from Greece likely limited due to few financial and trade links.

### Key cross-cutting policy recommendations (summary)
- Fiscal: Reduce fiscal deficit to bring debt firmly on a downward path; adopt a stronger medium-term framework with an explicit revenue and expenditure plan consistent with the deficit target.
- Monetary: Keep policy on hold; no easing needed while low inflation is largely imported.
- Housing: Prioritize supply-side measures; use macroprudential policies as first line of defense; coordinate across ministries and local governments.
- Financial stability: Monitor real estate and construction exposures; establish Financial Stability Council; amend Banking Ordinance to enhance crisis resolution.
- Structural reforms: Boost competition, improve infrastructure and education, ease business constraints, and integrate Haredi and Arab-Israeli populations into the labor force to raise productivity and reduce inequality.

*ISRAEL: STAFF REPORT FOR THE 2015 ARTICLE IV CONSULTATION (July 15, 2015).*

### 9.      The authorities’ views on developments and risks were very similar to staff’s. They had

### 9.      The authorities’ views on developments and risks were very similar to staff’s. They had

### Authorities’ overall views and near-term outlook
- Authorities became more optimistic in recent months on near-term growth and noted it was increasingly domestically-driven, with strong private consumption growth and relatively weak exports and investment.
- They estimated potential GDP growth at around 3 percent and thought that the output gap was small.
- The NAIRU was difficult to determine but had likely been trending down: in the past ten years there had been a sharp increase in participation and a drop in unemployment.
- They did not believe that global market turmoil would lead to capital outflows—past episodes had been associated with safe haven inflows.
- They noted Israel’s strong external position, with current account surpluses and large reserve buffers.
- With the financial sector largely domestically financed, they agreed that capital outflows would likely support growth through a weaker shekel.

### Shared policy challenges identified
- Strengthening the economy’s resilience to shocks.
- Increasing medium-term growth.
- Integrating the Haredi and Israeli-Arab populations.
- Commitment to reducing fiscal deficits, while noting the need to increase investment on infrastructure and education to close the productivity gap with other advanced economies.
- Recognition of the impact of low interest rates on housing prices and welcome of recent indication of easing downward pressures on inflation.
- Initiatives to ease housing supply constraints.
- Shared view that potential growth will come under pressure as the share of the Haredi and Israeli Arabs in the population rises rapidly in the near future.

### A. Fiscal Policy — Background findings
- Israel has a high, structural, and persistent fiscal deficit.
- By international accounting standards, the central government fiscal deficit is almost 1 percentage point higher than the 2½–3 percent reported.
- The current deficit originates from tax cuts between 2003 and 2010 that were not offset by sufficient expenditure reductions.
- The output gap is near zero, and employment growth has been strong.
- Efforts to reduce the deficit have repeatedly been deferred; the deficit ceiling has been revised twenty times since 1991; the expenditure ceiling has been revised 6 times since 2004.
- Planned upward revisions of deficit targets for 2014–18 were interrupted by the fall of the government and early elections; despite Operation Protective Edge (1 percent of GDP in total, of which 0.7 percent of GDP was covered in 2014), the central government deficit met the original target in 2014 (2.8 percent of GDP).
- The 2015 budget will only be adopted by parliament in November; until then monthly expenditure limits are governed by the “1/12-rule”.
- As debt repayments are projected to be much lower this year, the ceiling is not very binding, and spending is expected to grow in line with GDP growth.
- Overall, the deficit is expected to stay around 2.8 percent of GDP this year, exceeding the target stipulated in the Deficit Reduction Law (2.5 percent of GDP).

### A. Fiscal Policy — Risks, projections, and DSA results
- The fiscal deficit needs to be reduced to provide buffers for shocks (housing price correction, renewed conflicts, sharp recession).
- Under the baseline, debt would increase gradually to 69 percent of GDP by 2020.
- Under a growth-shock or sharp housing correction scenario, debt could rise well above 75 percent of GDP by 2020 (Annex II).

### A. Fiscal Policy — Required adjustment and options
- Under current law, deficit should be reduced to 2 percent of GDP next year and 1½ percent of GDP in 2019 (on national standards).
- Measures of around 1 percent of GDP will be needed to stick to the current expenditure ceiling, because planned initiatives in the coalition agreement and previous commitments would raise spending above the current ceiling.
- The real growth rate of the expenditure ceiling (around 2.6 percent) is barely below the growth rate of real GDP (3 percent), implying only a modest drop in the spending ratio.
- Staff advocated for an explicit revenue and expenditure plan for the entire 2016–20 period, consistent with the deficit targets:
  - Strengthen commitment control of new multi-year projects (enhanced top-down budgeting, spending reviews, improved cost estimates of multi-year projects).
  - Either lower the expenditure ceiling sufficiently to attain the deficit target, or plan commensurate revenue increases explicitly.
- Consolidation measures should have minimum possible impact on growth—preference for cutting current over capital spending and towards indirect rather than direct taxes—and reflect areas where revenues are low or spending is high relative to comparator norms.
- Scope exists for efficiency gains in both defense and non-defense spending (e.g., better targeting of social benefits).
- Tax expenditures are relatively high; authorities should consider a mix of revenue and expenditure measures.

### A. Fiscal Policy — Near-term budget guidance
- Next year’s budget should take an important first step: although 2015 budget likely passed only in November, the deficit in 2016 should be brought down by at least half a percent, equivalent to the reduction envisaged in the Deficit Reduction Law.

### A. Fiscal Policy — The authorities’ views and planned actions
- Authorities intend to reduce the deficit gradually, but not at the pace indicated in the Deficit Reduction Law.
- They emphasized Israel’s fiscal position is stronger than a decade ago when debt was above 90 percent of GDP and general government deficit around 7½ percent of GDP.
- They argued accommodating high-priority growth-enhancing spending (education, key infrastructure projects) justifies amending the Deficit Reduction Law to slow fiscal consolidation.
- Views differed on composition of adjustment:
  - Ministry of Finance (MoF): civilian expenditures low compared to other OECD countries but high economic outcomes; scope for improving government efficiency and reducing administrative spending; favors expenditure cuts but does not preclude revenue mobilization including broadening the tax base by rationalizing tax exemptions and introducing new taxation (e.g., estate tax).
  - Bank of Israel (BOI): more cautious about reducing civilian budget size; emphasizes scope for revenue gains from rationalizing tax exemptions.
- MoF plans to prepare a fiscal policy statement prior to the upcoming budget, including size of consolidation needs for medium term and possible measures; intends to initiate spending reviews in the coming year.

### B. Monetary and Exchange Rate Policies — Background findings
- Inflation is currently negative—well outside the BOI’s target band of 1–3 percent.
- Low inflation is largely imported: low inflation in partner countries, the appreciation of the shekel (between summer 2012 and summer 2014, the shekel appreciated by 17 percent in nominal effective terms), and the drop in oil prices.
- The BOI reduced policy interest rates by 2.4 percentage points since mid-2012 to 0.1 percent in March 2015.
- Two interest rate cuts in August and September 2014 halted the appreciation of the shekel and triggered a sharp depreciation against the US dollar.
- The BOI has intervened in the foreign exchange market aiming to smooth excess volatility.

### B. Monetary and Exchange Rate Policies — Staff view and rationale
- Staff view: no further monetary easing is needed at this stage.
  - Staff analysis suggests inflation will likely return to within the target band next year; a Philips curve model confirms that the growth pick-up, the shekel depreciation since last summer, and tapering energy price declines will bring inflation back within the band.
  - Markets expect low CPI inflation to be temporary; longer-term inflation expectations remain well-anchored.
  - GDP inflation bounced back to 2¾ percent y/y in the first quarter; CPI inflation has not followed because of strong terms of trade gains.
  - Overall policy mix is already very accommodative, with near-zero interest rates, and broadly neutral fiscal policy.
  - The output gap is small at best and unemployment has come down sharply in recent years.

### B. Monetary and Exchange Rate Policies — Exchange rate assessment
- At current levels, staff views the shekel as broadly in line with fundamentals; evidence from exchange rate models is mixed, average of three existing estimates suggests shekel around its fundamental value:
  - IMF EBA macroeconomic balance approach suggests the shekel is undervalued in 2014, reflecting current account in 2014 (4.3 percent of GDP) was well above EBA estimated norm (-0.2 percent of GDP). Staff view: EBA current account norm is too low as it omits structural shifts including expansion of mandatory household pension saving in 2008.
  - A modified EBA macroeconomic balance approach—adding a fixed effect dummy and pension contributions as share of GDP as additional variables—suggests a current account norm of 2 percent of GDP, implying the shekel was undervalued by about 9 percent in May 2015.
  - The EBA-like REER regression approach suggests the shekel was 0.1 percent above its fundamental value in 2014, implying an overvaluation of 0.5 percent as of May 2015.
  - A CGER REER panel regression type model suggests an overvaluation in the medium term of 6.8 percent.

### B. Monetary and Exchange Rate Policies — The authorities’ views
- The BOI shared the view that low inflation was mostly imported, and agreed no additional monetary easing was required at this stage.
- BOI forecasts inflation will reach the lower end of the target band in 2016Q1.
- BOI: tightening in the domestic labor market would lead to increased wage costs and strengthen inflation; sees less need for unconventional monetary policy measures, though such tools remain part of the toolbox.
- Monetary policy committee members noted difficult trade-offs: rising housing prices suggested higher interest rates to contain financial risks, but tightening impacts growth, inflation, and the exchange rate.
- BOI view: the shekel is somewhat overvalued, evidenced by sluggish exports even after accounting for weak world trade.
- The 2014 current account surplus (4.3 percent of GDP) reflected a sudden drop in repatriation of multinational firm profits and decline in oil prices, transfers from the US government (about 1 percent of GDP annually), and replacement of imported energy with domestic gas production, rather than improved competitiveness.

### C. Housing Sector Policy — Background findings
- Both demand and supply factors contributed to the housing price boom.
- Demand boosted by decline in interest rates, increasing population, and growing household incomes.
- Real estate tax system broadly in line with global standards, but distortions from the tax system and an underregulated rental market create a bias towards homeownership.
- Demand increased when housing supply dropped to a post-immigration boom low.
- Israel’s supply elasticity to prices is low compared to other advanced economies due to:
  - Highly centralized approach to land development (state owns 93 percent of Israel’s land).
  - Long process of obtaining licenses and building permits.
  - Lack of support from local governments for high density projects.

### C. Housing Sector Policy — Policy recommendations
- To contain further housing price increases, supply needs to be boosted through concerted efforts among relevant ministries and local governments.
- To contain the increase in leverage, macro-prudential measures should be used.

*ISRAEL — INTERNATIONAL MONETARY FUND (excerpt).*

### 30.      Macroprudential measures taken by the BOI have contained the increase in household

### _cr15261 - 30.      Macroprudential measures taken by the BOI have contained the increase in household

### Household leverage, macroprudential actions, and housing valuation
- Since 2009, the BOI has introduced a wide range of macroprudential tools to address vulnerabilities and boost banks’ loss absorption capacity.
- As a result, household credit to GDP has remained low compared to other advanced economies.
- Exposure of banks to real estate and construction has increased (see section D).
- Staff estimates suggest housing prices are currently some 30 percent overvalued.
- A housing price correction could depress consumption through wealth effects and would particularly affect recent homebuyers.

### Policy recommendations to contain housing price increases (supply-side)
- Planning procedures should be simplified.
  - Planning procedures are cumbersome; the time between initiating new building initiatives and finishing construction can range between 8 and 21 years.
- The zoning of available land and its release for development should be accelerated to allow the private sector to respond more effectively to rising demand.
  - Authorities could consider eliminating restrictions to building in big cities (adopted to discourage urbanization) and instead implement incentives for greater investment in infrastructure, education, and job creation in the periphery.
- Local governments should be given the means to support construction of high density residential buildings.
  - Property tax rates are lower for residential properties and for smaller units, so local governments prefer commercial properties and luxury buildings over high density residential buildings.
  - Higher intergovernmental transfers should be considered to help finance the cost of additional infrastructure and services required by new residential developments.

### Macroprudential policy recommendations (demand/financial side)
- Macroprudential policy should continue to be actively used to contain housing-related risks to financial stability.
  - Options include further tightening limits on loan-to-value (LTV) and payment-to-income (PTI) ratios.
  - Accelerate implementation of the recently-announced measure to gradually increase capital surcharges by 1 percent of outstanding mortgage lending.

### Authorities’ actions and views on housing and macroprudential measures
- Central government initiatives to boost housing supply:
  - Agreements with local governments to facilitate central government financing of infrastructure needed for new development.
  - A committee established to identify land for development and expedite planning.
  - Power to approve building plans decentralized to local committees.
  - Several authorities (Israel Land Authority, Planning Committee) placed under MoF command to improve coordination and shorten planning.
- Authorities noted macroprudential measures have reduced riskiness of new mortgages:
  - The average LTV and PTI ratios of new loans have declined to 52 and 26 percent, respectively.
  - Analysis of mortgages initiated between 2010 and 2013 by income decile suggests most mortgages were taken out by high income households.

### Financial sector overview and risks (Section D)
- Structural shifts and market developments:
  - The role of the non-bank financial sector has increased; assets of the nonbank financial sector now comprise about half of all financial sector assets.
  - Outstanding stock of corporate bonds grew from 5 percent of GDP in 2004 to 27 percent in 2013.
- Bank capitalization, liquidity, and regulatory metrics:
  - Since early 2015, all banks have met the new minimum core Tier 1 capital ratio of 9 percent.
  - The leverage ratio (7 percent) is high compared with other advanced countries.
  - Banks have limited exposure to the wholesale funding market; loan-to-deposit ratios are well below 100 percent.
  - Guidelines for gradual implementation of a liquidity coverage ratio have been enforced from the beginning of 2015.
- Stress test results and concentration:
  - In the BOI’s recent stress test, profitability (return on equity) would fall from around 7¼ percent to -4 percent, but all banks would be able to maintain capital ratios above 6 percent (down from 9½ percent).
  - Five banking groups account for 95 percent of banking sector assets.
- Key vulnerabilities and monitoring priorities:
  - Banks’ exposures: mortgage loans account for 31 percent of bank credit; real estate/construction account for 13 percent of bank credit.
  - Non-bank financial institutions and mutual funds are exposed to a potential correction in the corporate bond market after sharp declines in spreads and recent issuances concentrated in lower-rated real estate/construction borrowers.
  - Ongoing risk diagnosis should account for macro-financial feedback loops and spillovers, given the construction sector’s strong link to the rest of the economy.

### Financial sector policy recommendations and institutional reforms
- Strengthen macroprudential coordination and crisis resolution:
  - Establish a formal Financial Stability Committee (FSC) to coordinate and set macroprudential oversight; staff recommends an independent FSC with the BOI Governor taking the leading role in normal times.
  - Complete legislative amendment to the Banking Ordinance to enhance the crisis resolution framework by sending the draft legislation to the Knesset at the earliest possible time.
- Supervisory and regulatory enhancements:
  - Continue monitoring housing-related exposures across banks and nonbanks; enhance stress tests and sensitivity analyses.
  - Address delays and disagreements over FSC formation (membership representation) to avoid further postponement.

### Structural policy: productivity, labor participation, and poverty (Section E)
- Labor market and productivity facts:
  - Employment-to-population ratio increased from 36 percent in 1990 to 48 percent now.
  - Labor productivity for the economy fell from 70 percent of the US level in the early 1990s to 60 percent today.
  - Capital-to-labor ratio in Israel is well below that in other advanced countries.
  - TFP growth has been sluggish, reflecting in part lack of competition; Israel’s product market regulation is more restrictive than peers.
- Poverty and demographic challenges:
  - Poverty rate in Israel is near 20 percent.
  - Child allowances are now 60 percent lower than in 2002.
  - The share of the Haredi and Arab-Israeli population is projected to exceed 40 percent of the total population in twenty years—from 32 percent currently.
  - With 6.8 children per woman, the share of the Haredi population doubles every 15 years.
- Policy priorities to raise productivity and inclusion:
  - Raise productivity through greater competition and reduction of product market restrictions; continue reforms such as shortening business registration time and easing insolvency resolution.
  - Address infrastructure gaps (railroad, port, air transport) and improve education quality (PISA scores are poor) to support human capital.
  - Boost labor force participation rates of Haredi and Arab-Israeli populations to reduce poverty and safeguard long-run growth.
  - Consider a comprehensive poverty reduction strategy addressing rural infrastructure and transportation, education, and civil and military service arrangements.
- Government actions noted:
  - Expansion of Haredi units in the defense forces and opening of public employment centers in Arab-Israeli towns; preliminary evidence suggests participation is rising.
  - A committee with central bank and MoF representatives formed to propose measures to reduce credit costs for SMEs; authorities noted absence of a credit bureau may be contributing to limited SME access to credit.

*Italic: Source — IMF staff country report content unit _cr15261.*

### 56.      The authorities agreed on the importance of boosting labor force participation rates

### _cr15261 - 56.      The authorities agreed on the importance of boosting labor force participation rates

### Labor force participation and social policy
- Authorities agreed on the importance of boosting labor force participation rates of the Haredi and Arab-Israelis.
- Increasing employment rates was seen as important for growth and as a key tool to reduce poverty.
- The new government planned to raise child allowances, but only to undo the cuts in 2013—there was no intention to bring allowances back to the pre-2003 level.

### Productivity and labor quality
- Authorities agreed on the importance of boosting productivity.
- They were less concerned about the low productivity growth in recent years, attributing it partly to new labor force participants’ low skills and lack of education.

### Competition reforms
- Boosting competition is a priority for the new government.
- Sectors identified for increased competition include transportation, food, commodity imports, and banking.
- At the time of the mission there were not yet concrete proposals, but committees had been installed to come up with suggestions.

### Staff appraisal — macro outlook and risks
- The economy has been doing well and near-term growth prospects are favorable.
- Employment creation has been remarkable and unemployment is at multidecade lows.
- Inflation has been negative, but this reflects temporary external factors and not domestic weakness.
- Inflation is expected to return to the target band next year and no further monetary easing is needed.
- Risks to the outlook are balanced, and the real exchange rate is broadly in line with fundamentals.

### Fiscal policy: deficit and planning
- The fiscal deficit remains stubbornly high, leaving limited buffers to respond to shocks.
- The high, structural, and persistent fiscal deficit needs to be reduced.
- Adherance to the Deficit Reduction Law—with a deficit target of 1½ percent of GDP by 2019—would set debt on a firmly downward path and create buffers for shocks.
- While achieving the target is challenging, the government should address this challenge upfront, and not defer on the hard choices regarding how to reduce the deficit to future years.
- An explicit revenue and expenditure plan consistent with the deficit targets for the entire 2016–20 period should be produced.
- Commitment control of new multi-year projects should also be strengthened in order to avoid a deviation from the expenditure ceilings.

### Housing, financial stability, and macroprudential policy
- Housing prices continue to rise, and could pose risks to the financial system.
- Boosting supply would help contain social and financial risks from rising housing prices.
- The intentions of the new government to boost supply through various measures are welcome.
- Macroprudential measures have so far been effective in containing household leverage, and should continue to be used.
- An independent FSC should be established soon to help coordinate macroprudential policies across sectors.
- Risks from the financial sector’s rising exposure to the housing market must be closely monitored.

### Productivity, micro‑flexibility, and structural reforms
- In the past two decades, much of Israel’s output growth has come from steady employment growth.
- With unemployment already at historic lows, maintaining strong GDP growth will require boosting output per worker.
- Israel has a lot of macro-flexibility—it has managed to absorb an incredible increase in the labor force without high unemployment—but needs more micro-flexibility, that is, more competition at the micro level.
- The new government’s intention to boost competition in several sectors is welcome—although efforts to increase banking sector competition should ensure that financial stability remains paramount.
- Efforts should also continue to address infrastructure gaps and improve education.

### Inequality and poverty reduction
- Income inequality is among the highest in advanced countries.
- Reducing inequality requires concerted efforts from across government agencies, stakeholders, and communities.
- A comprehensive poverty reduction strategy could be formulated to address critical structural problems that hinder the effective inclusion of the Haredi and Israeli-Arab populations in society and the labor market.
- Structural problems cited include poor rural infrastructure and transportation and low quality of education.

*Source: _cr15261 - 56.*

### 65.      It is recommended that the next Article IV consultation with Israel be held on a standard

### _cr15261 - 65.      It is recommended that the next Article IV consultation with Israel be held on a standard

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

### Real economy: recent performance and projections
- Real GDP: 2010: 5.8; 2011: 4.2; 2012: 3.0; 2013: 3.2; 2014: 2.8; 2015 (Prel): 3.0; Projections: 2016: 3.3; 2017: 3.2; 2018: 3.0; 2019: 2.9; 2020: 2.9 (percent change).
- Domestic demand: 2010: 5.4; 2011: 5.5; 2012: 3.5; 2013: 2.7; 2014: 3.2; 2015 (Prel): 4.9; Projections: 2016: 3.2; 2017: 2.8; 2018: 2.8; 2019: 2.7; 2020: 2.7 (percent change).
- Unemployment rate: 2010: 8.3; 2011: 7.1; 2012: 6.9; 2013: 6.3; 2014: 5.9; 2015 (Prel): 5.4; Projections: 2016: 5.2; 2017: 5.3; 2018: 5.5; 2019: 5.5; 2020: 5.5 (percent).
- Output gap (percent of potential): 2010: 0.1; 2011: 0.6; 2012: 0.2; 2013: 0.3; 2014: -0.1; 2015 (Prel): -0.1; Projections: 2016: 0.0; 2017: 0.2; 2018: 0.1; 2019: 0.0; 2020: 0.0 (percent of potential).
- Potential GDP growth: 2010: 4.0; 2011: 3.7; 2012: 3.4; 2013: 3.2; 2014: 3.1; 2015 (Prel): 3.1; Projections: 2016: 3.1; 2017: 3.0; 2018: 3.0; 2019: 3.0; 2020: 2.9 (percent).

### Prices and inflation
- Overall CPI (end of period): 2010: 2.7; 2011: 2.2; 2012: 1.6; 2013: 1.8; 2014: -0.2; 2015 (Prel): 0.7; Projections: 2016: 2.2; 2017: 2.0; 2018: 2.0; 2019: 2.0; 2020: 2.0 (percent).
- Overall CPI (average): 2010: 2.7; 2011: 3.5; 2012: 1.7; 2013: 1.5; 2014: 0.5; 2015 (Prel): -0.1; Projections: 2016: 2.0; 2017: 2.1; 2018: 2.0; 2019: 2.0; 2020: 2.0 (percent).
- Inflation is below the target band; long-term inflation expectations remain well anchored within the target band.

### External sector and reserves
- Current account balance (billions of U.S. dollars): 2010: 7.9; 2011: 3.9; 2012: 4.5; 2013: 8.1; 2014: 13.0; 2015 (Prel): 11.6; Projections: 2016: 11.3; 2017: 11.3; 2018: 10.6; 2019: 10.3; 2020: 10.6.
- Current account balance (percent of GDP): 2010: 3.4; 2011: 1.5; 2012: 1.8; 2013: 2.8; 2014: 4.3; 2015 (Prel): 3.7; Projections: 2016: 3.6; 2017: 3.5; 2018: 3.2; 2019: 3.2; 2020: 3.2 (percent of GDP).
- Gross national saving (percent of GDP): 2010: 21.2; 2011: 21.9; 2012: 22.6; 2013: 22.4; 2014: 23.3; 2015 (Prel): 22.7; Projections: 2016: 22.6; 2017: 22.6; 2018: 22.4; 2019: 22.5; 2020: 22.5 (percent of GDP).
- Foreign reserves (end of period, billions of U.S. dollars): 2010: 70.9; 2011: 74.9; 2012: 75.9; 2013: 81.8; 2014: 86.1; 2015 (Prel): 87.7; Projections: 2016: 88.5; 2017: 89.3; 2018: 89.3; 2019: 89.3; 2020: 89.3 (billions of U.S. dollars).
- Exports of goods and services (percent of GDP): 2010: 35.0; 2011: 35.5; 2012: 36.2; 2013: 32.9; 2014: 31.8; 2015 (Prel): 29.4; Projections: 2016: 29.6; 2017: 29.8; 2018: 30.0; 2019: 30.2; 2020: 30.3 (percent of GDP).

### Fiscal outlook and public debt
- Central government revenues and grants (percent of GDP): 2010: 25.5; 2011: 26.0; 2012: 24.9; 2013: 25.7; 2014: 26.0; 2015 (Est./Proj.): 25.9.
- Central government total expenditure (percent of GDP): 2010: 29.1; 2011: 28.9; 2012: 29.0; 2013: 29.0; 2014: 28.8; 2015 (Est./Proj.): 28.7.
- Central government overall balance (percent of GDP): 2010: -3.5; 2011: -3.0; 2012: -4.1; 2013: -3.3; 2014: -2.8; 2015 (Est./Proj.): -2.8; Projections: 2016: -3.0; 2017: -3.0; 2018: -3.0; 2019: -3.0; 2020: -3.0.
- General government overall balance (percent of GDP): 2010: -4.6; 2011: -3.9; 2012: -5.1; 2013: -4.1; 2014: -3.6; 2015 (Prel): -3.6; Projections: 2016: -3.8; 2017: -3.7; 2018: -3.6; 2019: -3.6; 2020: -3.6.
- Public debt (percent of GDP): 2010: 71.1; 2011: 69.7; 2012: 68.3; 2013: 67.6; 2014: 67.1; 2015 (Prel): 67.2; Projections: 2016: 67.5; 2017: 67.8; 2018: 68.3; 2019: 68.8; 2020: 69.2.

### Monetary and exchange rate indicators
- NIS per U.S. dollar (selected historical values in tables/figures): examples shown include 2000–2015 averages and periods; figures indicate the shekel has appreciated and moved toward PPP, reducing misalignment.
- Policy rate and real policy rate: the Bank of Israel has continued to cut the policy rate; real policy rate is calculated as nominal policy rate minus one-year ahead inflation expectations.
- Two-year, five-year, ten-year inflation expectations: series shown with levels generally well anchored within the target band.

### Housing, household balance sheets, and credit
- House prices have risen strongly; price-to-income ratio pushed above many other advanced countries.
- Household debt (percent of GDP, 2014Q4): Israel around levels shown in figure — household debt is relatively low compared with many peers (figure).
- Housing loans (y/y percent change) and mortgage-taking have continued to rise.
- Population-to-dwelling stock ratio indicates potential demand for housing is high given supply shortages.

### Financial sector: banks and non-banks
- Regulatory capital to risk-weighted assets: 2008: 11.3; 2009: 13.7; 2010: 14.1; 2011: 14.0; 2012: 14.9; 2013: 14.6; 2014: 14.3 (percent).
- Regulatory Tier I capital to risk-weighted assets: 2008: 7.6; 2009: 8.3; 2010: 8.5; 2011: 8.4; 2012: 9.2; 2013: 9.7; 2014: 9.7 (percent).
- Capital as percent of assets (leverage ratio): 2008: 6.1; 2009: 6.5; 2010: 6.7; 2011: 6.3; 2012: 6.6; 2013: 7.0; 2014: 7.1 (percent).
- Customer deposits as a percent of total (non-interbank) loans: 2008: 107.2; 2009: 110.4; 2010: 104.7; 2011: 111.3; 2012: 113.0; 2013: 113.9; 2014: 115.8 (percent).
- Nonperforming loans to total gross loans (most recent series shown): levels around 3.4–3.5–2.9–2.2 across periods reported.
- Pension funds and life insurance assets: pension fund assets have continued to grow; life insurance assets have grown as well, with capital positions improving for insurers (surplus capital in percent of solvency requirements increased).

### Corporate and household sectors
- Corporate profitability: return on equity and return on assets remain below pre-crisis levels.
- Corporate leverage (Debt-to-Equity) ratios have declined further.
- Household net worth: around 4 times disposable income (ratio shown).
- Household sector borrowing: has picked up in recent years; total household sector borrowing (percent of GDP): 2010: 37.5; 2011: 38.3; 2012: 39.0; 2013: 38.6; 2014: 39.0 (series in tables).

### Key structural and comparative fiscal notes (from figures)
- The non-defense budget is relatively low.
- Goods and services spending, including defense, is the highest among advanced economies (as illustrated).
- Compensation of employees is moderately high, suggesting scope for savings.
- Social spending is low; further reduction could be achieved through better targeting.
- Reforms reduced pension spending, but raising female retirement age could save further.
- The VAT rate, at 18 percent, is below the advanced-economy median.

*Italic: Content extracted from the IMF staff report figures, tables, and text provided in the source content unit.*

### Annex I. Israel: Risk Assessment Matrix

### Annex I. Israel: Risk Assessment Matrix

### Globally-sourced risks
- 1. A surge in financial volatility  
  - Relative Likelihood: High  
  - Impact: Low/Medium  
  - Israel’s Preparedness: High  
  - Key points: Israel has foreign reserves amounting to 200 percent of short-term external debt, a current account surplus, and a positive net international investment position. The US government-guarantee program provides additional assurance. Prospective US monetary tightening could weaken appreciation pressures and benefit Israel.

- 2. Protracted period of slower growth in key advanced and emerging economies  
  - Relative Likelihood: High  
  - Impact: Medium  
  - Israel’s Preparedness: Medium  
  - Key points: Renewed appreciation of the shekel will hurt manufacturing exports but service exports, supported by IT start ups, will be less affected. Monetary policy can be eased further, potentially introducing unconventional policy measures. Fiscal policy stance can be eased by allowing automatic stabilizers to operate fully.

### Domestically-sourced risks
- 3. Financial imbalances from a protracted period of low interest rates continue to build, and eventually lead to a sharp reversal of a housing boom  
  - Relative Likelihood: Medium  
  - Impact: High  
  - Israel’s Preparedness: Medium  
  - Key points: If house prices fall sharply, macroprudential policies that the BOI has implemented in recent years can be reversed. If house prices continue to rise, tighter macroprudential policies can be implemented.

- 4. Further delays in fiscal consolidation, reversing the downward trend in government debt  
  - Relative Likelihood: Medium  
  - Impact: Medium  
  - Israel’s Preparedness: Medium  
  - Key points: General government debt is low relative to other OECD economies. However, the downward trend has stalled. The medium-term fiscal and framework is weak, and there is substantial scope to strengthen commitment to fiscal rules.

- 5. Failure of systemically important financial institutions  
  - Relative Likelihood: Low  
  - Impact: Medium-High  
  - Israel’s Preparedness: Medium  
  - Key points: Bank capital and liquidity requirements have been strengthened. A formal macroprudential oversight mechanism has yet to be established. Legislation of a new bank resolution is underway.

- 6. Heightened geopolitical risks in the Middle East  
  - Relative Likelihood: High  
  - Impact: Medium/High  
  - Israel’s Preparedness: N/A

*Italic: Annex I drawn from the source content provided.*

---

### Annex II. Israel: Debt Sustainability Analysis 2015

### Overview and recent developments
- Public debt-to-GDP ratio decreased from 94 percent in 2003 to 67 percent in 2014.
- Debt structure features debt maturity averaging around 7 years and debt held by non residents around 15 percent of the total.
- Despite improvements, high interest payments and elevated gross financing needs leave the country vulnerable to growth shocks.
- Most indicators are below early warning benchmarks, but Israel’s debt profile is highly vulnerable to growth shocks.

### Baseline projection (staff scenario)
- Under staff’s baseline scenario, public debt-to-GDP ratio is projected to keep increasing gradually to 69 percent of GDP by 2020.
- This path is worse than the authorities’ implicit goal of reducing public debt to 60 percent of GDP by 2020 and eventually to 50 percent of GDP over a longer horizon.
- Baseline assumptions:
  - Real GDP: projected to grow at 3 percent for 2015 and 3.3 percent for 2016 then stay around 3 percent afterwards. The output gap is expected to be broadly closed throughout the projection period.
  - CPI inflation: expected to rise to 2 percent in 2016 and remain around 2 percent throughout the projection period.
  - Budget deficit: expected to be at 2.8 percent of GDP in 2014 and 2015. Thereafter, projected to expand to around 3 percent of GDP in 2016 as various government projects would commence, then stay at 3 percent of GDP through 2020.
  - General government deficit: assumed to be larger than the budget deficit by 0.8 percentage points of GDP annually through 2020.
  - Primary expenditure: projected to stay around 37 percent of GDP through 2020.
  - Effective interest rate: projected to slowly decline from about 6 percent in 2014 to about 5¼ percent in 2020 due mainly to the lagged effect of declining interest rates in recent years and continued favorable borrowing conditions—facilitated by comfortable sovereign ratings (A+ and A1) and the U.S. debt guarantee program (about 15 percent of external debt until 2016)—remain favorable. Interest rates on new borrowing are assumed to increase gradually during the projection period.
- Gross financing needs: will decline to 6.7 percent of GDP in 2015, and then increase to 12 percent of GDP by 2019.

### Risks to the baseline
- Risks are broadly balanced:
  - If the government adheres to the Deficit Reduction Law targets, debt would decline to around 61 percent of GDP by 2020.
  - Risks of larger fiscal slippages exist, for example due to unforeseeable geopolitical shocks, collapse of the housing market, or disappointing returns to public investment.

### Shocks and stress tests — main outcomes
- Growth shock:
  - Scenario: Lower real GDP growth rates (by 1 standard deviation for 2 years starting in 2016).
  - Effects: Financing needs would increase by 2 percent of GDP to 13 percent of GDP by 2017 and keep increasing gradually through 2020. Debt-to-GDP ratio would rise to above 73 percent by 2020.
- Interest rate shock:
  - Scenario: Borrowing costs rise by 200 basis points (e.g., from a geopolitical shock).
  - Effects: Financing needs would increase marginally by ½ percent of GDP by 2020. Impact on public debt would be very small: less than 1 percent of GDP higher by 2020 compared to the baseline.
- Combined macro-fiscal shock:
  - Scenario: Exchange rate depreciation, expansion of the primary deficit, and decline in real GDP.
  - Effects: Financing needs would rise to above 14 percent of GDP and debt to above 75 percent of GDP by 2019.

### Tail risk scenario (sharp housing correction combined with a geopolitical shock)
- Outcome:
  - Public debt would rise to above 75 percent of GDP by 2018 and keep increasing gradually to around 77 percent of GDP by 2020.
  - Gross financing needs would increase to close to 15 percent of GDP by 2017 then stay around that level through 2020.
- Scenario assumptions:
  - Real GDP contracts by 3½ percent and remains below potential in 2016.
  - House prices drop by 20 percent in 2016.
  - The shekel/dollar exchange rate depreciates by 15 percentage points in 2016 and 10 percentage points in 2017 compared to the baseline.
  - Inflation increases by 3 percentage points in 2016 and 1 percentage point in 2017 compared to the baseline.
  - Interest rates increase by 200 basis points in 2016 and 150 basis points in 2017 compared to the baseline.
  - Revenue-to-GDP ratio is assumed to decline by ½ percentage points of GDP in 2016 and ¼ percentage points in 2017 compared to the baseline while nominal expenditure is assumed unchanged from the baseline for 2016–17 (thus expenditure-to-GDP increases).

*Italic: Annex II drawn from the source content provided.*

### Annex III. Israel: Macroprudential Policy Measures to Stabilize the

### Annex III. Israel: Macroprudential Policy Measures to Stabilize the Housing Markets

### Macroprudential policy response while tightening monetary policy
- August 2009: to reduce potential default losses in response to interest rate increases, banks were required to tighten their risk management, scrutinize the mortgage loans to households, and enhance disclosure, particularly with respect to loans carrying floating interest rates that were extended to households.
- March 2010: to reflect better the true risk inherent in bank business models, a new treatment was required for loans taken out by a “purchasing group”—individuals who organize themselves for the joint purchase of land rights, in part, to get tax benefits. Loans extended to purchasing groups were required to be classified as “construction and real estate” credit, which embed a higher risk.
- July 2010: To increase banks’ loss absorption capacity in the event of a housing crisis or an economic downturn, supplemental reserve requirements of 0.75 percent were instituted for all outstanding mortgages with a Loan-to-Value ratio (LTV) that exceeds 60 percent.
- October 2010: to further improve banks’ loss absorption capacity and reduce the supply of risky mortgages, a capital surcharge was imposed on high-risk housing loans. The risk-weight factor for mortgages with a floating component of over 25 percent, an LTV of at least 60 percent, and a mortgage value higher than NIS 800,000 was raised from 35 to 100 percent.
- May 2011: to reduce the probability of mortgage default in the event of an interest rate increase, the variable component of mortgages was capped at 1/3 of the principal amount of the loan, for mortgages with an adjustable rate period of less than 5 years. In addition, banks were asked to notify customers whose mortgage loans carry a floating interest rate component that applies to one-third or more of their loan.

### Macroprudential policy response while loosening monetary policy
- July 2012: a 100 percent capital surcharge was imposed on groups of borrowers, who buy new built residential properties collectively, and who also engage with third parties to execute the construction and development of residential projects.
- November 2012: LTVs for housing loans were capped at 70 percent —excluding first-time buyers, for whom a maximum LTV of 75 percent was imposed. In addition, the LTV for mortgage loans for investment purposes was capped at 50 percent.
- February 2013: To restrict the supply of mortgages, capital requirements and provisioning for mortgages was tightened. For loans with an LTV between 45 and 60 percent capital risk weights were raised from 35 percent to 50 percent. For loans with an LTV above 60 percent, the risk weight was raised to 75 percent. The allowance for credit losses from housing loans was raised — such that the ratio between the group allowance and the balance of housing loans is at least 0.35 percent.
- August 2013: To restrict the supply of risky mortgages the debt service-to-income ratio (DSI) of new loans was capped at 50 percent; capital surcharges were imposed on mortgages with DSI between 40–50 percent; the maximum repayment period was set to 30 years; and the floating component of mortgages was capped at two-third of the loan. This applies to all mortgages with an adjustable rate component, and comes in addition to the limitation imposed in May 2011.
- September 2014: a draft directive is issued, aimed at requiring banks to increase capital requirements by 1 percent of the outstanding mortgage lending gradually by January 1, 2017 to build buffers against mortgage credit risks.

*Annex III. Israel: Macroprudential Policy Measures to Stabilize the Housing Markets (from _cr15261 — Staff Report for the 2015 Article IV Consultation — Informational Annex)*

### 67.0 percent in 2014. Nevertheless, the authorities concur with staff that at current deficit

### 67.0 percent in 2014. Nevertheless, the authorities concur with staff that at current deficit

### Fiscal outlook and public debt
- Debt-GDP ratio was 67.0 percent in 2014.
- Staff and authorities concur that at current deficit levels and with potential growth around 3 percent, the debt-GDP ratio would inevitably start to rise.
- The decline in the ratio since 2003 was supported by high growth rates; with potential growth moderating, a further reduction in the debt-GDP ratio is most challenging and requires reducing future deficits.

### Medium-term budget framework and recent budget measures
- Ministry of Finance received TA in March focused on strengthening the medium-term budget framework; first steps toward implementation are already in progress.
- New government approved a biennial budget for 2015-2016 (budget still requires approval of the parliament) that incorporates measures to strengthen fiscal discipline:
  - Adjust government medium-term expenditure commitments to legislative constraints, upon approval of each annual budget.
  - Publish a semi-annual report of the government’s expenditure commitments and expected sources of revenue for the current year and for the following three years.
  - Concentrate government decisions that involve future budgetary commitments to designated bi-monthly meetings.
  - Conduct a spending review to systematically prioritize past programs and make space for new ones (expected to start in 2017).
- Ongoing deliberations consider requiring the government to identify budgetary sources for new future expenditure commitments and revenue cuts whenever these commitments are expected to violate budgetary legislative constraints.
- Budgetary measures for 2016 incorporated:
  - Cuts of 40 percent in the cost of the coalition agreements.
  - An across-the-board reduction of 4.5 percent in the budget of all offices.

### Authorities’ reservations on staff recommendations
- Authorities emphasize Israel's GDP growth rate is higher than in other advanced economies; for equal long-term debt-GDP targets, the benchmark deficit target in Israel should be higher.
- Authorities note recent discoveries of natural gas reservoirs in the Mediterranean and expected accumulation of assets in a wealth fund would provide an additional buffer against future shocks; an evaluation of the appropriate debt level should factor in such assets.
- Regarding staff’s recommendation to increase tax revenues through indirect taxes (paragraph 17), authorities point out the tax composition is already tilted toward indirect taxes and a further increase may adversely affect inequality as these taxes are typically regressive; their preference is to raise tax revenues by cancelling ineffective tax exemptions.

### Inflation, exchange rate, and monetary policy
- Monetary policy stance is very expansionary with the policy interest rate at a historic low of 0.1 percent.
- Monetary policy also uses foreign exchange interventions.
- As of July, headline inflation over the previous 12 months has been –0.3 percent.
- Bank of Israel decomposition of CPI over the same period:
  - Tradable inflation: –1.5 percent.
  - Non-tradable inflation: 0.5 percent.
- External factors identified as main drivers of recent headline inflation: fall in oil prices and appreciation of the exchange rate; domestic inflation, although positive, is also below desirable levels.
- Headline inflation deviates from the official target range of 1-3 percent.
- Inflation expectations for the next 12 months from the financial market and private sector forecasts increased since the beginning of 2015 and until recently hovered around the lower bound of the target range; weakness in economic activity during the second quarter and renewed decline in commodity prices have recently pushed inflation expectations and forecasts downward.
- Bank of Israel stands ready to use additional tools if necessary, including quantitative easing, further reduction of the policy rate and measures in the foreign currency market; however, with current stance already extremely expansionary, headline inflation driven mainly by external factors and expectations for a first rate hike in the US by the end of 2015, authorities have not found additional expansionary measures appropriate so far.

### Exchange rate dynamics
- Exchange rate has been under appreciation pressures for several years; strengthening of the US dollar together with aggressive interest rate cuts reversed that trend only temporarily towards the end of 2014.
- Fundamental pressures for appreciation stem from a persistent basic current account surplus (i.e. the current account plus foreign direct investment), partly originating from domestic gas production that substituted for energy imports.
- Bank of Israel counteracts effect of gas production on the current account by purchasing foreign currency at the same amount; this operation is expected to continue until a wealth fund will start to operate.
- Domestic institutional investors diversifying portfolios abroad have typically hedged positions against exchange rate risk, neutralizing potential offsetting effect of capital outflows.
- Since the beginning of 2015 the Shekel appreciated against the US dollar while most currencies depreciated; Israeli export contracted by 8.6 percent SAAR during the first half of 2015.
- Authorities estimated the Shekel to be overvalued during that period and when such episodes occur the Bank of Israel steps in and purchases foreign currency.

### Housing market
- Housing prices have nearly doubled since end 2007:
  - 97 percent nominal increase since end 2007.
  - 69 percent real increase since end 2007.
  - Prior to that, a decade-long real price depreciation of nearly 25 percent.
- Staff assesses housing prices are currently overvalued by 30 percent, based on deviation from a long-run equilibrium; staff’s estimate is largely explained by supply-side shortages and should NOT be interpreted as current price misalignment or deviation from the fundamental value, per staff wording.
- Recent rise in housing prices driven by low interest rates and supply shortages.
- Pace of completion of dwellings increased persistently since 2007; only since 2013 it has started to match household growth.
- Housing price inflation is still around 4 percent annually.
- Government measures to reduce housing prices and increase supply include:
  - Shifting state-owned land auctions from highest bidder to the offer with the lowest marketing price of finished apartments winning the auction.
  - Increasing purchase tax for owners of more than one apartment; consideration of cancelling exemption from betterment tax on inherited apartments to incentivize heirs to sell.
  - Urban renewal projects receive tax benefits to increase density.
  - Mobilization of large army bases from the center to the periphery to release land for development.
- Bank of Israel has launched a series of macro-prudential measures to safeguard financial stability.

### Financial sector and macroprudential measures
- Authorities share staff concerns about banks' exposure to real estate and construction.
- Since 2009 Bank of Israel launched macro-prudential measures mainly targeting the mortgage market; measures aim at safeguarding financial stability rather than reducing housing prices and target marginal, riskiest mortgages.
- Risk indicator improvements following Banking Supervision directives:
  - Share of mortgages with payment-to-income ratio higher than 40 percent fell from 23.8 percent to 0.9 percent over the past four years.
  - Share of mortgages with loan-to-value ratio higher than 75 percent fell from 9.7 percent to 2.0 percent.
- Construction industry credit risk:
  - Problematic credit risk in construction declined from 6.1 percent in 2011 to 3.7 in 2014.
  - Sectoral exposure regulations prevent banks’ exposure to the construction industry from exceeding 20 percent of their total credit.
- Progress toward establishing a Financial Stability Committee (FSC):
  - Road to establishing FSC described as rocky.
  - Government passed a resolution on June 28 to circulate within 180 days a draft law for the establishment of a FSC.
  - Regardless of holdups, the three financial regulators meet regularly in an informal coordination committee.

### Labor market and productivity
- Labor market is strong: unemployment is at a multi-decade low while the participation rate is rising.
- Policies supporting employment include earned income tax credit at low levels of income, stricter eligibility criteria for unemployment benefits, and reducing child allowances.
- Trends are accompanied by prolonged sluggish productivity growth and a rise in inequality and poverty rates.
- Authorities attribute weakness in labor productivity largely to rising participation of groups loosely attached to the labor market, especially the Haredi population and Arab women; new workers from these groups typically have weaker labor market skills, reducing average labor productivity.
- Challenge: continue raising participation while equipping new entrants with stronger skills to boost labor productivity and support more inclusive growth.
- Programs in place (examples given for Haredi and Arab populations) to address skills, education, vocational training, placement, child care subsidies, entrepreneurship support, and targeted vocational programs.
- Authorities agree increasing competition is key to raising Total Factor Productivity (TFP); negative TFP gaps against OECD averages are particularly noticeable in industries with low export shares.
- Noted reforms and priorities:
  - Reform in cellular communication increased competition significantly.
  - Reform in the food market is underway.
  - Boosting competition is a priority for the new government, but work is at early stages.

*IMF staff and authorities discussion as presented in the source content.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2015/_cr15261.pdf_