Concluding Remarks of 1998 Article IV Consultation Discussions--Israel

December 2, 1998

At the conclusion of annual Article IV bilateral discussions with the authorities, and prior to the preparation of the staff's report to the Executive Board, the IMF mission often provides the authorities with a statement of its preliminary findings.
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Israel—1998 Article IV Consultation Discussions

Preliminary Conclusions
December 2, 1998

1.  At the time of the last consultation discussions in November 1997, there was reason to believe that the period of slow growth that the Israeli economy had experienced would soon end. The authorities had taken measures to strengthen the fiscal position, paving the way for a more balanced fiscal/monetary policy mix than had been in place in preceding years. Also, the pace of structural reforms had been stepped up. All in all, conditions were being set to enable the economy to achieve a rate of growth more in line with its potential, coupled with continued convergence of inflation toward the average rate prevailing in other advanced countries.

2.  Subsequent developments have deviated from the expected path in two major respects. First, economic growth has continued to decelerate, in response to both a deterioration in the external environment and a further weakening of domestic demand. This has contributed to a sizable increase in unemployment. Second, since end-August, amidst turmoil in international financial markets, the shekel has depreciated markedly relative to the currency basket and the U.S. dollar. Given the large size of the tradable sector in Israel and peculiarities in the measurement of the housing price component of the CPI, the ensuing increase in the price level has been steep, seemingly interrupting the rapid progress that had been made in lowering inflation.

3.  While the depreciation of the shekel has confronted the authorities with new and difficult challenges, it has also provided—along with the improved outlook for the peace process—an opportunity to strengthen the basis for economic growth. The key policy challenges in the short term are to preserve orderly conditions in the foreign exchange market, and to ensure that the initial adjustment in the price level does not feed through to a higher rate of inflation than that prevailing prior to the depreciation. If these challenges are met, the depreciation will lead to a lasting improvement in international competitiveness, particularly of the traditional industries, offsetting the real appreciation experienced in the early phase of the disinflation process. In due course, export performance and the external position will strengthen and prospects for economic growth and job creation will improve substantially.

4.  To contain the immediate threats posed by the depreciation of the shekel, the Bank of Israel raised its discount rate by a total of 4 percentage points in October/November. This firm monetary policy response, which occurred against the background of uncertainty about the passage of the 1999 budget, provided a strong signal that price increases beyond those stemming directly from the depreciation of the shekel would not be accommodated. It succeeded in curbing inflation expectations, albeit at the expense of raising real interest rates.

5.  Looking ahead, a tight monetary stance will have to be maintained in the near term to safeguard stability in the foreign exchange markets and keep inflation expectations in check. However, as the authorities recognize, it would be inappropriate to aim at substantially reversing the recent depreciation of the shekel. At the same time, a protracted period of high real interest rates would further weaken domestic demand. Thus, economic policies in the next few months should strive to establish the conditions for a gradual easing of the monetary stance, without risking a rekindling of inflation or the re-emergence of pressure for a depreciation of the shekel. The essential requirements are, in our view, threefold:

  • first, the authorities should dispel doubts as to their intention to retain the 4 percent inflation target for the twelve months to December 1999. A revision of the target would raise inflation expectations, potentially unsettle financial markets, and adversely affect the upcoming wage negotiations. To that extent, it would be more likely to lead to an increase in nominal interest rates, rather than the hoped-for rate reduction;

  • second, the commitment to the medium-term fiscal consolidation program should be reaffirmed and the measures that the government has proposed to reach the 2 percent of GDP budget deficit target for 1999 should be enacted as quickly as possible;

  • third, the authorities should impress upon the social partners the critical need for wage moderation. In particular, it will be important to contain to a minimum any adjustment in wages intended to compensate for the direct price effects of the depreciation. Failure to do so would not only erode the competitive benefits of the depreciation, but also exacerbate underlying pressures on prices and undermine prospects for easing monetary conditions, to the detriment of future growth and employment performance.

6.  The methodology used to construct the consumer price index overstates (at least initially) the increase in the true cost of living associated with the decline in the dollar value of the shekel and, through the indexation mechanism, contributes at times to increases in wages that are unwarranted by productivity developments. It also risks making monetary policy decisions unduly dependent on a volatile index. While volatility in the CPI may be reduced when the new method of imputing rents is introduced, it would be preferable, as in many other countries, to express the inflation target in terms of the underlying rate of inflation, which in the case of Israel excludes the prices of housing, and fresh fruits and vegetables. At the same time, the authorities should urge that indexation in private contracts, including wage contracts, be based on the same underlying price index.

7.  In pursuing monetary policy goals, it is desirable to avoid as far as possible abrupt changes in monetary conditions. In this context, it would be useful to continue to explore whether limited intervention in the foreign exchange market can be undertaken without unduly encouraging risky behavior. Should such an approach be found feasible, intervention could ease the burden currently borne by interest rate policy in preserving stability. It could also facilitate a gradual reduction in the exposure of Israeli residents to foreign currency risk, and thereby lower the potential vulnerability of the Israeli economy to contagion effects from shocks that might hit other countries with weaker fundamentals.

8.  Recently, several welcome steps were introduced to strengthen the transparency and accountability of monetary policy. These could be further refined in the future, for example by publishing regularly the Bank of Israel’s inflation forecasts along with its assessment of the reasons for any deviations from the target. Moreover, in view of the lags in the monetary policy transmission process, the explicit inflation target should be set over a 2 to 3-year horizon, rather than only for the year ahead as at present. Meanwhile, the envisaged amendment of legislation governing the Bank of Israel should, in our view, reaffirm the Bank’s operational autonomy, with appropriate checks and balances, and identify the pursuit of price stability as the Bank’s primary objective. As the experience of many other countries has shown, this is the best contribution that monetary policy can make to promoting economic growth over the longer run.

9.  Turning to fiscal policy, the progress that the authorities have made over the past two years in reducing the budget deficit has been impressive, the more so since it has been achieved under adverse macroeconomic conditions. Nevertheless, the deficit remains large, particularly when measured on a basis consistent with conventions applied by other advanced countries. Israel’s public debt is also very high and additional pressures on expenditure may emerge in the future to deal with the deficits of the pension and health funds. All these considerations make it essential, in our view, to continue to pursue an ambitious medium-term fiscal consolidation program.

10.  The government’s budgetary plans for 1999, which aim to achieve a modest further cut in the operational deficit to 2 percent of GDP, are consistent with such a program, especially if allowance is made for the current weakness of economic activity. The official plans are also in line with the deficit reduction law adopted some years back. Their implementation is thus bound to enhance further the credibility of fiscal policy, while also raising national saving and strengthening the underlying external position. The authorities’ intention to pursue the deficit reduction target for 1999 through substantial cuts in nonessential expenditures is also laudable as it would not only obviate the risk of raising the tax burden, which is on the high side by international standards, but also make room for a substantial increase in growth-promoting spending on economic infrastructure, education and labor market programs. It is therefore to be hoped that the government’s budgetary plans for 1999 will soon be endorsed by the Knesset.

11.  The pursuit of further structural reforms, for example through the continuation of the government’s privatization program and the implementation of tax reforms intended to broaden the tax base and lower tax rates, remains desirable in view of the contribution they can make to raising longer-term potential growth. Reforms in economic structures and practices may also help in the short run to moderate the upward pressure on the price level stemming from the depreciation of the shekel. Israel’s success in opening up competition in the telecommunications area and countering anti-competitive behavior in the credit card industry illustrate this potential. Similar achievements may be feasible through the elimination of restrictive practices, notably concerning energy and trade in pharmaceuticals and cars.

12.  With regard to the labor market, recent increases in the minimum wage have been high in real terms, and may have contributed to job losses, especially in the traditional sector. To improve the employment prospects of unskilled workers, the minimum wage could be indexed to prices rather than wages and differentiated to take account of work experience. With the ongoing transition from traditional industry to high-tech sectors, shifting public expenditure toward appropriate education and training programs—as is the government’s intention— should also help in lowering unemployment.

13.  The accelerated privatization of banks in recent years is welcome, but has not sufficiently lowered the degree of concentration in the financial system. In that regard, the timely implementation of the large banking groups’ planned divestment not only from nonfinancial enterprises, but also from medium-sized banks, is important. To promote competition further, the authorities should encourage additional break-ups of financial conglomerates and explore ways to facilitate entry by foreign banks, whose presence in Israel remains extremely small. While there is no reason at present to be concerned about the soundness of the banking system, the increased volatility in financial markets and asset prices, and the large share of credit in—or linked to—foreign currency justify heightened vigilance and, perhaps, additional prudential measures, such as raising minimum capital requirements, demanding larger provisions, and encouraging banks to limit dividend payouts. Finally, in light of the close links between banks and other types of financial institutions, cooperation among the various supervisory authorities could benefit from greater formalization of arrangements and information-sharing practices. We welcome the creation of a committee to address such coordination issues.