Israel -- 1999 Article IV Consultation Discussions

December 12, 1999

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 -- 1999 Article IV Consultation Discussions

December 12, 1999

1.  Following three years of slow economic growth, the Israeli economy is now in a position to realize its full potential. After an exchange rate shock in late 1998 that delayed economic recovery, performance in recent months has evolved quite favorably, with reduced inflation and an apparently strong rebound in economic activity beginning in the second quarter of 1999, although unemployment and real interest rates remain high. Inflation will undershoot its 4 percent target, while real output growth will come in at or above the official forecast of 2 percent this year. The real exchange rate appreciation that had built up in 1996-1997 has largely been reversed, the current account deficit is quite low, and foreign direct investment inflows are at record highs. Foreign exchange controls have been liberalized and with an effectively freely floating exchange rate, banks and firms are appropriately taking greater account of exchange rate risks. The challenge now is to sustain and strengthen the nascent economic recovery while maintaining price stability.

2.  Meeting this challenge will require a more balanced mix of monetary and fiscal policies as well as the more expeditious implementation of a wide range of structural reforms. Specifically, monetary policy needs to ease prudently, while fiscal policy should remain focussed on consolidation. Such an approach would reduce real interest rates while freeing resources for the private sector, thereby stimulating investment and enhancing the overall efficiency of the economy, leading to high non-inflationary growth in output and employment.

Monetary Policy

3.  The authorities are to be commended for the very considerable progress that has been made to reduce inflation toward the levels in major industrial countries, following a protracted disinflation process. The key task of monetary policy will be to ensure that this progress is sustained and that the return on this investment is realized by adhering to the inflation targets. Given that this objective has clearly been achieved this year, the moderate and still uncertain pace of the recovery, and the substantial output gap and high unemployment rate, there is scope for a cautious easing of the stance of monetary policy over the coming year without significant risk to the achievement of the inflation target. As it will take time for an environment of low inflation to become fully accepted as a permanent feature of the economy, interest rates can only decline gradually as a precaution against a rapid depreciation of the sheqel via an abrupt portfolio shift.

4.  When an environment of low inflation becomes firmly entrenched, monetary policy will have more scope to increase its support of economic activity. Over time, the Bank of Israel will be in a position to adopt the practices in other advanced economies and ensure that inflation does not deviate significantly in either direction from the inflation targets.

5.  In the mission's view, the forward-looking inflation targeting regime has served the Israeli economy well and should remain in place. We commend the authorities for adopting a flexible exchange rate regime that allows monetary policy to concentrate on the inflation target. The authorities could, however, examine ways to further improve the policy framework, such as possibly changing the inflation target from a December-to-December basis to an average basis over a relevant period (which could be the current two-year horizon or possibly longer). Any such change would have to be introduced after widespread consultation and with maximum transparency, and would ideally contribute to a reduction in the frequency of interest rate changes. The mission also suggests that the Bank of Israel could usefully take a more prominent role in the formation of the public's outlook on inflation through a more comprehensive presentation of its own analysis of prospects for inflation in its Inflation Report. In addition, the Bank of Israel could enhance the public's understanding of the inflation process by presenting different economic scenarios and analyzing the tradeoffs they involve.

Fiscal Policy

6.  An easing of monetary policy will need to be supported by a fiscal policy that enhances the credibility of the low inflation environment through continued budget consolidation. The consolidation strategy should be one that provides a growth-oriented combination of tax and expenditure policies. In line with this approach, the mission strongly supports the government's decision to target a budget deficit of 2_ percent of GDP in 2000, and urges the authorities to resist any pressures to widen the deficit or to finance higher spending through a further increase in the tax burden. In addition, the government should as much as possible avoid a redistribution of expenditure away from items such as infrastructure investment that would support a recovery of economic activity and faster growth.

7.  In the medium term, the economic recovery presents a clear opportunity to accelerate the process of fiscal consolidation, aiming to achieve balance in the operational budget by 2003. If the recovery proves to be stronger than currently expected, the authorities should guard against allowing public spending to increase in line with revenues, as programs established in boom periods often turn out to be very hard to reverse once the economy returns to its trend.

8.  As inflation has declined to rates near those observed in industrial countries, the authorities could usefully begin to compile and publish a conventional, all inclusive, measure of the fiscal deficit, which would facilitate comparisons with the fiscal positions of other industrial economies. This does not imply that the current operational balance measure that is included in the Budget Deficit Reduction Law should be abandoned. Presentation of the conventional fiscal balance would make clear that substantial progress must still be made in reducing the deficit.

Structural Policies

9.  The mission commends the government for its ambitious structural reform agenda. In the mission's view the authorities have taken courageous and necessary steps to deregulate and improve the business environment. The mission supports in particular the initiatives to increase competition in the utilities sector, and to attract private sector capital and managerial expertise to economic infrastructure projects. Moreover, it would be desirable to accelerate the privatization process in banking and (as long as an appropriate regulatory environment has been established beforehand) in sectors such as electricity and telecommunications. In this regard, the authorities have correctly used the privatization program to pursue the microeconomic goal of increasing economic efficiency rather than the macroeconomic one of maximizing fiscal receipts.

10.  Tax reform is also a welcome aspect of the government's agenda, and in the mission's view it would be desirable to use this opportunity to lower marginal tax rates while widening the tax base. In addition, the reform should remove the distortions and asymmetries in the taxation of various financial investments, including the current discriminatory tax treatment of certain forms of foreign investment by Israeli residents.

11.  The practice of providing pension funds with access to long-term government bonds at a guaranteed real interest rate, while intended to safeguard retirement savings, has a number of undesirable consequences. It distorts long-term yields, potentially leads to a misallocation of resources from their most productive uses, and reduces liquidity in domestic capital markets, with important, negative implications for the authorities' privatization program. Consideration should be given to alternative arrangements that would avoid these effects.

12.  The mission strongly supports the prompt implementation of the Levine Committee's recommendations on amending the Bank of Israel Law, in particular establishing price stability as the foremost objective of the Bank of Israel. In addition, the mission urges the authorities to nominate a new Governor of the Bank of Israel as soon as possible.

13.  The mission urges the supervisory authorities to maintain strict vigilance over the banking sector's activities, and over those of the financial sector in general, in order to preserve the already low risk of financial distress.

14.  In the mission's view the tariff system should continue to be streamlined and remaining non-tariff barriers should be reduced in order to increase the efficiency of the Israeli economy.

15.  The economy is on the threshold of a marked improvement in economic performance. Indeed, the high quality of Israel's workforce, the entrepreneurial prowess of its business leaders, the outward-looking nature of the economy and the sound legal and institutional framework in which it operates, together with the peace process, suggest that with an appropriate combination of economic policies, Israel's high long-term growth potential can be realized.