Israel, Article IV Consultation—Concluding Statement of the Mission
IMF News, November 29, 2010
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- Published: November 29, 2010
Summary
- Israel passed through the global recession swiftly due to decisive policies and strengthened macrofinancial policy frameworks.
- Current challenges: sustain growth and low inflation while boosting medium-term prospects amid continued global uncertainty, capital outflows from advanced countries, shekel appreciation, and an overheating housing market.
- Policy recommendation overview:
- Tighten overall stance of policies more quickly than planned, with the onus mainly on fiscal rather than monetary policy.
- Monetary policy to focus on inflation and move further towards a neutral stance; foreign exchange intervention to become more symmetric.
- Rebalance housing supply and demand.
- Strengthen coordination for financial stability, enhance medium-term public spending procedures, and accelerate integration of minorities into the labor force.
Economic performance and recent policy actions
- Output and labor market:
- Output rose by 0.8 percent in 2009, and is set to grow around 4 percent in 2010.
- Unemployment is back down to around 6 percent.
- Crisis response and policy framework:
- Policy actions included cuts in policy interest rates to ½ a percent, pre-programmed foreign exchange intervention, accommodation of large automatic stabilizers taking the budget deficit to 5 percent of GDP, and steps to contain financial sector stress.
- Strengthened frameworks: strong Bank of Israel Law, increased bank capital requirements, a reinforced tripartite arrangement, entry into the OECD, a new fiscal rule targeting debt reduction, and a “two-year” budget framework.
- Withdrawal of stimulus:
- Bank of Israel (BoI) policy rate raised in steps to 2 percent.
- Forex intervention reduced and now discretionary.
- Headline fiscal deficit heading below 4 percent of GDP in 2010.
- Real interest rates remain negative and the budget is in structural deficit—overall policy stance remains expansionary.
Risks to competitiveness, inflation, and housing
- Exchange rate and competitiveness:
- Shekel appreciated by some 15 percent in real terms relative to pre-crisis levels and is still rising.
- Consequences: potential loss of export market share in 2010, falling FDI inflows, recent falls in exports and flat employment.
- Inflation and wages:
- Inflation recently returned into its 1-3 percent target range after a lengthy period just above it.
- Private sector nominal wage growth has picked up; inflation expectations across the medium term have risen to the top of the target band.
- Output gap has, in the mission’s view, all but closed.
- Housing market:
- Nominal house prices rose over 40 percent in just two years after taking off in 2008.
- Pace of house price inflation judged unsustainable and a potential risk to broader stability, notably the banking sector.
Fiscal policy recommendations
- Fiscal consolidation is the cornerstone to secure stable inflation, reduce domestic absorption, and protect competitiveness.
- Authorities’ plans:
- Two-year budget plans reductions in the headline fiscal deficit to 3 and 2 percent of GDP in 2011 and 2012 respectively, anticipating further reductions to 1 percent of GDP from 2014.
- IMF estimate: implies a structural consolidation of some 1½ percentage points of GDP over the next two years.
- IMF recommendation:
- Strengthen the planned fiscal stance for 2011 and beyond by some 1 percentage point of GDP in structural terms.
- Use a mix of expenditure and tax actions:
- Apply budget operation mechanisms to hold spending below budgeted authorizations, including retention of budget reserves.
- Address risks on the revenue side from generous official estimates; action may be needed on indirect taxes.
- Medium-term fiscal governance:
- Boost credibility of the new fiscal rules (targeting deficit reduction and capping real expenditure growth) through faster consolidation and strengthened medium-term spending procedures.
- Need for coordinated review of medium-term expenditure priorities and eventual systematic medium-term spending reviews to support the biannual budget system.
Natural resources revenue policy
- Review taxes on non-renewable resources (notably natural gas) and arrangements for spending proceeds.
- Ministry of Finance commission to review current tax arrangement is welcomed.
- Recommendations:
- Raise the “tax take” from these activities to advanced country norms.
- Adopt international best practice in pricing arrangements and intergenerational distribution of proceeds.
- First use of such tax receipts should be to reduce public debt given modest revenue estimates; if large additional finds occur, place revenues in a sovereign wealth fund.
Monetary policy, exchange rate, and external uncertainty
- Monetary stance:
- With buoyant output and employment and high inflation expectations, move further towards a neutral stance.
- If fiscal policy is tightened as recommended, policy rates could rise broadly as now anticipated (further increases of 75-100 basis points are anticipated during 2011).
- If fiscal tightening does not occur, a faster rise in policy rates will be needed to head off higher inflation, at the expense of competitiveness.
- Role in global uncertainty:
- Policymakers should remain ready to act decisively—swiftly raising policy rates if upside global risks materialize, and vice versa.
- Foreign exchange intervention and capital controls:
- Further FX intervention on both sides could help orderly market conditions but has limits because reserves and sterilization losses are considerable and persistent one-sided use undermines the floating regime.
- Capital controls could be considered only if focused and effective; better options may exist.
- Recommendation to consider issuing memoranda of understanding between the Government and the BoI on implementation of the Bank of Israel Law of 2010 and clarify the role of the new Monetary Committee in macroprudential decision-making.
Financial stability, supervision, and macroprudential policy
- Macroprudential and regulatory actions:
- Mid-2010: banks required to secure core capital of at least 7½ percent by year end.
- Non-bank sector: supervisory powers and capacity, transparency by market participants, and risk management by institutional investors are being strengthened, notably via Solvency II.
- Financial stability indicators:
- Improvements: capital adequacy (including Tier 1 relative to risk-weighted assets) and impaired loans improved; non-bank financial institutions advanced.
- Concerns remain: stress testing focused at sub-sector level and early stages; some risk indicators unavailable; credit quality in the corporate bond market remains a lingering concern; latent threat to banking stability if rapid house price inflation continues.
- Strengthen diagnosis and management of risks:
- Develop stress testing procedures with focus on systemic risk over longer horizons.
- Require full collaboration between and within supervisory institutions and routine guidance/feedback among authorities responsible for stability (BoI and MoF).
- Formalize arrangements irrespective of final supervisory architecture decisions.
- Do not await the anticipated FSAP to improve diagnosis and collaboration; address deposit insurance scheme and early bank resolution arrangements in that context.
- Non-bank supervision:
- Concerns about adequacy of resources, capabilities, autonomy and accountability of non-bank supervisors.
- Recommendation to move supervision out of the MoF, following OECD practice and options that include full independence.
Structural reforms and labor market
- Macrofinancial advice depends on continued structural reform: progress in education, research, business environment, and infrastructure.
- Highest priority: fully integrate minority populations into the labor force to lower social spending pressures and raise long-run productive potential.
Key findings and projections (selected exact figures)
- Output growth: 0.8 percent in 2009; around 4 percent in 2010; projected 3½ percent in 2011 and rising again in 2012.
- Unemployment: around 6 percent.
- Policy interest rate: cut to ½ a percent (pre-crisis response); raised in steps to 2 percent (current).
- Budget deficits and targets:
- Budget deficit reached 5 percent of GDP during downturn.
- Headline fiscal deficit heading below 4 percent of GDP in 2010.
- Authorities plan deficits: 3 percent of GDP in 2011, 2 percent of GDP in 2012, 1 percent of GDP from 2014.
- IMF structural consolidation estimate: some 1½ percentage points of GDP over the next two years.
- IMF-recommended additional fiscal strengthening: some 1 percentage point of GDP in structural terms for 2011 and beyond.
- Bank capital requirement target: core capital of at least 7½ percent by year end.
- Shekel appreciation: some 15 percent in real terms relative to pre-crisis levels.
- House prices: rose over 40 percent in just two years after taking off in 2008.
- Monetary policy tightening anticipated: further increases in the BoI policy rate of 75-100 basis points are anticipated during 2011.
- WEO global growth 90 percent confidence interval cited as 2—6 percent.
Source: Israel, Article IV Consultation—Concluding Statement of the Mission, November 29, 2010.