Public Information Notice No. Press Information Notice No. 98/16

Press Information Notice: IMF Concludes Article IV Consultation with Israel

March 10, 1998

The IMF Executive Board on February 11, 1998 concluded the 1997 Article IV consultation¹ with Israel.

Background

After several years of strong economic performance, the Israeli economy experienced a bout of fiscally induced overheating in 1995–96. A sharp tightening of monetary policy was needed in the absence of fiscal correction to deal with these excess demand conditions but had an inevitable impact on the economy. The situation was further exacerbated by extraneous events such as a deteriorating security situation and an unwinding of the effects of the early-1990s’ immigration wave. As a result, growth in 1997 was disappointing (2 percent), as was the concomitant sharp rise in unemployment (to almost 8 percent).

On the positive side, sluggish domestic demand and quiescent wage pressures against the background of the tight monetary policy led to a marked reduction in inflation during 1997, with the 12-month change in the overall CPI brought down to 7 percent by the end of the year, at the bottom of the authorities’ target range. Weakening demand in Israel and strengthening demand abroad, in combination with an improvement in the terms of trade caused by the appreciation of the U.S. dollar against European currencies, led the external current account deficit—which had ballooned from near balance early this decade to 5½ percent of GDP in 1996—to narrow to about 3½ percent of GDP in 1997.

Fiscal policy was tightened significantly in 1997. Having missed their fiscal targets for 1995 and 1996, the authorities strengthened their commitment to deficit reduction in 1997 with exceptionally strong efforts to rein in expenditures during the year. While final information for the year is not yet available—the target was an overall deficit of 2.8 percent of GDP—the 1997 outturn is likely to have represented a very significant improvement over that in 1996, especially in structural terms given the weak pace of economic activity. However, the level of the public-debt-to-GDP ratio, which stood at 103 percent in June 1997, is still very high. In early January 1998, the Knesset approved the state budget for 1998, targeting a deficit of 2.4 percent of GDP based on restraining the growth of expenditures.

Monetary policy in Israel aims at achieving an inflation target set by the government while simultaneously maintaining a commitment to keep the shekel trading within its diagonal exchange rate band. Over much of the past year, the shekel was kept at or near the appreciated limit of the diagonal exchange rate band as capital inflows exceeded those needed to cover the current account deficit. In order to maintain the exchange rate within the band, the Bank of Israel had to engage in foreign exchange intervention and subsequent sterilization, greatly increasing the share of net foreign assets in the money base. In June, the authorities approved a widening of the band from 14 percent to 28 percent by adjusting the limit on depreciation. Subsequent to the widening of the band, there was a steep drop off in capital inflows and, as a result, the Bank of Israel did not need to further intervene in the foreign exchange market.

Structural reform is an important element of the government’s economic program aimed at sustained growth. During 1997, significant progress was made in the areas of privatization—especially in regard to the banks—and the liberalization of capital account transactions.

In 1998, growth is projected to rebound somewhat under the assumption that the policy mix will shift in the direction of a better balance between fiscal and monetary policies and that the negative effects on growth of the security situation will ease.

Executive Board Assessment

Directors observed that, while growth had slowed and unemployment had risen in 1997, there were a number of encouraging features in economic developments that augured well for future economic performance. Of particular importance was the authorities’ success in attaining their targets for the fiscal deficit and inflation, as well as the substantial progress in structural reforms. Nevertheless, with unemployment rising, the economic situation remains difficult, and Directors called for vigorous efforts to set conditions that would permit sustained growth in line with Israel’s potential, together with a further substantial drop in inflation and a viable external position. They advocated steady pursuit of a strategy of strong and sustained fiscal consolidation and bold structural reform that would reduce the burden on monetary policy. Directors also stressed the critical role of the peace process for economic prosperity in Israel and the region.

Directors welcomed the achievement of the 1997 fiscal deficit target, which signaled a turnaround in the conduct of fiscal policy from the previous two years, when the deficit targets had been exceeded. Looking ahead, they stressed the importance of building on this achievement by launching an ambitious medium-term fiscal consolidation plan that would bring the deficit down to the low levels now being targeted in other advanced countries and reduce Israel’s still high public-debt-to-GDP ratio, while helping to prepare for the looming problems in the health and pension systems. Directors considered that the current medium-term plan, albeit in the right direction, is not sufficiently strong. They urged the authorities to press ahead with stronger adjustment aimed at achieving, at least, approximate balance by 2001 (in terms of the government’s accounting system). They noted that budgetary retrenchment along these lines would facilitate the task of monetary policy in lowering inflation, with consequent beneficial effects on the real interest rate and the real exchange rate, both of which are crucial to Israel’s growth. Directors also noted that Israel’s use of a fiscal accounting system akin to an operational budget concept obscured international comparisons of the fiscal situation, and that Israel’s budget deficit remains high by conventional standards of measurement.

In view of the need for a more ambitious medium-term fiscal consolidation effort than currently envisaged, Directors regarded the fiscal adjustment planned for 1998 as the minimum required, and stressed the critical importance of actually achieving the target, including through recourse to supplementary packages and contingencies in the budget if revenues turn out weaker than expected. Given the large size of the public sector in Israel, Directors strongly endorsed the emphasis in the 1998 budget on expenditure containment, in particular the curbing of the public sector wage bill.

Turning to monetary policy, Directors commended the authorities for persevering with a tough stance during 1997, which had resulted in inflation coming in at the bottom end of the target range. They encouraged the authorities to seize the opportunity provided by current favorable conditions to lower inflation further in 1998, to consolidate the progress made last year, and to make a major inroad into Israel’s long-held inflation psychology. To this end, Directors saw the need for lowering the inflation target range for 1998. They were confident that, with support from the full implementation of the 1998 budget, continued visible progress with disinflation would be compatible with, and would facilitate, a gradual but cumulatively meaningful easing of monetary conditions.

As regards the operational framework of monetary policy, Directors welcomed the increasingly forward-looking approach to inflation targeting being adopted by the Bank of Israel, and encouraged the authorities to extend the operational horizon for setting inflation targets. They noted that the credibility and transparency of this approach would be enhanced by the announcement of a clear and specific target path for medium-term disinflation to the level of other advanced countries. Moreover, most Directors were of the view that the achievement of this target path for inflation should be given primacy over the exchange rate, with the proviso that the task of keeping the real exchange rate within a viable range should be handled appropriately by fiscal and structural policies. To strengthen public accountability, Directors urged the Bank of Israel to publish regularly a report on the inflation outlook and the policies needed to keep inflation on track. Commenting on the ongoing debate on the central bank law, Directors observed that international experience underscores the importance of preserving the operational independence of the central bank, whose primary responsibility should be to achieve and maintain price stability. Any changes to the law governing the Bank of Israel should be drafted in accordance with this basic principle.

In the area of structural policies, Directors welcomed the concrete actions taken in 1997 to reduce the role of the state in the economy and to promote competition. Particularly notable was the successful acceleration of privatization—especially of banks—and Directors urged the authorities to seek to maintain this momentum in 1998 and beyond. Despite the significant achievement in 1997, Directors observed that more work needs to be done in a number of structural areas to set the stage for strong and sustained growth over the medium term. They identified in this connection domestic capital market reform, additional measures to increase competition, deindexation, and reform of the minimum wage system.

Directors commended the authorities for the steps they had taken over the past year to further liberalize capital account transactions. It was noted that the recent widening of the exchange rate band was consistent with these developments. While strongly supporting the authorities’ efforts in liberalizing the capital account, Directors stressed that this increased the importance of close supervision of the banking system and close monitoring of short-term external borrowing, as well as the maintenance of sound macroeconomic policies.