Public Information Notice No. 00/33

Public Information Notice: IMF Concludes Article IV Consultation with Israel

April 24, 2000

On March 23, 2000, the Executive Board concluded the Article IV consultation with Israel.¹

Background

Economic policies were tightened in 1997-98 in response to signs of overheating after years of rapid growth. Interest rates were raised and fiscal policy became contractionary. A tight monetary policy led to large capital inflows and a significant appreciation of the sheqel. These factors and a deceleration of immigration contributed both to an economic slowdown and to a decline in inflation from double digits to low single digits between mid-1996 and mid-1998. After a brief period of monetary easing, monetary policy was abruptly tightened again in late 1998 as the authorities sought to contain the inflationary impact of a large depreciation of the sheqel in the wake of the Russian/LTCM crisis. The response to the crisis was successful in arresting currency depreciation and managed to keep inflation on a declining trend.

After the elections held in May 1999, the renewed emphasis on the peace process contributed to greater business confidence. The Israeli economy appears to have turned the corner in 1999, with GDP growing by 5-6 percent in annual terms in the second half of the year, despite high real interest rates. However, recently released preliminary data suggest that growth may have decelerated in the last few months relative to the very rapid pace observed in the latter part of 1999, highlighting the fragility of the recovery. A strong sheqel and a significant output gap have contributed to a decline in inflation, which on a 12-month basis ended 1999 at 1.3 percent, significantly below its 4 percent target for the year. Unemployment has remained high, at about 9 percent of the labor force in 1998-99 compared to an average of 6-7 percent in recent decades. An increase in the current account deficit partly reflecting stronger domestic demand was primarily financed by a surge in FDI, especially into the high-technology sector.

The operational fiscal deficit in 1999 is estimated at 2¼ percent of GDP, slightly above the budgetary target of 2 percent.² This small underperformance largely reflects the fact that economic growth was slightly lower than assumed in the budget. The negative impact of the 1998 sheqel depreciation on corporate income taxes also contributed to the overrun, although this factor was more than offset by a sharp increase in relatively highly taxed consumer durables imports during the latter part of the year and higher revenue from real estate sales taxes.

With the sheqel trading within very wide bands, monetary policy has been fully geared towards the inflation target. However, despite a gradual series of cuts in the Bank of Israel's discount rate, renewed confidence in the economy and the still-large gap between Israeli and foreign interest rates have put upward pressure on the sheqel in recent months, resulting in a gradual drift toward the more appreciated end of the band.

The authorities have unveiled an ambitious structural reform agenda aimed at increasing competition and creating conditions for the private sector to absorb resources released by the process of fiscal retrenchment. Yet, delays in bank and telecommunications privatization are likely to have resulted in privatization revenues that are only about one-fourth of the expected amount of NIS 4.6 billion.

The fragile economic recovery now underway is expected to strengthen over the next two years. The staff's 3.8 percent growth forecast for this year is in line with current market views and the balance of recently released indicators of economic activity. Growth is expected to be led by exports, which should strengthen given the continued development of the export- intensive high technology sector and the faster pace of expansion in the world economy. On current policies, the trend toward low inflation observed last year is expected to continue.

Executive Board Assessment

Executive Directors commended the authorities for fiscal and monetary policies in 1999 that sustained the impressive gains in disinflation and laid the basis for economic recovery. However, they observed that the envisaged shift to a broadly neutral fiscal stance in 2000 represents an unwelcome pause in the authorities' fiscal efforts. They also stressed that continued commitment to fiscal consolidation would be needed to support the desired, gradual easing of monetary policy. Directors emphasized that such a shift in the policy mix, together with a renewed emphasis on structural reforms, would create the conditions for a substantial acceleration of growth and subsequent welcome reduction in the unemployment rate.

While welcoming the progress the authorities had made in strengthening central government finances over the last three years, Directors recommended that the authorities adopt a conventional measure of the government budget. On this basis, the deficit is large by industrial country standards. This, together with the very high level of indebtedness, underscored the need to achieve greater fiscal consolidation in 2000 and beyond. In this regard, Directors were encouraged by the authorities' intention to reduce central government spending significantly over the medium term, and by the initiative to restrain local government outlays.

Directors considered that achievement of the inflation target should remain the paramount objective of monetary policy. Noting that inflation had declined broadly in line with the authorities' target, some Directors considered that scope may exist for further cautious and gradual cuts in interest rates, provided fiscal policy is adequately supportive. Some other Directors considered that scope for further reductions in interest rates was limited at this time, given the risk of reigniting inflationary expectations. Directors welcomed the improvements made in the monetary policy framework and considered that the Bank of Israel should further take a more prominent role in shaping the public's inflation expectations through a more comprehensive public presentation of its own analysis of prospects for inflation.

Directors noted that the exchange rate bands had served the economy well in recent years. However, a number of Directors noted that, although the exchange rate band did not constrain monetary policy in 1999, the recent strengthening of the new sheqel could take the exchange rate to the more appreciated limit of the band. They suggested that with a continued appreciation of the new sheqel, and supposing that interest rates remained on a path consistent with achieving the inflation target, the usefulness of the exchange rate bands could be reassessed with a view to their possible elimination and the establishment of a pure inflation targeting regime.

Directors encouraged the authorities to implement expeditiously the Levin Committee's recommendations, specifically by presenting to the Knesset an amendment to the Bank of Israel Law that establishes price stability as the main objective of monetary policy and that ensures the central bank's independence.

Directors observed that Israel had already scored notable achievements in promoting structural reform and praised the authorities for the initiatives to increase competition in some overregulated areas. However, they argued that the pace of change needed to be stepped up in some areas, particularly bank privatization and increasing competition within the banking sector. Directors commended the authorities for the initiative to introduce a substantial tax reform by 2001 and stressed that such a reform should remove distortions in the treatment of capital income while addressing undesirable features in the taxation of personal income. Directors expressed their support for early passage of anti-money-laundering legislation. With regard to the labor market, Directors welcomed the authorities' intention to harmonize labor market regulations for Israeli, Palestinian, and foreign workers. They stressed the importance of preserving labor market flexibility which had served the economy well, particularly in the absorption of large immigrant inflows. They suggested that increased emphasis on retraining could contribute to facilitating the transition of workers from traditional to more dynamic, high technology sectors, and thus assist in reducing the unemployment rate. Directors commended the authorities for the success in liberalizing Israel's foreign trade and capital accounts, but noted that the existing controls on foreign investment by Israeli financial institutions distorted returns on investment and could lead to a misallocation of savings.

Directors welcomed the fact that, with an investment grade status of sovereign debt, a favorable credit rating outlook, and with declining inflation which created the scope for a reduction in real interest rates, the Israeli economy was less vulnerable to a financial crisis than in the past. Nevertheless, they emphasized that the authorities needed to continue to monitor the real exchange rate trends, conditions of access to international capital markets, the nature of external indebtedness, and the health of the banking sector. They welcomed the authorities' decision to proceed with a Financial Sector Assessment Program in 2000.

Directors praised the overall quality of Israeli economic statistics, but noted that quarterly GDP estimates were subject to large and frequent revisions, while unemployment statistics are only available on a quarterly basis. Moreover, Directors suggested that the dissemination of banking sector prudential statistics could be improved.