Public Information Notice No. 05/44

Public Information Notice: IMF Executive Board Concludes 2004 Article IV Consultation with Israel

March 29, 2005

On March 21, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Israel.¹

Background

Economic recovery is underway after a prolonged recession. Growth is being supported by more favorable global economic conditions, an improvement in the security situation, and appropriate policies, which have included tightening the fiscal stance and easing monetary policy.

Real GDP grew by an estimated 4.3 percent in 2004, with exports and private consumption leading the way. The economy is expected to continue to strengthen, albeit at a slightly lower growth rate this year. Unemployment remains high, but is on a declining path. The exchange rate was stable throughout 2004, balanced by the drop in interest rates and the rebound in economic activity. The current account remained near balance.

The recovery has proceeded hand in hand with a consolidation of the fiscal stance, an easing of monetary policy, and the implementation of key structural reforms. The government is establishing a credible commitment to maintain future deficits below 3 percent of GDP and to limit government expenditure growth, in real terms, to no more than 1 percent a year. While such a deficit is still relatively high, particularly in light of the large public sector debt—105 percent of GDP—it represents a marked improvement compared to 2003.

Monetary policy loosened during the first few months of 2004, as inflationary pressures continued to ease. Subdued inflation amid sheqel appreciation against the U.S. dollar during the second half of the year prompted the Bank of Israel to lower its policy rate by 20 basis points in December 2004 and again in January and February of 2005 to 3.5 percent.

While rebalancing their macroeconomic policy mix, the authorities have also embarked on structural reform policies aimed at boosting competition and efficiency. These included privatization in key sectors as well as further labor market initiatives. The authorities are also considering a major capital market reform in addition to other measures designed to enhance capital market development already underway.

Most financial soundness indicators for the banking system have improved, albeit marginally, due to the strengthened macroeconomic environment. While the quality of banks' loan portfolios has yet to improve, it is expected to strengthen further as the recovery takes hold.

Executive Board Assessment

Executive Directors welcomed the improvements in policies that have helped strengthen Israel's economic performance. Economic growth has resumed, prices and the exchange rate are stable, and competitiveness has increased. While a favorable external environment and a better security situation have been important factors, prudent policies have been instrumental in this outcome. In particular, the authorities have rebalanced macro policies and undertaken an ambitious fiscal consolidation, while easing monetary policy. The government's commitment to boost competition and efficiency, including through welfare reforms and privatization, has enhanced market confidence and laid the foundations for future growth. Directors considered that the policy agenda ahead should continue to focus on strengthening the fiscal position, reducing the high level of public debt, and implementing key structural reforms.

Directors welcomed the authorities' commitment to limit the growth of public expenditure. To that end, they urged the authorities to adopt a multi-year budgetary framework and a detailed spending plan to enhance credibility, and to help ensure that future budgets are more insulated from political pressures and reflect long-term priorities.

Directors emphasized the importance of accelerating debt reduction by abstaining from further unplanned tax cuts and broadening the tax base through the elimination of various tax exemptions. They encouraged the authorities to implement steadfastly their fiscal deficit target and respect the expenditure growth limit for the years ahead. Some Directors felt that the fiscal deficit and expenditure rules should be more ambitious in order to achieve a more pronounced decline in the stock of public debt than presently planned that would underpin lower interest rates, greater private investment, lower future taxes, and faster medium-term growth. Accordingly, the automatic stabilizers ought to be allowed to operate fully should revenues overperform, and should be reined in partially should revenues underperform.

Directors commended the Bank of Israel's (BoI) success in maintaining low inflation, and welcomed the reductions in interest rates last year. Given that inflationary pressures are subdued and the inflation outlook is well within the BoI target range, the current policy rate appears appropriate, provided the external environment remains stable.

Directors recommended that the authorities update the Bank of Israel Law to reflect international best practices, in order to reinforce the central bank's independence and enhance its transparency and accountability. The updated law should specify that the primary function of the central bank is to ensure price stability. It should also provide for instrument independence and the establishment of a committee to set monetary policy.

Directors considered that the BoI's current practice of using market-based indicators for implementing inflation targeting is broadly appropriate, but they saw scope for further enhancing inflation targeting tools and procedures. A few Directors cautioned that overreliance on market expectations of long-term real interest rates and inflation could contribute to price volatility. Directors welcomed the BoI's intention to strengthen its statistical forecasting models for assessing the inflationary outlook.

Directors welcomed the authorities' commitment to strengthen competition in the financial sector and the steps being taken to remove obstacles to capital market development. Regarding the authorities' plan to require banks to divest themselves of their mutual and provident funds, a number of Directors understood the authorities' preference for such a strong measure given Israel's highly concentrated financial system. Other Directors, however, recommended that the risks of the divestiture strategy be carefully weighed. These Directors noted that the plan might go against trends elsewhere toward universal banking and that other more conventional measures being undertaken to open up the sector could meet the same objective. In any case, it was broadly agreed that if the authorities proceed with the plan, the regulations already on the books should be vigorously enforced and the supervisory and regulatory functions enhanced, in order to mitigate systemic risk from the transfer of mutual and provident funds to the non-bank sector. It will also be important to proceed rapidly with the other capital market reform measures under way or planned.

Directors welcomed the strengthening of Israel's regime to counter money laundering and the financing of terrorism to a level comparable to best international practices. They noted the heightened cooperation between the relevant Israeli supervisory authorities and their counterparts in other countries.

Directors took note of the progress made in structural reforms, in particular the successful privatization of the national airline and the shipping entity in 2004. They concurred with the authorities' plans for privatization of the ports, utilities, and oil refineries in the period ahead.

Directors agreed that welfare reform has started to bear fruit, as indicated by the reduction in unemployment and the increase in labor force participation. They welcomed the recent strengthening of existing active labor market programs and new pilot initiatives, but noted the scope for increasing spending in this area, which remains low in comparison to that in OECD countries. Directors considered that expanded and well-targeted vocational training and employment services could further assist new job seekers in entering the labor market.

Directors observed that Israel meets the Special Data Dissemination Standard specifications for coverage, periodicity, and timeliness of the data, and that quality of the data is adequate for the purpose of surveillance.