Public Information Notice No. 06/33

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Israel

March 23, 2006

On March 22, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Israel.¹

Background

Following a strong performance in 2004, the economic expansion accelerated in 2005, supported by a relatively favorable global economic environment, an improvement in the security situation, and prudent policies. Real GDP grew at an estimated 5.2 percent in 2005. Inflation is slightly higher than a year ago, but remains in check. The unemployment rate continues to fall, but remains high. The exchange rate has been broadly stable over the past year, balanced by robust economic activity on the one hand and relatively low interest rates on the other.

The macroeconomic policies and structural reforms of recent years have opened up the economy, increased its competitiveness, and attracted foreign investment. Looking ahead, a key challenge is to sustain the ongoing fiscal retrenchment and thereby reduce the large stock of public debt relative to GDP.

Greater confidence in the macroeconomic outlook has been helped by the authorities' fiscal consolidation efforts, which are critical to putting public debt—about 100 percent of GDP—on a firm downward path. 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.

Given the renewed emphasis on fiscal consolidation, and inflation within the Bank of Israel's target range of 1-3 percent, monetary policy has been appropriately accommodative, notwithstanding recent increases in the policy rate. A proposed new Bank of Israel Law, currently under consideration, should strengthen the independence of the central bank and help facilitate its primary objective of price stability.

The authorities have continued to implement structural reform policies aimed at boosting competition and efficiency. These included privatization in key sectors and a major reform of the capital market, which has gone well to date. A rapidly changing financial system, however, requires greater scrutiny, and the authorities are committed to refining their supervisory and regulatory activities accordingly.

Executive Board Assessment

Executive Directors welcomed the continued improvement in the Israeli economy: export performance and economic growth are strong, the unemployment rate is falling, inflation expectations remain in check, and the exchange rate is broadly stable. A favorable external economic environment and an improved security situation have been important factors, but sound policies have remained instrumental to this outcome. Notably, fiscal consolidation and an appropriately accommodative monetary policy have underpinned the strong economic performance. Directors noted that, while the macroeconomic outlook is positive, there is further scope to enhance growth and reduce vulnerabilities, especially to external shocks. They stressed the need for the policy agenda to remain focused on strengthening the fiscal position, reducing the high level of public debt, and ensuring financial sector stability in a context of relatively high credit risk and rapid capital market development.

Directors welcomed the improved fiscal performance, and noted that limiting the growth of real public expenditures to one percent a year is a strategy that has served Israel well and should be continued. Directors encouraged the authorities to seize the opportunity provided by strong growth and a favorable fiscal outturn in 2005 to reduce the deficit to well below the 3 percent of GDP ceiling and thereby achieve a meaningful decline in the large stock of outstanding public debt. Such a fiscal consolidation would underpin lower real interest rates and lead to greater private investment, lower future taxes, and stronger medium-term growth.

Directors welcomed the authorities' intention to make the implementation of the multi-year tax reduction plan approved in 2005 conditional on a continuation of the downward-moving debt-to-GDP ratio. Most Directors emphasized the importance of accelerating debt reduction by abstaining from further unplanned tax cuts. Accordingly, automatic stabilizers ought to be allowed to operate fully should revenues over-perform. To sustain the fiscal consolidation efforts, Directors also 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 better reflect long-term priorities. A few Directors also called for a review of the fiscal rules to ensure that additional consolidation is achieved in good years.

Directors commended the Bank of Israel for its success in maintaining low inflation. With inflation expected to revert by the end of the year to the middle of the Bank of Israel target range, they felt the current policy rate is appropriate. Directors cautioned, nonetheless, that the Bank of Israel needs to closely monitor the pass-through from oil prices and exchange rate movements, and that rates may need to rise over time as the output gap closes and demand pressures mount.

Directors observed that Israel's strategy of inflation targeting—and the associated floating exchange rate regime—have served the country well, but noted that there is scope for further enhancing the analytical framework used to formulate policy and communicate it to the public. In particular, Directors welcomed the increased emphasis on the development of new macroeconomic models at the Bank of Israel as a central element of a forward-looking approach to monetary policy. Directors urged the passage of an updated Bank of Israel law to help reinforce central bank independence, enhance transparency and accountability, and aid in achieving price stability.

Directors noted that while the banking system has strengthened—as reflected in the improvement in key indicators—the level of problem loans remains high and the rapid development of the capital market has introduced new challenges to the supervisory and regulatory agencies. While welcoming the measures already taken to reduce the banks' exposure to credit risk and to increase banks' provisioning, Directors stressed that continued supervisory vigilance of the systemically important financial institutions will be essential to maintain financial stability. The need to pay close attention to the division of supervisory responsibilities to prevent regulatory arbitrage was also emphasized.

Directors saw scope for the supervisory authorities to enhance their oversight by cooperating and coordinating with their foreign counterparts, especially in the area of anti-money laundering. To that end, Directors encouraged the authorities to undertake a review of their practices given the revised Financial Action Task Force (FATF) recommendations.

Directors took note of the progress made in structural reforms, including measures to enhance public sector efficiency. Directors also welcomed the efforts to alleviate poverty, such as the work of the advisory group headed by the director general of the ministry of finance. They emphasized, however, that any measures should be accommodated within the current fiscal envelope and that they should be well-targeted to ensure adequate incentives to work and consistency with growth-promoting policies. Directors also stressed that cuts in some welfare benefits have contributed to social hardship, and that it is therefore important to ensure that there is a safety net to protect children, the elderly, and the disabled.

Directors observed that Israel meets the Special Data Dissemination Standards and its macroeconomic statistical system is generally adequate for Fund surveillance.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board.