International Monetary Fund - Concluding Statement of the Mission

International Monetary Fund
Israel - 2006 Article IV Consultation
Concluding Statement of the Mission
November 6, 2006
1. The Israeli economy is performing very well considering the significant uncertainties related to political and security developments earlier in the year. Real GDP growth is widely expected to reach 4½ percent and the current account to post a surplus of just under 5 percent of GDP in 2006; inflationary pressures are subdued; and the country is attracting record foreign investment. A major improvement in economic policies and enhanced policy credibility supported these developments.
2. But the economy is also benefiting from favorable external conditions, and thus now is the time to strengthen its resilience to shocks, particularly through public debt reduction. External demand is still exceptionally strong and global financial market conditions are unusually benign. This is an opportunity to advance fiscal consolidation and structural reform. Continued headway along both dimensions is crucial to nurture the confidence of investors who are again questioning the sustainability of consolidation in the face of renewed expenditure pressures. Moreover, without progress the government’s ability to respond to sudden unexpected changes in economic and social conditions will remain severely limited.
Economic growth and inflation
3. The foundation for continued real GDP growth of 4 percent or more in 2007 is strong. The impact of the conflict in the north on economic activity has been limited. The recovery has become increasingly broad based, with investment and employment accelerating and the central scenario is for external demand to slow down only modestly. Corporate balance sheets and profitability have improved and the real effective exchange rate is some way from being overvalued.
4. But the risks to activity lie mainly on the downside. Given the large external imbalances between the world’s major economies and geopolitical risks, external demand could slow down more abruptly than projected. Upward pressures on oil prices remain a distinct possibility because of limited spare production capacity. Financing conditions could suddenly deteriorate and risk premia rise. From a domestic perspective, the central scenario assumes a stable political and benign security setting. On both accounts downside risks prevail.
5. Over the medium run, headline inflation is projected to return toward the midpoint of the Bank of Israel’s (BoI) target range.Inflation could be running below the target range for some time but, assuming a stable exchange rate and oil prices, it would return toward the mid-point of the 1-3 percent target range later in 2007. In fact, excluding the effects of the exchange rate, the CPI is rising at about 2 percent already. The risks around this projection appear broadly balanced. Wage developments, including in the public sector, present an upside risk if activity evolves as projected or energy prices start rising again. By the same token, a sudden weakening in external demand or further appreciation of the exchange rate would soften price pressures.
Monetary policy
6. Monetary policy can afford some easing but, for as long as the downside risks to inflation do not grow noticeably, a fundamental change in the policy stance is not needed. There is a case for lowering interest rates because headline inflation is projected to be below the target range for some time; wage pressures still appear in check; and downside risks to the growth outlook predominate. But the central scenario is for above-potential economic growth in the year ahead and thus a significant addition of stimulus appears unnecessary. Moreover, if expenditure or the deficit in the 2007 budget exceeded the government’s proposals, questions about the country’s ability to advance consolidation might reemerge that could put upward pressure on interest rates.
7. The publication of minutes of discussions has added to the transparency of the monetary policy process but some scope is left for doing more. The headline inflation rate has recently moved rapidly and unpredictably, spending some time outside the target range. This is not an unusual experience among inflation-targeting countries. Also, it does not detract from the success of the BoI’s monetary policy, as evidenced by inflationary expectations that have been solidly anchored within the target range. However, maintaining this performance will require convincing the public that inflation can at times be outside the target range while policy is consistent with price stability over the medium run. The minutes are useful for that purpose. But it would also be helpful if past initiatives to publish fan charts were developed into a regular, more comprehensive inflation forecast that includes a discussion of the underlying assumptions and the risks. This is common practice among inflation-targeting central banks in advanced economies.
Fiscal policy
8. Fiscal policy needs to remain on a predictable and credible path toward a significantly lower debt-to-GDP ratio. Notwithstanding the war, the central government deficit is projected to fall to 1½ percent of GDP in 2006, which is a strong performance. Looking ahead, reducing the high, 90 percent debt-to-GDP ratio is crucial to lower the interest bill, which equals almost half of central government transfer and welfare expenditure. This, in turn, would gradually create room for automatic stabilizers to play freely without risking adverse debt dynamics during recessions; and for higher social outlays to meet the demands of an older population in the future.
9. The 2007 draft expenditure budget commendably advances the consolidation of the public finances but no efforts should be spared to hold the budget deficit appreciably below the ceiling in the Deficit Reduction Law. We support the principle that real expenditure unrelated to the war grow by at most 1.7 percent. However, a central government deficit of 2.9 percent of GDP probably entails a general government deficit close to 4 percent of GDP, which is not low by the standards of advanced economies, particularly in the current, buoyant macroeconomic environment. Also, leaving aside government asset sales, this deficit level would not cut the public debt significantly. Accordingly, pruning the many tax expenditure programs, which presently cost the public purse some 5 percent of GDP, should be seriously considered with a view to getting closer to the pre-war deficit targets.
10. Over the medium run, the 1.7 percent real expenditure growth ceiling must be adhered to rigorously and debt reduction be given priority over tax cuts. The central government deficit would then reach the proposed target of 1 percent of GDP in 2009, which is suitably ambitious. However, even with an average deficit of 1 percent—implying balance or surpluses in years of high growth—it would likely take until after 2025 to reduce the gross public debt to 60 percent of GDP, a standard many advanced economies are meeting already. At that time, Israel’s population would be aging and related welfare needs expanding rapidly, putting serious pressure on the economy. In short, the challenge presented by the public debt is major; the expenditure growth ceiling must be respected; and there is no room for tax rate reductions beyond those planned already—rather, current tax expenditures should be curtailed. In any event, tax rates will soon be at the average of advanced economies with similar welfare aspirations.
Fiscal governance
11. Avoiding the past mistakes that have boosted the public debt requires a more holistic and forward-looking fiscal policy debate. Currently, the focus of the debate is mainly on the short run, partly because there is no forward-looking, risk-based analysis of fiscal policy integrated in the budget process. This limits the public’s understanding of the full burden of high debt; and favors fiscal consolidation strategies that proceed opportunistically from one year to the next, relying on short-term cutbacks in discretionary expenditure rather than meeting well-specified medium-term priorities. Such strategies undermine the efficiency of the public sector and prompt investors to question the commitment to fiscal adjustment whenever shocks hit the economy.
12. Better fiscal governance could help improve the public’s appraisal of the detrimental impact of high public debt. The constituency for deficit and debt reduction for the benefit of future generations tends to be smaller than those for immediate tax cuts or expenditure increases. Countries have found various mechanisms useful to broaden the debt reduction constituency, from independent agencies that conduct fiscal analysis to ad-hoc committees that report on specific aspects of the public finances. One option for Israel could be a committee of independent experts, possibly similar in structure to the new National Economic Council, that publishes comprehensive fiscal policy analysis.
Financial sector developments and policies
13. Accelerated financial deepening is fostering economic growth but also raising new challenges for supervisors. The financial strength of banks and other institutions is benefiting from the economic expansion, competition between the various market players is rising, and their services and portfolios feature a greater choice of risk and return. This is a welcome response to the reforms that have been implemented over the past years. In this process, the traditional lines between the services offered by banks, insurance companies, and other institutions are becoming increasingly blurred. Also, questions arise as to whether institutional investors and households are understanding fully and pricing correctly the new risks they are taking on. This raises the need for proper risk management supervision, fuller disclosure and better advice to investors, and investor education.
14. The resources, independence, and cooperation of supervisors need to be buttressed commensurately. Key priorities are: (i) passing swiftly the draft BoI law; (ii) re-enforcing risk-based supervision by the BoI, also through the implementation of Basel II; (iii) adding resources to the supervision of insurance companies and pension and provident funds, and moving this activity outside the Ministry of Finance, consistent with future plans for the structure of supervision in Israel; (iv) improving the regulatory infrastructure for insurance companies, notably with the introduction of risk-weighted capital regulation; and (v) aligning prudential policies and practices across all sectors, including with respect to contingency planning.
Combating poverty
15. The proposal for an Earned Income Tax Credit (EITC) needs to be considered in the broader employment and poverty context. Other countries have found EITCs useful to reduce poverty. While attractive in principle, much hinges on the design of the program, particularly its fit within the local tax and welfare benefit system as well as labor market programs and regulations. Another issue is that an EITC would benefit some segments of the poor in Israel more than others and thus might trigger demands for more support under other programs. These technical and political economy interactions argue for considering an EITC in the context of a wider, budget-neutral review of poverty reduction and employment policies, as envisaged by the National Economic Council.