Recent Economic Developments, 80

01/11/1997
All Press Releases In Subject:
The Economy and Economic Activity
Recent Economic Developments, 80, April 1997 - September 1997


 Main Developments
  The Principal Industries
   The Labor Market
    The Balance of Payments
     Prices
      The Government
       The Money and Capital Markets



Previous Economic Developments 79


Main Developments

Between April and September 1997 (the period reviewed), Israel's economy continued to grow slowly, again falling short of its potential. The balance of payments deficit declined, unemployment rose but stabilized towards the end of the period, and there were indications of a slight fall in the inflation environment. Activity in the money markets was not uniform during the period: the large-scale import of capital by the private sector for credit purposes moderated, foreign investment in Israel increased, the exchange rate was very volatile, and the decline in the real long-term interest rate persisted.

GDP continued its sluggish growth of about 2 percent (annual rate), due to a combination of demand and supply factors. On the demand side, the slow increase of domestic demand persisted for several reasons: the ending of the effect of the influx of immigrants on demand, particularly for investment (in housing as well as machinery and equipment - essential for the recovery of the capital/labor ratio); the slowdown in the rise in public-sector demand; and security incidents with the resulting political uncertainty. On the supply side, various factors limited the potential growth of GDP: the cumulative decline in profitability in recent years, which reflected inter alia the effect of the policy mix in previous periods, and made it difficult for tradable domestic product to respond; and the rise in the minimum wage, which had an adverse effect mainly on unskilled-labor-intensive industries. The potential expansion of certain human-capital-intensive industries - in which the domestic demand for their products was less affected, while world demand for them is growing - may be limited by labor constraints in certain occupations. In addition, the tax burden rose due to legislative changes, further slowing the rise in both demand, mainly for private consumption, and supply.

Indicators of economic activity in 1997:III do not suggest that the above factors changed, so that the economic environment remained similar to that prevailing since mid-1996. On the demand side, no clear picture emerges: on the one hand, the rise in wholesale trade eased, immigration continued at a low level, the import of consumer goods remained the same as in 1997:II, and public expenditure expanded slowly: On the other hand, bank credit expanded rapidly, imports of capital goods increased, and there were signs that the decline in housing demand was coming to an end. On the supply side, the trade balance stopped declining in 1997:III, as capital goods imports rose, and unemployment stabilized (based on labor market indicators), suggesting that supply may have satisfied demand more fully. In contrast, the Bank of Israel survey of companies and indicators of profitability in industry suggest that constraints are still holding back the expansion of supply. The state-of-the-economy index, which incorporates several of the above indicators, changed direction at the beginning of the year, rising steeply in the first half of the year, but it declined again in 1997:III.

There was a trend reversal in the trade deficit (in current dollar terms): after declining since the beginning of 1996 and leveling off in the first half of 1997, it rose from 1997:II to 1997:III. This derived from a rise in goods imports, mainly of capital goods, and a moderate increase in goods exports. The average level of the trade deficit was still lower in 1997:III than in 1996:III, however, due to reduced economic activity, lower dollar trade prices, and the improved terms of trade for goods. The rise in goods exports varied greatly from one industry to another, with the human-capital-intensive ones continuing to expand relatively fast, while the decline in exports of unskilled-labor-intensive industries persisted.

The demand for labor increased more slowly than supply, so that unemployment continued to rise in 1997:II, with the real wage remaining steady. Labor-market indicators point to stability in the unemployment rate in 1997:III, after this had been rising since mid-1996. Employment and wages developed disparately, however, reflecting the uneven effect of changes in the composition of demand and of supply constraints on different industries.

The domestic budget deficit in the period reviewed was 2.1 percent of GDP, and the underperformance of both income and expenditure persisted. Financing the deficit of the public sector (which includes the Bank of Israel) was based on net borrowing from the public, due mainly to a significant rise in proceeds from the privatization of government corporations. The latter enabled the share of net borrowing from the public in the financing of the deficit to be reduced, and this, together with the lower demand for investment, led to a decline in the long-term interest rate. Real tax revenues were about 5 percent higher than in the equivalent period in 1996 - due mainly to legislative changes - so that the tax burden rose.

The money markets developed unevenly in the period reviewed. From April until mid-June the trends which had been evident since the beginning of the year persisted. During that period the interest on the Bank of Israel's sources remained unchanged, after a reduction of 2 percentage points in 1997:I; short-term real interest rose and capital inflow continued, pushing the exchange rate to the lower limit of the band. To prevent it from slipping below the limit, the Bank of Israel purchased a considerable amount of foreign currency (some $ 2.7 billion) from the public. To meet its monetary objectives, the Bank concur-rently absorbed surplus liquidity via auctions for interest-bearing deposits from the banks. On 18th June, the parameters of the exchange-rate band were changed, the foreign-currency market was liberalized further, and the central bank cut the interest on its sources by 1.2 percentage points. As a result of these steps, capital inflow for credit purposes slowed very considerably, the exchange rate against the currency basket went up rapidly, the CPI (Consumer Price Index) rose by more than 1 percent in both June and July, and inflation expectations increased, even though the exchange rate had fallen again. In the light of these developments, the interest rate was raised by 0.7 percentage points in September.

Despite this, capital inflow for credit purposes was not renewed. Investment by nonresidents continued, however, and the exchange rate declined and remained close to the crawling band's lower limit, without Bank of Israel intervention in the foreign-currency market.

Figure 1. State-of-the-economy index (average 1994=100)
Figure 2. Industrial production (index, average 1994=100)
Figure 3. Interest and the inflation environment
Figure 4. Housing starts and completions, and relative price


Table 1. Indicators of Business Activity, 1995-97
(all data, excluding construction are seasonally adjusted)


1996
1997
Apr-Sept**
*

1995 1996 III IV I II III 1996 1997
Rates of change (annual average, percent), compared with preceding quarter
State-of-the-economy
index

10.3 3.4 5.9 -5.1 9.8 6.6 -1.3 3.3 2.5 9
Large-scale retail trade 8.4 13.0 4.3 4.0 15.7 10.3 5.1 13.8 8.6 9
Industrial production (excl. diamonds) 7.9 5.2 7.6 -6.0 3.9 9.5 3.0 4.1 3.7 8
Industrial consumption
of electricity
6.3 2.2 5.8 -3.4 9.6 11.8 6.0 2.3 6.0 8
Rates of change (percent), compared with preceding quarter
Tourist arrivals 20.4 -5.4 -0.9 2.0 0.6 0.5 -6.0 -11.8 0.3 8
Immigrant arrivals -5.6 -6.4 8.9 12.6 -29.8 -5.6 30.7 -4.1 -12.5 8
Residential starts
(percent)
45.5 -16.7 14.5 -5.4 -22.6 8.7
-20.4 -8.8 6
of which
Government-initiated
148.9 -31.3 32.0 -14.4 -41.2 54.2
-37.7 2.5 6
Residential completions 12.7 27.9 0.8 14.4 8.7 -1.3
47.8 23.7 6
of which
Government-initiated
-22.7 114.1 49.7 13.4 2.4 19.6
69.0 107.8 6
Survey of companies
(percent)a
Net output
of industrial firms
26b 4b -1b -8 -8 9 -3b

9
Net sales
by commercial firms
24b -7b -14b -35 2b -1b 9b

9
*
Last month for which data available.
**
Compared with same period in preceding year.
a
Difference between the number of firms reporting a rise and those reporting a fall, as a percentage of all reporting firms.
b
Denotes non-significant result at 5 percent level.

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The Principal Industries

The economic environment remained unchanged in the period reviewed, and growth continued to be slug-gish. National accounts data for 1997:II indicate that GDP grew at an annual rate of 2 percent. Domestic use of resources rose faster than GDP, despite the existence of available resources, so that the volume import surplus rose. Nonetheless, the current-account deficit fell, in dollar terms, from its level in the equivalent period in 1996, due to lower dollar trade prices and a 3 percent improvement in the terms of trade.

Business-sector product rose at an annual rate of 4 percent in 1997:II. Preliminary data relating to several industries suggest that they varied greatly in their growth rates: the index of industrial production rose at an annual 9.5 percent, production of the cons-truction industry dropped by 15 percent (according to national accounts data), and indicators of hotels and guesthouses show that the slowdown in that industry persisted. A similar picture of inter-industry variation emerges from replies of firms parti-cipating in the quarterly survey carried out by the Bank of Israel: activity in manufacturing industry rose significantly, while that in hotels fell drastically. In 1997:III there was no significant change in the activity of any industry other than hotels, where the downward trend evident since the second half of 1996 continued.

Although the rise in industrial production accelerated in 1997:II, the annual rate of increase since the beginning of the year was 2.4 percent. Labor input was stable - both the number of employees and hours worked per employee - as was the real wage per hour, while profitability continued on its downward path. Production rose in all industries, but employment changed to different degrees in different industries: in the most human-capital-intensive ones1 stability of labor inputs was accompanied by an increase in the number of employees, whereas in the less human-capital-intensive ones2 labor input fell by 4 percent, with a greater decline in the number of employees. As stated, industrial profitability fell in the period reviewed: nominal unit labor cost (wages adjusted by labor productivity) were 10 percent higher than in the equivalent period in 1996, so that after adjustment by implicit price indices for tradable goods3, the average profitability of industrial firms declined by 3 - 5 percent. The slow rise of export prices in human-capital-intensive industries may indicate that exporting companies in this category were hardest hit4. Falling profitability reflects in part real apprec-iation, which continued despite the slower increase in domestic demand. Real appreciation in 1997 may have derived from a combination of a more moderate rise in prices of traded goods and wage rigidity due to a rise in the minimum wage and a skilled-labor constraint, among other things. Real appreciation and a rise in the minimum wage affect profitability mainly in unskilled-labor-intensive industries, and limit their ability to gear themselves up to demand changes. The decline of activity in these industries, with the closure of plants which did not adjust to changed demand and the greater openness of the economy, moderated the recorded fall in their profitability.

Although the decline in the production of the construction industry continued in 1997:II, it was less pronounced than in 1996; the number of employees was higher in 1997:II than in 1996:II, with fewer Israelis among them, and the number of building starts rose. The fall in domestic demand due to the ending of the effect of the large-scale immigration was especially notable in construction, due to both reduced requirements for housing and saturation of structures in the principal industries, and the industry's product fell for the third consecutive quarter. Residential building completions and starts increased from 1997:I to 1997:II, but both the number and area of starts in 1997:II were 9 percent lower than those in 1996:II. The decline in the supply of residential construction was less than that in demand, so that the proportion of unsold apartments in the 24 largest towns started rising in 1996:II, and reached 70 percent in the first half of 1997 compared with 61.5 percent in the first half of 1996. The rise in real prices of owner-occupied apartments in the period reviewed apparently reflects the short-term effect of changes in the exchange rate of the dollar. The stabilization of activity is also indicated by the increase in sales by the ten largest contractors, which persisted in 1997:III, the rise in private-sector building starts in the 24 largest towns, and the steady number of sales (based on land betterment tax data), after these had declined steeply in 1996.

The number of mortgages taken up continued to contract in 1997:II, in line with the trend evident since 1996:II. This was most notable among new immigrants and others eligible persons, whereas the number of young couples taking housing loans has risen since 1997:I. These changes between the groups reflect the fact that the housing demand associated with the influx of immigration tailed off.

The increase in the number of employees in the construction industry in 1997:II comprised a decline in the number of Israeli employees and a rise in foreign workers and those from the Autonomy and administered areas. The change in labor input is more significant because of the longer hours on average worked by foreign workers than by Israelis. The fall in the number of building starts and in infrastructure projects and the rise in the number of completions may explain the increase in the total number of employees, due to the labor-intensive nature of the final stages of construction in comparison with the other stages.

Indicators relating to hotels (and guesthouses) show a stable level of activity in the period reviewed. Bed-nights rose by 5 percent, mainly in 1997:III; the number of employees in hotels increased in 1997:II, and the hotel prices component of the CPI rose faster than the overall CPI - at an annual rate of 14 percent5. While bed-nights increased, their composition continued to change: tourist bed-nights continued to decline, but this was more than offset by the rise in those of Israelis. Nevertheless, the average occupancy rate fell by 1 percentage point. The slump in tourist bed-nights started in 1996:II and has persisted in 1997, despite the stable number of tourist arrivals. Jerusalem and the northern Israel were the areas worst affected by the decline in tourism.

1. Machinery and equipment, electric motors, and electronic components.
2. Food, beverages, and tobacco; textiles, clothing and leather; wood and wood products.
3. The wholesale price index (5.3 percent), and in the CPI - the index of industrial goods (6.5 percent), prices of traded goods (6.8 percent), and prices of traded goods excluding clothing and footwear (7.1 percent).
4. Even though wages in those industries are more closely linked to the dollar, there was a 5 percent drop in dollar prices of export, so that profitability was seriously eroded.
5. The dollar prices of exports and imports of tourist services in 1997:II were 13 percent and 6 percent lower respectively than in 1996:II.

Figure 5. Tourism (index, average 1989=100)

Table 2. National Accounts, 1995-97
(seasonally adjusted)


1996
1997
Apr-Sept**
*

1995 1996 III IV I II III 1996 1997
Rates of change (average annual rates, percent, constant prices), compared with preceding quarter
GDP 7.1 4.5 2.6 1.8 2.1 2.0
3.8 2.1 6
Business-sector product 8.8 5.2 1.4 2.9 0.2 4.0
4.2 1.8 6
Private consumption 7.4 5.2 5.1 -7.9 2.6 15.1
3.4 5.0 6
Gross domestic investment 10.2 6.8 3.2 -4.0 -23.0 15.1
4.4 -5.2 6
Goods & services exports 10.1 5.0 12.5 7.9 16.1 6.5
2.4 7.5 6
Goods & services imports 8.6 7.6 12.4 -6.5 -2.7 21.8
4.4 5.2 6
Public-sector consumption
1.8 5.5 2.6 7.4 2.1 -7.5
6.6 1.6 6
*
**
Last month for which data available.
Compared with same period in preceding year.

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The Labor Market

The increase in labor supply in 1997:II was not fully matched by the rise in demand, following the trend which had started in the second half of 1996. Unemployment continued to rise, and reached 7.6 percent, compared with its low level of 6.5 percent in 1996:II, and the real wage per employee post was steady (seasonally adjusted) at the level of 1997:I. The monthly unemployment figure1 rose until June and then remained stable. The stability of the unemp-loyment rate was also indicated by the slower rise of the number of claims for unemployment benefits and of the number of work-seekers in 1997:III.

The number of labor-force participants rose by 18,000 in 1997:II, and employed persons by 11,000 (seasonally adjusted). Most of the rise in the latter was in part-time work. The number of employees in the business sector was up by 0.9 percent, and in the public sector by 0.6 percent (annual rates), compared with 1996:II. These rates of increase are slower than that of the civilian labor force, which rose at an annual rate of 2.3 percent. Unemployment rose among men and women, and reached 6.7 and 8.8 percent respectively. According to the higher share of those who had worked in the previous 12 months, and the lower contribution of youngsters to unemployment, the share of those dismissed among the total number of unemployed rose. Nonetheless, the proportion of those seeking work for more than 27 weeks did not change significantly.

The number of foreign workers rose, albeit more slowly, despite higher unemployment. The main increase was in construction, followed by agriculture, in both of which industries there was a parallel decline in the number of Israelis. The Labour Force Survey for 1997:II shows great inter-industry variance in incremental employment of Israelis (vis-a-vis 1996:II). Business services took in the greatest number (more than 14,000, of whom 2,700 were in computer services). The greatest reductions in the number of employees were in construction (5,500) and community, social, and personal services (5,200).

The real wage did not change from 1997:I to 1997:II, and was 1.5 percent higher than in 1996:II. This comprised a 2.8 percent increase in the business sector and a 1.2 percent fall in the public sector. The former followed a steep rise in the minimum wage in April, due to both a legislative change and an increase in the average wage in the preceding periods - which derived from a large increase in public-sector wages and in wages in those industries in the business sector where productivity rose or where labor was in short supply. Industries differed greatly in incremental employment and the increase in wages, due to the uneven effects of demand changes and supply constraints (described above) on different industries.

1. Derived from the trend during the previous 12 months.

Figure 6. The labor market (thousands)
Figure 7. Real wage per employee post (NIS)


Table 3. Indicators of Labor Market Developments, 1995-97
(seasonally adjusted)


1996
1997
Apr-Sept**
*

1995 1996 III IV I II III 1996 1997
('000s)
Civilian labor force 2,110 2,157 2,172 2,174 2,185 2,203
2.9 2.1 6
Israelis employed 1,964 2,013 2,029 2,020 2,024 2,035
3.2 0.8 6
   Business sector***
1,401 1,436 1,458 1,430 1,416 1,457
4.1 0.9 6
   Public sector*** 564 577 569 588 599 585
1.8 0.6 6
Average hours worked
per employee***
38 38 36 39 39 37


6
Claims for
unemployment benefit
69 76 77 83 88 95 99 6.0 31.4 9
Work seekers 71 83 80 103 111 119 120 4.2 56.9 8
Real wage per employee post (NIS) 4,179 4,246 4,292 4,231 4,232 4,315 4,359 0.3 1.5 7
   Business sector 4,146 4,208 4,205 4,252 4,239 4,275 4,326 0.4 2.8 7
Unemployment rate (%) 6.9 6.7 6.6 7.1 7.4 7.6


6
*
**
***
Last month for which data are available.
Percent change compared with same period in preceding year.
Not seasonally adjusted.

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The Balance of Payments

In the period reviewed the trade deficit (excluding ships, aircraft, diamonds, and fuel) continued to decline, and reached a monthly average level of some $ 500 million - down by $ 200 million a month compared with the equivalent period in 1996. During the period reviewed there was a trend change in the deficit, and the decline evident since the beginning of 1996 slowed markedly in 1997:I and rose from 1997:II to 1997:III. In part, the fall in the dollar deficit reflects a drop in goods prices alongside an improvement in the terms of trade, and in part the slower rise in the volume of imports. Prices of imported goods were 5.6 percent lower in 1997:II than in 1996:II, while export prices were 2.5 percent lower. The strengthening of the dollar appears to have made a significant contribution to the fall in trade prices and the improvement in the terms of trade1. Just as the downward trend in the deficit in 1996 reflected primarily the steep fall in imported goods, its halt in 1997:I and its rise in 1997:III reflect the trend of goods imports. However, these imports were 5.4 percent lower in dollar terms in the period reviewed than in the equivalent period in 1996, the decline reflecting mainly the fall in dollar prices. Imports of consumer goods and intermediates (excluding diamonds and fuel) increased in 1997:I, and have remained unchanged since then. Imports of capital goods continued to fall until 1997:II, but rose in 1997:III. Goods exports climbed by 7 percent in dollar terms in the period reviewed vis-a-vis the same period in 1996, while exports of industrial goods increased by 7.7 percent, with wide variance in the growth rates of different industries. The steepest increase (22 percent, in dollar terms) was in exports of communications, control. supervision, and scientific equipment, while the fastest decline (23 percent) was in food exports. In general, exports of human-capital-intensive industries2 (not all of which rose) increased by 13 percent, while those of less human-capital-intensive industries3 fell by about 9 percent. These developments indicate the continued trend of structural changes in exports.

Services imports were up by 17 percent in 1997:II over 1996:II, and services exports by 10 percent, with a 4 percent rise in tourism exports. Although prices of services imports and exports fell, alongside an improvement in the terms of trade, this was not enough, so that the services import surplus grew in 1997:II. The current-account deficit was $ 600 million lower in 1997:II than in 1996:II, continuing the decline evident in 1997:I, so that in the first half of 1997 the deficit was $ 1.2 billion lower than in the same period in 1996. This was due mainly to the fall in dollar prices, the 3 percent improvement in the overall terms of trade (excluding diamonds), and a $ 170 million increase in unilateral transfers.

The current-account deficit contracted in both the private sector (by $ 360 million) and the public sector (by $ 250 million). In the former this was due entirely to the fall in the import surplus, while in the latter the decline in the import surplus was accompanied by a rise in unilateral transfers. The net foreign debt rose by half a percentage point of GDP in 1997:II over 1997:I, and the Bank of Israel's foreign reserves grew by $ 3.7 billion during the period reviewed, to $ 19 billion. Alongside this rise, in 1997:II the current-account deficit was financed mainly by short-term capital inflow in the private sector, which amounted to $ 2.8 billion. Long- and medium-term capital inflow was $ 700 million - up by $ 250 million over 1996:II - due entirely to an increase in public-sector borrowings together with a decline in net private investment from abroad. This reflects a drop in investment abroad by residents and a larger fall in investment in Israel by nonresidents in 1997:ll. Indicators of capital flows in 1997:III suggest that there were changes in the sources of financing the deficit: the rise in the inflow of short-term capital in the private sector ceased, and investment by nonresidents rose.

At the end of July foreign-currency controls were relaxed further: the upper limit on portfolio investment abroad by provident and mutual funds and companies was raised, institutional investors were permitted to make transactions in foreign securities directly with foreign brokers, all the restrictions on derivatives transactions by residents were removed, the amount of foreign currency residents were per-mitted to transfer to a nonresident or resident living abroad as a gift or support payment was increased, and recipients of restitutions payments from Germany and pensions from abroad were permitted to deposit the proceeds in accounts abroad. These steps represent another stage in the process of opening up Israel's financial markets to competition, and their integration into world money and capital markets.

1. The emergence of developed economies from the slump should have led to a greater rise in the prices of inputs than of manufactured goods, i.e., to a deterioration in the terms of trade of those countries. According to IMF predictions, a one percent deterioration in industrialized countries' terms of trade is expected. Nonetheless, the prices of imported intermediates fell by 6 percent, those of imported consumer goods fell by 5.6 percent, and those of industrial exports declined by 2 percent. Thus, the improvement in Israel's terms of trade was mainly due to the strengthening of the dollar, which accounts for a larger share of Israel's exports than of imports.
2. Machinery and equipment, electric motors, and electronic components.
3. Food, beverages, and tobacco; textiles, clothing and leather; wood and wood products.


Figure 8. Foreign trade ($million per month)

Table 4. Balance of Payments, Foreign Trade**, and the Reserves,
1995-97 ($ mill., current prices)


1996
1997
Apr-Sept
*

1995 1996 III IV I II III 1996 1997
Monthly averages
Trade deficit 673 672 657 517 500 472 526 682 499 9
Goods imports 1,775 1,857 1,845 1,741 1,774 1,733 1,798 1,866 1,765 9
   Consumer goods 304 329 338 310 325 324 318 328 321 9
   Capital goods 388 421 413 391 374 356 421 425 389 9
   Intermediates 1,082 1,107 1,093 1,040 1,075 1,052 1,058 1,113 1,055 9
Goods exports 1,101 1,185 1,188 1,224 1,274 1,261 1,273 1,184 1,267 9
   Industrial 1,037 1,116 1,129 1,158 1,202 1,195 1,204 1,113 1,199 9
Quarterly averages
Net current account -1,211 -1,337 -1,825 39 -934 -1,396
-2,004 -1,396 6
Long- and medium-term
capital flows
643 1,190 1,468 1,758 1,357 702
459 702 6
   Private sector 420 769 445 1,665 534 604
635 604 6
Short-term capital flows*** 490 495 1,113 -1,236 3,321 2,847
453 2,847 6
   Private sector*** 790 292 1,242 -1,170 3,345 2,844
373 2,845 6
Net foreign debt
(% of GNP)
23.50 20.81 22.35 20.81 20.49 20.94
21.59 20.94 6
End-period Bank of Israel
reserves
8,158 11,420 10,230 11,420 15,336 17,794 18,973 9,378 17,564 9
*
**
***
Last month for which data available.
Foreign trade data are seasonally adjusted, and exclude ships, aircraft, diamonds, and fuel.
Including the banking system.

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Prices

During the period reviewed the rate of inflation fell to slightly below the upper limit of the target rate set by the government, with considerable monthly fluctuations. The CPI rose by an annual 7.5 percent during the period reviewed, the adjusted CPI (excluding housing, fruit and vegetables, clothing, footwear, and controlled goods) climbed by 9.2 percent, wholesale prices went up by 7.5 percent, and inflation expectations for twelve months (as derived from the capital market) ranged between 8.5 and 9.5 percent. The rate of change of the CPI in the last twelve months (which neutralizes normal seasonaity) rose gradually to a peak of 13 percent in mid-1996, subsequently declining to a trough of 8 percent in May 1997. In the following months, the rate of increase of the CPI fluctuated widely, reflecting the volatility of the exchange rate; this was evident in the index of traded goods (excluding clothing and footwear) and of housing, which are the principal items affected in the short term by changes in the exchange rate1. The dollar exchange rate rose by 1.6 and 2.6 percent in June and July respectively, and fell in the following two months. The index of housing prices rose at an annual rate of 9.2 percent during the period reviewed - less than in the equivalent period in 1996. Nonetheless, this index increased by 2.5 percent in both June and July, as a result of steep increases in the price of owner-occupied housing, in prices of housing inputs, and in rent, all of which are influenced in the short run by changes in the dollar exchange rate. In the subsequent two months, as the dollar exchange rate fell, the rate at which housing prices rose slowed, and in September was negative. Wholesale and traded goods prices (excluding clothing and footwear), which are relatively closely linked to exchange-rate changes, rose by annual rates of 7.5 and 9.2 percent respectively - more than in the equivalent period in 1996 - despite the steep decline in dollar prices of traded goods. In these items, too, monthly fluctuations reflected changes in the dollar and currency-basket exchange rates.

1. There is, however, a significant difference between the index of traded goods and housing prices: exchange-rate fluctuations in the former may be smoothed by merchants, while changes in the dollar exchange rate has an immediate and an inevitable effect on housing prices index, since these prices are calculated and denominated in dollars.



Table 5. Selected Price Indicies, 1995-97
(annual rates of change during period, percent)


1996
1997
Apr-Sept
*

1995 1996 III IV I II III 1996 1997
CPI 8.1 10.6 4.4 9.2 10.8 9.6 5.4 10.8 7.5 9
CPI excl. housing, fruit & vegetables 8.8 10.1 7.2 8.7 6.3 10.8 5.2 11.0 8.0 9
CPI excl. housing, fruit & vegetables, controlled goods, clothing & footwear 9.2 10.2 9.2 5.1 10.1 7.5 10.9 10.6 9.2 9
Index of housing prices 13.6 13.2 -6.3 15.6 14.2 10.8 7.7 11.1 9.2 9
Wholesale price index 10.0 7.0 1.7 6.1 6.3 7.2 7.8 6.7 7.5 9
NIS/$ exchange rate 3.1 5.0 -10.5 14.6 11.5 10.7 6.5 4.4 8.6 9
NIS/currency-busket rate
5.8 3.0 -8.9 12.7 -0.8 11.3 1.0 3.2 6.0 9
*
Last month for which data available.

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The Government

The domestic deficits of the public sector and the government (the principal component of the public sector) fell by about half in the period reviewed compared with the equivalent period in 1996, to stand at 2.2 and 2.1 percent of GDP respectively. According to the development of the domestic deficit in the first nine months of the year, and of the foreign deficit in the first half of the year, and in view of the continuation of unilateral transfers to the public sector, it looks as if the government will meet the budget deficit reduction required by law, i.e., 2.8 percent of GDP. This will occur provided expenditure does not depart from the path it has followed in the last few years, for example as a result of implementing projects deferred from the beginning of the year. Since the beginning of 1997 there has been a significant shortfall in revenues and an equivalent under-performance on the expenditure side. The financing of the public-sector deficit is based on domestic sources, alongside the absorption of money from the public and a rise in the share of the sale of assets in total domestic financing. The large increase in proceeds from privatization made it possible to reduce net borrowing from the public via bonds, and therefore enabled a reduction in long-term interest rates.

Tax revenues rose by a real 5 percent vis-a-vis the equivalent period in 1996 - a more rapid rate of increase than that of gdp - due to legislative changes. The principal changes were the failure to update the income-tax brackets, the higher taxes on fuel, air-conditioners for cars, and tobacco, and the raising of government fees. The rise in the tax burden was one of the factors responsible for the decline in profitability in 1997. Furthermore, the increase in the share of income tax in GDP reduced individuals' disposal income, and thus had a moderating effect on private consumption. Most of the increase - some 11 percent - was in direct tax revenues. Indirect taxes on economic activity and property rose by a moderate 1.8 percent; within this category, property tax receipts increased by 19 percent in 1997:III, and by 2.2 percent during the period as a whole. Indirect tax receipts on imports continued to drop by about 4.5 percent. All categories of transfer payments to households, paid via the National Insurance Institute, rose by about 9 percent.



Figure 9. Government cash flows (NIS million, monthly average)

Table 6. The Budget and its Financing, 1995-97
(cash flows as percent of GDP)


1996
1997
Apr-Sept
*

1995 1996 III IV I II III 1996 1997
1. Government domestic expenditure 40.5 40.7 40.5 41.2 41.4 37.7 40.0 39.4 38.9 9
2. Government receipts 37.0 35.9 36.4 33.7 40.8 35.3 38.3 35.8 36.8 9
3. Domestic budget deficit (1)-(2) 3.5 4.7 4.1 7.5 0.7 2.4 1.7 3.6 2.1 9
4. Public-sector domestic deficit**  (5)+(6) 4.4 5.4 6.0 8.5 1.5 2.1 2.3 4.8 2.2 9
5. Government net borrowing from the public 3.3 2.6 2.9 3.6 4.5 4.6 1.4 2.1 3.0 9
6. Public-sector injection (9)-(8)-(7) 1.1 2.8 3.2 4.9 -3.0 -2.5 1.0 2.7 -0.7 9
7. Bank of Israel injection
-8.4 -3.4 -6.2 -3.5 -16.1 -7.0 -0.4 -3.8 -3.7 9
8. Private-sector foreign-currency conversions 7.1 1.9 3.7 1.1 17.5 10.8 -0.1 1.8 5.3 9
9. Change in monetary base
-0.3 1.3 0.6 2.4 -1.6 1.2 0.4 0.6 0.8 9
  * Last month for which data available.
 ** Budjet deficit plus Jewish Agency injection plus non-budgetary injection.


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The Money and Capital Markets

In the period reviewed there were uneven developments in the money market. The trends evident since the beginning of the year persisted until mid-June. The moderation of the rise in the CPI continued, the exchange rate remained near the lower limit of the band alongside considerable foreign-currency conversions by the private sector, despite persistent reductions in the interest on the Bank of Israel sources. Inflation expectations fell faster than did the interest rate, so that real short-term interest1 rose to 5.7 percent in June. The moderation of inflation and inflation expectations together with the lower level of activity enabled the Bank of Israel to lower interest in mid-June by 1.2 percentage points, concurrently with changes in the parameters of the exchange rate and further liberalization regarding foreign-exchange transactions. In order to give freer expression to market forces in the determination of the exchange rate and increase the risk associated with short-term capital inflow, the parameters of the exchange-rate band were altered. The rate of change of the lower limit of the band was slowed from 6 to 4 percent a year, and the upper level was raised by about 15 percent while maintaining its 6 percent rate of change. In the wake of the various steps taken, capital inflow for the purpose of foreign-currency credit slowed very considerably, Also, the exchange rate against the currency basket rose by 5.4 percent in ten days, contributing to a rise in the CPI of more than one percent in both June and July, accompanied by a rise in inflation expectations even though the exchange rate declined again and remained close to the lower limit of the band. At the same time the money supply continued expanding rapidly. In view of these developments, in September the interest rate was raised by 0.7 percentage points. Despite this, there was no renewal of the expansion of credit in and indexed to foreign currency. The conduct of the private sector may have been affected by the volatility of the exchange rate in the wake of the changes in the exchange rate band, which increased uncertainty regarding the expected rate of return. In 1997:lll there was export of capital by residents, on the one hand, and increased import of capital - amounting to $ 1.2 billion, double the amount in 1997:II - by nonresidents, on the other. Nonresidents import of capital is intended for both portfolio investment purposes, on the Tel Aviv Stock Exchange as well as in Israeli companies abroad, and for real investment. These developments resulted in the continued decline of the exchange rate.

The monetary base rose by NIS 1.3 billion - 0.8 percent of gdp - during the period reviewed. The entire increase was in 1997:ll, and reflected conversions by the financial sector, on the one hand, and the absorption of liquidity by the government, the Jewish Agency, and the Bank of Israel, on the other. In 1997:lll the activity of the Bank of Israel neutralized that of the government and the Jewish Agency, and private-sector conversions were negligible, so that there was no change in the monetary base. The absorption undertaken by the Bank of Israel in order to sterilize foreign-currency conversions was implemented primarily by means of the auctions for local-currency deposits, and these rose by NIS 25 billion from January to the end of September.

Narrow money (M1) averaged 13 percent higher in the period reviewed than in the same period in 1996 - parallel to the rate at which nominal GDP rose - and the broader money aggregates rose more rapidly. Unindexed resident time deposits rose rapidly in spite of the decline in nominal interest, apparently because of the expected rise in real short-term interest.

Bank credit to the public increased by 20 percent during the period reviewed, and credit indexed to and denominated in foreign currency rose more rapidly - by 37 percent (end-July figures). Preliminary data for August and September indicate that there has been some moderation in the rate at which the latter credit category has risen, alongside the discontinuation of foreign-currency conversions by the private sector.

Share prices rose by a nominal 18 percent during the period reviewed, continuing the trend apparent since the slump of July 1996. The share-price index reached a peak in July, and from then until the end of the period reviewed its trend has been unclear. The positive atmosphere in the stock market appears to derive from Treasury policy regarding budget cuts, continued investment from abroad, and the decline in short-term interest. During the period reviewed the privatization process was accelerated, and foreign investors participated in it. However, the privatization of public-sector corporations has not yet been accompanied by reforms intended to increase competition. Real long-term interest dipped during the period reviewed in the context of slacker demand for long-term capital - following a decline in both investment and the budget deficit, most of the latter being financed by net borrowing abroad and proceeds from privatization. All real interest rates for periods above three years were below 4 percent in September.

1. The effective nominal interest on the monetary loan at auction deflated by gross inflation expectations.

Figure 10. Monetary aggregates and credit (change in prev. 12 months)
Figure 11. Nondirected bank credit (NIS per month)

Table 7. Monetary Indicators
and Nondirected Bank Credit, 1995-97

(annual terms, percent)


1996
1997
Apr-Sept**
*

1995 1996 III IV I II III 1996 1997
Average rates of change, compared with preceding quarter
M1a (narrow money supply)
8.4 14.9 16.9 1.7 26.6 6.8 41.6 15.7 26.3 7
M2b 35.2 27.0 38.3 25.0 30.3 17.6 24.1 24.8 21.1 7
M3c 25.5 26.5 30.6 23.9 30.9 15.9 25.8 31.7 21.4 7
Nondirected bank credit 26.2 21.6 21.8 20.1 14.5 19.6 24.9 28.6 24.4 7
Unindexed local-currency 11.0 10.6 10.5 14.4 3.1 2.0 15.5 21.0 15.4 7
CPI-indexed 33.4 23.7 31.9 17.6 18.1 14.6 9.6 34.5 11.1 7
Foreign-currency indexed & denominated 54.6 40.0 26.3 33.3 27.7 57.3 62.4 32.6 58.4 7
*
Last month for which data available.
**
Compared with same period in preceding year.
a
Cash in the hands of the public and demand deposits.
b
M1 plus short-term local-currency deposits.
c
M2 plus foreign-currency-indexed and denominated deposits.


Figure 12. The sheqel exchange rate against the currency basket Figure 13. Yield on Treasury bills (end-period figures)

Table 8. Interest Rates, Yields,
and the Share-Price Index, 1995-97



1996
1997
Apr-Sept
*

1995 1996 III IV I II III 1996 1997
Nominal interest
Nondirected local-currency credit 20.2 20.7 21.9 20.7 19.7 19.0 17.7 21.2 18.5 8
SROs 15.6 16.1 17.6 16.2 15.0 14.5 13.6 16.7 14.1 9
3-month Eurodollar 13.3 13.8 15.1 13.9 12.8 12.3 11.3 14.3 11.9 8
Yield to maturity 5.9 5.4 5.5 5.4 5.4 5.7 5.6 5.4 5.6 9
Treasury bills 15.4 15.6 17.0 15.8 14.6 14.1 13.5 16.4 13.8 9
10-year bonds 4.3 4.5 4.9 4.4 4.1 4.0 3.7 4.6 3.9 9
5-year bonds 4.1 4.4 4.8 4.3 4.0 4.0 3.6 4.5 3.8 9
General share-price index (points) 90.7 92.4 84.4 93.0 116.3 127.9 139.4 89.6 133.7 9
*
Last month for which data available.