Recent Economic Developments, 83

01/08/1998
All Press Releases In Subject:
The Economy and Economic Activity
Recent Economic Developments, 83, January 1998 - June 1998


 Main Developments
  The Principal Industries
   The Labor Market
    The Balance of Payments
     International Developments
       and Their Economic Implications for Israel
       Prices
        The Government
         The Money and Capital Markets



Previous Economic Developments 82


Main Developments

In the first half of 1998 (the period reviewed) the level of economic activity in Israel was below its long-term potential, unemployment intensified, the inflation environment declined significantly, and the trade deficit shrank, buttressing the trends that had begun in the second half of 1997. These developments are the result of several factors combined: the slowing of domestic demand, including a sharp drop in investment; the marked increase in exports (especially those of high-tech industries, which expanded relatively quickly); a substantial rise in the real wage in the business sector (principally in the wake of the rapid reduction of inflation and the non-adjustment of nominal wages); as well as factors abroad, some of which are short-term. Among the causes of these developments in domestic demand and supply were the effects of long-term structural factors, including the tapering-off of the expansionary effect of the influx of immigrants on investment, and the ongoing process of the shift from traditional to high-tech industries; fiscal restraint, in the wake of which public consumption declined; tight monetary policy, expressed in the rise in long- and short-term real interest rates (despite the decline in nominal interest); and political and security uncertainty, which did not abate in the period reviewed. With regard to factors from abroad, import and export prices declined in dollar terms and the terms of trade improved, contributing positively to the balance of payments and domestic inflation. Alongside the crisis in East Asia, which has a negative effect on exports, there was an economic boom in some western countries (including the US, Germany, and France), to which Israel's exports were diverted.

The rate of price increases, which plummeted in the last four months of 1997, brought the annual inflation rate down to the lower limit of the target range (7 percent), declined in the period reviewed to 4.5 percent-below the 1998 target, thereby bringing inflation in Israel nearer to the long-term goal set by the government, namely, the inflation rate customary in the industrial countries. Concurrently, inflation expectations moderated, and the public adjusted its asset portfolio, increasing the unindexed component and extending the term of its deposits in that segment. These developments, together with the fact that the slowdown in prices encompassed all the items of the CPI (consumer price index), endorses the assessment that there has been a substantial reduction of the inflation environment, and that this has been internalized by the public.

Balance of payments developments showed a significant improvement. The current-account deficit fell to two-thirds of the quarterly deficit in 1997; goods exports rose rapidly in the period reviewed, and at the same time long-term capital flows increased as a result of the considerable capital inflow of the public sector, while that of the private sector (especially direct foreign investment) fell-and hence Israel's foreign-exchange reserves rose by $ 1.5 billion and its net external debt in GDP terms fell by 3 percentage points. Foreign-currency trading was relatively stable during the period reviewed (apart from a rise in short-term demand in April, before the announcement of the full foreign-exchange liberalization measures, after which there were no marked swings in either direction). Other than this, the various indicators show that during the period reviewed the trend of real appreciation that has prevailed for a long time slowed.

Most of the labor-market indicators reflect its slackness; the most prominent among these was the unemployment rate, which rose to 8.4 percent in 1998:l and 9.3 percent in May (trend data). Despite the indications of slackness, however, the real wage in the business sector rose by 5.5 percent, due inter alia to the overestimation of inflation by the parties involved in the negotiations on wage agreements (so that nominal wages are biased upward), and to the 8.5 percent rise in the minimum wage in April 1998, following the rise in the average wage in the previous two years. During the period reviewed the composition of business-sector employment continued to change, with a rise in the high-tech industries and a decline in the traditional ones, and this was reflected in the contribution of each industry to unemployment (see below).

During the period reviewed fiscal discipline was maintained by the government, in accordance with the target set in the Budget Deficit Reduction Law, and in January-June the deficit amounted to NIS 5.5 billion, compared with NIS 9.2 billion planned for the whole year.

With regard to monetary policy, the Bank of Israel reduced the nominal interest on its key interest rate every month in the period reviewed, with the exception of January, amounting to a total reduction of 2.4 percentage points; however, since inflation expectations fell faster than this, expected real interest, which stood at 5.2 percent in 1997, averaged 7.5 percent in the period reviewed. There were two reasons for the relatively gentle and cautious reduction of nominal interest: the desire to stabilize inflation at a low level, and the reduction of the gap between the local-currency and foreign-currency (in currency-basket terms) segments, which shrank to 6-7 percent in July (before adjustment for expected depreciation), and if this were to persist the stability of the foreign-currency market might have been disturbed. As it turned out, during the period reviewed activity on the foreign-currency market remained relatively calm, and there was no intervention by the Bank of Israel (except in the first few days of January). In mid-February, after the stock market slumped at the end of 1997, it rallied once more; the volume of activity expanded gradually, and in May share-price indices regained their August 1997 peak, despite the economic slowdown. This appears to be connected with the boom on stock markets in the industrial countries.
 

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, 1996-98
(all data, excluding construction are seasonally adjusted)


1997
1998
Jan-Juna
*

1996
1997
II
III
IV
I
II
1997
1998
Rates of change (annual average, percent), compared with preceding quarter
State-of-the-economy
index

3.3 4.6 10.0 -1.1 3.8 7.1 0.5 8.0 3.7 6
Large-scale retail trade 13.0 7.8 15.0 0.4 4.1 13.2 9.6 8.1 7.4 6
Manufacturing production (excl. diamonds) 5.2 1.9 13.1 -1.5 -1.3 6.8 -1.4 1.8 2.8 5
Business-sector consumption
of electricity
2.2 5.8 11.2 11.1 -6.7 10.6 8.6 5.0 5.7 5
Index of revenue
in commerce
4.3 0.9 4.4 -4.7 2.7 -0.6 14.3 0.7 0.7 4
Index of total revenue 6.4 1.5 7.7 -3.2 2.8 0.2 14.8 0.2 2.2 4
Rates of change (percent), compared with preceding quarter
Tourist arrivals -5.4 -6.0 1.0 -3.1 -3.4 -10.6 14.1 -9.9 -11.1 5
Immigrant arrivals -6.4 -6.6 -5.6 45.4 2.2 -32.9   -16.8 -5.8 3
Residential starts
(percent)
-18.1 -9.9 10.0 -2.0 -22.8 -4.6
2.3 -20.7 3
of which:
 Government-initiated
-29.2 -18.0 56.8 -27.2 -5.3 -12.8
-12.1 -5.7 3
Residential completions 35.4 21.7 1.7 3.8 11.8 -32.2
9.8 -20.0 3
of which:
 Government-initiated
132.2 36.4 20.7 -7.9 -14.6 -26.5
46.7 -30.3 3
Survey of companies (percent)b
Net output
of manufacturing firms
4c -2c 6c -1c -4c -4c -7c

6
Net sales
by commercial firms
-7c -8c -10c 3c -22 -13c -1c

6
*
Last month for which data available.
a
Compared with same period in preceding year.
b
Difference between the number of firms reporting a rise and those reporting a fall, as a percentage of all reporting firms.
c
Denotes non-significant result at 5 percent level.

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The Principal Industries

According to several indicators, economic activity declined during the period reviewed. National accounts data for 1998:l show a 0.5 percent fall in business-sector product (seasonally adjusted), coming in the wake of the contraction of domestic uses (by 6.6. percent)-with a steep drop in domestic investment, a fall in public consumption, and no change in private consumption (meaning a 2.3 percent decline in per capita consumption)1. Replies from firms participating in the Bank of Israel's quarterly survey indicate that the activity of firms in the construction, hotel, and manufacturing industries was lower in 1998:ll than in 1998:l. In commerce and transport, on the other hand, activity stabilized at a low level. The survey shows that, as in 1998:l, weak demand was the main factor restricting the expansion of economic activity.

Some of the indicators in Table 1 show that activity expanded moderately; these include the index of manufacturing production, which was up by 3 percent over the equivalent period in 1997, the index of large-scale retail trade, which rose even more, although this is connected inter alia with the gradual switch to retailing by means of large chains, and the state-of-the-economy index, which rose relatively rapidly in 1998:l but remained unchanged in 1998:ll.

The index of manufacturing production rose slightly in the period reviewed, up by 4 percent in annual terms over 1997:lV, after falling in the last two quarters of 1997. A more detailed breakdown shows that the export industries, primarily chemicals, transport vehicles, and electronic equipment rose the most compared with the same period in 1997 (8.6-10.5 percent), while mining and quarrying, textiles and clothing, wood, furniture, paper, and printing declined. The structural economic change which Israel has recently been undergoing (and which itself served to slow economic activity) is very apparent in the period reviewed, too. In the first four months of 1998 the product of the traditional industries was up by 3 percent (annual terms) over the last four months of 1997, while that of the high-tech industries rose three times as fast (by some 10 percent), and that of mixed industries dipped slightly.

Most of the indicators of construction activity show that the slowdown evident in 1997 persisted during the period reviewed. Construction starts fell in 1998:l, and so for the first time did completions (inter alia because of the decline in starts in previous periods); the rate at which mortgages were taken up fell significantly; this is connected with the drop in mortgage utilization by new immigrants, among whom potential home-buyers are gradually declining, and the continued rise in interest rates-and possibly also with expectations that apartment prices will continue to go down. Concurrently the pace of apartment sales slowed, construction time lengthened, and sales of cement (some of which is destined for the territories) fell. Nonetheless, despite the slowing of the pace of apartment sales, the stock of units under construction is declining, as is the stock of unsold units, whether their construction was initiated by the government or the private sector.

Indices of revenue in all commercial and services industries (seasonally adjusted) were about 2 percent higher (in annual terms) in the first four months of 1998 than in 1997:lV. Tourism, which has been declining gradually in the last two years, began to pick up in April and May, with a rise in bed-nights (seasonally adjusted), both of Israelis and tourists, but this compensated only partially for the decline in hotel income in 1998:l.

1 Since quarterly data of inventory investment is not very reliable, this has implications for estimates of GDP; it is therefore advisable to examine the other indicators in the upper panel of Table 1.
 

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

Table 2. National Accounts, 1996-98
(seasonally adjusted)


1997
1998
Jan-Juna
*

1996
1997
II
III
IV
I
II
1997
1998
Rates of change (average annual rates, percent, constant prices), compared with preceding quarter
GDP 4.5 1.9 2.1 1.9 1.2 1.2
2.4 1.6 3
Business-sector product 5.2 1.5 4.1 1.6 0.4 -0.5
1.2 1.4 3
Private consumption 5.2 3.3 15.6 -0.1 0.9 0.1
2.2 3.9 3
Gross domestic investment 6.8 -5.9 2.6 -4.0 8.3 -32.4
-7.9 -7.9 3
Goods and services exports 5.0 6.1 5.7 8.7 -9.5 10.7
6.8 3.5 3
Goods and services imports 7.6 2.6 15.8 -0.8 -1.4 -13.0
2.9 -0.4 3
Public-sector product
5.5 2.3 -6.7 -1.3 4.9 -1.4
7.8 -1.2 3
*
a
Last month for which data available.
Compared with same period in preceding year.

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The Labor Market

According to most indicators, the labor market slackened further in the period reviewed. In 1998:l the unemployment rate rose to 8.4 percent (after declining to 7.6 percent in the preceding quarter), rising persistently from January to May, when it reached 9.3 percent; employment among the working-age population fell to a trough of 49.2 percent in 1998:l; the number of work-seekers rose by 11,500 from the beginning of the year to May, while the number of claims for unemployment benefit increased by 9,900. The slackness in the labor market in 1998:l was expressed in the labor supply, which increased by 28,000 persons, and was not fully taken up by demand in the principal industries; thus the number of employees finding work was 10,000 less than the increment to the number unemployed.

However, despite these signs of slackness in the labor market, the real wage per employee post was 3 percent higher in the first four months of 1998 than in the same period in 1997. Wages rose in the business sector (up by 5.5 percent) and remained stable in the public sector, although the new wage agreements in the latter have not yet been finalized.

In 1998:l the number of Israelis employed was 2 percent higher than in 1997:lV, employment in construction falling and that in banking and education services rising. Alongside the increase in employment, the average number of hours worked per Israeli employed person was down by 2 percent from 1997:l (not seasonally adjusted), so that since then Israeli labor input has remained stable, in spite of the slow increase in GDP and the Israeli population of working age. In comparison with 1997:l, in 1998:l over half the incremental employees found work in the public services (26,000 persons), whereas the business sector is notable for the rise in employment in the high-tech industries (33,000 persons), offset by the decline in employment in the unskilled-labor-intensive industries (24,000 persons). At the same time, the number of hours worked per employee declined in the business sector, and rose slightly in the public services compared with 1997:l.

The real wage per employee post was up by 3 percent over 1997:l, the most prominent increases being in catering services (7.1 percent) and manufacturing (6.6 percent, with a decline in the number of posts). Concurrently, the real wage in the public sector remained stable (with a 2 percent decline in health services and a 0.5 percent increase in education services), while the extent of employment in it expanded. The trend of the real wage in the business sector appears to have been influenced inter alia by expectations of a higher rate of inflation than actually prevailed, causing the parties to the wage negotiations to set a higher nominal than real wage path.

The public-sector wage agreements for 1993-97 for most grades came to an end in the first half of 1997, but were not yet renewed in the period reviewed, although the negotiations were under way. The dispute between the Ministry of Finance and the General Federation of Labor (Histadrut) focuses on the transition from a non-contributory to a contributory pension, and on setting a guaranteed pension for veteran employees (the subject is currently before the labor court). No cost-of-living allowance was paid in February, the minimum wage was raised by 8.5 percent in April 1988, and the CPI-indexed wage components are updated continuously.

The number of immigrant work-seekers averaged 11,000 in the period reviewed, 5.5 percent above the average in the first half of 1997. At the same time, the number of valid labor permits held by foreign workers, which reached a peak in the second half of 1996, declined gradually, to stand at about 80,000 in the period reviewed, after a relatively sudden drop, compared with 105,000 in 1996:lV.

The number of unemployed persons reached 189,000 (seasonally adjusted) in 1998:l; 102,000 of these were men, and the characteristics of unemployment indicate that it is deepening: another 5,000 work-seekers were defined as having been unemployed for the last 12 months, the average amount of time work-seekers had been unemployed rose. as did the number of unemployed who were married and adult. The rise in unemployment, whose trend rise indicates that it reached 9.3 percent in May, reflects the structural change in the economy as well as the moderation of economic activity. On the one hand, the high-tech industries, which are not labor-intensive and are short of employees in specific occupations, expanded, while on the other, activity in the construction, hotel, and labor-intensive traditional industries contracted. Labor force movements indicate that in 1998:l the industries which are low-skilled-labor-intensive laid off 44,000 employees; this was offset to some extent by the rise in employment over and beyond the increase in the general labor force in both the high-skilled-labor-intensive industries (accounting for the employment of an incremental 22,000 persons), and the public services (6,000 persons).


The delayed response of employment (and unemployment) to changes in the rate growth

Changes in the economy's rate of growth are reflected by changes in business-sector employment and in the unemployment rate. Experience shows, however, there is a time lag between changes which occur in the course of the business cycle and the response of the labor market, even when labor market factors play a central role in changing the growth rate. Uncertainty about the extent and duration of the change in the level of activity whish surrounds the start of an economic slowdown or its reversal, and the costs of laying off workers or hiring new ones, result in employers preferring to wait at first, and not to adjust the number of employees to the changes in the level of activity. At this stage, they choose to change labor input by changing the number of man-hours worked per week rather than alter the number of employees.

Thus, for example, despite the contribution of the labor market to the downturn of the late 1980s, it showed a delayed response to the change in the level of economic activity. The first signs of the slowdown were evident as early as the second half of 1987: GDP stood still, in the 1987:IV the rise in imports halted too, and there was a notable decline in the total use of resources. In the labor market, however, the lower level of activity was reflected after a lag, i.e., starting in 1988*, and more strongly in 1989. Various labor-market indicators gave expression to the recession - a decline in the demand for labor, an increase in the number of job seekers, recipients of unemployment benefit and unemployed, and a slight rise in the rate of unemployment (from 6.1 percent in 1987 to 6.4 percent in 1988). Labor input in the business sector rose only minimally in 1988 - in agriculture, manufacturing industry, and construction it declined, rising markedly in private services. Nevertheless, the number of employees in the business sector rose by 3.2 percent in 1988, faster than the rate in the early 1980s (1.9 percent); stability of labor input was achieved by reducing the number of hours worked a week per employee. In 1989, as the slump took stronger hold, the labor market became even stacker - the rise in business-sector employment rate rose to 8.9 percent of the civilian labor force.

The lag in the response of the labor market to changes in the level of activity is also evident when the economy is coming out of a recession. Although there was a small rise in activity in the second half of 1989, business-sector employment fell by 3 percent. As the economy continued to recover in 1990, employment in the business-sector increased too, but relatively slowly.

In the light of the above, it is to be expected that when the economy starts to recover, the improvement will not be reflected by employment and unemployment data immediately, but only at a later stage.

* Employment indicators derived from Labor Exchange data points to a small rise in the number of unemployed persons as early as the end of 1987.

Figure 6. The labor market (thousands)
Figure 7. Real wage per employee post (NIS, 1995 prices)
Figure 8. Six-monthly Rates of Change, Business-Sector Product, Business-Sector Employment with a Six-month Lag. 1985-91
Figure 9. Six-monthly Rates of Change, Business-Sector Product, Business-Sector Employment with a Six-month Lag. 1985-91

Table 3. Indicators of Labor Market Developments, 1996-98
(seasonally adjusted)


1997
1998
Jan-Juna
*

1996
1997
II
III
IV
I
II
1997
1998
('000s)
Civilian labor force 2,158 2,209 2,206 2,220 2,227 2,255
2.8 3.3 3
Israelis employed 2,014 2,040 2,037 2,042 2,057 2,066
1.9 2.1 3
   Business sectorb
1,436 1,446 1,457 1,461 1,448 1,436
0.5 1.4 3
   Public sectorb 577 594 585 588 606 625
4.8 4.4 3
Average hours worked
per employee
b

37.8 37.8 36.7 38 37.2 38.6
1.9 -1.3 3
Claims for
unemployment benefit
76 97 96 100 103 107 113 29.3 18.6 6
Work seekers 83 119 120 122 122 127 136 56.8 13.0 5
Real wage per employee post (NIS)c 4,280 4,388 4,373 4,397 4,427 4,491 4,536 2.1 3.3 4
   of which: Business sectorc
4,275 4,441 4,476 4,433 4,490 4,581 4,683 2.8 4.8 4
Unemployment rate (%) 6.7 7.7 7.7 8.0 7.6 8.4


3
*
Last month for which data are available.
a
Percent change compared with same period in preceding year.
b
Not seasonally adjusted.
c
Index: 1994=100.

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The Balance of Payments

In 1998:l the deficit on the balance-of-payments current account was $ 0.5 billion, two thirds of the average quarterly deficit in 1997, and 60 percent of the deficit in 1997:l. This decline in the current-account deficit was due entirely to the sharp reduction on the civilian goods account, which was partly offset by the increase in defense imports, the increase in the deficit on the services account, and the fall in unilateral transfers. Concurrent with the improvement in the balance-of-payments current account, long-term capital inflow increased significantly vis-?-vis the quarterly average of the last few years, the other private-sector capital imports, including foreign direct investment in Israel, declined, and capital inflow of the government increased substantially. Thus, the surplus on the basic balance of payments, which relates to the financing of the current account solely by long-term capital flows, rose to stand at $ 1.5 billion, and since short-term capital flows remained relatively stable, the foreign-exchange reserves rose significantly, by $ 1.2 billion. and the net external debt (as a percentage of GDP) declined by about 3 percent.

The average monthly level of the trade deficit (excluding defense imports, ships, aircraft, fuel and diamonds, seasonally adjusted) amounted to $ 374 million in the period reviewed, 19 percent below the level of the first half of 1997, thereby continuing the contractionary trend of the deficit that has been evident since the beginning of 1996. The decline in the trade deficit reflected stability in goods imports and a rise in their exports, and is the outcome of the slowing of domestic demand, the decline in the prices of imports and exports, the expansion of international trade and, it would seem, a slowing in the process of real appreciation against the currency basket (see section on prices). In 1998:l Israel's import prices fell by 1.6 percent, and export prices declined by about 0.5 percent, so that the terms of trade improved by approximately 1 percent.

With regard to goods imports, consumer goods were up slightly over the second half of 1997, as were intermediates, while capital goods fell by 7 percent and fuel by 10 percent (largely due to the decline in its dollar price). On the other hand, goods exports rose by some 5 percent over the second half of 1997, with a 6 percent increase in manufacturing exports. Nonetheless, the trends indicate that the additional manufacturing exports, which peaked at the beginning of the period, declined towards the end of it. There was a relatively steep rise in exports from high-tech industries (communications equipment, medical and scientific equipment, engines, and electrical equipment), as well as in those of textiles and clothing, the marked increase in the former industries' share in exports indicating the intensity of the structural change the economy has been undergoing of late. In the period reviewed there was a shift towards the west in goods exports, with exports (excluding diamonds) to the OECD countries and the US up by 13 percent over the equivalent period in 1997 (current prices), accounting for almost two-thirds of total exports. Exports (excluding diamonds) to East Asia, on the other hand, fell by 18 percent, and accounted for only 8 percent of exports, compared with 11 percent in the same period in 1997.

On 14 May the foreign-exchange control regime was changed in two main areas: a new General Permit was issued (replacing the several existing ones), allowing all transactions in foreign currency and with nonresidents except a few which concern institutional investors and certain futures transactions. In addition, the provision that a transaction must be executed via an authorized dealer was annulled. These changes mean that there is no longer any need to prove the existence of a permit in order to implement a transaction, and so there is also no need to submit documents to prove its legality. At the same time, the permit to undertake transactions in foreign currency and with nonresidents is contingent on the reporting requirement. The revision of the foreign-exchange control regime occurred without any change in capital flows.


Figure 10. Foreign trade ($million per month)

Table 4. Balance of Payments, Foreign Tradea, and the Reserves, 1996-98
($ mill., current prices)


1997
1998
Jan-Jun
*

1996
1997
II
III
IV
I
II
1997
1998
Monthly averages
Trade deficit 660 476 469 450 473 373 376 491 374 6
Goods imports 1,853 1,775 1,738 1,780 1,797 1,761 1,784 1,761 1,772 6
   Consumer goods 328 322 324 314 322 324 316 326 320 6
   Capital goods 420 382 357 413 375 351 382 371 367 6
   Intermediates 1,104 1,070 1,056 1,052 1,100 1,085 1,086 1,064 1,086 6
Goods exports 1,193 1,298 1,268 1,330 1,324 1,388 1,408 1,269 1,398 6
   Industrial 1,124 1,229 1,202 1,258 1,257 1,323 1,341 1,200 1,332 6
Quarterly averages
Net current account -1,277 -809 -1,372 -1,075 96 -537
-1,666   3
Long- and medium-term
capital flows
1,213 1,299 688 2,265 573 2,049
1,312   3
   of which: Private sector 803 993 694 1,512 1,097 604
1,438   3
Short-term capital flowsb 430 1,284 2,922 -485 -745 120
2,941   3
   of which: Private sectorb 221 1,296 2,919 -427 -776 185
2,981   3
Net foreign debt (% of GNP) 20.07 18.29 20.30 20.20 18.29 17.72
30.19   3
End-period Bank of Israel reserves 11,464 20,091 17,793 18,982 20,091 21,340 21,315 15,368 21,523 6
*
Last month for which data are available.
a
Foreign trade data are seasonally adjusted monthly averages (excluding ships, aircraft, diamonds, and fuel).
b
Including the banking system.

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International Developments
and Their Economic Implications for Israel

During the period reviewed the dollar strengthened against most of the currencies traded in Israel: by 7 percent against the dollar, 4.5 percent against the Swiss franc, and 0.8 percent against the mark and the florin. The dollar weakened by 0.8 percent against sterling.

The most prominent recent global economic development has been the financial crisis in East Asia, which began last summer (in Indonesia, Malaysia, the Philippines, and Hong-Kong), and spread to Korea at the end of 1997, manifesting itself through a steep drop in growth rates in those countries and a slight decline in the world growth rate. Thus, after an annual average GDP growth rate of 7-8 percent in those five countries in 1990-96, negative growth is expected in 1998. This contraction explains most of the slowing of world GDP growth forecast by the IMF (from 4 percent in 1997 to about 3 percent in 1998). As the financial crisis deepened in 1997 the value of the currencies of the countries concerned plummeted (only in January 1998 were there some signs of a rally), increasing their competitiveness in goods markets; in the context of the decline in their domestic demand the rise in the volume of their trade moderated, its direction changed, and their current-account surplus soared. An estimate of the effect of the crisis on the current account of the OECD countries in 1998 indicates that the total deterioration/contraction was $ 53 billion, half of it vis-?-vis Korea, with an even greater fall in countries in the region of the crisis (excluding China). Thus, according to OECD estimates, in 1998 the Asian crisis will be reflected by a 1.3 percent decline in GDP growth in Japan, and a 0.4 percent decline in the US and the EU.

The Asian crisis also has repercussions on the nominal side. First, the large devaluations in the countries involved reduced the prices of their exports, thereby contributing to the decline in world inflation in 1997. Second, the low growth rate in Asia contributed significantly to the sharp drop in world prices of raw materials in 1997, the demand for which is particularly high in the countries involved in the crisis. Thus, according to the IMF estimate, annual inflation in the advanced countries in 1998 will remain at the low level reached in 1997 (about 2 percent), while in the developing countries it will rise to 10 percent (a 2 percentage-point increase). In the financial markets, long-term interest rates in most of the industrial countries continued to fall, while in short-term interest the trend was mixed.

Global developments in general had conflicting effects on Israel's economy. First, the fall in demand in the countries involved in the crisis and their neighbors led to a 30 percent drop in Israel's exports to them (including Japan), most of it in diamond exports (40 percent), in the first five months of 1998. Second, in the wake of the crisis and the shift in the value of the currencies of Israel's trading partners, trade could be diverted to cheaper sources of imports, and this helped to reduce the (dollar denominated) trade deficit (for example, the lower prices of vehicles from Japan, which account for over half of Israel's vehicle imports, declined, and there is also considerable substitutability between them and vehicles from other countries). Third, following the decline in the prices of fuel and other raw materials, Israel's terms of trade improved (intermediates are its principal goods imports), leading to the contraction of Israel's import surplus. Fourth, the economic recovery in the US, Germany, and France in 1997, expressed in their accelerated growth rates, had a positive effect on Israel's exports, much of which are directed to those countries.

With regard to 1999, the IMF forecasts more rapid world GDP growth than in 1998, mainly in the developing countries, but slower than in 1997, as well as a moderation of the rate of foreign trade growth, and a continued decline in inflation.

Table 5. Indicators of Economic Development in Advanced and Developing Countriesa, and Estimate for 1998-99


1996 1997 Estimate
1998
Estimate
1999
Annual rate of changeb
World GDP
   Total 4.1 4.1 3.1 3.7
   Advanced countries 2.7 3.0 2.4 2.5
   Developing countries 6.6 5.8 4.1 5.3
World trade
   Total 6.6 9.4 6.4 6.1
   Advanced countries
      Imports 6.4 8.6 6.8 5.6
      Exports 5.9 9.8 6.2 6.0
   Developing countries
      Imports 9.3 12.1 5.2 7.8
      Exports 8.7 10.8 7.4 6.7
Inflation (CPI) </TD<
   Advanced countries 2.4 2.1 2.1 2.0
   Developing countries 13.7 8.5 10.2 8.5
Short-term interestc (%)
   Dollar deposits 5.6 5.9 6.1 6.1
   Yen deposits 0.7 0.7 0.7 1.2
   DM deposits 3.3 3.4 3.9 4.5
Unemployment rate
   OECD countries 7.5 7.2 7.1 7.0
a
According to "World Economic Outlook", Israel is classified as an advanced country.
b
Apart from interest and unemployment rates, which are shown as percentages.
c
3-month LIBOR rate.
SOURSE: "World Economic Outlook", (IMF), and OECD "Economic Outlook".


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Prices

The CPI rose more slowly in the period reviewed, by 4.5 percent annual rate, with the rise occurring almost entirely in 1998:II. As this slowdown was evident in all the main CPI items, and as inflation expectations (as derived from both the capital market and the Bank of Israel's survey of companies) fell to their lowest level since these figures were calculated, it may be said that the inflation environment has declined significantly-a development which started in October-December 1997. In the period reviewed, inflation fell below the 7 percent lower limit of the 1998 target. Inflation expectations for the next twelve months also went lower than 7 percent, so that there has been some convergence to the rate set by the government as the long-term target of economic policy.

The moderation of the rate of increase of housing prices compared to that prevailing during the previous three years made a greater contribution to the slowdown of inflation than any other main item. Due to the heavy weighting of housing in the index (more than 20 percent), its slower rise in the period reviewed contributed about one fifth of the total rise in the index compared to about one third of the rise from the beginning of 1994 to the middle of 1997. (If the analysis is restricted to owner-occupied housing only, this effect is even more pronounced.) This slowdown reflects the weakness in housing demand, which resulted from the pronounced drop in the number of new immigrants arriving, political uncertainty, the relatively high rates of interest, and the general downturn in economic activity.

The rise in price indices which exclude the categories with high price-volatility slowed to about 4 percent, roughly half the rate in the same period in 1997. There was a marked seasonal effect on the overall index in the second quarter. Thus, whereas those categories with weak seasonality showed low volatility in the whole period reviewed, clothing and footwear prices declined rapidly in 1998:I and rose even faster in 1998:II; fruit and vegetable prices followed a similar pattern, but at a lower level. The relatively steep rise in the CPI in 1998:II was also due in part to the sharp depreciation, in April, of the NIS against the dollar and the currency basket.

The average nominal depreciation of the NIS in the period reviewed and the decline in foreign-trade prices in 1998:I apparently moderated the long-term trend of appreciation. Real appreciation is a world-wide phenomenon, and is partly due to productivity of the tradables sector rising faster than that of nontradables; a similar trend was evident in Israel from the end of the 1970s until 1997. There are indications that appreciation continued during the period reviewed (prices of tradables in the consumption basket continued to rise more slowly than those of nontradables, and this is even more pronounced if prices of seasonal items are excluded). On the other hand, for the first time there are indications of real depreciation-the exchange rate of the NIS against the currency basket (and the dollar) rose faster than did the CPI, and the wholesale price index went up by 1.7 percent, in annual terms, in the first half of 1998, the lowest rise for a long time.
 


 
Table 6. Selected Price Indicies, 1996-98
(annual rates of change during period, percent)


1997
1998
Jan-Jun
*

1996
1997
II
III
IV
I
II
1997
1998
CPI 10.6 7.0 9.6 5.4 2.4 0.3 8.9 10.2 4.5 6
CPI excl. housing, fruit and vegetables 10.1 6.7 10.8 5.2 4.8 -0.5 10.0 8.5 4.6 6
CPI excl. housing, fruit and vegetables, controlled goods, clothing & footwear 10.2 7.8 7.5 10.9 2.7 3.0 4.4 8.8 3.7 6
Index of housing prices 13.2 7.5 10.8 7.7 -1.9 5.1 3.9 12.5 4.5 6
Wholesale price index 7.0 5.9 7.2 7.8 2.5 -0.6 4.1 6.8 1.7 6
NIS/$ exchange rate 5.0 7.9 10.7 6.5 3.1 6.0 9.0 11.1 7.5 6
NIS/currency-busket rate
3.0 3.7 11.3 1.0 3.6 3.6 8.9 5.1 6.2 6
*
Last month for which data are available.

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The Government

Public-sector consumption went down by 1.4 percent in 1998:I, an expression of the continuation of the fiscal restraint which characterized 1997. The domestic deficit in the period reviewed (cash basis, excluding credit) was 1.8 percent of GDP, marginally higher than the 1.6 percent in the first half of 1997, the increase deriving from the fact that government's expenditure rose faster than its revenues. The deficit in January-June 1998 was NIS 3 billion, while the budgeted deficit for the whole year is NIS 8.4 billion. An analysis of the path of income (involving smoothing the effect of non-recurrent income) and expenditure reveals that there are significant lags in both income (of about NIS 4.7 billion) and expenditure (of about NIS 3.7 billion), with NIS 3.5 billion of the latter deriving from the allocation to the price reserve. Among the reasons for the shortfall on the revenue side may be listed the decline of the growth rate to below the rate assumed in drawing up the budget-a decline of 1.0-1.5 percent-and non-implementation of the plan to improve tax collection. It is however difficult to determine whether budget developments in the period reviewed seriously endanger the achievement of the government's annual budget deficit target, as this is defined in terms of the total deficit, including the Bank of Israel's income from investing the foreign reserves, which is expected considerably to exceed the budget forecast.

The deficit of the public-sector-the government, the Bank of Israel and the Jewish Agency-reached some NIS 3.2 billion, compared with NIS 3 billion in the equivalent period in 1997. In 1997, however, domestic borrowing from the public greatly surpassed the amount required to finance the deficit, so that there was significant absorption, whereas in 1998 borrowing has fallen slightly short of the deficit financing requirement, with the budget showing an injection of 0.3 percent of GDP, compelling the Bank of Israel to employ monetary instruments to absorb this excess liquidity.

Tax revenues in the first half of 1998 were 1.5 percent higher, in real terms, than in the equivalent period in 1997. The reasons for the slow increase were: a real 4 percent rise in direct taxes, which was the result of a rise in real wages; a real decline in import taxes, arising from a real fall in imports; and steady indirect taxes, reflecting the slowdown in economic activity. On the other hand, in January-May 1998 transfer payments to households rose relatively fast, by 12 percent in real terms, with a very marked 25 percent increase in unemployment grants, which started their rapid real rise in 1997, and which accounted for about a sixth of the total increase in transfer payments in the period reviewed.
 

Figure 11. Government cash flows (NIS million, monthly average)
 
Table 7. The Budget and its Financing, 1996-98
(cash flows, as percent of GDP)


1997
1998
Jan-Jun
*

1996
1997
II
III
IV
I
II
1997
1998
1. Government domestic expenditure 40.7 39.8 37.2 39.1 41.6 40.7 39.8 39.2 40.3 6
2. Government receipts 35.9 36.9 34.8 37.5 34.8 39.2 38.1 37.6 38.6 6
3. Domestic budget deficit (1)-(2) -4.7 -2.9 -2.4 -1.7 -6.9 -1.6 -1.8 -1.6 -1.7 6
4. Public-sector domestic deficita  (5)+(6) 5.4 3.3 2.1 2.3 7.3 1.5 2.3 1.8 1.9 6
5. Government net borrowing from the public 2.6 2.3 4.5 1.3 -1.0 1.4 1.6 4.5 1.5 6
6. Public-sector injection (9)-(8)-(7) 2.8 1.0 -2.4 0.9 8.3 0.0 0.7 -2.7 0.4 6
7. Bank of Israel injection
-3.5 -6.7 -7.0 -0.5 -4.0 -3.2 0.1 -11.4 -1.6 6
8. Private-sector foreign-currency conversions 1.9 6.8 10.6 -0.1 -0.0 1.7 1.7 13.9 0.8 6
9. Change in monetary base
1.3 1.1 1.2 0.3 4.2 -1.5 0.7 -0.2 -0.4 6
* Last month for which data available.
a Budjet deficit plus Jewish Agency injection, plus non-budgetary injection.


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The Money and Capital Markets

The Bank of Israel lowered its key nominal interest rate in every month in the period reviewed except January, by amounts between 0.3 and 0.5 percentage points. This steady reduction of the rate of interest, which was made possible by the decline in the inflation environment, totaled 2.4 percentage points by the beginning of August, and followed a period of no-change in interest since September 1997, when the rate was increased by 0.7 percentage points. The steady reduction in the interest rate, implemented over a relatively long period of time, was based on several factors: the decline in the inflation environment, first indications of which were noted towards the end of 1997, and which was reflected by inter alia the actual inflation rate, expectations regarding future developments, and changes in the money supply; assessments of the effect of other factors on the inflation environment (such as real activity and the development of prices abroad); greater uncertainty in international money and capital markets; and the gradual reduction of the interest differentials between Israel and the advanced economies. The main policy instrument used in the gradual lowering of the interest rate was the auction among the banks for monetary deposits in the Bank of Israel, as a result of which banks' deposits in the central bank expanded in the period reviewed by NIS 5.8 billion, compared with a rise of NIS 25 billion during the whole of 1997, reaching NIS 35.8 billion at the end of the year.

In the period reviewed, the rate of reduction of the nominal interest rate was slower than the decline in inflation and inflation expectations, so that real interest rose to a high level in comparison with its past level. Nominal interest minus inflation expectations2, i.e., the expected real rate of interest, which reached an average of 5.2 percent in 1997, rose to an average of 7.5 percent in the period reviewed. Thus, the slowdown in demand was accompanied by high real interest rates, as there was an awareness that sharper cuts in nominal interest would probably cause shocks in the foreign-currency market since international capital flows, which are sensitive to arbitrage differentials, could reverse direction if the differentials between interest in Israel and abroad contracted too rapidly.

Foreign-currency activity in the period reviewed remained calm, except for the first three weeks in April, when the calm was shattered by uncertainty in the period prior to the expected announcement that far-reaching liberalization measures were to be implemented and that the NIS was becoming a freely convertible currency. During those three weeks, demand for foreign currency surged, but was satisfied without the need for intervention by the Bank of Israel, and the NIS/currency-basket exchange rate rose by 5 percent. Immediately after the announcement of the program, calm returned to the foreign-currency market, the NIS appreciated by 1.5 percent against the currency basket and the dollar, and it turned out that inflation expectations had not been affected by the accelerated depreciation in April. The Bank of Israel did not intervene in the foreign-currency market throughout the period reviewed (except for the very first days of 1998), and the exchange rate against the currency basket generally moved close to the lower limit of the crawling exchange-rate band. The calm in the foreign-currency market was maintained despite the continued gradual narrowing of the yield differentials between the local-currency and foreign-currency segments (which were between 5.4 and 7.5 percentage points at the end of July, before deducting expected depreciation). The situation was clearly reflected in the extent and direction of capital flows: first, there was significant moderation in residents' and nonresidents' capital inflow to Israel; second, estimated import of capital sensitive to interest differentials (mainly short-term credit) contracted in January-May to less than half its level in the same period in 1997, and third, the inflow of capital less sensitive to interest differentials (mainly portfolio investments and deposits) declined even more markedly-in April and May these actually reversed direction and became capital outflow.

The consolidation of a lower inflation environment, the calm on the foreign-exchange market, and the possibility of narrowing the yield differentials between the foreign-currency and local-currency segments played a part in slowing their rise, changing the composition of the monetary aggregates and credit, and gradually raising the share of unindexed assets in the public's portfolio during the period reviewed. The money supply expanded at an annual rate of 9 percent, slower than its growth in each of the years 1995-97, when it averaged 14 percent, but still above the concurrent increase in potential nominal GDP. One possible explanation for this is that the decline in nominal interest and inflation tend to increase the demand for money at all levels of GDP. The 80 percent increase (annual rate) in Treasury bills was also noteworthy as was the stability (in dollar terms) of deposits in or indexed to foreign currency. Bank credit expanded relatively moderately (by 14.7 percent, compared with 18 percent in 1997, annual terms), but faster than the nominal increase in economic activity. The expansion of bank credit derived from a rise in its unindexed component (with a fall in the rate of increase, in dollar terms, of credit in foreign-currency or indexed to it), and took place alongside a rise in both short- and long-term interest, and a rise in mortgage interest, which by the end of the period reviewed reached the high level of July 1996. The rise in mortgage interest apparently reduced the number of those taking up mortgages, and is explained mainly by the rise in the yield to maturity of government bonds (the result of high real interest in long-term local-currency deposits), which are the mortgage banks' indexed sources.

From the beginning of the year until mid-February, small turnover in share trading was recorded, and the General Share Price Index fell to a seasonal low. Since then, the index has risen rapidly, and in May 1998 it surpassed the peak it had reached in August 1997. In the period reviewed, the index rose despite the low level of activity on the domestic market and the slow rate of growth relative to the economy's long-term potential, and may be connected to the renewed capital-market boom in the advanced economies (which rose by 10 percent in March-June 1998), and to the recovery in some East Asian stock-markets following the crisis.

2 Nominal interest in the auctions minus gross inflation expectations derived from the capital market.
 

Figure 12. Monetary aggregates and credit (change in prev. 12 months)
Figure 13. Nondirected bank credit (NIS million per month)

Table 7. Monetary Indicators and Nondirected Bank Credit, 1996-98
(annual terms, percent)


1997
1998
Jan-Jun
*

1996
1997
II
III
IV
I
II
1997
1998
Rates of change Average
Compared with preceding quarter
During perod
M1a
14.9 14.3 26.6 28.5 -1.3 5.3 20.7 13.8 9.7 5
M2b 27.0 25.8 17.6 24.9 25.0 31.3 11.1 22.4 19.1 5
M3c 26.5 24.6 16.0 23.7 20.1 28.4 15.3 21.7 20.2 5
Nondirected bank credit 21.6 18.2 19.4 17.9 13.2 9.9 19.1 18.3 14.5 5
   Unindexed local-currency 10.6 8.6 2.0 8.6 23.9 10.7 21.5 4.2 17.2 5
   CPI-indexed 23.7 19.0 14.0 15.9 18.5 8.8 9.1 14.1 6.7 5
   Foreign-currency indexed & denominated 40.0 32.3 57.3 33.5 -4.8 10.2 30.4 48.3 21.9 5
*
Last month for which data available.
a
Narrow money supply (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 14. The sheqel exchange rate against the currency basket
Figure 15. Yield on Treasury bills (end-period figures)

Table 9. Interest Rates, Yields, and the Share-Price Index, 1996-98


1997
1998
Jan-Jun
*

1996
1997
II
III
IV
I
II
1997
1998
Nominal interest
Nondirected local-currency credit 20.7 18.7 19.0 18.0 18.2 17.7 16.5 19.5 17.2 5
Average monetary loan 16.1 14.3 14.5 13.6 14.1 13.5 12.2 14.8 12.8 6
SROs 13.8 12.2 12.3 11.5 12.0 11.5 10.5 12.7 11.1 5
3-month Eurodollar 5.4 5.6 5.7 5.6 5.7 5.5 5.6 5.6 5.5 6
Yield to maturity
Treasury bills 15.6 14.1 14.1 13.5 14.1 13.4 12.2 14.3 12.8 6
10-year bonds 4.5 4.0 4.0 3.7 3.9 4.7 4.9 4.1 4.8 6
5-year bonds 4.4 3.9 4.0 3.6 4.0 5.0 5.4 4.0 5.2 6
General share-price index (points) 92.4 129.2 127.9 139.4 133.1 131.5 146.4 122.1 139.0 6
*
Last month for which data available.