Recent Economic Developments, 85

01/02/1999
All Press Releases In Subject:
The Economy and Economic Activity
Recent Economic Developments, 85, July 1998 - December 1998


 Main Developments
  The Principal Industries
   The Labor Market
    The Balance of Payments
     International Developments
       and Their Effect on Israel
       Prices
        The Public Sector
         The Money and Capital Markets



Previous Economic Developments 84


Main Developments

In the second half of 1998 (the period reviewed), against the background of financial crises and shocks throughout the world, the NIS depreciated relatively quickly against the currency basket and the dollar; the rate of price increases accelerated, apparently a temporary phenomenon (with some real depreciation); and private-sector capital flows in the balance of payments reversed direction, and changed from capital inflow in the first half of the year to an outflow from September. At the same time, various trends which had started in 1997 persisted: economic activity remained below its potential, and the current balance-of-payment deficit continued to contract.

Macroeconomic developments in the period reviewed are closely linked to those in the global economy. The decline in world trade had an adverse effect on exports, and through them, also on industries not directly related to exports. The fall in world prices, which led to a decline in import and export goods prices and to an improvement in the terms of trade, helped to reduce the current-account deficit; with the reduction in capital inflow, related to the crisis in Russia and in world financial markets, the exchange rate rose. In addition to the effects of world developments on the economic slowdown in Israel, other contributory factors were the level of economic uncertainty and the observance of monetary discipline and of the government's budget.

National accounts data of the use of resources indicate a low level of demand in 1998:III; investment and exports of goods and services were lower than in 1997:III, and public-sector consumption rose only slightly. A similar indication is obtained from the contraction of goods and services imports in 1998:III. Most other indicators of economic activity also suggest a low level of activity in the period reviewed.

Prices rose faster in the period reviewed. The Consumer Price Index (CPI) rose by about 6 percent, compared with a 2 percent rise in the equivalent period in 1997. The surge occurred from September to November, and followed the sharp depreciation of the NIS which started in mid-August. Nevertheless, several indicators (mainly the low CPI in December, and the downward trend in inflation expectations) show that the reaction of prices to the depreciation was a one-time reaction; other indicators (including the persistent lack of calm on world markets and the level of inflation expectations) suggest that the return to the inflation environment prevailing in the first half of the year is not yet firmly based. The acceleration of prices occurred at about the same time in all seasonally-adjusted price indices, and covered all the major categories in the CPI. Inflation expectations (taken from the capital market as well as from the Bank of Israel's companies survey) went up with the rise in the indices. The rate of price increases slowed considerably in November following the sharp increase in the Bank of Israel interest rate, and inflation expectations also started falling. Price rises in the period reviewed brought the rise for 1998 to the middle of the target inflation range for the year (7-10 percent).

The downward trend of the balance-of-payment current-account deficit, which had started in 1997, persisted in 1998, and although it rose by $ 1.3 billion in 1998:III, the total from January to September was significantly below that in the equivalent period in 1997. World price changes which reduced dollar prices of goods imports and exports and also improved the terms of trade contributed to the continued reduction of the deficit. On the other hand, exports felt the effect of the slowdown in world trade. Trend data of goods exports in 1998 show that there was a gradual reduction in their rate of increase, until they declined in 1998:III, rising again in 1998:IV. Goods imports did not change significantly. The most notable development in the balance of payments in the period reviewed was the reversal of private-capital flows: whereas in the first half of the year there had been an inflow of $ 1.7 billion, in the second half this turned into an outflow of $ 1.1 billion, most of it from September to November. Higher expectations of depreciation of the NIS and a rise of the exchange-rate-risk premium-due to the international financial crisis-which reduced the yield differential between Israel and abroad led nonresidents to realize some of their stock-exchange investments (as occurred in other stock exchanges, too), and caused Israelis to reduce their foreign-currency credit and to increase their foreign-currency deposits. In December, nonresidents' real investments rose again.

Most labor market indicators show that the slackness which has prevailed for a long time, the result of a low level of economic activity, continued. Nevertheless, unemployment data and indicators of the depth of unemployment suggest that the situation eased a little. This was due to short-term measures introduced to reduce unemployment and to an exceptional rise in the number of public-service employees, partly the result of local-authority elections. The real wage per employee post, which had risen in the first half of the year, fell in the second, due to an unexpected rise in the rate of price increases (although the amount of compensation for this increase is still under negotiation). Despite the fall in the real wage, its level remained higher that in the equivalent period in 1997, in both the business and public sectors (2.3 percent and 0.5 percent respectively). Measures initiated by the government to absorb work seekers into employment covered their inclusion in vocational retraining courses and increasing the number of employees in the public services. Thus the rate of unemployment and the number of job seekers fell (although they rose slightly in November and December), and the number of claims for unemployment benefit declined.

The budget was adhered to in the period reviewed, and the total deficit for 1998 was in line with the target set in the Budget Deficit Reduction Law-2.4 percent of GDP. The composition of the deficit differed, however, from that planned in the original proposal: the domestic deficit was higher than the target, due a shortfall of tax collection, and the surplus on overseas transactions exceed that projected as a result of an increase in the Bank of Israel's profits arising from transactions abroad. These differences between the planned and the actual budget, along with the rise in public consumption and the exceptional increase in the number of public-service employees, provide no indication of fiscal restraint in this period.

Monetary policy: at the beginning of the period reviewed the Bank of Israel cut the interest rate by 1.5 percentage points, alongside various other policy measures-the inflation target for 1999 was set at 4 percent, and the slope of the lower limit of the exchange-rate band was lowered to 2 percent. Later in the same month (August) the financial crisis erupted in Russia, causing shocks throughout the worlds financial markets. The Bank of Israel refrained from changing the interest until October, because it assessed, inter alia, that it was too early to determine whether the inflation environment had changed, and that the rise in inflation expectations to a great extent reflected an increase in the risk premium due to the global crisis. As inflation continued rising, however, and in order to prevent price rises from being translated into a higher inflation environment, the rate of interest was hiked by a cumulative 4 percentage points. As a result, the interest-rate gap between Israel and abroad widened, private-capital imports, which are sensitive to changes in interest, grew, inflation expectation declined, accompanied by a fall in the rate of price increases. In the period reviewed the Bank of Israel persisted in its policy of non-intervention in the foreign-exchange market-a policy based on its strategy of not intervening in the market as long as the market is functioning properly-and the exchange rate, which hitherto had been very close to the lower limit, rose. In October the exchange rate rose above the midpoint of the band (sometimes going as high as 4 percent above it), and remained in that vicinity/environment until the Bank announced the increase in the interest rate (towards the end of the month). After several days below the midpoint of the currency-basket exchange-rate band, the rate again went above it, and remained at about 2 percent above it until the middle of November, when the Bank of Israel raised the rate of interest again. Since then the exchange rate has followed a slow downward trend, with significant turnover in foreign-currency trading.

There were marked fluctuations in security prices in the period reviewed, due among other things to the volatility experienced in stock markets throughout the world, and the rise in inflation and in inflation expectations. In October, as stock market prices fell throughout the world, causing nonresidents to leave the Tel Aviv Stock Exchange (TASE), and with the rise in inflation expectations, prices on the TASE plummeted, but thereafter moved up again until the end of the year, albeit more slowly than abroad.
 

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, 1997-98
(all data, excluding construction are seasonally adjusted)


1997
1998
July-Deca
*

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

4.9 2.8 4.3 6.7 2.6 1.5 0.6 1.7 1.1 12
Large-scale retail trade 7.9 6.4 6.3 13.2 7.2 -2.1 3.4 7.4 3.6 12
Manufacturing production (excl. diamonds) 1.9 2.7 -1.6 6.4 2.5 1.6 2.7 2.0 2.5 11
Business-sector consumption
of electricity
5.8 4.7 -7.5 11.1 9.3 -15.4 46.8 6.6 1.6 10
Index of revenue
in commerce
4.1 6.3 5.5 -1.2 -1.6 2.6 -14.6 4.3 -0.1 11
Index of total revenue 4.6 1.0 4.6 -0.8 3.6 -2.1 -12.1 5.8 0.4 11
Rates of change (percent), compared with preceding quarter
Tourist arrivals -6.0 -4.8 -6.5 -8.3 18.7 -4.8 -2.4 -3.7 -1.1 12
Immigrant arrivals -5.4 -20.6 2.2 -32.7 -8.9 21.7   8.1 -23.7 9
Residential starts -9.9 -35.7 -22.8 -0.2 -16.3 -14.5 -67.5 -20.7 -44.8 10
of which:
 Government-initiated
-18.0 -51.5 -5.3 -10.6 -41.0 10.0 -74.6 -33.2 -64.6 10
Residential completions 21.7 -33.1 11.8 -31.3 16.8 -10.8 -71.5 25.6 -51.4 10
of which:
 Government-initiated
36.4 -34.8 -14.6 -24.5 40.2 -9.7 -83.0 10.2 -48.5 10
(percent)b
Net output
of manufacturing firms
-3c -8c -5c -5c -8 -13 -7

12
Net sales
by commercial firms
-12c -14c -14c -18 -7c -13c -17

12
*
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

Most of the indicators used to assess economic activity suggest that the low level prevailing since 1996 continued in the period reviewed, led by the slowdown in world trade and low level of domestic demand.

The sources side of national accounts data for 1998:III show a 2 percent increase in GDP (which means a reduction in per capita GDP, and a rate of growth below that of potential GDP); a 1.2 percent rise in business sector domestic product; and a decline in goods and services imports. The use of resources side, on the other hand, indicates an increase of less than 1 percent compared with the equivalent period in 1997; private consumption was 3.4 percent higher; investment was stable; and public consumption rose by half a percent. The effect of the contraction of world trade was reflected in goods and services exports, which plummeted by 19 percent from 1998:II to 1998:III-with the decline in goods exports to South East Asia particularly marked.

The Bank of Israel's research department quarterly survey of companies shows that activity in all the principal industries except transport and communications continued to fall in 1998:IV. The survey returns also indicate that the decline in activity was slower than previously, as the main reason for the decline was the weakness of domestic demand, whereas in manufacturing, companies reported on a rise I exports.

Some of the indicators in Table 1 show that activity increased moderately: the index of industrial production was 2.5 percent higher (until November) than in the equivalent period in 1997; the index of large-scale retail trade, which rose even faster, by 5.6 percent, although this was affected by the gradual move towards the large retail chains; imported intermediates fell to their lowest level in a long period; and the state-of-the-economy index, which had risen relatively quickly in 1998:I, has been falling since then, and in the period reviewed was 1.1 percent higher than in the equivalent period in 1997.

Indices of manufacturing show that the upward trend of production per hour of labor (labor productivity) continued in the period reviewed, with a slow rise in the manufacturing index and a reduction in the number of hours works. An analysis of the two-digit industries indicates that the main contribution to the increase in output was made by the export industries, including chemicals and electronics (which increased by 3 percent and 1 percent respectively), while the other industries, including transport vehicles (also an export industry), moved in the opposite direction. Output of the textile and clothing industry, whose share of total output has been contracting for a long time, rose relatively quickly, and that of mining and quarrying, which serves as inputs in the construction and road-surfacing industries. (For the geographical distribution of exports, see the section on the balance of payments.)

Most indicators of activity in the construction industry in the period reviewed showed a continuation of the decline which has prevailed throughout 1998. In October and November, however, there was a marked rise in sales, due to a reduction of the interest on mortgages and the announcement that the exchange rate against the dollar, in terms of which sales contracts are written, was being frozen at the level prevailing prior to the depreciation of the NIS. The number of mortgages taken up also rose, apparently as the current mortgage arrangement was coming to an end, and construction time for urban public building contracted. In the period reviewed (up to October), the number of building starts and completions were significantly below the figures in the equivalent period in 1997, and the number of apartments under construction by the Ministry of Construction and Housing went down gradually. Housing prices in the CPI, which remained stable during the first half of 1998, rose faster in the period reviewed than did the CPI; rents, too, which are usually quoted in dollars, rose twice as fast as the CPI.

Sales revenue indices in all commercial and service industries (based on VAT data, seasonally adjusted) show that in 1998:III revenue fell slightly from its level in the first half of the year. Tourist bed-nights increased somewhat, although the number of tourist arrivals fell by 1 percent from their level in the equivalent period in 1997.
 

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

Table 2. National Accounts, 1997-98
(seasonally adjusted)


1997
1998
July-Deca
*

1997
1998
IV
I
II
III
IV
1997
1998
Rates of change (average annual rates, percent, constant prices), compared with preceding quarter
GDP 2.2 1.7 2.2 2.0 1.6 1.4
2.4 1.8 9
Business-sector product 1.9 1.2 4.5 0.6 0.1 1.2
2.3 1.6 9
Private consumption 4.0 3.5 -1.7 4.2 8.2 3.2
4.5 3.4 9
Gross domestic investment -6.6 -5.9 35.9 -26.0 -23.0 30.4
-11.7 0.2 9
Goods and services exports 7.2 3.6 -12.3 8.3 24.6 -18.8
10.9 -1.0 9
Goods and services imports 2.6 2.2 -2.1 -2.8 13.0 -5.4
2.5 0.4 9
Public-sector product
1.5 2.8 -1.4 8.0 1.9 -6.0
1.4 0.5 9
*
a
Last month for which data available.
Compared with same period in preceding year.

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The Labor Market

Despite the continued low level of economic activity, several labor-market indicators changed direction; nonetheless, it seems that there was no turnaround regarding the slackness which has persisted for a long time, and the indicator changes were the result of government policy, whose effective time span is unclear. In 1998:III, incremental employment exceeded the increase in the labor force, and the rate of unemployment fell to its lowest quarterly level since the beginning of the year-8.4 percent. There was a 1 percent rise in labor input, entirely accounted for by the increase in the number of employees in the public services. The number of work seekers declined, as did the number of claims for unemployment benefit. On the other hand, the real wage per employee post was lower than in the first half of the year.

The government initiated a number of activities intended to lead to the integration of work seekers in employment (including them in training and vocational retraining courses), the criteria for receiving unemployment benefit were enforced more rigorously (reflected by the rise in the recorded number of those refusing jobs offered to them by the Employment Service), and many workers were given employment in the public services. These steps reduced the number of work seekers and the rate of unemployment, and raised the number of part-time employees, which reduced the number of hours worked per employee.

The number of Israelis employed in 1998:III rose by about 38,000 (2 percent) from 1998:II, seasonally adjusted, with marked differences between industries: 31,000 found work in the public services, mainly in health and social welfare, and community services, while employment in education remained stable. In the business sector, on the other hand, 7,000 additional employees were taken on: the number in services (including business services, hotels and catering, commerce and transportation) rose, and in construction, manufacturing, banking, and agriculture, it fell. As employment increased, the average number of hours worked per week by Israelis fell in all industries to its lowest level for a long time (this is not apparent in Table 3 due to the rounding of the data), with the reduction among women greater than among men. Labor input of Israelis rose by 1 percent, all in the public sector.

The real wage per employee post went down gradually during the period reviewed because of the unexpected rise in prices, thereby offsetting part of its real rise in the first half of the year some of which was due to the unexpected fall in inflation. The average level of the real wage in the second half of the year remained above its level in the second half of 1997 in both the public and the private sectors (by 2.3 percent and 0.5 percent respectively). The new cost-of-living agreement signed in August granted a half percent increase, and as it was apparently expected that inflation would remain low till the end of the year, it was agreed that employees would receive an advance of only 0.25 percent in January 1999 (if the CPI rose by more than 2 percent from July to December 1998). There is an agreement in principle between the sides, however, that employees will be compensated during 1999 for that part of the existing agreement for which they have not received compensation; negotiations are currently underway on the extent of the compensation.

The real wage in manufacturing in the period reviewed was 4.6 percent higher than in the equivalent period in 1997, and it rose in public administration, education, agriculture, and commerce, too. It fell markedly in banking and financial services (by 8.75 percent), and in health and social welfare.

On September 9, 1998, a collective wage agreement for the public services was signed for 1998, granting a one-time payment of 30 percent of the basic wage. The wage tables were not changed, and the other claims of the General Federation of Labour (Histadrut) and the government were left open for discussion, with the understanding that no further organizational steps be taken till the end of 1998. For certain grades of employees the wage agreement for 1998 has not been signed yet, and the issue of compensation for 1997:IV, which was not covered by an agreement, is still to be discussed, too.

Immigrants' share of the labor force, which has followed an upward trend, reached 15.4 percent in 1998:III, its highest to date. Immigrants' rate of participation in the labor force (54.6 percent) and their unemployment rate (11 percent) remained high compared with those of the veteran population; their share of the number of employed persons increased to 15 percent, and their share of the unemployed, to 21 percent.

The number of valid labor permits for foreign workers, which fell at the beginning of 1998, rose gradually throughout the rest of the year, reaching about 80,000 in November, some 10,000 more than in November 1997. The number of workers from areas under the Palestinian Authority, Judea, and Samaria rose during the year, although the breakdown month by month is unknown.

The number of unemployed reached about 190,000 in 1998:III, seasonally adjusted, a fall of about 20,000 from the previous quarter. The characteristics of unemployment indicate a certain easing of the situation compared with 1998:II: the number of work seekers who had not worked during the previous 12 months declined by 12,000, the length of time to find a job fell, and the share of young people and single people among the unemployed rose. In 1998 the government decided on a number of steps to advance the integration of an additional 20,000 work seekers in the labor market. The number of training and vocational retraining courses for the unemployed will be increased, 16,000 additional places on training courses are being provided, and extra resources are being devoted to this area. Against this background, the rise in the number of employed persons registered as working part time was exceptional, and in 1998:III the number reached a level some 50,000 more than the average number in 1997. At the same time, the real rise in the business-sector wage recorded in the period reviewed, and the wage increases expected in 1999 (compensation already agreed upon in principle for the price rises in 1998, and wage agreements as yet unsigned) will make it even more difficult to absorb the unemployed in employment.

A comparison of the changes in employment by industry with the rise in the labor force shows that in 1998:III those industries defined as unskilled-labor-intensive contributed 12,000 to the number of unemployed; in contrast, the public services absorbed some 24,000 more new workers than the rise in the total labor force, and the high-tech industries some 8,000.

Trend data of the National Insurance Institute regarding claims for unemployment benefit indicate that in the period reviewed, the number of claims fell from month to month, with the number of ongoing claims falling, and a slower rate of increase of new claims compared with the first half of the year and with the second half of 1997. The data reveal that about half of those who receive unemployment benefit do so for the full period of their entitlement; every month about 2,500 receive unemployment benefit higher than the average wage in the economy; and in the last few years the increase in the number of recipients of unemployment benefit significantly exceeds the rise in the number of unemployed in the same period.


Figure 6. The labor market (thousands)
Figure 7. Real wage per employee post (NIS, 1995 prices)
 
 

Table 3. Indicators of Labor Market Developments, 1997-98
(seasonally adjusted)


1997
1998
July-Deca
*

1997
1998
IV
I
II
III
IV
1997
1998
('000s)
Civilian labor force 2,209 2,264 2,227 2,256 2,259 2,276
2.2 2.6 9
Israelis employed 2,039 2,065 2,055 2,061 2,048 2,086
0.6 2.4 9
   Business sectorb
1,446 1,446 1,448 1,435 1,435 1,467
0.2 0.4 9
   Public sectorb 594 620 606 621 613 627
3.4 6.6 9
Average hours worked
per employee
b

38 37 38 37 37 37
0.8 -2.9 12
Claims for
unemployment benefit
96 108 102 107 112 110 104 26.7 6.9 12
Work seekers 143 157 151 156 164 155 152 23.8 3.0 12
Real wage per employee post (NIS)c 4,387 4,494 4,437 4,503 4,527 4,514 4,431 2.7 1.7 10
   of which: Business sectorc
4,418 4,552 4,471 4,558 4,630 4,580 4,438 4.2 2.3 10
Unemployment rate (%) 7.7 8.8 7.7 8.6 9.3 8.4


9
*
Last month for which data are available.
a
Percent change compared with same period in preceding year.
b
Not seasonally adjusted.
c
1994=100.

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The Balance of Payments

The balance-of-payment current-account deficit in 1998:III reached $ 1.3 billion. Although this is higher than the deficit in 1997:III, the total deficit from January to September 1998 was significantly lower than those in the equivalent periods in 1997 and 1996. The financing of the deficit in 1998:II differed from that in 1997:III and 1996:III: the government's long-term loans changed into significant repayments; the share of imported private capital in the financing of the deficit rose despite the reduction in financial investments from abroad and despite the reversal in August of the direction of long-term-capital flows (see below).

In 1998, the trade deficit continued its downward trend, but it fluctuated and its composition changed. Nevertheless, after declining sharply in the first half of the year, the deficit rose by 10 percent in the period reviewed, and its monthly level (excluding defense imports, ships, aircraft, fuel, and diamonds, seasonally adjusted) was $ 385 million, up from $ 347 million in the first half of the year.

Goods exports (excluding diamonds) fell by 4 percent from 1998:II to 1998:III; two thirds of the decline derived from the reduction of exports to the European Union. The economic crises in countries in South East Asia were reflected in sharp swings in exports to them (a 16 percent drop in 1998:III, and a 22 percent surge in the last quarter).

The trend of goods exports during 1998 shows that their rate of increase declined gradually; they fell in 1998:III, and rose again in 1998:IV. Over the year as a whole, goods exports rose more slowly than in 1997 (by 7.3 percent compared with 9.5 percent), and in the period reviewed industrial exports-the main component of goods exports-were 2 percent lower than in the first half of the year, the result of the slowdown in the expansion of world trade. (Adjusting for the effect of price changes, the fall in the volume of exports in 1998:III was half a percent smaller than the fall in dollar terms.)

In 1998, the long-term structural change in the composition of industrial exports continued, with a relatively rapid increase in the human-capital-intensive industries, against a slow rise (or even an actual decline) in the exports of the traditional industries. However, whereas in the first half of the year the process accelerated, in the period reviewed it faltered, and in some human-capital-intensive industries the trend reversed (engines and electrical equipment, electronic components and computers, and machinery and equipment).

Diamond exports went down by 9 percent in the period reviewed compared with the first half of 1998, when they were lower than in below the previous half year. The decline (in both worked and unworked diamonds) was the outcome of the crises in countries in South East Asia, to which a large share of Israel's diamond exports are directed.

Total goods imports for the year did not change significantly, nor did their composition. Consumer goods imports remained stable in the period reviewed, while imports of intermediates, which provide an indication of current activity, fell in current dollar terms by 2 percent. On the other hand, imports of capital goods, indicating future activity, grew by 9 percent. Adjusting for the effect of price changes abroad, these imports were very volatile: the (??) nominal rise of 8.5 percent in capital goods in 1998:III becomes a 2 percent fall in volume terms; in contrast, imported intermediates change in the opposite direction, from a fall of 2 percent to a rise of 1.6 percent.

Private-capital flows reversed direction in the period reviewed, due to the shocks in the financial markets abroad, and inter alia against the background of the change in yield differentials between Israel and abroad. In the first half of 1998 private sector capital movements amounted to imports of $ 1.7 billion, turning into exports of $ 308 million in the period reviewed, mainly in September-November, when they totaled $ 1.1 billion. The exchange rate of the NIS against the currency basket rose by 2 percent at the beginning of August, and by another 3 percent at the end of the month, whereas for a long time it had generally been close to the lower limit of the exchange-rate band. In August the Bank of Israel cut the interest rate by 1.5 percentage points, and the slope of the lower limit of the band was reduced (these two steps act in opposite directions on the yield differentials between Israel and abroad). In addition, liberalization in May made it easier for the private sector to carry out transactions with abroad. It was still worthwhile to extend the potential flow of capital between Israel and overseas, and thereby to raise the premium on exchange-rate risk (which itself reduces the interest-rate gap between Israel and abroad). This was the background against which the financial crisis in Russia took place, and the financial shocks throughout the world which came in its wake; these raised the assessment of exchange-rate risk and the liquidity requirements of foreign investors. Thus, from August, nonresidents sold some of their financial investments in the stock exchange, Israelis increased their foreign-currency deposits, and foreign-currency credit fell sharply (from September net credit repayments amounted to $ 1.3 billion). The reversal of the direction of capital flow led to steep depreciation of the NIS in October, and it was only after the interest rate was raised in November (see below) that gradual appreciation occurred, continuing into the beginning of 1999.

Despite the turnaround in the flow of private capital, the Bank of Israel's foreign reserves grew by some $ 1.3 billion in the period reviewed, about one third of the increase being due to exchange-rate differentials which are not the result of capital movements. Exchange-rate differentials made a very large contribution to the growth of the reserves in the period reviewed, after making a negative contribution in the first half of 1998, and in 1996 and 1997.

On May 14, 1998, the foreign exchange control regime changed, and most constraints still in force on activities and transactions were removed. A broad permit was granted which allowed most transactions which required a permit, with a few restrictions on institutional investors and transactions in futures with nonresidents remaining in force. In order to complete the process and to ensure a proper information system which would enable timely reaction to exceptional movements in the market, by operating appropriate policy instruments, the Knesset passed an amendment to the law, which took effect on November 10, 1998. The amendment extended the authority of the Controller of Foreign Exchange to require a report on any activity or transaction covered by the permit, as a condition of its implementation. At the same time it also reinforces the secrecy obligation applying to Exchange Control staff according to which noone may reveal any knowledge or document he or she has received, unless the Governor considers it necessary for purposes of criminal charges.


Figure 8. Foreign trade ($million per month)

Table 4. Balance of Payments, Foreign Tradea, and the Reserves, 1997-98
($ milllion, current prices)


1997
1998
July-Deca
*

1997
1998
IV
I
II
III
IV
1997
1998
Monthly averages
Trade deficit 475 366 466 359 336 401 368 454 385 12
Goods imports 1,778 1,770 1,801 1,755 1,773 1,772 1,780 1,792 1,776 12
   Consumer goods 322 322 325 324 318 333 314 318 324 12
   Capital goods 385 378 373 350 376 373 414 395 394 12
   Intermediates 1,072 1,070 1,103 1,082 1,079 1,065 1,052 1,080 1,059 12
Goods exports 1,304 1,404 1,335 1,396 1,437 1,371 1,411 1,338 1,391 12
   of wich Industrial 1,234 1,333 1,267 1,331 1,365 1,295 1,342 1,269 1,318 12
Quarterly averages
Net current account -809 -772 96 -566 -444 -1,305
-773   9
Long- and medium-term
capital flows
1,299 894 573 2,028 348 306
2,433   9
   of which: Private sector 993 566 1,097 712 470 516
1,660   9
Short-term capital flowsb 1,284 124 -745 76 -327 622
-577   9
   of which: Private sectorb 1,296 146 -776 140 -362 660
-531   9
Net foreign debt (% of GNP) 18.20 19.05 18.20 19.18 18.99 19.05
28.75   9
End-period Bank of Israel reserves 20,332 22,675 20,332 21,603 21,322 21,715 22,675 19,190 21,955 12
*
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 Effect on Israel

The world financial crisis that began in the second half of 1997 was concentrated initially in South-East Asia, spreading to Russia in 1998, and to Brazil subsequently; it was accompanied by shifts in international capital flows and plummeting prices on major world stock markets. The global crisis also affected Israel: at first this was confined to foreign trade, but since August 1998, when turmoil erupted in Russia and persisted in Brazil, it was expressed in a sharp reduction in capital inflow,which became outflow in 1998:lV. The Russian crisis gave rise to a 150 percent devaluation of the rouble, default on the national debt, and the reluctance of the IMF to extend aid. This caused share prices to fall on world stock markets, so that risk assessments were raised and private investors in advanced economies displayed greater caution, leading to a reduction in the flow of private capital to the countries in crisis. At the same time, however, the flow of private capital to other emerging countries also contracted considerably (see diagram). Similar considerations on the part of financial investors and short-term borrowers in Israel also increased demand for foreign currency, so that there was steep local-currency depreciation, and the rapid action of the transmission mechanism (from depreciation to prices) led to an exceptional rise in the CPI, albeit with less intensity than might have been predicted on the basis of past experience.

The slowdown in the expansion of world trade-from 9.9 percent in 1997 to 3.3 percent in 1998-dampened Israel's GDP growth rate. According to estimates based on the Bank of Israel's macroeconomic model this, together with the decline in import and export prices, on the one hand, and the improvement in the terms of trade, on the other, was responsible for the reduction of GDP by almost one percent. The slowdown in the world inflation rate and the rapid decline in commodity prices also contributed to the moderation of Israel's inflation rate compared with the equivalent period in 1997.

The Euro, which is to replace the national currencies of eleven of the countries in the EU, was launched at the beginning of 1999. Although the currencies will be fully replaced only in another three years, since the beginning of 1999 the government bonds of those countries have been converted from their currencies into the Euro, and the financial returns of companies are given in Euros. The purpose of creating a new currency bloc is to enhance integration and increase the efficiency of the cross-border movement of goods. This will affect Israel's foreign trade in several ways. First, foreign-exchange fees between the countries using the Euro will be annulled, according a relative advantage to trade between those countries and damaging Israeli companies trading with them. On the other hand, greater prosperity and efficiency in the Euro-bloc countries will increase the general demand for goods there, including those produced by Israel, and currency unification will reduce exporters' foreign-exchange costs.

On January 4, 1999 the Bank of Israel began publishing the representative rate of the NIS against the Euro (until the year 2001 it will also continue to publish representative rates for the currencies of the countries in the EU). Concurrently, the composition of the currencies comprising the currency basket was changed, with the Euro replacing the DM and the French franc. For the purpose of the currency basket, the Euro is calculated according to the weights of those two currencies, on the basis of the appropriate conversion coefficients published by the European Central Bank, and the units now comprising the currency basket are: dollar, 0.67; Euro, 0.23; sterling, 0.06; yen, 6.5 (changes in the composition of the currencies are made after a year, in coordination with the Ministry of Finance, after reassessing the composition of Israel's trade). During 1998 the dollar weakened against the currencies of most of Israel's trading partners, and especially against the yen-by 12 percent altogether, and by some 23 percent in the period reviewed.

Table 5. Indicators of Economic Development in Advanced and Developing Countriesa, and Forecast for 1999


1996 1997 Estimate
1998
Forecast
1999
Annual rate of changeb
World GDP
   Total 4.3 4.2 2.2 2.2
   Advanced countries 3.2 3.2 2.0 1.6
   Developing countries 6.5 5.7 2.8 3.5
World trade
   Total 7.0 9.9 3.3 4.4
   Advanced countries
      Imports 6.5 9.2 4.6 4.6
      Exports 6.3 10.4 3.3 3.7
   Developing countries
      Imports 9.5 10.4 -0.7 5.7
      Exports 8.7 11.3 2.9 5.4
Inflation (CPI) </TD<
   Advanced countries 2.4 2.1 1.6 1.6
   Developing countries 14.1 9.2 10.2 8.4
Commodity prices
   Fuel 18.4 -5.4 -30.5 8.4
   Nonfuel -1.2 -3.3 -15.6 -0.6
Short-term interestc (%)
   Dollar deposits 5.6 5.9 5.5 5.1
   Yen deposits 0.7 0.7 0.7 0.5
   DM deposits 3.3 3.4 3.7  
Unemployment rate
   OECD countries 7.5 7.2 7.1 7.0
a
According to "World Economic Outlook", Israel is classified as an advanced economy.
b
Apart from interest and unemployment rates, which are shown as percentages.
c
3-month LIBOR rate.
SOURSE: "World Economic Outlook", (IMF, December 1998) and OECD "Economic Outlook".


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Prices

The steep depreciation of the shekel that began in mid-August, was passed on to prices directly because of the transmission mechanism and the effect of depreciation on the index of housing prices in the CPI, causing the rate of price increases to accelerate between September and November. Thus, during the period reviewed prices rose by 6.3 percent, compared with 1.9 percent in the same period in 1997. Price indices adjusted for seasonal effects evinced a similar pattern, with a marked rise in the retail price index (especially in 1998:lV), which in the past few years has risen more moderately than the CPI. The acceleration of price increases encompassed all the principal components of the CPI. Inflation expectations (both as derived from the capital market and on the basis of the Bank of Israel's survey of companies) also rose; in December, following a sharp interest-rate hike by the Bank of Israel, the rate of price increases slowed notably and inflation expectations fell.

Following the price increases in the period reviewed, the CPI rose by 8.6 percent for the year, remaining within the 7-10 percent inflation target range. Although several indicators point to a gradual return to the 4 percent inflation environment, it is still too early to tell whether this environment has indeed been fully established. On the one hand, the decline in actual and expected inflation, the low growth of economic activity, and the recent depreciation indicate that this environment is below its level in the period reviewed and in the year as a whole. On the other hand, the factors which could preclude the attainment of this environment include economic uncertainty in the context of the approaching general elections and in particular the attendant fiscal uncertainty, the persisting turmoil in international financial markets, and the wage agreements that have yet to be concluded.

The depreciation of the shekel against the dollar and the currency basket that had begun in August (after the crisis in Russia) accelerated in the subsequent two months, and slowed markedly in the rest of the year. In the period reviewed the rate at which the shekel appreciated against the currency basket was more than twice as fast as the rate at which the CPI and the retail price index rose, and the increase in the prices of tradable goods included in the CPI outstripped that of nontradables. All these are indications of real local-currency depreciation, after a long period of real appreciation. Nonetheless, these indications are not so clear-cut for the year as a whole. Local-currency depreciation exceeded the rise in the CPI, (but retail prices, and prices of both tradables and nontradables rose at similar rates, and all that can be said is that the trend of real appreciation moderated.

Prices of all the principal CPI components (excluding clothing and footwear) rose by more than 5 percent in the period reviewed, with prices of fruit and vegetables rising by double this rate. Because of the large weight of the housing index in the CPI, and because it is calculated taking the exchange rate into consideration, it made the greatest contribution to the rise in the CPI -some 1.3 percentage points. In January the Central Bureau of Statistics will change the method of calculating housing prices in the CPI.
 


 
Table 6. Selected Price Indicies, 1997-98
(annual rates of change during period, percent)


1997
1998
July-Dec
*

1997
1998
IV
I
II
III
IV
1997
1998
CPI 7.0 8.6 2.4 0.3 8.9 7.4 18.8 3.9 12.9 12
CPI excl. housing, fruit and vegetables 6.7 8.5 4.8 -0.5 10.0 2.2 23.8 5.0 12.5 12
CPI excl. housing, fruit and vegetables, controlled goods, clothing & footwear 7.8 8.8 2.7 3.0 4.4 6.1 22.6 6.7 14.1 12
Index of housing prices 7.5 8.8 -1.9 5.1 3.9 13.1 13.4 2.8 13.3 12
Wholesale price index 5.9 8.2 2.5 -0.6 4.1 0.6 31.7 5.1 15.1 12
NIS/$ exchange rate 7.9 18.2 3.1 6.0 9.0 21.2 39.2 4.8 29.9 12
NIS/currency-busket rate
3.7 20.6 3.6 3.6 8.9 28.7 45.8 2.3 37.0 12
*
Last month for which data are available.

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The Public Sector

Public consumption declined by 4,2 percent (seasonally adjusted and at constant prices) in 1998:lll, after rising in the first half of the year, and in real terms it was 2 percent above its average level in 1997 as a whole as well as in each quarter. Public-sector employment rose markedly in 1998:lll, as did transfer payments; infrastructure investment fell in comparison with the equivalent quarter in 1997, however, (although road-building increased). Although the decline in infrastructure investment (not seasonally adjusted) made it easier to adhere to the budget framework, it essentially limited the budget's positive contribution to future economic growth.

According to the Accountant-General's estimate, based mainly on cash data, the 1998 deficit target (2.4 percent of GDP, on the basis of the total deficit) has been attained. However, the budget did not develop entirely as planned, and the assessment is that there was no further fiscal restraint. On the one hand, there was a marked deviation from the domestic deficit (it was exceeded by NIS 3.8 billion), while on the other, there was a similar surplus in activities abroad. A comparison of the planned and actual execution of the various items shows that domestic expenditure was in accordance with its planned levels, while domestic income fell short of these (because the economic slowdown was more marked than had been assumed when the budget was planned and the intended intensification of tax-collection was not achieved). A comparison of the foreign budget items shows that interest and capital gains revenues from the realization of the Bank of Israel's foreign-exchange reserves surpassed their planned levels. This was because profit amounted to NIS 3.9 billion, compared with a forecast NIS 1.6 billion, interest payments to abroad were lower than expected, and also because of cross rates (which inter alia affected the revaluation of the US government loan received in November), as well as because of other factors.

The deficit of the public sector (comprising the government, the Bank of Israel, and the Jewish Agency) amounted to 5.4 percent of GDP in the period reviewed, compared with 4.7 percent of GDP in the same period in 1997, alongside a change in the composition of its financing. Whereas in 1997 domestic capital borrowing was negligible and financing was based entirely on the Bank of Israel's injection and a change in the monetary base, in the period reviewed most of the financing was in the form of borrowing from the public, and in 1998:lV, in the wake of the rapid local-currency depreciation, the government enlarged the share of dollar-indexed bonds in its net borrowing (thereby easing the pressure on the exchange rate). The government also sold assets, and in December received NIS 1.2 billion following the privatization of Israel Chemicals Ltd.

Tax receipts were 1.9 percent higher in real terms in the period reviewed than in the same period in 1997; this slow rise is the result of the real 3.3 percent increase in direct taxes due to the rise in real wages, as well as of the stability of import taxes and indirect taxes on domestic production-reflecting the absence of change in merchandise imports and the economic slowdown in Israel. On the other hand, in July-November 1998 transfer payments to households rose by a real 7.2 percent, surpassing the rise in real wages, but because of the rapid rate of price increases during the period reviewed they rose more slowly in real terms in the second half of the year than in the first. National Insurance Institute income support and unemployment benefit payments rose particularly steeply (by 22.6 and 10 percent respectively).
 

Figure 9. Government cash flows (NIS million, monthly average)
 
Table 7. The Budget and its Financing, 1997-98
(cash flows, as percent of GDP)


1997
1998
July-Dec
*

1997
1998
IV
I
II
III
IV
1997
1998
1. Government domestic expenditure 39.7 39.3 41.4 40.4 36.7 37.9 42.2 40.2 40.1 12
2. Government receipts 36.8 36.0 34.6 38.9 35.1 36.0 34.4 36.0 35.2 12
3. Domestic budget deficit (1)-(2) -2.9 -3.3 -6.8 -1.5 -1.7 -1.9 -7.8 -4.2 -4.9 12
4. Public-sector domestic deficita  (5)+(6) 3.3 3.7 7.2 1.4 2.2 2.7 8.1 4.7 5.4 12
5. Government net borrowing from the public 2.3 2.8 -1.0 1.4 1.5 2.6 5.4 0.2 4.0 12
6. Public-sector injection (9)-(8)-(7) 1.0 0.9 8.2 0.0 0.7 0.1 2.7 4.5 1.4 12
   7. Bank of Israel injection
-6.7 -1.1 -4.0 -3.1 0.1 2.6 -4.0 -2.2 -0.7 12
   8. Private-sector foreign-currency conversions 6.7 0.3 0.0 1.7 -0.1 -0.2 -0.1 -0.1 -0.2 12
   9. Change in monetary base
1.1 0.1 4.2 -1.4 0.6 2.5 -1.4 2.2 0.5 12
* 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

From the beginning of 1998 the Bank of Israel lowered the interest rate each month (by between 0.3 and 0.5 percentage points), reducing it from a nominal 14 percent at the end of 1997 to 11 percent in August 1998. On 6 August three steps were taken: the inflation target for 1999 was set at 4 percent, the slope of the lower limit of the exchange-rate band was reduced from 4 to 2 percent, and the interest rate was cut by 1.5 percentage points. The backdrop to the gradual reduction of the Bank of Israel's key interest rate until August was the evidence of a decline in the inflation environment. Because of the desire to bolster this achievement while refraining from unduly reducing the yield spread vis-?-vis abroad, the interest rate was reduced more slowly than the rate at which price increases and inflation expectations slowed, so that the expected real interest rate rose until August, to stand at 7 percent compared with 5 percent in 1997. The reduction of the Bank of Israel's interest rate in August to less than 10 percent was reflected by the decline in the real interest rate (deflated by inflation expectations). This policy was considered to be necessary in order to buttress the reduction of the inflation environment-given the economic slowdown, the inflation target for 1999, and the reduction of the slope of the exchange-rate band-as well as to maintain stability.

The local-currency depreciation that resulted from the turmoil on international financial markets led to the acceleration of price increases and inflation expectations, so that the real interest rate fell. The global crisis and the narrowing of the yield gap led to the reversal of capital flows in September; this trend was exacerbated in October, with the sharp shekel depreciation, bringing in its wake a steep rise in inflation expectations and prices, so that on 26 October the Bank of Israel announced that within the framework of the monetary program for November the interest rate would be raised by 2 percentage points. Since the first announcement of an interest-rate hike did not lead to a significant drop in inflation expectations, it was feared that the price increases would be translated into a higher inflation environment, and so the interest rate was raised further two weeks later. This exceptional step did in fact lead to an immediate additional decline in inflation expectations; the interest-rate spread between Israel and abroad widened (inter alia because of a modest reduction of interest rates abroad), inflow of private capital (which is sensitive to interest-rate changes) increased, and local-currency appreciation began, persisting at the beginning of 1999, too.

An analysis of categories of private-sector capital flows by their sensitivity to interest-rate spreads shows that the trend reversal encompassed all the categories. However, developments changed at the beginning in November, when the Bank of Israel raised the interest rate. Thus, in categories that are less sensitive to interest-rate spreads there was extensive capital outflow (a marked rise in residents' foreign-currency deposits), while in those that are more sensitive capital outflow stopped in November, becoming extensive capital inflow in December (particularly of short-term credit from Israeli banks-$ 360 million). Capital flows of nonresidents also changed notably in the period reviewed: between August and October there was extensive realization of investments in the Tel Aviv Stock Exchange by nonresidents (with capital outflow of $ 300 million in 1998:lll, representing some 15 percent of foreign-owned shares not held by parties at interest). In the last two months of the year, partly as a result of the privatization process, investments of nonresidents rose.

The turbulence on the financial and capital markets in the period reviewed was also evinced by the differing trends of the monetary and credit aggregates in each quarter. After its increase slowed to 9 percent in the first half of the year, the narrow money supply rose steeply from July, then declined in November-December, after the interest rate was raised. The increase in inflation expectations should have led to a reduction in the real money held by the public, but seasonal factors (public-sector wage increments in July and September) partly explain this. M2, which incorporates unindexed liquid assets, rose in 1998:lll at the same rate as in the first half of the year, but this increase slowed markedly in 1998:lV because of uncertainty regarding the rate of price increases, expressed in the lower share of long-term deposits (up to one year). Nondirected bank credit increased notably in 1998lV, alongside a rise in the share of credit in and indexed to foreign currency, while deposits in and indexed to foreign currency also rose.

In the capital market, at the end of the period reviewed the general share-price index stood at a level that was 5 percent lower (in nominal terms) than at the beginning, after fluctuating widely during the period. In October the share-price index fell to its lowest level during the year, then began to recover slowly until the end of the year. The plunge in October was due inter alia to the exit of foreign investors from the stock market, and was similar to the drop in world stock markets. The falls in the share-price index should be viewed in the context of the global financial crisis and rise in inflation expectations, as well as of the continued low profitability of most industries. The stock market rallied in November and December-concurrent with the recovery of world stock markets in the west and most emerging economies-albeit less sharply.
 

Figure 10. Monetary aggregates and credit (change in prev. 12 months)
Figure 11. Nondirected bank credit (NIS million per month)
Figure 12. The sheqel exchange rate against the currency basket


Table 8. Monetary Indicators and Nondirected Bank Credit, 1997-98
(annual terms, percent)


1997
1998
July-Dec
*

1997
1998
IV
I
II
III
IV
1997
1998
Rates of change Average
Compared with preceding quarter
During perod
M1a
14.3 11.6 -1.3 5.3 17.2 27.6 20.0 5.2 23.43 11
M2b 25.8 21.9 25.0 31.3 13.0 26.9 6.0 24.2 13.5 11
M3c 25.3 21.2 20.9 28.6 15.7 21.9 25.6 22.6 23.9 11
Nondirected bank credit 18.2 15.0 13.2 9.9 18.5 15.8 40.3 15.7 27.7 11
   Unindexed local-currency 8.6 15.4 24.0 10.8 21.6 18.4 28.8 18.9 23.6 11
   CPI-indexed 19.0 13.0 18.5 8.8 10.9 15.5 21.9 20.0 18.3 11
   Foreign-currency indexed & denominated 32.3 17.0 -4.8 10.2 25.0 12.8 85.8 6.5 46.4 11
*
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 13. Yield on Treasury bills (end-period figures)
Figure 14. Flows of private capital to emerging economies ($ bill.)

Table 9. Interest Rates, Yields, and the Share-Price Index, 1997-98


1997
1998
July-Dec
*

1997
1998
IV
I
II
III
IV
1997
1998
Nominal interest
Nondirected local-currency credit 18.7 16.1 18.2 17.7 16.4 14.5 15.5 18.1 14.9 11
Average monetary loan 14.3 12.0 14.1 13.5 12.2 10.4 12.1 13.9 11.2 12
SROs 12.2 10.1 12.0 11.5 10.3 8.7 9.6 11.7 9.1 11
3-month Eurodollar 5.6 5.4 5.7 5.5 5.6 5.5 5.1 5.7 5.3 12
Yield to maturity on
Treasury bills 14.1 12.3 14.1 13.4 12.2 10.5 13.0 13.8 11.8 12
10-year bonds 4.0 4.8 3.9 4.7 4.9 4.8 4.9 3.8 4.9 12
5-year bonds 3.9 5.0 4.0 5.0 5.4 4.9 4.6 3.8 4.7 12
General share-price index (points) 129.2 137.5 133.1 131.5 146.4 136.8 135.1 136.3 136.0 12
*
Last month for which data available.