Recent Economic Developments, 86

01/05/1999
All Press Releases In Subject:
The Economy and Economic Activity
Recent Economic Developments, 86, October 1998 - March 1999


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



Previous Economic Developments 85


Main Developments

The most prominent development in the period between October 1998 and March 1999 (the period reviewed) was the return to a low inflation environment, which appears to be consistent with the 4 percent inflation target for 1999. The CPI accelerated sharply in September-October 1998, in the wake of the marked local-currency depreciation of August-October 1998, then began to decline in 1999:l. This was due primarily to the response of monetary policy in November to the sharp local-currency depreciation and the rise in the inflation environment and expectations at the beginning of the period reviewed. Alongside these developments, the trends that had emerged in the preceding year were consolidated: economic activity remained below its potential long-term level, and the continued recession was expressed in the decline in per capita GDP and the rise in the unemployment rate. Another prominent feature arising from Israel's foreign-trade figures (measured in current dollars) for 1999:l is the fall in exports, especially manufacturing exports (including those of high-tech industries, such as machinery and equipment and electronic components). This seems to be a result of the global slowdown in economic activity and trade. Imports stabilized, so that the trade deficit widened, in contrast with the trend prevailing since the beginning of 1997.

At the end of the period reviewed, after world financial markets had settled to some extent, nonresidents appeared to return to portfolio investment in Israel, with increased capital inflow after outflow at the beginning of the period reviewed (especially in October 1998), alongside notable rallies on the stock market. Despite the shocks to the global economy, Israel has not experienced a crisis, primarily due to the response of interest-rate policy, the non-intervention in the foreign-exchange market, the adherence to fiscal discipline, and the economic situation, particularly the marked improvement in the balance of payments in the last two years.

The factors explaining the low level of demand (principally domestic demand) in the period reviewed were also in evidence throughout 1998 (see Bank of Israel Annual Report, 1998). The most salient of them are the continued adherence to tight monetary and fiscal policy, slowing of global trade, waning effect of the influx of immigrants which caused residential construction investment to decline, and political-security uncertainty. Uncertainty intensified in the period reviewed, as the general elections were brought forward to May 1999, and there was a delay in approving the budget (which was passed only in February 1999), causing the implementation of some government plans to be deferred.

According to National Accounts data on use of resources, the level of demand fell in 1998:lV, in line with the trend evident throughout the year. Thus, compared with the equivalent period in 1997-98, investment (mainly in buildings and inventory) declined, and private and public consumption rose slightly. Imports of goods and services continued to increase mildly. According to the various indicators of economic activity, this remained moderate in the period reviewed, and may even have slowed further.

Economic developments during the period reviewed support the attainment of the 1999 inflation target provided that fiscal and monetary discipline is maintained, the foreign-exchange market remains stable, and nominal wages continue to rise moderately. On the other hand, assessments of price rises in the coming twelve months indicate that the inflation environment is above the 1999 target of 4 percent. At the beginning of the period reviewed (especially since October 1998) the rate at which the CPI rose accelerated (to 4.4 percent at the beginning of 1998:lV), in response to the sharp local-currency depreciation in October (there was significant but less steep depreciation in mid-August). The price increase was expressed in all the indices, and inflation expectations rose concurrently.

Following two substantial interest-rate hikes by the Bank of Israel at the end of October and in mid-November-while adhering to the strategy of not intervening directly and continuously in the foreign-exchange market-inflation expectations plummeted (whether derived from the capital market, assessed by forecasters, or reflected in the Bank of Israel's Survey of Companies), the rate at which the CPI rose moderated significantly and was low or even negative in December-March, and there was local-currency appreciation (vis-a-vis the dollar and the currency basket). As in the previous episode (of price rises at the beginning of the period reviewed), prices fell in most of the principal CPI items, as did the adjusted CPI and the index of wholesale prices.

The declining trend of the current-account deficit persisted in 1998 alongside the continued rise in exports, thereby contributing to the ongoing improvement in the terms of trade; this acted to offset the negative effect on exports of the global slowing of world trade. Data on the trade deficit since the beginning of 1999 indicate that the trend has reversed, however, i.e., there is a deterioration, due to both a marked drop in exports and stabilization of imports. The most marked development in exports is the decline in manufacturing exports in 1999:l (compared with 1998:l), especially of the high-tech industries. In 1998:lV the terms of trade deteriorated by 0.7 percent over 1998:lll (import prices rose by 1.6 percent, and export prices by only 0.8 percent). Data from the Bank of Israel's Foreign Exchange Control Department show that the high level of foreign direct investment in Israel continued during the period reviewed, and amounted to $ 1.1 billion. The extent of foreign-currency credit extended to residents began to rise again in 1999:l. This was due inter alia to the wider interest-rate differential (vis-a-vis abroad) at the end of 1998 and the tranquillity on the international financial markets after the crises they had experienced during most of 1998. The sharp rises in the exchange rate of the NIS against the currency basket were partly reversed, and its volatility declined.

According to the various labor-market indicators, the slump that has been evident in it for a long time persisted. During the period reviewed government involvement intensified in an effort to reduce (measured) unemployment, both by increasing public-services employment and by intensifying attempts to get workseekers to participate in vocational and retraining courses. In addition, measures were introduced to prevent the workshy from exploiting the system. All of these caused the number of workseekers to stabilize, along with a slight increase in the number of persons requesting unemployment benefit, after this had dipped in 1998:lV. According to the January unemployment figures, however, this has risen slightly, after declining in the second half of 1998.

At the end of March 1999 an agreement in principle was reached between the Ministry of Finance and the Histadrut (General Federation of Labor) regarding the wage accords for 1997-98, which applies to civil-service employees. The agreement states that employees will receive a wage-increment of 4.6 percent for 1998 (incorporating a 1.6 percent increase paid as a nonrecurring payment in October 1998), and another 0.2 percent as a wage-increment for 1997:lV. The Histadrut undertook to refrain from taking organizational measures until the beginning of October 1999.

From the framework agreement it can be inferred that if prices rise in line with the inflation target, the real average wage in the public services can be expected to rise moderately in 1999, but only provided that the cost level determined in the agreement is maintained when it comes to converting it into specific agreements for individual grades and pay scales. No accord has yet been reached regarding the wage agreement for 1999 and the calculation of wage drift for the year.

Data on the domestic deficit (excluding net credit extended) for 1999:l indicate that the planned level has been exceeded on both the expenditure and the income sides. The 1999 National Budget, which was approved after a delay (only in February 1999), adheres to the deficit target (for 1999) set in the Budget Deficit Reduction Law and does not include a tax hike. But the budget is extremely tight, and if current trends persist without any corrective measures there is a great danger that its limits will not be observed.

As stated, monetary policy served to enable the return to a low inflation environment consistent with the 4 percent target for 1999, after inflation expectations, and actual prices, had risen in the wake of the rapid depreciation of August-October 1998. Consequently, the Bank of Israel raised the interest rate for November by a relatively high 4 percentage points, in two coterminous stages (at end-October and mid-November) of 2 percentage points each. As a result of this extreme measure, inflation expectations fell rapidly, the interest-rate differential between Israel and abroad widened, capital inflow increased, the real interest rate rose, and the NIS appreciated gradually-a trend that continued and even intensified in 1999:l. In the context of the development of the other fundamentals, the monetary policy response and policy of non-intervention in the foreign-exchange market helped to avert an economic crisis in Israel like those that emerged in many countries during the period reviewed. In view of the tight policy, actual price indices declined and the economy reverted to a low inflation environment that increases the probability that the 1999 inflation target will be attained. All these enabled the Bank of Israel to reduce the interest rate at the end of February and the end of March, by half a percentage point each time.

During the period reviewed the various stock market indices rose steeply. The general share-price index was 20 percent higher (in nominal terms) at the end of the period than at the beginning. Most of the increase occurred in February and March, after marked falls in October. The surge in Israel's stock market was con-current with the rally on western stock markets and those of most emerging economies. The cessation of sales of portfolio investments by foreign investors was particularly marked, as this has characterized the market since the crisis in Russia last August, and these investments even increased at the end of the period reviewed.
 

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, 1997-99
(all data, excluding construction are seasonally adjusted)


1998
1999
Oct-Mara
*

1997
1998
I
II
III
IV
I
1998
1999
Rates of change (annual average, percent), compared with preceding quarter
State-of-the-economy
index

4.9 2.7 7.2 2.8 1.4 -0.5 -1.0 4.6 -0.7 2
Large-scale retail trade 7.8 6.6 10.4 10.7 -3.0 1.9 7.0 8.1 4.1 2
Manufacturing production (excl. diamonds) 1.9 2.9 8.0 1.7 1.9 1.8 -5.7 1.3 3.5 1
Business-sector consumption
of electricity
4.4 2.6 8.4 57.5 -26.3 7.3   -1.8 7.8 12
Index of revenue
in commerce
4.4 1.8 -1.9 4.8 -1.2 -0.8 7.4 5.3 0.6 1
Index of total revenue 4.6 2.3 0.1 3.1 -0.9 7.0 -8.4 6.3 1.8 1
Rates of change (percent), compared with preceding quarter
Tourist arrivals -6.0 -4.7 -7.9 18.6 -4.9 -2.7 3.9 -9.1 4.2 2
Immigrant arrivals -5.4 -15.4 -32.7 -8.9 21.7 14.4   -1.7 -14.6 12
Residential starts -9.9 -21.2 -0.2 -16.3 14.5 5.7   -13.2 1.0 12
of which:
 Public sector
-18.0 -44.4 -10.6 -41.0 10.0 -20.6   -30.4 -53.9 12
Residential completions 21.7 -21.6 -31.3 16.3 -10.4 -12.9   19.2 -37.6 12
of which:
 Government-initiated
36.4 -22.7 -24.5 40.2 -9.7 -26.2   -4.7 -29.4 12
Survey of companies (percent)b
Product of manufacturing
firms (not adjusted)
-3c -8c -13 -10 -6 -1c -6c

3
Product of manufacturing
firms (adjusted)
-3c -8c -7 -8 -13 -3c 1c

3
Sales by commercial
firms (not adjusted)
-12c -13c -22 -14c 13c -28 4c

3
Sales by commercial
firms (adjusted)
-12c -13c -22 -5c 11c -15c 8c

3
*
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

The recession continued in 1998, expressed in a decline in per capita GDP and additional rise in the unemployment rate. The moderation of domestic demand was sharper than that of supply, so that pressure was created for real depreciation, which occurred at the end of 1998. On the sources side, the slower growth of business-sector product persisted; this rose by 1.8 percent, and by only 0.6 percent in the second half of the year1. Imports of goods and services also increased by a moderate 2.1 percent.

A review of the use of resources side in the National Accounts for 1998 shows that domestic uses rose by only 0.7 percent; gross domestic investment fell by 7.6 percent, expressing a steep drop in investment in construction and transport vehicles, as well as inventory reduction. Private consumption rose by a moderate 3.3 percent, and domestic public consumption by 1.8 percent. The increase in goods and services exports slowed to 6 percent in 1998, compared with 7.6 percent in 1997, alongside a marked rise in services exports (excluding tourism services, which continued to fall). The slowdown in the growth rate of exports was more moderate than in world trade, because exports were diverted from non-traditional markets to Europe and because of the continuous improvement in the terms of trade since 1996.

Replies from firms participating in the Bank of Israel's Survey of Companies indicate that the recession persisted in 1999:l. Companies reported a fall in economic activity in all the principal industries excluding commerce and communications. The decline in activity was particularly notable in construction and its allied industries. The Survey also shows that, as in previous quarters, the main reason for the decline in activity was slack domestic demand. Manufacturing companies reported a (slight) dip in exports, compared with a rise in previous quarters.

According to most of the indicators in Table 1, economic activity continued to be moderate in the period reviewed, and this trend may even have intensified. The State-of-the-Economy Index fell by 0.7 percent in this period, compared with the equivalent period in 1997-98. The large-scale retail index and the index of revenue rose more slowly than in the equivalent period in 1997-98. The index of manufacturing production, on the other hand, was higher (3.5 percent) than in the equivalent period in 1997-98, even though most of the rise occurred in 1998:lV. The indices of manufacturing show that the rising trend in unit labor output was checked during the period reviewed (labor productivity remained unchanged) alongside stagnation in both the activity measured by the index of manufacturing output and the number of hours worked. According to an analysis of two-digit industries, manufacture of chemicals and transport vehicles was higher in 1998:lV than in 1998:lll, while that of electronics equipment and textiles and clothing dipped.

Indicators of construction activity continue to point to a decline, expressed in a low level of starts and completions, especially with regard to those initiated by the government. However, the rapid local-currency depreciation that began in October 1998, expressed in the decline in dollar terms of prices of new and second-hand apartments, and the change introduced at the beginning of 1999 in the mortgage arrangement, caused the number of mortgage-takers to rise, and apartment purchases soared in 1998:lV (when a monthly average of 1,650 apartments were sold throughout Israel, compared with a monthly average of 1, 130 in the first three quarters). Preliminary data from the beginning of 1999 point to a renewed decline in apartment sales and mortgages taken, similar to the situation that prevailed for most of 1998. Tourist arrivals were up in the period reviewed over the equivalent period in 1997-98, but since the beginning of 1999 they have been declining.

1 Because of the diificulty of making seasonal adjustments to stock, an accurate picture of the extent of business-sector product in 1998 can be obtained only from six-monthly data, and not from quarterly data.
 

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

Table 2. National Accounts, 1997-99
(seasonally adjusted)


1998
1999
Oct-Mara
*

1997
1998
I
II
III
IV
I
1998
1999
Rates of change (average annual rates, percent, constant prices), compared with preceding quarter
GDP 2.7 2.0 0.6 4.4 0.9 -0.1
2.7 2.8 12
Business-sector product 2.6 1.8 0.5 4.5 -0.2 -1.8
2.8 0.7 12
Private consumption 4.1 3.3 2.8 7.4 3.5 -0.1
4.7 3.4 12
Gross domestic investment -6.1 -7.6 -32.6 -34.3 35.0 11.1
1.6 -9.7 12
Goods and services exports 7.6 6.0 8.8 26.1 -13.9 6.2
3.9 3.0 12
Goods and services imports 2.8 2.1 -5.3 13.2 -6.7 12.6
3.9 3.0 12
Public-sector product
1.9 2.3 6.2 4.7 -3.6 1.6
0.3 2.1 12
*
a
Last month for which data available.
Compared with same period in preceding year.

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The Labor Market

The unemployment rate rose from an annual average of 7.7 percent in 1997 to 8.6 percent in 1998. This rise was due mainly to the moderation of the rise in the demand for labor as a result of the recession, while the civilian labor force continued to expand at a rate similar to that of 1997. The unemployment rate understates the slump in real business-sector activity, as it is offset by the steep 6 percent rise in public-services employment in 1998 (most of it in the second half of the year). The principal contribution to the rise in the unemployment rate came from construction and its allied industries, although unemployment was also high among persons with a low level of schooling (up to 10 years). In the composition of employment some stabilization of the share of foreign workers and rise in that of those from the Autonomy and the administered areas can be discerned. Note the decline in the average number of hours worked per employee in the business sector, reflecting the increased share of persons in part-time work (principally in 1998:lV). This constitutes another indication of the depth of unemployment, as many employers first reduce the number of hours worked before dismissing employees. Despite the higher unemployment rate, the real wage per employee post continued to rise in 1998, by an average of 2.4 percent (by 3.2 percent in the business sector), and unit labor cost in the business sector dipped by 0.2 percent. These developments might be explained by the fact that the wage agreements, which are signed for periods a year or two and set nominal wage levels, assumed a higher rate of inflation than actually transpired in the first eight months of 1998, so that the real wage rose more than planned during that period. Price increases in September-November 1998 offset the rise in the real wage (in 1998:lV the real wage per employee post fell by 0.3 percent against 1997:lV, and declined slightly again in January 1999).

Preliminary labor-market data for 1999 indicate a rise in the unemployment rate (as measured from the monthly trend data to January) and a slight increase in the number of requests for unemployment benefit. The number of workseekers stabilized in 1999:l, to stand at 154,000 in March. This stabilization is connected with the measures introduced by the government, especially directing unemployed persons to vocational and retraining courses, as well as steps to prevent the workshy from exploiting the system.

Demand for labor by the business-sector companies surveyed by the Ministry of Finance was lower in 1998:lV than in 1998:lll, and this decline encompassed all the principal industries excluding financial services. The lower demand for labor was evident in all the major firms, after remaining stable in previous quarters.

On March 29, 1999, after a strike lasting a few days, an agreement was reached in principle regarding the wage accords between the Histadrut and the Ministry of Finance for 1997-98, applying to civil-service employees who are members of the Histadrut (physicians, teachers, and others are not part of this agreement). Under this agreement, employees will receive a wage-increment of 4.6 percent (incorporating a 1.6 percent increase as a nonrecurring payment made in October 1998), and another 0.2 percent for 1997:lV. The increment for 1997 will be paid retroactive to January 1, 1998, and the increment for 1998 will be paid retroactive to January 1, 1999. The agreement also stipulates that for employees receiving the minimum wage the increment will not be considered part of their wage, so that their income support payments will not be deducted (and they will thus receive an additional increment over and above the 6.4 percent hike in the minimum wage made in April 1999). The Histadrut for its part undertook to refrain from organizational measures until October 15, 1999, but no settlement was made regarding the 1999 wage agreement or the method of calculating the wage drift for the year.


 

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

Table 3. Indicators of Labor Market Developments, 1997-99
(seasonally adjusted)


1998
1999
Oct-Mara
*

1997
1998
I
II
III
IV
I
1998
1999
('000s)
Civilian labor force 2,210 2,272 2,258 2,256 2,278 2,296
2.4 3.1 12
Israelis employed 2,041 2,076 2,064 2,045 2,089 2,108
1.8 2.6 12
   Business sectorb
1,446 1,448 1,435 1,435 1,467 1,456
1.3 0.6 12
   Public sectorb 594 628 621 613 627 652
3.1 7.6 12
Average hours worked
per employee
b

38 37 37 37 37 37
-1.8 -0.3 12
Claims for
unemployment benefit
96 108 107 111 110 105 108 22.5 1.2 3
Work seekers 143 157 156 164 155 152 155 20.5 0.9 2
Real wage per employee post (NIS)c 4,377 4,499 4,514 4,525 4,508 4,447 4,459 2.3 -0.5 1
   of which: Business sectorc
4,419 4,557 4,554 4,620 4,577 4,476 4,459 3.5 0.1 1
Unemployment rate (%) 7.7 8.6 8.6 9.3 8.3 8.2


12
*
Last month for which data are available.
a
Percent change compared with same period in preceding year.
b
Not seasonally adjusted.
c
At January 1995 prices.

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The Balance of Payments

The improvement in the balance-of-payment current-account deficit was maintained in 1998, with the deficit declining to $ 2.3 billion, down from $ 4.9 billion in 1997 (according to the new definition-see Box 1.1 in the Bank of Israel Annual Report, 1998). Imports declined, and goods exports (excluding diamonds) continued rising, and those of services increased even faster. This process were abetted by the ongoing (since 1996) improvement in the terms of trade, which compensated for the contractionary effect of the slowdown in world trade on exports.

In December 1998, however, and even more markedly in 1999:I, the downward trend of the trade deficit reversed, and the deficit grew, with goods exports declining, particularly industrial exports. The trade deficit (excluding ships, aircraft, diamonds, and fuel, seasonally adjusted) rose moderately in the period reviewed compared with the equivalent period in 1997-98 to $ 408 million, monthly average. The period should be split into two subperiods, however, with a different trend evident in each: the first was 1998:IV,when the trade deficit continued declining, and went down by about 5.5 percent from the level in the previous quarter, with a further rise in exports and a modest increase in imports. Concurrently, there was real depreciation, which, if maintained, is likely to boost exports in the future. The second subperiod was 1999:I, when the opposite trend was evident: the trade deficit grew, with a fall in exports (by 5.7 percent from the previous quarter) and steady imports. The decline in industrial exports was most notable, particularly those of high-tech industries, such as electronic components and computers (which went down by 9.2 percent from the level in the previous quarter) and of machinery and equipment (which fell by 13.5 percent). The decline may have been a reflection of the deceleration of world trade in 1998. The drop in exports was accompanied by a deterioration in the terms of trade, which went down by 0.7 percent from 1998:III to 1998:IV, reflecting a 1.6 percent rise in import prices and a 0.8 percent rise in export prices. The downward trend of exports of diamond (worked and unworked) reversed in the period reviewed, with a rise of 11 percent from 1998:IV to 1999:I. This followed a step decline in diamond exports in 1998 due to the crises in East Asian countries, to which a large share of Israel's diamond exports is directed. Among the different components of imports, the 15 percent rise in current dollar terms in capital goods imports in 1999:I compared with 1998:I was a prominent feature. Imports of consumer goods remained steady in the period reviewed, while raw material imports fell by 7.4 percent compared with the equivalent period a year earlier.

Data from the Department of Foreign Exchange Control in the Bank of Israel show that foreign direct investment in Israel continued at a high level, and amounted to about $ 1.1 billion. Moreover, there are signs of a revival in nonresidents' financial investments, following a period of repatriation which started in August 1998 in the wake of the crisis in Russia. Foreign-currency credit to residents started rising again in 1999:I, due inter alia to the rise in interest differentials towards the end of 1998, and to a certain decline in the volatility of the exchange rate, as the NIS appreciated, partially offsetting the sharp depreciation which preceded it. Towards the end of 1998, the government issued $ 250 million of 30-year bonds in the US, bearing 7.25 percent interest, 225 basis points above the interest on similar US government bonds. The high interest spreads relative to those on previous issues of the government (when they were 50-75 basis points above the interest on comparable US bonds) reflect the deterioration in the conditions under which emerging economies raise credit abroad.


 

Figure 8. Foreign trade ($million per month)
 

Table 4. Balance of Payments, Foreign Trade, and the Reserves, 1997-99
($ milllion, current prices)


1998
1999
Oct-Mara
*

1997
1998
I
II
III
IV
I
1998
1999
Monthly averages
Trade deficit 466 363 353 330 396 374 442 401 408 3
Goods imports 1,777 1,768 1,764 1,772 1,768 1,769 1,758 1,781 1,764 3
   Consumer goods 322 322 325 318 333 312 330 325 321 3
   Capital goods 384 377 351 377 371 410 407 362 408 3
   Intermediates 1,071 1,069 1,087 1,077 1,064 1,047 1,021 1,093 1,034 3
Goods exports 1,311 1,405 1,411 1,442 1,371 1,395 1,316 1,380 1,356 3
   Industrial 1,242 1,336 1,344 1,369 1,296 1,333 1,265 1,313 1,299 3
Quarterly averages
Net current account -1,228 -574 -709 -531 -1,635 578
-725   12
Long- and medium-term
capital flows
1,317 853 2,174 558 178 504
1,610   12
   of which: Private sector 1,001 598 866 698 377 452
1,258   12
Short-term capital flowsb 819 -105 34 -375 293 -373
-283   12
   of which: Private sectorb 831 -91 99 -409 331 -384
-283   12
Net foreign debt (% of GNP) 18.54 18.70 19.73 19.80 19.67 18.70
29.03   12
End-period Bank of Israel reserves 20,332 22,674 21,603 21,322 21,715 22,674 21,983 21,603 21,938 3
*
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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Prices

The CPI rose by 2.9 percent in the period reviewed, compared with a rise of 0.7 percent in the equivalent period in 1997-98. The period can be divided into two subperiods, as can be seen in Figure 9: in September-November 1998 there was a steep rise of 5.7 percent (4.4 percent in 1998:IV), in the wake of the steep depreciation of the NIS, and from December 1998 to March 1999 there was a decrease of 1.3 percent (1.4 percent in 1999:I). These changes emphasize the rapid passthrough from the exchange rates against the dollar and the currency basket on the one hand to prices on the other, in the period reviewed. Thus, from September to November 1998 all price indices accelerated, including those which allow for seasonal adjustments. The rise in the index of wholesale prices, which in the last few years was lower than the rise in the CPI, was particularly notable. Together with depreciation and the acceleration in prices, inflation expectations (derived from the capital market data) also surged. Following two steep increases of two percentage points each in the rate of interest for November, one towards the end of October, and the other in mid-November, the price indices rose more slowly or actually declined from December 1998 to March 1999, and the NIS appreciated against the dollar and against the currency basket. As occurred in September-November, when all prices accelerated together, in December-March nearly all price indices went down together, including those which allow for seasonal adjustment and that of wholesale prices. Some of the increased rapidity of the pass-through from the exchange rate against the dollar to prices may be due to the change introduced at the beginning of the year in the method of measuring housing prices in the CPI.

The fact that prices of tradable goods rose faster than did prices of nontradables in the period reviewed (especially in 1998:IV) reflects the moderation of the long-term trend of real appreciation and the creation of real depreciation.

The decline in the CPI referred to above, supported by the ongoing monetary policy directed towards achieving the inflation target and preserving stability, and the absence of signs of an upsurge in activity, support the assessment that the economy is reverting to a low inflation environment consistent with the target inflation path set for 1999. The reduction in inflation expectations, the monetary conditions reflected in the appreciation of the NIS against the dollar, and the level of real interest, also support the above assessment. Uncertainty related to the approaching elections, however, particularly in the fiscal area, offers challenges as well as risks regarding the consolidation of the inflation environment at its present level.
 

Figure 9. Monthly rate of change of the CPI
 
Table 5. Selected Price Indicies, 1997-99
(annual rates of change during period, percent)


1998
1999
Oct-Mar
*

1997
1998
I
II
III
IV
I
1998
1999
CPI 7.0 8.6 0.3 8.9 7.4 18.8 -5.5 1.3 5.9 3
CPI excl. housing, fruit and vegetables 6.7 8.5 -0.5 10.0 2.2 23.8 -1.4 2.1 10.5 3
CPI excl. housing, fruit and vegetables, controlled goods, clothing & footwear 7.8 8.8 3.0 4.4 6.1 22.6 2.9 2.9 12.3 3
Index of housing prices 7.5 8.8 5.1 3.9 13.1 13.4 -17.9 1.5 -3.5 3
Wholesale price index 5.9 8.2 -0.6 4.1 0.6 31.7 -3.4 0.9 12.8 3
NIS/$ exchange rate 7.9 18.2 6.0 9.0 21.2 39.2 -13.2 4.5 9.9 3
NIS/currency-busket rate
3.7 21.6 3.6 8.9 28.7 45.8 -20.2 3.6 7.9 3
*
Last month for which data are available.

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The Government

In 1998, the government met its total deficit target, but its domestic deficit exceeded the planned amount by 1.1 percent of GDP. This was made possible by the fact that- in line with current accounting practice-government income includes the Bank of Israel's real realized profits (which in 1998 amounted to 1.1 percent of GDP). Tight fiscal policy as pursued in 1997 was maintained in 1998, but it had a less contractionary effect in 1998; public consumption rose by 1.8 percent, compared with 1.4 percent in 1997.

In the course of 1998, and especially in 1998:IV, there were indications that the environment was less favorable with regard to the ability to persevere with fiscal discipline-the rise in public-sector employment, which tends to become permanent, and some increase in the net-public-debt/GDP ratio, inherent in which is a rise in future interest payments. Statutory tax rates were not reduced in 1998, after rising in 1997, and the share of public-sector investment in GDP increased by only 0.2 percent of GDP, after falling by 0.5 percent of GDP in 1997. Hence, the composition of the budget showed no change towards encouraging sustainable economic growth.

In 1998:IV local authorities showed a significant deficit of 7.9 percent of GDP, and over the period as a whole the deficit was 4.9 percent of GDP. Both the deficit and the levels of income and expenses which it reflects showed an increase from the equivalent period a year earlier in terms of percent of GDP. From January to March the local authority deficit (cash basis, excluding net credit granted) exceeded the planned level, both on the income side and the expenses side.

The lag in expenses is explained mainly by the allocation of 5 percent of the budget to the inflation reserve, and the delay in approving the budget (it was not passed until February). On the income side, the shortfall, which is real (i.e., above that explained by prices) follows the trend-which started at the end of 1997-of underachievement of income compared with the forecast. The 1999 budget passed by the Knesset keeps to the 1999 deficit target set out in the Budget Deficit Reduction Law, and does not include tax increases, but it is a very tight budget, and there is a grave risk that it will be breached during the year. This is because a significant share of the inflation reserve will apparently be used for wage payments in the wake of public-sector wage agreements, and because money from the reserve will be allocated to financing expected future election expenses and other items. In addition, the difficulty of intensifying tax-collection encountered in 1998 still exists, and is likely to increase the risk of not attaining the deficit target.

The government's domestic deficit (including the Jewish Agency) reached 5.4 percent of GDP in the period reviewed, compared with 4.3 percent in the equivalent period in 1997-98. The deficit was financed mainly by the government drawing down from its deposits with the Bank of Israel (injection), and by the continued rise of the proceeds of privatization. The government's tax receipts rose slightly in real terms in the period reviewed compared with the equivalent period a year earlier. This is the result of the continued slow rise of direct taxes, a certain decline in receipts from import taxes due to steady goods imports, and level indirect taxes because of the slowdown in economic activity. In the five months to February 1999, transfer payments to households rose by a real 3.2 percent compared with the equivalent period in 1997-98, a faster rise than that of the real wage; prominent among National Insurance payments was the rapid rise (17.3 percent) of income support payments.
 

Figure 10. Government cash flows (NIS million, monthly average)
 
Table 6. The Budget and its Financing, 1997-99
(cash flows, as percent of GDP)


1998
1999
Oct-Mar
*

1997
1998
I
II
III
IV
I
1998
1999
1. Government domestic expenditure 39.4 39.2 40.3 36.5 37.0 42.9 39.6 40.6 41.3 3
2. Government receipts 36.5 35.9 38.8 34.8 35.2 35.0 37.9 36.5 36.4 3
3. Domestic budget deficit (1)-(2) -2.9 -3.3 -1.5 -1.7 -1.9 -7.9 -1.8 -4.1 -4.9 3
4. Domestic deficit of public-sector
(incl. Jewish Agency)
a  (5)+(6)
3.3 3.7 1.4 2.2 2.6 8.2 2.4 4.3 5.4 3
5. Government net borrowing from the public 2.3 2.8 1.4 1.5 2.6 5.5 0.6 0.2 3.1 3
6. Public-sector injection (9)-(8)-(7) 1.0 0.9 0.0 0.7 0.1 2.7 1.8 4.1 2.3 3
   7. Bank of Israel injection
-6.6 -1.1 -3.1 0.1 2.6 -4.0 1.8 -3.5 -1.1 3
   8. Private-sector foreign-currency conversions 6.7 0.3 1.7 -0.1 -0.2 -0.1 -0.4 0.8 -0.2 3
   9. Change in monetary base
1.1 0.1 -1.4 0.6 2.4 -1.4 3.3 1.3 0.9 3
* 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

At the beginning of the period reviewed, the NIS depreciated rapidly, owing to the shocks in overseas markets from August 1998, and against the background of the narrowing of yield spreads between Israel and abroad. The sharp 15 percent depreciation of the NIS against the dollar from August to October (monthly averages) led to accelerated price increases and to a rise in inflation expectations. In order to prevent the price rises from spilling over into accelerated inflation, the Bank of Israel announced on October 26 a steep two percentage-point increase in its key interest rate, as part of its monetary policy for November. The announcement lowered inflation expectations to some extent, but not by an amount compatible with the achievement of the inflation target. The Bank of Israel therefore increased the interest rate again, two weeks after the previous rise, by another two percentage points. This drastic step had the immediate effect of rapidly reducing inflation expectations and halting price rises. Interest differentials between Israel and abroad widened (also partly due to a modest fall in interest rates abroad), capital inflow to Israel increased, and the NIS appreciated, and continued to do so even more strongly at the beginning of 1999.

In February and March 1999, the private sector began a small inflow of capital, concomitant with the appreciation of the NIS against the currency basket (a monthly average of about 3.5 percent since the beginning of the year) and a rise in real interest (Figure 3). In those months, inflation expectations fell, as did price indices, enabling a reduction in the interest rate at the end of February and at the end of March, by a half a percentage point each time. At the end of March, interest reached 12.5 percent, but the differential between local-currency and foreign-currency interest remained relatively high (particularly after the reduction of interest abroad). The M1 money supply contracted by 8 percent during the period reviewed (mainly after the rise in interest at the end of 1998), compared with a rise of 2.5 percent in the same period in 1997-98. Nevertheless, in the twelve months from March 1998 the money supply rose by about 13 percent, a faster increase than that of actual nominal GDP. In 1999:I, M2 rose significantly (mainly resident time deposits of up to 3 months), after easing off in 1998:IV. Foreign-currency d eposits followed the opposite trend, rising in October, with a slower rise at the end of 1998, and in March, an actual decline. The reason for these developments may lie in rise in interest and the decline in inflation expectation expectations in November 1998. Nondirected bank credit rose by 18 percent in the period reviewed, more than in the equivalent period a year earlier2. The rise in the share of credit denominated in and indexed to foreign currency is particularly notable, especially in 1998:IV. The yield-to-maturity graph of bonds was higher in March than at the beginning of the period reviewed, apparently due to the rise in short-term interest. This explanation is compatible with the fact that the rise in interest for bonds with shorter residual maturity was greater than the rise in those with longer maturities.

In the capital market, the general share-price index was 22 percent higher (nominally) at the end of the period than at the beginning, due mainly to the significant increases in February-March. The steep rises in the stock exchange, following the falls in October 1998, occurred against the background of the recovery in stock exchanges in advanced economies and in those in most emerging markets.

2 This figure is also based on preliminary data for February and March, and therefore does not appear in Table 8.
 

Figure 11. Monetary aggregates and credit (change in prev. 12 months)
Figure 12. Nondirected bank credit (NIS million per month)
Figure 13. The sheqel exchange rate against the currency basket


Table 7. Monetary Indicators and Nondirected Bank Credit, 1997-99
(annual terms, percent)


1998
1999
Oct-Mar
*

1997
1998
I
II
III
IV
I
1998
1999
Rates of change Average
Compared with preceding quarter
During perod
M1a
14.3 12.1 5.3 17.2 29.6 13.1 -8.7 2.5 -8.0 2
M2b 25.8 22.6 31.3 13.0 26.9 6.9 34.5 29.2 19.9 2
M3c 25.3 22.1 28.6 15.7 21.9 23.6 27.8 25.3 24.3 2
Nondirected bank credit 18.2 16.0 9.9 18.5 15.8 35.1 13.1 11.5 21.6 2
   Unindexed local-currency 8.6 16.3 10.8 21.6 18.4 26.1 24.7 18.2 27.7 2
   CPI-indexed 19.0 13.9 8.8 10.9 15.5 21.9 22.9 10.8 20.6 2
   Foreign-currency indexed and denominated 32.3 18.3 10.2 25.0 12.8 64.3 -9.9 4.7 15.2 2
*
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. Yield on Treasury bills (end-period figures)

Table 8. Interest Rates, Yields, and the Share-Price Index, 1997-99


1998
1999
Oct-Mar
*

1997
1998
I
II
III
IV
I
1998
1999
Nominal interest
Nondirected local-currency credit 18.7 16.2 17.7 16.4 14.5 16.2 17.7 18.1 16.8 2
Average monetary loan 14.3 12.0 13.5 12.2 10.4 12.1 13.6 13.8 12.8 3
SROs 12.2 10.2 11.5 10.3 8.7 10.5 12.1 11.9 11.1 2
3-month Eurodollar 5.6 5.4 5.5 5.6 5.5 5.1 4.9 5.6 5.0 3
Yield to maturity on
Treasury bills
14.1 12.3 13.4 12.2 10.5 13.0 13.7 13.7 13.4 3
10-year bonds 4.0 4.8 4.7 4.9 4.8 5.0 5.2 4.3 5.1 3
5-year bonds 3.9 5.0 5.0 5.4 4.9 4.6 5.6 4.5 5.1 3
General share-price index (points) 129.2 137.5 131.5 146.4 136.8 135.1 146.8 132.3 140.9 3
*
Last month for which data available.