Israel--1997 Article IV Consultation
Concluding Statement of the Mission
  1. The mission’s diagnosis of the Israeli economy based on its work over the past two weeks is generally positive. This is not because we already find in the current situation firm evidence of an imminent reacceleration of growth. It is rather because we see a clear turnaround in policies toward the better. This will in time generate a powerful force of recovery in the economy which is known for its remarkable ability to convert such challenges as the absorption of a massive wave of immigration into impressive output growth and job creation. To draw this conclusion and make constructive suggestions for even better policies, as well as warning against possible pitfalls, this report begins with a review of the year just past.

  2. When the mission last visited here, the economy was showing clear signs of strain. The excess demand conditions evident in the first half of 1996--which trace back to a major easing of fiscal policy in late 1994--had to be dealt with by a sharp tightening of monetary policy in the absence of fiscal correction, with a predictable impact, particularly on investment, exports, and employment in the traditional sector. In the meantime, another failure to meet the budget deficit target led to a further erosion of the credibility of fiscal policy. Inflation reverted back to higher than 10 percent from the 8 percent recorded in 1995, and the inflation target was missed, albeit by a small margin. In addition, as a result of both the overheating and the policy mix, the current account deficit rose above 5 percent of GDP in 1996, clearly a potential danger.

  3. Growth in 1997 has been disappointing, as has been the concomitant sharp rise in unemployment. Although the security situation and the unwinding of the effect of the immigration wave obviously played a significant part, this result should be seen as the confirmation of lessons repeatedly learned elsewhere in the world that, once excess demand conditions are allowed to take hold, it is extremely difficult to put an economy back on a sustainable path without some transitional pain. This is particularly true in a situation where fiscal policy is not ready to play its part in dealing with such conditions and instead acts in a way that exacerbates the problem, as it did in Israel in 1996.

  4. All that being said, developments during 1997 include many encouraging features that augur well for future economic performance. First and foremost, fiscal policy seems to be well on its way to delivering what was sorely needed, namely to meet the deficit target despite the prevailing difficult economic circumstances. Also, inflation has been brought well within the target range; the current account deficit has been reduced to a more manageable level; high-tech industries have recorded double digit export growth despite a significant real appreciation since mid-1996; and the slowdown in growth has come to a halt and there is now a consensus that a further weakening of economic activity is highly unlikely in the period ahead.

  5. As another development of note over the past year, the authorities have taken new steps to liberalize capital account transactions and they have announced their intention to shift, by mid-1998, to a regime where most capital account transactions are allowed. This program is important and, along with the Government’s issuance of debt securities in foreign markets outside of the aegis of the U.S. Government loan guarantees, indicates that Israel is coming of age as a full partner in the international financial system. While laudable, this development also increases the importance of sound financial policies and close supervision of the banking system. In fact, whether the Israeli economy will succeed in reaping the full benefits of globalization will depend not only on how well high-tech industries will be able to compete in the international marketplace, but even more importantly on how well the authorities will be able to compete vis-a-vis those of trading partners in the arena of economic policy making.

  6. The main economic policy challenge now confronting policy makers is how to get growth back to the 4 to 5 percent range on a sustained basis, in line with what appears to be Israel’s potential, while continuing to make progress toward achieving an inflation performance on par with that in other advanced economies as well as ensuring a viable current account position. It may be more correct to view the two latter goals rather as critical preconditions for favorable medium-term growth, but at any rate, what is important in this connection is that the greater the contribution of fiscal policy toward these macro stability goals, the more likely is the growth objective to be attained. Another point to emphasize is that as Israel’s labor force growth slows, economic growth will have to rely on faster labor productivity growth, that can come only through capital deepening (via high rates of investment) and technical progress. The importance of fiscal consolidation and structural reform in this context is clear.

  7. With these observations and considerations as background, the following paragraphs discuss in detail a number of key issues in individual policy areas, starting with fiscal policy.

  8. Notwithstanding the commendable progress made in 1997 in reducing the budget deficit, the need for additional fiscal consolidation over the medium term is recognized in the Government’s plan to narrow the deficit to 1½ percent of GDP by 2001. While this plan is in the right direction, the mission sees, in light of the considerations discussed above, a strong case for greater fiscal adjustment, namely to achieve--at a minimum--approximate balance in terms of the Government’s accounting system by 2001. Such a fiscal consolidation would make the fiscal position of Israel, measured on a common accounting basis, comparable to that already achieved, or about to be achieved, by many in the group of advanced countries to which Israel belongs. Moreover, the high level of outstanding government debt also argues for a stronger fiscal consolidation effort. In addition, as in many other countries, potential problems with the cumulated liabilities of existing pension funds are looming in the distance, and having a strong fiscal position is a first line of defense, although addressing pension problems fundamentally will require major reform measures in the near future.

  9. Given the large size of the total public sector in Israel--with overall primary expenditures amounting to close to 50 percent of GDP according to data for 1996--it is important that the needed fiscal consolidation be based on restraining the growth of spending. In this connection, in light of sharp gains in relative public sector wages in recent years, we support the Government’s determination to contain salary increases granted to public sector workers to no higher than expected inflation in the upcoming wage negotiations. We would also urge that additional cuts in investment subsidies be made as these payments can lead to projects, not otherwise economically feasible, being undertaken. Further cuts in this area would help to ensure that the most productive investments are made, those that will lead over the long run to higher productivity. Among other areas, there are indications that the health care system could become an even larger drain on the public finances over the near term if steps are not taken now aimed at improving the incentive structure and increasing operational efficiency, flexibility, and competition.

  10. In view of the need for greater medium-term fiscal consolidation, we regard the size of the planned cut in the fiscal deficit in 1998 as the minimum required, and thus stress the critical importance of ensuring that the targeted deficit reduction is achieved. The experience of 1995 and 1996 provides a clear warning that vigilance against revenue shortfalls is essential. The authorities should stand fast to make full use of the contingency plans contained in the draft budget to deal with such shortfalls, including the strengthening of the expenditure monitoring and control mechanisms which have been used with success this year.

  11. Since late 1994, monetary policy has been the main bulwark in the fight against inflation. The restrained monetary policy over the last few years has been necessary and the fruits of that policy, in terms of declining inflation, are now being observed. Inflation is likely to be comfortably within the target range for 1997. Looking ahead, and in assessing the appropriateness of the current stance of monetary policy, it is essential to remind ourselves of the critical importance of broad price stability for the sake of long-term growth and the fact that, on balance, inflation has declined by only a small margin over the past several years. Given that, and with prevailing economic conditions (featuring low import prices, an absence of excess demand, and the apparent abatement of housing price pressures) offering an opening for a major stride toward low inflation, the mission believes that it is time to focus on the task of putting the long-held inflationary psychology in this country to rest.

  12. Implications of this, which are of immediate relevance, are threefold. First, monetary policy, supported by the full implementation of the 1998 budget, should aim to bring inflation down to the bottom of the established target range for 1998. Second, and somewhat related, it is desirable--particularly given the emerging consensus that a further slowdown in growth is unlikely in the period ahead--to wait at least until after the Knesset’s approval of the draft 1998 budget and the satisfactory confirmation of the results sought in the upcoming wage negotiations before considering interest rate reductions. Third, a specific medium-term target path for inflation should be announced without delay. As a reasonable option, we would suggest a target range of 5 to 8 percent for 1999 and 4 to 7 percent for 2000, followed by 3 to 5 percent for 2001 and 2 to 4 percent for 2002. Such a disinflation path toward advanced country standards is clearly feasible, and should go hand in hand with high and sustained growth if pursued in the context of a significant further fiscal consolidation of the kind the mission is calling for and the structural reform agenda being contemplated by the authorities.

  13. As regards operational aspects of the inflation targeting framework, the mission understands that, with a view to reducing volatility while ensuring the achievement of progressive and sustained disinflation, the Bank of Israel has been gradually extending its operational horizon, placing increased focus on the likely evolution of inflation eighteen months to two years ahead. This is clearly appropriate. Such an approach should be combined, for accountability and transparency, with the Bank of Israel’s quarterly publication of a report on the inflation outlook one to two years hence and its policy implications. This would be consistent with the well-accepted practices used by some other advanced countries employing inflation targeting (the United Kingdom, for example). As another point with an equally critical bearing on the issue of interest rate volatility, the mission urges that the Central Bureau of Statistics start using as soon as possible, for the estimation of the cost of housing (and changes thereof) in the overall CPI, a method based on rentals rather than on house prices.

  14. As the final point on monetary policy, we note that there are discussions underway concerning changes in the basic law governing the Bank of Israel. In considering modifications to the existing legislation, it is critical that policy makers keep in mind the experience of other advanced economies (particularly those countries such as New Zealand and the United Kingdom where major legislative/institutional changes have been made), which underscores the importance of an operationally independent central bank dedicated to the primary goal of achieving price stability as the best contribution monetary policy can make to long-term growth. In addition to clearly spelling out the primary goal and the independence of the Bank of Israel, any new law should also ensure that the Bank be provided with sufficient instruments of monetary control to achieve its primary objective. Possible amendments to the existing law for any other issues should be considered only in conjunction with those pertaining to these three basic elements.

  15. Turning to structural issues, the further opening of Israel to global financial markets discussed above requires a revitalization of efforts to reform the domestic capital market. For a variety of reasons, the recommendations of the committee formed last year to examine structural changes in the domestic capital market have not been implemented. While no one package of measures should be viewed as sacrosanct, it is important that efforts in this area not be postponed. Pension fund reform to reduce the Government’s involvement in providing subsidized investment vehicles, besides being necessary for fiscal reasons, would represent a good beginning for broadening and deepening the domestic capital market.

  16. The Government has made important progress this year in accelerating privatization, especially in regard to banks, and we trust that the proceeds from privatization will be used to reduce the very high level of government debt. We urge the authorities to continue pushing ahead, not only with privatization, but with their program of deregulation and decreasing other forms of government intervention in the economy. Structural reforms are important not only from the standpoint of increasing microeconomic efficiency, but also as a way of strengthening overall macroeconomic performance. Trade liberalization, increased competition, and a minimum wage system with greater attention to its economic impact are but a few of many examples that can be cited in this connection. Finally, a reduction in the use of indexation would increase the flexibility of the economy to adjust to changing circumstances and would help break, once and for all, inflationary expectations. Such a step can only succeed, of course, as part of a convincing agenda aimed at achieving industrial-country rates of inflation.

  17. In concluding, we would like to reiterate that much has been accomplished thus far this decade and that the Israeli economy’s medium-term prospects are favorable provided that the right policies are pursued. We would emphasize, in particular, the importance of strong fiscal consolidation and ambitious structural reform which, in conjunction with a restrained monetary policy, would promote sustained growth while facilitating the task of bringing down inflation from its current, unacceptable level. It is true that such efforts have already begun in earnest this year, but much more work remains. What we would like to see in the period ahead is for Israel--as some other advanced countries have done--to play its leadership role in promoting better economic performance world over through its own unwavering efforts to stick to appropriate policies. In fact, this is a basic responsibility of advanced economies.