I. Overview
Author:
International Monetary Fund
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Publication Date:
07 Nov 1995
eISBN:
9781451819427
Language:
English
Keywords:
ISCR; CR; U.S. dollar; foreign currency; budget deficit; monetary policy; private sector; exchange rate; economic activity; Currencies; Imports; Budget planning and preparation; Inflation; Eastern Europe; rate of inflation; rate of return; managed float; rate of change; nominal rate
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This paper reviews economic developments in Israel during 1990–94. During the first half of 1993, there was a significant slowing of the domestic economy largely as a result of a substantial scaling down of the public support provided to housing construction for immigrants, who were arriving to Israel in lesser numbers than originally estimated. In response to this slowing and to signs of a moderation in inflation, during the third quarter of 1993, the Bank of Israel reduced its lending rate from 12 percent to 9 percent in successive stages.

Abstract

This paper reviews economic developments in Israel during 1990–94. During the first half of 1993, there was a significant slowing of the domestic economy largely as a result of a substantial scaling down of the public support provided to housing construction for immigrants, who were arriving to Israel in lesser numbers than originally estimated. In response to this slowing and to signs of a moderation in inflation, during the third quarter of 1993, the Bank of Israel reduced its lending rate from 12 percent to 9 percent in successive stages.

Recent economic developments in Israel need to be seen against the background of the massive wave of immigration from the former Soviet Union that began in 1990. Although this wave ebbed to an annual flow of around 80,000 immigrants in 1993 and 1994, it has totaled over 600,000 immigrants since 1990, thereby increasing Israel’s population by 13 percent. In contrast to earlier immigration waves, the main emphasis of policy has been on providing the immigrants with initial settling-in and housing allowances, rather than absorbing them in public sector employment. This approach has contributed to a markedly greater degree of labor market flexibility, while at the same time allowing further substantial progress in consolidating the budget deficit and in adopting more market oriented supply-side reforms. The overall success of this strategy is reflected in an annual average rate of GDP growth of 6 percent since 1990, or around double the average rate recorded in the second half of the 1980s.

During the first half of 1993, there was a significant slowing of the domestic economy largely as a result of a substantial scaling down of the public support provided to housing construction for immigrants, who were arriving to Israel in lesser numbers than originally estimated. In response to this slowing and to signs of a moderation in inflation, during the third quarter of 1993 the Bank of Israel reduced its lending rate from 12 percent to 9 percent in successive stages. The easing of monetary policy in mid-1993 did not foresee the boost to economic confidence that would flow from the signing of the Oslo Peace Accord in September 1993 nor the start of a trend toward large multi-year wage increases in the public sector.

Beginning in the latter part of 1993, there was a significant upturn in domestic economic activity. This upturn gathered momentum in 1994 and for the year as a whole real GDP increased by 64 percent, or almost double the rate recorded in 1993. Although residential investment remained subdued, nonresidential investment increased by almost 17 percent. At the same time, private sector consumption rose by almost 9 percent in 1994, in large measure reflecting the substantial multi-year real wage increases granted in the public sector; increased consumer spending by immigrants as they became more fully absorbed in the domestic economy; and uncertainty surrounding the various vehicles for private sector savings due to the steep decline in stock market prices.

The strengthening in the economic recovery resulted in a 7% percent increase in private sector employment during 1994. At the same time, public sector employment increased by over 5 percent. Despite the continued rapid rate of increase in the Israeli labor supply, the overall rate of unemployment was reduced from a peak of 11.2 percent in 1992 to 6.9 percent by the first quarter of 1995. While the unemployment rate among immigrants has been approximately halved since 1992, it remained at around 12 percent at end-1994, reflecting the continued difficulties of the immigrants to fully adapt to the domestic economy. In contrast, unemployment among the established population declined to below 6 percent by the first quarter of 1995, which corresponds to around the rate in 1987 when the economy was previously considered to be at a high level of employment.

Over the past eighteen months, wage developments were characterized by a substantial increase in public sector wages and by continued moderation in private sector wage settlements. While the public sector wage increases in 1994 started out as an attempt to correct relative wage distortions within that sector, they resulted in a 10 percent real increase in the average public sector wage in 1994, with a further 5 percent real wage increase in prospect for 1995. In contrast, private sector real wages per hour declined by 2½ percentage points in 1994, bringing the cumulative decline in this measure of wages to around 10½ percent since mid-1990.

Beginning in the second half of 1993, consumer price inflation picked up under the impetus of domestic demand pressures and of specific supply problems, especially in the housing sector. By end-1994, overall consumer price inflation reached 144 percent, which exceeded the Government’s 8 percent inflation target for that period. In response to this acceleration, monetary conditions were markedly tightened in the last quarter of 1994 and in the first six months of 1995 price inflation decelerated sharply to an annual rate of 5½ percent. Price performance in the early part of 1995 was also aided considerably by an unusually large decline in the prices of fruit and vegetables.

Between the second half of 1993 and end-1994, the Bank of Israel raised its lending rate in a series of steps from 9 percent to 17 percent. Until mid-1994, the Bank of Israel responded tentatively to the increased signs of an upturn in inflation. During the fourth quarter of 1994, however, interest rates were raised decisively by a cumulative 4½ percentage points in three successive 1½ percentage point steps. Against the background of signs of a moderation in inflationary expectations, the Bank of Israel reduced its lending rate in a series of steps by 4 percentage points during the first six months of 1995 to 13½ percent.

In July 1993, the Bank of Israel reduced the preannounced rate of crawl of its “diagonal” exchange rate band from an annual 8 percent to 6 percent. The new pace of crawl was thought to be consistent with the Government’s 8 percent inflation target for 1994. Failure to meet that target, however, resulted in a 6 percent real effective appreciation of the currency, as measured by unit labor costs, between mid-1993 and early 1995. In September 1994, the Government announced an inflation target range of 8-11 percent for 1995, but it did not modify the slope of the exchange rate band.

The pickup in domestic demand since mid-1993, coupled with the real appreciation of the currency, resulted in a considerable deterioration in Israel’s external current account balance. This balance, which was in small surplus between 1990 and 1992, moved to a deficit totaling US$2.8 billion, or around 4 percent of GDP in 1994. The deterioration in the current account through 1994 is explained both by the widening in the private sector’s trade deficit and by a weakening in the balance of the services account. Preliminary indications for the first half of 1995 suggest a further substantial deterioration in the trade account, on the basis of which the external current account deficit for the first half of 1995 is estimated to have widened to around 6 percent of GDP.

The sharp increase in domestic interest rates toward the end of 1994 substantially improved the relative attractiveness for domestic firms to borrow abroad under Israel’s crawling exchange rate regime. Between November 1994 and May 1995, such external borrowing exceeded US$2.5 billion. As a result, notwithstanding the widening in the external current account deficit, Israel’s net international reserves rose from US$6.5 billion at end-1993 to a record US$9.6 billion, or the equivalent of more than four months’ import payments, by April 1995.

The buoyancy of the domestic economy in 1994 contributed to a reduction in the overall budget deficit from 2.8 percent of GDP in 1993 to 1 percent of GDP in 1994. This reduction occurred despite the substantial increase in public sector wages referred to above and despite a 4½ percentage point increase in real public consumption. These factors were more than offset by a combination of better than budgeted revenue collections—on account of the more buoyant than anticipated domestic economy and the high level of corporate stock market profits in 1993—and a further significant reduction in defense spending. On the basis of this improved budget performance, Israel’s public debt to GDP ratio declined from 99 percent in 1993 to 92 percent in 1994, thereby continuing the significantly downward trend in this ratio that has been in evidence since the 1985 stabilization program.

II. Output, Employment and Prices

1. Overview

Over the past five years, economic developments in Israel were importantly influenced by the large wave of immigration from the former Soviet Union. Although this wave ebbed to an annual flow of around 80,000 immigrants a year in 1993 and 1994, a cumulative 600,000 immigrants have arrived in Israel since 1989, thereby boosting the population by around 13 percent. This inflow has had the effect of considerably increasing labor market flexibility and creating substantial investment opportunities. In reflection of these factors, real GDP growth averaged around 6 percent a year over the past five years, or approximately double the rate of growth in the second half of the 1980s (Table 1 and Chart 1).

Table 1.

Israel: Selected Economic Indicators

(Percent change, unless otherwise indicated)

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Sources: Bank of Israel; and Central Bureau of Statistics.

Excluding military purchases from abroad.

Contribution to GDP.

Chart 1.
Chart 1.

Israel: SELECTED INDICATORS OF REAL ACTIVITY

Citation: IMF Staff Country Reports 1995, 105; 10.5089/9781451819427.002.A001

Source: Central Bureau of Statistics.

In mid-1993, there was a significant slowing in economic activity mainly on account of a slump in residential construction as the Government reduced its support for housing construction for the new immigrants. This slowing proved to be short-lived, however, as economic activity picked up strongly in the second half of the year under the impetus of a significant easing in monetary policy and renewed optimism following the signing of the Oslo Peace Accord in September 1993. Real GDP growth increased from 3½ percent in 1993 to 6½ percent in 1994, while preliminary national accounts data point to an annual 5 percent rate of GDP growth in the first quarter of 1995.

The strong expansion in economic activity over the past two years was supported by a very high level of nonresidential investment and by substantial strength in private sector consumption. In the latter respect, the rate of household savings as a share of national income declined from a peak of 20 percent in 1992 to 16¼ percent in 1994 (Chart 2). Among the factors accounting for this decline in private savings were the substantial real wage increases granted to public sector employees, the changed consumption behavior of the immigrants, and speculative purchases of durables in response to the real appreciation of the currency. The resulting expansionary impact of domestic demand on economic activity was increasingly offset by a sharp pickup in import demand and by a deceleration in export growth.

Chart 2.
Chart 2.

Israel: SELECTED INDICATORS Of SAVING, INVESTMENT AND THE CURRENT ACCOUNT

(In percent of GDP)

Citation: IMF Staff Country Reports 1995, 105; 10.5089/9781451819427.002.A001

Source: Bank of Israel.

A distinguishing characteristic of recent labor market developments has been the relative moderation in private sector wage increases and the substantial increase in private sector employment. In reflection of the markedly changed labor market situation that followed the large influx of immigrants, real wages per hour in the private sector declined by a cumulative 10 percent since 1990 notwithstanding an appreciable increase in labor market productivity. This wage moderation, together with the rapid rate of economic activity, facilitated a reduction in the unemployment rate from a peak of 11.2 percent in 1992 to 6.9 percent by March 1995, or to a level well below the 8.9 percent that prevailed immediately prior to the immigrant wave.

Following the 1985 Economic Stabilization Program, consumer price inflation remained stuck in a range of between 15–20 percent. The markedly changed labor market conditions that flowed from the large influx of immigrants facilitated a reduction in inflation from that range to a low point of 9½ percent in 1992. More recently, however, inflation picked up to 14½ percent in 1992 under the impetus of an easing in financial policies and in reflection of specific supply side problems, especially in the housing sector. A marked tightening in monetary policy at the end of 1994 broke the trend toward rising inflationary expectations and by June 1995 the underlying rate of inflation had been reduced to around 9½ percent.

2. Aggregate economic activity

During the early 1990s, Israel experienced rapid economic growth. This growth was led by a marked pickup in nonresidential investment, as businesses responded to the improved labor market situation following the arrival of the immigrants, and by a substantial expansion in residential investment, as the Government supported the construction sector to provide housing for the new immigrants. In 1993, however, real GDP growth slowed to 3.5 percent mainly as a result of a slump in the construction sector as the Government phased out its support for housing construction in the wake of a lesser number of immigrants arriving to Israel than anticipated. In response to this slowing, monetary policy was eased substantially in mid-1993, as indicated by a reduction in the Bank of Israel’s lending rate from 12 percent to 9 percent during the second and third quarters of the year (see Chapter III below).

During 1994, real GDP increased by 6½ percent, while business sector activity rose by over 7 percent (Tables 2 and 3). The recovery was led by an upsurge in all components of domestic demand. Continuing the strong upswing of the previous year, nonresidential investment increased by 17 percent, while there was a significant rebound in private residential investment. At the same time, private consumption increased by 9 percent in 1994 representing a further decline in the private saving ratio. The strength in domestic demand was not fully matched by the growth in domestic production, as a result of which the external current account deficit widened to 4 percent of GDP in 1994 (see Chapter V below). The problems on the supply side were reflected in a 0.9 percent average annual decline in labor productivity and a 0.8 percent average annual decline in total productivity in 1993 and 1994, in part reflecting the absorption of the new immigrants In the economy.

Table 2.

Israel: Supply and Use of Resources, 1991–94

(Annual rate of change, in percent)

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Sources: Central Bureau of Statistics.

Imports (c.i.f.), exports (f.o.b.), excluding factor payments and general government interest from or to rest of world. Exports at effective exchange rate.

Excluding change in stock.

Excluding direct defense imports.

GNP less gross product of public services, nonprofit institutions, and ownership of dwellings. At market prices.

Table 3.

Israel: Saving and Investment Balance

(In percent of national income)

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Source: Bank of Israel.

Preliminary national accounts data for the first quarter of 1995 suggest that GDP continued to grow at an annual rate of 5 percent in the quarter. This growth was mainly supported by a further steep decline in the household savings rate and was accompanied by a further widening in the external current account deficit to around 6 percent of GDP.

a. Fixed investment outlays

In 1993, overall investment stagnated as a consequence of the fall in public residential investment. However, mainly in reflection of strength in nonresidential investment, overall investment activity maintained a strong momentum in the second half of 1993 and in 1994 (Table 3). Underpinning the considerable strength in nonresidential investment were relatively low real interest rates, the hopes raised by the peace process, and a booming stock exchange that provided firms with a cheap and abundant source of capital. The business sector stock of capital increased by 6.4 percent in 1993 and 8.1 percent in 1994, despite the fact that the net rate of return on capital fell in both years by a cumulative 3.6 percent. Moreover, public spending shifted from current to capital expenditures, boosting public investment in infrastructure, especially roads, after several years of neglect. In reflection of these factors, overall investment rose to 21¾ percent of national income in 1994, which was around 1 percentage point above the corresponding level over the previous four years.

Public residential investment plunged by 64 percent in 1993, which was mainly responsible for a 27 percent fall in total residential investment (Table A2). This compares with a 27 percent average growth In residential investment in the period 1990–92, when the Government was actively engaged in supporting this sector to meet the needs of the new immigrants. The drop in public housing investment since 1993 mainly reflected a basic change in government policy away from direct intervention in the construction sector and from providing guaranteed prices to building contractors. This policy had led to an excess supply of dwellings in sparsely populated areas and to the construction of housing that did not adequately meet the immigrants’ needs. Beginning in 1993, the Government switched to a housing policy that relied more on the market, while at the same time easing zoning restrictions and increasing land sales to increase the availability of land for housing. Although the public component of residential investment continued to drop by 29 percent in 1994, it was partially offset by a 12 percent increase in the private component of residential construction as demand for housing remained remarkably strong. At the same time, nonresidential construction grew by 30 percent in 1993 and by 11 percent in 1994.

Nonresidential investment growth was constant at around 17 percent in both 1993 and 1994. This growth was somewhat lower than the average 20 percent of the three previous years, but substantially above the average for the second half of the 1980s before the immigration wave started (Table A2). These comparisons are suggestive of how the “immigration effect” propagated economic activity and how the business sector has responded to the markedly improved profit situation since the late 1980s. Investment in machinery and equipment increased by 14 percent in 1993 and by 17 percent in 1994. It is noteworthy that in 1994 the imported component of investment grew by 26 percent, while the domestic component went up by only 2 percent.

b. Consumption expenditures

Since 1991, private consumption has risen at an annual average rate of 8 percent, representing an increase of almost 5 percent a year in per capita terms. Following some moderation in 1993, private consumption picked up to almost 9 percent in 1994 and is estimated to have increased at an even faster rate in the first quarter of 1995. In reflection of this upturn, the private saving ratio declined from a peak of 20 percent of national income in 1992 to 16¼ percent by 1994 and to an even lower level in the first quarter of 1995 (see Chart 2). Amongst the hypotheses that have been advanced to explain the recent decline in the private savings ratio have been the large multi-year wage increases granted to public sector employees in late 1993 and 1994; the changed consumption behavior of the new immigrants; the lack of adequate vehicles for saving following the stock market crash in 1994; and the greater degree of optimism among the public about the peace process. A considerable degree of uncertainty remains, however, about the degree to which the decline in savings is a cyclical phenomenon or a more permanent secular trend.

Nondurable consumption (excluding food, beverages, and tobacco) grew by around 13 percent in both 1993 and 1994. By contrast, durable goods consumption, after growing at an average of more than 20 percent between 1990 and 1992 was almost constant in 1993, before increasing by 11 percent in 1994, sustained by lower interest rates and lower import prices. This pattern was primarily influenced by passenger car sales, which plunged by 14 percent in 1993, before recovering by 9 percent in 1994. Services consumption grew by an average 8 percent in 1993 and 1994.

Public consumption (excluding defense imports which are typically quite volatile) increased by 1 percent in 1993 and 4 percent in 1994. The emphasis shifted from defense to civilian expenditures: the former dropped by 3 percent in 1993 before increasing somewhat in 1994, mainly in reflection of the sharp rise in employees’ compensation.

3. Activity bv sectors

Industrial production (excluding diamonds) was strong during the early 1990s and this strength continued in both 1993 and 1994: production rose by 6.8 percent and 7.2 percent in 1993 and 1994, respectively (Table A1 and Chart 1). Growth in electronics, transport equipment and optics—which have become the most advanced and largest industrial sectors (about 28 percent of total manufacturing industry)—moderated from a peak of 8.2 percent in 1992 to 4.5 percent in 1993 and 3.5 percent in 1994. Among the traditional sectors, chemicals, textiles, and metals and machinery registered growth rates above 10 percent.

Table 4.

Israel: Origin of Gross Domestic Product of the Business Sector, 1990–1994

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Source: Bank of Israel Annual Reports.

Construction was largely influenced by the sharp decline in public investment. After increasing strongly in 1991 and 1992, the output of this sector plunged by 7 percent in 1993 before recovering by 7 percent in 1994. The growth rate in water and electricity production has matched almost exactly the pattern of the manufacturing industry.

Agriculture, whose share in business GDP has steadily declined to little more than 4 percent in 1994, was hit by two consecutive bad years: production increased by an average 1 percent in both 1993 and 1994. Wheat production in particular dropped to one third of its 1992 level due to unfavorable weather conditions. Relative prices in agriculture have been declining following a tendency common to most developed countries, but in 1994 this trend was reversed for some crops, notably vegetables, leading to an improvement in farmers’ annual income.

Trade and services, excluding transport, have been the fastest growing sector of the Israeli economy. The boom started in 1992 when output leapt by 11.3 percent, an expansion that slowed only slightly in 1993 before accelerating to 12 percent in 1994. Retail trade, the major component of this sector, increased by an average 9 percent in 1993 and 1994. However, the most pronounced growth was registered in tourism: both in terms of tourist arrivals and bed nights in tourist hotels, the index doubled between 1991 and 1994 and this trend appears to have accelerated in the early part of 1995.

4. Employment and wages

a. Labor force and employment

In recent years, the Israeli labor market has been characterized by an unprecedented dynamism, which has permitted a notable reduction in the unemployment rate. This drop in unemployment came despite a sharp increase in the labor force originating from the influx of immigrants from the former Soviet Union (FSU) and from a higher rate of participation. Underlying the favorable employment performance over the past five years has been the rapid rate of economic growth and the considerable moderation in private sector wages.

During 1994, the labor force continued to grow strongly, albeit at a rate below that of the peak years of immigration in 1990 and 1991. The active population increased by 4.8 percent in 1993 and 4.3 percent in 1994, boosted substantially by the arrival of approximately 80,000 new immigrants in both 1993 and 1994 (Table 1 and Chart 3). At the same time, the labor force was boosted by a further increase in the participation rate in both years, which reached 53.6 percent in 1994. This higher participation rate reflected both an increase in participation among the established population as well as higher participation rates (particularly for women) among the recent immigrants. The cumulative growth in the labor force during the 1990s has been 23 percent, with almost one half of the increase coming from new immigrants from the FSU. The new immigrants, who in general are better educated and qualified than the domestic population, now account for over 11 percent of the Israeli labor force.

Chart 3.
Chart 3.

Israel: SELECTED LABOR MARKET INDICATORS

Citation: IMF Staff Country Reports 1995, 105; 10.5089/9781451819427.002.A001

Source: Bank of Israel.

Employment grew by 6.9 percent in 1994, following a 6.1 percent rise in 1993. Business sector employment of Israelis grew by more than 7 percent in each year, with the services and public utilities sectors showing particularly strong expansion. In 1994, the growth rate in public sector employment also jumped sharply, from 3.5 percent to 4.8 percent. In contrast to 1993, when part of the increase in Israeli employment could be attributed to the replacement by Israelis of workers from the West Bank and Gaza Strip (WBGS), 1994 saw an increase in Israeli employment without much decline in non-Israeli workers. A continued decline in workers from the WBGS (from 84,000 to 69,000) was nearly offset by an increase in foreign workers from Eastern Europe and Asia (from 16,000 to 28,000).

After peaking at 11.2 percent in 1992, the unemployment rate fell to 10 percent in 1993 and to 7.8 percent in 1994—a level below that prevalent before the current immigrant wave began in 1989 (Table 1 and Chart 3). This trend continued into 1995, with an unemployment rate of 6.9 percent reported in the first quarter of the year. The fall in joblessness was particularly sharp among the recent immigrants, whose unemployment rate fell from 30 percent in 1992 to 14 percent in 1994 despite continuing immigration and a trend toward increased labor force participation. Unemployment among the established population fell to 6.4 percent in 1994 and to below 6 percent in the first quarter of 1995, a level which is considered to be at or below the current “natural” rate of unemployment. The present rate of unemployment corresponds approximately to that prevailing in 1987, when the economy was previously overheated.

Several factors contributed to the sharp decline in the unemployment rate in recent years. First, strong GDP growth clearly played a key role in generating more jobs. GDP growth averaged 5.7 percent per year during 1990–94, well above the trend growth rate in the late 1980s. Second, real wages in the private economy declined by more than 5 percent over the period, facilitating higher employment levels. Thirdly, underlying the decline of real wages was a set of labor market policies which increased labor market flexibility substantially. Among the most important measures were the partial deindexation of wages, a tightening of eligibility for unemployment benefits, and the use of limited wage subsidies for new jobs.

b. Wage developments

There was a marked divergence between the trends in real wages in the public and private sectors in 1994 (Table 1 and Chart 3). Growth in real business sector wages has been virtually nil since 1992, preserving the 5 percent drop registered in 1990–92. When the increase in working hours is taken into account, real wages per hour worked declined by nearly 2 percent in 1994, bringing the cumulative decline in real wages per hour since 1990 to around 10 percent. This drop reflects two facets of the current labor market situation. On the one hand, new entrants into the labor force—particularly new immigrants—are hired at below average wages, so there is a compositional effect, which has lowered the mean. In addition, wages among current workers have also grown very modestly. The restraint in business sector wages has generated only modest increases in unit labor costs, despite recent declines in labor productivity. Real unit labor costs grew by 1.8 percent in 1993 and 1.9 percent in 1994.

Public wages increased by 10 percent in real terms in 1994 on top of a 1 percent increase in 1993. This sharp rise resulted from a generous set of multi-year wage agreements signed with public sector trade unions beginning in the second half of 1993. In addition to increases in average wages across the board, the agreements incorporated provisions for new job classifications at the top end of the scale and provided for increased promotion rates. These factors will contribute to further significant real rises in public sector wages in 1995. Despite the large wage concessions granted in the public sector, there was no significant progress in reforming the structure of the civil service, an issue pending since the 1988 Sussman report recommended a sweeping reorganization of the civil service. Moreover, it is not clear whether the different adjustments in wages across the various categories of public sector workers has eliminated the relative wage disparities that they were intended to correct.

One of the notable features of wage behavior in 1994 and early 1995 has been the relative lack of spillover to date from public sector wage increases to private sector wages. This development reflects the increased flexibility of the private sector labor market and the relative weakening of private sector trade unions in recent years, 1/ as well as the fact that the Government severed the formal link between civil service salaries and those in loss-making public enterprises.

c. Price developments

Following the 1985 Economic Stabilization Program, consumer price inflation remained stuck in the range of 15–20 percent. The relative stickiness in inflation in the five years through 1990 reflected a considerable degree of inflation inertia and in particular the continued, albeit reduced, indexation of wages. 2/ The large influx of immigrants in the early 1990s facilitated a distinct decline in inflation, which reached a low point of 9½ percent in 1992.

With a view to molding inflationary expectations and providing a nominal anchor to the economy, in late 1991 the Bank of Israel adopted a “diagonal” exchange rate policy (see Chapter III below). This change in exchange rate regime was subsequently supported by the announcement of specific inflation targets for the year ahead. These targets were progressively reduced to 10 percent for 1993 and to 8 percent for 1994. However, the target for 1995 was set at a range of 8–11 percent following the disappointing price performance in the previous year.

In mid-1993, there was a significant, albeit transitory, moderation in inflation in response to the slowing in the economy and to some easing of pressures on housing prices. However, following the subsequent easing of financial policies and the strong pick up in economic activity, there was a renewed increase in the underlying rate of inflation. Thus, excluding housing prices and the prices of fruits and vegetables from the consumer price index, inflation rose from around 8 percent in 1993 to 10¼ percent by the end of 1994. Moreover, reflecting the continued rapid rate of increase in housing prices and the unusually large increase in the prices of fruit and vegetables, the overall consumer price index accelerated from a 12-month rate of 11.3 percent at end-1993 to 14½ percent by end-1994, thereby significantly breaching the authorities’ 8 percent inflation target for the year (Tables A9 and A10 and Chart 4).

Chart 4.
Chart 4.

Israel: CONSUMER PRICES

(Percent change from one year earlier)

Citation: IMF Staff Country Reports 1995, 105; 10.5089/9781451819427.002.A001

Sources: Central Bureau of Statistics, Monthly Bulletin of Statistics; and data provided by the Bank of Israel.

In response to the rise in inflationary expectations, during the last quarter of 1994, the Bank of Israel sharply increased its lending rates (see Chapter III). These increases contributed to a moderation in the underlying rate of inflation to around 9½ percent by June 1995. During the first half of 1995, fruit and vegetable prices declined sharply because supply conditions improved, while the increase in housing prices—often expressed in U.S. dollars—moderated as this currency weakened vis-á-vis the shekel. In reflection of these factors, overall consumer prices increased at an annual rate of around 5½ percent in the first half of 1995, while the 12-month rate of consumer price inflation was reduced to 9¾ percent by June 1995.

III. Monetary Policy Developments

1. Overview

Over the past four years, the principal objective of monetary policy has been to reduce inflation from the 15–20 percent plateau that prevailed in the five years following the 1985 Economic Stabilization Program. In this respect, an important instrument of policy was the introduction in December 1991 of a diagonal exchange rate band, which was intended to provide a nominal anchor to the economy, and which since 1992 was complemented by the announcement of specific inflation targets for the year ahead. The attainment of these targets, was complicated, however, by the pressures on monetary policy to stimulate economic growth in order to allow for the absorption of Israel’s massive immigrant wave.

In mid-1993, against the background of faltering economic growth and signs of a moderation in inflation, monetary policy was eased substantially (Table 5 and Chart 5). This easing did not anticipate the boost to economic confidence that would flow from the signing of the Oslo Peace Accord in September 1993 nor the very large real wage increases that would be conceded to public sector employees. As a result of this easing, during the latter part of 1993 and early 1994 there was a substantial pickup in the rate of monetary and credit expansion, while for 1994 as a whole the authorities’ inflation target was substantially exceeded.

Chart 5.
Chart 5.

Israel: MONETARY INDICATORS, JANUARY 1991 – APRIL 1995

Citation: IMF Staff Country Reports 1995, 105; 10.5089/9781451819427.002.A001

Sources: Bank of Israel; IMF, International Financial Statistics.
Table 5.

Israel: Selected Monetary Policy Indicators

(Percentage change)

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Source: Bank of Israel.

First quarter of 1995 on first quarter of 1994.

March 1995 on March 1994.

Beginning in December 1993, the Bank of Israel began to raise its lending rate gradually from the then prevailing rate of 9.5 percent. The further raising of interest rates through September 1994 did little more than keep up with the increased pace of inflation. However, in the last quarter of 1994, interest rates were raised sharply by a cumulative 4½ percentage points to 17 percent by year-end. This abrupt tightening in policy contributed to the breaking of inflationary expectations and to the very much more favorable inflation performance in early 1995. Against that background, the Bank of Israel lowered its lending rate by a cumulative 3½ percentage points in the first half of 1995 to 13½ percent by end-June 1995.

Since the fourth quarter of 1994, monetary policy has been complicated by a surge in short-term capital inflows that has predominantly resulted from domestic enterprises borrowing abroad in response to the large differential between domestic and foreign borrowing rates. The Bank of Israel responded to these inflows by large-scale sterilized intervention in the first half of 1995, which succeeded in maintaining the currency at close to the midpoint of its band and which prevented a secondary expansion in the monetary and credit aggregates.

2. Recent interest rate and exchange rate developments

a. Interest rate developments

The Bank of Israel affects liquidity in the economy, and thus the level of interest rates, mainly by managing the amount of bank reserves. This is done by extending monetary loans to the commercial banks through regular monetary auctions and through the provision of liquidity from the discount window. In principle, the volume of liquidity is determined by the Bank of Israel, while the rate of interest is set by the market. However, in practice, in the context of its monthly monetary program, the Bank of Israel indicates the rate of interest that it will be targeting in the period immediately ahead.

Since 1990, when the wave of immigration from the FSU gathered momentum, interest rates were periodically used to foster activity, conditioned nevertheless by the constraint imposed by the exchange rate system. Thus, for example, in late 1992 the Bank of Israel reduced the cost of the discount-window loan in order to stimulate economic activity and employment. At the same time the midpoint rate of the exchange-rate against the currency basket was raised by 3 percent and the slope of the band was reduced from 9 percent to 8 percent. The result was an increase in the demand for foreign assets and for domestic credit, which put pressure on foreign exchange reserves. In the event, the marginal interest rate on the discount-window loan was raised from 11.4 percent to 12.3 percent in February 1993 (Table A15 and Chart 5, lower panel). This tighter policy stance was maintained until midyear, in order to prevent a renewal of the capital outflow of end-1992 and beginning 1993.

In the second and third quarters of 1993, domestic interest rates were reduced by a cumulative 3 percentage points, against the background of decelerating inflation, a slowdown in economic activity, and calm in the foreign exchange market (Chart 5). In response to these reductions, there was a strong reacceleration in the monetary and credit aggregates, as well as a strong pickup in asset prices. In spite of the relatively low level of domestic interest rates, the demand for foreign exchange by the private sector remained subdued. In part, the low demand for foreign assets could be explained by a further reduction in the slope of the exchange rate band from 8 percent to 6 percent, which reduced the relative attractiveness of foreign-denominated assets. Moreover, the buoyancy of the stock market might have offered an alternative domestic asset with an expected yield superior to that which could be obtained elsewhere.

With hindsight, it is apparent that the interest rate cuts in mid-1993 were excessive. However, part of the sharp reacceleration in the growth of the monetary and credit aggregates that occurred in late 1993 and early 1994 probably resulted from general euphoria in asset markets following the mid-September 1993 breakthrough in the peace process. In December 1993 and January 1994, the Bank of Israel raised the interest rate on its monetary loan to 10.5 percent in response to the expansion of the monetary and credit aggregates as well as to the rise in inflation.

During the first three quarters of 1994, the Bank of Israel increased interest rates in line with the pickup in consumer price inflation and market-based inflationary expectations (Table 6 and Chart 6). As a result, real interest rates remained basically unchanged. This stance proved to be insufficient to prevent a further acceleration in the rate of inflation. In response to this acceleration, in the last quarter of 1994, the Bank of Israel raised interest rates by a cumulative 4.5 percentage points in three successive 1.5 percentage point steps. This tightening reduced the rate of growth of the monetary and credit aggregates and sent a strong anti-inflationary signal to economic agents.

Table 6.

Israel: Selected Interest Rates

(Percent per year)

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Source: Bank of Israel.

Weighted by the volume of credit of the two components.

In dollar terms.

Gross yield to maturity in secondary market.

The difference between interest rates on overdraft credit and SROs.

Nominal rate deflated by change in the CPI over the same period.

Chart 6.
Chart 6.

Israel: INFLATION RATE, INFLATION RATE TARGET AND INFLATIONARY EXPECTATIONS

Citation: IMF Staff Country Reports 1995, 105; 10.5089/9781451819427.002.A001

Source: Bank of Israel.

The results of the more aggressive monetary policy stance at the end of 1994 began to be felt in early 1995. Inflation decelerated significantly, although given the lags of monetary policy, the improvement in price performance may have reflected measures taken in early to mid-1994 as well as the unusually large decline in the prices of fruit and vegetables. Inflationary expectations, however, came down, as did the rate of growth of M1 (Charts 5 and 6). Against this background, the Bank of Israel reduced its lending rate by 3½ percentage points during the first six months of 1995 to 13½ percent by end-June 1995.

The liberalization measures implemented since 1985 have reduced the degree of segmentation in the credit market and have led to a marked narrowing of interest rate differentials in the economy. This can be gauged by examining the narrowing of both domestic interest rate spreads and interest rate differentials vis-á-vis foreign rates (Table 6 and Chart 8, upper panel). Given the high degree of concentration that characterizes the Israeli banking system, the authorities have been taking measures to enhance competition by deregulating markets and increasing access to foreign finance so as to reduce the traditionally large spread between domestic deposit and lending rates. In the event, the interest rate spread between non-indexed shekel deposits and loans fell from 33 percentage points at end-1987 to close to 6.5 percent by end-1994 (Table A15). 1/ At the same time, the cost of foreign currency denominated credit in Israel converged to that in world markets, with the spread between the domestic borrowing rate in U.S. dollars and the Libor U.S. dollar rate narrowing from 11.8 percentage points at end-1987 to 1.2 percentage points in 1994.

b. Exchange rate policy

Since 1985, exchange rate policy has played a major role in Israel’s economic stabilization effort. In July 1985, the Government abandoned a managed float and fixed the exchange rate to the U.S. dollar in order to provide a nominal anchor to the economy. Since then, the regime has undergone successive transformations. In mid-1986, the exchange rate was pegged to a trade weighted basket of five currencies; 1/ in January 1989, a currency band system was adopted, with a central parity measured relative to the currency basket and with a 3 percent fluctuation zone around this parity; 2/ and in March 1990 the band’s width was enlarged to 5 percentage points on either side of the central rate.

Although by end-1991 domestic inflation had declined to about 20 percent, its level was still notably higher than the rates prevalent in Israel’s major trading partners. The market’s perception that devaluations would take place from time to time led to considerable uncertainty and speculation in foreign exchange markets, which damaged the credibility of exchange rate policy. Against this background, in December 1991, the Bank of Israel introduced a “diagonal” exchange rate system, with an initial rate of crawl of 8 percent and a band of 5 percentage points on either side of the central rate (Chart 7, bottom panel). Under this arrangement, the midpoint of the band was to be devalued daily vis-á-vis the currency basket according to a preannounced path, which was set at a level equal to the difference between Israel’s official inflation target and a forecast of foreign inflation for that year. The preannounced crawling central parity rate was intended to stabilize currency expectations and to discourage speculative capital movements, while at the same time maintaining downward pressures on inflation.

In July 1993, the preannounced rate of crawl was reduced from an annual 8 percent to 6 percent, while at the same time the central point of the band was depreciated by 2 percent (Chart 7, lower panel). 1/ The new pace of crawl was thought to be consistent with the Government’s 8 percent inflation target for 1994. In conformity with the preannounced rate of crawl, the currency depreciated by 5.7 percent vis-á-vis the currency basket in the 12 months ended in December 1994. The failure to meet the inflation target resulted in a real effective appreciation of the currency during 1994 of 2.4 percent measured by relative changes in the CPI and of 8.7 percent measured by unit-labor costs 2/ (Chart 7, upper panel).

Chart 7.
Chart 7.

Israel: SELECTED EXCHANGE RATE INDICATORS

Citation: IMF Staff Country Reports 1995, 105; 10.5089/9781451819427.002.A001

Sources: Israeli authorities; IMF, Information Notice System.1/ Price index of industrial prices in Israel divided by industrial production in selected countries times the NIS exchange rate index (currency basket).2/ Weekly average of daily rates. Updated to June 14, 1995

While the band allowed for a 5 percent variation of the exchange rate in each direction, during 1994 the rate remained within a range of less than 2½ percentage points of either side of the midpoint of the band. This policy had the effect of reducing the uncertainty related to expected exchange rate changes and thereby increased the sensitivity of capital flows to interest rate differentials. In response to the tighter monetary policy stance in the last quarter of 1994, there was a surge in capital inflows, as agents took advantage of the higher interest differential by borrowing abroad rather than domestically. The Bank of Israel engaged in heavy sterilized intervention in order to avoid an appreciation of the currency. As a result, during 1994 the Bank of Israel purchased around US$650 million from the public, whereas in the period January-May 1995 foreign exchange purchases were close to US$3 billion (Chart 8). In early June 1995, the authorities widened the band around the central parity rate from 5 percentage points to 7 percentage points with a view to allowing greater variability within the band in order to inhibit borrowing from abroad. 3/

Chart 8.
Chart 8.

Israel: STERILIZATION OF SHORT-TERM CAPITAL INFLOWS

Citation: IMF Staff Country Reports 1995, 105; 10.5089/9781451819427.002.A001

Source: Israeli authorities.

In September 1994, against the background of an inflation rate well above target, the Government announced an inflation target range of 8–11 percent for 1995. The slope of the band was kept constant, however, since the anticipated rate of exchange devaluation of 6 percent was considered to be consistent with the difference between the center of the domestic inflation target range and the expected rate of inflation abroad. In the first five months of 1995, the currency was devalued by over 4 percentage points relative to the currency basket, before it was allowed to appreciate by around 4 percentage points following the widening of the exchange rate band in early June 1995.

Since 1992, the crawling exchange rate band, has been complemented by the announcement of official inflation targets. The inflation target for 1992 was set at 14–15 percent; that for 1993 at 10 percent; and those for 1994 and 1995 at 8 percent and 8–11 percent, respectively (Chart 6). The inflation target has gained importance and is viewed by some as a credible commitment that can become the economy’s key nominal anchor. However, while the inflation target was met in 1992, inflation was above target in 1993 and significantly so in 1994. The lack of success in meeting the inflation target has introduced considerable ambiguity as to whether the target is a policy objective or a forecast by the authorities.

In July 1994, the Bank of Israel introduced a two-sided system for foreign exchange trading. Under this system, market-making banks quote bid and ask prices to their customers throughout the trading day, and interbank transactions and trading between the banks and the Bank of Israel is conducted on a continuous basis. In order to increase the volume of exchange, the Bank of Israel allowed banks to increase their foreign-currency position so as to avert the need for it to intervene in the market repeatedly. In the event, short-term intervention by the Bank of Israel in the market has declined steeply.

3. The monetary and credit aggregates

a. Monetary aggregates

In 1993, there was a rapid expansion in the monetary aggregates, especially in the last four months of the year (Tables 5 and 7, and Chart 5). This development was associated with a pick-up in economic activity; the general euphoria in asset markets following the mid-September 1993 breakthrough in the peace process; and the generally supportive stance of monetary policy since mid-1993, which kept interest rates low compared with their level at the beginning of the year. In the event, during the 12 months ended December 1993, the monetary base grew by 34 percent; the narrowly defined money supply (Ml) by 28 percent; and M2, which also includes interest-bearing short-term local currency deposits (self-renewing overnight deposits (SROs) and resident time deposits) and Treasury bills, rose by 31 percent. 1/ The average rates of growth of these three aggregates in 1993 at 31 percent, 24 percent, and 38 percent, respectively, were significantly higher than the average 15 percent rate of growth in nominal GDP in the year.

Table 7.

Israel: Principal Monetary Aggregates

(Percentage change)

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Source: Bank of Israel.

First quarter of 1995 on first quarter of 1994.

In 1994, developments in the rate of growth of the monetary aggregates were uneven, reflecting the tightening of monetary policy in the last quarter of the year and the resulting portfolio adjustments (Table 7). For the 12 months ended December 1994, M1 grew by 5.2 percent in nominal terms, while M2 increased by 38 percent over the same period. The different behavior of the two aggregates reflects the increase in the demand for interest bearing deposits that resulted from the tighter monetary policy stance. On average, M1 and M2 were 21 percent and 33 percent, respectively, higher than their averages in 1993. Foreign currency linked deposits increased by 18 percent in 1994 after a contraction of almost 10 percent in the previous year. The relatively slow expansion of foreign currency linked deposits can be attributed to the moderate devaluation expectations, given the stability of the currency around the midpoint of the exchange rate.

In late 1994 and in early 1995, following the steep rise in interest rates, M1 decreased in nominal terms. With the recent reduction in interest rates, M1 has resumed a growth path consistent with the growth of nominal GDP. In contrast, despite the tightening in the monetary policy stance, M2 registered a similar pace of expansion in the first five months of 1995 as it did during 1994.

b. Credit aggregates

As with the monetary aggregates, during 1993 there was a very rapid pace of credit expansion with much of the expansion registered in the last four months of the year (Table 8 and Chart 5). In addition to the buoyancy of economic activity during this period, the increased demand for local currency credit was connected with the lowering of interest rates by the Bank of Israel in mid-1993 and with the concurrent stock market boom. Indeed, in face of lower interest rates, economic agents shifted to assets with higher rates of return—mainly shares, real estate, and consumer durables. In this process, they increased their demands for local currency credit. As a result, for 1993 as a whole, nondirected local currency credit was over 40 percent above the level in the previous year. Foreign exchange credit, on the other hand, increased on average by just 9 percent, effectively shrinking in real terms. Medium- and long-term credit rose at an annual average rate of 24 percent, up from 19 percent in 1992, with the main part of this increase in the form of nondirected indexed credit.

Table 8.

Israel: Commercial Bank Credit to the Private Sector 1/

(Percentage increase of end-of-period figures)

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Source: Bank of Israel.

Commercial banks and their overseas offices. Includes credit to local authorities.

First quarter 1995 on first quarter of 1994.

During 1994, there was some slowing in the rate of increase in nondirected local currency credit but it continued to expand by around 25 percent (Table 8). The relative slowing in the pace of credit expansion in 1994 was partially the result of a tighter monetary policy stance, but it was also attributable to the Tel Aviv Stock Exchange plunge starting in February 1994 and the resulting reduction in the volume of financial transactions (Chart 9). Loans more closely related to real activity, such as overdraft credit, continued to expand at rates similar to those registered in 1993.

Chart 9.
Chart 9.

Israel: INDICATORS OF STOCK MARKET BEHAVIOR, 1989 – 1994

Citation: IMF Staff Country Reports 1995, 105; 10.5089/9781451819427.002.A001

Source: Bank of Israel.

In response to the sharp increase in domestic interest rates toward end-1994, there has been a shift from unindexed credit to credit indexed to the CPI and to foreign currency (Table 8). At the same time, foreign currency credit, mainly of a short-term nature, accelerated substantially in the last months of 1994 and even more quickly during the first five months of 1995. As a result, despite some slowing in the pace of domestic currency credit expansion, overall banking system credit continued to increase at a 12-month rate of around 29 percent, close to that registered during 1994.

The rapid growth of foreign currency credit since end-1994 reflected the differential between the cost of local and foreign currency borrowing rates, adjusted for expected changes in the exchange rate. A factor contributing to this process was the low degree of exchange rate variability that resulted from the Bank of Israel’s holding the currency at close to its central rate. In the event, the Bank of Israel responded to these flows by substantial sterilized foreign exchange market intervention, mainly through a reduction in the net amount of its monetary loan outstanding, which shrank from NIS 18.7 billion in the last quarter of 1994 to NIS 6.3 billion in May 1995 (Chart 8, lower panel). In addition, in June 1995, the exchange rate band was widened from 5 percent to 7 percent on each side of the central with a view to signaling the monetary authorities’ tolerance in the period ahead for greater exchange rate variability as a means to discourage speculative short-term foreign currency borrowing.

4. Capital market developments

Until 1985, the Israeli financial system was characterized by massive government intervention, which had an adverse effect on the efficiency and performance of the capital and foreign exchange markets. This heavy intervention stemmed from the Government’s need to finance substantial budget deficits and from its desire to guide the allocation of the remaining funds. With the marked contraction in the budget deficit that followed the 1985 Economic Stabilization Program, the Bank of Israel and the Ministry of Finance embarked on a gradual process of reforming the capital market with the objective of reducing the market’s segmentation and stimulating the introduction of market-based allocative mechanisms. These reforms led to a sharp reduction in interest rate spreads, a marked decrease in reserve requirements, and a major reduction in the extent of government intervention in the market. 1/

Between 1988 and end-1993, the Israeli stock market experienced an unprecedented period of growth. Indications of the boom over this period include a 750 percent increase in the general stock market price index and a tenfold increase in stock market capitalization to US$51 billion (Chart 9). The marked increase in stock prices was accompanied by a substantial expansion of equity offerings and in the number of companies listed on the stock exchange. The number of equity issues increased from 37 in 1988 to 285 in 1993, with the amounts raised by issues of shares and convertible securities increasing by over 1600 percent in real terms over the same period (Table A21). This increase in stock market activity was associated with the improved performance of the economy, with the acceleration of the peace process, and with the easing of monetary policy in mid-1993 that facilitated a rapid expansion in local currency credit. 2/

In February 1994, the Tel Aviv Stock Exchange fell markedly, bringing the boom to an end. The Mishtanim two-sided share price index dropped by around 32 percent during the year, whereas the general share price index registered a fall of 38.5 percent (Chart 9). 3/ As a result of the steep fall in prices in the secondary market, there was a 47 percent real contraction in capital issues in the primary market (Table A21). The plunge in the stock market is mainly to be explained by high domestic interest rates; by a reassessment of the speed of the peace process; and by the loss of confidence in the market due to an investigation by the Securities Authorities on trading irregularities. Since February 1995, however, the stock market has recovered by over 25 percent, probably underpinned by the reduction in domestic interest rates.

The market value of listed government bonds fell by some 6.5 percent in real terms during 1994, after having risen continuously since 1989 (Table A22). In part, this reduction reflected the fall in prices due to the smaller demand for bonds as private sector savings declined. However, it was also the result of the rise of inflationary expectations and of short-term interest rates both domestically and abroad. The average real yield on 10-year government bonds rose from 2.6 percent in 1992 to 3.2 percent in 1994 (Table 6). The slope of the yield curve changed significantly during the year, becoming steeper by midyear as inflationary expectations deteriorated. This was followed by a flattening in the yield curve in the last months of the year under the impact of the tightening of monetary policy. A noteworthy trend in the government securities market was the downward trend in the proportion of bonds with a term to maturity of over ten years, from around 27 percent in 1992 to 18 percent in 1994, reflecting a shift in the Treasury borrowing patterns.

Net issues of private negotiable bonds have been negative in recent years, as corporations displayed a preference for raising funds in the stock market. Gross borrowing through issues of bonds averaged NIS 0.4 billion from 1991 to 1993, dropping to NIS 20 million in 1994. The stock of such bonds fell by 12.7 percent in real terms during 1994, reaching NIS 10.8 billion at year end. While the relatively high real interest rates might explain the particularly low level of placements in 1994, the reasons behind the longer-term trend are to be found in the high fixed costs of floating bonds; in the competition with government securities; and in the relative attractiveness of bank credit as a source of finance.

5. Institutional investors

Institutional investors such as mutual funds, provident funds, pension funds, and life insurance schemes are the main instruments through which the public invests in the capital market. 1/ While mutual funds cater to the public’s short-term needs, provident funds, pension funds, and life insurance schemes provide vehicles for the investment of savings for the longer term. Until 1985, institutional investors were constrained in their operations by an array of government restrictions. Prominent among those were mandatory investment requirements on government bonds, which resulted from the Government’s need to finance its large budget deficits. However, since the late 1980s, the restrictions imposed on institutional investors’ operations were progressively reduced and the availability of financial instruments was enhanced. As a result, the attractiveness of saving through such schemes has increased substantially.

In 1994, investments in provident funds accounted for NIS 103.7 billion or 24 percent of the public’s asset portfolio. However, this represented a real decline of about 7 percent from the balance registered in December 1993, as a result of negative yields and substantial withdrawals due to the funds’ worsening performance (Table A23). Until 1985, most investments of provident funds were in CPI-linked securities and in earmarked bonds issued by the Government. In the event, these funds enjoyed relatively high returns and low risks. With the substantial reduction in the supply of earmarked bonds that has characterized the reforms of the financial system over the past decade, the share of negotiable securities in these funds increased. While the average yield between 1990 and 1993 has remained stable at around 5 percent in real terms, the variability in the returns increased, raising the funds’ perceived riskiness. When the prices of most tradable assets fell in 1994, redemption from these funds became widespread.

At the end of 1994, the assets of mutual funds represented around 5 percent of the public’s financial assets portfolio, amounting to NIS 18.8 billion (Table A23). This figure represents a real decline of close to 54 percent from their balance in 1993 that was mainly due to large redemptions resulting from a shift of investments from the capital market to the real estate market. The loss of value of mutual funds also reflects the negative yields that characterized all types of such funds, particularly those specializing in stocks. The public’s assets in pension funds grew by 4 percent in real terms in 1994 and amounted to NIS 57.8 billion or 17 percent of the public’s total asset portfolio. This moderate rate of increase reflected a surplus of redemptions relative to deposits, apparently caused by demographic factors, combined with a positive return of around 5 percent. In the event, the Treasury continued to issue bonds earmarked to the pension funds. The public’s holdings in life insurance plans. 75 percent of whose assets consist of earmarked bonds, also increased by 5 percent, reaching NIB 2.5 billion in December 1994.

IV. Public Finances

1. Overview

Over the past five years, the principal objective of fiscal policy has been the consolidation of the public finances. In this respect, notwithstanding the substantial pressures emanating from the large wave of immigration from the former Soviet Union, considerable progress was made in reducing the budget deficit. Thus, within the framework of the 1992 Deficit Reduction Law, which was aimed at providing assurance that budget discipline would be maintained despite the influx of immigrants, the general government’s domestic budget deficit was reduced steadily from over 7 percent of GDP in 1990 to below 2 percent of GDP in 1994 (Table 9 and Chart 10). Over the same period, the overall government deficit was reduced from 4k percent of GDP to 1 percent of GDP. The maintenance of budgetary discipline over this period facilitated a reduction in the public debt to GDP ratio, which had peaked at 172 percent in 1985, from 112 percent in 1990 to 92 percent in 1994.

Table 9.

Israel: Overall Indicators of General Government Activity

(In percent of GNP)

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Source: Bank of Israel, Annual Report.

In 1993 and 1994, the reduction in the budget deficit was attained while at the same time increasing the level of public infrastructure expenditures and reducing tax rates on corporations and middle-class household incomes. In this respect, budget discipline was facilitated by a further decline in the proportion of budget spending on defense and by the strong cyclical increase in tax revenues. These factors were more than sufficient to offset very large and unplanned increases in public wages and employment as well as the bail-out of the kibbutzim (the collective farms) and the defense industries. The higher-than-planned expenditures necessitated the introduction of a supplementary budget in October 1994 in the amount of NIS 5.6 billion, or around 2 percent of GDP.

The 1995 budget projects a domestic deficit for the central government of 2.75 percent of GDP, which, while below the 3 percent budget deficit targeted for 1994, is above the 2 percent of GDP actual budget outturn for 1994. The 1995 budget maintains the emphasis of the previous year’s budget on infrastructure spending, especially in the areas of eduction and roads, as well as on further reductions in corporate and income tax rates. The foreign component of the budget, which has traditionally been in surplus, is budgeted to register a deficit of close to 1 percent of GDP in 1995, mainly on account of interest payments on loans contracted under the U.S. government loan guarantee scheme.

Chart 10.
Chart 10.

Israel: SELECTED INDICATORS OF GENERAL GOVERNMENT ACTIVITY 1/

(In percent of GNP)

Citation: IMF Staff Country Reports 1995, 105; 10.5089/9781451819427.002.A001

Source: Bank of Israel.1/ On a National Accounts basis.

While progress has been made in reducing the budget deficit over the past five years, public sector expenditures and revenues remain relatively high as a proportion of GDP. Thus, in 1994 general government revenues exceeded 53 percent of GDP, compared with 54½ percent of GDP in 1990, while general government expenditures amounted to 54 percent of GDP, compared with 58% percent of GDP in 1990 (Table 9 and Chart 10). Israel’s tax burden is presently comparable to that in France and Germany, but about 5 percentage points higher than that in countries at a similar stage of development.

The privatization program initiated in the late 1980s has been strongly opposed by vested interests. This opposition resulted in a relatively slow pace of privatization through 1994. The sales of a few state-owned companies in early 1995 signal some renewed momentum in the process, but the prospect of a large scale operation would appear to be linked to an option scheme designed by the Ministry of Finance to garner public support. At the moment, the Government retains control of large parts of the real economy and has a predominant influence on the banking system. Moreover, important sectors of the economy, including the defense industry and the kibbutzim, continue to be highly dependent on public support.

2. Recent trends in the Government’s finance

a. The budget deficit

In 1992, tight control over the domestic component of the central government’s deficit was imposed by enacting the Deficit Reduction Law. This law mandated the elimination of the domestic component of the deficit (excluding local governments) by 1995 and set specific targets for each year’s domestic deficit to GDP ratio. During the 1994 budget process, however, the provisions of the law were relaxed by establishing that future budgets need only target domestic deficits that are below that targeted for the previous year, without specifying an end date for a balanced domestic budget. In reflection of the application of this law, the domestic component of the general government deficit was reduced from 7.3 percent of GDP in 1991 to 4.4 percent of GDP in 1993 and to 1.9 percent of GDP in 1994 (Table 9 and Chart 10).

In both 1993 and 1994, the actual domestic deficit was lower than forecast, thanks to a combination of higher revenues and lower expenditures. 1/ However, in October 1994, a NIS 5.6 billion supplementary budget was enacted in order to cover unplanned outlays on public wages, on the peace agreement with Jordan, and on budget support to the kibbutzim and the defense industry. The supplementary budget was financed from a cyclical increase in tax collections due to stronger economic growth and one time factors such as the higher corporate profits stemming from capital gains on stock market transactions in 1993.

During 1994, the greater part of the deficit was financed from foreign sources including drawings under the U.S. loan guarantee arrangement. At the same time, domestic financing of the deficit declined from 3.0 percent of GDP in 1993 to 0.8 percent in 1994, while the proceeds from the net sales of state properties were negligible (Table 10). Despite a lower overall borrowing requirement, toward the end of 1994 the Government drew temporarily from its deposits with the Bank of Israel a total of about NIS 2.5 billion.

Table 10.

Israel: Sources of Total Public Deficit Financing

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Sources: Central Bureau of Statistics; and the Bank of Israel.

b. Revenues

The long range trends in government revenues display two general traits: (a) the burden of taxation as a percentage of GNP has remained high, if compared with countries with approximately equal per capita income; and (b) the ratio between direct and indirect taxation has grown in the past two years reverting a tendency that lasted from 1986 (Table 11 and Chart 11). As regards the tax burden, some measures to reduce it have been taken in recent years. In particular, the immigrant absorption levy on individual incomes was abolished; the corporate income tax was reduced by one percentage point to 38 percent; income tax brackets were reduced for middle income households; and continued progress was made in reducing custom duties to “third countries” not covered by the EU or U.S. free trade agreements. Despite these reductions in tax rates, however, the tax to GDP ratio increased in 1994 further to 40.6 percent from around 38.4 percent in 1991 (Table 11). 1/ This strengthening reflected both cyclical factors and the progressive nature of the Israeli tax system.

Between 1986 and 1992, the composition of tax revenues progressively shifted toward indirect taxation. In 1993, the tendency toward increased reliance on indirect taxation was reversed as the VAT was reduced from 18 percent to 17 percent and as various levies on foreign trade were reduced as part of the trade liberalization process. Moreover, in 1994, there was a sharp increase in direct taxes, far in excess of GNP growth, mainly as a result of business sector growth, the hike in public wages, and the progressiveness of the tax structure. Buoyant economic activity also boosted corporate tax collections, as many companies began to register profits and as the stock market yielded large capital gains.

c. Expenditures

Since the 1985 Economic Stabilization Program, public expenditures declined markedly from over 70 percent of GDP in 1985 to 54 percent of GDP in 1994 (Tables 11 and 12). The long-term downward trend was prompted mainly by modest real increases in defense expenditures over this period and by lower interest payments on both the domestic and the foreign debt. Because a large share of defense materiel is purchased abroad, external expenditure dropped from 14½ percent of GDP in 1985 to 44 percent of GDP in 1994. The ratio of domestic expenditures to GDP was almost constant at slightly above 52 percent between 1986 and 1992, before declining to 51 percent of GDP in 1993 and 49½ percent of GDP in 1994.

Table 11.

Israel: General Government (SNA) – Receipts, Expenditure, and Deficit, 1989–94

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Sources: Bank of Israel computations, based on national accounts items from the Central Bureau of Statistics.

Structures and equipment.

Nominal interest paid to residents by general government and the Bank of Israel.

Subsidies to domestic production, imports and exports.

Subsidy element of credit to firms and export credit.

Nominal interest paid on foreign public debt less interest received on foreign reserves.

Maintenance of diplomatic missions abroad; Bank of Israel expenditure in coins and banknotes.

Direct and indirect taxes (including import duties on direct defense imports).

Domestic operating profit of the Bank of Israel plus other income from property and entrepreneurship (rent, dividends, interest).

Table 12.

Israel: General Government Expenditure, by Type of Intervention, 1989–94

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Sources: Central Bureau of Statistics.

Estimated from the general government consumption figures; for 1989–94 provisional estimate based on change in number of employee posts. The 1994 figure is based on national budget estimates regarding the wage agreement reached with the teachers in May 1993.

Despite the significant cutback that has taken place since the mid-1980s, defense expenditures remain high if compared with other industrialized countries due to the unsettled situation in the Middle East. While in 1985 defense expenditures absorbed as much as 20.7 percent of GDP, by 1993 this proportion had dropped to 10.9 percent of GDP before declining by another percentage point in 1994 (Table 12). Total defense consumption in 1994 was down by 9.5 percent mainly because defense imports, which have a tendency to fluctuate randomly, were unusually low. The burden of public interest payments dropped by almost one percentage point of GNP between 1992 and 1994.

A distinguishing feature of public expenditures over the past two years has been the sharp increase in public wages. Over the past few years, the number of public employee posts have been growing at an average rate of around 5 percent. Moreover, in 1993 and 1994, public employees received unprecedented real wage increases. These hikes were triggered when the Government gave in to pressures to correct relative wage disparities from specific groups, such as the teachers and the academics, whose earnings had been eroded over the years relative to other professional categories in the public sector. This process, however, rapidly spilled over to the rest of the public sector work force. As a result, civil servant wages in real terms increased by over 10 percent in 1994 and they are scheduled to increase by a further 5 percent in 1995. Apart from the obvious negative consequences for the long-term fiscal position, these public wage increases risk spilling over into the private sector.

Welfare payments, which remained high through the early 1990s, increased further in 1994 due to the reintroduction of child allowances (Table 12). At the same time, health and education expenditures increased, in part due to wage increases, but especially in the case of education because the Government fulfilled a commitment to improve the quality of education as a budget priority. In contrast, business subsidies were drastically cut from 6.9 percent of GNP in 1992 to 4.3 percent of GNP in 1994, following an effort to reduce the dependency of firms on government transfers. An exception were the kibbutzim and the defense sector, whose debt write-offs were covered in part by the supplementary budget approved in October 1994.

A notable feature of the budget in both 1993 and 1994 was the increased emphasis on infrastructure spending. In the initial years of the recent immigration wave, public housing projects to accommodate the new immigrants were accorded precedence. However, as the situation normalized, the emphasis shifted toward more general priorities like road construction. A positive aspect of this process was the rise in the overall level of public infrastructural investment after several years of stagnation.

In recent years, the National Insurance Institute (NII), which is part of the government budget, has been in chronic deficit. In 1993, the last year for which data are available, expenditures of the Nil exceeded revenues by 2.8 percent of GNP. The long-term stability of the system was improved by the passage of the Health Insurance Law that came into effect in January 1995 and that introduced a 4.8 percent charge on net salaries in place of fixed contributions. Further, the flat rate social security tax on individuals was replaced by a progressive tax with three brackets. However, these increases were offset in part by a 2 percent reduction in the social security tax paid by employers.

The total revenue of the Health Fund is expected to reach NIS 5.0 billion in 1995, an increase of NIS 1.5 billion over 1994, but it will still be insufficient to balance its budget. The problems of the Health Fund stem from the absence of built-in control mechanisms to limit the provisions of the public health care system: every year the Government specifies in the budget the basket of health services that will be financed through the Health Fund and the difference between revenues and expenditures is then appropriated from the budget.

d. The stock of debt and its financing

In reflection of the greater degree of budget discipline, Israel’s public debt declined from a peak of 172 percent of GDP in 1985 to 112 percent of GDP in 1990 and to 92 percent of GDP in 1994 (Table 9 and Chart 10). 1/ The domestic and foreign components of this debt in 1994 were 72 percent of GDP and 20 percent of GDP, respectively, with both of these components on a clearly declining path. The improved public debt position is reflected in the BBB+ rating that Standard and Poors assigned informally to Israel’s senior long-term foreign currency debt in October 1993, which rating was officially confirmed in February 1995.

The gross public domestic debt declined by 0.3 percent in real terms—after increasing by 3.8 percent in 1992 and 2.4 percent in 1993. At the same time, the gross external debt declined in real NIS terms due to the real revaluation of the shekel, although in U.S. dollar terms it rose from US$20.4 billion in 1993 to US$22.6 billion in 1994. As a share of the total public debt, the external component increased to 27 percent in 1994, mainly reflecting the increased borrowing under the U.S. government loan guarantee program. The interest payments on the total public debt declined from 6.3 percent of GDP in 1993 to 5.9 percent of GDP in 1994 (Table 13).

Until 1991, virtually the entire domestic debt offered rates of returns linked either to the CPI or to the U.S. dollar. Starting in 1992, the Treasury began to issue “Gilon” bonds, bearing variable interest rates, which in that year represented 3 percent of total tradable securities. 2/ This percentage rose in 1993 and 1994 by around 18 percent. As a result, the proportion of CPI-linked borrowing declined from 79 percent of the total in 1992 to 68 percent in 1994, while U.S. dollar-linked borrowing declined to 15 percent of the total in 1994. Unlinked securities however still amount to less than 2 percent of the total debt. For the future, the Treasury has been authorized by law to issue “Shahar” bonds bearing a fixed interest coupon.

Table 13.

Israel: Gross Public Sector External Debt, 1985–94

(In percent of GNP)

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Source: Bank of Israel, The Money and Capital Markets. Annual Survey, 1995.

The average maturity of the domestic debt rose from 9.6 years in 1992 to 10.0 years in 1994, while the term of the negotiable part of the government domestic debt remained at around 8 years. Over this period, negotiable securities declined from 68.9 percent of the Government’s gross debt to 63.7 percent in 1994. While the cost of nontradable securities remained constant at around 5.3 percent, the cost of negotiable debt in 1994 increased to 3.8 percent, compared to a level that had been around 3.4 percent since 1990. Factors that might explain the increased rate of return on negotiable debt include the lower savings rate, the high interest rates both in Israel and abroad, and the wave of bond redemptions by the mutual and provident funds.

The average term of the outstanding gross external debt was 11 years at the end of 1994, while the average term of the new loans increased in 1994 to 13 years from 9 years in 1992. Since around 90 percent of the external debt is denominated in U.S. dollars, its average cost is heavily influenced by U.S. interest rates. Over the period 1990–93 the cost of new external borrowing decreased to 6.5 percent, but in 1994 it went up to 7.6 percent. In the past, the main component of external borrowing was in Israel Bonds. However, since 1993, the main part of new borrowing has taken place under the U.S. guarantees program, with the amount of such borrowing in 1993 and 1994 totaling US$4.3 billion.

3. The 1995 budget

a. The budgetary process

The Ministry of Finance in Israel has a dominant role in setting fiscal policy objectives and it maintains a highly centralized control over each ministry’s expenditures specifying in detail their annual budgets. While in the past budgeting control was relatively weak due to a lack of periodic reviews of the single items, in recent years the Ministry of Finance has enhanced its monitoring procedures. This improved control has been reflected in budget deficit outturns that have been lower than the targeted deficits. The Deficit Reduction Law has induced a better management of public resources, although it does not establish sanctions in case the target is not met. Moreover, since 1991, budgets have been drafted in a multiyear framework, with the next year’s budget set out in full detail, whereas the medium-term plan specifies only the level of functional allocations.

The budgetary process for 1995 was quite lengthy and the budget was approved in late December 1994 just before the deadline. However, not all the issues had been resolved by that time. In particular, agreement had not been reached on an incomes policy in a tripartite negotiation with the unions and the employers. Three weeks after the budget was approved, the Government lowered the tax burden by NIS 860 million, which was financed by NIS 140 million in increased dividends from state-owned companies and by NIS 720 million in expenditures cuts. 1/ At the same time, the employers’ social security tax was reduced from 4.95 percent to 3 percent. Further, in January 1995, the Government repealed a capital gain tax that had earlier been proposed and that had contributed to depress stock exchange prices.

b. The main planks for the 1995 budget

The government budget for 1995 targets a domestic deficit of NIS 9.9 billion, or 2.75 percent of GDP, which is lower than the 3.0 percent targeted for 1994 as required by the amended Deficit Reduction Law (Table 14). The deficit is to be financed by net domestic borrowing of NIS 1.7 billion. The remainder will come from borrowing under the U.S. government loan guarantees.

Table 14.

Israel: 1995 Government Budget and Past Outcomes

(In billions of new sheqalim)

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Source: Ministry of Finance.

The 1995 budget follows closely the general pattern of the previous two years’ budgets. It is characterized by several measures aimed at lowering the tax burden—in particular reducing the progressiveness of Income taxation—while at the same time emphasizing the maintenance of an increased level of infrastructural spending. In addition to the changes in the social security contributions and the health tax mentioned above, the corporate tax rate was reduced by a further 1 percentage point to 37 percent.

With regard to income taxes, in January 1995, the 30 percent income tax bracket was widened and the 35 percent rate bracket was abolished. As stated above, the net effect of these reductions is estimated to be NIS 860 million. An additional NIS 1.2 billion reduction on a yearly basis is planned for September 1995, when the 30 percent income tax bracket will be further widened together with the 40 percent bracket. A further measure contained in the 1995 budget was a levy on all workers varying between 0.7 percent and 0.9 percent of income to finance the Hisadrut. Following these changes, the top marginal tax rate is 60 percent, but this rate drops to 50 percent at the highest income levels since the marginal rates on the social security tax, on the Health Fund tax, and on the Histadrut tax all drop to zero for incomes above 4 times the average wage.

In the original budget, real expenditures, excluding debt repayments were planned to rise by 8.5 percent to NIS 129.0 billions and as a share of GDP they would stand at 49.6 percent. Most of the increase was to be appropriated for social services, especially education, and for transfers to local governments. In part reflecting increased wage payments, public sector civilian consumption would grow by 14 percent in real terms, while transfers to individuals, institutions, and local authorities would increase by 6 percent. The increase in civilian expenditures is mirrored by the lower share of expenditures allocated to defense and to interest payments in line with the long-term trend initiated after the stabilization program. Defense expenditures will account for 17.8 percent of the total (versus 24 percent in 1986), while interest payments are planned to be 31.0 percent of the total (compared to 49 percent in 1986). Following the pattern of the last two years, public investment will increase by 19 percent, and will be spent mainly on roads and industrial infrastructure. Subsidies on credit will continue to decline sharply in reflection of the decreasing volume of housing loans destined to new immigrants.

In spite of the recently enacted tax reductions, government revenues are projected to grow by 9 percent in real terms in 1995, with taxes projected to grow by 8 percent. After the tax cuts introduced in January 1995, direct taxes on income will grow by around 7 percent. Indirect taxation in 1995 is also expected to increase by 7 percent in 1995, notwithstanding the fact that lower import taxes, lower sales taxes on computers, and lower excise taxes on fuels, will reduce indirect tax revenues by a cumulative NIS 560 million over the year.

4. Public enterprises and the privatization process

a. Public enterprises

Public companies still play a central role in the Israeli economy. In 1993, the public enterprises had total revenues equivalent to 16.7 percent of GDP, contributed 18.3 percent of total exports, and employed 3.9 percent of the Israeli workforce. In addition, the four largest banks, which account for 90 percent of the banking system, were yet to be privatized.

Although the financial health of the public enterprises has improved in the aggregate, the defense sector and the collective farms remain beset by financial difficulties. The three state-owned defense companies—TAAS, Rafael, and Israeli Aircraft Industries—which make up 70 percent of the domestic military sector, have been hard hit by the world-wide downturn in weaponry sales and by their difficulty to keep their technological edge. The Government has already provided US$1.18 billion in support to these industries and it estimates that over the next four years an additional US$1½ billion may be needed despite the substantial cut that has already been effected in these industries’ workforce. As regards the kibbutzim, during 1994 the Government devised a rescue package totaling NIS 5.9 billion: NIS 2 billion was to come from land sales leased to the kibbutzim, while the Government and the banks were to write off NIS 3.9 billion of debts. In addition, some kibbutzim were to transfer to the Government and the banks part of the stock they owned in industrial companies.

b. Privatization

The privatization process in Israel has been slow and has been a disappointing element in the structural reform process started following the 1985 Economic Stabilization Program. Despite repeated commitments to hasten the sale of public companies, the Government was challenged by a number of powerful vested interest groups. As a result, from 1986 until March 1991, only US$430 million worth of holdings in public companies had been sold. In the following four years, up to the first quarter of 1995, proceeds from privatization sales totaled US$3 billion.

In 1993, only few small companies were sold, with revenues adding up to US$1.2 billion of which about US$600 million came from the sale of minority stakes in banks. In the course of 1994, the privatization process stalled as the planned sale of large conglomerates encountered mounting opposition from the workers and the management of these enterprises, while the slump in the Tel Aviv Stock Exchange was used as an excuse to postpone some large operations. Only one major privatization was approved by the Government in 1994: in November 1994 it was announced that Elco Group would purchase a controlling stake in Shekel, a department store chain. In 1994, total revenues from privatization amounted to US$204 million, which compares with a budget target of US$1.5 billion.

At the start of 1995, new impetus was given to the privatization process by the sale of Shikun U’pituah, a residential and commercial construction firm, for NIS 850 million. On the same date, the Knesset approved the sale for US$230 million of the 25 percent controlling stake of Israeli Chemicals, the country’s biggest chemical and fertilizer company. This divesture was expected to be completed by July 1995 with a public offering of a further 22 percent on international markets. However this operation was delayed due to unfavorable conditions abroad. The sale of Israeli Shipyards was completed in early 1995, despite labor market opposition, only after a decision by the Knesset Finance Committee to close the company altogether in the absence of its privatization. Further major privatization operations planned for 1995 include a 25 percent sale of Bezek, the telecommunications company, expected to raise about US$700 million; the national air carrier El Al, just out of receivership; Zim Israeli Navigation; and the two largest commercial banks, Bank Leumi and Bank Hapoalim.

In early 1995, the Government expressed support for an options scheme that was proposed by an official committee encharged with finding the means to garner public support for the privatization process. Under this scheme, every registered voter would be endowed with a fully negotiable option to acquire at a substantial discount on the market price those enterprises to be privatized. During the first stage of the operation, options on shares representing NIS 6 billion, or US$2 billion, would be distributed to about 3 million citizens through their bank accounts. Each option would have a strike price of between NIS 1400–1600 and would be worth between NIS 400–600.

The options scheme would aim at achieving three objectives simultaneously: (a) the swift divestiture of public companies, mostly by cash transactions; (b) an equitable distribution of the benefits across the general population, which should contribute to overcome the interference of influential lobbies and the reluctance of some political groups; and (c) the development of the Israeli capital market that has been hampered by its limited size and the concentration of power in a few hands. Before the options scheme could be put into effect, however, anti-trust legislation would need to be devised to prevent the emergence of monopolies especially in public utilities. Moreover, steps would need to be taken to put an adequate regulatory framework in place. It is not expected that this scheme will be put into effect before 1996.

V. External Sector

1. Overview

Over the past three years, the principal development in the external sector was the opening of a sizable external current account deficit that has mirrored a worsening in Israel’s trade balance (Table 15). After a cumulative surplus over the 1990–92 period, the current account balance swung to a deficit of US$2.8 billion, or 3.7 percent of GDP, by 1994. Preliminary figures for the first quarter of 1995 point to further widening of the external current account gap to an annual rate of over US$5 billion, or around 6 percent of GDP, which has mainly reflected a further worsening in the trade balance.

Table 15.

Israel: Balance of Payments Summary

(In percent of GDP)

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Sources: Central Bureau of Statistics.

The financing of Israel’s external current account deficit has not constituted a particular problem over the past two years. In part, the deficit was financed by a cumulative drawdown of around US$4.5 billion under Israel’s US$10 billion loan guarantee agreement with the United States. Moreover, the sharp increase in domestic interest rates toward the end of 1994 substantially increased the relative attractiveness for domestic firms to borrow abroad under Israel’s crawling exchange rate regime. As a result, notwithstanding the widening in the external current account deficit, Israel’s net international reserves rose from US$6.5 billion at end-1993 to a record US$9.6 billion, or the equivalent of more than four months’ import payments, by May 1995.

Over the past two years, Israel has continued to make progress in the area of reducing restrictions on both current and capital account transactions. The main measure in the area of trade liberalization has been the continued unilateral reduction of tariffs on imports from “third countries” in Eastern Europe, Asia, and Latin America, which are not covered by Israel’s free trade arrangements with the United States and the European Union. At the same time, further significant steps were taken to allow Israeli companies and the provident funds to invest more freely abroad.

2. Exchange rate and competitiveness

As discussed in Chapter III above, Israel continued to maintain the “diagonal band” exchange rate system introduced in December 1991. The rate of crawl of the band was reduced from 9 percent to 8 percent in January 1993 and further cut to 6 percent in July 1993 (while depreciating the central rate by 2 percent). The reduction in the rate of crawl, combined with a higher-than-anticipated inflation rate, produced a reversal of the trend toward improvement in the real effective exchange rate (REER), that had held sway between 1989-1992 (Table A30 and Chart 7). The CPI-based real effective exchange rate (REER) appreciated by 4.5 percent between July 1994 and January 1995. Falling labor productivity contributed to a slightly sharper increase in the unit labor cost-based REER.

Two additional developments adversely affected the competitiveness of the Israeli economy. The continuing reduction of trade barriers and liberalization of access to foreign exchange (discussed below) contributed to a reduction of the “shadow” price of imported goods; thus, the conventional REER measures have understated the true appreciation of the currency during 1993 and 1994. 1/ The second development was a deterioration in Israel’s terms of trade, amounting to 8.0 percent between the fourth quarter of 1993 and the end of 1994. Partially offsetting these factors, however, were reductions in employers’ taxes totaling around 2½ percentage points of labor costs over the past 18 months.

3. Developments in the current account

The worsening of Israel’s external current account since 1992 has reflected a deterioration in both the trade balance and the services account. Reflecting strong economic growth and an appreciation in the currency, the civilian trade deficit widened from US$3.5 billion, or 5.4 percent of GDP, in 1992 to US$4.6 billion, or 6.3 percent of GDP, in 1994 (Table A31 and Chart 12). During the first half of 1995, there was an additional sharp jump in the trade gap of around 2½ percent of GDP. The services balance also deteriorated in 1993 and 1994, climbing from US$1.7 billion in 1992 to US$3.6 billion in 1994, while the level of unilateral transfers remained roughly constant in U.S. dollar terms. A significant part of the deterioration in the external current account over the past two years has reflected a marked drop in private sector savings.

a. Exports

Exports of goods and services were favorably affected by the world economic recovery in 1993 and 1994. Exports of goods (excluding diamonds) grew by 11.5 percent in U.S. dollar terms during 1994, on top of an 11 percent rate of growth in 1993 (Table A37 and Chart 12). The 1994 growth can be decomposed into a 12.2 percent growth rate of export volume coupled with a 0.7 percent fall in prices. This rate of volume growth significantly exceeded the growth in Israel’s export markets, producing an increase in market share in both 1993 and 1994.

Chart 12.
Chart 12.

Israel: SELECTED FOREIGN TRADE INDICATORS, 1987–1995 1/

Citation: IMF Staff Country Reports 1995, 105; 10.5089/9781451819427.002.A001

Sources: Bank of Israel; and IMF, International Financial Statistics.1/ Trade figures exclude ships, aircralts, and diamonds.

The improvement in goods exports in 1994 was led by an 20 percent rise (in U.S. dollar terms) in the net exports of diamonds, consisting of a 23.7 percent increase in volume and a drop of 3.3 percent in prices (Table A36). Industrial product exports, comprising 72 percent of total exports, rose by 12.3 percent in 1994 despite the decline in their prices. High technology industrial exports performed particularly well—machinery, communications, medical, and scientific equipment grew in excess of 15 percent in 1994. Exports of agricultural products were less dynamic, showing a growth rate of only 8.7 percent. In the first five months of 1995, there was a deceleration in the growth rate of exports of industrial products, which were 7.6 percent above the same period in 1994 in U.S. dollar terms. Net diamond export growth also slowed, albeit to a still strong 13 percent growth rate.

The geographic distribution of exports in 1994 reflects the resurgence of world economic activity (Table A38). While growth was fairly strong in exports to the United States (13.6 percent) and Europe (8.6 percent), the most dynamic area for Israeli goods exports was the newly opened markets in Asia, where sales climbed by more than 25 percent. Exports to Thailand grew by 69 percent, to US$248 million, while those to India increased by 54 percent, reaching US$350 million in 1994. In the first quarter of 1995, growth in exports was led by Israel’s traditional markets in Europe and the United States (up 23 percent over the same period in 1994), while growth moderated in the Asian markets (to 9 percent).

The exports of services has shown much less dynamism than that of goods in recent years (Table A32). Total services income shrank by 2 percent in U.S. dollar terms in 1993, and grew by only 4 percent in 1994. The major factor in this relative stagnation has been a substantial decline in factor service income, which fell by 24 percent in 1993 and by an additional 4.5 percent in 1994. Services income from the Occupied Territories also declined significantly, reflecting the impact of the autonomy agreements and the repeated closures of the border. Foreign exchange income from tourism, on the other hand, has been robust; growth was 14.6 percent In 1993 and 7.4 percent in 1994. Tourist arrivals grew by 11 percent in 1994 to 1.8 million.

b. Imports

Despite the strong performance of exports in 1993 and 1994, the trade balance deteriorated substantially due to an even greater acceleration of imports. The volume of goods imports rose by 13 percent in both 1993 and 1994 (Table A33 and Chart 12). Not only did imports grow more quickly than exports in percentage terms, but import growth was on a much larger base, accounting for the worsening of the trade balance. The bulk of the deterioration in the current account, however, was due to the sharp deterioration in the services account in 1994, where services imports grew by 14.3 percent in U.S. dollar terms.

During 1993, the increase in goods imports was driven primarily by a jump in military imports and investment goods. Military imports increased from US$1.4 billion in 1992 to US$2.1 billion in 1993, an increase of 45 percent. Investment goods imports rose by 14.3 percent in volume and consumer goods grew by 10.2 percent over the same period.

In 1994, military imports fell back to near their 1992 level, but the growth in both industrial and consumers goods imports accelerated (Table A34). Investment goods imports climbed at a 23.7 percent pace, while imports of raw materials (excluding diamonds and fuel) also grew rapidly (10 percent) in response to the strong growth of domestic demand. 1/ Consumer goods imports grew by nearly 20 percent in volume, reflecting the acceleration of private consumption spending. A further indication of the increase in consumption spending is found in the fact that imports of consumer nondurables grew much more quickly (24.4 percent) than those of durable goods (14.6 percent). In the first five months of 1995, this consumption binge continued, while investment import growth decelerated. Consumer imports grew by 20.3 percent over the same period in 1994 in U.S. dollar terms, while investment goods grew by 11 percent. Sharp growth in raw materials inputs continued, with a 25 percent jump in dollar imports over 1994 levels.

Expenditures on the service account grew sharply in both 1993 and 1994, despite a reduction in services from the WBGS (Table A32). Liberalization of foreign exchange restrictions on Israelis travelling abroad—as well as the easing of Israeli political isolation due to the ongoing peace process—produced a sharp increase in expenditures on travel and tourism abroad. These imports rose by 25 percent in U.S. dollar terms in 1994, on top of 38 percent growth in 1993 for a total increase of more than US$400 million. For the first time, in 1993 and 1994 Israel had a net deficit on the travel and tourism account. During 1994, there was also strong growth in expenditures on freight and transportation (up 11.4 percent) and on interest payments abroad (up 10.9 percent).

4. The capital account, reserves, and external debt

Since 1993, the Israeli economy has experienced a tendency toward increasing capital inflows, which have more than covered the current account deficits, thereby permitting a significant increase in foreign exchange reserves. Inflows of short-term and long-term capital totaled US$2 billion in 1993 and US$1.1 billion in 1994, compared to a capital outflow of US$2.1 billion in 1992 (Table A39). This trend accelerated in early 1995, as large quantities of short-term private capital entered the country in response to the favorable differentials between foreign and domestic borrowing rates produced by the tightening of monetary policy in late 1994.

The net inflows of capital reflect different trends between the public and private financial sectors. The private sector recorded a net outflow of capital in 1994, led by the banking sector’s capital exports of US$1.3 billion, which were largely induced by the further reduction in legal reserve requirements on the banking system’s foreign currency deposits. In contrast, the public sector imported capital in 1994 mainly due to a further US$2.4 billion in drawings under the US$10 billion loan guarantee program with the U.S. Government. Analysis of developments in the private non-financial sector in 1993 and 1994 are complicated by the large size of the errors and omissions item in the balance of payments (a positive US$900 million in 1993 and US$1.6 billion in 1994), which probably largely reflects unrecorded private capital flows. Thus, although the nonfinancial private sector is recorded in the balance of payments statistics as having had an inflow of around US$400 million, the Bank of Israel estimates that true capital imports of the nonfinancial public sector were on the order of US$1.7 billion.

Long-term capital flows dominated the capital account in both 1993 and 1994. There was a net inflow of long-term money totaling US$1.8 billion in 1993 and US$2.5 billion in 1994, mainly reflecting borrowing under the U.S. loan guarantee program (Table A39). Net foreign direct investment was negative in both 1993 and 1994, as the liberalization of the capital account allowed Israeli institutions to substantially increase investment abroad from US$651 million in 1992 to US$826 million in 1994. By contrast, short-term recorded flows were only US$160 million in 1993 before becoming negative in the amount of US$1.3 billion in 1994. Of course, there were likely significant additional short-term inflows reflected in the large positive errors and omissions item.

During the first half of 1995, short-term capital flows flooded into the country largely in reflection of foreign currency borrowing by Israeli companies in response to the differential between domestic and foreign borrowing rates and the expectation that the currency would not depreciate much with respect to its central rate (Chart 8). In addition, a net US$500 million in long-term capital is estimated to have moved into the country in the first half of 1995 and the errors and omissions item continued to grow, suggesting further unrecorded inflows.

Foreign currency assets of the Bank of Israel grew by US$1.25 billion in 1993 and rose by a further US$410 million in 1994 (Table A43). During 1994, however, there was an initial drop in reserves in conjunction with the loose monetary policy early in the year. This was followed by a sharp increase toward the end of the year as monetary policy was substantially tightened and as the Bank of Israel began to sterilize the capital inflows, which were attracted by high interest rates in the fourth quarter. Foreign reserves grew by US$1.1 billion in the fourth quarter alone and by a further US$2.8 billion in the first five months of 1995 to reach a record level US$9.6 billion, or approximately 4 months of imports in May 1995.

The large current account deficits in 1993 and 1994 have their counterparts in a significant increase in foreign liabilities. Gross external debt rose from US$34.1 billion in 1992 to US$36.0 billion in 1993 and to US$40.0 billion in 1994 (Table A42). However, net liabilities grew much less quickly, as foreign assets also accumulated at a rapid pace. In 1994 alone, foreign assets rose by US$3.2 billion, the majority of which came from higher foreign assets in the commercial banking sector. Net external liabilities declined to 22.6 percent of GDP in 1994, after rising slightly to 24.5 percent of GDP in 1993 (Chart 13).

Chart 13.
Chart 13.

Israel: SELECTED BALANCE OF PAYMENTS INDICATORS, 1987–1994

Citation: IMF Staff Country Reports 1995, 105; 10.5089/9781451819427.002.A001

Sources: Bank of Israel; IMF, International Financial Statistics.Excluding ships and alrcrafts. Figure for 1995 is based on January to May data.

5. Exchange and trade liberalization

Following the 1985 Economic Stabilization Program, Israel substantially liberalized its trade system largely within the context of its free trade agreements with the United States and the European Union. During 1993 and 1994, there was a continuation of the liberalization process both in the trade and capital accounts. On the trade side, Israel ratified the Uruguay Round of the GATT in 1994 and submitted its timetable for implementation of the agreement to the WTO. Moreover, in September 1993, Israel moved to full current account convertibility by accepting the obligations of Article VIII under the Fund’s Articles of Agreement. As part of this process, in early 1995 port fees were adjusted to apply to both exports and imports so as to eliminate a previously existing implicit export subsidy.

Since September 1991, Israel has been engaged in a program of unilateral tariff reductions on imports from “third countries” in Asia, Eastern Europe, and Latin America, with which countries Israel does not have free trade agreements. The basic goal of the program is to reduce tariffs to 12 percent on processed goods and 8 percent on semi-manufactured products and raw materials by September 1996. 1/ During 1993 and 1994, Israel reduced tariffs under this program fully in line with the annual schedule of reductions that had been established.

The peace process has produced a further improvement in the Israeli trade environment. The secondary Arab boycott on Israeli products has been dropped by Kuwait and Saudi Arabia. Moreover, Israel has recently announced the conclusion of negotiations for a trade agreement with Jordan, which would include tariff reductions, establish a free-trade zone, and include other liberalization measures.

Over the past several years, Israel substantially liberalized its capital account in part with the objective of subjecting the domestic banking system to increased competition. By the early 1990s all restrictions had been removed on external borrowing and substantial progress had been made in lifting controls on outward investment. 2/ During 1994, additional steps were taken toward liberalizing restrictions on foreign investment by Israeli firms. Provident funds were authorized to invest up to 2 percent of their portfolios in foreign securities abroad, and Israeli companies were permitted to make unrestricted direct investment abroad. Companies were also permitted to hold foreign securities up to 10 percent of their equity or 5 percent of annual sales (whichever is greater). Foreign currency restrictions on Israeli citizens traveling abroad were raised (from US$3,000 to US$7,000) and restrictions on the use of credit cards abroad were lifted.

While substantial progress has been made in liberalizing the capital account over the past several years, there are still a number of areas where significant foreign exchange restrictions continue to exist. Thus, despite the relaxation of restriction on the provident funds, life insurance companies and pension funds are still not permitted to invest any part of their assets abroad. Moreover, exporters must be paid in foreign exchange, but they may not retain more than 10 percent of their yearly exports in foreign exchange abroad.

APPENDIX I: Israel: Medium-Term Balance of Payments Scenarios 1/

The sharp widening of the external current account deficit in 1994 and early 1995 has led to concerns about the sustainability of the present balance of payments position over the medium term. In this appendix, a baseline scenario, which is calculated on current policies, projects continuing large external current account deficits in future years that could prove to be unsustainable. An alternative scenario explores the impact of a significant tightening of fiscal policy.

1. Underlying methodology and assumptions

The external sector approach, on which the scenarios are based, includes the following simple export and import equations:

Exports:

ln⁡X = α + βln⁡PX* + γln⁡RER + δln⁡AD + εln⁡WD(1)

Imports:

ln⁡M = a + bln⁡Pm* + cln⁡RER + dln⁡AD(2)

where: PX* , Pm* = world prices of exports and imports

RER = Real US dollar exchange rate (in CPI terms)

AD = real aggregate demand in Israel

WD = real world demand

The data on export and import prices are based on the fall 1995 IMF WEO assumptions. Export prices are defined as the weighted average GDP deflator in partner countries and import prices are defined as the projected export unit value growth in partner countries. The equations are operationalized using multi-year impulse response coefficients as the elasticities. 1/

It is assumed that medium- and long-term financing of the external current account stays relatively steady until 1999, when the last of the U.S. loan guarantees will have been used. Short-term capital flows drop sharply in 1996 (as speculative capital transfers decline) and subsequently fall in a linear fashion to US$2.3 billion in 2000. Military imports are assumed to remain constant in dollar terms. It is also assumed that net transfers remain constant throughout the period, although this may be an optimistic view particularly with respect to U.S. foreign aid.

2. The baseline scenario

The baseline scenario assumes that the domestic fiscal deficit will continue to decline at the rate of 0.25 percent of GDP per year, as targeted in recent years (implying a drop from 2.75 percent of GDP in 1995 to 1.5 percent of GDP by 2000). The entire fall in the fiscal deficit is assumed to derive from more restrained current expenditure policies, as public real investment is assumed to grow at a constant 3.5 percent per year. The scenario also assumes slight declines in the rate of growth of private consumption and investment, consistent with a moderation in overall economic growth. As regards the exchange rate, the baseline scenario assumes that the nominal rate depreciates at the present 6 percent rate of crawl of the band. Inflation is assumed to decline slowly from 10 percent in 1995 to 5 percent by 2000, which implies that there would be an initial real appreciation of the shekel. The real exchange rate begins to depreciate in 1998 as inflation falls below 8.5 percent.

On the basis of the foregoing assumptions, the staff projects a deterioration in the external current account deficit in 1995 and 1996, reaching a peak of almost 7 percent of GDP in 1997–98 before declining modestly in 1999–2000 (Table I.1 and Chart I.1). This increase in the external current account gap is sparked by the strong growth of domestic demand in 1994–95 and is sustained by the real appreciation experienced in 1994–97. As interest rates decline in response to falling inflation, the flow of short-term capital diminishes. Less short-term capital and the end of medium-term flows from the U.S. loan guarantees in 1999 produce a significant deterioration in the overall balance in 1999–2000. As a result, the central bank’s international reserves are increasingly drawn down from the very high level they reach in 1995. The cumulative external current account deficits are also reflected in the increase in the level of net external liabilities from 35 percent of GDP in 1995 to around 53 percent of GDP by the end of the period.

Table I.1.

Israel: Medium-Term Balance of Payments Outlook—Baseline Scenario

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Sources: Bank of Israel; Ministry of Finance; and Fund staff estimates.

Includes borrowing under US loan guarantee program.

Includes E&O.

Chart I.1.
Chart I.1.

Israel: MEDIUM–TERM OUTLOOK, 1995–2000 1/

Citation: IMF Staff Country Reports 1995, 105; 10.5089/9781451819427.002.A001

Sources: Israel Central Bureau of Statistics; and Fund staff estimates.1/ The data for 1994 are actual figures.

The staff scenario envisages a moderation of economic growth to an average 4.5 percent per year in 1996–2000 from the high rate of expansion prevalent in 1994 and 1995. This drop in growth in part reflects a reduction in the rate of the economy’s growth potential as the wave of immigration ebbs. It also reflects a more sustainable level of consumption growth over the period, as well as the increase in import penetration and weak export growth in 1995–97. 1/

3. An alternative fiscal adjustment scenario

The alternative scenario attempts to capture the effects of a more rapid fiscal consolidation process on economic growth and on the external current account (Table 1.2 and Chart I.1). It is assumed that the domestic fiscal deficit is cut from 2.75 percent of GDP in 1995 to 0.5 percent of GDP by 1996, and that small but growing surpluses are run in 1997–2000 to counteract anticipated external fiscal deficits. The domestic fiscal surplus in 2000 would reach 0.75 percent of GDP. As in the baseline scenario, all of the fiscal adjustment is assumed to come from more restrained current expenditures. The nominal exchange rate is assumed to depreciate at the same 6 percent rate for 1996–2000, but the rate for 1995 is assumed to depreciate somewhat within the band as the anticipated tighter fiscal stance allows for an earlier easing of inflation and interest rates.

Table I.2.

Israel: Medium-Term Balance of Payments Outlook—Fiscal Adjustment Scenario

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Sources: Bank of Israel; Ministry of Finance; and Fund staff estimates.

Includes borrowing under US loan guarantee program.

Includes E&O.

Fiscal adjustment produces a large improvement in the external current account balance compared to the baseline. The external current account deficit falls from nearly 6 percent of GDP in 1995 to around 2 percent of GDP by 2000. The cut in government spending improves the current account through three channels. First, the reduction in public consumption directly reduces imports by cutting aggregate demand. Second, private consumption also grows more modestly in response to lower government transfer payments, further reducing import demand. Finally, the cut in spending eases inflationary pressures quickly, which allows the nominal exchange rate to decline slightly in late 1995 and early 1996. The real exchange rate improves both because of the nominal depreciation and due to lower inflation in 1996–2000. 2/ The more competitive real exchange rate boosts exports while further cutting imports compared to the baseline scenario.

GDP growth drops more sharply in 1996 in the fiscal adjustment scenario than in the baseline scenario due to lower government spending. However, the adjustment provides the basis for an export-led recovery, which raises growth to an average of 5.5 percent in 1998–2000, well above the rate in the baseline. Private savings also recover more quickly.

3. Conclusions

Both staff scenarios project that Israel will continue to experience relatively strong economic growth over the medium term (Chart I.1). However, the results of the staff’s baseline scenario suggest that Israel could face high external current account deficits in 1995 and into the medium term based on current policies. While high short-term capital inflows and access to additional U.S. loan guarantees suggest that financing of the external current account is not an immediate problem, the continued rapid accumulation of external debt is certainly undesirable over the medium term and raises questions of long-term balance of payments sustainability. The alternative scenario demonstrates that an improvement in public savings would substantially reduce the external current account deficit to more moderate levels while facilitating export-led growth. Although the precise results of the simulations are sensitive to the assumptions chosen and should be taken as suggestive rather than conclusive, the general trends are fairly robust.

A Measure of the Monetary Policy Impulse in Israel 1/

This appendix evaluates monetary policy in Israel and its effect on the inflation rate using a measure of monetary impulse proposed by McCallum and Hargraves (1994) (McCH). It also includes a generalization of this measure based on a Kalman filter forecast of the policy effects. The McCH measure is defined as the sum of the money base growth rate and an average of the past growth rates of velocity. Hence, it is an indicator of nominal GDP expansion implied by the current monetary policy stance. It is intended to satisfy two criteria: first, it takes into account a variable, base money, under the direct control of the central bank; second, it focuses on a medium-term horizon. The McCH methodology is applied to the case of Israel using both annual and quarterly data; the generalized impulse measure, however, hinges on an estimate of the relation between base money and nominal GDP, hence only the quarterly time series is sufficiently large to invoke asymptotic properties.

The McCH measure calculated on annual data suggests that from 1989 to 1992 monetary policy has been quite consistent, as the monetary impulse oscillated around 20 percent. In 1993, however, monetary policy loosened in response to a decrease in the rate of real GDP growth, before the Bank of Israel sharply tightened its policy stance toward the end of the year. In 1994, the monetary impulse measure fell from about 30 percent to 2 percent. The McCH measure based on quarterly data reveals that the monetary policy easing was more pronounced than the annual data would suggest. The two generalized measures of monetary impulse confirm substantially the evaluation of monetary policy in 1994, but diverge widely on the interpretation of the policy stance in 1993.

2. The McCallum-Hargraves measure of monetary impulse for Israel

Indicating by DLX and DLB respectively the growth rates (i.e., the change in natural logarithms) of nominal GDP and of monetary base (adjusted for changes in reserve requirements), the growth rate of velocity is DLV = DLX − DLB. Averaging over the past four years, one obtains:

DLVBARt = (1/N) ∑i=0N=1DLVt−i

where N is either 4 or 16 depending on whether the data are annual or quarterly. With quarterly data the McCH monetary impulse measure is:

IM1 = DLB + DLVBARt−1(1)

while with annual data the lagged term is replaced by the contemporaneous observation:

IM = DLB + DLVBAR(2)

In the words of McCH, IM1 and IM “… are GDP-velocity-adjusted rates of base growth, and represent nominal growth rates of GDP that are implied—on average, from a medium term perspective—by current monetary policy actions.” 1/ This measure of monetary impulse has clear links to a body of literature that advocates targeting nominal—rather than real—variables, 2/ in particular nominal GDP, because the relations between nominal and real variables have not been clarified convincingly on theoretical or empirical grounds. Specifically, it is hard to assess in what proportion a monetary shock will affect real GDP growth and inflation and with what lag. For this reason, it was advanced that monetary policy should target a path for nominal GDP consistent with the long-run real rate of growth plus a low inflation rate.

The McCH monetary impulse measure can be interpreted in this context as a backward looking index: the base velocity term depends only on past values, and therefore the expected future effects of current actions do not influence the evaluation of monetary policy. A generalized measure of monetary impulse can be expressed as:

RxIMh|t = DLBt + F(E(DLVt+1|Ωt))…… (E(DLVt+h|Ωt))(3)

where the notation E(z|H) indicates the mathematical expectation on the stochastic variable z conditional on a set H; F is a generic function; the subscripts refer to discrete time intervals; Ωt is the set of information at time t; and h is the time horizon of monetary policy. The set Ωt extends to all the past values of the relevant variables and includes the true dynamic interaction between base money and nominal GNP as well as the objectives pursued by the monetary authority. Equation (3) in essence defines a measure of monetary impulse which focuses on future changes in velocity expected by individuals who form rational expectations based on the current monetary policy stance and the past dynamic interaction between nominal GDP growth and base money expansion.

The approach proposed to estimate the expectational term in (3) is based on the theory of linear control systems and on an econometric method which takes advantage of the so-called Kalman filter (see Kalman (1960)). In essence it is postulated that the central bank acts so as to minimize an intertemporal expected quadratic loss function—whose argument is the difference between actual nominal output and a prespecified target—by following an optimal monetary policy rule expressed in terms of a dynamic equation. This, in turn, implies that the monetary authority knows (to a good approximation) the relationship between monetary policy and nominal output which can be estimated to obtain forecasts of nominal output consistent with the monetary stance. One could observe that even if the central bank targets real output and ignores the effects of monetary policy on the price level, or vice versa, the correct relation between money and nominal output, provided that it is reasonably stable, can still be estimated from historical data.

A natural way to calculate the measure of monetary impulse defined in (3) is to obtain a one step ahead forecast for DLX using a dynamic model of the kind:

DLXt = S(L)DLBt(4)

where S(L) is a polynomial in the lag operator L and a one step ahead forecast for DLB from a univariate time series model. 1/

For both purposes one can resort to an algorithm known as the Kalman filter from the original contribution by Kalman (1960) and Kalman and Bucy (1961). The basic idea is to express the dynamic relationship in a particular form, called state-space representation, and apply the Kalman filter to obtain a sequentially updating linear projection of the dependent variable. Before giving the results of this estimation, it is useful to clarify two issues of crucial relevance in the present framework. First, the focus is on base money rather than on the interest rate because in the words of McCH “… any short-term nominal interest rate is an ambiguous indicator of monetary policy stance. Specifically, high interest rates are associated with tight monetary policy from a short-term perspective, but with an easy monetary policy from a longer-term point of view. Moreover, whether a particular level of interest rates corresponds to a ‘tight’ or ‘easy’ monetary stance depends on economic conditions at the time.” Second, it must be stressed that monetary shocks have only temporary effects on velocity growth in the absence of fiscal shocks.

2. The results

Chart II.1 shows for different time spans the McCH measure of monetary Impulse calculated on annual data. The upper panel is dominated by the plunge in the monetary impulse resulting from the stabilization program of July 1985. The lower panel, which focuses on the period after the stabilization program, reveals how the relatively stable pattern of monetary policy was interrupted in 1993 by a large impulse, followed in 1994 by a sharp tightening.

Chart II.1.
Chart II.1.

Israel: MONETARY IMPULSE (ANNUAL RATES)

Citation: IMF Staff Country Reports 1995, 105; 10.5089/9781451819427.002.A001

Sources: Bank of Israel and Staff Estimates

Chart II.2 depicts the McCH measure calculated with quarterly data. The upper panel shows in greater detail the effect of the stabilization plan, while the pattern in the lower panel essentially confirms that monetary policy was loose between the end of 1992 and the beginning of 1993. Moreover it shows that the tightening in 1994 reduced the monetary impulse to around its lowest level since 1986.

Chart II.2.
Chart II.2.

Israel: MONETARY IMPULSE (ANNUALIZED QUARTERLY RATES)

Citation: IMF Staff Country Reports 1995, 105; 10.5089/9781451819427.002.A001

Sources: Bank of Israel and Staff Estimates

Chart II.3 portrays a comparison of three measures of monetary impulse: RxIM1 is the measure obtained by using the one period ahead forecast and AvgRxIM1 is the measure obtained by constructing an average of two-period ahead forecasts and two past observations on velocity growth. 1/ Two main features deserve attention. First, it is remarkable that RxIM1 and IM1 almost coincide in the initial two periods and that afterwards, in 1993, AvgRxIM1 and IM1 are relatively close. Second, all three measures display a similar pattern starting in the last quarter of 1993, and indicate that monetary policy has been relatively tight.

Chart II.3.
Chart II.3.

Israel: MEASURES OF MONETARY IMPULSE (Annualized quarterly rates)

Citation: IMF Staff Country Reports 1995, 105; 10.5089/9781451819427.002.A001

Sources: Bank of Israel and Staff Estimates

It is also noteworthy that the monetary impulse during 1994 oscillated regularly, while the Bank of Israel discount rate changed very little in the first half of the year and increased sharply in the second half. Particularly between September and December 1994, the discount rate increased cumulatively by 450 basis points, but all three measures show an increase in the monetary impulse.

Cyclical and Discretionary Factors in Israeli Fiscal Policy 1/

1. Introduction

The main purpose of this appendix is to provide estimates of the stance of fiscal policy in Israel over the last decade by breaking down the fiscal deficit into its cyclical and noncyclical components, and by deriving estimates of the fiscal impulse. This is done by applying what has become known as the IMF methodology, 2/ which allows for the decomposition of the fiscal balance of a given year into its trend, cyclical, and discretionary components. It is shown that following a sharp contraction in the discretionary fiscal balance in 1985 and 1986, during the implementation of the 1985 Economic Stabilization Plan, the fiscal policy stance loosened in the late 1980s and particularly in the early 1990s, in the wake of the wave of immigration from the former Soviet Union. Since 1993, however, fiscal policy turned significantly contractionary, with discretionary fiscal policy actions by the Government playing a major role in the process.

2. Methodology

The methodology involves decomposing the overall fiscal balance of a given year into its trend, cyclical, and discretionary components. This is done by calculating the cyclical and trend components of the deficit and deriving the discretionary deficit by subtracting these values from the total observed deficit. The fiscal impulse is defined as the change during a given year in the discretionary component of the government balance expressed as a share of current GDP.

Modeling the trend and cyclical deficits involves choosing a base year (t=0) in which the level of output is deemed to be equal to potential. This base year is used as a reference (in our particular case, 1994), in such a way that a positive discretionary deficit is interpreted as an expansion relative to the base year, whereas a negative discretionary deficit is contractionary relative to the deficit that obtained in the year t=0.

It is assumed that trend components of revenues have a unitary elasticity relative to potential (trend) output. Thus, in any given year the trend component of each revenue item is proportional to potential output, where factors of proportionality are given by the respective item’s share in GDP in the base year. Trend components of spending (excluding expenditures on unemployment benefits and interest payments) in any given year are obtained likewise. Unemployment benefits in the base year are used to calculate trend unemployment benefit spending, under the assumption that the average benefit is kept constant in real terms, and that benefits increase at the same rate as the labor force.

Cyclical revenues derive from the existence of a gap between actual and potential output in a given year. Cyclical revenues, therefore, are postulated to deviate from their trend level in proportion to the deviation of actual output from potential output using their respective share in the base year. Cyclical expenditures on unemployment benefits are derived on the basis of estimates of the number of cyclically unemployed workers 1/ and on the assumption that the average benefit is kept constant in real terms. 2/ Spending on other items are assumed to be unaffected by the cycle. Once the trend and cyclical components have been computed, deriving the discretionary components involves subtracting these values from the observed figures. In order to assess the expansionary character of fiscal policy in a given year, relative to the preceding year, one needs only take differences of the discretionary balance, so as to eliminate the levels of the base year and to obtain the fiscal impulse.

The measurement of trend or potential output and the identification of the current position of output in relation to trend (i.e., the output gap) are important elements in the technique used to decompose the budget balance into the action of automatic stabilizers, trend factors, and discretionary actions. Given the difficulties involved in implementing empirically the concept of potential or trend output, there is scope for a statistical method for decomposing the real GDP series into a trend and a stationary cyclical component. The alternative followed in this paper was to smooth real GDP using a Hodrick-Prescott (HP) filter. 1/

Chart III.l shows the potential output series obtained with this procedure as well as the gap that corresponds to it. After the recessionary years around the implementation of the stabilization plan in 1985, the economy’s actual output exceeds trend in 1987, before falling below it in the final years of the 1980s and in the early 1990s. Since the beginning of the decade, however, both actual and trend output have been growing very fast and the estimate indicates that by 1994 the economy was overheated, with actual output slightly above trend.

Chart III.1.
Chart III.1.

Israel: OUTPUT AND POTENTIAL OUTPUT

Citation: IMF Staff Country Reports 1995, 105; 10.5089/9781451819427.002.A001

Sources: Bank of Israel and staff estimates.

The methodology of cyclically adjusting the budget balance described above has certain limitations, especially in the case of Israel. In decomposing the deficit into a cyclical and a structural component, the technique assumes that only unemployment benefits are affected by the cycle. It is conceivable, however, that other government transfers increase during a recession. One such case would be a situation in which the Government makes transfers to cover the operational losses of public enterprises in a downturn. Similarly, there are difficulties associated with measuring the magnitude of discretionary actions taken by the Government.

The technique attributes to discretion many factors affecting government spending and revenue that are, at least in the short run, largely exogenous to government decisions. For instance, spending on welfare programs might change faster than would be expected on the basis of a neutral stance as a result of rapid demographic changes, a consideration that might be of particular importance in the case of Israel, due to the impact of immigration on the structure of Israeli population. Another source of difficulty in estimating the impulse is the fact that high inflation, such as that which prevailed in Israel in the mid-1980s, might bias the magnitude of the impulse calculated according to the technique described. For example, under the standard methodology, a worsening of the Government’s balance owing to an inflation-induced rise in nominal interest payments would be assumed to affect economic activity in the same way as any other increase in spending. Rational bondholders, free from money illusion, however, recognize that inflation erodes the real value of their assets and, therefore, would be willing to save their higher interest income, so as to restore the real value of their bondholdings. As a result, private savings will rise by precisely the same value that inflates the nominal measure of the government deficit and there should be no additional impulse to demand stemming from this source of government spending. 1/

3. The evolution of fiscal stance

Table III.1 decomposes the budget deficit into its cyclical and noncyclical components. It shows that after the impressive reduction in the structural deficit that followed the implementation of the Economic Stabilization Plan in 1985, the underlying budget deteriorated from a deficit of 1.8 percent of GDP in 1987 to a deficit of 6.9 percent of GDP in 1991. Since 1992, however, this trend has been reversed and the structural deficit fell to 1.9 percent of GDP in 1994, a year when the economy was basically operating around or above potential.

Table III.1.

Israel: Cyclical and Structural Domestic Government Balances

(In percent of GDP, 1980–94)

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Source: Staff estimates based on data from the Bank of Israel.

The lower part of Table III.1 shows the evolution of the primary budget balance and its decomposition. It is noteworthy that since the implementation of the anti-inflationary plan in 1985, the primary structural balance has been in surplus, with the exception of the small deficits recorded in 1991 and 1992. The trend, however, is similar to that observed in the overall structural balance, indicating that the deterioration that occurred in the late 1980s was not due to the need to keep interest rates high in the aftermath of the program, but due to a worsening of the noninterest balance. By 1994, the primary structural balance registered a surplus of 3.1 percentage points of GDP.

Impulse estimates are presented in Table III.2. The first line gives the “overall fiscal impulse” or the yearly change in the discretionary fiscal balance expressed as a share of current GDP. It provides an estimate of the direction taken by the fiscal authorities over the course of that year. The table also shows the breakdown of revenue and expenditure impulses in their most important categories. The table shows that after several years of very large positive impulses, the direction of fiscal policy changes drastically in 1985, reflecting discretionary actions affecting both revenue and spending items. Thus, from an overall positive fiscal impulse of 14 percentage points of GDP in 1984, the fiscal impulse moves to a negative 3.9 percentage points of GDP by 1986. In this respect, the impulse on revenues fell from a positive 6.3 percentage points of GDP in 1984 to a negative 2.3 percentage points and a negative 2.9 percentage points of GDP in 1985 and 1986, respectively. 1/ From the expenditure side, the impulses of spending on both civilian and military goods and services were significantly reduced in the period between 1984 and 1986, as were the impulses associated with current and credit subsidies. The impulse on noninterest spending moved from a positive 5.4 percent of GDP in 1984 to a negative 2 percentage points of GDP in 1986.

Table III.2.

Israel: Domestic Balance Fiscal Impulse by Items

(In percent of GDP. 1981–94)

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Source: Staff estimates based on data from the Bank of Israel.

Includes transfers from the public, revenues from property, imputed pensions and depreciation.

Chart III.2.
Chart III.2.

Israel: IMPULSE ON PRIMARY BALANCE AND INFLATION

(1981–1994)

Citation: IMF Staff Country Reports 1995, 105; 10.5089/9781451819427.002.A001

Source: Bank of Israel and Fund staff estimates.

In 1988 and 1989, the Israeli economy grew slowly, reflecting the lagged effects of the 1985 stabilization program and the impact of adverse supply shocks such as unfavorable climatic conditions and the Palestinian uprising (Intifada) that started in December 1987 and that stifled growth in sectors intensive in labor from the Occupied Territories. The Government that took office in December 1988 actively used fiscal policy to promote economic growth. During this period, but particularly in 1989, the overall fiscal impulse turned positive again, with both revenue and spending decisions contributing to expand the deficit over and above what it would have otherwise increased based on normal trend or cyclical factors. While in 1988 and 1989 no major tax changes were introduced, the impact of the 1987 tax reform, which reduced tax rates and initiated a program of import tariff reductions, could still be felt, as captured by the impulse measures associated with those items. On the expenditure side, current transfers, noncredit subsidies, and defense spending explain the positive impulse recorded in the 1988–89 period.

A primary objective of economic policy since 1989 has been the absorption of the massive inflow of immigrants into the economy. Although the authorities’ basic economic strategy toward the immigrants has stressed the promotion of private sector rather than public sector employment, their absorption impacted on the government accounts since there was a need to cater to the immigrants’ housing needs and to provide them with subsistence grants and training immediately after their arrival. Accordingly, up until the election of a new administration in mid-1992, the Government increased substantially spending on housing through both direct public sector construction and through public guarantees to private constructors. As a result, the overall fiscal impulse jumped to 2.8 percent of GDP in 1989. Interestingly, the impulse of spending in that particular year was negative, reflecting cuts in transfers, subsidies and investment. It was mainly the revenue side that contributed to the expansionary fiscal policy, as receipts fell over and above what could be expected from the fall in taxation that would have resulted from the downturn in economic activity. This fall was particularly marked in the case of foreign trade taxes and in direct taxes. In the following years up to 1992, discretionary expenditure dominated the positive trend in the overall impulse, although the revenue side was also a net contributor.

In mid-1992 budget priorities changed. Public support to housing construction was reduced and spending shifted toward infrastructural investment and the education sector. Tax policy continued to be guided by the gradual reduction in tax rates, particularly for the business sector, in order to promote private sector investment. At the same time, the principal objective of fiscal policy has been the consolidation of the public finances. Thus, in 1992, a Deficit Reduction Law was enacted which set out a path for gradually eliminating the domestic component of the budget deficit by 1995, aimed at providing assurance to the private sector that the large deficits budgeted for 1991 and 1992 would be of a temporary nature and that budget discipline would be maintained despite the influx of immigrants. In the event, the fiscal impulse was notably reduced in 1992 and the fiscal stance turned contractionary in the following years, as captured by the negative impulse registered in 1993 and 1994.

The negative overall fiscal impulse that obtained in both 1993 and 1994 was due to a combination of negative revenue and spending impulses. Turning first to the revenue side, it is noteworthy that during the last two years the revenue impulse was negative, indicating discretionary tightening from the revenue side. This tightening was registered in spite of the measures taken to reduce the tax burden, such as the abolition of the immigrant absorption tax on individual incomes, the 1 percentage point reduction of the corporate income tax, and the reduction of income tax brackets for middle income households. Indeed, the positive impulse registered on indirect taxes on domestic production, due to a reduction in the VAT rate from 18 percent to 17 percent, and that resulting from the progress made in the trade liberalization process, were more than offset by the negative impulse on direct taxes and on other revenue components. There are at least two reasons that explain why a negative direct tax impulse was recorded in spite of the above mentioned reductions in tax rates. First, it reflects the combination of the progressive nature of the Israeli tax system with rapidly rising incomes, a process that was boosted by the hike in public wages in 1994. Second, part of the negative revenue impulse in 1994 was due to the higher corporate profits stemming from capital gains on stock market transactions in 1993, which in the methodology being used gets translated into higher discretionary revenues.

On the spending side, impulses on defense expenditures have been systematically negative since 1987. A similar trend can be observed in the evolution of current and credit subsidies. Unemployment benefit payments, over and above those explained by trend and cyclical causes, provided a positive impulse in the first years of the decade, but became negative in the last two years. 1/ Other current transfers have provided negative impulses in the past two years, contrary to the experience in the beginning of the decade, particularly in 1991, when they were used to help in the immigrant absorption process. Another noticeable feature of discretionary public expenditures over the last year has been the sharp increase in public wages. Civil servant wages increased by over 10 percent in 1994, in real terms, and the number of public employee posts has grown by around 5 percent. As a result, the impulse of civilian spending exceeded 0.5 percent of GDP last year, reverting the trend of negative or very low impulses registered in this item since the beginning of the decade.

Table A1.

Israel: Industrial Production, 1990-94

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Sources: Central Bureau of Statistics, Monthly Bulletin of Statistics.
Table A2.

Israel: Investment, 1989-94

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Sources: Central Bureau of Statistics, Monthly Bulletin of Statistics; and data provided by the Bank of Israel.

Including shipping and aircraft.

Table A3.

Israel: Consumption, 1989-94

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Sources: Central Bureau of Statistics, Monthly Bulletin of Statistics: and data provided by the Bank of Israel.

Including clothing, footwear, personal effects, fuel and electricity, and other goods.

Household equipment, furniture, and personal transport equipment.

Including residential services and expenditures of private nonprofit institutions serving households.

Including indirect taxes on salaries and imputations for government commitments to pay retirement pensions.

Table A4.

Israel: Gross Private Income and Savings, 1990-94 1/

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Sources: Central Bureau of Statistics, Monthly Bulletin of Statistics; and data provided by the Bank of Israel.

Excludes from incomes the subsidy component of government loans to the business sector.

The interest on the domestic public debt is calculated in nominal terms. Includes also local authorities, national institutions, and nonprofit institutions financed mainly by the Government.

Direct taxes on income and national insurance contributions.

Table A5.

Israel: Labor Market Indicators, 1977-94 1/

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Sources: Bank of Israel, Annual Reports; Central Bureau of Statistics, Monthly Bulletin of Statistics; and data provided by the Bank of Israel.

Beginning in 1985, the data are based on the 1983 census and correspond to the population aged 15 and over. Prior to 1985, the data correspond to the population aged 14 and over.

Rate of change for 1988 and 1989 reflects hours actually worked and not number of workers from the territories, which declined only slightly.

For Israeli population.

Table A6.

Israel: Business Sector Employment and Labor Input by Industry, 1988-94 1/

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Source: Bank of Israel.

Employment figures are annual averages; labor input figures are weekly averages.

Includes other employees from the administered areas except for those employed in public services.

Table A7.

Israel: Real Wages, Labor Costs, and Productivity, 1987-94

(Percentage change)

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Sources: Bank of Israel, Annual Reports; Institute for Research on Output and Productivity; and data provided by the Bank of Israel.

Real wages in the public sector and real consumption wages in the business sector are deflated by the consumer price index; real production wages are deflated by the implicit price index of business sector net domestic product at factor cost.

Measured on an hourly basis; deflated by the implicit price index of business sector net domestic product at factor cost.

Business sector net domestic product per man-hour estimated from the expenditure side.

Ratio of real labor cost per man-hour to labor productivity.

Table A8.

Israel: Real Wages, 1980-94 1/

(Average 1989 - 100)

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Source: Data provided by the Bank of Israel.

Average monthly wage per employee post at constant prices: Central Bureau of Statistics data based on employers’ returns to the National Insurance Institute, deflated by consumer price index.

Table A9.

Israel: Consumer Price Index by Economic Sector, 1992-94

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Sources: Central Bureau of Statistics.
Table A10.

Israel: Selected Price Indexes, 1990-94

(Percent increase during the period, at annual rates)

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Sources: Central Bureau of Statistics, Monthly Bulletin of Statistics; IFS; and data provided by the Bank of Israel.

The index of controlled prices comprises the following items: flour, eggs, frozen meat and poultry, edible oils and margarine, milk and milk products, property tax, municipal rates, electricity, water and gas for household use, school fees (kindergarten, elementary, and secondary), cigarettes and other tobacco products, public urban and interurban transport, mail and telephone, and gasoline, oils, and licenses for private cars. The weight of these items in the consumer price index is about 18.5 percent.

The index of uncontrolled prices comprises items not listed in the preceding footnote.

Excluding fruit, vegetables, and controlled prices.

Change during the period, quarterly changes are at actual rates.

A new five-currency basket was introduced in August 1986: U.S. dollar, deutsche mark, pound sterling, French franc, and Japanese yen.

Table A11.

Israel: Bank of Israel Accounts, 1991-95

(In millions of new sheqalim, end of period)

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Sources: IMF Data Fund; and Bank of Israel.
Table A12.

Israel: Monetary Survey, 1990-94

(In millions of new shegallm: at and of period)

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Source : Bank ot Israel Research Department.

From December 1992 New Report.

Quasi-money consists of time and savings, deposits, CDs, and other deposits.

Table A13.

Israel: Financial Aaaata of the Public, 1989-95 1/

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Sources: Bank of Iarael, Research Department: Recent Economic Development: and data provided by Bank of Israel.

The public consists of individuals and corporations excluding the Government, Bank of Israel, ordinary banking corporations, and banks abroad. It includes social and life insurance funds but does not include the assets of these funds held out of the ordinary banking system.

Consists of liquid financial assets (M3) and mudium-term assets as defined above.

Since February 1954, bank shares that were converted into savings schames are included under “Savings schemes” instead of “Bank deposits”

Defined to exclude bond holdings of pension funds and insurance companies

Table A14.

Israel: Commercial Bank Credit to the Private Sector, 1991-95 1/

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Source: Bank of Israel, Research Department.

Commercial banks and their overseas offices. Includes credit to local authorities.

Starting 1992, new reporting system.

Includes indexation increments on NIS credit linked to the CPI.

Table A15.

Israel: Interest Rates. 1994-95

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Source: Information provided by the Bank of Israel.

All interest rates converted to monthly terms at compound interest

In October 1987, the Bank of Israel started using suction on monetary loans. The interest specified is the waighted average of these loans.

Commercial banks’ monetary loans from the Bank of Isreal (maximum bracket).

Weighted average of rates on mostly short-term shequl, including directed and nondirected credits.

Deposits of NIS 10,000 and over. From September 1988 it represents the weighted avarage interest for all deposits.

Banking system mean interest and exchange rate differentials on 12-month deposits of $50,000 and over (see also footnote 5).

Table A16.

Israel: Real Ex Post Interest Rates on Various Types of Credit and the Public’s Assets, 1992-94

(Annual rates in parcant, before tax)

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Source: Data provided by the Bank of Israel.

Includes directed credit and nondirected foreign currency linked credit.

Euro in dollar terms for three months is the base for interest on dollar loans, excluding public companies.

Average for all time deposits.

Interest rate differential defined as the gap in nominal percentage points on an annual basis between the effective rate on overdrafts and tha rate on certificates of deposit.

Table A17.

Israel: Intermediation Structure (Asset Side) of Ordinary Banks, 1988-93 1/

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Source: Annual Report. Supervisor of Banks. 1993.

Israeli offices; end-of-period data at December 1993 prices; not including contingent accounts.

Comprising credit to the public and acceptances.

Comprising deposits with banks, and investments in securities and fixed assets.

Table A18.

Israel: Resarve Requirements on Deposits 1/ and the Interest Rate Brackets, 1987-94

(In parent of deposits)

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Source: Information provided by tti* Bank of Isreal.

Net of permitted deficit.

Currently a ramunaration of 9.3 parcant par year is paid on the interest-bearing portion of reserves hold against deposits.

As of February 25, 1988, the same reserve requirements also apply to deposits of up to three months.

As of February 25, 1988, the same reserve requirements also apply to deposits of longer than three-month maturity.

As of November 28, 1991, the same reserve requirements apply to all deposits of Longer than three months.

Table A19.

Israel: Sources of Change in Unindexed Local-Currency Assets, 1991-94

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Source: Data provided by the Bank of Israel. 1/ Excluding changes resulting from the revaluation of government bonds and FATAM deposits.

Net government borrowing from the private sector less the early redemption of the State of Israel bonds.

Includes the injection of the Jewish agency. Sale of tradabls bonds is not considered as absorption. Includes interest payments on internal debt.

Consists mostly of absorption/injection generated by various items in the Bank of Israel’s balance sheet. (Such as interest paid on liquid assets in local and foreign currency).

This the residual item (i.e., change in the unindexed local-currency assets less change in money base), and represents the effect of the deposit multiplier.

Table A20.

Israel: Factors Affecting M3 Base, 1991-95

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Source: Information provided by the Bank of Israel.

Currency held by public and liquid assets of banking institutions.

PATAM deposits are denominated in foreign currency.

Nominal increase deflated by rise in consumer price index.

Table A21.

Israel: Principal Stock Market Indicators, 1990-94

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Sources: Bank of Israel; and Central Bureau of Statistics.

Shares, convertible securities, and exercised options.

At December 1994 prices (monthly inflation). Market value--end-of-year figures; volume of trade--on and off the floor.

Ratio of monthly volume of trade (on and off the floor) to average monthly market value of the stock of shares.

Deflated by end-of-month CPI.

Table A22.

Israel: Principal Bond Market Indicators, 1990-94

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Sources: Bank of Israel; and Central Bureau of Statistics.

At December 1994 prices.

Including public sector corporations.

Ratio of the central bank’s sales and purchases in the secondary market to total volume of stock exchange trade in bonds.

Ratio of monthly volume of trade (on and off the floor) to market value of the stock of bonds. Calculated from monthly ratios.

Table A23.

Israel: Institutional Investor Indicators, 1991-94

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Sourca: Bank of laraal.
Table A24.

Israel: Summary Budgetary Transactions on Cash Basis, 1988/89-1995

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Source. Fund staff calculations from data provided by the Ministry of Finance

The 1991 budget only covered nine months, as the Government shifted the budgetary year from financial years to calendar years.

The overall deficit as calculated by the staff differs from that of the authorities in that it does not include loans from and repayments to the National Insurance Institute as, respectively, revenue and expenditure. Instead the staff considers these to be financing items

Includes (net) borrowing through saving schemes.

Under a special investment agreement, the assets of the National Insurance Institute are invested in CPI—linked government bonds.

The last redemption under the Bank share arrangement took place in 1991

Government revenue is seasonally strong in the first quarter of a calendar year Taking this into account, revenue in the 1991 would would have been about 1.5 percentage points of GDP higher.

Table A25.

Israel: Central Government Revenues, 1988/89-1995

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Source: Fund staff calculations from data provided by the Ministry of Finanece

See footnote 1 to Table A24.

Includes value—added tax on imported goods and services.

Mainly earmarked income. As from 1992, this item also includes revenue from apartment sales.

Table A25.

Central Government Revenues, 1988/89 - 1995

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See footnote 1 to Table A24.

Nominal changes deflated by CPI changes.

The real increase in 1991 is calculated by comparing the annualized 1991 figures (not seasonally adjusted) to the 1990/91 figmes.

The real increase in 1992 is calculated by comparing the 1992 figures to the annualized 1991 figures.

The realchange in the 1994 budget is calculated by comparing the 1994 budget figures to the 1993 estimates using the CPI-inflation target of 8 percent as deflator.

Table A26.

Israel: Budget Expenditure 1988/89–1995

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Source: Fund staff calculations from data provided by the Ministry of Finance.

See footnote 1 to Table A24.

Excludes interest payments to Bank of Israel.

Starting in 1992, investment grants are classified as “other current transfers”.

Table A26a.

Israel: Budget Expenditure 1988/89–1995

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Sec footnote 1 to Table A24.

Nominal changes deflated by CPI changes

The real increase in 1991 is calculated by comparing the annualized 1991 figures (not seasonally corrected) lo the 1990/91 figures

The real increase in 1992 is calculated by comparing the 1992 figures to the annualized 1991 figures

The real change in the 1994 budget is calculated by comparing the 1994 budget figures to the 1993 estimates, using the CP1 inflation target of 8 percent as deflator

Table A27.

Israel: Budget Expenditure 1988/89–1995

Functional Classification

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Source Fund staff calculations from data provided by the Ministry of Finance.

See footnote 1 to Table A24

Table A28.

Israel: Central Government Expenditures and Domestic and Foreign Debt Service

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Source Fund staff calculations from data provided by the Ministry of Finance

See footnote 1 to Table A24.

Includes debt service payments to Bank of Israel.

Excluding debt service payments to Bank of Israel.

Table A29.

Israel: The Currency Basket of the Israeli Sheqel, 1986–94

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Sources: IMF, International Financial Statistics; and data provided by the Israeli authorities.
Table A30.

Israel: Exchange Rate Developments, 1985–94

(Index number 1985 = 100: period averages)

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Sources: IMF, International Financial Statistics; and data provided by the Israeli
Table A3l.

Israel: Balance of Payments Summary, 1988–1995

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Sources: Bank of Israel; and Central Bureau of Statistics.
Table A32.

Israel: Balance of Payments - Services, 1987–94

(In millions of U.S. dollars)

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Sources: Central Bureau of Statistics, Monthly Bulletin of Statistics; and data provided by the Bank of Israel.
Table A33.

Israel: Civilian Import Voluma and Price Indicators, 1987–94

(Percentage change from previous year)

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Sources: Central Bureau of Statistics, Forelun Trade Statistics Quarterly; data provided by the Bank of Israel; and Fund staff estimates.

Value data deflated by Fisher type unit value indices.

Based on U.S. dollar data.

Table A34.

Israel: Commodity Composition of Civilian Imports (c.i.f), 1987–94 1/

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Sources: Central Bureau of Statistics, Foreign Trade Statistics Quarterly; and Monthly Bulletin of Statistics.

Excluding imports from occupied areas and direct imports of military goods. A revised classification of commodity categories applies in 1987 and thereafter.

Returned and re-exported imports, and items not specified elsewhere.

Table A35.

Israel: Origin of Imports, 1988–94

(Percent of total)

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Sources: Central Bureau of Statistics, Monthly Bulletin of Statistics; and IMF, Direction of Trade Statistics.
Table A36.

Israel: Commodity Composition of Exports. 1987–94 1/

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Sources: Central Bureau of Statistics, Foreign Trade Statistics Quarterly; and Monthly Bulletin of Statistics.

Including returned exports (except diamonds): excluding exports to Occupied Territories.

Numbers do not add up because total Includes “other exports,” mainly scrap metal.

Table A37.

Israel: Export volume and Price Indices, 1987-94

(Percentage change from previous year)

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Sources: Central Bureau of Statistics, Foreisn Trade Statistics Quarterly, and data provided by the Bank of Israel.

Value data deflated by Fisher type unit value indices.

“Other industrial products” includes rubber and plastic rubber and plastics through 1989; from 1990 rubber and plastics are included under chemicals.

Based on data in U.S. dollars.

Table A38.

Israel: Destination of Exports, 1988-94

(Percent of total)

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Sources: Central Bureau of Statistics, Monthly Bulletin of Statistics; and IMF, Direction of Trade Statistics.
Table A39.

Israel: Capital Account Transactions, 1989-94

(In millions of U.S. dollars)

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Sources: Central Bureau of Statistics, Monthly Bulletin of Statistics.

Excluding errors and omissions.

Loans to the private nonfinancial sector.

Table A40.

Israel: Indicators of External Indebtedness, 1987-94

(In millions of U.S. dollars)

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Sources: Central Bureau of Statistics, Monthly Bulletin of Statistics; data provided by the Bank of Israel; and the staff calculations.

Net of foreign assets of commercial banks. Bank of Israel’s reserves, holdings of other monetary institutions, and export credit.

Table A41.

Israel: Indicators of Debt Service, 1989–94

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Sources: Central Bureau of Statistics, Monthly Bulletin of Statistics; and data provided by the Bank of Israel.

Excludes short-term debt.

Table A42.

Israel: Assets and Liabilities in Foreign Currency, 1990–94 1/

(In millions of U.S. dollars)

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Sources: Central Bureau of Statistics.

End-period balances. Figures msy not add due to rounding.

The figures of liabilities in this table are consistent with those published by the Central Bureau of Statistics. The data published by the Controller of Foreign Exchange are slightly different because they were revised on different dates.

Table A43.

Israel: Official Gold and Convertible Foreign Exchange Reserves, 1985–94

(In millions of U.S. dollars: end of period)

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Sources; IMF, International Financial Statistics; and data provided by the Bank of Israel.

National value.

References

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  • Hamilton J.D., Time Series Analysis, Princeton University Press, 1994.

  • Harvey H.C., Forecasting, Structural Time Series Models and the Kalman Filter, Cambridge University Press, 1989.

  • Kalman R.E., A New Approach to Linear Filtering and Prediction Problems, Journal of Basic Engineering, Transactions ASME, Series D 82, pp. 5–108, 1960.

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  • Kalman R.E. and R.S. Bucy, New Results in Linear Filtering and Prediction Theory, Journal of Basic Engineering, Transactions ASME, Series D 83, pp. 95–08, 1961.

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  • McCallum B.T., Robustness Properties of a Rule for Monetary Policy, Carnegie-Rochester Conference Series on Public Policy, 29, pp. 173–204, 1988.

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  • McCallum B.T. and M. Hargraves, A Monetary Impulse Measure for Medium-Term Policy Analysis, IMF Working Papers WP/94/146, December 1994.

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  • Bank of Israel Annual Report, Various Issues.

  • Blanchard, 0. J., Suggestions for a New Set of Fiscal Indicators, OECD Working Paper No. 79, April 1990.

  • Dahan, M., A Fiscal Impulse Measure for Israel, Bank of Israel Economic Review 68, pp. 23–37, April 1994.

  • Heller, P. S., R. D. Haas, and A. S. Ahsan, A Review of the Fiscal Impulse Measure, IMF Occasional Paper No. 44, 1986.

  • Kreis, E. S., The Inflationary Process in Israel, Fiscal Policy, and the Economic Stabilization Plan of July 1985, in Mario I. Blejer and Ke-Young Chu (eds.) Fiscal Policy, Stabilization and Growth in Developing Countries, IMF 1989.

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  • OECD, Estimating Potential Output, Output Gaps and Structural Budget Balances, mimeo, 1994.

  • Ortega, A. O., O Piano de Estabilizacao Heterodoxo: A Experiencia Comparada de Argentina, Brasil e Peru, National Bank for Economic and Social Development, Rio de Janeiro, 1989.

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  • Razin, A. and Sadka, E., The Economy of Modern Israel: Malaise and Promisse, The University of Chicago Press, 1993.

1/

Trade union weakening have come on two fronts. The trade union federation (the Histadrut) has suffered from a series of scandals which have caused a decline in prestige, resources, and membership. In addition, since the start of the recent immigrant wave in late 1989, there has been a continued trend toward decentralization of wage bargaining to the firm level, which has increased the flexibility of wage bargaining.

2/

In recent years, formal wage indexation has been limited at the national level to 85 percent of the rate of inflation above a threshold of 6 percent.

1/

The adjustment of deposit rates to a tightening of monetary policy tends to be slower than that of credit rates since a large part of credit is extended at floating interest rates. This might bias somewhat the picture at end-1994. Nevertheless, the long-term trend is clear.

1/

These currencies were the U.S. dollar, the deutsche mark, the British pound, the French franc, and the Japanese yen.

2/

The introduction of the band in 1989 was based on the view that the undergoing liberalization of exchange controls implied potentially sizable flows of capital to and from Israel. Under these circumstances, increased flexibility of the exchange rate was considered to be desirable in order to maintain control over monetary policy and the level of official foreign exchange reserves. The adoption of an exchange rate band was viewed as a useful policy step that would allow some degree of flexibility for absorbing capital flows without necessarily abandoning the role of the exchange rate as an anchor to inflation expectations.

1/

The 2 percentage point depreciation of the currency in July 1993 was intended to compensate exporters for the elimination of preferential rates of export insurance, as part of Israel’s program to eliminate multiple currency practices.

2/

From 1993 Q4 to 1994 Q3.

3/

At the same time, the weight of the U.S. dollar in the currency basket was increased by 3.2 percent, with a corresponding decrease in the weights of the four other currencies that make up the basket. The U.S. dollar now comprises 54.8 percent of the basket, the deutsche mark 24.2 percent, the French franc 5.6 percent, the pound sterling 8.3 percent and the Japanese yen 7.1 percent. In addition, there was an 0.8 percent devaluation of the shekel. This devaluation was intended to compensate exporters for the equal spreading of port duties between exporters and importers, from which exporters had formerly been exempt.

1/

MlB, which adds foreign-denominated demand deposits of Israeli residents to Ml increased by just 18 percent during the year, reflecting the more moderate demand for foreign currency assets.

1/

For details about the process of financial liberalization see Chapter II of SM/94/112 (5/6/94).

2/

For details see Selected Economic Issues and Statistical Appendix (SM/94/112).

3/

The Mishtanim share price index represents the 100 most heavily traded stocks.

1/

Provident funds are long-term (15 years) saving funds, which are heavily favored by tax exemptions to savers.

1/

In the last two years, the deficit of local governements, which is not covered by the Deficit Reduction Law, has increased significantly and in 1994 it has been roughly equal to the central government budget deficit.

1/

The ratio of total revenues to GNP in Israel has been remarkably stable at around 54 percent since 1989. In 1994, a year in which actual revenues exceeded the projected level by NIS 5.6 billion, this ratio only slightly decreased to 53.1 percent. Transfers from abroad continued on their declining path and reached 5 percent of GDP down from 6.3 percent of GDP a year earlier. An important factor in the relative decline in transfers was the strengthening of the shekel vis-á-vis the U.S. dollar, in which currency most transactions are denominated.

1/

If Israel’s public debt were defined according to the Maastricht criteria, the total gross debt to GDP ratio would decline from 117 percent in 1993 to 110 percent in 1994, compared to an average of 70 percent in the countries of the OECD.

2/

The interest on these bonds is adjusted every six months on the basis of the average yield of Treasury bills in the past two months plus an additional 1.5 percent.

1/

These cuts were specified only in March 1995 and their amount was increased to NIS 900 million: they targeted the aid to the defense industry and kibbutzim, NIS 350 million; mortgage subsidies, NIS 250 million; and across the board cuts in expenditures of NIS 300 million.

1/
One may define the “shadow” exchange rate as follows:
REERshadow = e/ p* (l+tm)P

where e’> e is a shadow nominal exchange rate which reflects the value of foreign currency taking into account the scarcity induced by foreign exchange restrictions. As trade is liberalized, tm falls, while as foreign exchange restrictions are eased, e’ falls (toward e). Both of these effects appreciate the shadow REER.

1/

Imports of diamonds grew by 15 percent in 1993 and 16 percent in 1994 in U.S. dollar terms.

1/

For footwear, wood and electrical products, the deadline has been pushed back to September 1998, while for clothing and textiles it will be September 2000.

2/

Currently, individuals are free to invest in securities abroad provided that they are deposited in Israel, and specialized mutual funds can invest up to 50 percent of their assets abroad.

1/

Prepared by Mr. J. Franks.

1/

The export elasticities are derived from the impulse response coefficients in Beenstock, Michael, Yaakov Lavi and Sigal Ribon, 1994. “The supply and demand for exports in Israel,” Journal of Development Economics 44:333–350. The impulse response for growth in the capital stock has been included in the constant term. The import income elasticities are derived from the impulse response coefficients in Beenstock, Michael, Yaakov Lavi, and Akiva Offenbacher, 1994. “A macroeconometric model for Israel, 1962–90,” Economic Modelling. 11:413–462. For the aggregate demand elasticity, both the Beenstock et al, and independent OLS estimates gave unreasonably high import demand elasticities (on the order of 2.5) due to the simultaneity between strong economic growth and trade liberalization in recent years. The scenarios presented in this appendix are based on an assumed import income elasticity of 1.5.

1/

In both scenarios, the staff assumes that consumption growth will fall as immigrants are more fully absorbed into the Israeli economy. This slower growth will generate a recovery in the private savings ratio in the medium term.

2/

Real depreciation begins in late 1996 in this scenario, compared to 1998 in the baseline scenario.

1/

Prepared by Mr. F. Scacciavillani.

1/

One should observe that these measures have a direct link to the Andersen-Jordan (1968) equation, developed at the St. Louis Federal Reserve Bank, that focused on the relationship between changes in nominal measures of economic policy and changes in nominal income. This differs from most macroeconomic models whose implicit reduced forms specify relationships between levels of nominal money balances and the level of real output.

2/

The original work is often attributed to Brunner and Meltzer, e.g., Brunner and Meltzer (1967). A more recent reference is McCallum (1988).

1/

The classic method for identifying and estimating feedback rules was proposed by Box and Jenkins (1970) in the context of ARIMA models.

1/
RxIM1 relies merely on short-term expectations so it includes only one period ahead projection of the velocity, i.e., expression (3) reduces to:
RxIM1t = DLBt + E(DLVt+1|Ωt);
the second measure, AvgRxIM1, assigns a smaller weight to the forward looking expectations because the velocity term is calculated as an arithmetic average of two period ahead forecasts and two lagged observations on DLV, in symbols:
AvgRxIM1t = DLBt + (1/4) [DLVt−1 + DLVt + E(DLVt+1|Ωt) + E(DLVt+2|Ωt)].
1/

Prepared by Mr. D. Gleizer.

2/

See Heller et al. (1986).

1/
The cyclical unemployment rate (Utc) is calculated as follows:
Utc = 1/β [(YtP − Yt)/Yt]
where β is an Okun coefficient that can be estimated by ordinary least squares as:
[(Yt − Yt−1)/Yt−1] = α + β ⋅ [Ut−1 − Ut] + εt

where Ut is the rate of unemployment observed at time t.

This measure is thus multiplied by the labor force in order to derive the number of cyclically unemployed workers. In all the calculations, the figures used refer to the established Israeli population only, that is, they exclude the new immigrants. The implication is that all immigrant unemployment is assumed to be structural in nature.

2/

These assumptions imply that discretionary spending on unemployment benefits reflects either a change in the benefit that accrues per unemployed or a change in the share of beneficiaries or a combination of both.

1/
The HP filter is a statistical technique for determining the trend in real GDP, by finding the sequence that simultaneously minimizes a weighted average of the gap between output and trend output, at any point in time, and the rate of change in trend output at that point in time. More precisely, the trend Y* for t = 1 2.. T is estimated to minimize
∑(yt − yPt)2 + (λ/T) ∑[(yt+1 − yt) − (yPt − yPt−1)]2

where the summation for the first term is from t=1 to T and for the second term from t=2 to T. The results reported here are based on A=100, which has become standard in the literature. Since the HP filter fits a trend line symmetrically through the data, it displays an end-point problem if the initial and final observations do not reflect similar points in the economic cycle. That is, the trend will be pulled upwards or downwards towards the path of actual output for the first few and the last few observations. To address this problem, it is advised to use projections which go beyond the short-term to the end of the current cycle (OECD 1994, pg.7). Thus, the staff’s projections in SM95-186 were used to extend the period of estimation until 2000 to give more stability to estimates.

1/

Another potential source of distortion results from the inflation erosion of tax revenues due to the delay between the time when tax liabilities accrue and the time when payment is received by the government, the so-called “Tanzi effect”. Indeed, when inflation accelerates, the real value of tax revenues collected by the government falls. In the methodology above, this is captured as a positive impulse in the same way as a discretionary reduction in tax rates. If inflation slows down, on the other hand, the erosion of tax revenues is reduced and this is captured as a negative revenue impulse analogous to an increase in tax rates. As a result, the methodology classifies as discretionary changes in the fiscal balance those factors that merely reflect the impact of inflation on the government accounts. It is possible to argue, however, that inflation should be taken into account in the budget process and that the decision to alter the strength or direction of fiscal policy should be undertaken in view of the expected impact of the inflationary environment on the fiscal balance, as much as the impact of the economic cycle are included. In this view, only the erosion of tax revenues derived from the unexpected portion of inflation should be adjusted for in the impulse measure. Moreover, the collection of the inflation tax by the Government should also be incorporated, since it curtails private demand.

1/

The large positive impulse in 1984 reflected mainly the erosion of tax revenues due to high and accelerating inflation. Indeed, tax revenues fell from 42.3 percent of GDP in 1983 to 35.4 percent in 1984, despite the measures taken by the authorities to minimize the impact of inflation on taxation. The breakdown of the revenue impulse shows that the bulk of the change stems from revenues from taxes imposed on domestic production and income. While a precise estimate of the impact of inflation on tax revenues and, thus, on the impulse, requires very detailed knowledge of the tax system and of the collection structure, Chart III.2 presents a rough estimate of the impact of inflation on the impulse (on a primary basis) derived by using a measure of potential tax revenues when calculating the elements used in the derivation of the discretionary deficit, namely the actual and the neutral deficits. As can be seen from Chart III.2, during the period of high inflation, and during stabilization, the differences between a nonadjusted and an inflation-adjusted measure of the primary fiscal impulse are significant. The surge in inflation from 145.7 percent in 1983 to 373.8 percent in 1984 had a major impact on tax collection and, therefore, on the fiscal impulse as usually measured. After adjusting for tax erosion, one observes that, while still substantial, the stance of fiscal policy was less expansionary than captured by the unadjusted measure. The two measures are also significantly different in 1985 and 1986. The rapid deceleration of inflation in the second half of 1985 reduced the erosion of tax revenues, biasing the fiscal impulse measure upward. When correcting for inflationary effects, one observes that the fiscal stance was tighter than indicated by the uncorrected fiscal impulse. The adjustment for 1986 actually shows that the fiscal stance was tighter in 1985 than in 1986, contrary to what is depicted by the usual measure, since the latter was also capturing the fact that inflation deceleration was reducing erosion and assigning this to discretionary tax increases. Since 1988, the difference between the two measures is inconsequential.

1/

As noted, the cyclical unemployment rate was estimated on the basis of the established population only. Therefore, the increase in unemployment in the wake of the immigration wave gave rise to an increase in beneficiaries over and above what could be expected on the basis of trend behavior. This is captured in the calculations as an increase in discretionary policy, leading to a higher impulse.

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Cover IMF Staff Country Reports
Israel: Recent Economic Developments
Author:
International Monetary Fund
Volume/Issue:
Volume 1995: Issue 105
Publisher:
International Monetary Fund
ISBN:
9781451819427
ISSN:
1934-7685
Pages:
152
DOI:
https://doi.org/10.5089/9781451819427.002
Chart 1.

Israel: SELECTED INDICATORS OF REAL ACTIVITY
Chart 2.

Israel: SELECTED INDICATORS Of SAVING, INVESTMENT AND THE CURRENT ACCOUNT

(In percent of GDP)
Chart 3.

Israel: SELECTED LABOR MARKET INDICATORS
Chart 4.

Israel: CONSUMER PRICES

(Percent change from one year earlier)
Chart 5.

Israel: MONETARY INDICATORS, JANUARY 1991 – APRIL 1995
Chart 6.

Israel: INFLATION RATE, INFLATION RATE TARGET AND INFLATIONARY EXPECTATIONS
Chart 7.

Israel: SELECTED EXCHANGE RATE INDICATORS
Chart 8.

Israel: STERILIZATION OF SHORT-TERM CAPITAL INFLOWS
Chart 9.

Israel: INDICATORS OF STOCK MARKET BEHAVIOR, 1989 – 1994
Chart 10.

Israel: SELECTED INDICATORS OF GENERAL GOVERNMENT ACTIVITY 1/

(In percent of GNP)
Chart 12.

Israel: SELECTED FOREIGN TRADE INDICATORS, 1987–1995 1/
Chart 13.

Israel: SELECTED BALANCE OF PAYMENTS INDICATORS, 1987–1994
Chart I.1.

Israel: MEDIUM–TERM OUTLOOK, 1995–2000 1/
Chart II.1.

Israel: MONETARY IMPULSE (ANNUAL RATES)
Chart II.2.

Israel: MONETARY IMPULSE (ANNUALIZED QUARTERLY RATES)
Chart II.3.

Israel: MEASURES OF MONETARY IMPULSE (Annualized quarterly rates)
Chart III.1.

Israel: OUTPUT AND POTENTIAL OUTPUT
Chart III.2.

Israel: IMPULSE ON PRIMARY BALANCE AND INFLATION

(1981–1994)