Public Information Notice No. 10/10

Public Information Notice: IMF Executive Board Concludes 2009 Article IV Consultation with Israel

January 25, 2010

On January 15, 2010, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Israel.¹

Background

The economy expanded rapidly following the 2001–03 downturn, with growth averaging over
5 percent in 2004–07. Supported by strong exports and contained government spending, the external current account remained in significant surplus while the exchange rate was largely stable. Inflation stayed close to the target band, before soaring fuel prices led to its sharp upward climb after mid-2007. Driven by strong fiscal tightening efforts, and also aided by rapid economic growth, the central government fiscal accounts steadily improved from a deficit of 5¼ percent of GDP in 2003 to balance in 2007, whereas public debt was lowered from 99 percent of GDP to below 80 percent of GDP during the period.

Trends changed, however, in the latter half of 2008, as the deepening global financial crisis took its toll. Exports and growth slowed, reducing growth to 4 percent and the current account surplus to 1 percent of GDP for the year. Alongside, unhindered operation of automatic stabilizers pushed the central government deficit up to 2¼ percent of GDP in 2008. Banks—with robust balance sheets—remained relatively resilient, although non-bank financial institutions and the domestic corporate bond market were strained. In this context, Israel’s “safe haven” appeal rose and capital inflows surged, leading the real effective exchange rate to rise by some 15 percent between end-2007 and mid-2008.

Strong policy measures were adopted in response to the impact of the global crisis. Near-term fiscal targets for expenditure and deficit were relaxed in the 2009–10 budget, even though an increase in some excises and a temporary 1 percentage point rise in the Value Added Tax (VAT) rate—programmed to be reversed at end-2010—acted as a partial offset. With headline inflation and inflation expectations rapidly falling and shekel appreciating, the Bank of Israel rapidly reduced policy rates from 4.25 percent in February 2008 to 0.5 percent in April 2009, and adopted unconventional monetary measures—intervening in the foreign exchange (FX) market and purchasing long-dated government bonds. Targeted efforts to relieve financial market strains were also taken, including setting up public-private bond funds and offering guarantees for bank capital raising.

In part reflecting this policy support, growth returned in the second quarter of 2009 and signs of a sustained recovery have strengthened in recent months. In this context, fiscal receipts have surprised on the upside, likely bringing the central government deficit to 5 percent of GDP and debt to about 80 percent of GDP for 2009, both better than budgeted. Inflation expectations have recently risen back to within the target band and the current account surplus has rebounded strongly on the back of reviving exports. Against this background, the Bank of Israel discontinued its pre-announced FX interventions and government bond purchases in Summer 2009, and began raising policy rates for September 2009, to 1.25 percent for January 2010. And on the fiscal side, the authorities reduced the VAT rate by half a percentage point to 16 percent from end-December, bringing forward by one year half of the cut that had been planned for end-2010.

Executive Board Assessment

Directors observed that the resilience of the Israeli economy during the global crisis reflected strong policy responses, robust fundamentals, prudent bank supervision, public debt reduction, and structural reforms in recent years.

Directors cautioned, however, that the global outlook remains highly uncertain, and the slower medium-term global growth would have adverse implications for Israel’s potential growth rate. They therefore agreed that long-term anchors in Israel’s policy frameworks should be strengthened to allow a flexible response of policies to short-term developments and to stimulate long-term supply. Directors welcomed the various steps that have been taken in this direction--including the adoption of a declining target path for fiscal deficits, the recent tightening of the monetary stance, steps towards adoption of the new Law for the Bank of Israel, and various actions to bolster prudential supervision.

At the same time, Directors recognized that challenges remain. The credibility of the new deficit ceiling rules has yet to be fully established. Public debt is high and is expected to rise in the near term before resuming its downward track. Although economic growth has resumed relatively early, upward pressures on the shekel could pose new risks. In this light, Directors underscored that further efforts are needed to address downside risks—notably, moderation in the forthcoming public sector wage settlements, including as a signal to private sector settlements.

Directors noted the importance of strengthening the fiscal framework. Steps to reconcile aggregate spending ceilings with the sum of undertakings on specific programs should be a priority. A reform of the fiscal rules—with the adoption of a framework anchored by explicit medium-term debt targets—would help establish the priority assigned to debt reduction and allow fiscal flexibility in the short term. This should be accompanied by multi-year spending ceilings with appropriate countercyclical properties. Strengthened medium-term budget planning would reinforce credibility and improve spending efficiency.

Given economic recovery and the history of high inflation, Directors welcomed the steps taken to begin withdrawal from unconventional monetary policy measures—including preprogrammed foreign exchange intervention—and to increase interest rates. They noted the authorities’ commitment to avoid targeting specific levels of the exchange rate. Discretionary interventions should be formally terminated, for all but the most exceptional market circumstances, once the policy interest rate is well above its effective floor on a sustained basis. Directors urged an early completion of all steps to adopt the Bank of Israel Law.

While noting that the Israeli banking system has weathered the crisis well, Directors saw scope for a further strengthening of the banking prudential framework. Comprehensive banking stress tests, regular publication of a financial stability report by the Bank of Israel, and closer coordination among various regulators would all strengthen transparency and stability. Some Directors recommended consideration of a formal deposit insurance scheme.

Directors welcomed the priority attached by the authorities to effective supervision of the non-banking sector, noting a need to strengthen the budget, staff, and autonomy of the non-bank regulators. In this context, separation of the pension and insurance regulator from the Ministry of Finance would reflect international best practice. Regular publication of risk analyses by non-bank regulators was also encouraged.