Public Information Notice No. 11/8

Public Information Notice: IMF Executive Board Concludes 2010 Article IV Consultation with Israel

January 24, 2011

On January 7, 2011, the Executive Board of the International Monetary Fund (IMF) concluded the 2010 Article IV consultation with Israel, and considered and endorsed the staff appraisal without a meeting.¹

Background

Israel was mildly affected by the global recession: following a slowdown in 2009, output is projected to grow by some 4 percent in 2010, led by consumption and exports. Credit from domestic and foreign sources to households has been buoyant—at annual rates of some 8 percent in 2009 and 2010, reflecting the resilience of the banking sector. Credit to non-financial firms however has been largely flat. As recovery has taken hold, unemployment has fallen from its peak of 8 percent in early 2009 to 6 percent in 2010. With public debt a little below 80 percent of Gross Domestic Product (GDP), there were no signs of budget funding stresses. The strength of long-term prospects has also been underscored by the recent entry into the Organization for Economic Co-operation and Development (OECD) and by the discovery of significant offshore natural gas reserves.

As the growth outlook improved in the second half of 2009, the stance of policies was tightened. On the fiscal side, this largely reflected automatic stabilizers. The budget deficit is estimated to have declined to 3.9 percent of GDP in 2010 and is planned to strengthen to 3 percent in 2011. Moreover, new fiscal rules were adopted in 2010 comprising deficit and spending ceilings.

On the monetary policy side, the Bank of Israel raised policy rates from their floor of half a percent to 2 percent by October 2010. In August 2009, the central bank also discontinued its daily purchase of US Dollars in the Foreign Exchange market, although it continues to intervene to stem the appreciation of the shekel, with reserves reaching US$70 billion in 2010. Alongside, a new Bank of Israel Law was adopted in 2010 formalizing established inflation targeting practices.

In this context, the shekel came under considerable appreciation pressures, rising in real terms to some 15 percent above pre-crisis levels. This was reflected in export market share falling in the first half of 2010 and, in conjunction with global developments, outright export declines in the third quarter of 2010. Nevertheless, the strong shekel has helped to contain inflation, which has recently fallen back into its 1-3 percent target range after an extended period above it.

Israeli banks appear well-capitalized and liquid. In 2010, capital adequacy ratios rose for most banks, and impaired and non-performing loan ratios declined. However, nominal house prices have risen 40 percent over the past two years. Macroprudential measures were adopted by the Bank of Israel alongside supply side measures to stabilize the sector.

Executive Board Assessment

In concluding the 2010 Article IV consultation with Israel, Executive Directors endorsed the staff’s appraisal, as follows:

Robust fundamentals—including sustained pre-crisis fiscal consolidation—and a swift monetary and fiscal policy response to the external downturn allowed Israel to pass through the global recession relatively unscathed. In part, this reflects the innovation of the “two-year” budget cycle, which helped to stabilize expectations in mid-crisis and established an important precedent for the future.

In that light, steps taken to withdraw policy stimulus have been appropriate. As economic growth rose through 2009-10, the budget deficit strengthened faster than planned. Alongside, the increase in the policy rate of the Bank of Israel in several steps helped to secure a decline of inflation back into its target range, with medium-term inflation expectations also remaining in range.

The resilience of the economy has been strengthened by the adoption of new fiscal rules capping spending and deficits, a new Bank of Israel Law, and by the entry into the OECD.

At the same time, strains have emerged. In particular, inflation expectations have risen towards the upper end of the target band, nominal house prices have boomed, and the shekel has appreciated significantly. Though all these developments reflect Israel’s relatively strong economic performance, the authorities will need to keep them under control.

Accordingly, the additional policy tightening that is planned, including further fiscal deficit reduction in 2011-12, and the anticipated further increases in the policy rates of the Bank of Israel are welcome.

But in light of the emerging strains, additional action may be required. This would reinforce the credibility of the overall policy framework, but it should be designed to avoid compounding upward pressure on the shekel. Accordingly, fiscal policy should carry the burden of the additional effort, and so a stronger than planned structural fiscal consolidation is recommended for 2011 and 2012. In this context, monetary policy rates should rise broadly as is now anticipated. But if fiscal policy remains as planned, policy rates may need to rise further and more rapidly than planned—even if this puts further upward pressure on the shekel—in order to stem inflation.

With the balance of monetary and fiscal policy tightening adjusted as recommended, other policy instruments—notably foreign exchange intervention—can play a supportive role. Without this rebalancing, however, there is risk that intervention could become unduly one-sided, and the “managed” float regime could become misperceived as flexible in one direction only.

The strengthening in supervision and regulation of the financial sector and the robust indicators of financial stability are welcome. However, further progress is needed to strengthen the diagnosis and management of risk. To this end, the development of stress testing procedures focusing on systemic risk, and the enhancement of the collaboration between and within supervisory institutions is strongly encouraged. Furthermore, in line with typical OECD practice, supervision of non-banks might be further strengthened by locating it outside the Ministry of Finance.

Finally, in parallel with further strengthening of structural reforms, including in education, research, the business environment, and infrastructure, effective management of resources anticipated from discovery of significant natural gas reserves will also be necessary. In particular, the first use of tax proceeds from gas should be to reduce public debt, and additional funds from this source should be placed in a Sovereign Wealth Fund.