Bank of Israel Annual Report

Chapter 1: The Economy and Economic Policies

After five years of rapid growth, Israel's economy suffered a reversal in the second half of 2008, and started sliding towards a recession, against the background of the increase in the severity of the global crisis and its effects on the economy. Although GDP increased by an average of 4 percent over the year, in the fourth quarter it actually contracted.
In the first part of the year, the trends that characterized the period of rapid growth continued– –a high level of economic activity, low unemployment, a surplus in the current account of the balance of payments, a high rate of saving, a significant cumulative reduction in the public debt/ GDP ratio, and a high level of profitability in the business sector.
The effects of the crisis became more acute towards the end of the year, expressed in steep declines in exports and tax revenues and a decline in private consumption. Employment stopped rising, wages dropped, and unemployment started to climb.
The turnaround was also evident in inflation: till September it was high, reflecting the increase in global oil and commodity prices and the excess demand in the economy, and then it declined sharply, in light of the fall in world prices and the moderation of excess demand. The CPI increased by 3.8 percent in 2008, exceeding the upper limit of the inflation target range.
Monetary policy in 2008 closely reflected the effects of global developments––the changes in world prices and the changes in assessments of the seriousness of the crisis and its effects on Israel. From September the interest rate was reduced significantly several times, and it reached its lowest level ever. In 2008 the Bank of Israel bought considerable quantities of foreign currency to increase the level of the reserves, and against the background of rapid appreciation of the shekel.
There was great upheaval in Israel's financial system, but it was moderate compared with the situation abroad. Prices of shares and corporate bonds fell, and spreads in the credit market widened considerably. The financial institutions, including the banks, exhibited resilience. The strongest impact was on the nonbank credit market, which became the principal risk of the financial system and the main cause of the contraction of the supply of credit.
The public debt/GDP ratio declined further, albeit more slowly than before, and the deficit increased, due to the continued cuts in tax rates, the slowdown in activity, and the falls in the capital market, which had an adverse effect on tax revenues.
The permeation of growth into the weaker sections of the population via the labor market was evident in the increase in employment among the low-educated, and was reflected in a reduction in the incidence of poverty in 2007 and the first half of 2008.
There is a need for a policy to deal with the expected recession, aimed at minimizing its negative effect on growth, employment and welfare. It will be judged not only in the light of the decisions taken, but also in light of the ability to implement them quickly and on the required scale. In the financial area it is important that lessons be learned and implemented. Moreover, the policy must meet the long-term challenges facing the economy and society.

Chapter 2: GDP, Uses and the Principal Industries

GDP grew by a somewhat lower rate in 2008 than in the previous years. In the first part of the year, growth slowed as the economy approached full employment while in the latter part of the year business sector product contracted as a result of the financial crisis and the global slowdown that led to a drop in domestic and international demand.
Global economic developments dominated the Israeli economy this year. These included a sharp transition from boom to recession in the developed countries, which was accompanied by the collapse of several major financial institutions and the precipitous drop in asset values worldwide.
Surplus demand, which first appeared in the previous year, began to grow during the first part of the year. Employment and the capital stock grew rapidly, which was accompanied by a slight drop in productivity, an increase in inflation and an appreciation in the real exchange rate. Towards the end of the year, the trend was reversed with a sharp drop in demand and an increase in the rate of unemployment, as well as a real depreciation and a decrease in inflation.
During the first part of the year, the shekel strengthened significantly, which was a continuation of the real appreciation that began in 2007. The magnitude of the appreciation was larger than could be explained only by economic developments and indeed there was a depreciation at the end of the year which offset the over-appreciation.
The rate of growth in private consumption slowed as a result of the uncertainty regarding the future economic situation and the drop in the value of financial assets. Current consumption grew moderately during the course of the year while the purchases of durable goods dropped precipitously.
Exports were significantly affected by the global slowdown. The export of services began to contract already in the second quarter of the year while manufacturing exports fell only in the fourth quarter. The increase in exports during the course of the year was primarily due to the chemical and petroleum industry, while the other industries began to stagnate at an earlier stage.
The drop in manufacturing exports was the result of a number of domestic and international economic developments: the decline in global demand, the continued worsening in the terms of trade and the real appreciation.
There was a slowdown in the rate of growth in the construction sector this year and residential housing starts, though they stabilized this year, reflected a downward trend in public construction since the beginning of the decade and stability in private construction. The stability in private construction, together relative price stability until last year, reflected the balance between demand and supply forces. This year saw a turnaround in the prices of rented and owned housing, which increased following a prolonged downward trend.
The slowdown in the economy, particularly during the second half of the year, was also manifested in the commerce and service industries.

Chapter 3: Inflation and Monetary Policy

The consumer price index rose by 3.8 percent in 2008, the second consecutive year when it exceeded the upper limit of the inflation target of 1-3 percent a year.
Inflation did not follow a uniform path during the year: it was high during the first half of the year, continuing the previous year’s trend, due to the large increases in world prices for energy and food and to vibrant local activity. During the second half of the year the inflation environment fell heavily as a result of the sharp drop in energy prices and worldwide commodity prices, the slowdown in local real activity, and the worsening of the global financial crisis from September onwards. In the fourth quarter, inflation expectations for twelve months ahead actually fell to a negative rate. The accelerating housing item prevented a more substantial decline in inflation during the second half.
Monetary policy during the year was conducted against the background of the global crisis that began in the summer of 2007 and worsened during 2008. Until September inflation was above the upper limit of the targeted level concurrent with expectations of a recession in financial and real activity. This background led to frequent changes in the direction of the interest rate, because of frequent changes in the assessment of the scale and timing of economic risks: the interest rate for January was increased by 0.25 percentage points, to 4.25 percent; in each of the months March and April it was cut by 0.50 percentage points, and starting from June it was increased by four consecutive steps of 0.25 percentage points each, back to a rate of 4.25 percent.
From September onwards, in view of the worsening of the global crisis and growing signs of a major downturn in real activity, all the considerations employed in interest rate decisions supported sharp reductions in the rate, which was cut to a historically low level: at the end of the year it stood at 2.5 percent. The rate cuts continued at the beginning of 2009 as well, and as the rate approached its zero bound there was a need to employ additional policy tools. Thus, in February 2009 the Bank of Israel announced it would start operating in the secondary market of local government bonds, so as to directly influence long term interest rates.
After more than a decade without intervention in the foreign-exchange market, in 2008 the Bank of Israel began to purchase foreign currency, intending to increase the country’s foreign exchange reserves. The timing of the purchasing program was picked according to the sharp and continuous appreciation of the NIS, which supported the increase in the reserve in a manner consistent with other monetary-policy objectives.
Credit and liquidity data indicated that certain sectors were beginning to suffer from credit difficulties, as was expected in view of the slowdown in real activity and the increased perception of risk by the financial sector. Since mid-September, activity in the IPO market for nonbanking credit was restrained. However, these developments were not indicative of a liquidity problem that was prevalent in the American and European economies (mainly since September).

Chapter 4: The Financial System and Its Stability

The global financial crisis worsened in 2008 and threatened to paralyze the world’s financial system. As a result of the crisis, a serious liquidity shortage developed in the global financial system, including at the very core of the interbank money market. Many banks and financial institutions worldwide collapsed or encountered serious difficulties, and an unprecedented level of government injection was required in order to save them. The financial crisis encroached heavily on real activity as well, and by the second half of the year nearly all of the world’s countries were suffering from a considerable downturn in activity and part of them had entered a recession.
The financial markets in Israel were hit by the crisis as badly as other financial markets worldwide, and their reaction reflected concern over the implications of the crisis for real activity in Israel: Prices of shares and corporate bonds fell heavily, the volatility in the markets increased greatly and the yield margins in the credit market rose sharply, thereby increasing the cost of raising credit in the economy. In addition, the exchange rate of the shekel appreciated sharply until June, followed by a large depreciation later in the year.
The profitability of the banks and the insurance companies in Israel was also badly hit in comparison with previous years, although despite the deterioration in their position, the financial institutions in Israel remained resilient compared with those abroad. This was due to their favorable situation prior to the crisis, and because the banking system in Israel is conservative and operates under comprehensive regulation and close supervision. Also alleviating the adverse impact on Israeli compared with foreign institutions were their limited exposure to toxic assets worldwide and their low reliance on the local and international capital markets for raising sources.
The domestic corporate bond market was the center of risk for the local financial system due to its rapid and unbalanced development during recent years, which was reflected by the increasing amount of capital raised for financing investments in real estate abroad—an industry that was initially at the center of the financial crisis.
Growing uncertainty and savers’ desire to move to lower risk channels of savings led to increased withdrawals from mutual funds specializing in bonds and from the provident funds. These funds were compelled to realize large volumes of assets, which spurred the rise in yields in the corporate bond market.
Due to the seriousness of the crisis, the Israeli government and the Bank of Israel adopted a number of measures that were aimed at expanding the availability of credit in the economy and reducing its cost, and at encouraging real activity. The measures adopted included: the granting of guarantees to local banks for raising capital, the establishment of Manof (leverage) funds, large cuts in the interest rate, and intervention in the foreign currency market and the government bond market.

Chapter 5: The Labor Market

The labor market in 2008 generated more employment, suffered less unemployment, and paid higher nominal wages; however, it also reflected the reversal in the business cycle during the year.
In the first half of the year, the labor market approached full employment, reflecting the concurrence of rapid employment growth and a falling unemployment rate. The participation rate leveled off after a protracted upturn and nominal wage per employee post increased perceptibly.
Indications of slowdown came into clear sight in the second half of the year. Employment stopped growing and began to contract, unemployment increased (especially among the high-skilled), and nominal wage per employee post declined in most industries. The labor market seems to have responded to recession more rapidly this time than in the past.
In contrast to previous years, the growth of employment in the business sector was driven by several industries that are intensive in low-skilled labor—lowtechnology trade and services—and these industries made a salient contribution to the decrease in the unemployment rate. The combination of stronger demand for low-skilled labor and greater laxity in law enforcement caused the employment of non-Israelis to grow swiftly.
The effect of the global crisis was felt initially in high-tech industries. The growth of employment slowed in high-tech services and stopped in hightech manufacturing, and the increase in nominal wage in high-tech industries slowed relative to the past and relative to other industries.
In 2007, the Government set employment and poverty targets as part of its socioeconomic agenda. An important goal of the “Agenda Forum” was to boost the employment rate among sectors of the population that are prone to especially low rates. The employment target will be harder to attain during the impending recession than in 2007–2008.
With the economy tumbling into recession, labor-market policy should strive to minimize the blow to labor demand and invest in human capital, toughen enforcement in regard to the employment of non-Israelis, and ease the qualifying terms for unemployment compensation.

Chapter 6: The General Government, Its Activity and Financing

The budget deficit excluding credit extended rose in 2008 to exceed the upper limit of the target, and the general government’s deficit, which is measured in accordance with National Accounts definitions, was 2.4 percent of GDP, compared with 0.2 percent in 2007. The increase in the deficit this year was due to a steep fall in tax revenues.
After the sharp drop in the public-sector debt/GDP ratio in 2007, its rate of decline slowed in 2008, and the debt reached 78 percent of GDP. This was the result primarily of the stability of the exchange rate in relation to its rise in 2007 and the marked expansion of the budget deficit. This ratio remained higher than the accepted rate in the developed countries, but its contraction in recent years has significantly narrowed the gap.
The tax/GDP ratio fell by 2.6 percentage points in 2008—about 1 percentage point of it due to tax cuts—to stand at 33.9 percent. Revenues were substantially lower than forecasts made at the beginning of the year, mainly because of the impact of developments in the capital market. Israel’s tax/GDP ratio is currently lower than those of most of the developed countries, as is the tax rate on wages. The progressive nature of taxes on wages has declined and has begun to approach the rate accepted in the developed countries.
The public expenditure/GDP ratio, which has declined consistently since 2002, continued to contract by a similar rate in 2008, to reach 43.3 percent—placing Israel at the midpoint of the distribution of developed countries, after being at the top of the distribution at the beginning of the decade.
The budget was fully utilized in 2008—the result of extensive under-utilization from the middle of the year and the fact that a large part of budget expenditure was brought forward in December.
Because of the global economic crisis, its influence on Israel, and expectations that it will persist in 2009, the government’s objectives in the next few years are to ease the slowdown and prevent the ongoing damage which it could inflict on the economy, minimizing the impact on the weaker segments of the population, and creating the infrastructure for sustainable future growth. The credibility the government has acquired in recent years—reflected in the moderate rise in the yield on government bonds—enables it to allow the automatic stabilizers to work, as well as to even stimulate economic activity to some extent.
If the crisis develops in accordance with current predictions, the debt/GDP ratio is expected to grow in the next two years. The extent and duration of this trend depends on the fiscal policy which the government adopts: a fiscal rule based on increasing expenditure in accordance with the current upper limit will enable the debt/GDP ratio to begin declining in 2011, and if the slowdown is more protracted than forecast, in 2012. This policy, together with its advantages in the financing sphere, will require decisions to be made about marked reductions in the expenditure path to which the government has committed itself in the next few years, making a very small increase in civilian expenditure possible.
A policy of increasing expenditure in line with the long-term plans adopted by the government, without reducing other expenditure or increasing taxes, will obviate returning to the declining debt/GDP path in the next few years, and will even lead to its discontinuation, especially if the crisis deepens or lasts longer than expected. As a result, the burden of future debt-servicing payments and Israel’s risk premium are liable to rise.

Chapter 7: The Balance of Payments

The current-account surplus amounted to $1.6 billion in 2008, compared with $4.5 billion in 2007.
The development of the current account changed sharply during the year. In the first three quarters imports and exports continued to expand, but there was a turnaround in 2008:IV, as the real economic crisis worsened globally: exports and imports fell by about 10 percent (in dollar terms) from their average in the first three quarters of the year.
The global economic crisis was exacerbated in 2008:IV and led to a $1.2 billion fall in exports (excluding seasonal goods, aircraft, and diamonds); on the other hand, there was a $1 billion decline in expenditure on imported fuel (compared with the average in the first three quarters of the year).
There was marked nominal and real local-currency appreciation in 2008 (relative to Israel’s trading partners), despite the moderation of economic activity in Israel. This reason for this exceptional development, involving the strengthening of the NIS alongside the moderation of economic activity, was that the global economic crisis affected Israel’s economy to a lesser extent than it did other countries, giving rise to heightened net capital inflow in the first three quarters of the year.
Against the backdrop of the global economic crisis, (gross) capital flows in the trading portfolios abroad of residents and in Israel of nonresidents diminished appreciably this year—in contrast with the long-term trends. Direct capital flows into and out of Israel have not yet been affected by the crisis, however.
This year the Bank of Israel greatly increased its foreign reserves, and this improved the economy’s resilience at the time of the global economic crisis. An international comparison of reserves in 2007 shows that their level in Israel is not exceptional relative to countries with a similar risk level.

Chapter 8: Welfare Policy Issues

In 2007 and the first half of 2008, the extent of poverty was reduced according to most of the accepted measures: the incidence of poverty, the SEN index and the proportion of the poor consuming below the poverty line. However, the extent of poverty still remains high, both in comparison to the OECD countries and in historical terms.
The extent of poverty is especially high among the Arabs and the ultra-Orthodox, who are characterized by low levels of employment and high birth rates.
The incidence of relative poverty has declined despite a rise of 4.2 percent in the poverty line. This was the result of an increase in per capita median income during the period, due to the high rate of economic growth. This led to an even larger reduction in poverty in absolute terms. (From 2006 until August 2007, the incidence of relative poverty fell by 1.5 percentage points, while it fell by 2.5 percentage points in absolute terms.)
The reduction in the extent of poverty was primarily the result of an improvement in the relative situation of weaker populations in the labor market, particular their increased rate of employment, which reflects on the one hand the trickling down of growth to the weaker populations during this period and on the other hand the effect of the cutbacks in welfare benefits.
The incidence of poverty before transfer payments and taxes fell to a level similar to that during the late 1990s. However, the direct effect of welfare policy through transfer payments remained limited in 2007, further to its continuous significant weakening since 2001. Therefore, the incidence of poverty after transfer payments and taxes was significantly higher in 2007/8 than during the late 1990s.
During the last decade, the extent of poverty has increased among households with at least one income earner. This development reflects the entry of weaker segments of the population into the workforce and the inability of the welfare policy to ensure a reasonable level of welfare for workers. It is important to remember that the very entry into the workforce will have additional positive effects in the long term which will intensify as the new workers become better integrated in the labor market.
In October 2008, an earned income tax credit was introduced in a number of locations in Israel. This will work to increase the welfare of low-earning workers and thus is in line with the overall policy of fighting poverty by increasing employment. The extension of the earned income tax credit (EITC) program to additional locations is expected to increase its positive effects.

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