A Macroeconomic Analysis of the Israeli Economy and Its Ability to Withstand Financial Shocks

The 2007 Caesarea Forum took place at a time of prosperity and impressive macroeconomic achievements for the Israeli economy. Rapid GDP growth, declining unemployment, a reduction in the public-debt-to-GDP ratio, an increase in the current account surplus and in foreign investments, and low inflation are key indicators of Israel’s positive macroeconomic situation. These factors also support Israel’s successful entry into the globalization process.

The major challenge of economic policy over the next few years will be to provide a response to security needs and to needs in the social sphere (including the war on poverty and upgrading the educational system), while at the same time continuing the growth process and maintaining the strength and stability of Israel’s economy.

Three primary factors have contributed to the multi-annual improvement in Israel’s economy: continued rapid growth in GDP and world trade as well as in international capital transactions; relative calm on the security front, in terms of the number of terrorist attacks; and the government’s macroeconomic policy.

The combination of maintaining fiscal discipline through ongoing structural reforms and applying a relatively flexible interest policy designed to target inflation supports economic growth and financial stability. As a result, there has been a significant decline in the budget deficit and in the public-debt-to-GDP ratio – factors that have contributed to a drop in the real interest rate and in Israel’s “country risk” rating. Despite these achievements, the ratio of public debt to GDP remains very high in comparison to the accepted level in countries with an international credit rating similar to Israel’s or even lower.

According to the basic scenario presented here, which presumes the continuation of favorable background conditions, the economy’s growth momentum will be sustained over the next few years, though with lesser intensity than we have witnessed over the past three years. This scenario involves an average GDP growth rate of about 4.3% during the forecast period (2008-2012), compared to an average of about 5% for 2004-2007. In addition, the drop in the unemployment rate is expected to continue, as is the steep decline in the public-debt-to-GDP ratio – from 87.8% of GDP in 2006 to 71.4% in 2012.

Given the expected increase in capital reserves, employment, and productivity, the drop in the projected GDP growth rate reflects the fact that the cyclical factors that were at work when the economy emerged from the recession in the second half of 2003 have run their course.

For the economy to surpass an average annual growth rate of 4.3%, there will need to be an increase in a number of budget items that are conducive to growth, such as investing in infrastructure and R&D, encouraging a rise in the employment rate, and accelerating structural reforms to increase competition in the economy. Significant progress in the political sphere can also be expected to produce much higher growth rates than those in the basic scenario.

A look at the way the economy and financial markets have coped with the upsets of the past year (the Second Lebanon War and two crises in the global markets) supports the opinion that the positive developments have increased the economy’s strength and its resilience in the face of shocks. Indeed, the reactions in Israel’s capital market and foreign currency market were moderate compared with those of other countries. Without the favorable macroeconomic infrastructure of the past few years, it is reasonable to assume that the shock waves would have led to substantial export of capital, financial instability, and damage to the economy.

The revaluation of the shekel (mainly against the dollar) reflects, to a large extent, the achievements of the economy in recent years, along with developments in currency markets around the world. On the macroeconomic level, the revaluation of the shekel in real terms is taking place against the backdrop of a relatively balanced policy mix and attests to the fact that the current account surplus is greater than the net investments of Israeli residents in overseas markets. This revaluation, which began in the second quarter of 2006, was made from a relatively comfortable exchange rate that reflected a significant real devaluation in the recession years of 2001-2003. Consequently, at current levels, no substantial damage to economic growth is anticipated. In any case, we believe that, given the present conditions, direct intervention by policy makers (for example, in the foreign currency market) is not required.

At this favorable juncture in Israel’s economy, the research team has nevertheless chosen to focus on an analysis of those risks that could damage the development of the economy if they materialized. In particular, the economic implications of a possible deterioration in the security situation along with the onset of a global recession were examined, similar to developments in the early 2000s. In the team’s assessment, such a two-pronged shock is the major macroeconomic risk confronting Israel in the coming years.

Given the high level of public debt relative to GDP, the analysis indicates that, despite favorable macroeconomic developments, the economy is still highly vulnerable to a strong negative shock in the event of a protracted worsening of the security situation or a sharp slowdown in the global market. A recession, coupled with a significant rise in the unemployment rate, the real interest rate, and the public-debt-to-GDP ratio, would be expected outcomes in this context. Nonetheless, fiscal discipline clearly plays a critical role in determining the economy’s ability to withstand financial shocks; hence, failure to maintain reasonable discipline could exacerbate the negative impact of such shocks and take us back to the errors of the past.

The members of the team believe that the Bank of Israel has acted correctly in demonstrating flexibility, yet caution, in setting the monthly interest rate. True, the inflation environment in the Israeli economy continues to be low, but it displays a high degree of volatility relative to the accepted level in Western countries. This volatility, and the consequent failure to meet the inflation target, could create uncertainty in economic and financial parameters and even jeopardize the credibility of Israel’s monetary policy.

In light of the high volatility of the inflation rate, it is recommended that the government and the Bank of Israel consider a series of measures to bolster the inflation-targeting regime, among them clarifying the time frame of the target, extending the horizon of the inflation target from a yearly target to a longer term, and emphasizing the definitions of the consumer price index, omitting the volatile factors. It is further recommended that the Bank of Israel publish its inflation forecast in a regular and transparent manner, specifying the interest rate that forms the basis of the forecast.

Full Report (Hebrew)