The Israeli Economy: Maintaining a Thriving Economy in the Shadow of Terror Prof. Zvi Eckstein Deputy Governor, Bank of Israel The Jerusalem Center for Public Affairs March 26, 2007

Macroeconomic Picture

Real GDP per Capita Israel vs. USA Source: BEA, PWT, OECD, BOI Israeli GDP per capita, thousands NIS, 2000 (left scale) Ratio of Israel to USA GDP per capita (right scale)

Running an Economy Under Terror In the past years (2000-3) the terror in Israel has become a part of every day life. –A continuous impact on GDP growth. –High level of defense consumption. –Larger impact on lower social classes. –Great impact on uncertainty which influences economic activity in the macro and micro levels.

Implications of Terror (Eckstein and Tsiddon (2003)) With high rates of terror, output, consumption, investment and exports decline significantly. In times of terror, non-durable consumption and GNP per capita reduced by about 3.2% annually, while exports and investments reduced by 14%. GDP could have been 12% higher.

Defense Expenditure as percent of Total General Government Expenditure

Predicted GDP per Capita under the existence of terror

GDP Growth and Unemployment Rate Source: CBS and BOI*BOI Forecast

Budget Framework Today Keeping the Public Expenditure under 47% of GDP What is the desirable rate of public expenditure? Main services that we need to take into consideration: security, health care, education, etc. Decrease of the budgetary deficit to around 1%, so that the public sector debt would be about 60% of GDP. Fiscal stability supports the financial stability, and both set the ground for annual GDP growth of 4-5% and more.

General Government Expenditure (% of GDP) Target: keeping expenditure under 47% Differences in expenditure components need to be noticed

Gross Public Debt (% of GDP, Maastricht terms) Target: being below 60% *assuming adherence to expenditure target

Monetary Policy, and Inflation and Exchange Rate Evolution

Managing Monetary Policy : Bank of Israel Targets Achieving price stability, adhering to inflation target (1-3%). Promoting financial stability. Banking Supervision: Supporting the stability and efficiency of the banking system Developing the capital market in a global economic atmosphere ensures efficiency in consumption, investments and production. Short term interest rate

Monetary Policy in 2006 and 2007 Inflation in the past 12 month was below target bound (-0.8%). Main impact factors: depreciation of the $ and decreasing of the gas prices in the past 6 month. Decrease of risk premium and default spreads of the Israeli economy. Current account surplus.

The NIS/$ Exchange Rate During 2006 the US dollar depreciated to the NIS in about 8% and to the Euro in about 10%. The rate NIS/Euro hasn’t changed much.

General CPI and CPI Excluding Housing and Energy Influence (rate of change, last 12 months) % General CPI General CPI excluding housing and energy

Israeli Shahar - US Government 10 Year Spread

Current account and the Goods and Services Account right left Current account surplus supports the interest rate gap and the sustaining of GDP growth.

The Importance of Transparency and Moderation in Monetary Policy Management Policy steps should be moderate in order to prevent panic in markets. Keen decisions should be taken only in crisis times. Keeping policy transparent. Signaling agents in the markets regarding policy fundamentals.

Monetary policy and Inflation in 2007:  Private forecasters: 2.0%.  Capital market: 1.4%.  The economic atmosphere enables BOI being at a low interest rate of 4%, while achieving prices and financial system stability.

Inflation in the Past 12 Months and Expected (Breakeven) Inflation Gradual return to the target bound

Reforms

The Israeli Economy Weaknesses Financial markets: –Money markets are not at the world’s high standards –High centralization, low level of competition and efficiency in the banking system. –Banks are the main suppliers of financial services – change had begun in 2000 prior to Bachar reform.

The Israeli Economy Weaknesses Labor market: –High poverty. –Low participation/employment rate. –Foreign workers. Education system. - low levels of basic knowledge: Need to reform Low productivity in low-tech sectors. Infrastructures: –Low urban development in peripheral areas. –Lack of public transportation and low quality of roads in peripheral areas.

What needs to be done? Financial markets: –Enhancement of efficiency, competition and financial instruments: Following the world. Labor market: –Active Labor Market Policies: US/UK examples –Reduction of foreign workers –Compliance with labor laws Infrastructure improvement. More reforms …”Doing Business” by the World Bank.