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Hebrew PresentationThe Governor of the Bank of Israel spoke today to the Knesset Finance Committee. The following are the main points of her remarks.
My lecture will cover the macroeconomic environment, monetary policy and our considerations when formulating it, and I will refer as well to the foreign exchange market, to financial stability, and to the fiscal situation.
A macroeconomic survey of Israel’s economy begins naturally with the global economic situation, because as a small and open economy we are very affected by the economic situation worldwide. World trade is the most important global variable in terms of the impact on Israel’s economy, because it reflects the demand for Israel’s exports. In 2012–13, world trade increased at a relatively low rate of 3 percent and below, and in 2014 a recovery is expected, though we still don’t see it in the data. From the perspective of our major export markets, the situation in Europe still reflects an expectation for very moderate growth, and in the US, despite expectations for recovery, the first quarter was marked by negative growth, and we still don’t see a full recovery.
GDP in Israel grew by 2.7 percent in the first quarter of 2014. This is a low rate relative to the past, but is higher than the growth rate we see in major advanced economies. In the first quarter we saw a troubling development of moderation in private consumption, which was a stabilizing component of growth throughout the years of the crisis, in contrast to exports which suffered from the moderation in world trade. We assess that the weakness in private consumption is temporary, but it is nonetheless troubling when we examine the recent period’s data. In the past two years, exports, in particular goods exports, were disappointing. This is of course related to sharply declining world trade, but also to exchange rate developments. Services exports continue to increase over the course of the period, and this is definitely an encouraging development.
Labor force data are good, both compared to the past and compared to the global environment. The unemployment rate, which increased for a relatively short period at the worst part of the global crisis, is in a trend of decline, which has drawn out despite the labor force participation rate continuing to increase, and thus the employment rate has increased. It should be noted that this is a very different development than in major advanced economies—in the US we saw a decline in unemployment with a sharp decline in the participation rate—people left the labor force after assessing that their chances of finding work are small. By us, people are joining the labor force, a phenomenon which also includes relatively weaker populations—these people join the labor force at a low wage, of course, but the result is an increase in household income, as I will show in a bit.
In the housing market, we have seen a sharp increase in prices since 2007, after an extended decline in real prices in the decade prior to the current rising cycle. At the beginning of the process, home prices increased in line with rents, though in recent years rents have increased at a much more moderate rate than home prices. The most direct route to moderating home prices is, of course, increasing the supply. In recent years there has been an increase in the rate of building starts, and we assess that should construction continue at its current rate of over 40,000 new homes per year—a rate which is greater than the increase in number of households—with an emphasis on areas in high demand, we will be able to see a change in the trend in home prices. The decline in building starts in the recent quarter is certainly troubling in this regard.
Monetary policy works, as its central goal, to achieve price stability, and subject to that, to support economic policy and financial stability. The tools at our disposal are the Bank of Israel interest rate, direct intervention in the foreign exchange market, and since the Banking Supervision Department is part of the Bank of Israel, we also have a range of macroprudential tools that the Supervisor of Banks can utilize. Inflation over the previous 12 months was 1 percent, at the bottom of the target range, and no less important are inflation expectations, both short term and long term, which are within the target range, indicating that the Bank of Israel’s monetary policy is relied on by the public, which believes that the inflation target will be maintained over time.
In the past decade the Consumer Price Index has increased by about 25 percent—that is, an average rate of about 2.07 percent per year, very close to the midpoint of the target range. Various components of the CPI increased at a more rapid pace, which lead to the public’s sense that the cost of living increased during those years. We are of course very aware of the price increases of certain components, such as food and housing, though less attention is paid to the more moderate increase, and even decline, in components such as clothing and footwear, education, and communications. Such a detailed analysis indicates where it is nonetheless important to focus our efforts, and it is clear that promoting competitiveness can impact on the cost of living—in the area of food, for example. Furthermore, the salary per employee post increased only slightly relative to the CPI over the course of the period, though net household income increased more, very similar to the rate of increase in per capita GDP. The implication is that the benefits of growth trickled down to households, whether that is due to more people joining the workforce or is the result of a decline in taxes.
Getting back to monetary policy, the Bank of Israel interest rate is currently 0.75 percent, slightly higher than interest rates in major advanced economies, and much lower than interest rates in emerging markets, some of which still have problems of inflation, and some of which experienced sharp depreciations. We saw a relatively rapid appreciation of the shekel in the first half of 2013, in light of relative geopolitical calm and, at the same time, the beginning of natural gas production. Since then the pace of appreciation has moderated. In 2013 many currencies strengthened against the dollar, while the shekel’s appreciation against the dollar was relatively atypical. In 2014, the shekel has strengthened by about 1.6 percent against the dollar, but we are not atypical in this regard, and in many countries, such as New Zealand, Australia, and the UK the currency’s appreciation against the dollar was much sharper.
What is behind the appreciation in Israel? Israel’s economy is in a relatively good situation. We have a continuing current account surplus, and net foreign direct investment by nonresident investors who see Israeli companies as attractive for investment. This all means that there are basic forces which are leading to an inflow of foreign currency into the economy, and these are forces which policy does not attempt to offset. In addition, in the period up to the first quarter of 2013, nonresidents sold foreign exchange, and this contributed to shekel appreciation. Since then, there is no real trend in nonresidents’ activity in the foreign exchange market; that is, we can’t say that it is nonresidents who are leading to the prolonged appreciation. In recent weeks, we again see nonresidents selling more foreign currency, but it is still difficult to establish that this is a change in the trend. In contrast, in 2011, when the Bank of Israel interest rate was much higher than that in the US, we saw the entry of nonresidents into short term investments, and at that time we also took steps that stopped that trend.
Institutional investors invest part of their assets under management abroad, which should have contributed to weakness of the shekel. However, institutional investors hedge their investment abroad against currency appreciation, an activity that involves selling foreign currency, and thus we don’t get the support such activity could have given us toward weakening the exchange rate.
As I noted, the policy does not attempt to act against the basic macroeconomic forces which lead to the appreciation of the shekel. In March 2008, the Bank of Israel began to increase the foreign exchange reserves to a level in line with the needs of the Israeli economy. In retrospect, the lessons of the financial crisis indicated that countries with high levels of foreign exchange reserves were more resilient in the face of the effects of the crisis. There are currently two components of the Bank of Israel’s policy in the foreign exchange market. Beginning in August 2009, the Bank has intervened in the market when there have been unusual fluctuations in the exchange rate that are not in line with fundamental economic conditions, or when the foreign exchange market has not operated in an orderly manner. In May 2013, the Bank launched the “natural gas plan”, which is intended to moderate the pressure on the exchange rate as a result of the production of domestic natural gas (“Dutch disease”), and within this framework the Bank of Israel began to purchase foreign exchange on the market, and committed to do so at least until a sovereign wealth fund is established in 2018.
Among the Bank’s objectives, we also deal with financial stability. A radar diagram can show that the risks in the domestic and global financial systems are markedly lower than the level they were at during the global financial crisis. Specifically, domestic financial market risk is very low, but it should be remembered that it measures the risk as reflected in the market, and to the extent that the risks are underpriced, a chart like that would not show it. In general, the domestic financial market continues to display stability despite a challenging global environment, and low interest rates in Israel and abroad. The main risks to the system are the high exposure of households to the housing market, which is liable to present a risk should there be changes in market conditions, including employment and the interest rate, and the underpricing of risks in the corporate bond market, which is liable to impact on the allocation of resources in the economy and on pension savers.
In the housing market a rapid increase in outstanding mortgages over time can be seen, in parallel with an increase in the share of housing credit in the banks’ overall credit portfolio. This is a risk that we are aware of, and also act to reduce, and the steps taken by the Supervisor of Banks have markedly reduced the risk characteristics of new mortgages, as reflected in, for example, the loan to value ratio and the payment to income ratio.
In the corporate bond market there has been a decline in spreads against the background of accelerated net investment in corporate bond mutual funds, which are buying bonds that don’t necessarily meet all the standards met by bonds that are purchased by institutional investors. This is definitely a component of risk that we must be aware of.
The banking system remains robust. The core capital ratio is about 9.4 percent, and the return on equity is around 8.7 percent. The system continues to increase the volume of credit to households, in parallel with continued contraction of credit to the business sector. As we published last month, operating efficiency in the banking system is low in international comparison, and steps are needed to improve efficiency, including reducing salary expenses and balancing the remuneration mechanisms for senior executives. In this regard, I will note that the Supervisor of Banks was the first regulator to issue guidelines with regard to senior executive salaries, which are intended to ensure that the senior executive remuneration structure does not provide incentives for taking on excess risks, and the banks, of course, implemented the Supervisor’s guidelines. The Minister of Finance is promoting a bill that would affect the norms for senior executive salaries. I am definitely of the opinion that there is a place for that, and I believe that norms need to be broad, and not focused on a specific sector, such as the financial sector, in light of the fact that this sector manages other peoples’ money. I think that these norms should apply as well to companies which benefit from monopolistic power, on those that have purchased assets from the state, that manage natural resources, that have benefited from concessions, and so on—I believe that the norm should be extended to all public companies, and I am sure that as the norm expands, the banks will also meet it.
The Banking Supervision Department is very diligent in promoting competitiveness and fairness in the banking system, and in the past year it dealt with several main issues in this regard: managing a current account through various fee tracks, dealing with fees (cancelling, reducing, repricing, increasing transparency), making it easier to transfer payment orders between bank accounts, opening bank accounts over the Internet, formulating a framework for bringing in a new player—credit union, and more. There are important issues that are still being dealt with, such as a periodic comprehensive report to the customer (banking ID), a system to identify dormant accounts, publishing comparative data on interest rates, and more.
The government budget deficit is expected to meet the target this year, but it is important to note that in light of the relatively good macroeconomic state of the economy, it is a relatively high deficit by international comparison. The debt burden is in fact low compared with previous years, but the burden of interest payments is high by international comparison, due to the risk premium that the Israeli economy must pay. I want to explain why I think that we need to continue to work to reduce the debt burden. In 2002, the debt was about 100 percent of GDP, and when the economy was hit by a recession and the deficit soared due to the macroeconomic situation, yields jumped to 12 percent. This was a signal to the government that it must reduce the budget, and it was forced to do so at the height of the recession, thus making it sharper. In contrast, in 2009 we were forced to again increase the deficit, when faced with the global economic crisis and its effect on the growth of the economy, but yields did not rise because it was clear that we were after a prolonged effort to improve the fiscal situation, and that the increase in the deficit was temporary in light of the crisis. When the government acts in a manner which indicates fiscal reliability, investors show the readiness to finance a deficit to the extent it occurs as a result of an unexpected shock.
In response to Knesset members’ questions, the Governor added:
As far as the impact on the economy of the geopolitical situation, there is no doubt that an improvement in the geopolitical situation will positively impact on the economy. At the same time, the Israeli economy displayed resilience in the face of previous geopolitical events, such as Operation Cast Lead and the Second Lebanon War. Now, as well, we do not see an increase in the perception of the economy’s risk. In light of the events of recent days, I will perhaps note that I hope that we succeed in getting back to restraint and maintain the delicate fabric of Israeli society with all its sectors.
As far as the proposed zero VAT on homes law, as I noted in the past, I believe that the proposal is likely to fan home price increases in the short term, in light of the fact that what is required in the market is increased supply. The proposal also refers to tight supervision of prices and specifications, and I believe that it will be very difficult to apply this supervision. Thus, I am concerned that the benefit is liable to mainly reach the pockets of the contractors and not those of households, perhaps through informal arrangements between buyers and contractors, and thus it will not achieve its goal. Likewise, despite the proposal being changed since it was first presented, it still does not provide a response for the weakest population groups. Another issue is the permanent effect of the proposal on the tax system: the proposal is brought to deal with a problem which exists today but it is not clear if it will still exist in the distant future, but in the future it will be difficult to forego the exemption, and we know many exemptions which were granted in the past and are difficult to cancel today.
As far as employing Arab and ultra-Orthodox employees at the Bank of Israel: There are currently eight Arab employees at the Bank of Israel, as opposed to two a few years ago, and nine ultra-Orthodox employees have joined, though it is not clear if we can always identify who is ultra-Orthodox. In any case, the percentage is still low relative to the share of these sectors in the overall population, and I believe that we need to continue to make efforts in this area.
As far as credit to small businesses: The volume of bank credit to small businesses increased by 7 percent in 2013, to a level of NIS 70 billion, and the increase is partly the result of banks’ efforts in this area. Progress in the area of securitization will also help to expand the supply of credit to small businesses.
As far as the exchange rate: I noted the issues that we are working on, including dealing specifically to offset the effect of natural gas production on the exchange rate. There are also some issues that are not in our court, such as cancelling the tax exemption for nonresidents in bond investments. We follow the developments in the exchange rate, and also study the policy measures adopted in other countries. As I noted, the developments this year in the exchange rate are not atypical when compared with other countries.
As far as the economy in the Arab sector: There is no doubt about the importance of economic activity in the Arab sector to the overall economy. This is an area in which the Bank of Israel does not have policy authority, except for my role as economic advisor to the government, in the framework of which we conduct research and publish policy recommendations.
As far as credit unions: Setting up credit unions was one of the recommendations in the report issued by the team to increase competitiveness, headed by the Supervisor of Banks. We believe that it is appropriate to provide the conditions for setting up these unions, we recently published a draft document that describes the credit union licensing process, and we requested responses from the public to the document. The last thing we want in this regard is to allow the setting up of credit unions that will not be stable. We studied the issue and the models around the world, and in our assessment the capital requirements we presented are those that will ensure that unions such as these that are set up will be stable and will be able to operate for a long time.