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 Governors' Presentation

Remarks by the Governor at the Press Conference

The Full Report

Remarks by the Governor at the press conference marking the publication
 of the Bank of Israel Annual Report for 2013
The following are the main points of the Governor’s remarks at the press conference held today at the Bank of Israel.  The presentation she used is attached.
Good morning, everyone. I appreciate that you have come and I am pleased to present the main points of the Annual Report for 2013.
Israel’s macroeconomic situation is good, particularly when compared to the challenging global reality (Slide 3).  Growth is higher than the average of the advanced economies, but lower than the average among developing economies.  The Israeli labor market is characterized by unemployment that is lower than in the eurozone and lower than the average among advanced economies.  If we closely analyze the components of the economy, we see various challenges, some of which I will try to cast light upon, while the Director of the Research Department will also discuss some of them in the presentation he will make after mine.
The Bank of Israel’s monetary policy is intended to achieve price stability over time, and to support government policy and financial stability. The background conditions under which monetary policy operated this year were:
·        Inflation is low, but expectations are well anchored within the target range (slide 5).  Looking forward as well, expectations are anchored within the target range, which indicates the credibility of monetary policy.
·        The exchange rate, which mainly affects the tradable sector, shows a prolonged trend of appreciation, although its strength has diminished since May.  The appreciation is taking place against the background of a surplus in the current account, the production of natural gas, a large volume of direct investments, and a process in which institutional investors are hedging their investments abroad against holdings in the shekel (slide 6).
·        The global economic environment is moderate, which is reflected in global trade.  This environment is causing moderate growth in our economy—and particularly weakness in the export industries and a positive product gap, which means that production is lower than potential, given the growth in human capital and in the working-age population (slide 7).  The low growth is reflected in a decline in hours per employee, a moderate increase in productivity (as a result of the low exploitation of capital) and a virtual standstill in the number of salaried posts in the business sector.  There are structural and frictional components to the decline in unemployment—the efficiency of the search for work has improved greatly in recent years, and therefore, despite the relatively low unemployment rate, we are not characterizing the economy as in full employment, which is reflected in the product gap.
·        Against this background, and against the background of continuing accommodative monetary policy abroad, which is reflected in near-zero interest rates and quantitative easing programs on the part of the major central banks (and in this context I refer to Chapter 7 of the Report, which illustrates the effect of monetary policy abroad on policy in Israel), the Bank of Israel reduced its interest rate and resumed its intervention in the foreign exchange market beginning in May (slide 8).  The relatively good performance of Israel’s economy in a moderating global environment can also be attributed to the accommodative monetary policy’s support for economic activity.  According to an estimate made by way of the Research Department’s DSGE model, a decline of one percent in the interest rate contributes 0.4 percentage points to growth.  Foreign exchange purchases are intended to offset the excess effect of the production of natural gas on the current account; we are also acting in order to moderate the excess volatility in the exchange rate that does not derive from economic forces.
The housing market:
·        Home prices continued rising this year with some moderation at the end of the year, alongside stability in rents.  This development hints that demand pressures in the housing services market moderated (slide 10).  The rate of increase in rental prices was similar to the rate of increase in the non-tradable segment of the Consumer Price Index, which reflects less demand pressure for housing services.
·        The rapid expansion of mortgages continues, with a decline in the risk characteristics following the Banking Supervision Department’s directives and limitations (slide 11).
·        There was a significant increase in the amount of building completions of new homes, and the high volume of building starts continues—with both reaching levels that exceed the annual flow of new households derived from demographic changes.  If this volume of building starts continues over time and includes demand areas as well, it is expected to lead to a reduction of pressure on prices, and possibly also to a turnaround (slide 12).
Financial stability:
This is the place to mention the fact that, as part of our role to support financial stability, the Bank of Israel has established a new division within the Research Department—the Financial Division—which monitors and analyzes the state of systemic financial stability.  This division will soon publish a report on financial stability.
The picture of the economy’s stability can be presented in a multi-dimensional manner by way of a radar diagram (slide 14), which includes real data, accounting data and survey data, as well as data representing the impression of risk levels by investors from Israel and from abroad.  As of the end of January, 2014, the diagram indicates that the financial system and the economy are stable.  The red diagram reflects the situation at the end of 2008, when almost all risk indices, both global and domestic, were at peak levels at the height of the global financial crisis.  The blue diagram indicates the relatively low levels of the current indices, with most of the measured risks reflecting the global macroeconomic situation—moderate growth, high unemployment and low indices reflecting consumer confidence and business security.  These obviously also have implications on the domestic macroeconomic risk reflecting moderate growth.  In contrast, the market risk indices both in Israel and worldwide are relatively low, and a gap has opened—both in Israel and worldwide—between the real situation and investors’ impression of risk levels.  This gap is apparently affected by the search for yields in a low interest rate environment, but possibly also by expectations of an increase in corporate profits that will accompany the recovery of the global economy.
As part of the lessons from the crisis, all international economic institutions are recommending that cooperation between the various entities regulating and supervising the various parts of the financial system be closer and more entrenched.  Most of the weaknesses uncovered during the crisis were in the unsupervised parts of the system and in the interfaces that rapidly transferred risks from one part of the system to others.  For this purpose, the International Monetary Fund recommended the establishment of a financial stability committee to establish and coordinate cooperation between all financial regulatory authorities (the Supervisor of Banks, the Commissioner of Capital Markets, Insurance and Savings, the Payment and Settlement Systems Oversight and the Israel Securities Authority) and the stabilizing entities (the Bank of Israel and the Ministry of Finance) with the aim of identifying, preventing and reducing systemic risks (slide 15).
The Committee’s functions are to define, analyze, assess and monitor systemic risks; examine risks and exposures in the financial system in order to identify and assess systemic risks; promote exchange of information among the financial regulatory authorities, and between them and the stabilizing entities; improve coordination and cooperation between the financial regulatory authorities and the stabilizing entities in analyzing, assessing, developing and operating tools and methods for preventing and reducing systemic risks; warn when a systemic risk is liable to constitute a material risk; recommend measures to prevent or reduce identified systemic risks; and monitor the actions taken as a result of the warnings and the implementation of recommendations (“adopt or disclose”).
The fiscal situation:
As of now, budgetary control has been regained, and the deficit returned to the 3 percent of GDP range last year after having increased to 4 percent of GDP in 2012, and it is expected to remain in this range during the current year (slide 17).  The government adopted an expenditure rule that is less accommodative than the previous rule, and is obligated to a deficit path that will bring the debt to GDP ratio to slightly above 60 percent by the end of the decade, compared with about 67 percent currently.  According to the deficit path, the deficit is supposed to be 2.5 percent of GDP in 2015 and 2 percent in 2016 (slide 18).
The budgetary picture for the next few years will require a significant adjustment in order to meet the targets set (slides 19, 20).  The expenditure dynamic derived from demographics and the dynamics of wages, together with the plans for investment in transportation, the continued operation of programs in the field of education, wage agreements in the healthcare system and the planned additions in defense in 2016, will require a significant reduction in the planned expenditures in order to meet the expenditure rule that has been adopted.  In addition, the current tax rates, together with the expected decline in tax receipts as a result of zero VAT on housing will also require a significant increase in tax receipts in order to meet the deficit path to which the government is committed.  The more possible it will be to increase tax receipts by way of cancelling exemptions and reducing tax avoidance, the more possible it will be to suffice with a more moderate increase in tax rates.  But it is not reasonable to assume that it will be possible to fill in the missing taxes in 2015 and thereafter without some increase in tax rates.
Against the background of price stability that has been achieved in the past decade, and the credibility that it will be maintained as reflected in long-term inflation expectations, there is no benefit to the indexing mechanisms in the economy, and they may even create distortions.  It is therefore recommended that the government continue reducing the indexing mechanisms in Israel:
(1)   It is recommended to move to a fiscal rule denominated in nominal terms and not dependent on inflation fluctuations from year to year as currently accepted.
(2)   The cancellation of the method of two taxation tracks (nominal and real) on capital gains in Israel and a transition to uniform nominal taxation will contribute to the efficient distribution of the assets portfolio, financial stability, and an increase in transparency of tax collection.
In response to questions from reporters:
·        What economic implications could there be of the cessation of diplomatic negotiations?
All kinds of possible scenarios can be sketched out that may happen if the diplomatic negotiations do not succeed.  As a rule, security quiet and the potential for positive change in the political situation are certainly the considerations guiding decision-makers in this area.
·        The Bank of Israel’s position regarding VAT on homes and the budgetary rule was not accepted.  Does the government take you seriously?
The role of the economic advisor to the government is to provide its detailed opinion, and it is absolutely provided.  At the end of the day, the government needs to make the decisions, and it has many considerations.  The example of the budgetary rule is an example of a case in which a fruitful discussion was held, and in the end, a decision was made that is different from the initial positions of the policy makers.
·        Perhaps it is worthwhile for the Bank of Israel to give up its demand to head the financial stability committee, thereby removing the main obstacle to its establishment?
There are many issues that we discuss with the relevant entities regarding the establishment of the committee.  The Bank of Israel has a role defined by law to support financial stability.  The Bank of Israel’s role in monitoring and tracking financial stability is very important, and therefore, as even the International Monetary Fund recommended, it is important that the Bank have the central role in this committee.
·        Does your personal relationship with the decision-makers affect economic policy?
The answer is simple—No.
To:       The Government and the
            Finance Committee of the Knesset,

 A full translation of the report will be available within several weeks.

I am honored to submit herewith the Bank of Israel Annual Report for 2013, in accordance with Section 54 of the Bank of Israel Law, 5770–2010.

The economy grew by 3.3 percent in 2013, and economic developments continued to be superior to those in many advanced economies. However, the growth rate was moderate considering that the start of natural gas production contributed to growth during the year. Excluding this contribution, growth was slower than in 2012. Contributing to the slower pace of growth were the slowdown in exports, the need to reduce the budget deficit, and a decline in the growth rate of activity in the construction industry.

The slowdown in exports was the main factor in the slower rate of growth in the economy. The weakness in exports derived largely from the slow growth of world trade, and also reflected the cumulative negative effect of the appreciation of the shekel. This mainly affected goods exports, while services exports continued to expand at a sound rate. Despite the slowdown in exports, a current account surplus was maintained during the year, even excluding the contribution of natural gas to that account. This was because imports slowed as well, principally due to the slower increase in investment in the economy.

Despite the slow pace of growth and the moderation of demand for workers by the business sector, the unemployment rate declined during the year and the employment rate continued to increase. Contributing to this development was the high rate of employee recruitment to the public services, primarily in the education and the healthcare industries, and a decline in frictional and structural unemployment. The decline resulted from increased efficiency in the process of matching job-seekers with employers, a favorable and very important phenomenon that has been taking place for the past few years.

The inflation rate in 2013 was 1.8 percent, near the midpoint of the target range. Inflation was low during the first half of the year, but in the second half it increased to near the midpoint of the target range. Three principal developments contributed to the increase in prices during 2013: prices of housing services increased, food prices increased at a higher rate than in other countries, and electricity prices increased. However, the decline in communications prices continued as a result of the increased competition in the mobile communications industry. Inflation expectations fluctuated within the target range—evidence of the credibility of monetary policy.


Developments in the financial markets during the year reflected the good state of the economy compared with other countries and a decline in the risks attributed to the economy. These developments included an increase in financial asset prices, a narrowing of yield spreads between Israel and abroad, a large volume of foreign investment in Israel, and the appreciation of the shekel.


Home prices increased by 6 percent in real terms in 2013, a slightly lower rate of increase than in 2012, and since 2008 they have increased by approximately 60 percent in real terms. There was also a further increase in the volume of new mortgage loans granted to home buyers this year. The growth in housing credit increases the risks to the banking system, and in 2013 the Supervisor of Banks adopted additional measures with the aim of reducing these risks. Building starts remained elevated in 2013, and in each of the last three years their number was slightly higher than the incremental number of homes needed to supply the housing requirements deriving from demographic growth. The number of building completions also increased in 2013. If the number of starts remains high and also includes areas in demand, this could contribute to a reduction in the pressure in the housing market, and stabilize and even bring down prices.

Monetary policy in 2013 continued to focus on supporting activity and maintaining financial stability. In view of the moderation of demand, the absence of inflation pressures and the existence of pressures for an appreciation of the shekel, the Bank of Israel reduced the interest rate three times in the course of the year, and at the end of the year the rate was 1 percent. This policy reflected a broad perspective of the economy-wide aspects relating to the level of the interest rate. The measures which the Supervisor of Banks adopted regarding housing credit helped in enabling monetary policy to achieve the correct balance between support for activity and the potential implications of an interest rate reduction on the risks to the banking system. The Bank of Israel resumed its purchases of foreign currency in 2013, both as part of the program that was implemented during the year for the purpose of offsetting the impact of natural gas production on the exchange rate and in accordance with the policy announced by the Bank in 2009, whereby it would intervene in the foreign exchange market when the fluctuations in the exchange rate are not consistent with fundamental economic forces. These measures were intended to slow the appreciation process and thereby support exports and import-substitute industries producing for the domestic market, areas that are of special importance for the level of activity and employment in the economy.


Fiscal policy acted to reduce the budget deficit this year by means of tax increases and by making cuts in programs for the expansion of expenditures that deviated from the amount permitted under the expenditure rule. Although the deficit was expected to contract only in 2014, the decrease occurred in 2013, earlier, and more sharply, than planned. This resulted from large one-time revenues and lower than planned expenditures in the course of the year, among other factors. The budget deficit totaled 3.1 percent of GDP—less than the previous year’s deficit and the deficit target.


In the short term, economic policy will have to continue coping with the challenge of spurring growth in the economy as a whole, and in particular of alleviating the negative impact on exports, in view of moderate global activity and the low level of interest rates worldwide. These concerns should be addressed while continuing to maintain financial stability and a declining budget deficit.


Looking ahead, over the long term, economic policy is faced with the dual challenge of ensuring that growth is sustainable and inclusive. For this purpose, action must be taken to increase labor productivity in the economy, since it is low by international standards, and to enhance the integration of populations with low labor force participation. At the time same, action must be taken to ensure that the benefits of growth reach as many segments of the population as possible. In order to achieve these two objectives, it is necessary to improve the level of education for all sectors of the population, broaden and deepen integration in the labor market, increase competition in the economy, thereby also facilitating a reduction in the cost of living, and maintain a reasonable level of public services.


An improvement in the regulation of the financial system will increase its resilience to crises in the future, and adjustments in pension arrangements will assist both individuals and the economy as a whole in dealing with the implications of the projected increase in life expectancy and the aging of the population. An important lesson learned from the global crisis that relates to maintaining financial stability is that cooperation among all the authorities concerned is the best way of achieving this objective. Accordingly, and in line with the recommendation of the IMF, a financial stability committee should be established, with the participation of the Bank of Israel, the Ministry of Finance and the three supervisors who head the authorities charged with supervision of the financial system.