The IMF mission to Israel led by Mr. Bas Bakker today presented the Minister of Finance, Mr. Moshe Kahlon., and the Governor of the Bank of Israel, Dr. Karnit Flug, with its preliminary 2015 Article IV Consultation Concluding Statement on Israel's economy. The IMF is expected to publish within two months its final report on the Israeli economy for 2015.
The original text of the document, in English, is attached. For convenience, an unofficial translation into Hebrew is attached as well. The English version is the binding one:
1. Israel’s economy is performing well. This is visible in GDP growth—Israel has not had the sharp post-crisis slowdown that many other countries have experienced. It is also visible in employment creation—since 2007, employment has grown from 59 percent of the working age population ratio to 68 percent.
2. Nevertheless, policy makers are confronted with a number of challenges. The fiscal deficit remains stubbornly high, leaving limited buffers to respond to shocks. Inflation is negative—well below the Bank of Israel’s (BOI) target—but housing prices continue to rise. Labor productivity is low and the gap with the United States is widening. And income inequality is among the highest in advanced countries.
3. The economic outlook is positive. Growth this year is expected to rebound to 3 percent (from 2.8 percent in 2014), the result of strong private consumption growth—driven by rapid employment growth, near-zero interest rates, falling import prices, and the rebound from the impact of military operations last year. Inflation will turn positive, reaching ¾ percent at the end of the year and the target band next year. There is not much slack in the economy: staff judges that the output gap is near zero. In the medium term, output will grow around 3-3 ¼ percent—in line with our current estimate of potential output growth.
4. Risks to the outlook are balanced. Growth could disappoint if growth in Israel’s trading partners were weaker, geopolitical tensions in the region heightened, or the shekel appreciation continued. A sharp correction in housing prices could also slow growth. Growth could also be stronger than expected, for example, if trading partner economies recover faster or investment in the natural gas sector increases. Monetary tightening in the United States would likely help Israel, as it would exert downward pressure on the shekel, which would boost growth and inflation.
Rebuilding fiscal space
5. By international standards, Israel has a high, structural, and persistent fiscal deficit.
· If we use international accounting standards and include the inflation compensation of indexed bonds above instead of below the line as is currently done, the deficit is almost 1 percent higher than the 2½-3 percent reported in Israel.
· Israel’s deficit is structural. The current deficit originates from tax cuts between 2003 and 2010, which were not offset by sufficient expenditure reductions. It is not the result of cyclical weakness: compared with 2007—when Israel had a balanced budget—the unemployment rate has fallen from 7.3 to 5.4 percent, even though the labor force participation rate has increased sharply.
· Efforts to reduce the deficit have repeatedly been deferred. In theory, Israel has an expenditure rule and a deficit rule underpinned by a debt target, but they have been revised so often that in practice there is no effective fiscal anchor.
6. The fiscal deficit needs to be reduced. Current levels leave few buffers to deal with shocks, such as housing price correction, renewed conflicts, or a sharp recession. The decline in debt—from 94 percent in 2003 to 67 percent in 2014—has already almost come to a halt, and if deficits are not reduced, public debt will start to edge up again. If deficits stay around 3 percent (4 percent on international standards) and with real GDP growth around 3 and inflation around 2 percent, the debt ratio will converge to 80 percent of GDP over the longer term. Sticking to the current deficit law that reduces the deficit to 1½ percent of GDP by 2019 is critical. If adhered to, the debt ratio would converge to 50 percent of GDP over the longer term.
7. Reducing the deficit will be a challenge.
v Measures will be needed to stick to the current expenditure ceiling. This is because the plans in the coalition agreement would raise spending above the current ceiling.
v The expenditure ceiling is not tight enough to bring about the desired deficit reduction. The real growth rate of the expenditure ceiling (around 2.6 percent) is barely below the growth rate of real GDP (3 percent).
8. This challenge should be addressed immediately and not put off to the future. Policy makers need to decide how to reduce the deficit. If civilian expenditure is considered too low to be reduced, then measures on the revenue front should be identified. In this context, the mission advocates an explicit revenue and expenditure fiscal framework to meet the 1½ percent of GDP deficit target. This framework should explicitly identify the policies in the next 4 years to bring down expenditure and raise revenue to meet the medium-term deficit targets. Adjustment efforts should seek to minimize the impact on growth. This favors raising revenues from indirect rather than direct taxes and finding savings from current rather than capital spending.
9. Next year’s budget should take an important first step in reducing the deficit. The 2015 budget will likely be passed only in the fall—too late to introduce new measures. As the fiscal deficit for this year is likely to exceed the deficit target in the current law (2¾ percent of GDP rather than 2.5 percent), the deficit in 2016 should be brought down by at least half a percent relative to 2015, equivalent to the drop envisaged under the current deficit law.
Bringing inflation back to target
10. Low inflation does not reflect domestic weaknesses, but is largely imported. Our analysis suggests that low inflation is mostly the result of the fall in oil prices and the lagged impact of the shekel appreciation in the first half of 2014, while increased competition in the telecommunication industry and one-off reductions of electricity and water rates have also contributed. The temporary nature of low inflation is also evident in inflation expectations, which remain well anchored within the target band.
11. Inflation is expected to return to the target band in 2016—the result of the shekel depreciation in the second half of the 2014, the tapering of energy price declines, robust domestic growth, and tightening labor markets which are expected to exert upward pressure on wages. Indeed, since February, a strong rebound in consumer prices has been visible.
12. This suggests that monetary policy can be put on hold. With little slack and unemployment at historic lows, further stimulus is not needed. The overall policy mix (with broadly neutral fiscal policy and near zero interest rates) is already very accommodative
Managing risks from rising housing prices
13. Boosting the supply of housing is critical to contain housing price increases. Housing prices have increased sharply in recent years, as demand—further boosted by low interest rates—has increased and supply has not kept up. In this context, the mission welcomes the intentions of the new government to boost supply through various measures and to concentrate several housing-related authorities into one ministry to shorten the planning process.
14. Macroprudential measures remain vital to containing risks to financial stability emanating from the housing sector. So far, measures have been effective in containing household leverage. However, further tightening may be needed in the future.
Safeguarding financial stability
15. The financial sector is stable but exposure to the housing/real estate/construction sector has risen. Banking sector credit to the housing/real estate/construction sector accounts for around 44 percent of loans. The real estate/construction sector has also been active in the corporate bond market, where spreads have been low even for issuances with low ratings and weak collateral. In this context, risk diagnoses and assessments should be done on an ongoing basis. Stress tests―ideally covering not only credit and market but also liquidity risks―should take into account the interconnectedness of various institutions and instruments as well as macro-financial feedback loops.
16. Efforts to increase banking sector competition should ensure that financial stability remains paramount. Increasing competition could lead to reduced fees, improved services, and increased access to credit, but it could also raise risks to financial stability—particularly if it would lead to weak new banks or rapid credit growth and an erosion of credit standards. It will thus be important to keep prudential policies strong.
17. The adoption of remaining key recommendations from the 2012 FSAP should be completed. Pending legislative initiatives to reduce systemic risk (amendment to the Mutual Funds Law and an amendment to the Banking Ordinance to strengthen the crisis resolution framework) should be finalized. A formal Financial Stability Committee, focused on macroprudential policies in normal times, should be established with the BOI Governor taking the leading role.
Addressing low productivity and income inequality
18. Labor productivity in Israel is relatively low, and the gap with the United States has been widening. Productivity is partly low for benign reasons: sharp increases in the working age population (fueled by high birthrates and immigration) and an increase in the labor force participation rate have kept production labor-intensive and thus labor productivity growth low. However, TFP growth has also been very low. Productivity will come under further pressure from the rapidly rising share in the population of the Haredi and Israeli Arabs—groups that have generally lower education, productivity, and participation levels.
19. Without an increase in labor productivity growth, GDP growth will slow in the future. In the past two decades, much of Israel’s growth has come from the use of additional labor. With the increase in the labor force participation rate likely to level off and unemployment already at record lows, future employment growth will likely slow to the rate of working age population—some 1½ percent. If productivity does not pick up, GDP growth will slow accordingly.
20. Raising productivity should become a priority. Israel has a lot of macro-flexibility—it has managed to absorb an incredible increase in the labor force. But what Israel needs is more micro-flexibility, that is, more competition at the micro level. According to OECD product market restrictions indicators, Israel has too much regulation and restriction, and not enough competition.
21. We therefore welcome the intentions of the new government to boost competition in several sectors, including transportation, food, the financial sector, and commodity imports. Efforts should also continue to address infrastructure gaps and improve education.
22. Income inequality is high. This reflects both high inequality of labor-income, with a high share of both high-paying and low-paying jobs relative to other countries; as well as less redistribution through the tax/transfer system than in other countries. Poverty is concentrated among the Israeli-Arab and Haredi populations, which have lower labor force participation rates, less education, and larger families, but even among non-haredi Jews income inequality is higher than in almost all advanced countries.
23. Reducing inequality requires concerted efforts from across government agencies, stakeholders, and communities. A comprehensive poverty reduction strategy could be formulated to address critical structural problems hindering the effective inclusion of the Haredi and Israeli-Arab populations in society and the labor market, including poor rural infrastructure and transportation and low quality of education.
We would like to thank the authorities and private sector counterparts for their cooperation and hospitality.