The Balance of Payments
In 2004, as in 2003, the current account ended the year with a $ 0.5 billion surplus after deficits since the early 1990s (Table 1.1.1).1 The improvement in the past two years is especially conspicuous in view of the economic growth that occurred during this time; in the past, growth had been accompanied by current-account deficits. The positive level of the current account, coupled with price and exchange-rate stability, have made the opening conditions for 2005 among the best that the economy has ever known.
The current-account improvement in 2004 coincided with an 18 percent expansion of activity on goods and services account of the balance of payments, surpassing the 2000 level. The goods account grew more vigorously than the services account. These growth performances were abetted by the continued global economic recovery but outperformed the recovery by a wide margin (Figure 1.1.1). The financial account also expanded for the second straight year. Foreign investment was $ 6.6 billion as against $ 6 billion in 2003 and resident investment (net of the change in foreign reserves) increased to $ 9.2 billion as against $ 6.1 billion a year earlier. In foreign investment, issues by technology companies on foreign exchanges increased perceptibly and direct investment declined significantly. In resident external investment, the increase in external deposits of the banking system stood out.
The increase in exports of goods and services contributed to the upturn in imports because some imports serve as intermediates for exports. The expansion of imports in 2004 was also related to the increase in domestic demand. All types of imports (raw materials, consumption goods, and capital goods) increased, as opposed to the trend in 2003, when the economic slowdown held the increase in imports to a negligible rate while exports rose twice as rapidly. Notably, the rate of increase in exports of goods and services in the past two years surpassed that of domestic growth by far. As a result, the deficit on account of these two forms of activity fell to half its level in the preceding two years. It was this expansion that made a contribution to the change in the current account.
Much of the increase in current-account activity during the past two years traces to high-tech industries, which account for nearly half of industrial exports, and software and R&D services, the exports of which are recorded in the services account. These industries together exported $ 15 billion in 2004. The regional geopolitical improvement in 2004 boosted inbound tourism by 40 percent. However, tourist arrivals remained 38 percent under the 2000 level and tourism revenue fell short of the 2000 level by $ 1.6 billion than in 2000.
The upturn in global interest rates in the second half of the year was reflected in the factor- income account, raising the net interest income of the private sector (banking and nonbanking), whose external assets increased by $ 8 billion. The change in interest rates had hardly any effect on general-government expenditure because almost all general-government liabilities are long-term and at fixed interest rates. The wage-expenditure component has improved considerably in recent years because the population of foreign and Palestinian workers has declined. Since its peak in 2001, wage expenditure for foreign workers has fallen by $ 0.8 billion and that for labor from the Palestinian Authority areas by $ 0.7 billion, with the combined expenditure on both totaling $ 1.5 billion.
The net financial account (foreign investment less resident external investment except for reserve assets), which had run a surplus for many years, recorded its first deficit in 2002, the crisis year, and the deficit increased to $ 2.6 billion this year (Figure 1.1.2).
Turning to the distinction between capital instruments and debt instruments in the net financial account, the economy has had a surplus of capital instruments in all recent years. Thus, foreign investment in shares (direct and portfolio), a reflection of foreign investors' confidence in Israel, exceeds resident investments in these instruments abroad. In debt instruments (bonds, credit, and deposits), in contrast, the domestic economy is in deficit. This is a consequence of the surplus in capital instruments, since the typical level of the current account ranges from balance to a small surplus.
The capital-instrument surplus declined from $ 4.3 billion in 1999-2001 to $ 2.2 billion in 2003 and 2004 (annual averages in both periods) as resident external investment expanded more quickly than foreign investment, and not due to a decline in Israel's attractiveness to foreign investors. Indeed, all factors that tend to attract foreign investment-the growth rate, technological innovation-which had an upward effect on investments in these industries (see box in the chapter on foreign investment)- the geopolitical situation, confidence in economic policy, greater efficiency in the capital markets, privatization, and the deregulation process-have shown signs of improvement in the past two years. However, the factors that encouraged residents to invest in foreign capital instruments were more intensive. Important factors of this type include the globalization process in which large Israeli firms are participating, reflected among other things in rather large acquisitions of production lines abroad, and the high-tech recovery, which has caused investments in these industries to rise.
The net debt-instrument deficit climbed from $ 2.6 billion on average per year in 2001-2003 to $ 4.7 billion in 2004, largely due to an increase in the surplus of sources of the banking system, which the system invests abroad; the lowering of the liquidity ratio on commercial banks' deposits with the Bank of Israel; a decline in demand for forex credit, and the tax reform, all of which made foreign assets relatively more profitable for households and institutional investors to hold.
In response to the factors that abetted change in the net financial account, the banking system, which operates mainly by means of debt instruments, transferred $ 7.3 billion (cumulative terms) in other sectors' excess forex sources out of the country in the past two years, including $ 2.7 billion in the last quarter of 2004. In contrast, the private sector and general government had surpluses (Table 1.1.1).
Net direct investment flows turned around in 2004 and became negative for the first time in many years as foreign investment declined steeply and net portfolio investment became positive after three years of decline, largely due to an increase in Israeli high-tech issues on foreign exchanges (Figure 1.4). Some of the change traces to one large transaction that was recorded both as an increase in foreign portfolio investment and an increase in direct resident investment abroad.
Foreign investment: In 2004, Israel maintained its share in the total capital inflow to emerging-market economies but the composition of the total, in terms of types of investments. changed sharply relative to these economies. As stated, direct investment declined steeply, from $ 4 billion in 2003 to only $ 1.6 billion in 2004, whereas portfolio investments climbed from $ 2 billion to $ 5.4 billion in the respective years (Table 1.1.2). The decrease in direct investment occurred despite the upturn in mergers and acquisitions around the globe and the improvement in Israel's macroeconomic fundamentals. However, it originated in the timing of a small number of large investment transactions and a technical shift from the direct-investment line to the portfolio-investment line, as opposed to a decrease in Israel's attractiveness to foreign investors. For example, nonresidents realized a $ 0.7 billion direct investment in a telecommunications company due to privatization processes in this industry that matured during the year. In the fourth quarter of 2004 and in early 2005, agreements were concluded for the performance of $ 1.9 billion in direct investments that will largely be reflected in the 2005 data, which are expected to show a large increase relative to the long-term average. Foreign direct investors in Israeli high-tech shares abroad sold $ 0.5 billion of their holdings to foreign portfolio investors in view of the relatively high prices that Israeli technology shares were commanding. Furthermore, capital raising by VC funds and investments in start-up companies, which reflect nonresidents' confidence in Israeli technology, increased vigorously even in American terms. The recovery of real global demand for high-tech products was accompanied in 2004, in contrast to 2003, by an upturn in international capital issues and led, as stated, to a rapid increase in Israeli technology share issues on American exchanges, at $ 2.8 billion as against $ 1 billion in 2003-a rate exceeding the upturn in issuing by domestic companies. In all, $ 5 billion was invested in shares (directly and for the portfolio) in 2004, the highest level in the past four years.
The global uptrend in investments in emerging markets' stock exchanges in 2004, occasioned by poor yields on risk-free assets in developed countries and the decline in the riskiness of the emerging markets, was also evident on the Tel Aviv Stock Exchange and prompted nonresidents to invest $ 0.5 billion in shares, mostly in the fourth quarter of the year, as against negligible investment in the bond market. Nonresident activity in government bonds is expected to increase in 2005 as several reforms in this market go into effect.
Resident investment: The worldwide high-tech recovery and the continued integration of Israeli firms into the globalization process acted to sustain the upturn in the direct investment flows of Israeli firms abroad and encouraged two changes in the patterns of investment-from the acquisition of marketing channels to the acquisition of production lines and from financing by means of loans to financing by equity investment. Investment flows in the portfolio assets of households and institutional investors slowed in the second half of the year, mainly due to the appreciation of the NIS and a decline in the prices of foreign assets, even though the January 2005 tax reform will make it relatively more profitable to hold assets abroad. (See box in the NIS-Forex Market section.) The business sector expanded its external depositing vigorously due to increases in exports and external issues and as hedging for the innovative financial instruments that financial companies in this sector issued to residents in 2004. As stated, the banking sector deposited much more money abroad than before, as the narrowing of the NIS-forex interest spread created surpluses of forex sources.