Summary:

In 2003 there was a turnaround in business-sector activity due to the global economic recovery and some improvement in Israel's security situation, supported by a change in the fiscal and monetary policy mix. GDP rose by 1.3 percent and business-sector product by 1.8 percent, after a 3 percent decline in each of the two preceding years. Nevertheless, the year as a whole, and especially the first half, was characterized by a moderate level of economic activity, a decline in per capita GDP, and a rise in unemployment.  The CPI (Consumer Price Index) fell by 1.9 percent, significantly below the price-stability target, as a result of local-currency appreciation and the economic slowdown.

Until March there was uncertainty regarding the government's commitment to checking the expansion of the budget deficit and the public debt. In the context of the static security and political situation, this was also expressed in high real interest rates-both long- and short-term. In March, with the publication of the government's economic program, the approval of the US government loan guarantees, temporary renewal of the peace process, and subsequent rapid conclusion of the Iraq war, uncertainty abated and Israel's risk premium declined markedly alongside an improvement in the monetary indicators-inflation expectations and the nominal and real yield curves. Against this backdrop, the Bank of Israel was able to gradually and continuously reduce its key interest rate, which declined by 4 percentage points until the end of the year. These policy changes affected economic activity in 2003 in two directions: on the one hand, the sharp cuts in the government's current expenditure, which fell in real terms for the first time since 1985, reduced both government and private direct domestic demand in the short term because of the contraction of transfer payments and decline in the public-sector real wage. On the other, the coordinated economic policy mix led to a positive turnaround in firms' and households' expectations, contributing to a sharp rise in share prices, and this had a beneficial effect on private consumption in the second half of the year. The real interest rate, whose high level at the beginning of the year had hampered the recovery of investment, dipped towards the end of the year, supporting the stabilization of investment alongside initial signs of a rally in the second half of 2003.

The main challenge confronting economic policy is to stimulate sustainable growth while raising the employment rate and combating poverty, which expanded as a result of both the protracted economic slump and long-term factors partly arising from government policy. One aspect of this policy is the continued successful economic policy mix implemented in 2003, alongside a return to a declining budget deficit path through the reduction of current expenditure. This path supports low long-term interest rates and enables the Bank of Israel to set nominal interest at a rate that is consistent with low long-term real interest, supporting a return to growth while maintaining stability. Other important components include an increase in infrastructure investment and the implementation of structural changes which will increase competition. Another aspect is extending the policy adopted in the last two years to combat poverty. Till now this consisted of cuts in transfer payments and a reduction in the number of foreign workers. At the next stage the government will have to act so as to make the labor market more attractive to the low-income population. This can be done by: (i) further reducing the number of foreign workers; (ii) improving the education system serving the weaker segments of the population, and making it more efficient; (iii) reforming taxation and transfer payments, and introducing a negative income-tax program; (iv) establishing compulsory occupational pension plans. It is important to create mechanisms which will make a distinction between individuals who are capable of working and those who are not, to ensure that only the latter receive transfer payments.

1. main developments

The deterioration in economic activity was checked in 2003 and a positive trend was evident in the second half of the year, due to the recovery of the global economy and some improvement in Israel's security situation. The turnaround was supported by a coordinated change in the fiscal and monetary policy mix. After declining for two years, GDP rose by 1.3 percent and business-sector product by 1.8 percent. Notwithstanding, the level of economic activity remained moderate in 2003; per capita GDP declined by 0.5 percent and the unemployment rate rose to 10.7 percent of the civilian labor force. The CPI dipped by 1.9 percent in 2003, below the price stability target, as a result of the economic slowdown and local-currency appreciation vis-à-vis the dollar.

After two years in which economic activity contracted due to the Intifada, which erupted in late September 2000, and the slump in world trade-especially in the high-tech industry-these two areas began to pick up in the course of 2003. The economic recovery in the US (Table 1b), which accelerated during the year, was first expressed in the traditional industries, later extending to the high-tech industry, which accounts for a large share of Israel's exports. This year the rise in exports was the engine of the turnaround in GDP, contributing 2.5 percent to its growth differential. Concurrent with this development, Israel's security situation improved somewhat, in the context of the ‘Hudna,' (ceasefire) which led to a temporary lull in terrorist attacks and a fall in their number relative to the two preceding years. This improvement was expressed in an increase in private consumption in the second half of the year and a recovery in the commerce and the catering and hotel services industries during the year; the recovery was not evident in all industries, however, chiefly construction.

Economic policy affected activity in two directions in 2003. First, until March there was considerable uncertainty regarding the government's commitment to the deficit targets in view of the ongoing economic slowdown, the security-political uncertainty, and expectations of a war in Iraq. This served to prolong the negative trends of the previous two years, among them the steep rise in the public debt/GDP ratio, increase in the statutory tax rate, and high real interest rates which, while maintaining financial stability, hampered the recovery of investment. All these were compounded by the moderating effect on domestic demand of government spending cuts which, while necessary in order to avert the risk of a financial crisis, with even worse implications for GDP, reduced demand in the short term. Second, in March, following the announcement of the government's economic program, which reduced the deficit from 7 to 4 percent of GDP by slashing current expenditure, the approval of the US loan guarantees, the temporary renewal of the peace process, and the subsequent rapid conclusion of the war in Iraq, uncertainty abated considerably. This led to a sharp fall in Israel's risk premium, and was also expressed in all the main monetary indicators-inflation expectations and the nominal and real yield curves. In the context of the positive global developments and improvement in the domestic fiscal situation, which implied a reduction in real public expenditure for the first time since the ESP (Economic Stabilization Program) of 1985, as well as the cyclically-adjusted deficit in 2003, the Bank of Israel was able to gradually and credibly reduce its key interest rate. The successful economic policy mix served to change firms' expectations, and this, together with the recovery on global stock markets, led to a sharp rise in the General Share-Price Index during the year. The recovery in the capital market, alongside renewed expectations of future tax cuts, supported the surge in private consumption in the second half of the year. Furthermore, the decline in real interest bolstered the stabilization of investment during the year, together with initial signs of recovery in imports of investment goods in the second half of the year. The rise in wealth and expected disposable income was also bolstered by decisions that reduce public expenditure in the long run, such as contending with the pension funds' actuarial deficit by raising the retirement age and updating the transfer payments mechanism.

The unemployment rate, which continued to rise in 2003, averaged 10.7 percent of the civilian labor force. Although there was no significant recovery in the demand for labor, the unemployment rate did not increase substantially during the year. This was due in part to the expansion of employment in the knowledge industries, as well as to the government's determination to reduce the number of foreign workers, making it possible for the first time in many years to replace them with Israeli workers, especially in construction. In 2003, after a long period in which public-sector employment expanded, this process came to a halt, adding 0.3 percent to the unemployment rate. In the labor market, too, there were indications of a turnaround in the second half of the year, mainly an increase in the real wage after a marked decline throughout the recession.

The current-account deficit of the balance of payments contracted in 2003, as a result of the recovery of exports. Another factor underlying the decline in the deficit was the low level of economic activity, which in 2003 was accompanied by a relatively slow rise in imports of goods and services. The improvement in the current account stemmed from the decline of the share of investment in total sources available, and a smaller decline in the share of savings. If the process of emergence from the recession takes hold, this trend may well be reversed because the end of a slump is generally characterized by a rise in investment. The indicators of real depreciation attest to a mixed picture; the recovery of the mixed and traditional industries (primarily in the first half of the year) was affected with a lag by the real depreciation of 2002, which was partly offset during 2003.

The CPI declined by 1.9 percent this year, significantly below the target of price stability, defined as 1–3 percent. The deviation from the inflation target is explained by the appreciation of the NIS vis-à-vis the dollar, and by the moderate level of economic activity. The appreciation was the outcome of the trend reversal in capital inflows, mainly of short-term flows which are motivated by interest-rate differentials, but also in direct investment, influenced by the recovery of the high-tech industry. Capital inflows were stimulated by the decline in the risk premium in emerging markets in general, and in Israel in particular, as well as by interest rates, which were higher during the year than in the advanced economies.

Monetary policy served in 2003-and especially at the beginning of the year-to bolster the price and financial stability attained after the sharp interest-rate hikes in mid-2002, in view of the exceptional depreciation and belated response of fiscal policy in 2002. Its main goal was to attain the lowest interest rate possible to support economic recovery. In the first half of 2003, and especially the first quarter, it was still difficult to assess how imminent was the danger of exceptional depreciation as had occurred in 2002. It seemed at that time that the risk embodied in a too rapid interest-rate cut outweighed that of one that was too slow, as the former could undermine stability in the foreign-currency market, requiring a greater and more protracted interest-rate hike at a later stage. Consequently, the interest rate was reduced gradually, alongside constant monitoring of the response of inflation expectations and the foreign-currency market. In retrospect, this has not been sufficient to minimize the deviation from the calendar-based inflation target.

The lengthy economic slowdown caused poverty to increase (see box). This was also due to the cuts in transfer payments and other items, which impact on the poor in the short term. The government was obliged to make these cuts during the slump in order to avert the danger of a financial crisis, which could have had even worse repercussions. One of the main challenges facing the government was to curtail and even reverse the trend of the expansion of poverty (which could eventually impair growth) by increasing the employment rate. In order to achieve this, it is necessary to improve the policy of the last two years, which to date has involved cutting transfer payments and expelling foreign workers. It is particularly important to reinforce the economic incentives that will encourage those segments of the population which have not participated in the labor market for a long time to enter and remain in the labor force.

The Economy: Development and Policies - PDF file