The Consumer Price Index (CPI) rose by 4.4 percent in the 12 months to March 1998, and during the period reviewed the rise was even slower, 1.3 percent in annual terms. In five of the last seven months, the CPI has actually fallen. Indices taking seasonal adjustments into account also moderated sharply, rising by 2-3 percent, annual rate, in the period reviewed. Inflation expectations for the following 12 months also declined steeply, to 5-6 percent at the end of the period reviewed. This is the first significant reduction over a number of consecutive months, from the 10 percent inflation environment prevailing since 1992. In light of the consistent effect of the basic factors affecting inflation, a real opportunity exists to advance rapidly towards achieving the price stability prevailing in the industrial economies, in accordance with the government's decisions.

The factors leading to the economic slowdown in the period reviewed were effective throughout 1997, and are fully described in the Bank of Israel Annual Report, 1997. Processes associated with the ending of the expansionary effects of the influx of immigrants dampened domestic demand, mainly in investment in the principal industries and in construction. Investment in 1997:lV was 2 percent lower than in 1996:lV, and according to indicators of the construction industry and of capital goods imports, the slowdown persisted in 1998:l, too. Investment is also affected by the continued political and security uncertainty, which had an adverse effect on incoming tourism, too. Nonetheless, capital stock continued to rise markedly in 1997. Private consumption eased, rising by only 0.9 percent in annual terms in 1997:IV. Indices of turnover based on VAT receipts also show that consumption moderated. Economic policy, characterized by fiscal and monetary discipline in order to restore the balance-of-payments deficit to a sustainable path and attain the inflation target, served to keep the expansion of domestic demand low. Fiscal restraint, which enabled the attainment of the 1997 deficit target after two years of large deviations, is continuing to moderate the rate of expansion of public consumption, while tight monetary policy has kept real short-term interest rates relatively high.

The reduction of excess demand acted both to slow the rate of price rises and to dampen economic activity, as reflected by the various economic indicators during the period reviewed: business-sector product in 1997:IV was a mere 0.4 percent higher than in 1997:lll, the state-of-the-economy index rose at an annual rate of 1.6 percent during the period reviewed, and industrial production went up at a similar rate, and on average actually declined in the period reviewed compared with the preceding one. The tourist industry continued to suffer in the context of the tension vis-a-vis Iraq. The Bank of Israel's survey of companies supports these findings, firms' replies pointing to domestic demand as the major barrier to the expansion of activity. In the labor market, labor input in the business sector fell, but the real wage rose, apparently due to the sharp decline in inflation and the rise in the minimum wage. The easing of excess demand served for the first time in a long period to restrain real appreciation, compared with the trend of the last few years, and actually led to slight real depreciation in 1998:I. In 1997, this process was accompanied by some diversion from domestic to overseas markets, with a reduction of imports and growth of exports, but the improvement in the trade deficit halted in the period reviewed as imports stabilized and even rose slightly while export growth slowed.

Beyond the effect of lower excess demand, the modest rise in the exchange rate, which moved along the lower limit of the crawling band until March 1998, and the decline in dollar import prices also contributed to the fall in inflation. Inflation expectations fell due to wider recognition of the action of disinflationary economic forces, in particular the credibility of economic policy regarding commitment to the inflation target, and also as a result of adaptation to the slowdown in price rises. The fall in inflation expectations supports the reduction in the inflation environment.

Several factors hamper the return to a faster growth path. Demand for Israel's exports is expected to be adversely affected by the economic crisis in East Asia, as its ability to compete with exports from those countries declines and as world demand falls, reflected by the expected contraction of world trade. The first indications of the adverse effect can be seen in the decline in exports to Asian countries in the period reviewed, although its full extent is not yet clear. Labor shortages in high-tech occupations also make it difficult for some leading export industries to expand. The erosion of business-sector profitability - related to the rise in the real wage, and in particular to the further increase in the minimum wage in April 1998, and reflected in a rise in unit labor cost - has continued. The heavier tax burden in 1997 also acted as a disincentive to growth. The reduction of public-sector investment in the infrastructure is expected to harm the chances of growth in the longer term. Security and political uncertainty makes it harder to utilize the opportunities embodied in the globalization process, and also harms incoming tourism. Tension due to the actions of Iraq also impaired tourism, and could have longer-term results.

The moderation of both price increases and inflation expectations enabled monetary policy to gradually reduce nominal interest. Because actual and expected inflation declined faster than interest, monetary restraint was expressed in a rise in real short-term interest during the period reviewed. The combination of a sharp reduction in the inflation environment and cautious monetary policy often finds expression in high real interest rates for a while - a characteristic of economies undergoing rapid disinflation. The combination of high real interest rates and continued tight fiscal policy helps to dampen domestic demand. This caution is necessary, however, for two main reasons. The first is to ensure that the opportunity created in the last few months to significantly reduce inflation is not missed, and this is a process which requires time. The second is that the uncertainty in the foreign-currency market, due mainly to the uncertainty regarding the implications of continued liberalization and the Asian crisis, also requires particular caution in the conduct of monetary policy.

The exchange rate remained close to the lower limit of the band during the period, and the Bank of Israel did not intervene in trading, except for a few days in December and January. In April, in the context of uncertainty as the estimated date of the introduction of another significant step of liberalization approached (Independence Day), the foreign-exchange market became more volatile. The exchange rate against the currency basket rose quite sharply to about 4 percent above the lower limit of the band in mid-April, and declined to 2.9 percent above it at the end of April. The average quarterly level of capital inflow remained high, although from November 1997 to February 1998, in view of the crisis in Asia, nonresidents' portfolio investments in Israel's stock market halted, as did offerings abroad by Israeli companies, while direct investment remained high. Since February the stock market has rallied, against the backdrop of the return of foreign investors.

In 1997:IV the rate of growth remained below its potential and slowed even a little further. GDP rose by 1.2 percent from the previous quarter (in annual terms), and business-sector product by only 0.4 percent. Imports of goods and services declined slightly, and their exports fell steeply. Private consumption grew slowly, after remaining stable in 1997:III. Investment rose sharply, after declining in the previous quarter. Public consumption rose to its level in 1996:IV. Note that the breakdown of quarterly national accounts data is sometimes problematic, and data of exports and investments for 1997:IV are inconsistent with other indicators such as foreign-trade or construction data.

The slowdown of industrial activity became more severe in the period reviewed. The index of industrial production, seasonally adjusted, rose on average by a cumulative 1.4 percent, annual rate, after declining in 1997:III. It was 3 percent lower on average in the period reviewed than in the previous period, although it was 2.5 percent higher than in the equivalent period a year earlier. The number of employees increased by a half of one percent, and the number of their hours worked fell by one percent in the period reviewed compared with the previous period (annual rates). In the period reviewed production declined from the previous period in nearly all industries, the electronic equipment industry remained stable, while only the transport vehicles industry increased. High-tech industries in total (machinery and electrical equipment, transport vehicles, and electronic equipment) slowed down by less, thereby preventing an even sharper decline in total industrial production. This was expressed in the continued growth of exports of the high-tech industries (see section on the balance of payments).

The construction industry also slowed down further in 1997:IV. The number of residential building starts, mainly private, plunged by 22.8 percent, following the downward trend of 1997. Residential completions accelerated in 1997:IV, so that the number of apartments in process of building declined by 8.3 percent compared with 1997:III. The number of Israelis employed in construction declined by 7.4 percent from 1997:III according to the Ministry of Construction and Housing. There was a sharp decline (of 30 percent) in the number of permits for private construction of apartments in the large towns, and in the number of transactions, based on the number of property tax and land betterment tax files opened. According to partial data for January-February 1998, there was a slowdown in the number of starts and completions of apartments under construction initiated by the Ministry of Construction and Housing in both urban and rural areas, in the number of housing loans taken up, and in apartment sales by the ten largest companies. Nevertheless, the number of transactions registered by the property tax and land betterment tax authorities in the first few months of 1998 rose to a level 2.7 percent higher than in the equivalent period a year earlier.

The number of tourists arriving by air continued to decline in 1997:IV and 1998:I, and was 11 percent lower than in the equivalent period a year earlier. The number of tourist bed-nights was 12 percent below than in the preceding period (seasonally adjusted, annual rates). The tension in the Gulf area also damaged tourism, which has suffered since the beginning of 1996. This could cause long-term harm due to the adverse effects on investment in tourism and the loss of the market share of world tourism.

The Bank of Israel survey of companies supports the results arising from data of the principal industries. Thus in 1998:I there was some decline in industrial activity (seasonally adjusted). The data, not seasonally adjusted show that output fell, as did domestic sales, domestic orders, and exports (but the latter not significantly). The shortage of domestic orders was quoted as the main limitation on companies' activity. Some of the companies reporting increased exports mentioned labor constraint as preventing output growth. All industries recorded reduced output apart from electronics, electricity, and transport vehicles, and chemicals, rubber, and plastics (with non-significant increases). For the eighth consecutive quarter, companies reported a fall in the utilization of machinery and equipment. Trading companies reported a seasonal decline in sales, although seasonally adjusted the fall was not significant. Construction firms reported a reduction - for the fifth consecutive quarter - in the extent of building works carried out. That in 1998:I applied to both residential and infrastructure construction. The downturn in hotel activity which started in mid-1996 continued, mainly in tourist bed-nights. Transport and communications companies also reported lower activity.

The sales revenue index of trade, as well as that of trade and services, rose slowly in the period reviewed compared with the previous period, by 0.5 and 1.1 percent respectively (annual rates). The large-scale-retail-trade index rose by 8.6 percent compared with the equivalent period a year earlier, similar to its rise in 1997 and below its 12.8 percent rise in 1996. In 1998:I it rose at an annual rate of 12 percent, but this should be treated with caution in light of the great volatility of this index.

The moderate activity level of industries was reflected in 1996-97 in the nonrealization of potential GDP, i.e., of the production capacity inherent in the available factors of production - capital and labor. The Bank of Israel Annual Report, 1997 estimates the output gap, the average deviation from the potential in 1997, at 5 percent of GDP. Labor utilization (the actual unemployment trend compared with natural unemployment) and capital utilization are usually taken as indicators of the approach towards or distancing from potential output. The current indicators, including the trend of unemployment, changes in utilization of equipment, and responses in the survey of companies, as well as utilization according to business-sector electricity consumption (Table 1), show that the economy is still on a path below that of its potential output.

In 1997:IV, the rate of unemployment fell, with a rise in both the civilian labor force and the number of employed persons (in the public sector), but data on the number of work-seekers and claims for unemployment benefit show that unemployment worsened. In the period under review, the number of work-seekers (excluding those applying for income support) rose on average by 3,000 (about 2.5 percent) compared with the preceding period, and the number of claims for unemployment benefit went up by 7,000 (about 7 percent). The number of work-seekers rose by 10,000 (5,00 excluding claims for income support), and claims for unemployment benefit increased by 7,000. The number of unemployment black-spots grew to 20 in March, most in the south of the country. Unemployment is on the increase in the main towns, too. Those laid-off accounted for 60 percent of newly registered work-seekers in March.

The number of employed Israelis increased by 0.9 percent in the period reviewed compared with the preceding period (seasonally adjusted). The number employed in the business sector, not seasonally adjusted, fell by 0.8 percent, mainly in construction, with the number employed in manufacturing at a standstill in 1997:III and 1997:IV. The public sector continued to expand, and increased by 3.3 percent, reflected by the decline in unemployment in 1997:IV. The number of hours worked per employee was 4.5 percent lower in 1997:IV than in 1996:IV. According to unadjusted data of the National Insurance Institute, the number of employee posts declined marginally in the period reviewed, with the business sector contracting and the public sector growing, and compared with the equivalent period in 1996-97 there was no change in either sector. These data emphasize the extent of the slowdown of labor demand in the business sector.

The real wage per employee post rose by 2.3 percent (seasonally adjusted) compared with the equivalent period in 1996-97. This reflects a relatively steep 3.4 percent rise in the private sector and a more moderate one in the public sector. The real wage per employee post (unadjusted) fell in both sectors in the period reviewed compared with the preceding period, in the public sector a steep seasonal decline, and in the business sector a moderate one. In contrast, the industry survey shows that the hourly wage rose significantly in real terms in 1997:III and 1997:IV (seasonally adjusted), despite the fact that hourly output remained unchanged. The minimum wage was raised by 8.5 percent in April 1998, due to a rise in the average wage, following significant increases in 1996-97.

In 1997, the net goods and services account showed an improvement of $ 1.5 billion; in 1997:IV there was an improvement of 0.6-0.8 percent compared with both 1997:III and 1996:IV (in annual terms). There was a slight decline in unilateral transfers from the level in 1996:IV, so that the net current account ended with a surplus of $ 164 million compared with $ 39 million in 1996 (the surplus in the current account derives from the receipt of the US economic aid). Private-sector medium- and long-term capital flows remained at a relatively high level ($ 1.4 billion) in 1997:IV, alongside small-scale short-term capital inflow of the nonfinancial private sector.

According to data of the Bank of Israel Foreign Exchange Control, there was a decline in the current account in 1998:I.* Capital inflow, on a quarterly basis, remained at a high average level in the period reviewed. Capital exports by the commercial banks and purchase of foreign currency by the Bank of Israel bridged the gap. Foreign-currency credit from authorized dealers was renewed in 1998:I, and amounted to $ 1 billion, having eased off for about half a year. Nevertheless, foreign-currency-indexed credit fell significantly in the period reviewed so that the two together, credit in and indexed to foreign currency of the nonfinancial private sector rose by only $ 0.5 billion in 1998:I. From November 1997 until February 1998 there was a halt in nonresidents' portfolio investments in shares on the Tel Aviv Stock Exchange and in issues overseas, against the background of the crisis in Asia, but in March they recovered. Nonresidents' direct investment remained at a relatively high level throughout the period reviewed. The Bank of Israel foreign reserves reached $ 21.3 billion at the end of the period, compared with $ 19.0 billion at the beginning.

According to national accounts data, there was on average no real appreciation in 1997:IV, in contrast to the long-term trend. The price of exports went down by 0.7 percent, and the price of imports (excluding defense exports, ships and aircraft) rose by 0.6 percent, compared with an increase of only 0.1 percent in the prices of business-sector output. Nevertheless, compared with 1996:IV there was real appreciation which accumulated in the first three quarters of 1997. An indication of real depreciation may be obtained by comparing inflation abroad, plus the depreciation of the exchange rate, with domestic inflation. In the countries whose currencies make up the currency basket, average inflation was 2 percent. The value of the basket rose by 4.8 percent in the previous 12 months, and by 3.6 percent in the previous 6 months. The CPI rose by 4.4 percent in the previous 12 months, and by 1.3 percent in the previous 6 months. In other words, according to this indicator, there was real depreciation of 2.5 percent in the last year, and of 4 percent in the last 6 months (in annual terms).

* Foreign-exchange control data are on a cash basis, and are not always consistent with Central Bureau of Statistics data.

Continuing the gradual liberalization of foreign-exchange control, just before Independence Day the Prime Minister, the Ministry of Finance, and the Bank of Israel announced a change in the regime. Whereas to date every foreign-exchange transaction was forbidden unless specifically permitted, henceforth every foreign-exchange transaction is permitted unless specifically forbidden. All the restrictions regarding foreign-exchange transactions that formerly applied to households and the business sector have been lifted, except for those regarding investment by institutional investors and derivatives transactions of nonresidents. Among the principal transactions that are now permitted are unlimited investment abroad by individuals, unlimited unilateral transfers, unrestricted holdings of foreign currency, removal of restrictions on making payments in foreign currency in Israel or abroad, and on receiving foreign-currency from nonresidents; the requirement to present documentation upon making foreign-currency transactions is annulled, and foreign-currency transactions may be undertaken directly with foreign financial entities. There will nonetheless be a reporting requirement regarding transactions, so that foreign-currency flows can be analyzed.

The main transactions to which restrictions still apply concern institutional investors and derivatives transactions by nonresidents. The remaining restrictions on resident institutional investors are the probibition of direct and portfolio investment abroad by pension funds and insurance companies, and of direct investment abroad by provident funds, and the limitation of the foreign-currency investment of the latter to 5 percent of their portfolio. These restrictions will be removed gradually at the forthcoming stages, in accordance with the tax policy regarding residents' investments abroad. At present there are no limitations on investment abroad by banks and mutual funds. The restrictions on nonresidents' NIS/foreign-currency derivatives transactions will be removed once the implications of the removal of the restrictions on households and individuals have been examined. This step is intended to remove the one-month time-limit on NIS/foreign-currency derivatives transactions denominated in foreign currency and implemented by nonresidents (there is currently no restriction on such transactions by residents, but are limited to a one-month horizon for nonresidents). Note that for some time nonresidents have been permitted to deposit and borrow local currency, invest in the TASE, and undertake derivatives transactions in foreign-currency- indexed local currency without any restrictions.

These measures come in addition to a series of liberalization measures announced by the Ministry of Finance and the Bank of Israel in August 1997 and implemented in three stages. First, the upper limits on investment abroad by institutional entities were raised, and the ceiling on portfolio investment abroad by firms and mutual funds was annulled. In January 1998 the amount individuals were permitted to send abroad as a support payment or gift was increased, and residents were allowed to buy foreign currency in order to place it in a foreign-currency-denominated deposit and undertake unlimited NIS/foreign-currency derivatives transactions. In April the implemented of the third and final stage of liberalization was announced, and Israeli banks were permitted to purchase sheqels from banks abroad, thereby enhancing the sheqel's convertibility. The number of categories of nonresidents' deposits was reduced to two, one in local currency and one in foreign currency, and any transaction permitted in local currency was permitted in foreign currency, too. Employers of short-term foreign workers were permitted to buy foreign currency in order to pay their wages without having to present a visa and employment permit.

An important condition for significant progress in the liberalization process is dealing with the asymmetry in the taxation of portfolio investments of residents in Israel and abroad (see Bank of Israel, Annual Report, 1997, Chapter 6). The gap between the taxation of portfolio investments in Israel and abroad contributed to the asymmetry of capital flows, and detracts from the effectiveness of progress in liberalization as regards its contribution to the diversification of the investment portfolio and the moderation of real appreciation.

The slowdown reflects primarily the direct influence of the crisis on the GDP of the South-East Asian countries - and of Indonesia, Korea, and Thailand, in particular - due to the steep fall in foreign financing sources and plummeting asset prices; the rise in their exports will not be sufficient to lift their economies within the forecast period. The decline in foreign financing sources will affect all the developing countries and economies in transition to some extent. The forecast for the immediate future for Japan was downgraded because of the weakness of its financial system in general, and its banking system in particular, and the delay in introducing essential structural changes. Despite the fiscal incentives and the measures introduced in order to support the financial system there, it is feared that economic stagnation will persist. The crisis will have only a modest effect on economic activity and prices in the countries of North America and western Europe, and will serve to prevent overheating (especially in the US) in the context of high share prices. A deterioration in these countries' balance of payments vis-a-vis Asia is also expected.

The IMF lists several reasons for the crisis. Investor confidence was undermined by overheating, expressed in large balance-of-payments deficits and soaring asset and share prices. Adherence to fixed exchange rates hampered the prosecution of an appropriate monetary policy. Inefficient banking supervision and incautious management caused the quality of loans to deteriorate. Alongside the political uncertainty, economic uncertainty rose due to the absence of reliable economic information. External factors also played a part. These included large capital inflows into these countries because of the underestimation of risk, and the growing strength of the dollar, which reinforced currencies in the region that were indexed to it. Hesitancy in adopting stabilizing economic policies exacerbated the situation, although the commitment to introducing the necessary measures is significantly greater now, except in Indonesia.

The economic effect on Israel is evident in two main spheres: exports and capital flows. The worldwide slackening in economic activity, especially in the countries of South-East Asia, and the greater competitiveness of their exports, will harm Israel's exports. An estimate of the expected effect on domestic exports and GDP may be found in Bank of Israel Annual Report, 1997, Chapter 6 (between 2 and 2.5 percent of exports, and 0.6 and 0.8 percent of GDP). Foreign-trade figures show that exports to the countries involved in the crisis (Thailand, Indonesia, the Phillipines, Korea, and Malaysia) plummeted to a quarterly rate of $ 140 million in 1997:lV and the first two months of 1998 compared with over $ 200 million in the first three quarters of 1997. Exports to other Asian countries (Hong Kong, Singapore, Taiwan, and Japan) also slowed significantly in the first two months of 1998, after rising in July-December 1997.

As stated, developments in Asia might affect capital movements to many countries, and to Israel in particular. Investors' confidence in the countries involved in the crisis, whose overseas sources of capital shrank, was seriously undermined. Under certain circumstances, the loss of confidence and increased awareness of risk could also find expression in the attitude of foreign investors to Israel, causing the direction of capital flows to change. The capital inflow to the Latin-American countries, for example, has hardly been affected, however, and in some cases it has even risen. The capital inflow into Israel has also remained high, with the exception of a period of adjustment from November 1997 to February 1998, when nonresidents' investments in shares traded on the Tel Aviv Stock Exchange (TASE) halted and offerings abroad by Israeli firms were deferred; recovery in both these areas was evident in March, however.

In view of these risks, it is important to continue with a supervisory and cautious economic stabilization policy that will keep the financial markets on track, aim at continuing to improve the balance of payments, and prevent an increase in credit risk in the banking system. Another lesson of the recent episode is that a managed exchange rate hampers the conduct of an appropriate monetary policy in the face of demand pressures and capital flows.