1. ECONOMIC DEVELOPMENTS IN 1999
2. ECONOMIC POLICY IN 2000-2002
3. EXPECTED DEVELOPMENTS IN 1999-2002
Tables
1. ECONOMIC DEVELOPMENTS IN 1999
This summary of developments in 1999 is based on incomplete data and preliminary estimates originating from the Central Bureau of Statistics (CBS), the Ministry of Finance, and the Bank of Israel. As the information is up-to-date to mid-October at the latest, the final data may differ significantly.
Main developments
In 1999, GDP continued to grow slowly, and per capita GDP and total productivity both fell; the rate of unemployment rose further, while the rate of inflation slowed considerably. Nevertheless, several indicators (including the companies survey, foreign-trade data, and data of revenue in the trade and services industries) suggest that activity picked up during the year. Domestic demand (estimated via the domestic use of resources) rose significantly faster than in the previous two years. However, since this acceleration occurred mainly in investment in diamond stocks and in ships and aircraft (following a sharp decline in 1998), it was reflected by a steep rise in imports, and as the growth of exports (excluding diamonds) slowed against the background of the sluggish increase in world trade, there was no parallel acceleration in GDP. The development of imports (which accelerated, even after deducting direct defense imports, ships, aircraft, and diamonds) and of exports resulted in a rise in the current-account deficit, despite continued improvement in the terms of trade. Nevertheless, the increase in nonresidents' direct investment and unilateral transfers on the capital account will probably allow the rise in the deficit to be financed without needing to increase Israel's foreign debt, and may even enable it to fall. According to current estimates, the rate of inflation during the year is expected to be below the target of 4 percent set by the government, similar to the rate prevailing in the year prior to the rapid depreciation at the end of 1998. The rise in prices of imports and exports in 1999 was higher than that of GDP, so that for the first time in several years there was real depreciation.
Economic developments in 1999 apparently reflect on the one hand some expectations in the business sector that demand will expand in the next few years, and on the other, the implications of the world-wide financial crises of the last two years, and the continued endogenous slowdown in the rise of demand after its rapid increase in the first half of the decade. Developments in 1999 were also affected by monetary policy-which aimed at attaining the current year's inflation target and progressing towards the long-term target of price stability, similar to the norm in industrialized countries-and by fiscal policy, the targets of which were set out in the Budget Deficit Reduction Law. Some evidence of expectations of a recovery in demand can be seen in the increased investment in machinery and equipment, in land transport vehicles
1 and in intangible assets. In contrast, the decline in goods inventory and in raw material stocks (excluding diamonds) continued, possibly affected by the rise in short-term real interest rates. The deceleration in world trade in the last two years in the wake of the financial crises in a number of emerging markets and Russia contributed to the significant slowdown in the rate of increase of exports (excluding diamonds), and to an increase in imports due to the fall in their international prices-despite real depreciation in 1999. The decline in the foreign-currency prices of imports also contributed to the moderation of domestic inflation. The continued process of adjustment of domestic demand was reflected mainly in the construction industry, with a marked decline in activity in the last two years from the high level it had reached in the mid-1990s, as well as in a sharper slowdown in the rise in consumption of consumer durables. The rise in real interest rates for all time periods apparently also played a role in these developments. The moderate increase in current per capita private consumption continued, whereas the rise in public consumpt
ion (excluding direct defense imports) accelerated, exceeding the rise in population and in GDP. The public-sector deficit grew considerably in 1999, and the budget deficit is expected to exceed its target for the year.
Real GDP increased by 2 percent in 1999, slightly less than the rate of population growth, so that for the second year in succession per capita GDP declined, by 0.3 percent, within the range of the forecast in the National Budget for 1999. The rise in business-sector product slowed by more than did GDP-from 2.2 percent in 1998 to 1.6 percent in 1999, significantly below the potential growth rate derived from the increase in capital stock and in the labor force. As a result of this slowdown, the increase in labor input continued to be slack, and the unemployment rate rose to 8.9 percent. Although the rate of increase in the number of Israelis employed in the business sector accelerated in 1999, it remained low, at about 1 percent. The real wage in the business sector rose by 1.7 percent in the first seven months of the year compared with the equivalent period in 1998. Domestic demand (estimated via domestic use of resources excluding direct defense imports, ships, and aircraft) rose by 3.8 percent, significantly above the 0.9 percent rise in 1998, and much faster than the growth of GDP. Nevertheless, the increase in investment in stocks (mainly of diamonds) contributed markedly to the rise in domestic demand, and omitting this component the rise was only 2.1 percent, compared with 1.8 percent in 1998. As domestic demand rose faster than GDP, the import surplus (excluding direct defense imports) at constant prices increased by 2.6 percent of GDP. On the other side, Israel's terms of trade continued to improve (by more than 3 percent), and was one of the factors serving to reduce the balance-of-payments current-account deficit at current prices, which rose by only 0.7 percent of GDP.
Monetary policy in 1999 acted to consolidate the low rate of inflation, while attempting to prevent Israel from being pulled into the financial crises which affected several countries (in particular Russia at the end of 1998, and Brazil in 1999). Accordingly, the Bank of Israel acted to prevent the steep price rises resulting from the sharp depreciation of the NIS from turning into an inflationary process, and raised its key interest rate by 4 percentage points in November 1998. As a result, and due to the relative calm in globsl financial markets following the devaluation in Brazil, the NIS appreciated at the beginning of 1999, and the CPI declined, offsetting some of the price rises which had occurred at the end of 1998. Against this background, the Bank of Israel gradually reduced the interest rate by a total of 2 percentage points from the end of February till August. Inflation expectations throughout the year remained above the government's inflation target of 4 percent, and even rose in the third quarter of the year with the rapid depreciation of the NIS. The average expected effective real interest rate in the first nine months of the year was 7.1 percent, about half a percentage point higher than in the equivalent period in 1998. Real (indexed) medium- and long-term interest rates were also above those in 1998. On the stock exchange, share prices rose by more than 30 percent from the beginning of the year until the end of September. The NIS/currency-basket exchange rate at the beginning of October was the same as that at the end of 1998, but this fact masks appreciation in the first half of the year followed by depreciation thereafter. Nonresidents' direct investment in the first nine months of 1999 exceeded their total direct investment during the whole of 1998.
1. Most of the rise in the import of machinery and equipment was due to progress in establishing the Intel factory in Kiryat Gat, reflecting investment decisions made several years ago with a promise of a considerable government subsidy. Even after deducting this component, however, the rate of increase of investment in machinery and equipment and in land transport vehicles in 1999 accelerated considerably.
Private consumption
The rise of private consumption decelerated in 1999, and reached 2.7 percent (a per capita increase of 0.7 percent). The slowdown was more pronounced in purchases of consumer durables, which showed zero growth, but the expansion of consumption of other goods also slowed. The following factors may be responsible for the slacker rise in private consumption:
- The continued diminution of the effect of purchases by new immigrants who arrived at the beginning of the 1990s, an effect which was also evident in decreased activity in residential construction in 1998-99.
- The continued high level of unemployment, and its further rise, which increased the level of uncertainty among some households regarding their future income, and may have exacerbated the liquidity constraint in some cases.
- The high real interest rate that prevailed throughout the year, which may have led to the postponement of households' consumption.
- The delay in implementing wage agreements in the public sector, creating liquidity constraints for some workers in that sector, especially in the light of high real interest rates.
Gross domestic investment
Investment in fixed assets rose by 2.6 percent in 1999, after falling by 3.9 percent in 1998. The rise reflects a marked increase in investment in the principal industries, excluding housing, the decline in which was exacerbated. Investment in the principal industries rose by 7.6 percent, following a fall of 2.7 percent in 1998, so that gross business capital stock at the beginning of the year 2000 will be some 6.8 percent above that at the beginning of 1999-a steeper increase than in the previous year (6.4 percent) and greater than that of business-sector product and of capital stock in the past. The different components of investment in the principal industries did not all develop uniformly, and were affected by some non-recurring investments decided upon several years ago which incorporated significant public financing (ships, aircraft, and the Intel plant). Although investment in machinery and equipment, transport vehicles, and intangible assets (R&D capital) accelerated (even after deducting the above exceptional items), investment in structures and earthworks declined even more sharply than in 1998. In the light of the rise in real interest and the continued reduction in return on capital in 1999, and considering the stock of unused commercial and industrial structures, the development in investment may reflect expectations of a recovery in demand in the next few years. Nevertheless, taking into account the different developments in the various categories of investment, it is too soon to determine whether the trend in investment demand has reversed direction. Physical stocks in the principal industries (excluding diamonds) continued to contract in 1999, albeit more slowly than in 1998. Housing investment fell by 9 percent (after a reduction of 6.7 percent in 1998), reflecting the adjustment of residential construction activity to the drop in demand resulting from the ending of the effect of mass immigration in the early 1990s. This can be seen from the fact that the rate of ownership of apartments among the
immigrants who arrived at the beginning of the decade is now equal to that of the veteran population. The rise in mortgage interest rates also had a moderating effect on housing demand.
The labor market
The continued slow growth of GDP was also reflected in the labor market: the number of employed persons went up by only 1.7 percent, similar to the increase in 1998, and the average rate of unemployment rose to 8.9 percent, up from 8.5 percent in 1998 and 7.7 percent in 1997. The slower rise in unemployment in 1999 was made possible by the reduction in the number of foreign workers (including Palestinians), so that the number of employed Israelis increased by 2.1 percent, as well as by the slowdown in the growth of the labor force, from 2.7 percent in 1998 to 2.5 percent in 1999. As unemployment rose, it also deepened: the share of all unemployed persons who had been seeking work for more than six months rose from 24 percent in 1998 to 29 percent in the first half of 1999.
The public sector's share in employment and in labor input rose again in 1999, but the gap between developments in the public services
2 and the private sector contracted. The number of employed persons in public services increased by 3.6 percent, compared with a rise of 5.7 percent in 1998, while the number of employed persons in the business sector grew by about 1 percent, up from 0.2 percent in 1998, due to the rise in the number of those employed in high-tech and service industries. Employment in construction fell steeply, however, declining in the traditional industries, too. The composition of the change in private-sector employment reflects, in addition to the cyclical change, trend changes evident in many industrialized countries.
The number of foreign workers fell in 1999, apparently due to the slowdown in construction activity in which many of them are employed, and also as a result of government efforts to reduce their number. The decline was only marginal, however, indicating the difficulty in replacing them. The number of Palestinian workers who are residents of the Palestinian Autonomy and of the administered areas also fell, so that the share of non-Israeli workers in the business sector declined from 11.4 percent in 1998 to 11.1 percent in 1999.
The average real wage per employee post was 0.7 percent higher in the first seven months of the year than in the same period in 1998. This was the result of a 1.7 percent rise in the business-sector real wage and a 1.8 percent decline in the wage in public services (not including the retroactive 4.8 percent wage increment for this period agreed by the government and the General Federation of Labour (Histadrut) in the 1998 wage agreements not yet implemented). The rise in the business-sector real wage, which followed a 3 percent increase in 1998, encompassed most industries, and accelerated during the year. Thus, the real wage for May-July was 3.5 percent higher than in May-July 1998. Some of the rise in the wage may be explained by a 1.5 percent increase in labor productivity due inter alia to the change in the industrial composition of employment and the dismissal of low-paid workers, as well as by excess demand for workers in high-tech and other industries. The minimum wage was increased in April by 6.4 percent.
The number of new immigrants who arrived in the first half of the year was 15.8 percent higher than in the first half of 1998, despite the smaller pool of potential immigrants in the last few years. The rate of unemployment among immigrants in the first half of 1999 was lower than in the first half of 1998, while overall unemployment in the whole population remained unchanged, so that the gap between immigrants and the veteran population narrowed. In effect, the rate of unemployment was the same for immigrants who arrived in 1991 and 1992 as for the whole population.
2. Employment in public services includes, in addition to the public sector, workers in the private sector who are employed in public services, such as education, health, and welfare. Payment for a significant part of private-sector activity in these areas is made by the public sector.
Fiscal developments
Public consumption (excluding direct defense imports) and transfer payments by the National Insurance Institute rose faster than GDP, so that public expenditure increased from 54.6 percent of GDP in 1998 to 55.0 percent in 1999. As a result, and due to a decline in public-sector non-tax income, the overall public-sector deficit (excluding the Bank of Israel) increased from 4.0 percent of GDP in 1998 to 4.5 percent in 1999. . The increased activity of the public non-profit organizations-which receive the bulk of their income from the government-made a major contribution to the rise in public expenditure in 1999. Despite the fact that National Insurance Institute payments again rose faster than GDP, their rate of increase was considerably below that in previous years. Only one third of the deceleration can be attributed to the slowdown in the increase in unemployment benefits and income support payments, and the rest reflects a slacker rise in nearly all other National Insurance benefits. Public-sector investment as a share of GDP also declined in 1999. The total deficit (excluding credit extended) of the government-the main component of the public sector-was NIS 10 billion at the end of September, and the domestic deficit was NIS 7.6 billion. Judging by budgetary developments till the end of September, it seems that the total deficit, calculated according to the definitions in the Budget Deficit Reduction Law, will exceed the government's target of 2 percent of GDP. The domestic deficit is expected to be significantly greater than that forecast in the 1999 budget, mainly because income (from taxes and other sources) in real terms is below the original estimate, while the income surplus
vis-a-vis abroad is expected to be similar to that forecast.
The wage agreements for 1998 (and the end of 1997) signed in May 1999 by the Histadrut and the government included a 4.8 percent wage increase. It was also agreed that the increase would be paid retroactively for the period from January 1999. Nevertheless, negotiations with most of the public-sector professional trade unions on the implementation of the details of the agreement are still under way, so that it has not yet been put into effect (except for the agreements with nurses and social workers). Regarding wage negotiations for 1999, only the initial feelers have been put out. In 1999 an agreement was reached on the transfer of new public-sector employees from non-contributory to contributory pension schemes, but its implementation in certain sectors is still subject to delay.
Prices
The CPI rose at an annual rate of 1.2 percent from the beginning of 1999 until September. Some of this slow rate reflects an offset to the steep price increases at the end of 1998, which were followed by reductions at the beginning of 1999. In the twelve months to September 1999 the CPI rose by 5.3 percent; a slightly longer-term view also indicates that the rate of inflation in the last two years (since the end of 1997) has declined to a level below that prevailing at the beginning of the decade. The low rate of inflation takes Israel one step closer to the rates evident in the industrialized countries.
The sharp deceleration in inflation since the beginning of 1999 encompassed almost all the components of the CPI and the indices which adjust for the items characterized by high short-term volatility: the CPI excluding housing, fruit and vegetables, and clothing and footwear rose by 2.4 percent, annual rate, and the index excluding also items whose prices are supervised by the government rose by 2.9 percent (annual rate) since the beginning of the year. Most of these indices rose by about 6-7 percent in the twelve months to September 1999, and only the index also excluding items whose prices are controlled by the government rose by 7.5 percent. The index of wholesale prices rose at a slow rate-only 2.6 percent since the beginning of the year. The rate of price increases accelerated from the first quarter of the year to the second, but then stabilized at about 4-5 percent. Nonetheless, inflation expectations for the next twelve months, derived from the capital market (on the basis of the difference between the gross yield on indexed and unindexed bonds) did not fall during the year, and stayed at 5-6 percent throughout the period.
The slow rate of price rises, following the sharp increases at the end of 1998, was affected by monetary policy in 1999 and by the steps taken at the end of 1998 to prevent the steep increases from becoming an inflationary process. The policy, together with other important factors-contributed to the continuation of the restraint imposed on domestic demand (excluding direct defense imports, ships, aircraft, and diamond stocks) until it reached a level below that of the potential growth of GDP. This restraint was one of the factors contributing to the reduction in inflation.
The depreciation of the NIS at the end of 1998, and the ensuing moderation of price rises contributed to the faster increase of import and export prices relative to prices of business-sector product (i.e., real depreciation), despite the fall in dollar prices of imports and exports. Real depreciation in 1999 in terms of export prices amounted to 3.6 percent, and in terms of import prices, 0.4 percent. There was real depreciation also in adjusted indices of imports and exports. The real depreciation was even greater bearing in mind the long-term trend of appreciation in Israel and the industrialized countries which apparently reflects the development of demand and the faster progress in rationalization in the tradables goods sector.
The balance of payments
The balance-of-payment current-account deficit grew to $ 1.3 billion (1.4 percent of GDP), reversing the downward trend of the last two years following the peak deficit of $ 5.3 billion (5.5 percent of GDP) reached in 1996. The rise in the deficit reflects a surge in imports (an increase of 12.9 percent in terms of volume, excluding direct defense imports), while the rate of increase of exports rose only slightly. Excluding the diamond industry, the expansion of exports decelerated from 9.9 percent in 1998 to 6.6 percent in 1999, whereas the rise in imports accelerated from 3.7 percent in 1998 to 9.2 percent in 1999. On the other hand, the terms of trade continued to improve in 1999 (with a fall in dollar prices of imports and exports excluding diamonds), and this helped to retard the rise in the deficit. An analysis of the 1.6 percent of GDP increase in the deficit suggests that it resulted from a combination of a 1.1 percent of GDP increase in investment and a fall in the gross national saving rate. The rise in the deficit in 1999 seems to be related to a marked increase in domestic demand in several spheres where there is no domestic production, such as commercial passenger aircraft, raw diamonds, overland transport equipment, and machinery and equipment in several industries. The slow growth of world trade-which rose by an annual 3.6 percent in 1998 and 1999 compared with an 8.4 percent average in the previous two years-was another factor slowing the increase in exports (excluding diamonds). The decline in the dollar prices of imports, due to the slowdown in world trade, may also have contributed to the acceleration of imports.
The moderation in export growth covered most components of exports. Industrial exports expanded by 6.5 percent in 1999, down from 10.4 percent in 1998, and exports of services (other than tourism) grew by 5.8 percent, compared with 18.1 percent in 1998. Agricultural exports also decelerated. Exports of tourist services rose by 11.1 percent in 1999, a sharp reversal of the downward trend of the previous three years. This is a very significant development in the light of the hopes that tourism will play a major role in the recovery of the economy in the year 2000. Diamond exports expanded by 9.3 percent, making up for most of the reduction which ensued from the crisis in East Asia-a major market for Israel's diamond industry. The rise in diamond exports and the sharp rise in their dollar prices are related to the recovery in Asia in 1999. Nevertheless, net exports, after deducting diamond imports, were considerably lower than in 1998 due to the recovery of stocks. This indicates the industry's expectations of further expansion.
Goods imports in dollar terms rose by 11.5 percent in 1999, reflecting a jump of imports of capital goods and diamonds and a modest increase in imports of consumer goods. Imports of production inputs fell. These facts are consistent with the rise of domestic demand for imports with slow growth of domestic production. Services imports (apart from capital and labor services) grew by 9.8 percent, and included the continued increase in expenditure on tourism (of 10.9 percent, or 10.2 percent in volume terms).
There were no exceptional developments in the capital account in 1999, following the sharp decline in capital inflow in 1998 due to the halt in the rapid expansion of short-term foreign-currency domestic credit. The government reduced its borrowing abroad, as the possibility of doing so under the guarantee of the US government had been fully utilized. In contrast, there are signs of an increase in long-term capital raised abroad by the private sector. Direct investments by nonresidents rose significantly, and the total of $ 2.1 billion in the first nine months of 1999 exceeded that for the whole of 1998 ($ 1.8 billion). The increase in direct investment in Israel is all the more striking in the light of the sharp decline of nonresidents' investments in emerging markets, among whom Israel is counted. It may reflect international investors' positive assessment of the way Israel's economy functioned at the time of the crises in East Asia, Russia, and other developing economies.
The foreign-currency reserves in the Bank of Israel reached $ 21.8 billion in September 1999, similar to their level in September 1998. On receipt of the economic aid from the US, the reserves had reached $ 22.7 billion in December 1998.
Monetary developments
The main aim guiding monetary policy in 1999 was the achievement of the inflation target for the year, and progress towards the long-term target of price stability, similar to the norm in industrialized countries. The policy also attempted to maintain the stability of the financial markets as far as possible, against the background of the financial and economic crises which afflicted several countries, and progress in the liberalization process which made Israel more open to international capital flows. Current estimates are that the CPI will rise in 1999 by less than the target 4 percent determined by the government. At the beginning of August, the government set the inflation target for the years 2000 and 2001 at 3-4 percent.
In November 1998, the Bank of Israel raised its key interest rate-the main instrument of monetary policy-twice, by a total of 4 percentage points, in response to the exceptional rise in the exchange rate, which was reflected in rapid price rises and increased inflation expectations. These steps were taken to reduce the effect of the devaluation on prices, and to prevent inflation from accelerating. These measures and the relative tranquillity in world markets helped to restore calm to the foreign-exchange market and to bring inflation back to the environment prevailing in the first half of 1998. This enabled the Bank of Israel to reduce the interest rate by half a percentage point in February, April, May, and August 1999, until it reached a (nominal effective) level of 12.3 percent. Inflation expectations for the next twelve months (derived from the capital market), which had risen sharply in October 1998, declined at the end of 1998 to about 7 percent, and during most of 1999 (until September) were between 5 percent and over 6 percent. This is higher than the target set for the next two years, although part of the yield gap reflects the risk premium demanded by investors in unindexed assets. The Bank of Israel's real derived rate of interest moved in accordance with the development of inflation expectations, from more than 7 percent at the beginning of 1999 to about 5.5 percent at the end of the year, higher than the level which characterized monetary policy in 1996-98. The slope of the yield curve of Treasury bills (up to one year) remained moderate during most of the year, indicating that the public did not expect a significant change in nominal interest rates in the following year.
The main instrument through which the Bank of Israel effectively determines the rate of interest remained the auction for banks' fixed-term deposits in the Bank. These rose from NIS 36 billion at the end of 1998 to NIS 45 billion in September 1999.
The foreign-currency market was calm during most months of the year. The NIS/currency-basket exchange rate stayed in the lower half of the exchange-rate band, the width of which is about 35 percent. The Bank of Israel persisted in its policy of not intervening directly in this market in order to allow market forces to determine the exchange rate. In the first quarter of 1999 the NIS appreciated by 10 percent against the currency basket, compared to its rate at the end of 1998, and it was less volatile. In April the NIS depreciated, but appreciated again in May and June. In the third quarter, against the background of uncertainty regarding economic policy decisions for the year 2000, and the contraction of the interest differentials between the NIS and the currencies comprising the basket, the NIS depreciated by about 5 percent against the basket. At the end of September, the exchange rates of the NIS against the currency basket and the dollar were similar to those at the end of 1998. Capital inflow by nonresidents grew in 1999, mainly for purposes of direct investment in Israel, and capital inflow by residents fell, reflecting a more moderate expansion of foreign-currency credit while foreign-currency deposits rose.
The money supply grew by some 9 percent in the twelve months to September 1999, similar to the increase in nominal GDP and to the sum of the inflation target and growth of potential GDP. Thus, taking into account the level of nominal interest, similar to that in the equivalent period in 1998, and the expansion of activity in the financial market, which also requires the use of the money supply, it appears that the actual increase in the money supply is not out of line with the demand for it. SROs (interest-bearing overnight deposits) rose slightly faster than the money supply, while fixed-term local-currency interest-bearing aggregates (for up to one year) rose much faster, by more than 20 percent, only slightly below their rate of increase in 1997-98. Foreign-currency deposits grew reasonably from the beginning of the year, but the volatility of the changes in them, paralleling developments in the foreign-currency market, is noteworthy.
Nondirected bank credit grew by 13 percent, in annual terms, until September. This is faster than the rise in nominal GDP, but slower than the rate in previous years. Unindexed credit and CPI-indexed credit both increased at rates similar to that of the total aggregate. Credit in or indexed to foreign currency expanded at a rate similar to local-currency credit, after falling at the end of 1998 in view of the pronounced changes in the foreign-currency market and the greater risk and uncertainty associated with taking such credit. There were changes in the characteristics of foreign-currency credit taken, however, it being less widely dispersed, taken by a small number of companies, and mainly long-term.
Share prices rose by about 30 percent till September, and turnover was higher than in 1998. This occurred mainly in the first five months of the year. Although there is not always a strong connection between developments in stock markets abroad and the Tel Aviv Stock Exchange (TASE), the experience of the TASE was consistent with the weakening of the effect on the global economy of the world financial crisis which erupted in 1998, and with the continued surge in the US financial markets.
