ECONOMIC OUTLOOK
September 13, 1999

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Main Remarks
Recent Economic Developments
Macroeconomic Developments, 1997 - 2000
Forecast for Economic Developments in 2000
Underlying assumptions and risk factors in the 2000 forecast
Reduction of the deficit law
Current Economic Indicators


Note: the economic analysis of 1999 and the forecast for economic developments in 2000 are based on data published by July 1999.

Main Remarks

This edition of Economic Outlook begins by describing recent economic developments, foremost with reference to the National Accounts data for the first half of 1999. The data, which point to a standstill in growth of economic activity (and a decline of 2 percent per capita), justify and necessitate further inquiry-an inquiry that provides several reasons for cautious flickers of optimism. Some observers regard another recently released figure-a steep 24 percent increase of sales of new dwellings-as one of the indicators that portend the end of the slump. This figure, like the National Accounts data, requires further observation, and this additional look prompts us to delete it from the list of indicators that point to a turnabout.

A third indicator-one that does not lend itself to superficial analysis-is the standstill in non-diamond industrial exports and the decrease in one of its components: high-tech exports. This development, most of which is explained by a decrease in world demand, occasioned by the crises of the past few years, evokes concern, although these exports have been recovering consistently in the past few months.

This publication presents the macroeconomic forecast for 2000, including its components and underlying assumptions. Growth next year is expected to climb to 3 percent and the unemployment rate will probably dip slightly relative to 1999. We expect growth to pick up next year for four reasons: a decline in the dampening impact of the decrease of immigration on domestic demand, petering out of the downward phase of the business cycle, the favorable effect of bimillennium tourism, and a recovery in world economic activity. Our analysis of expected developments in 2000 also relates to economic policy and its effect on the economy over the next few years. The analysis was written after the 2000 - 2001 inflation target of 3 - 4 percent, a package of dozens of structural changes, and the spending ceiling and composition of the budget were approved, and after the taxes needed to meet the budget deficit target-2.5 percent of GDP-were set forth. The extent to which each of these resolutions (taken in the past few weeks) is met will affect the state of the economy in the years to come.

We also list factors of uncertainty that may keep the forecast from coming to pass, for better or worse. Such factors exist every year, but two of them are unique to 2000 and occupy a central position in the forecast: the effect of the Y2K bug and the impact of bimillennium tourism. Another important factor of uncertainty pertains to the new government's performance and the complexion of its economic measures. The government's resolve and executive ability will be tested in the upcoming period and will affect the business sector's economic decisions. Another uncertainty factor pertains to the peacemaking process; our forecast assumes that no dramatic political and security events will occur, for better or worse.

This publication concludes by referring to an amendment-the third-to the Reduction of the Deficit Law. We examine the turnabouts that this statute has experienced, the extent of compliance with its provisions, and its advantages and drawbacks; we also compare Israel's deficit law with similar laws in other countries. Although the background factors are totally different, the basic principles invoked by various countries that chose to reduce their budgets by legislation, or to stipulate a balanced budget by legislation, are strikingly similar.

Recent Economic Developments

Non-diamond industrial exports have increased somewhat in the past few months, but the level over the past twelve months only slightly exceeds that in the previous twelve months. Stagnant if not decreasing exports have been typical of the traditional industries for the past few years. This year, for the first time, this effect has embraced the high-tech industries as well.

The recent monthly indicators have been overshadowed by preliminary National Accounts estimates that point to a standstill in GDP growth in the first half of 1999 relative to the previous half-year. The estimates fall short of the forecast and suggest that the economic slump is worsening. However, a slightly closer look at the data points to several developments that are interesting and somewhat encouraging. The steep increase in investment, a favorable sign in anyone's view, corresponds to the Bank of Israel's survey of companies and the Manufacturers Association's expectations survey, which were dominated by an optimistic tenor with respect to expected economic developments in the near future.

The National Accounts Data

The National Accounts data for the first half of 1999, released by the Central Bureau of Statistics, indicate that the downturn in activity has worsened although the composition of demand showed a somewhat encouraging change.

The per-capita GDP graph indicates that the downtrend that has continued monotonously for the past two years shows no sign of leveling off, let alone turning the corner. The first-half 1999 data are especially troubling in view of the fact that, for the first time since the downturn began, Gross Domestic Product of the business sector declined during the first half of 1999 relative to its level in the preceding half-year. (Total product still grew.) Below, however, we take exception to this gloomy presentation in several ways.

When the CBS released the second-quarter 1999 data, it revised the data for previous quarters and years in view of additional data that it had received and processed. Thus, the CBS added 0.2 percent to the growth rate for each of the years 1997 and 1998, pursuant to several previous upward adjustments. This is an important point because it is not random; after additional data are received and processed, it is altogether possible that the 1999 figures will also be adjusted upward.



Examination of the rates of (non) growth, and its composition, points to several characteristics:

Although the slowdown has deepened, the composition of sources and uses today is totally different from the composition in the past two years. The data portray an economy that is expanding its investments at a very rapid pace. This abrupt turnaround provides a reason for cautious optimism, especially when exports are growing handsomely as well. However, all of the investment sources are imported. Demand for machinery and equipment of domestic manufacture has not increased and neither private consumption nor production is recovering. (On the contrary, the monthly indicators point to a decline.) Only imports are surging.

Relatively swift expansion of exports - Although the monthly foreign-trade data point to a severe slowdown in non-diamond industrial exports, the real figures point to a growth rate of 8.5 percent (in annual terms) in the first half of 1999 versus the previous half. The National Accounts data include not only non-diamond industrial exports but exports of diamonds and services, both which are showing are a clear uptrend. Exports of tourism services are also increasing after a deepening three-year slump. The situation in exports of non-diamond goods, although inauspicious, has been improving in the past few months. (This is discussed at greater length below.) By inference, most of the growth shown in the CBS data originates in exports of services, not of goods.

Selected Macroeconomic Indicators-Real Percent Change



Imports of Goods, Quantity Change, by Components


Total imports of goods Imports net of ships, aircraft, diamonds, and fuel Consumption goods Production inputs (excluding diamonds and fuel) Capital goods (excluding ships and aircraft)
Quantity Percent Change



1997 1.5 0.2 2.7 1.3 -4.8
1998 0.6 3.9 3.5 4.6 2.0
First-half 1999 vs. first-half 1998 9.4 5.2 0.5 3.8 14.2


Source: CBS

Vigorous iin imports - This is the most salient figure of all. The rapid growth in this indicator is the source of the stepwise increase in the growth rate of total uses. As the table shows, the main factor in the increase is capital goods. Israel's terms of trade continue to improve in the first half of the year, dollar-nominated import prices falling by a very significant 5.3 percent (despite an increase of more than 20 percent in fuel prices in the second quarter of the year) and export prices decreasing by only 0.9 percent. This improvement, which has been taking place since 1996, is helping Israel improve its balance of payments.

Steep increase in investment - After two straight half-years of decline, this indicator rose very strongly in the first half of 1999, possibility signaling a turnabout in business-sector expectations.

Continued decrease in construction activity - Here there is nothing new to report. The level of construction activity is continuing to adjust itself to the lower level of demand occasioned by the decrease in immigration.

Sluggish growth of private consumption - In the past few years, Israel experienced a rather strong upturn in private consumption in tandem with falling per-capita GDP. The fact that the economic slump has evolved into a decline in per-capita private consumption indicates that the turnabout in the business-sector expectations, as reflected in various surveys, and the strong increase in investments have not penetrated the household sector.

To analyze the data a little more deeply, several comments are needed:

The quarterly National Accounts data are provisional, as the CBS stresses. They are flawed not only by a high degree of volatility but also by retroactive corrections that are significant (and that sometimes make the new data irrecognizable). For example, when the first-quarter 1999 figures were initially released about three months ago, they reported a growth rate during that time of 1.3 percent in annual terms. This figure was corrected in the data released this month; now it turns out that GDP decreased in the first quarter by 1.1 percent. Therefore, we strongly recommend that one disregard developments described in a single quarter and wait for half-years at least (and apply due caution even then).

The retroactive adjustments in the annual CBS data are almost always upward and extend backward for years. The first estimate of the 1997 growth rate (October 1997) was 1.9 percent. The most recent CBS publication, released almost two years later, points to a much higher rate: 2.9 percent. It is altogether possible that this will recur with respect to the 1999 figures.

Several sales of start-up companies, in significant sums, are already known to have occurred in the first half of 1999. Sales in hundreds of millions of dollars-the return for a product or a service developed-will eventually be added to the GDP figures for 1997, 1998, and/or 1999-depending on when the activity took place. It may take a year or two to recognize and record real activity in the first half of 1999.

High-Tech Exports-Have We Lost Our Touch?

One of the salient characteristics of the past few years is the unprecedented blossoming of high-tech export industries and the concurrent decline of traditional industries. The graph below shows dollar rates of change in the exports of non-diamond industries, with high-tech industries marked in darker color. (Since the dollar-denominated prices of products in most industries declined last year, the quantity rates of change in most industries are greater than the dollar rates of change shown in the graph.)



The abrupt structural change-from traditional to high-tech industries-stems not only from a natural process that all Western economies have been experiencing but from policy measures as well. The main ones follow:

Import-liberalization policy - In one of the most important structural changes Israel has made in the past few years, non-tariff barriers (prohibitions and restrictions created on various pretexts) have been replaced since 1991 with very steep tariffs that diminished steadily to low or zero rates on a predefined trajectory over a specified period of time. The reform has had far-reaching implications in matters such as price levels, growth rates of private consumption, saving on foreign currency, and the composition of imports in terms of goods and countries of origin. It has also affected the composition of Israeli production: enterprises that had been protected from foreign competition until the reform were forced to lower their prices and compete for the consumer's wallet. Many succumbed to cheaper and, at times, higher-quality products and shut their doors. Capital-intensive enterprises replaced labor-intensive ones and utilized the resources thus released.

Minimum wage - In 1997, the minimum wage was raised by law from 45 percent of the national average wage to 47.5 percent. (The effective rate of increase was greater because several criteria in computing the minimum wage were deleted from the definition.) The traditional industries' wage costs increased (and would have risen even more steeply were it not for the shameful fact that compliance with Israel's minimum-wage law is very low), helping accelerate the outflux from these industries. One traditional industry stands out for its success in adjusting to the changing conditions: domestic textile enterprises moved some of their production lines to countries and areas-Jordan, Egypt, the Palestinian Authority-that pay much lower wages than Israel's.

Monetary policy - The tough monetary policy applied in the past few years has had different effects on different industries. High domestic interest rates and the strong sheqel have been more harmful to traditional industries than to high-tech. Traditional industries cannot raise money in domestic and overseas capital markets as high-tech companies can. Moreover, high-tech companies have higher earnings ratios and, in some cases, unique products, making it easier for them to contend with a strong currency by raising prices and/or reducing margins. Manufacturers of traditional products find this harder to do.

Government policy - The efficacy of government policy in supporting R&D and the possibility of improving is again being debated. Without delving into this specific issue, one may definitely point to the favorable contribution of this support and of the generous support, which has commanded less attention, that is given by means of significant tax relief.

These four policy decisions are converging with natural processes-technological progress, a large influx of well-schooled immigrants with experience with technological fields, and changes in world demand-to accelerate the changeover from traditional to high-tech industries.

The high-tech export data gave Israel a fail-safe cause to pat itself on the back for three years-until the middle of 1998, when even this sector of industry joined the export slump that came into view. The graph below shows rates of change in industrial exports in the first eight months of 1999 relative to the corresponding period in 1998. Like the graph that shows the 1998 growth rates, this graph speaks for itself and, in this case, clearly signals the existence of a problem. In the past few months, however, the downtrend in industrial exports has been arrested and the upturn has resumed.



In view of the sharp turnaround in high-tech activity-from double-digit growth to steep decreases-an attempt to discover the causes must be made not only at the macro level but in the micro domain.

Inquiries about the condition of several companies shows that some firms have indeed run into difficulties, which were said to be temporary and that stemmed from specific problems at the company or in its industry. One of the companies had not received the go-ahead to place a new product on the market, another has had very low growth rates for some time, a third was sold off along with all of its domestic activity, and a fourth company claimed that its customers have been spending heavily (in capital and in labor) to prepare for the Y2K bug, thereby depressing demanfor new technological systems. All of these are micro-economic explanations.

Several companies explained that the crises in Southeast Asia, South America, and Russia had affected demand from those regions. Even though these regions usually do not figure importantly among the export targets of Israeli firms, they were definitely among the targets that had had the strongest growth rates. Notably, quite a few firms replied, "Everything's okay here." To reconcile this answer with the dollar decreases in exports, one may note the steep depreciation of the sheqel. This increased the companies' profitability and, therefore, enhanced earnings even if exports did not increase.

The most important reason for the abrupt turnabout in exports seems to be the slowdown in the growth of world trade. In the estimation of the International Monetary Fund, world trade grew by a sluggish 3.5 percent per year in 1998 - 1999 as against 6 - 7 percent in previous years. The steep downturn traces to world crises that originated in Southeast Asia and Russia (in 1997 - 1998) and in Brazil (1999). These crises actually had a favorable effect on Israeli exports until about a year ago; until then, the decrease in demand for exports had not been felt and the decreases in world prices of goods were helpful to Israeli manufacturers. The negative effect of the crisis was felt only later on-apparently because long-term contracts concluded before the crises depressed demand. As stated, the decline has been halted in the past few months.





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