The recession which has been in evidence since the end of 2000 continued and deepened in 2002. GDP per capita contracted by 3.1 percent, due to the stagnation of private consumption and a marked reduction in investment and exports. The recession encompassed all the principal industries, which suffered from the contraction of demand; labor productivity and total factor productivity continued to decline, and the drop in profitability further undermined the stability of firms. The standstill in economic activity affected the labor market: the real wage was eroded by 5.7 percent, and the unemployment rate rose from 9.3 percent in 2001 to 10.3 percent. The contraction of households' current income, the erosion of financial assets, and the internalization of the depth and persistence of the recession-in the context of the worsening of the liquidity constraint-led to a steep drop in both private consumption and the private saving rate.

The recession is the outcome of two negative shocks-the exacerbation of the armed conflict with the Palestinians (the Intifada) and the economic slowdown and crisis in the global high-tech industry. In contrast with 2001, when the loss of GDP due to the Intifada was similar to that incurred as a result of the fall in demand for Israel's exports, in 2002 the Intifada was the chief cause of the contraction of economic activity. According to a new aggregate estimate, the direct economic damage due to the persistence of the Intifada in 2002 was between 3.1 and 3.8 percent of GDP. The fall in exports resulting from the global economic slump cut GDP by 1.4 percent in 2002.

In this difficult year economic policy could-and should-have bolstered stability and mitigated the negative effect of the external shocks. Just before the beginning of the year an understanding was reached between the Ministry of Finance and the Bank of Israel regarding coordinated policy measures which would have expressed fiscal restraint alongside monetary expansion-a policy mix which would have helped to contain the economic deterioration. The agreement was not implemented, however, because the 2 percentage-point reduction of its key interest rate by the Bank of Israel in December 2001 was not accompanied by the fiscal measures intended to support it, thereby leading to simultaneous fiscal and monetary expansion. Given these conditions, especially in the context of the exacerbation of the security situation at the beginning of the year, there was sharp local-currency depreciation, which was rapidly translated into protracted price increases, which overshot the inflation target by far, further imperilling the stability of the financial system. These developments required vigorous measures aimed at monetary restraint and fiscal consolidation, namely, a steep rise in the Bank of Israel's key interest rate, and a fiscal adjustment combining heavier taxes and cuts in both transfer payments and government spending while realigning the deficit target upwards. The swings in economic policy were not beneficial, and the high level of real interest towards the end of the year, as well as the increased likelihood that the deficit target for 2002 will not be attained, do not improve the chances of emerging from the recession.

The slump in the labor market persisted in 2002, with the deepening of the recession due to the continuation of the security unrest and the global slowdown. The slump was expressed in the 1.1 percent decline in the number of persons employed in the business sector, with a slight rise in hours worked per employee. The unemployment rate rose steeply, and averaged 10.3 percent. The participation rate dipped by 0.2 percentage points, in contrast with the long-term upward trend, offsetting 0.5 percentage points from the rise in the unemployment rate. The continued rapid expansion of public-services employment (by 3.1 percent) worked in the same direction. Although the decline in the employment rate encompassed most of the business sector, the 3.9 percent contraction of employment in manufacturing was notable. The number of foreign workers remained unchanged, and employment of Palestinian workers declined.

The nominal wage per employee post fell by 0.4 percent in 2002, an occurrence not seen in the past. The real wage was eroded by 5.7 percent-something that has not happened since the 1980s-explained primarily by the recession, but also by the unexpected inflation, the absence of a valid cost-of-living agreement until the end of the year, and the freeze imposed on the minimum wage. The decline in business-sector wages was led by financial and business services, where there had been a marked increase in 2001. Real unit labor cost in the business sector rose by a moderate 1.3 percent in 2002 due to the decline in labor productivity, but this was partly offset by the erosion of the real wage.

In 2002, as well as in the Arrangements Law accompanying the 2002 budget, far-reaching legislative changes were introduced which substantially cut transfer payments, especially to recipients of child allowances, income support, and unemployment benefit. The object of the legislation was primarily to bring down growing fiscal costs, as well as to encourage participation in the labor market, thereby increasing households’ income. In the absence of a comprehensive system analyzing recipients’ needs and helping them to find employment during a period of rising unemployment, and without a reduction in employment of foreign workers, poverty will increase.

Fiscal policy in 2002 had to contend with the repercussions of the expansionary budget submitted to the Knesset in October 2001, a modified version of which was approved in February, and with the effect of the deterioration in the security situation and the recession. Against this backdrop, with the budget deficit expanding rapidly in the first half of the year and the financial shocks intensifying, the government had to implement an economic emergency package in order to help restore economic stability. The package attained its main objective and checked the expansion of the deficit for the moment, although at a level that was well above the target set at the beginning of the year. Most of the deficit reduction was achieved by raising the tax rate, an approach which hinders current economic recovery and will hamper sustainable growth in the future, once the security situation and economic activity allow this. Moreover, basing the recovery on short-term measures, some of which will expire by the end of 2002 while others are based on accounting adjustments, confronts the government with the extremely difficult task of inspiring confidence in its commitment to reducing the deficit.

At the end of 2002 the deficit stood at 4.0 percent of GDP, in line with the target set in the middle of the year, but above the 3.0 percent target determined when the budget was approved. The deficit in 2002 was larger than it was in 1993, so that after a decade of deficit reduction targets there has been retreat in this sphere. The (gross and net) public debt/GDP ratio, which returned to the level of the mid-1990s, also attests to a lack of progress in attaining the fiscal targets set by the last few governments. Although the special circumstances of 2001-2002 served to increase the deficit, a long-term comparison adjusted for the effect of the business cycle and security expenditure shows that there was no progress in this respect, and this is particularly prominent in view of the marked progress made by the developed countries. Since no fiscal adjustment was made in previous years, when economic activity expanded more quickly and the security situation was relatively stable, the government had to adopt fiscal restraint just at a time-the second half of 2002-when economic activity slowed and security needs rose.

The general government deficit, which is the generally accepted aggregate for the fiscal stance, was 5.2 percent of GDP in 2002-up by more than 2 percentage points over 2001. The general government expenditure/GDP ratio, which is larger than in any other developed country, continued to rise in 2002, because of the persistent rapid real rise in public consumption-both civilian and security-and not solely because of the decline in GDP. Nonetheless, the increase in public-services wages slowed in 2002, and per capita transfer payments even declined after years of very rapid expansion. In addition, investment in the transport infrastructure rose appreciably in 2002 (by NIS 1 billion), an appreciable development in view of the effort to check the rise in the deficit.

In 2002 the government made several decisions with long-term fiscal implications: to gradually reduce the deficit to 1 percent of GDP by 2007, to increase infrastructure investment, reform income tax rates, involving a marked reduction in net receipts by 2008, and at the end of 2002 to permit the expiry of part of the tax hikes and cuts in transfer payments implemented in 2002 as emergency regulations. However, an examination of the internal consistency of the various decisions shows that without large and ongoing cuts in current expenditure the government will not be able to adhere to them all, the deficit will be significantly greater in 2007 than in 2002, and the government debt/GDP ratio will continue to grow.

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The relative stability in the exchange rate and prices during the previous three years was disturbed in 2002. The consumer price index rose by 6.5 percent, far above the targeted range of inflation for the year of 2 to 3 percent. The exchange rate of the shekel against the dollar rose by 9.8 percent,1 and the volatility of the exchange rate increased considerably. Concurrently, the slowdown in activity prevailing in the economy for the past three years intensified: Business sector GDP and business sector employment fell by 3.1 percent and 1.2 percent respectively, while the unemployment rate rose to 10.3 percent. Government borrowing increased greatly in 2002, and the government debt expanded by 9.0 percent of GDP.

The supply of sources for credit from abroad decreased, against the background of the uncertain security situation, the continued slump in domestic activity and the continued worldwide economic slowdown. The reduced supply coupled with the large increase in government borrowing pushed up the cost of raising capital for the public sector and private sector appreciably. This was reflected by a large and consistent rise in real interest rates.

The unexpected 2 percentage point cut in the interest rate at the end of 2001 (see below) and the fiscal expansion during the first half of 2002 (in contrast to the government decision) led to increased uncertainty and to instability in the financial markets. This was apparent inter alia from the large fluctuations in the exchange rate and share prices, the large and consistent increase in nominal and real interest rates and from other indicators (see Chapter 2).

The exceptional rise in the exchange rate and in prices occurred in the first half of the year. Due to this situation and in order to adhere to the long-term inflation target, the Bank of Israel raised the monetary interest rate by 5.3 percentage points during the first half of the year, from 3.8 percent at the end of December 2001 to 9.1 percent in July 2002. Most of the rise in the interest rate (a cumulative increase of 4.5 percentage points) was made in the interest rate that was set for the months June and July. These monetary measures, along with the government's decision to adjust the State budget, stopped the upsurge in the exchange rate and prices. During the second half of the year, prices rose by only 0.4 percent in annual terms, although the large fluctuations in the price index continued. However, nominal and real interest rates for all terms remained high throughout the second half of the year, as did the uncertainty and instability in the financial markets.

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The consumer price index rose by 6.5 percent in 2002, considerably more than the 2.3 percent level of inflation targeted for the year. A major difference was apparent between the first and the second half of the year: During the first half, prices rose by 6.3 percent along with a large rise in inflation expectations. In the second half, prices increased by a moderate rate of only 0.2 percent, and inflation expectations fell, although they only reverted to within the targeted range of inflation towards the end of the year.

Economic developments during 2002 were affected by the economic program that was implemented at the end of 2001. Apart from structural changes in the financial markets, this program included a one-time 2 percentage point cut in the Bank of Israel's interest rate to 3.8 percent, and a government decision (which was not implemented) to revert to fiscal restraint that would lead to a downtrend in the budget deficit. At the time, it was believed that these changes would result in a one-time exchange rate adjustment (which would be reflected by a real depreciation) and a decline in interest rates for all terms without undermining financial stability and price stability.

The exchange rate rose appreciably and continually during most months of the first half of the year, to a greater extent than was expected. The level of uncertainty, as reflected by the implied volatility in foreign currency options, also rose sharply. Background developments in this respect were as follows:

It soon became clear that the government would be unable to revert to a fiscal contraction, as was apparent from large-scale government borrowing and from the frequent rises in the budget deficit target for 2002 and the following years. The security situation deteriorated, culminating in Operation Defensive Shield in the second quarter of the year. The government attempted to restrict the Bank of Israel's ability to maintain price stability by adopting a proposal to change the Bank of Israel Law. Concurrently, the public redirected their investments from unindexed shekel assets to dollar assets, nominal and real bond yields rose sharply, the inflation expectations derived from the capital market and from analysts' forecasts increased, and a real threat to financial stability and price stability was perceived. All these factors were expressed by a large rise in inflation expectations, which also reflected the loss of the public's credibility in macroeconomic policy. As a result of these developments, the Bank of Israel raised the interest rate for June and July by a cumulative rate of 4.5 percentage points, following two interest rate hikes by a cumulative rate of 0.8 percentage points during the first half of the year.

Following the interest rate hikes, the markets were calm during the second half of the year in comparison with the first half: Prices rose by only 0.2 percent, and the exchange rate fell (during most of the period), the bond markets were relatively calm, and the inflation expectations derived from the capital market declined (during most of the period), although they remained above the inflation target. The decline in inflation expectations was not consistent. This was because of various developments, such as the lowering of the three largest banks' credit rating in September, the threat of war with Iraq in the last quarter of the year and the geopolitical situation in Israel, which created uncertainty in the markets and halted the decline in inflation expectations. Although inflation expectations reverted to within the targeted range of inflation and despite the relative calm in the markets, the level of uncertainty in the markets during the second half of the year was higher than in the past.

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The value of the public's portfolio of financial assets fell by 5 percent in 2002 and totaled NIS 1,214 billion, after rising in real terms since 1995. Two major developments in the portfolio during the year were the large decrease in share prices in Israel and abroad, which was the main reason for the decline in the portfolio's value, and the move from unindexed shekel assets to CPI-indexed assets or foreign currency assets.

The positive trends in the composition of the asset portfolio during the last decade came to an end in 2002. The growth in the proportion of unindexed shekel assets that began in 1993 ceased, concurrent with an increase in the proportion of CPI-indexed assets, which had fallen consistently since the mid-1990s. This development reflected the increased uncertainty over the development of inflation in the course of the year. But in the foreign currency component and the share component of the portfolio, the trends characteristic of the previous years became stronger: The proportion of foreign-currency denominated and indexed assets increased, due to the positive accrual of assets of this type and the depreciation of the shekel, and the proportion of shares in Israel and abroad decreased as a result of the large downturn in the equity markets.

The structural development of the asset portfolio was not uniform throughout the year: During the first half of the year, the public increased the proportion of CPI-indexed and foreign currency indexed assets, and reduced the proportion of unindexed assets in the portfolio due to the large depreciation of the shekel and expectations that this depreciation would continue, and as a result of the rise in inflation expectations. During the second half, following the interest rate hikes in June and after the foreign currency market had become more stable and inflation expectations had fallen, the public increased the proportion of un-indexed assets without changing the proportions of CPI-indexed and foreign currency assets. The developments in the portfolio during the second half of the year only partly offset the structural changes that occurred in the portfolio during the first half.

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Yields-to-maturity on government bonds and Treasury bills rose during 2002, after falling in 2001. In the equity market, prices fell heavily for the second consecutive year concurrent with the downturn in share prices abroad.

The development of yields-to-maturity on unindexed bonds was not uniform in the course of the year. During the first half of the year, yields-to-maturity, on CPI-indexed government bonds, unindexed bonds and Treasury bills exceeded their level in 2001, and the slopes of the yield curves became positive and steeper. In the same period, the implied volatility of shekel-dollar options issued in the Bank of Israel's weekly tenders rose considerably leading to a very large growth in turnover in options and futures contracts in the stock market and in the banking system.

During the second half of the year, following consecutive increases in the Bank of Israel's shekel interest rate, the large upturn in yields ceased, and the slopes of the Treasury yield curve became negative, reflecting expectations of a reduction in the interest rate within the term of the year. However, the level of bond yields and the level of uncertainty during that period, as reflected by derivatives trading, remained high. Yield developments during 2002 were accompanied by a large growth in average daily turnover in CPI-indexed bonds, Shahar fixed-rate unindexed bonds and Treasury bills series.

Although subject to uncertainty, the markets managed to function well as investors engaged in diverse areas of activity, and turnover in assets and derivatives increased.

The composition of the government's issues of trabable bonds changed during the second half of the year. Issues of unindexed bonds decreased, issues of CPI-indexed bonds increased, and the term-to-maturity of the bonds that were issued contracted.

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Institutional investors' share of the public's asset portfolio amounted to 36 percent at the end of 2002, much the same as that at the end of 2001. A decrease in the proportion of provident funds, advanced study funds and mutual funds was offset by an increase in the proportion of life insurance plans and new pension funds. However, the proportion of institutional saving in the public's asset portfolio was lower than at the end of the 1980s, when it exceeded 50 percent.

The public chose to withdraw money from the provident funds, the advanced study funds and the mutual funds in 2002. The continued withdrawal of money from the provident funds is attributed to the fall in prices in most forms of investment and especially in the equity market, which adversely affected the provident funds' yields. The withdrawals from the advanced study funds and the mutual funds during the year marked a change in trend compared with previous yields, and resulted from the negative real yield that the funds achieved in 2002 compared with a positive real yield in previous years.

During the first half of 2002, institutional investors channeled their funds into CPI-indexed and foreign currency indexed holdings, mainly at the expense of their investments in shares and unindexed holdings, emulating the trend apparent in the public's financial asset portfolio. This change resulted from the matching of financial asset holdings to developments in actual and expected inflation. During the second half of the year, this trend became less noticeable due to the decline in inflation expectations and to the stability in the markets. Institutional investors increased their unindexed holdings to some extent, at the expense of their investments in CPI-indexed holdings.

Until 2002, the overseas investments of the provident funds, pension funds and life insurance plans were restricted to 5 percent of their total assets. This limitation was raised to 20 percent at the beg-inning of the year, and was abolished completely on January 1, 2002.

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The management of the foreign exchange reserves portfolio, whose average level in 2002 was $ 24 billion, is subject to the Bank of Israel Law 5714-1954 and the relevant legal interpretations which have been added over the years, together with a set of rules which reflect the Bank's responsibility for the reserves.2 Against the background of the changes in macroeconomic policy and exchange-rate policy, the role played by the reserves has also changed: currently, their main functions are to support financial stability in the economy, to provide a safety net for emergency situations, and to afford the government flexibility in dividing its liabilities between NIS and foreign currency. These aspects of the role of the foreign reserves are similar to those of the reserves of other countries that are comparable to Israel with regard to their macroeconomic policies and their exchange-rate regimes. Studies of the levels of the reserves held by those countries suggest that the level of Israel's reserves is not very different from its expected level.

The holding-period rate of return on the foreign exchange reserves in 2002 was 5.2 percent, down from 6.4 percent in 2001. This reflected the reduction in yield to maturity in capital markets that resulted from the persistent worldwide slowdown in economic activity and the worsening stock market crisis on the one hand, and the low yield to maturity, mainly in the US market, on the other. In NIS terms the holding-period rate of return in 2002 was 17.8 percent, compared to 14.9 percent in 2001, reflecting NIS weakness in these years against the currencies in which the reserves are invested.

The yield on the reserves is greatly affected by the composition of the neutral benchmark, due to the relatively low risk taken in the portfolio, a risk that derives from deviations from the benchmark. Much effort has been invested in the last few years in the area of asset allocation (securities not in the benchmark), while on the other hand the scope of positions in the areas of duration and currency management has declined, in accordance with the policy of reducing exposure in these fields. In 2002 the holding-period rate of return was 20 basis points higher than that on the benchmark; this yield differential reflects the contribution of portfolio asset management.

Asset-selection decisions contributed 20 basis points to the yield differential in 2002. This derived from investment in Treasury Inflation-Protected Securities (TIPS) (6 basis points), Eurobonds (6 basis points), mortgage-backed securities issued by the Government National Mortgage Association (GNMAs) (5 basis points), and securities-lending activities (3 basis points). Currency management contributed 3 basis points, while the duration management contribution was a negative 2 basis points.

The exposure of the reserves to the banking system is limited to 25 percent of the value of the portfolio. In 2002 the exposure averaged 20 percent, about half of which was used in securities-lending activities, which have a very short investment horizon. The exposure is managed under a system of quotas and rules which plays a central role in the credit-risk management of the portfolio.

The liquidity of the reserves, that estimates the proportion of the portfolio that can be realized quickly without reducing its value, is very high: 90 percent of the reserves portfolio is invested in very liquid assets, and the rest in assets with lower liquidity. Bearing in mind the high level of the reserves, it seems that the level of liquidity is satisfactory. The high liquidity of the reserves is due on the one hand to the Bank of Israel Law and to the investment policy derived from the spirit of the Law that requires conservative management of financial risks, and on the other hand to considerations of profitability, which in the last few years have led to only partial use of the degrees of freedom to invest in assets with low liquidity.

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During the year 2002, the NIS (New Israeli Sheqel) depreciated against the currency basket by 13.0 percent and against the US dollar by 7.3 percent. The difference reflects the weakening of the dollar against the other currencies in the basket-euro, sterling and yen. Between December 19, 2001 and December 31, 2002, the NIS depreciated by 16.6 percent against the currency basket and by 11.2 percent against the dollar-this period includes the weakening of the NIS which occurred in late December 2001 as a result of the exceptional two-percentage-point reduction of the interest rate. On December 31, 2002 the representative rate of the NIS was set at 4.737 against the dollar and 5.0467 against the currency basket.

During the first half of the year, the NIS weakened almost continuously, reaching its weakest levels of the year in mid-June at 4.994 against the dollar and 5.1674 against the currency basket, a depreciation of 13.1 percent and 15.5 percent, respectively, from its levels at the beginning of the year. During the second half of 2002 the NIS strengthened somewhat. The exchange-rate trend was more varied and the trading range was more moderate than they had been in the first half of the year.

The primary factors affecting the NIS exchange rate during 2002 include the change in the mix of macroeconomic policy-to monetary expansion, marked by the exceptional two-percentage-point reduction in the interest rate, and fiscal contraction, which was not upheld-announced in late December 2001, slack fiscal discipline and a growing budget deficit, the interest-rate differential between the NIS and the US dollar which widened sharply, especially in the first half of the year, an erosion of confidence in economic policy which contributed to concerns of a financial crisis, net capital outflow from Israel and other geopolitical risks including an exacerbation of the security situation and the threat of war against Iraq.

The volatility of the NIS/dollar exchange rate was 8.3 percent in 2002, more than double the rate of 4.0 percent in 2001. In spite of this rise, the volatility of the NIS is still lower than that of other currencies, both of emerging and advanced economies. Probable reasons for this include minimal offshore trading, a low level of speculative activity, and the exchange-rate band, which can impose a limit on volatility.

The average daily turnover of foreign exchange in Israel's foreign currency market reached $ 5.2 billion in 2002, representing a 20 percent increase over 2001 and an 89 percent increase from the 2000 level. The growth of the market in recent years may be attributed in large measure, although not exclusively, to the increased participation of foreign financial institutions, acting on their own behalf and on behalf of their clients. Foreign exchange turnover includes activity in the NIS/FX market as well the non-NIS sector (i.e. FX/FX) and the foreign-exchange-indexed sector of the market. The growth rate of the NIS/FX sector of the market-12 percent in 2002-was slower than in previous years, perhaps due to the market's maturity and its approaching equilibrium.

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Israel's external and foreign-exchange activity showed a contraction in the volume of balance-of-payments activity in 2002, and various developments threatened financial stability. These were the results of the cumulative negative effects on the economy of internal and external shocks, and macroeconomic policy that did not react appropriately to the deterioration in the economic situation.

The reduced volume of balance-of-payments activity on both the current account and the financial account reflected the worldwide slowdown, the slump in the high-tech industries and the crisis in international financial markets combined with the security-related events in Israel. Most of these factors also acted to increase the current-account deficit; their effect was offset by Israel's economic recession that tended to reduce imports, and by real depreciation of the NIS. As a result the current-account deficit stabilized at about 2.1 percent of GDP in 2002, similar to its level in previous years.

The crisis in international financial markets and in issues of high-tech companies led to the cessation of such offers abroad by Israeli companies, so that the sharp reduction in the inflow of long-term capital continued in 2002.

The most marked effect of the external events in 2002 on nonresidents was a fall in their direct investments in Israel. These investments, which in the past acted as a stabilizer as they were less affected by short-term considerations, declined for the first time to a level lower than in the years prior to the 'bubble' of 1999-2000. This was due to the realization that the world crisis, particularly in high-tech, was an extended one. Moreover, nonresidents assessed that the risk in investing in Israel rose in 2002, so that their special deposits in Israel went down by $ 0.8 billion, the first time they had fallen in many years.

The total of Israelis' investment abroad fell in 2002, and its composition changed: while their direct investment remained stable and their portfolio investment actually increased, other investments fell. A notable feature was the rise in households' deposits abroad, which was due to the rise in Israel's risk assessment among other things. Since 2001 the nonbanking private sector has had a net capital outflow, and this strengthened in 2002 due to domestic developments, while the public sector and to an even greater extent the banking sector offset this with net capital inflow.

Macroeconomic policy did not react appropriately to the economic developments and external shocks, and undermined financial stability: (i) The budget was based on an assumption of renewed growth-an assumption that resulted in a rise in the deficit-and was amended in the light of the recession only in mid-2002, and even then it still involved a rise in the deficit. (ii) Based on a government undertaking to reduce the deficit, the Governor of the Bank of Israel made a surprisingly steep cut in the interest rate at the end of 2001, and when it became apparent that the government was not meeting its commitment, the Bank raised the interest rate sharply in the middle of 2002. (iii) In addition to the above there was public disagreement and a lack of coordination between the Ministry of Finance and the Bank of Israel that peaked when at the beginning of 2002 the Ministry proposed an amendment to the Bank of Israel Law without coordinating with the Bank-an amendment that would have weakened the commitment to the target of price stability and the Bank's ability to act towards its achievement.

The damage caused to 'external financial stability,' i.e., stability related to the economy's activities vis-a-vis abroad and in foreign currency, could be seen in various parameters in the NIS/foreign-exchange market and in Israel's credit risk: the NIS depreciated rapidly in the first half of the year in two stages, with a pause in March; exchange-rate risk, expressed by the implied standard deviation of NIS/dollar options, rose sharply at the end of 2001 and remained high throughout 2002; households increased their demand for foreign currency and foreign assets; Israel's credit-risk premium rose, and the international rating agencies announced their inclination to lower Israel's credit rating.

At the end of the first half of the year the Bank of Israel raised the interest rate by a cumulative 4.5 percentage points in order to prevent financial and price stability from being harmed, and the government introduced tight fiscal measures. The combined effect of these steps was marked: the NIS appreciated rapidly after its long depreciation, and inflation expectations fell. The implied standard deviation, however, indicating exchange-rate risk, remained significantly higher than at the end of 2001.

In contrast to these negative developments, there were also several positive ones in 2002: the current-account deficit did not rise, and remained at a low level relative to the GDP, and is not a burden on the economy; the net external debt continued on its downward path, mainly the short-term net debt (the short-term debt minus short-term assets); capital flows did not reverse and the positive investment flow into the economy continued; the NIS/foreign-currency market continued to become more efficient, particularly in the area of derivatives, and even when stability was under attack the market continued to function properly, with large turnover and a modest rise in spreads; Israel's credit rating was not lowered, despite the external and internal shocks; no direct intervention in foreign-currency trading was needed, and moderate policy steps taken with regard to the rate of interest and the budget deficit managed to stop the deterioration. These positive developments, that occurred despite the shocks, resulted from the long-term policy of liberalization and improvements of the markets.

The foreign-exchange liberalization process that began more than a decade ago was completed on 1 January 2002, when the final restriction on institutional investors was removed. This means that foreign-currency control has been completely abolished, and the NIS has become a freely convertible currency. Various provisions of the tax reform came into effect, significantly reducing the discrimination against activity abroad or in foreign currency vis--vis activity in Israel and in NIS, thereby contributing to the proper functioning of the financial markets. Nevertheless tax discrimination has not totally disappeared as some of the provisions of the reform relating to activity vis-a-vis abroad are being introduced gradually, over several years, and tax rates still differ between foreign-currency financial assets and those in NIS, and between insurance companies and provident funds on the one hand and other sectors on the other. Completion of the tax reform and maintaining the NIS as a freely convertible currency are cornerstones of economic policy, and increase the openness of the economy and allow it to reap the maximum benefits from integration into international financial markets and from the globalization of capital flows. These benefits derive from the contribution of foreign investment to economic growth and from the contribution of foreign financial institutions to the integrity, streamlining and stabilization of the financial system and the financial markets, as well as from the public's ability to diversify its assets and liabilities portfolios and to readily adjust their composition to changing conditions.

The argument is occasionally heard for restricting the economy's financial openness, despite its many advantages, on the grounds that it makes the economy more vulnerable. Although reducing the openness of the economy might indeed lower its vulnerability to external financial shocks, reimposing control is an inappropriate policy for several reasons: first, openness is essential for the economy in the era of the global economy and international standards. Second, taking a comprehensive view, openness contributes to economic stability by helping the economy and the financial markets to develop, whereas a closed economy creates artificial stability that inthe intensity of the harm caused by shocks. Third, experience shows that most financial crises occur in fixed-exchange-rate regimes that tried to implement rapid liberalization programs that were unsuitable for the existing economic situation; in Israel, on the other hand, the process of liberalization took place over the last decade as the exchange-rate regime became more flexible and openness was achieved gradually, in accordance with the economic situation and the financial system. Finally, experience has shown that long-term control restrictions are inefficient and their operation is very costly.

The openness of the economy, its sensitivity to external shocks, and its constant scrutiny by nonresidents drive home the importance of a well-considered, cautious and consistent macroeconomic policy. One component of such a policy is the preservation of financial stability. External financial stability requires constant improvement of the NIS/foreign-currency market on the one hand, and diligent monitoring and analysis of activity in it on the other.

The NIS/foreign-currency market is the most liquid and the deepest of Israel's financial markets. Over the last ten years it has undergone a gradual process of improving efficiency and deepening. This was due to the liberalization of foreign-currency control, the greater flexibility introduced into the exchange-rate regime, the improvement of trading arrangements, and in the last few years also the activities of foreign financial institutions in the market. Since the beginning of 1998 the market has functioned properly without the Bank of Israel having to intervene in trading even when the market was experiencing shocks, indicating that the market has a suitable infrastructure that enables the completion of the process of making the exchange-rate regime more flexible.

Over the last ten years the exchange-rate band widened. It continues to do so as an intrinsic component of the regime, but nevertheless still limits the area in which the exchange rate can fluctuate; it can thus have a negative effect on market players when the exchange rate approaches one of the limits of the band, as the Bank of Israel is committed to intervening in trading to protect the limits. Abolishing the exchange-rate band regime and switching to a floating exchange rate will allow full use to be made of the exchange rate as a shock-absorber mechanism. For this reason, and against the background of globalization and increased worldwide capital flows, the number of countries that have adopted floating-exchange-rate regimes has grown, and the number of those operating fixed exchange rates has shrunk.

Managing a policy of maintaining stability necessitates the study of the conditions for market stability, past experience, the factors that cause and exacerbate the damage, and the processes that undermine stability. Constant monitoring is required so that these processes can be identified as early as possible, distinguishing between transient negative developments and the start of a process that could undermine stability. The analysis of market activity by sector and the monitoring of changes in sectoral activity are of paramount importance to enable the behavioral patterns of the different sectors in periods of calm and of crisis to be identified, primarily those of the large financial market players and of households. Such analysis and monitoring are based on comprehensive, detailed and up-to-date information. Over the last few years, as liberalization proceeded, the Foreign Exchange Activity Department (formerly the Foreign Exchange Control Department) established information systems that consolidate comprehensive and detailed data on economic activity vis--vis abroad and in foreign currency. These systems make it possible to carry out the ongoing analysis of the data needed for purposes of monetary policy, for monitoring market stability and for identifying trouble spots and processes that could undermine stability. The department processes the information gathered and regularly publishes the results with minimal delay, with the intention of improving the quality and accessibility of information available to the players in the financial markets. This derives from the awareness of the fact that transparency of markets contributes to their integrity, thereby enhancing their stability.

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This report has two sections. The first deals with Israel's economic activity vis--vis abroad: with activity in the balance of payment current account and financial account, with Israel's international investment position (IIP), and with the external debt and the economy's credit risk. The second section discusses activity in the NIS/foreign-currency market: the activity-with nonresidents and between the sectors-of residents in the different sectors in assets and liabilities in or indexed to foreign currency, and the activity of nonresidents in local-currency assets and liabilities (including NIS/foreign-currency futures).

The data in this report derive mainly from reports to the Foreign Exchange Activity Department from the banks, companies, institutional investors and individuals. Other sources of information used in this report are reports submitted to other Bank of Israel departments, data of the Accountant General in the Ministry of Finance on government activity, Stock Exchange Authority data, and current-account data of the Central Bureau of Statistics.

In 2002, the NIS depreciated by 13 percent against the five-currency 'basket' and by 7 percent against the US dollar. The implicit standard deviation in options, an indicator of exchange-rate risk, widened significantly to 8.6 percent on average. The exchange rate behaved unevenly during the year, depreciating rapidly in the first half and appreciating slightly in the second half, and fluctuated within each half-year as well.

The steep and surprising rate cut in December 2001, implemented as part of a package deal, caused the NIS-forex market to turn around: exchange-rate risk climbed steeply, an abrupt process of adjustment of households' portfolios ensued, and the NIS depreciated rapidly until the middle of February. In April 2002, in view of the sensitivity of the NIS-forex market-which was high to begin with-the pace of depreciation picked up again due to the decline in security, the increase in the budget deficit, and concern about the downgrading of Israel's sovereign rating.

Two interrelated developments explain the turnabout that occurred at the end of 2001:

* In the second half of 2001, market players became increasingly convinced that the real activity recession would not be short-lived and that its cumulative adverse impact on the economy was rising; the ongoing global slowdown was reflected in continued declines in nonresident investment; and the protracted domestic recession and the escalating security unrest caused the current account to worsen steadily. As a result, the basic account-a reflection of the long-term forex supply-ended 2002 with a deficit, i.e., a net capital outflow, for the first time in many years.

* There was an upturn in uncertainty about economic policy and, for this reason, about the future course of the exchange rate. The uncertainty was reflected in a steep increase in exchange-rate risk, rapid currency depreciation, a sharp increase in yields on government bonds, and a significant deviation of inflation expectations from the targets for 2002 and the longer term.

Analysis of developments in 2002 leads one to believe that the real activity recession, which changed the composition of capital flows, would have led to depreciation and a higher level of risk even in the absence of uncertainty about economic policy. However, the uncertainty led to an upsurge in exchange-rate risk and a severe response, especially by households. The resolve displayed by the Bank of Israel in June, coupled with the government's efforts to head off a further increase the budget deficit, staunched the rapid depreciation process even though the economy did not improve in terms of real activity. This analysis underscores the importance of an intelligent and coordinated economic policy at all times and particularly at a time of economic duress.

These developments led to a recomposition of the private-sector portfolio: forex assets of the nonbanking private sector increased by $ 4 billion and their share in the total portfolio climbed from 14 percent at the end of 2001 to 16 percent a year later. The main reason was an increase in external assets-an accumulation of deposits with foreign banks and the acquisition of foreign bonds by households. The balance of assets held in Israel did not change significantly in 2002.

Part 2 is divided into two chapters.

Chapter 1 presents a comprehensive analysis of developments in the NIS-forex market and attempts, by ex post argumentation, to draw a connection between trends in the NIS exchange rate against the five-currency basket and changes in forex supply and demand by various market sectors and those who affect them.

Chapter 2 reviews developments in the main components of residents' portfolios of forex assets and liabilities and nonresidents' portfolios in NIS.