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Bank of Israel Annual Report, 2003 - The Governor's letter The Governor's letter, PDF file8 Nissan, 5764 To: The Government and the The Annual Report of the Bank of Israel for 2003 is submitted herewith,
in accordance with section 59 of the Bank of Israel Law, 5714–1954. The report
comprises six parts which have been prepared by the Research, Monetary, Foreign
Currency, Foreign Exchange Activity, and Comptroller’s Departments, as well as
a statistical appendix on CD-Rom. The report contains information and analyses
based on data from the Central Bureau of Statistics, monetary data, and figures
on foreign-currency activities collected in the Bank of Israel. There was a turnaround in 2003, and economic activity rallied: GDP and
business-sector product rose, after declining in the two preceding years. The
recovery was led by the expansion of exports, and to a lesser extent by the
growth of private consumption. The turnaround was driven by the global economic
recovery and the slight improvement in Israel’s security situation, supported
by the coordinated change in the policy mix-fiscal restraint and the gradual
reduction of the Bank of Israel’s key interest rate. Nonetheless, the decline
in per capita GDP persisted and the unemployment rate rose. The CPI (Consumer
Price Index) dipped by 1.9 percent in the course of the year, falling below the
price-stability target; this development was influenced by local-currency
appreciation against the dollar as well as by the recession. Economic developments display the difference in the situation at the
beginning and end of the year. Until March there was uncertainty regarding the
government’s commitment to the deficit targets, alongside political-security
concerns and doubts as to the outcome of the war in Iraq. These continued the
negative trends of the last two years, among them a steep rise in the public
debt/GDP ratio, an increase in the statutory tax rate, and a relatively high
interest rate, which was intended to restore price stability while maintaining
financial stability. As of March-in the wake of the announcement of the
government’s economic recovery package aimed at reducing the budget deficit by
slashing its current expenditure, the approval of the US loan guarantees,
temporary renewal of the peace process, and subsequent rapid conclusion of the
war in Iraq-uncertainty abated markedly. The improvement led to a steep fall in
Israel’s risk premium, and was expressed by all the main monetary indicators,
with a decline in inflation expectations and in the nominal and real yield
curves. Against this backdrop, and with the aid of positive developments in
western economies, it was possible to reduce the Bank of Israel’s key interest
rate gradually and on an ongoing basis. The successful economic policy mix
played a major role in changing firms’ expectations which, together with the
surge in global stock markets, caused share prices to soar, supporting the
recovery of private consumption in the second half of 2003. The decline in the
real short- and long-term interest rates also bolstered the stabilization of
investment in the course of the year. Although the employment rate remained steady in 2003, the unemployment
rate continued to rise, reaching an average of 10.7 percent of the civilian
labor force. The relatively moderate increase in the unemployment rate, despite
the slight expansion of the demand for labor, derived inter alia from
the determined efforts to reduce the number of foreign workers, which made it
possible to increase the number of Israeli workers-especially in construction-for
the first time in many years. This year, after a long period in which
public-services employment rose, this trend slowed notably, and most of the
increase in employment was in the business sector. The main objective of macroeconomic policy in the next few years should
be to utilize Israel’s economic growth potential by means of the business
sector. In order to return to sustainable growth it is necessary to ensure the
stability of prices, ongoing reduction of the public debt/GDP ratio, and
balanced current account of the balance of payments. The macroeconomic
framework that will support these conditions is a mix comprising a return to
declining public debt and deficit paths, open financial markets, and the lowest
possible monetary interest that is consistent with price stability. A mix of
this kind will also support a low level of long-term interest, thereby serving
to augment investment. The government decided to adopt a deficit target of 4 percent of GDP for
2004, and a new set of targets for 2005–2010 according to which public expenditure
will rise by no more than 1 percent a year, with a deficit ceiling of 3 percent
of GDP. According to revised assessments, the deficit in 2004 is expected to be
close to the target, notwithstanding the fact that the budget reserve-including
the part designated to contend with macroeconomic shocks-is already fully
committed. A question which is often asked is whether it is advisable to
continue reducing taxes in order to stimulate demand and supply. Note, in this
context, that progress was made in 2003 in restoring public confidence in
fiscal policy by means of the Economic Recovery Package. Tax reductions, which
could undermine the government’s adherence to the deficit target, could damage
its credibility, especially in view of the recurring deviations from the
deficit targets of the last few years due to unrealistic revenue forecasts.
Consequently, and because Israel’s tax burden is no greater than the accepted
rate in many advanced economies, it is advisable to avoid reducing the tax rate
in the near future, as this could cast doubts on the government’s ability to
alleviate its debt burden and debt-servicing costs, while at the same time, once
circumstances are appropriate, to improve the composition of tax receipts. In
view of the public debt/GDP ratio, which is high by international standards,
greater emphasis should be placed on the objective of reducing the debt in the
medium term. Moreover, it is incumbent upon the government to plan its budget in a
way that is consistent with attaining its target of restricting the growth of
expenditure to 1 percent a year. In this context, it is important to place the
aspiration to increase efficiency in public-sector employment on the public
agenda. To date, the efforts to attain fiscal restraint have been based on wage
cuts, but without making any significant decisions as to the number of public-services
employees in the long term. A planned process that is coordinated with the
unions and implemented over several years could contribute to efficiency while
minimizing the adverse effect on the public services. For many years there was under-investment in the infrastructure. In
order to close the gap between levels of infrastructure in Israel and western
economies and boost economic growth, it is necessary to invest about
NIS 20 billion each year in the next five years-half this amount in land transportation.
Most of the projects should be implemented by government and private companies,
while a minority can be financed via the budget. In recent years progress has
been made in some mass transportation projects, but not all of them are
advancing at the desired rate, and this could constitute an obstacle once
sustainable growth resumes. It is therefore recommended that a Ministerial
Committee for the Infrastructure be established, which will determine
priorities among projects, be responsible for the implementation of plans,
remove impediments, and monitor progress on an ongoing basis. It is also
recommended that when the budget is in the process of being prepared a special
government session be set aside in which entities concerned with projects
involving roads, railways, water, electricity, gas and other aspects of the
infrastructure are required to give a quarterly progress report to both the
government and the public. In many areas, including electricity, ports, air
freight, bus services, and oil refining, the level of competition is very low,
and it is important to make progress in the structural changes intended to
augment it. As regards social welfare, the government should persevere with its
policy intended to increase the employment rate, in order to bring it into line
with the average in the rest of the world. Till now this has involved reducing
the number of foreign workers and cutting transfer payments. The cost of
employing foreign workers should be increased in order to cause their number to
continue falling. It is important to complement these measures by policy steps
which will give low-income segments of the population an incentive to enter the
labor force. These steps should include the reform of transfer payments, as
well as the introduction of a negative tax system as well as the subsidization
of work-sustaining services, such as child care and transportation of employees,
in addition to a compulsory occupational pension at market rates. Work training
and placement systems should also be improved and made more efficient. Additional
changes aimed at increasing individuals’ ability to participate in the labor
force, such as increasing the efficiency and quality of education, especially
for disadvantaged groups, are also required. The problem of poverty has grown in recent years. The government must
set long-term targets for combating it, as is customary in the advanced
economies. It is also important to create mechanisms which will distinguish
between individuals who are able to work and those who are not, in order to
ensure that transfer payments are directed mainly to the latter. In this
framework it is important to extent means tests to include all components of
income, including imputed housing services. In general, in order to boost and entrench growth the government must act in accordance with long-term national targets as regards the budget and debt aggregates, infrastructure investment, increasing competition, raising the employment rate, and combating poverty. All this should be achieved while maintaining price and financial stability. This policy will enable Israel’s economic growth potential to be utilized and social cohesion to be intensified. Yours sincerely, David Klein |
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