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Bank of Israel Annual Report, 2003
Summeries
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Research Department
The Economy: Developments and Policies
Summary
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In 2003 there was a turnaround in business-sector activity due to the
global economic recovery and some improvement in Israel's security situation,
supported by a change in the fiscal and monetary policy mix. GDP rose by 1.3
percent and business-sector product by 1.8 percent, after a 3 percent decline
in each of the two preceding years. Nevertheless, the year as a whole, and
especially the first half, was characterized by a moderate level of economic
activity, a decline in per capita GDP, and a rise in unemployment. The CPI (Consumer Price Index) fell by 1.9
percent, significantly below the price-stability target, as a result of
local-currency appreciation and the economic slowdown. |
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Until March there was uncertainty regarding the government's commitment
to checking the expansion of the budget deficit and the public debt. In the
context of the static security and political situation, this was also expressed
in high real interest rates-both long- and short-term. In March, with the
publication of the government's economic program, the approval of the US
government loan guarantees, temporary renewal of the peace process, and
subsequent rapid conclusion of the Iraq war, uncertainty abated and Israel's
risk premium declined markedly alongside an improvement in the monetary
indicators-inflation expectations and the nominal and real yield curves.
Against this backdrop, the Bank of Israel was able to gradually and
continuously reduce its key interest rate, which declined by 4 percentage
points until the end of the year. These policy changes affected economic
activity in 2003 in two directions: on the one hand, the sharp cuts in the
government's current expenditure, which fell in real terms for the first time
since 1985, reduced both government and private direct domestic demand in the
short term because of the contraction of transfer payments and decline in the
public-sector real wage. On the other, the coordinated economic policy mix led
to a positive turnaround in firms' and households' expectations, contributing
to a sharp rise in share prices, and this had a beneficial effect on private
consumption in the second half of the year. The real interest rate, whose high
level at the beginning of the year had hampered the recovery of investment,
dipped towards the end of the year, supporting the stabilization of investment
alongside initial signs of a rally in the second half of 2003. |
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The main challenge confronting economic policy is to stimulate
sustainable growth while raising the employment rate and combating poverty,
which expanded as a result of both the protracted economic slump and long-term
factors partly arising from government policy. One aspect of this policy is the
continued successful economic policy mix implemented in 2003, alongside a
return to a declining budget deficit path through the reduction of current
expenditure. This path supports low long-term interest rates and enables the
Bank of Israel to set nominal interest at a rate that is consistent with low
long-term real interest, supporting a return to growth while maintaining
stability. Other important components include an increase in infrastructure
investment and the implementation of structural changes which will increase
competition. Another aspect is extending the policy adopted in the last two
years to combat poverty. Till now this consisted of cuts in transfer payments
and a reduction in the number of foreign workers. At the next stage the
government will have to act so as to make the labor market more attractive to
the low-income population. This can be done by: (i) further reducing the number
of foreign workers; (ii) improving the education system serving the weaker
segments of the population, and making it more efficient; (iii) reforming
taxation and transfer payments, and introducing a negative income-tax program;
(iv) establishing compulsory occupational pension plans. It is important to
create mechanisms which will make a distinction between individuals who are
capable of working and those who are not, to ensure that only the latter
receive transfer payments. |
Main developments
The deterioration in economic activity was checked in 2003 and a
positive trend was evident in the second half of the year, due to the recovery
of the global economy and some improvement in Israel's security situation. The
turnaround was supported by a coordinated change in the fiscal and monetary
policy mix. After declining for two years, GDP rose by 1.3 percent and
business-sector product by 1.8 percent. Notwithstanding, the level of economic
activity remained moderate in 2003; per capita GDP declined by 0.5 percent and
the unemployment rate rose to 10.7 percent of the civilian labor force. The CPI
dipped by 1.9 percent in 2003, below the price stability target, as a result of
the economic slowdown and local-currency appreciation vis-à-vis the dollar.
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After two years in which economic activity contracted due to the
Intifada, which erupted in late September 2000, and the slump in world
trade-especially in the high-tech industry-these two areas began to pick up in
the course of 2003. The economic recovery in the US (Table 1b), which
accelerated during the year, was first expressed in the traditional industries,
later extending to the high-tech industry, which accounts for a large share of
Israel's exports. This year the rise in exports was the engine of the
turnaround in GDP, contributing 2.5 percent to its growth differential.
Concurrent with this development, Israel's security situation improved
somewhat, in the context of the ‘Hudna,' (ceasefire) which led to a temporary
lull in terrorist attacks and a fall in their number relative to the two
preceding years. This improvement was expressed in an increase in private
consumption in the second half of the year and a recovery in the commerce and
the catering and hotel services industries during the year; the recovery was
not evident in all industries, however, chiefly construction. |
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Economic policy affected activity in two directions in 2003. First,
until March there was considerable uncertainty regarding the government's
commitment to the deficit targets in view of the ongoing economic slowdown, the
security-political uncertainty, and expectations of a war in Iraq. This served
to prolong the negative trends of the previous two years, among them the steep
rise in the public debt/GDP ratio, increase in the statutory tax rate, and high
real interest rates which, while maintaining financial stability, hampered the
recovery of investment. All these were compounded by the moderating effect on
domestic demand of government spending cuts which, while necessary in order to
avert the risk of a financial crisis, with even worse implications for GDP,
reduced demand in the short term. Second, in March, following the announcement
of the government's economic program, which reduced the deficit from 7 to 4
percent of GDP by slashing current expenditure, the approval of the US loan
guarantees, the temporary renewal of the peace process, and the subsequent
rapid conclusion of the war in Iraq, uncertainty abated considerably. This led
to a sharp fall in Israel's risk premium, and was also expressed in all the
main monetary indicators-inflation expectations and the nominal and real yield
curves. In the context of the positive global developments and improvement in
the domestic fiscal situation, which implied a reduction in real public
expenditure for the first time since the ESP (Economic Stabilization Program)
of 1985, as well as the cyclically-adjusted deficit in 2003, the Bank of Israel
was able to gradually and credibly reduce its key interest rate. The successful
economic policy mix served to change firms' expectations, and this, together
with the recovery on global stock markets, led to a sharp rise in the General
Share-Price Index during the year. The recovery in the capital market,
alongside renewed expectations of future tax cuts, supported the surge in
private consumption in the second half of the year. Furthermore, the decline in
real interest bolstered the stabilization of investment during the year,
together with initial signs of recovery in imports of investment goods in the
second half of the year. The rise in wealth and expected disposable income was
also bolstered by decisions that reduce public expenditure in the long run,
such as contending with the pension funds' actuarial deficit by raising the
retirement age and updating the transfer payments mechanism. |
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The unemployment rate, which continued to rise in 2003, averaged 10.7
percent of the civilian labor force. Although there was no significant recovery
in the demand for labor, the unemployment rate did not increase substantially
during the year. This was due in part to the expansion of employment in the
knowledge industries, as well as to the government's determination to reduce
the number of foreign workers, making it possible for the first time in many
years to replace them with Israeli workers, especially in construction. In
2003, after a long period in which public-sector employment expanded, this
process came to a halt, adding 0.3 percent to the unemployment rate. In the
labor market, too, there were indications of a turnaround in the second half of
the year, mainly an increase in the real wage after a marked decline throughout
the recession. |
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The current-account deficit of the balance of payments contracted in
2003, as a result of the recovery of exports. Another factor underlying the
decline in the deficit was the low level of economic activity, which in 2003
was accompanied by a relatively slow rise in imports of goods and services. The
improvement in the current account stemmed from the decline of the share of
investment in total sources available, and a smaller decline in the share of
savings. If the process of emergence from the recession takes hold, this trend
may well be reversed because the end of a slump is generally characterized by a
rise in investment. The indicators of real depreciation attest to a mixed
picture; the recovery of the mixed and traditional industries (primarily in the
first half of the year) was affected with a lag by the real depreciation of
2002, which was partly offset during 2003. |
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The CPI declined by 1.9 percent this year, significantly below the
target of price stability, defined as 1–3 percent. The deviation from the
inflation target is explained by the appreciation of the NIS vis-à-vis the
dollar, and by the moderate level of economic activity. The appreciation was
the outcome of the trend reversal in capital inflows, mainly of short-term
flows which are motivated by interest-rate differentials, but also in direct
investment, influenced by the recovery of the high-tech industry. Capital
inflows were stimulated by the decline in the risk premium in emerging markets
in general, and in Israel in particular, as well as by interest rates, which
were higher during the year than in the advanced economies. |
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Monetary policy served in 2003-and especially at the beginning of the
year-to bolster the price and financial stability attained after the sharp
interest-rate hikes in mid-2002, in view of the exceptional depreciation and
belated response of fiscal policy in 2002. Its main goal was to attain the
lowest interest rate possible to support economic recovery. In the first half
of 2003, and especially the first quarter, it was still difficult to assess how
imminent was the danger of exceptional depreciation as had occurred in 2002. It
seemed at that time that the risk embodied in a too rapid interest-rate cut
outweighed that of one that was too slow, as the former could undermine
stability in the foreign-currency market, requiring a greater and more
protracted interest-rate hike at a later stage. Consequently, the interest rate
was reduced gradually, alongside constant monitoring of the response of
inflation expectations and the foreign-currency market. In retrospect, this has
not been sufficient to minimize the deviation from the calendar-based inflation
target. |
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The lengthy economic slowdown caused poverty to
increase (see box). This was also due to the cuts in transfer payments and
other items, which impact on the poor in the short term. The government was
obliged to make these cuts during the slump in order to avert the danger of a
financial crisis, which could have had even worse repercussions. One of the
main challenges facing the government was to curtail and even reverse the trend
of the expansion of poverty (which could eventually impair growth) by
increasing the employment rate. In order to achieve this, it is necessary to
improve the policy of the last two years, which to date has involved cutting
transfer payments and expelling foreign workers. It is particularly important
to reinforce the economic incentives that will encourage those segments of the
population which have not participated in the labor market for a long time to
enter and remain in the labor force. |
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The Economy: Development and Policies - PDF file (1.32Mb)
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Output and the Principal Industries
Summary
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After two years in which economic activity contracted, against the
backdrop of the exacerbation of the armed conflict with the Palestinians and
the global economic slowdown, the deterioration was checked in 2003, and a
positive trend emerged thanks to the relative easing of the security situation
and the global economic recovery. Business-sector product grew by 1.8 percent,
after declining by 2.8 percent in 2002, and labor productivity rose by 1.5
percent. |
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Alongside the
signs of recovery, which multiplied in the second half of the year, aspects of
the slump were still in evidence, however: fixed investment continued to
shrink, and the sharp contraction of inventories persisted; wages in the
business sector declined in both nominal and real terms, and unit labor costs
fell by 3.6 percent; the rate at which new jobs were created did not
accelerate, Hours worked did not increase, and the unemployment rate rose to
10.7 percent. |
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The turnaround
that emerged in the course of the year was supported by an appropriate economic
policy mix: the government slashed public spending, as a necessary precondition
for returning to a declining budget deficit and debt path, and initiated
structural changes designed to accelerate the recovery and support sustainable
growth. The gradual reduction of the Bank of Israel's key interest rate, by a
cumulative 3.9 percentage points during the year, served to ease monetary
restraint while maintaining financial stability. |
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Output and the Principal Industries - PDF file (1.26Mb)
- Main Developments
- Aggregate Demand and Supply
- The Real Exchange Rate, Saving and Investment
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The Principal Industries
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Main developments - Complete text - PDF file (0.08Mb)
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Manufacturing - Complete text - PDF file (0.23Mb)
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Agriculture - Complete text - PDF file (0.31Mb)
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Transport and communications - Complete text - PDF file (1.04Mb)
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Construction - Complete text - PDF file (0.73Mb)
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Commerce and services - Complete text - PDF file (0.21Mb)
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The information and communications technology (ICT) industry - Complete text - PDF file (0.27Mb)
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The Labor Market
Summary
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The labor market continued to slump in 2003 as the
recession persisted. Labor input in the business sector was flat, the
unemployment rate climbed to 10.7 percent, and unemployment intensity worsened.
Employment of Israelis in the business sector expanded by 2 percent after no
change in 2002. Employment of foreign workers decreased steeply and perceptible
numbers of foreign workers in the construction industry were replaced by
Israelis. Labor input in the public services contracted slightly after many
years of uninterrupted increase due to vigorous measures to reduce the share of
government in economic activity. |
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Nominal wage per employee post declined by 2.1
percent and fell more rapidly in the public services, where a collective agreement
stipulating a progressive wage cut was concluded. Labor productivity increased
by 1.5 percent after two years of uninterrupted declines. As a result of this
factor and the 2.4 percent real wage decrease in the business sector, unit
labor cost fell steeply, attesting to greater business efficiency. |
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Labor relations in 2003 deteriorated in view of the
pension-fund arrangements, the raising of the compulsory retirement age, and
plans for far-reaching changes in the public services and government-owned
companies. The effects of legislative changes that slashed transfer payments
and toughened citizens’ eligibility for them were perceptible during the year.
The stringencies, although prompted by the need to reduce government
expenditure and raise the participation rate, dealt the welfare of needy
families a severe blow. |
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The Budget and the General Government
Summary
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The general-government deficit
exceeded 5 percent of GDP in 2003 for the second year in a row and the gross
general-government debt climbed to 107 percent of GDP. The central
government-budget deficit ballooned to 5.6 percent of GDP, the highest level
since the 1985 Economic Stabilization Program and 2.6 percent of GDP over the
target. The deficit level dropped markedly during the year-from 7 percent of
GDP in the first half of the year to less than 4 percent in the second half-due
to the application of the Economic Recovery Plan. Since the deficit-cutting
provisions of the plan were based largely on reducing expenditure,
general-government expenditure declined in 2003 after years of rapid growth and
a deceleration in 2002. Thus, the deficit increase in 2003, unlike those in
2001 and 2002, traced to a decline in government revenues-tax revenues in
particular-and not to rising expenditure. The credibility of fiscal policy was
enhanced in 2003 by the results of the war in Iraq, which eased Israel's
expected long-term defense burden, and the receipt of US loan guarantees, which
lowered the risk of a financial crisis in the short term. |
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The deficit resumed its upward
march shortly after the mid-2002 ‘Economic Defensive Shield' program because
the budget was again based on overoptimistic assumptions. Thus, in view of the
impending war in Iraq, the depreciation of the NIS, and the upturn in interest
rates on the government debt in the middle of 2002, another economic plan was
needed. The 2003 Economic Recovery Plan restored confidence in fiscal policy
because its immediate deficit-cutting measures were largely permanent and
because it included additional steps to further reduce government outlays
several years ahead. Furthermore, structural matters such as pension
arrangements, the retirement age, and the structure of National Insurance
benefits were addressed. The resulting credibility was further enhanced by the
successful enshrinement of most of the main measures in agreements with the
Histadrut (albeit after a lengthy struggle). However, the methods used to
approve the plan-as well as some additional measures that were authorized along
with the 2004 budget-touched off vehement public controversy due to the use
(and the threat of use) of legislation to amend existing agreements and the
hasty debate of several structural provisions of the plan. |
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In addition to the
contribution of the economic plan to financial stability, the composition of
the plan-especially the decisive share of expenditure-cuts in reducing the
deficit and the attempt to leave infrastructure investment unscathed-is
conducive to sustainable economic growth, as soon as global economic
developments and domestic security make this possible. To apply the plan in
full, however, the Government will have to make a long-term commitment to its
implementation, a condition that was not fulfilled in the past. Moreover, at
the time the plan was approved, the deficit was expected to surpass the
Government's targets for several years ahead and the general-government debt
was expected to continue rising even under the assumption that the plan would
be fully applied. For these reasons, and since Israel still has very high
levels of general-government expenditure and deficit by international
standards, another large adjustment had to be made in the 2004 budget,
alongside a significant raising of the deficit target. An additional sizable
adjustment will probably be needed in the 2005 budget as well. The economy has
been paying a heavy price for these recurrent adjustments in the coin of
institutional instability, disruption in planning the activities of budgeted
entities, and labor disputes. The harm was compounded in 2003 by overaggressive
attempts to slash expenditure in several fields-e.g., in the general grants for
municipal authorities-that had to be reversed and required additional
adjustments immediately after the budget was approved. The budget measures
applied in the past two years, taken as a whole, have also changed the
composition of expenditure in a way that is less conducive to reducing
inequality. Although the acceptable extent of inequality is a matter of
sociopolitical preference, it is important for the Government to promptly
invoke policy measures that will spare individuals who are incapable of working
from too much harm, especially in regard to education and health. Such measures
should aim to sustain the social mobility and earning potential of such people
and their children and, thereby, to allow the economy to utilize its growth
potential. |
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Israel's
tax rates have undergone far-reaching changes in the past two years (including
early 2004)-increases in 2002 and 2003 and cuts in 2004. These adjustments
increased the indirect-tax burden, mainly due to the raising of the fuel and
cigarettes excises. The direct-tax burden hardly changed but was significantly
recomposed: general tax rates on wages were lowered and exemptions were
revoked-especially in regard to regional benefits-and households' income from
financial assets was taxed. The full application of the income-tax reform,
planned for 2006, will eliminate most of the gap between Israel and the
developed countries in tax rates on earned income in the three highest deciles.
Concurrently, the imposition of taxation on households' capital income narrowed
one of the most conspicuous gaps in tax-system structure between Israel and
developed countries. |
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Monetary Department
Inflation, Monetary Policy, and Developments in the Money and Capital Markets
Chapter 1: Main Developments
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In 2003 consumer
prices declined 1.9 percent, following a rise of 6.5 percent in 2002. The price
decline in 2003 represents a shortfall from the targeted price rise of between
1 and 3 percent starting in 2003 and defined as price stability; this followed
an upward deviation in 2002. In the past two years, prices rose at an average
annual pace of 2.3 percent overall, as opposed to an average annual rate of 0.9
percent during the years 1999 to 2001. The NIS appreciated against the dollar
by 6.4 percent in 2003, following a 9.8 percent depreciation in 2002. The fall in the exchange rate strongly
affected the housing component, which went down by 6.7 percent. The price index
excluding housing declined at a more moderate rate of 0.5 percent.
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The decline in prices
in 2003 was partly an outcome of the fall in the exchange rate and partly a
delayed response to the continuing weakness in local demand, which was also
influenced by the high level of real interest rates in the second half of 2002,
reflecting the high degree of uncertainty in that period. The exchange-rate
decline in the course of 2003 from the high level it attained at the end of the
first half of 2002 is a reflection of the significant improvement, as of March
2003, in several underlying factors: the publication of the economic plan by
the new government and its approval in the Knesset, approval of US government
guarantees for new Israeli bond issues in the US and the swift and successful
conclusion of the war in Iraq. These factors led to a gradual and continuous
improvement in most of the relevant indicators used to assess the inflation
environment (for details, see Chapter 2). Against this backdrop, the Bank of
Israel commenced the process of reducing interest rates, which continued
throughout the year. Between January and December 2003, the Bank of Israel
interest rate was reduced by 3.9 percentage points (from 9.1 percent in
December 2002 to 5.2 percent in December 2003.)
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The improvement in the
underlying conditions described above and the reduction of interest rates by
the Bank of Israel led to a continuous rise in the prices of all local
financial assets, reflected in a concomitant decline in the yields to maturity
of negotiable bonds of all terms, leading to a decline in interest rates on all
term deposits and credit and a rise in share prices. Thus, as a case in point,
from January 2003 to December 2003 the yield to maturity of a non-linked
ten-year bond declined from 11.4 percent to 7.0 percent, the real yield to
maturity of a linked ten-year bond declined over the same period from 5.9
percent to 4.1 percent, and share prices rose by more than 50 percent. Housing
prices, on the other hand, declined by about 6 percent—a drop that reflected
the continuing slump in the construction sector and the decline in the exchange
rate against the dollar.
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There was also some
improvement in real activity in 2003, especially in the second half. Business
product in 2003 rose by 1.8 percent, following a 2.8 percent decline in 2002. A
rise of 6.1 percent in exports and a moderate rise, of 1.7 percent, in private
consumption led to the moderate product growth. Domestic public consumption,
which rose significantly in 2002, declined by 0.6 percent in 2003, and the
decline in gross local investment continued, although at a more moderate rate
than in 2002.
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The decline in the Consumer Price Index (CPI) in
2003 represented, as stated, a shortfall from the targeted price stability (1
to 3 percent), following an upward deviation in 2002. At the same time, an
examination of price developments over a longer period reveals that the average
monthly rate of inflation during the years 1999 to 2003 was 1.6 percent in
annual terms with no detectable upward or downward trend. However, volatility
around this average rate is relatively strong (a monthly standard deviation of
about 6 percent). This stems partly from volatility in the exchange rate and is
primarily the result of the tradition of high inflation in previous years (this
subject is dealt with in Chapter 2). The large standard deviation
characterizing the monthly price change makes a current evaluation of the
inflation environment difficult and is one of the reasons why the response of
monetary policy to price shocks is gradual. The significance of such a response
is, among other things, an acceptance of the possibility of temporary
deviations from the inflation target (see below for expansion on this subject).
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Chapter 2: Monetary Policy, Inflation and Prices
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The consumer price index fell by 1.9 percent in 2003, a downward
deviation from the inflation target of between 1 and 3 percent, defined as
price stability. This followed an upward deviation from the inflation target in
2002, when annual inflation amounted to 6.5 percent. The development of prices
was not uniform in the course of the year. Prices rose by 0.8 percent in the
first quarter of the year, but subsequently fell by a cumulative rate of 2.7
percent. The fall in prices during the year resulted mainly from the continued
appreciation of the NIS against the dollar, and derived partly from the
slackness in domestic demand.
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The decline in the NIS exchange rate in the
course of the year resulted inter alia from the major improvement in
background conditions from March onwards, namely the publication of the new
government’s economic program, the US government’s approval of loan guarantees
for Israel, the rapid and successful outcome of the war in Iraq and the
worldwide downtrend in the risk premium required for investment in emerging
economies, including Israel. As a result of these developments, uncertainty in
the markets decreased considerably, as was reflected by the significant and
continued improvement in the majority of indicators that showed a decline in
expected inflation. One-year inflation expectations also fell, to within the
targeted range of price stability, while nominal and real yields for all terms
fell continually, concurrent with a decline in the inflation expectations
reflected by longer terms as well.
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Against
this background, the Bank of Israel began to reduce the interest rate in April
and the rate reduction continued until the end of the year. Over the year as a
whole, the Bank of Israel cut the interest rate by a cumulative 3.9 percentage
points.
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The Public’s Financial Asset Portfolio
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The value
of the public's portfolio of financial assets rose by 12.3 percent in nominal
terms during 2003 and reached a total of NIS 1,385.9 billion following a
moderate increase of 1.8 percent in 2002. The increase in the value of the
portfolio in 2003 encompassed all local assets, while the foreign currency
asset component contracted slightly. The development of the
asset portfolio in the course of the year was affected by two main factors-the
decrease in the yield/risk ratio expected from investment in local assets, and
by the capital market taxation reform.
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The decrease in the
yield/risk ratio on local assets from March onwards was reflected by a rise in
the prices of all local financial assets (shares, bonds and Treasury bills), as
compared to a decrease in the prices of foreign currency assets. The reduction
in the Bank of Israel's interest rate resulting from the decline in inflation
expectations supported the upturn in the prices of local assets. The reform in
capital market taxation, which went into effect in 2003, was one of the reasons
for the public's move from non-tradable assets (deposits at the banks and
saving schemes) to tradable assets (Treasury bills and bonds).
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A notable increase was
recorded in the local and foreign share component of the portfolio in 2003,
reflecting the rise in share prices. In the portfolio exclusive of the share
component, the proportion of unindexed assets rose, while the proportion of
CPI-indexed assets and foreign currency assets fell. The distribution of the
asset portfolio by investment term remained largely unchanged. Among all terms,
the proportion of assets held via the banks fell (the decrease encompassed all
indexation types), while the proportion of bonds and Treasury bills increased.
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The Securities Market
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Yields to maturity, both nominal and real, declined during 2003, thus
continuing the trend evident in the last few years except 2002. The decrease in
yields began in March with the announcement of the economic program, the
receipt of guarantees from the US and the swift conclusion of the war in Iraq.
As yields to maturity declined, financial uncertainty eased, reflected among
other things by the prices of financial derivatives. Yields continued along the
downward trend during the rest of the year, and by its end had reached the
levels which had prevailed at the end of 2001. In the equity market, the trend
evident in 2001and 2002 reversed, and the leading indices rose sharply on high
turnover. This occurred against the background of a decrease in financial
uncertainty, the process of lowering the interest rate and the increased
efficiency of many firms.
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The turnover in Treasury bills
increased significantly in 2003. In contrast, there was a slight decline in the
turnover of government bonds although it still remained higher than in previous
years.
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The net amount of tradable capital
raised by the government in the domestic market declined in 2003 in contrast to
the expansionary trend of previous years as, the government turned to borrowing
abroad, principally within the framework of the guarantees, thus also
contributing to the decrease in yields in the government bond market. In 2003,
there was a sharp increase in the issue of corporate, primarily nontradable,
bonds.
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Institutional Investors
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Institutional investors' share of the public's
asset portfolio amounted to 36.7 percent at the end of 2003 compared to 35
percent last year. The balance of institutional investors' assets increased
this year and, in December, amounted to approximately NIS 508 billion compared
to NIS 433 billion last year. The main increase was evident in mutual funds and
to a lesser extent in profit-sharing life-insurance schemes – an increase that
was partially offset by the decline in the proportion of established pension
funds and guaranteed-yield life-insurance schemes.
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The trend for the withdrawal of money from
provident funds remained
unchanged during the year despite the relatively high yield in the fixed income
and equity markets with the public increasing its deposits mainly in mutual
funds specializing in unindexed assets, especially in Treasury bills. The high
positive accrual in these funds proved worthwhile, inter alia, as the revenue
from investments in short-term loans was tax-exempt in 2003.
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During 2003, institutional investors directed
their investments into unindexed and share holdings, a trend that characterized
the public's financial asset portfolio in general. This change is attributed,
inter alia, to the adjustment of financial asset holdings to the expected
decline in inflation, reduced interest in the markets and the increase in share
prices.
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Towards
the end of the year a reform in the pensions sector was put into operation.
Within the context of the reform, the government reduced the issue of earmarked
bonds for the pension funds. The greater part of the money that was invested in
these funds will be transferred to the equity market.
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Foreign Currency Department
Chapter 1: Investment of the Foreign Exchange Reserves
Abstract
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The average level of the Bank of Israel's foreign exchange
reserves portfolio was about $ 24 billion in 2003.
The reserves are managed in accordance with the Bank of Israel Law 5714-1954
and the legal interpretations which have been added over the years, together
with a set of rules which are appropriate to the Bank's character and which
reflect the functions that the reserves fulfill. Accordingly the reserves are
invested in foreign-currency-denominated bonds issued by or fully guaranteed by
foreign governments, and in foreign-currency deposits in foreign banks outside
Israel.
As part of the management of the reserves, the Bank may perform transactions
with banks and investment banks outside Israel, and may use derivative
financial instruments such as futures provided their underlying asset is one
which the Bank is authorized to hold. The bank may also carry out transactions
with a limited number of domestic institutions, such as the government and the
banking corporations.
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In the past the main
purpose of the reserves was to provide the liquidity required by the Bank of
Israel to enable it to intervene in the foreign-currency market and to defend
the exchange rate. That was the situation when the exchange rate was fixed or
managed according to strict rules. Over time the role of the reserves changed, due
to changes in macroeconomic and exchange-rate policy. Currently, the reserves
have two types of function: (1) possible uses of the reserves, i.e., the
option of transferring them to another entity in exchange for either cash NIS
or a financial commitment, the most important use being the sale to the
government of the foreign currency required to service its debts. (2) Benefits
to the national economy stemming from the very fact that Israel has reserves of
sufficient magnitude. The most important benefits are the lowering of the
probability of a crisis in Israel's foreign-currency market and the improvement
of Israel's standing in the international financial environment. The functions
of the reserves provide a basis for determining their appropriate size as well
as for defining the investment policy for the management of the reserves
portfolio.
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The holding-period
rate of return on the foreign exchange reserves in 2003 in terms of the
numeraire was 2.2 percent, down from 5.2 percent in 2002. This reflected the
low level of yields to maturity throughout 2003 in the capital markets in which
the reserves are invested. In NIS terms the holding-period rate of return in
2003 was negative, -1.3 percent, compared to 17.8 percent in 2002, reflecting
the effect of the strengthening of the NIS against the dollar and its weakness
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The yield on the
reserves in 2003 was 21 basis points higher than that of the neutral
benchmark-the hypothetical portfolio that serves as a criterion for the
assessment of the investment performance of the reserves and as an anchor for
the management of their financial risks. The yield spread between the reserves
and the benchmark reflects the active management contribution. The yield on the
reserves is greatly affected by the composition of the benchmark, due to the
relatively low risk taken in managing the portfolio, risk that derives from
deviations from the benchmark. Much effort has been invested in the last few
years in the area of decisions on asset allocation, i.e., in a composition
different from that of the benchmark, and decisions on the choice of assets not
in the benchmark. 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.
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The contribution of
asset-selection decisions to the yield spread between the portfolio and the
benchmark was also 21 basis in 2003. This derived from investment in Treasury
Inflation-Protected Securities (TIPS) (about 7 basis points), Eurobonds and
GNMA mortgage-backed securities (about one basis point for each of these two),
and securities-lending activities (about 2 basis points). Currency management
contributed 4 basis points, while the duration management contribution was a
negative 2 basis points.
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The exposure of the
reserves to the banking system is limited to 25 percent of the value of the
portfolio. In 2003 this exposure averaged 18 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.
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The
liquidity of the reserves, a measure of the proportion of the portfolio that
can be realized quickly without reducing its value, is very high: about 88
percent of the reserves portfolio is invested in very liquid assets, and the
rest in assets with lower liquidity. Bearing in mind the purposes for which the
reserves are held, it seems that their 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, which require
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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Chapter 1: Investment of the Foreign Exchange Reserves - PDF file (2.17Mb)
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Chapter 2: Developments in Israel's Foreign Currency Market in 2003 - PDF file (1.05Mb)
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Foreign Exchange Activity Department
The Balance of Payments: Israel’s Foreign Currency Activities
Overview and Policy
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Israel's external and foreign-exchange
activity in 2003 reflects the trend of stabilization and improvement in the
NIS/foreign-currency market and the balance of payments, as well as in Israel's
financial stability, which is connected with both of them. This trend is the
result of the amelioration of the main processes which had caused the volume of
activity in the balance of payments to contract and undermined external
financial stability in 2001 and 2002. The decline in economic activity was
checked, and towards the end of 2003 the first signs of recovery were evident.
Although the conflict with the Palestinians continued, it was less intense than
in previous years; the credibility of macroeconomic policy-which had been
eroded in 2002-was rehabilitated, due to both the government's firm commitment
to the downward path of the deficit and the government debt and the Bank of Israel's
cautious and considered prosecution of monetary policy. The global economic
slowdown ceased, and there were indications that the slump in the high-tech
industry and financial markets was coming to an end. These processes were
expressed in the appreciation of the NIS vis-a-vis the dollar and its
stabilization against the currency basket, alongside a reduction in
exchange-rate risk, which reverted to the level evident at the end of 2001.
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The current account of the balance
of payments was almost balanced in 2003-compared with a deficit of 1.3 percent
of GDP in 2002-for the first time in ten years. This was achieved by virtue of
the rise in goods and services exports, the acceleration in global economic
activity, and the decline in imports of investment and durable goods as a
result of the protracted economic slowdown.
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The decline in the financial account
that had characterized the last two years halted, while the extent of direct
foreign investment doubled, bringing it back to the level that had prevailed
before the surge in the high-tech industry.
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The course of the exchange rate in 2003
reflects the considerable contribution of nonresidents to the
strengthening of the NIS. This is the outcome of their activity in short-term
instruments, primarily derivatives, and their long-term activities, i.e.,
direct and portfolio investment.
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The activity of nonresidents was affected
both by domestic developments, expressed in the decline in the level of risk
ascribed to Israel's economy, as well as in global trends. The elimination of
the threat from Iraq, the receipt of the US loan guarantees, the establishment
of a new government, and the formulation of a new economic program with tighter
fiscal control, together with the global process of the diversion of capital to
emerging markets where interest rates are relatively high, against the backdrop
of falling yields in the advanced economies and change in the perception of
global risk-all led to short-term capital inflow in 2003:II, expressed in
marked local-currency appreciation alongside the weakening of the dollar
against most world currencies. The contraction of the yield gap between Israel
and the advanced economies led to the cessation of this trend in the second
half of the year. Forecasts by foreign financial entities of expected NIS
appreciation during 2003 (in contrast to predictions by Israeli forecasters),
and the pattern of activity of nonresidents in the NIS/foreign-currency market
in the first half of the year, indicate that they succeeded in rapidly
identifying the change in the market fundamentals and altering the direction of
their short-term NIS exposure-switching from the position against the NIS which
they had held in the last few years to the reverse in the last three quarters
of 2003. These developments attest to the fact that against the backdrop of the
process of Israel's integration into the global economy, the correlation
between Israel and emerging markets has soared this year with respect to the
exchange rate, capital flows, and the levels of exchange-rate and country risk.
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The improvement in financial stability,
which is associated with economic activity vis-a-vis abroad and in foreign
currency, was expressed in various parameters of the NIS/foreign-currency
market as well as in Israel's credit risk: exchange-rate risk, measured
by the implied volatility of NIS/dollar options, fell during the year and reverted
to its end-2001 level; this decline reflected inter alia the restoration
of macroeconomic credibility, particularly in the context of the marked
reduction in the Bank of Israel's key interest rate in the course of 2003,
leading to a 3.5 percentage-point decline in the NIS/dollar interest-rate
differential. At the same time Israel's credit risk, which is measured
from the risk premium implicit in prices of government bonds traded abroad,
contracted, in accordance with the global trend of a decline in the country
risk attributed to emerging markets. The backdrop to the improvement in these
parameters of financial stability and the strengthening of the NIS was the
marked amelioration in several long-term variables. These included the US
government loan guarantees, which enabled Israel's government to borrow
$ 9 billion; the improvement in Israel's basic account, reflecting
the balanced situation in the current account and the rise in foreign
investment in Israel; Israel's net external debt, which has become a net
surplus since 2002 and reflects Israel's position as a net lender to other
economies; and the exposure of the business sector to exchange-rate
risk, which declined alongside a rise in the heterogeneity of this sector, also
serving to enhance financial stability.
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The improvement in the basic account,
reflecting the long-term supply of foreign currency in the NIS/foreign-currency
market, exerted basic pressure for appreciation-after this account contracted
continuously in 2001 and 2002 and became negative. This trend makes the
market less sensitive to the effect of short-term more volatile exchange-rate
changes.
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During 2003 the process of perfecting the the
NIS/foreign-currency market persisted, expressed inter alia in
the issuance of new financial instruments, together with the contraction of the
supply of local-currency assets as a result of the expiry of dollar-indexed
government bonds (Gilboa). The expansion of this market, which is the
deepest and most liquid of Israel's financial markets, appears to have been
checked, however. In the last ten years this market has been gradually
perfected and deepened, against the backdrop of the liberalization of
foreign-exchange control, increased flexibility in the exchange-rate regime,
and greater activity of foreign entities. The decline in the extent of currency
conversions, increase in market spreads, and reduction in exchange-rate risk
call the long-term path of this market into question. While these trends may
express the conclusion of the development process, they may also reflect
structural problems, such as the extent to which the domestic market is
developed and discrepancies in trading patterns between domestic and foreign
banks. Particularly notable is the low level of exchange-rate risk, by
both historical and international standards, in view of assessments regarding
its expected increase as a result of the long-term structural changes mentioned
above. The future trend of this variable is highly significant with regard to
monetary policy, because its decline offset the effect on the exchange rate of
the marked interest-rate cuts made during the year.
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Against the backdrop of the growing openness
of the economy, its greater sensitivity to external shocks, and the fact that
it is subject to continuous scrutiny by global financial markets, the
prosecution of responsible and considered macroeconomic policy, in accordance
with the standards currently prevailing in developed economies, assumes
especial importance, in addition to the creation of the conditions that will
enable the economy to continue developing and becoming more perfect. Note, in
this context, the need to remove the last obstacle that will enable the economy
to operate with a completely free exchange rate and full liberalization-the exchange-rate
band. Although this band, which has widened over the last ten years, is no
longer effective, it embodies a potential distortion in the perception of risk
by market players: by providing costless insurance against exchange-rate risks
it constitutes a negative incentive to the further development of the market,
and especially to the development of derivatives aimed at managing the risk of
the business and financial sectors. The annulment of the exchange-rate band and
the shift to a floating exchange rate regime will prevent the generation of
distortions of this kind, enabling the exchange rate to operate as a
shock-absorber, as is customary in developed economies worldwide, while making
it more flexible, thus also bringing it into line with some emerging markets.
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The private sector's exchange-rate-risk
management is a pivotal part of the process of market development at a time of
transition to a floating exchange rate. In the long term, as a result of the
convergence of the domestic inflation rate in recent years to the levels
evident in advanced economies, the rate is expected to vary without a clear-cut
trend-in contrast to the constant and ongoing trend of depreciation that
prevailed until the late 1990s. In this situation the allocation of
responsibility for exchange-rate risk between the central bank and the private
sector requires the former to act to attain price stability, which should serve
to reduce the long-term volatility of the exchange rate, and the latter to
manage risk in a thoughtful and systematic way, in order to minimize the effect
of short-term fluctuations on business outcomes. Despite the rapid development
of the derivatives market, the increased volume of use, and the development of
a variety of instruments for different players and uses, the intensity with
which the business sector uses hedging instruments is still low relative to the
extent of its activity and the exposure to exchange-rate risk implicit in this.
One of the main problems precluding greater use of instruments intended to hedge
against risk is the way they are currently presented in financial statements,
which constitutes a negative incentive to using them. Consequently, the
authorities should take the initiative to regulate matters in such a way as to
bring about a more efficient distribution of risks, contributing thereby to the
greater stability of both the business sector and the market as a whole.
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At the beginning of 2003 the last remaining
(and ineffective) restriction in the area of foreign-exchange control-the
quantitative restriction on investment abroad by institutional investors-was
removed. This concluded the process of the liberalization of foreign
exchange which began over ten years ago and embodies marked economic
benefits. It constitutes an important part of the macroeconomic strategy of
increasing the openness of the economy, enabling the fulfillment of its growth
potential. The advantages implicit in increased integration with world
financial markets are expressed in the contribution of foreign entities to the greater
efficiency of the markets, the part played by foreign investment in the
development of the economy, as well as in the improvement of the process of
allocating the public's asset and liability portfolios. This process is still
in its initial stages, and the foreign securities component of the public's
asset portfolio is still small by international standards, despite expectations
of its rapid expansion. These expectations were based on the assessment that
the process of interest-rate cuts has virtually concluded, on the interest-rate
differential vis-a-vis abroad, which is low by historical standards, and on the
completion of the process of liberalization. The low proportion of investment
in foreign securities is explained by tax discrimination between profit on
investment in Israel and abroad, and also apparently by the home bias of
domestic entities-i.e., the tendency to invest less in foreign assets than is
derived from the optimum portfolio, based on yield and risk considerations. The
regulations regarding tax reform, which went into effect at the beginning of
2003, appear to have reduced the tax discrimination between investment in
foreign-currency assets and in assets abroad, on the one hand, and in
local-currency assets, on the other, but the existence of interim arrangements
during the year has limited the effect of the changes on residents' investment
considerations. It will be possible to utilize all the benefits implicit in the
liberalization process once the tax discrimination is completely annulled. This
should serve to optimize the allocation of the public's portfolio, particularly
by institutional investors, notably increasing the foreign-asset component-in
accordance with the experience of the advanced economies-and significantly
reducing the sensitivity of institutions to fluctuations in the domestic
capital market, which is shallow in relation to the extent of the assets they
manage.
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In order to achieve a policy aimed at
attaining the stability of prices and the financial markets it is necessary to
analyze the preconditions for this-based inter alia on past
experience-as well as the factors which create and increase vulnerability and
the processes which undermine stability. Constant monitoring is required in
order to identify such processes at the earliest possible date, while
distinguishing temporary negative trends from the onset of a damaging process.
Special importance is attached to the sectoral analysis of economic
activity-identifying the patterns of behavior of the various sectors, chief
among them the major financial players and households, at times of crisis and
of calm, and monitoring changes in their activity. The basis for monitoring and
analysis of this kind is extensive, detailed, and up-to-date data. In the last
few years, concurrent with the liberalization process, the Foreign Exchange
Activity Department has constructed extensive and detailed databases of
economic activity vis-a-vis abroad and in foreign currency. These make it
possible to analyse monetary policy needs on an ongoing basis, track the
stability of the economy, and identify focal points of vulnerability and
processes in which stability is undermined. The data are processed within the
Department and published from time to time with a minimal lag, with the object of
improving the quality and accessibility of the information available to the
players in the financial markets. The Department also publishes surveys of
various kinds, press releases, and studies in the areas in which it
specializes, as well as holding meetings intended to create channels of direct
communication between it and the various market players. This is done in the
realization that transparency in the markets makes them more perfect, thereby
increasing financial stability.
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This report has three sections. The first
analyzes market developments within the accepted international framework of the
balance of payments, namely, economic activity vis-a-vis nonresidents in
foreign and local currency; this includes activities in both the current and financial
accounts of the balance of payments, as well as Israel's international
investment position (IIP).
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The unique nature of Israel's economy and the
prominent part played by the exchange rate require a separate framework for
analyzing it so that it is possible to identify all the forces acting on the
exchange rate. The second part of this report deals with NIS/foreign-currency
activity, including the foreign-currency activity of the various resident
sectors (in the denominated and indexed segments, vis-a-vis nonresidents, and
among sectors), assets and liabilities, and nonresidents' activity in
local-currency assets and liabilities (including NIS/foreign-currency forward
transactions).
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The liberalization process has exposed Israel's economy
to international capital movements and made it more sensitive to external
financial risks, so that it is necessary to continually monitor its external
financial stability; financial stability is analyzed in the third part
of this report, in the context of activity in the NIS/foreign-currency market
and vis-a-vis abroad, the external debt, and credit risks.
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The Balance of Payments
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In 2003 Israel was favorably affected by
global economic developments that caused its current-account activity to
increase. These effects overcame the contractionary impact of domestic economic
and security developments since late 2000. The combined result was a
significant improvement in the balance-of-payments deficit, which finished 2003
at the lowest level in a decade (Table 1.1).
The financial account also expanded this year, after a two-year downtrend, and
foreign direct investment (FDI) increased markedly. Thus, 2003 was a turnaround
year after two years of doldrums.
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Most of the favorable change in
the current account traces to the global economic expansion that began in 2002,
after a severe downturn in 2001 (Figure 1.1). The expansion was manifested in
faster growth of goods and services exports than of imports and, in the last
few months of the year, in an uptrend in high-tech exports as well.
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Two domestic factors affected the
capital account: the belated and slow recovery of real domestic activity, which
began only in the second half of the year, and the security unrest that began
in late 2000. The belated recovery dampened the annualized growth rate of
imports of capital goods and consumer durables and had a downward effect on the
capital-account deficit. The ongoing security situation is the factor of
greatest influence on tourism revenues, which increased only slightly in 2003,
whereas global developments in tourism have hardly any effect on Israel’s
inbound tourism at the present time.
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In the factor-inputs account, the
downtrend in nonresident and resident activity in 2001 and 2002 stopped in
2003. The increase in FDI, reflecting the global economic recovery, led to an
increase in dividend payments to shareholders abroad. The decline in global
interest rates reduced net interest income due to the structure of domestic
assets and liabilities; most public-sector assets are short-term and earn
floating interest, whereas public-sector liabilities are long-term and at fixed
interest.
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In the financial account, the downtrend
in nonresident and resident activity in 2001–2002 was braked in 2003.
Financial-account activity increased slightly in 2003, although not to the
level observed in the ‘bubble’ years of 1999–2000. Net capital inflows in the
financial account (excluding net reserve assets), which were considerable
during the global boom years-largely due to Israel’s high-tech
orientation-ceased in 2001, changed into the country’s first net capital outflow
in 2002, and remained such in 2003, although on a smaller scale than in 2002
(Figure 1.2).
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The nonbanking private sector, a
net importer of capital during the boom years-except for 2002, when domestic
factors led to a capital outflow-again became an importer of capital in 2003,
albeit at a scanty $ 0.8 billion, mainly due to global effects. The
banking sector, in contrast, was a significant exporter of capital in 2003-at
$ 2.7 billion-due to domestic factors: payback of forex credit by residents
and continued gradual reduction of secondary liquidity ratios on forex
deposits. Concurrently, the public sector was an importer of capital due to the
issue of bonds backed by US government guarantees, and its behavior in this
regard offset some of the capital outflow created by the banking sector.
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Activity in the NIS-Forex Market
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The exchange rate responded in 2003 to
rather large-scale nonresident activity in short-term instruments and long-term
direct and portfolio investment. This activity was affected by global trends
and domestic developments that reduced the estimate of Israel’s country risk
and exchange-rate risk-the dispelling of the Iraqi threat, the establishment of
a stable government, the formulation of a new economic plan-and a global process
of redirection of capital to emerging markets, prompted by lower yields in
developed countries and a change in the perception of global risk. These
factors induced a short-term capital inflow from the middle of February until
the end of the first half of the year, manifested in a 13 percent depreciation
of the NIS against the dollar and against the five-currency basket. The
contraction of the yield spread between Israel and developed economies brought
the trend to a halt during the second half of the year and led to mild
depreciation.
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Favorable trends in several long-term
factors also contributed to stability in the forex market. They include the
capital-mobilization guarantee arrangement with the US Government, the
expansion of foreign direct investment (FDI), and the balancing of the current
account. As a result, the basic account, a reflection of long-term forex
supply, returned to a positive level in 2003 after declining steadily from
October 2000 and tumbling into deficit in late 2002. Nonresidents’ patterns of
activity in the forex market show that they quickly noticed the change in the
economy’s underlying factors-reversal of the direction of nonresidents’
short-term exposure to the NIS, from a position against the NIS, as in recent
years, to a pro-NIS position from June 2003 on.
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Nonresidents’ and residents’ behavior in
the forex market also reflected an upturn of confidence in macroeconomic policy
after a decline in 2002. The improvement traces to the Government’s
demonstration of a commitment to a declining path of deficit and debt and
gradual and transparent rate-cutting by the Bank of Israel, which caused the
NIS-forex spread to narrow by 3.7 percentage points during the year.
Exchange-rate risk sank steeply to the December 2001 level, a conspicuous
development in view of the narrowing of the interest spread. The decline,
reflecting among other things the restoration of confidence in macroeconomic
policy, allowed the Bank of Israel to cut the rate considerably without leading
to rapid adjustment of the public’s portfolio. In the last quarter of the year
and in early 2004, however, residents’ response to the narrowing of the
interest spread intensified somewhat, as reflected in the amassing of forex
assets by individuals and a drawdown of forex liabilities by the business
sector. Institutional investors continued to increase their external
investments as part of their long-term strategy of portfolio diversification.
Their activities in 2003 were influenced by the narrowing interest spread and
the transition to forex assets that it induced, the redemption of Gilboa bonds,
and expectations of continued price increases in global markets. However, some
institutionals still had low rates of external investment, mainly because their
external investments were more heavily taxed than their domestic investments.
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The balance of nonbanking private-sector
assets in forex increased by $ 5 billion in 2003 and their share in the
portfolio decreased, for the first time in several years, by 2 percent.
Household assets expanded by $ 2 billion after a $ 3 billion upturn
in 2002.
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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.
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Chapter 2 reviews developments in
the main components of residents’ portfolios of forex assets and liabilities
and nonresidents’ portfolios in NIS.
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External Financial Stability
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Israel's financial stability improved in 2003.
Domestic and external financial markets were less uncertain and volatile than
in 2002, the structure of domestic liabilities in forex improved, and the
underlying domestic and global conditions for financial stability were better.
Developments in financial stability were affected mainly by the decrease in
Israel's country risk, abetted by the redirection of global capital flows from
developed markets to developing markets-among which Israel is included-and by
an improvement in the credibility of economic policy and the state of the
domestic economy.
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The effects of events in 2002-foremost the substantial
capital outflow by households and the increase in risk and uncertainty in view
of the economic downturn and geopolitical developments-were hardly in evidence
by the beginning of 2003. The trend in Israel's International Investment
Position in 2003 pointed to greater exposure to exchange-rate changes but the
composition of assets and liabilities changed in a way that expressed greater
financial stability. On the liabilities side, there were several positive
developments; the shares of the nonbanking private sector in total liabilities,
of capital instruments, and of direct investment increased. On the assets side,
although vulnerability to market risks increased (asset prices declined and the
NIS appreciated), the nontradable proportion of total assets declined.
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The ratios of short-term external debt to short-term
assets and liquid assets of the Bank of Israel (foreign reserves) were low,
indicating that the liquidity of the domestic economy improved. Net external
debt continued to decrease and Israel was a net lender to the rest of the world
for the second year.
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The process of development in the NIS-forex market
spent itself in 2003, as indicated chiefly in the deceleration of growth in
trading volumes. However, the share of nonresidents in trading remained higher
than in the past. This aside, trading margins widened and exchange-rate
volatility was lower at the end of 2003 than before December 2001. It is not
clear whether this marks a level of long-term stability in the NIS-forex market
or a passing phenomenon.
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Outstanding gross external debt was $ 71 billion
at the end of December 2003-$ 3.4 billion (5 percent) higher than the 2002
level. The gross debt/GDP ratio declined (in dollar terms) from 65 percent in
2002 to 63 percent in 2003 due to appreciation of the NIS during 2003.
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The structure of external debt and external debt
assets is very important in assessing the financial strength of an economy.
Israel's share of tradable debt in gross external debt climbed to a record
level of 30 percent in 2003 as against 28 percent in 2002. The tradable
proportion of total government external debt also established a record at 56
percent. An increase in tradable debt means that financial stability has
worsened, since under such conditions foreign creditors may offer their debts
for sale in the market in one stroke, thereby raising the price of debt issues
to the government and other debtors. However, Israel's large surplus of
short-term assets-$ 29 billion at the end of 2003, up $ 4 billion (18
percent) from the end of 2002-reflects its ability to pay back short-term debt.
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At the end of 2003, the exchange-rate exposures of
different sectors headed in different directions relative to December 2002. The
depreciation exposure of the business sector decreased considerably; the
vulnerability of households, due to their appreciation exposure, remained
relatively high.
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Developments in 2003 underscore the powerful effect of global
developments on Israel's financial stability and, accordingly, the need to
monitor continually the state of the economy vis-a-vis the rest of the world. However, economic
policy also had a vast influence on the relative standing of Israel's economy.
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