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Bank of Israel Annual Report, 2004
Summaries
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Research Department
The Economy: Developments and Policies
Summary
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Per capita GDP rose by 2.5 percent in 2004,after declining for three consecutive years.
GDP growth,which was led by the business sector,led to a turnaround in the
unemployment rate,which declined to 10 percent of the labor force in 2004:IV.
Macroeconomic policy attained its targets this year:the budget deficit contracted to 3.9
percent of GDP,slightly below the target level set by the government,and the CPI
(Consumer Price Index)rose by 1.2 percent during the year,a rate that is in line with the
price-stability target.Alongside the return to GDP growth,the current account of the
balance of payments was in surplus.Notwithstanding,unemployment was still high and
above the rate prevailing in the developed countries. |
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The same factors which led to the protracted recession of the last few years acted in the
opposite direction in 2004 and helped to boost growth.The main ones among these were
the recovery of world trade and the high-tech industries,and the relative calm on the
security front.All export industries expanded,particularly high-tech but also the services,
contributing 3.2 percent to the rise in GDP.In addition,private consumption rallied
markedly in the wake of the rise in real wages and the restoration of consumer confidence. |
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The two components of macroeconomic policy—fiscal and monetary—were
coordinated this year,and this served to support business-sector growth.The contraction
of the budget deficit sustained the reduction of domestic interest rates,making it possible
for the Bank of Israel to reduce its key rate steadily and gradually to an historically low
level.The decline in the share of government consumption in GDP in the last two years
served to enhance the credibility of macroeconomic policy,supported the reduction of
Israel's risk premium and the turnaround in the capital market,and enabled tax rates to be
reduced.Although the fall in government consumption acted directly to reduce demand,
the tax reductions backed by a simultaneous contraction of the government debt,as well as
low real interest rates,served to increase private consumption and domestic investment. |
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The main challenge facing macroeconomic policy in the coming years is to support the
persistence of the growth process led by the business sector while at the same time further
reducing the unemployment rate.This should be done by continuing to reduce the
government expenditure/GDP ratio,so as to allow a reduction in the share of the deficit
and the government debt in GDP,as this will support the low level of real interest,which
promotes investment.
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While the return to growth is a necessary condition for alleviating poverty in the long
run,it does not guarantee the ongoing reduction of the poverty rate,because of the
unbalanced nature of Israel’s economic growth in the last decade which was concentrated
in high-skill-intensive industries.Hence,special policy measures are required in order to
reduce poverty,primarily measures which should be anchored in quantitative targets for
alleviating poverty in the long run (ten years)as an additional target of the government’s
economic policy.Priorities should be set for government spending with the emphasis on
investment in education and the infrastructure.The policy of reducing the number of
foreign workers should continue,the government should subsidize the costs of child-care
with low earning power,a negative income tax system should be introduced,and
compulsory pensions should be implemented on terms that are worthwhile for low earners. |
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Alongside these measures,the reform of the education system along the lines
recommended by the Dovrat Committee should be implemented and structural changes
should be made in various spheres in order to increase competitiveness.Competition
should also be intensified in the financial sphere and the recommendations of the Bachar
Committee,which are in line with this aim,should be implemented. |
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Research Department
Output and the Principal Industries
Summary
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Economic activity expanded in 2004, continuing the trend of recovery that had begun in the second half of 2003. The recovery of the economy is due to a great extent to the development in externalities - the resurgence of the global economy and the marked amelioration in Israel's security situation. These changes led to a sharp rise in demand, especially for exports, which grew particularly rapidly. The rally was expressed in the rapid growth rate of business-sector product, which was endemic throughout the principal industries as well as in the labor market: employment continued to rise, the unemployment rate fell throughout the year, and the average wage increased. The rise in total factor productivity (TFP) outstripped that in wages, so that unit labor cost declined.
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TFP soared as a result of the increase in factor utilization, after its contraction during the recession had led to the creation of excess capacity. This excess, in conjunction with the policy of fiscal restraint and the fact that the recovery was led by exports, explains why the process has not yet been accompanied by significant pressure to raise prices, create real appreciation, and generate a current-account deficit in the balance of payments - features which generally characterize Israel's economy at times of economic expansion. |
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Economic policy in 2004 was distinguished by monetary expansion and the reduction of public expenditure alongside cuts in taxes. This policy, and the fact that its two targets - price stability and the deficit target - were attained, served to entrench financial stability and enable the process of economic recovery to become firmly established. |
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Despite the trend of recovery, the effects of the recession are still evident. Per capita GDP was still lower in 2004 than in 2000; the unemployment rate is higher than both Israel's long-term average, and the rate in developed countries; the level of per capita GDP declined in Israel relative to the OECD countries and the US, for the eighth year in succession.
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Research Department
Chapter 2: The Labor Market
Summary
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The dominant influence on the labor market in 2004 was the economic recovery in the business sector which led to an increase in employment and real wages and to a decrease in the rate of unemployment. Government policy had a decisive impact in 2004 through its contribution to public confidence and economic stability which are essential elements for stable growth in output and employment. At the same time the government worked to reduce labor costs and employment in the public sector. Despite the reduction in the rate of unemployment, it remained high at 10.4 percent on average. In addition, the rate of growth in labor input was lower than that of employment due to, among other things, the increase in the proportion of part-time workers. These trends indicate that the labor market is still weak and that the level of economic activity is lower than its potential.
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In the business sector, the labor market has been reacting to changes in the business cycle in Israel during the last three years. During 2001 and 2002, employers adjusted the number of workers and the level of wages to the fall in real output, resulting in a decrease in the real wage and a relatively moderate increase in unit labor costs. In this way, they moderated the negative impact on their profitability and could react quickly, through increased hiring, to the positive turnaround in economic activity in the second half of 2003 and during 2004. This was first manifested in the services and commerce sectors and in the hi-tech sectors and later on in the other sectors. The expansion in employment during this period was accompanied by a sharp increase in worker productivity and cumulative erosion of 10 percent in unit labor costs.
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The government "from welfare to employment" policy formulated during the years 2002 and 2003 was aimed at transferring the focus of public assistance from welfare support to greater personal responsibility and an increased demand for labor. As part of this policy, and as a result of budget constraints, transfer payments were cut significantly in recent years and eligibility was tightened. In addition, measures were taken to significantly reduce the number of foreign workers in the economy. Despite these policies, unemployment intensified and the proportion of "chronically unemployed" increased. Furthermore, a large proportion of the additional workers absorbed into the labor market in 2004 were hired for part-time and low-paying jobs. These trends indicate that, despite the decline in unemployment, government policy has not yet succeeded in achieving a stable and sustainable increase in employment, particularly among weaker segments of the population. Thus, more should be done to encourage employment and to minimize the negative impact on weaker populations through programs targeted at defined groups, the institution of a negative income tax, incentives for employment in peripheral areas, etc.
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Research Department
Chapter 3: The Budget and the General Government
Summary
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In 2004, the government deficit amounted to 3.9 percent of GDP which is somewhat less than the target determined during budget approval and represents a substantial reduction from its level of 5.6 percent of GDP in 2003. The deficit of the general government, which is measured according to the National Accounting rules2, declined to 5.1 percent of GDP in comparison to 5.6 percent of GDP in 2003. The decline in the deficit and rapid economic growth made it possible to also reduce the ratio of public debt to GDP, which had increased substantially during the previous three years. The reduction in the deficit was achieved through the continuing real decline in government spending, which was even lower than the amount budgeted, the more rapid than expected growth in GDP and the steep rise in the import of consumption goods. These factors enabled the government to meet the deficit target despite the implementation of significant tax reductions, some of which were approved in earlier periods while others were planned for the end of 2004 and implemented early or added during the course of the year. However, the decline in the deficit this year is primarily the result of the high level of the deficit during the first half of 2003. In comparison to the second half of 2003, the period following the implementation of the Economic Recovery Plan, the ratio of the deficit to GDP remained stable, despite rapid economic growth, reflecting moderate declines in both expenditure and revenues. During the past two years, total employment in the general government also declined, with the number of hours worked falling by 2.8 percent. This was the first time since the 1985 Stabilization Program that such a reduction continued for two consecutive years. The timing of expenditure in 2004 differed from past years and was characterized by particularly low levels from June to November and an exceptionally high level in December. |
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The restraint in spending made it possible to reduce tax rates in a credible manner, which is likely to contribute to sustainable economic growth. Specifically, the reduction in income tax rates on wages during the past two years brought them down to the common levels in developed countries. However, the reduction in tax rates limited the decline in the ratios of the public debt and the deficit to GDP, despite the acceleration in economic growth. In view of the high level of debt in Israel, which exceeds the common levels world wide, it is important that fiscal policy converge to a path which will enable a substantial reduction in the debt to GDP ratio in coming years and thereby contribute to reducing the risk attributed to the Israeli economy. The fiscal targets for the years 2005-2010, if met, will in fact enable such a reduction although this is conditional on the government exploiting the planned moderate increase in its spending to reduce the deficit and the debt and not only to reduce tax rates. |
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The trend of general government expenditure this year represents a continuation of the cycle which began at the end of 2000 when the proportion of public expenditure in GDP reached its lowest level since the mid-1990s. During the first two years of the cycle, the real rate of growth in pubic spending accelerated even beyond the rapid rates of growth which characterized the 1990s and the share of public expenditure in GDP rose by 4 percent. The increase in public expenditure during this period encompassed transfer payments, defense expenditure and civilian consumption. Following a slowdown in mid-2002, an absolute decline in public spending was recorded in 2003 and 2004 which returned its proportion of GDP to a level similar to that in 2000. Among the components of public expenditure, the proportion of GDP of transfer payments and civilian consumption (net of the one-off addition for vacation pay) returned to its level in 2000 while the proportion of defense consumption declined (though it remained higher than at the beginning of the period). Therefore, the rise of the deficit during this period is primarily explained by the decline in revenues which was due, in the beginning of the period, to the major slowdown in economic activity and later to the reduction of tax rates. |
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1 The general government is composed of the central government, the National Insurance Institute, the local authorities, non-profit organizations (the Sick Funds, universities, yeshivas, etc. whose primary source of income is the general government) and the National Institutions (the Jewish Agency, Keren Hakayemet and the World Zionist Organization). Its activity is measured according to the National Accounts definitions which differ from those of the government budget (see Text Box 3.1).
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2 Although the calculation in Israel does not include exchange-rate valuation adjustments of the public debt.
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Research Department
Chapter 4: Welfare Policy
Summary
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Social policy in Israel is to be seen against the background of long-term processes such as the fall in demand for unskilled workers that has resulted inter alia from the economy's exposure to imports, high technology oriented growth and the permission granted for the mass entry of foreign workers and during recent years, the slump in the labor market. These processes, which derived partly from the economy's integration in the global economy - in itself a welcome development - have reduced the weak populations' earning ability, adversely affected security of employment, deepened the extent of poverty and expanded income gaps. As a result, the importance of social policy, which is intended to help the weak populations, has increased in the globalization era. This policy also assists in the successful absorption of new immigrants.
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Following a general analysis of social policy, this year the chapter focuses on transfer payments and on the area of education. Until the beginning of the decade, the number of transfer payment recipients had increased rapidly and the volume of payments had reached over 14 percent of GDP. Despite their contribution to the welfare of the weak strata, transfer payments failed to prevent the extent of poverty and inequality in disposable income from increasing. It is doubtful whether the growth in transfer payments could have been maintained, especially in view of the negative incentives to work inherent in them.
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Since the beginning of the 2000s and especially since 2002, transfer payments have become much less generous (particularly child allowances, unemployment benefit and the income guarantee payment). The policy turnaround derived from a conceptual change of reducing government involvement in assuring the population's welfare while focusing on encouragement to participate in the labor force, against the background of the low labor force participation rates - as well as from budgetary necessity. Due to these changes, the generosity of the allowances in Israel is relatively low compared with Western countries. The changes were accompanied by programs - few in number and late in implementation - for encouraging integration in employment, and together with the slump in the labor market, exacerbated the extent of poverty in the short term. However, the reduction in the number of foreign workers contributed to the integration in employment of unskilled Israeli workers.
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The social services (such as education and welfare) increase the benefit of service recipients, and have positive implications for the rest of society as well. Government involvement is also important because of the need to assure the quality of the services. During recent years the government has placed an emphasis on increasing the efficiency of the social services and improving their quality. In addition, a number of services that were still financed by the state have been privatized concurrent with a decrease in the government's share in the financing of other services.
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The national expenditure on education amounts to approximately 10 percent of gross domestic product, a ratio that has been rising for a long time, and is the largest component of public consumption. The volume of resources that Israel allocates to education is no less than that usual in Western countries.
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Over the years the resources available to schoolchildren have increased, the distribution mechanisms have improved and the discrimination that was practiced against various sectors has decreased. As for educational achievements, most of the usual indexes show a substantial and continued improvement and (inadequate) reduction in achievement gaps by nationality, ethnic origin and socio-economic status. Yet there are also a number of indicators pointing to a decline in the level of knowledge of those completing high school and until recently, comparative examinations showed that Israel was falling behind on the scale of achievements.
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In recent years calls have grown for a comprehensive reform of the education system, based primarily on a reorganization and increase in efficiency without a significant growth in resources. The main principles of the "National Education Plan" (the Dovrat Report, January 2005) are a strengthening of public education, a reduction in the differentials in the allocation of resources and in educational achievement, and an increase in the school's independence.
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Monetary Department
Inflation, Monetary Policy, and Developments in the Money and Capital Markets
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Chapter 1: Main Developments
Summary
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1. The Economy, Inflation and Monetary Policy |
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The consumer price index rose by a moderate 1.2 percent in 2004, after falling by 1.9 percent in 2003 and rising by 6.5 percent in 2002. The housing price component of the index dropped by 2.5 percent in 2004 while the CPI excluding housing rose by 2.3 percent. The rate of increase in the CPI during 2004 was close to the lower limit of the targeted rise in the index of between 1 and 3 percent defined as price stability that was set with respect to 2003 onwards. This followed an exceptional downward deviation in 2003 and an upward deviation in 2002. The moderate development of prices during the last two years and other indicators (which will be detailed later) support the assessment that the price stability which characterized the Israeli economy since 1999, although temporarily disturbed in 2002 and 2003, is not a transitory phenomenon. During the years 1999 to 2004, consumer prices rose by an annual average rate of 1.4 percent, compared with an annual average rate of 10 percent during the years 1992 to 1998.
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The main factors responsible for the slow pace of price increase in 2004 were the moderate development of the exchange rate in the course of the year, following the decline in the exchange rate during 2003, and the continued slump in activity and in the labor market during the years 2001 to 2003. Despite the rapid expansion of business sector activity in 2004 (see below), the sector still remained with production capacity surpluses. This was apparent from the modest development of wages and unit labor cost in the business sector. Nominal wages per employee post (FTE) rose by a moderate 1.5 percent in 2004 following a decrease of 1.8 percent in 2003, and the nominal unit labor cost (the proportion of the wage bill in business sector GDP) fell by 2.8 percent following a decrease of 3.9 percent in 2003.1 It should be noted that the continued decrease in unit labor cost in 2003 and 2004 followed on from a moderate increase during the years 2000 to 2002. The trend in this indicator was undoubtedly a major factor behind the moderate pace of price developments during recent years as a whole and during the past two years in particular.
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Price developments in 2004 were affected by the moderate development of the exchange rate, which fell by 1.2 percent against the dollar and rose by 1.8 percent against the currency basket, after declining by 6.4 percent against the dollar and 0.5 percent against the currency basket in 2003.3 The development of the exchange rate and consumer prices was not uniform in the course of the year. The shekel rose against the dollar by 2.9 percent and consumer prices increased by 1.4 percent in the first half of the year, but fell by 3.9 percent and 0.2 percent respectively in the second half.
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During the first four months of the year, the Bank of Israel maintained the process of interest rate reduction that began in 2003. This was due inter alia to the low level of inflation expectations for a year ahead (as reflected by capital market data and professional forecasters' assessments) in the first quarter of the year, a level that was below the center of the targeted range of inflation. During January-April, the Bank of Israel cut the interest rate by a cumulative 1.1 percentage points. From May to November, the interest rate was left unchanged. In December, the rate was cut by 0.2 percentage points and in each of the months January and February 2005, was cut by another 0.2 percentage points to a level of 3.5 percent. The Bank of Israel's interest rate in real terms (the nominal interest rate, less inflation expectations for a year ahead derived from the capital market) also fell during the initial months of the year, and in the second half of 2004 reached an average of 2.3 percent compared with 4.6 percent in December 2003.
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The Bank of Israel maintained the process of interest rate reduction during the four months of 2004 despite the rise in medium and long-term interest rates, which are determined by the markets,5 and the upturn in the exchange rate (against both the dollar and the currency basket) in that period. Concurrent with the interest rate reduction, inflation expectations for a year rose, and in May 2004 market expectations reached 2.0 percent while private forecasters' assessments reached 2.6 percent. The moderate upturn in bond yields (which matched the development of bond yields in the USA during the same period) ceased in mid-year. In the second half of the year, long-term yields-to-maturity stabilized and short and medium-term yields fell slightly, developments that were behind the Bank of Israel's decision to cut the interest rate in December 2004. During the year as a whole, the differential between long and short-term interest rates expanded (the slope of the real and nominal yield curves became steeper), a development that was indicative of monetary expansion.
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The downtrend in CPI-indexed and unindexed bond yields for all terms continued during December 2004 and January 2005, developments that affected the decision to further reduce the interest rate in January and February 2005.
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Despite the contraction in the differential between the monetary interest rates in Israel and the USA (as a result of the Bank of Israel's reduction in the interest rate during the initial months of the year and the continued rise in the interest rate in the USA during the second half), the shekel strengthened against the dollar in the second half of 2004 due to the concurrent weakening of the dollar against the euro. The fall in the exchange rate against the dollar during the second half of the year had the effect of reducing consumer prices in that half.
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A major factor that contributed to exchange rate and price stability in 2004, and which facilitated a further reduction in the monetary interest rate, was the government's budgetary policy. This policy was reflected by a decrease in domestic public consumption, and by a reduction in the budget deficit and government borrowing for the purpose of financing the deficit. The budget deficit amounted to 3.9 percent of GDP in 2004, close to the target of 4.0 percent of GDP and compared with a deficit of 5.6 percent of GDP in 2003. The government's domestic borrowing totaled NIS 13.0 billion in 2004, compared with NIS 23 billion and NIS 24 billion respectively in 2003 and 2002.
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The moderate development of the exchange rate and prices, concurrent with the combination of an expansionary monetary policy and contractionary fiscal policy, supported a rapid growth in activity and employment in the business sector during 2004. Leading the growth in activity in 2004 were the decline in the entire range of interest rates in 2003 and the increase in global activity in 2004. The 6.2 percent growth in business sector GDP was based on a rapid 14.6 percent expansion in exports and a 5.2 percent increase in private consumption. Domestic public consumption fell by 1.5 percent, and investment in fixed assets dropped by 2.1 percent. The fall in investment was comprised of a further decrease in investment in housing, structures and other construction works - 6 and 10 percent respectively - and an 8 percent increase in investment in machinery, equipment and transportation equipment, a turnaround that followed a continued decline during the years 2001 to 2003.
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In contrast to the moderate development of consumer prices, the wholesale price index rose by 2.9 percent and 5.2 percent respectively in 2003 and 2004. The relatively rapid increase in wholesale prices appears to have resulted from the increase in the prices of raw materials, most of which are imported from the eurozone, due to the strengthening of the euro against the dollar in recent years. During the years 2002 to 2004 the shekel depreciated against the euro by an annual average of 11 percent as compared to 1 percent against the dollar. Concurrent with the strengthening of the euro, the dollar prices of imported inputs for domestic production rose by 5.6, 8.5 and 15.7 percent respectively in the years 2002 to 2004.
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The large increase in world prices for oil contributed to the steep rise in the prices of imported inputs in 2004. The fact that the increase in the prices of imported inputs and wholesale prices was not reflected by a rise in consumer prices can be attributed to the relatively low level of domestic demand resulting from the recession in previous years. In addition, the increase in prices of imported consumer goods was less than that of imported production inputs, and amounted to 1.4 percent, 6.8 percent and 2.8 percent in dollar terms respectively during the years 2002 to 2004.
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In an inflation targeting regime, in which the central bank's interest rate is the principal tool for the management of monetary policy, the money supply in the economy is determined by demand on the part of the public. In 2004 the means of payment (M1) expanded by 19 percent. This expansion, which is much higher than that derived from the increase in activity and prices, mainly reflects a delayed response to the large decline in the nominal interest rate during 2003 and at the beginning of 2004. The broader monetary aggregate (M2), which includes time deposits, expanded by a more moderate rate of 8 percent in 2004, following an increase of 2.5 percent in 2003. This development, reflecting a slow pace of expansion in time deposits, partly resulted from the relatively rapid growth in the supply of Treasury bills, which serve as a substitute for deposits of the public at the banks.
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Bank credit to the public, which expanded considerably during the years 2000 to 2002, at an average annual rate of 10 percent, remained stable in 2004 after contracting by 2.8 percent in 2003. The moderate development of bank credit during the last two years reflects the stricter terms that the banking system imposed for the extension of credit. Demand for credit appears to have increased in view of the rapid growth in business activity. The private sector supplied businesses' growing demand for credit by means of an increased volume of private issues. This increase was due to the decrease in government borrowing and the decline in interest rates during the last two years.
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Monetary Department
Chapter 2: Monetary Policy, Inflation and Prices
Summary
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The Consumer Price Index (CPI) rose in 2004 at a modest rate of 1.2 percent-slightly above the bottom limit for price stability targets. This came following a year in which price changes were below the lower limit of the target range and actually went down by 1.9 percent. Among the factors that contributed to the return of inflation to its target limit were the economic recovery that gained momentum in 2004, consecutive reductions in interest rates by the Bank of Israel since 2003, and a rise in the price of production inputs imported from overseas. Despite the forces that increased the rate at which prices rose, price changes were moderate this year-apparently due to excess production capacity remaining in the market following the recession from 2001 to 2003, and the appreciation in exchange rates for the second consecutive year.
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The economic climate was relatively stable this year, thanks to the macroeconomic policy, and both internal and external conditions. Thus, for example, inflation expectations were generally at the target limit, and foreign currency trading was stable, with low standard deviations. There was a gradual devaluation of about 6 percent in the shekel/dollar exchange rate until May, followed by a revaluation at a rate of around 7 percent for the remainder of the year. Stability in the foreign currency market is also evident in light of the continued decline in short-term interest rate differentials between Israel and abroad, which reached historically low levels: interest differentials between the shekel and the dollar came to only about 1 percent in February 2005, after having dropped to 1.65 percent at the end of 2004, while at the end of 2003 and 2002 they stood at 4.2 percent and 7.85 percent respectively.
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Against the background of relatively low inflation expectations and market stability, Bank of Israel interest rates continued to fall in 2004 as well. Until April, the Bank continued to reduce nominal interest at a cumulative rate of 1.1 percentage points, to 4.1 percent-a level that was maintained until November. Towards the end of the year, as conditions were again suitable for further reductions, the Bank lowered interest rates by 0.2 percentage points in December, and again in January and February 2005. The nominal interest rate in Israel was 3.9 percent at the end of 2004, and after two additional reductions in early 2005, interest rates in February stood at 3.5 percent.
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Monetary Department
Chapter 3: The Public's Financial Assets Portfolio
Summary
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The value of the public's portfolio of financial assets rose by 10.7 percent in nominal terms during 2004 and reached a total of NIS 1,512.5 billion (Table 3.1) following an increase of 12.2 percent in 2003. The increase in the value of the portfolio in 2004 encompassed all assets, although the main contribution came from the share component (shares in Israel and abroad) whose value grew by 29.8 percent. The main factors that led to the rise in the value of shares in Israel during 2004 were the upsurge in real activity and the relatively calm security situation. As a result of the increase in the value of shares in Israel and abroad, the proportion of the share component of the asset portfolio was the highest since 2001, at a quarter of the value of the portfolio.
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The value of the portfolio excluding shares rose by 5.6 percent in 2004 compared with an increase of 4.6 percent in 2003.
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The size and the composition of the asset portfolio in 2004 was mainly affected by the following factors: the low inflation prevailing during the year and the expectations of price stability in the future, the continued implementation of the reforms in the capital market, and a restrictive fiscal policy that was reflected by a low level of government borrowing.\
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An examination of the asset portfolio excluding the share component shows that the multi-year trends in the indexation composition of the portfolio continued: a decrease in the proportion of CPI-indexed assets concurrent with an increase in the proportion of unindexed assets and foreign-currency assets.
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Monetary Department
Chapter 4: The Securities Market
Summary
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Yields to maturity, both nominal and real, declined moderately in 2004, following a relatively sharp decline last year. The nominal yields reached a similar average level to those at the end of 2001, and the real yields reached a lower level. In the first half of the year the yields on medium- and long-term bonds increased, while during the second half the yields for all terms declined, especially the short and the medium.
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Share market prices rose moderately this year-as opposed to the sharp increases recorded in 2003-with a sharp rise of turnovers in shares and in derivatives on the share index, to record heights. In the Treasury-bill and government-bond market, trade turnovers increased impressively this year, reaching a higher level than in previous years.
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The volumes of activity in derivative financial assets were characterized in 2004 by a mixed trend: trading volumes in interest-rate derivatives in the banking system and the stock exchange contracted, against the background of the decreased uncertainty, which was reflected in the prices of options, and in the low volatility characterizing the exchange rate this year. As opposed to these, the volume of trade in share derivatives traded on the Tel Aviv Stock Exchange increased, and especially the volumes of activity in interest derivatives and CPI derivatives offered by the banks. The Maof clearing house at the stock exchange inaugurated a real-time security-control system in 2004, whose characteristics are detailed in Section 5.
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During the year, the government reduced the deficit and the net negotiable domestic borrowing; at the same time the volumes of issues in the corporate bond market, the stock market and the convertibles market grew sharply.
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Monetary Department
Chapter 5: Institutional Investors
Summary
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| The proportion of the savings that the public held in their asset portfolio by means of institutional investors1 remained unchanged in 2004, and amounted to 37 percent at the end of the year (Table 5.1). The balance of institutional investors’ assets increased during the year—in a continuation of the trend of recent years (except for 2002)—and totaled NIS 559 billion at the end of 2004 compared with NIS 505 billion at the end of 2003. The increase was recorded largely among the mutual funds and to a lesser extent, among the other institutional investors. |
| For the first time in a decade, the provident funds recorded a positive accrual in 2004. Three are three main reasons for this change: (1) tax considerations—earnings on old deposits in the provident funds remain exempt from tax, while alternative forms of investment are taxable; (2) the improvement in the state of the economy, as a result of which the public have less need to withdraw money for current consumption; (3) the expectation of a further improvement in the funds’ performance. |
| The mutual funds continued to record a positive accrual, principally among the funds specializing in bond investments and those specializing in government bonds, although the amount accrued in all the mutual funds in 2004 was less than in 2003. This change was part of the adjustment of the public’s asset portfolio: During a period of low interest rates on deposits at the banks, the public were inclined to seek alternative fixed-income investments. The advanced study funds and the pension funds for new members also recorded a positive accrual. |
| In 2004 the mutual funds directed the majority of their investments to equities and to CPI-indexed assets, most particularly at the expense of their investments in unindexed shekel assets, a development that increased the tradability of the asset portfolio. This change resulted inter alia from the low yields expected on unindexed shekel assets due to the end of the process of cuts in the Bank of Israel’s interest rate and the abolition of the tax preference for certain shekel assets that was practiced until 2003 (Treasury bills and certain government bonds). In 2004 the other institutional investors2 chose to increase their investments in corporate bonds, shares and foreign assets, mainly at the expense of their investments in shekel deposits. Behind this change was the decline in interest rates in the economy and the search for alternative forms of investment that would yield a higher return, the consolidation of inflation expectations close to the center of the price stability target, the relative stability in the exchange rate of the shekel against the dollar, the growth in private sector issues, and the upturn in prices in the equities market at the beginning and the end of the year. Also contributing to the redirection of sources from the banks to the capital market were the tax reform, the pension reform, and the banks’ tighter credit extension policy that was reflected inter alia by increased investment in corporate bonds. |
| Savers’ awareness of the superior performance of the private provident funds during recent years over that of the funds managed by the banks, was apparent in 2004 from the much more rapid transfer of money from the banks’ provident funds and advanced study funds to private organizations. During 2004 the growth in the volume of assets managed by private companies encompassed the mutual funds as well. Even though the Bachar Committee’s recommendations have yet to be implemented, the very fact that they have been published and the interest that the public have displayed in the matter appear to have increased savers’ awareness of the relative efficiency of the private organizations. |
| Progress was made in a number of reforms relating to institutional investors in 2004. The most important among them is the reform of the capital market (the Bachar Committee’s report), which is centered on the separation from the banks of the ownership and management of the provident funds, the mutual funds and the underwriting companies. |
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Monetary Department
Diary of Events in the Money and Capital Markets in 2004
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| January |
| Bank of Israel interest rate |
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Rate reduced by 0.4 percentage points to 4.8 percent |
| Pension funds |
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The issue of earmarked bonds for the new pension funds ceased. It was decided that these bonds would be issued only if their balance after an additional issue would not exceed 30 percent of the funds' assets. |
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The Knesset passed the third reading of the bill raising the retirement age: to 64 for women and 67 for men. |
| Insurance companies |
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The reform in the insurance industry was implemented, increasing the transparency of insurance schemes and changing the composition of the industry's fees. |
| February |
| Bank of Israel interest rate |
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Rate reduced by 0.3 percentage points to 4.5 percent |
| March |
| Bank of Israel interest rate |
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Rate reduced by 0.2 percentage points to 4.3 percent |
| Repo auctions |
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The Bank of Israel started carrying out Repo transactions with the banking corporations and members of the stock exchange. In these transactions the Bank sells 1-year Treasury bills by auction at a uniform price known in advance, and buys them back two weeks later. |
| The stock exchange |
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Market-makers were authorized for trade in derivatives on the value of the euro in the Tel Aviv Stock Exchange. |
| April |
| Bank of Israel interest rate |
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Rate reduced by 0.2 percentage points to 4.1 percent |
| Pension funds |
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New directives were issued covering the operation of the new pension funds as actuarially balanced yield funds. A new scale was set for their management fees––0.5 percent of the fund's assets and up to 6 percent of the current payments (compared to 8 percent previously). |
| The stock exchange |
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The stock exchange's derivatives ("Maof") clearing house started operating a system for real-time collateral control in derivative trading. The system calculates the collateral required from clearing-house members during trade on a continuous basis throughout the trading day and in real time. Hitherto the calculation was made once a day at close of trade. |
| May |
| The stock exchange |
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The stock exchange launched a new system for trading in nontradable bonds issued to institutional investors (excluding mutual funds) without a prospectus. The system enables institutional investors to trade in these bonds by means of a separate trading system. |
| July |
| Income tax |
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A tax of 15 percent was imposed on tracker funds (exchange traded funds, ETFs) traded in the Tel Aviv Stock Exchange that mirror international indices. The tax was made retroactive to January 2004. |
| August |
| The Securities Law |
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The Knesset passed an amendment to the Securities Law that deals with the change in the method of underwriting and the way in which securities have to be offered to the public. |
| Real estate investment trusts (REITs) |
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A memorandum for a real estate investment trusts law was submitted to the Knesset along the lines of the recommendations of the committee set up to explore the introduction of REITs in Israel. Among the recommendations: the funds to be established should be traded on the Tel Aviv Stock exchange; most of their assets should be invested in income-generating assets; most of their profits should be distributed as dividends; and they be granted tax relief. |
| September |
| Pension funds |
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New directives were issued simplifying the transition from one new pension fund to another. |
| The stock exchange |
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With the development of the tracker-fund market during the last year and in the light of experience gained, the Board of Directors of the Tel Aviv Stock Exchange authorized the issue of ETFs on the index of hedging funds, on commodities and on "shorts"––funds that move in the opposite direction to the index that serves as their basis asset. The Board also issued rules governing the companies that issue the certificates in the tracker funds and added a minimal capital ratio requirement. |
| November |
| The reform in the capital market |
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The government approved the recommendations in the report of the Bachar Committee for the reform of the capital market, the essence of which was the separation of the provident and mutual funds from the banks. The government also decided to set up a committee comprising the Director Generals of the Prime Minister's Office and the Ministry of Finance to examine proposed changes to the report and to submit its findings to the Prime Minister and the Minister of Finance. |
| Institutional investors |
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The Shaarei Ribit company won a Ministry of Finance tender to set up and operate the database of interest rates for the provident funds, insurance companies and pension funds. The interest rates will serve to capitalize the cash flows of the nontradable assets of these investors––deposits, loans and nontradable bonds. The transfer to assessment of the nontradable assets of the institutional investors is planned for April 2005. |
| Commercial securities |
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The Knesset approved a change in the definition of a commercial security in the Securities Law to include also securities not traded on the stock exchange. Thus the status of commercial securities in the traded and nontraded markets were brought into line. |
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The Knesset Finance Committee approved an amendment to the securities regulations easing the issue of commercial securities, and allowing issues via shelf prospectuses. |
| December |
| Bank of Israel interest rate |
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Rate reduced by 0.2 percentage points to 3.9 percent |
| January 2005 |
| Bank of Israel interest rate |
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Rate reduced by 0.2 percentage points to 3.7 percent |
| Income tax |
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In the context of the reform of income tax on individuals that came into effect in January, the tax rates on capital gains, interest income and income from dividends on foreign securities, currently at 35 percent, were brought into line with those applicable to those on securities traded on the Tel Aviv Stock Exchange. The significance of this change is that tax on capital gains and on interest income from foreign securities is 15 percent, and on income from dividends, 25 percent. Pension funds, provident funds and advanced study funds that are exempt from tax on investments in Israeli securities will be exempt also from tax on investment in foreign securities. |
| State Loan Law |
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The Knesset passed an amendment to the State Loan Law permitting the integration of market-makers into the government-bond market. |
| Commercial securities |
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Stamp duty was cancelled starting with the issue of nontradable commercial securities. |
| February 2005 |
| Bank of Israel interest rate |
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Rate reduced by 0.2 percentage points to 3.5 percent |
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Diary of Events in the Money and Capital Market in 2004 - PDF file (0.04Mb)
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Foreign Currency Department
Chapter 1: Investment of the Foreign Exchange Reserves
Summary
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| The average level of the Bank of Israel's foreign exchange reserves during 2004 was about $26 billion. The reserves are managed in accordance with the Bank of Israel Law, 1954 and the legal interpretations of the Law, as well as a set of rules which reflect the character of the Bank and the functions of the foreign exchange reserves. Accordingly, the reserves are invested in foreign currency denominated bonds either issued or fully guaranteed by foreign governments and in foreign currency deposits with foreign banks abroad. As part of the management of reserves, the Bank is permitted to carry out transactions with commercial and investment banks outside of Israel and to use financial derivatives, such as futures contracts, on the condition that the underlying asset is one that the Bank is permitted to hold. The Bank is also permitted to carry out transactions in foreign currency with a limited number of local entities such as the government and banking institutions. |
| The functions of the foreign exchange reserves have changed over the years as a result of changes in the macroeconomic environment, which includes monetary and exchange rate policy. Currently, there are two categories of functions: 1Possible uses of the reserves, i.e. the possibility of selling them (in exchange for shekels) or lending them, with the main use being the sale of foreign exchange to the government for the servicing of its debt; and 2Benefits to the economy arising from the fact that the State of Israel possesses a particular quantity of foreign exchange reserves. The primary benefits are the reduction of the probability of a crisis in Israel's foreign exchange market and the improvement in Israel's international financial standing. The functions of the reserves serve as a basis both for determining their desired size and for defining the investment policy according to which they are managed. |
| The management of the reserves portfolio, in accordance with the investment policy derived from the functions of the reserves, is anchored to a hypothetical benchmark portfolio. The composition of the benchmark portfolio is determined by rules which govern its currency composition, its duration in each currency, the types of assets included within it and the dispersion of these assets along the yield curve. The management of the reserves portfolio relative to a benchmark fulfills three functions: the benchmark portfolio serves as a "risk-free portfolio"; the yield on the benchmark portfolio provides a basis for evaluating the yield on the invested reserves; and the restrictions on permitted deviations from the benchmark define the degrees of freedom for the active management of the reserves portfolio (which relate primarily to currency risk and that part of interest-rate risk measured by duration). |
| The holding period yield of the reserves in terms of a numeraire was 1.7 percent in 2004 as compared to 2.2 percent in the previous year. This yield reflects low yields-to-maturity during 2004 in the capital markets in which the reserves are invested, in addition to capital losses as a result of the increase in yields-to-maturity during the year. The holding period yield in shekel terms was 1.8 percent for the year in comparison to -1.3 percent in 2003. This reflected the weakening of the shekel against the non-dollar currencies in which the reserves are invested which was approximately offset by its strengthening against the dollar. |
| This year the holding period yield on the reserves was higher than the benchmark yield by 3basis points, a difference which reflects the contribution of the management of the portfolio. The yield on the reserves is determined to a large extent by the composition of the benchmark in view of the relatively small magnitude of deviations from the benchmark. It is these deviations which account for the managed risk of the portfolio. In recent years, a significant amount of effort has been invested in choosing an allocation of assets in the portfolio different from that of the benchmark and in selecting assets not included in the benchmark reserves portfolio. In contrast, the extent of the positions in duration and currency management has been reduced in accordance with the policy of reducing exposure in these areas. |
| The contribution of the decisions regarding the selection of assets, which accounts for part of the yield spread against the benchmark, was 9 basis points this year. Most of this contribution was a result of the investment in Eurobonds (about 6 basis points) and GNMA mortgage-backed securities (about one basis point) and securities-lending activity (about 2 basis points). The contribution of currency management contributed about 2 basis points while that of interest rate risk management (duration and dispersion) was a negative 6 basis points. |
| The exposure of the reserves to the banking system averaged 19 percent of the total reserves in 2004. A large proportion of the exposure was utilized in securities lending, an activity with a very short investment horizon. Some of the exposure reflects the investment in fixed-term deposits in order to benefit from higher yields relative to government bonds with the same maturity (the TED spread). This exposure was managed according to a set of rules and quotas which play a central role in the credit risk management of the portfolio. |
| The reserves have a high level of liquidity which is a measure of that portion of the portfolio which can be quickly realized without a loss in value. About 85 percent of the reserves portfolio is invested in highly liquid investments while the rest is invested in assets with lower liquidity. In view of the objectives in holding reserves, the level of liquidity appears to be adequate. The high level of liquidity is dictated by the Bank of Israel Law and the investment policy derived from the spirit of that law, which call for a conservative approach to the management of financial risk, and by considerations of profitability which have led in recent years to only partial exploitation of the degrees of freedom to invest in less liquid assets. |
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| 1 A glossary of terms used in this chapter can be found in Appendix 1.1. The first use of a glossary term in the main text is marked in italics. Various aspects of the management of foreign exchange reserves are discussed in the first chapters of previous issues of the Annual Report of the Foreign Currency Department. These reports can be found on the Bank of Israel site: www.bankisrael.gov.il. |
| 2 The average level of reserves in this report is calculated on the basis of the daily balances of reserves assessed at their full market value. All the holding period yields in this report are expressed in terms of a numeraire unless otherwise specified. |
| 3 According to the Law, it is permissible for the Bank to hold gold as foreign reserves but this has not been done for several years since it is not considered economically worthwhile. |
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Chapter 1: Investment of the Foreign Exchange Reserves - PDF file (1.70Mb)
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Foreign Currency Department
Chapter 2: Developments in Israel's Foreign Currency Markets in 2004
Summary
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| During 2004, the NIS (New Israeli Sheqel) was stable against the currency basket, depreciating by a modest 0.8 percent. This was the result of moderate appreciation against the US dollar - 1.6 percent, coupled with depreciation of 6.2 percent against the euro. The NIS also depreciated in real terms against the currency basket due to a smaller rise in the consumer price index in Israel than in that of its main trading partners. |
| During the first five months of the year the NIS depreciated against the dollar, reaching NIS 4.634 in mid-May against the background of portfolio adjustments by domestic Israeli investors out of NIS and into foreign currency during January and February followed by net sales of NIS against foreign currency by foreign financial institutions during March, April and early May. |
| From May and then on balance until the end of the year, the NIS strengthened against the dollar primarily due to the weakening trend of the US dollar on world markets. The NIS closed the year at 4.308 against the dollar. Other factors which supported the NIS against the dollar during the year include: the perceived improvement in the geo-political environment and relative calm in the security situation, an increase in foreign investment in Israel, rising global capital markets, the positive domestic economic environment which was supported by continued global growth, the 2004 budget deficit which came in below target, a balanced current account and the decline in global credit risk premiums. |
| An international comparison shows that the NIS appreciated against the dollar noticeably less than other currencies, of both advanced and emerging economies. Possible reasons for this include the low level of domestic interest rates and resultant narrow interest rate differential against the dollar, as well as the low volatility of the NIS/dollar exchange rate. |
| The NIS market was characterized by stability in 2004 both in comparison to previous years and in comparison with other emerging market currencies. This was reflected by a narrow NIS/dollar trading range, a decline in the volatility of the NIS/dollar exchange rate to 4.3 percent from 7.5 percent in 2003, and a narrowing of the interbank bid-offer spread to 0.45 agorot from 0.6 agorot in 2003. |
| The average daily turnover of foreign exchange in the NIS market totaled $1.65 billion in 2004, representing a marginal decline from the $1.68 billion registered in 2003. This was the first year since the establishment of bilateral NIS/dollar trading in which there was no growth in average daily turnover. Spot market turnover declined to an average of $722 million per day in 2004 after $748 million in 2003 and $827 million in 2002. This can be attributed almost exclusively to a decline in interbank spot activity. |
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Chapter 2: Developments in Israel's Foreign Currency Markets in 2004 - PDF file (1.04Mb)
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Foreign Exchange Activity Department
The Balance of Payments: Israel’s Foreign Currency Activities
Overview and Policy
Summary
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| Israel’s external and foreign-exchange activity in 2004 reflects a trend toward stabilization and improvement in the operation of the NIS/foreign-currency market and in the balance of payments, as well as a trend toward financial stability of the economy connected to these areas. The improvement, starting in 2003 with clear signs that the deterioration in the economy during 2001 and 2002 had been halted––grew stronger and consolidated itself during the year. The improvement is a consequence of the continuation and strengthening of developments that took place in the basic variables and the background conditions of the economy, against the backdrop of accelerated activity in the global economy: emergence from the slowdown and the transition to export-oriented growth while meeting the objective of price stability and a certain reduction in the level of unemployment in the economy, even though the economy has still not realized its full growth potential; reinstatement of the credibility of macroeconomic policy––which had been eroded in 2002 and already showed signs of recovery in 2003––thanks to cautious and prudent policy accompanied by reducing the rate of interest by 6.2 percentage points in the past two years; government policy which followed a stable and coherent track of budgetary discipline, and an accelerated pace of implementation of structural reforms and changes; evidence of recovery in the world economy, as expressed both in the increased tempo of growth and in world trade, including the high-tech industry whose impact on the Israeli economy is considerable, and in positive trends in the global financial markets; the confrontation with the Palestinians which indeed continued, yet its intensity decreased and conditions were created for the renewal of the political process. All these processes were expressed in the stability of the NIS which even appreciated by 1.6 percent relative to the dollar, and stabilized at a low level of exchange-rate risk, even though a certain rising risk trend could be discerned in the last few months of the year. |
| The current account of the balance of payments showed a surplus of about half a billion dollars––a continuation of the trend that developed in 2003 in contrast to the characteristics of the past decade. This surplus reflects the continuing recovery in the world economy, together with a pronounced growth in the volume of world trade and an acceleration in the level of activity of the Israeli economy which was expressed in a growth in exports at all levels of technological intensity. This surplus was also created against the background of the depreciation in the real exchange rate since 2001, which expresses the market’s competitive ability vis-a`-vis overseas markets. As opposed to last year, all components of imports grew this year in view of the recovery in the economy. |
| In the financial account the expanding trend in activity that began last year continued this year, even though the activity level of nonresidents and Israelis is still lower than in 2000, which represents a financial bubble in the world economy. Nonresident investment grew slightly, with a sharp change in its composition––an abrupt decline in the volume of direct investment and a pronounced growth in the volume of investment in the commercial securities portfolio. The decline in direct investments is conspicuous against the background of the improvement in macroeconomic conditions in Israel and the increased volume of mergers and acquisitions in the world, but it does not appear to reflect a change in the assessment of the attractiveness and the risk of the Israeli economy. |
| The stability in the NIS/ foreign-currency market was expressed in a moderate volume of capital movement relative to previous years and can be viewed as a consequence of a balance between forces that affected the exchange-rate in opposing directions: short-term factors that operated for most of the year in the direction of weakening the local currency, and long-term factors that acted to strengthen it, following the trends evident in 2003. |
| The main factors influencing short-term activity were the considerable contraction in the interest-rate differential between the NIS and the dollar––6.2 percentage points during the past two years, a more moderate contraction in the yield differential, and a greater contraction in the effective differentials as a result of the introduction of the tax reform. This year too, short-term forces operated with greater intensity, reflecting changes in world exchange rates, a consequence of global imbalances, changes in global investment patterns that are also affected by these problems, and changes in the perception of risk of the US dollar. The major long-term forces that operated to support the NIS were: nonresident investments that grew slightly in comparison with the previous year––against the background of the world economic recovery in general, and the high-tech sector in particular; continuity and even growth in the current-account surplus; the surplus created in the economy’s basic account comprising these movements, as well as the long-term movements of Israeli residents. All these are expressed in the existence of a stable and continuous supply of foreign currency in the market, thereby helping to reduce the sensitivity of the exchange rate to the influences of short-term movements as well as avoiding greater volatility in the exchange rate. |
| In continuation of the trends that developed during the past year, a further improvement was recorded this year in financial stability connected to the activity of the economy vis-a`-vis abroad and in foreign currency accompanied by stabilization at a low level of yield and risk. The stability of the markets, including the NIS/foreign-currency market, is a consequence of pursuing a rational and steady process of reducing interest rates––while maintaining a high level of credibility in the public’s eyes––to the lowest level in the history of the economy, as well as reducing the interest-rate differential relative to the dollar to a historically low level, together with the lowest level of exchange-rate risk, both in comparative historical terms and in comparative international terms. At the same time, the credit risk of the economy, which reflects the level of risk of the economy from the perspective of the international financial markets, contracted, similar to the trend that characterized other emerging markets, and the financial status of the economy, as measured by the international credit-rating agencies, also stabilized. The ending of tax discrimination, which constitutes the final stage in the process of removing the restraints in the economy vis-a`-vis abroad, did not harm the stability of the markets, despite the dire warnings of various entities in the economy that opposed these processes. The improvement in financial stability, in tandem with the process of reducing interest rates while maintaining the low level of risk of the exchange rate and the risk to the country, reflects the influence of a series of long-term variables that underlie the external stability of the economy: the improvement in the economy’s basic account; the guarantees arrangement that enables Israel to raise funds on international markets guaranteed by the US administration, and whose exploitation is one of the reasons for the growth in the reserves managed by the Bank of Israel, and which contribute to strengthening the resistance of the economy to external shocks; the net external debt, which since 2002 has become a net asset surplus which amounted to about 12 billion dollars at the end of this year; an improvement in the robustness of the business sector, including ending the exposure of the business sector to exchange-rate risk that in previous years constituted a potentially threat to the stability of the market––because of the fear that the rapid closure of the large gaps that were widespread in those years was liable to increase the fluctuations in the exchange rate. |
| The resilience and the stability of the markets were put to the test in 2004, a consequence of a significant process of adjustment of the public’s asset portfolio, a development that could have been expected against the backdrop of the completion and maturation of three long-term processes being managed in the Israeli economy during the past decade: first––completion of the disinflation process together with the rapid reduction of domestic interest levels and the interest differentials vis-a`-vis abroad; second––completion of the process of liberalization during the past year, which allowed Israeli residents full freedom of action, including reallocation of their asset portfolio and increasing their involvement in global markets; and third––as part of the process of removing the restrictions vis-a`-vis abroad, the tax discrimination between NIS assets and domestic foreign currency assets had already been removed in 2003, and during the year it already become clear that the tax discrimination between NIS assets and assets abroad would follow suit at the beginning of 2005. The completion of the process of removing the restrictions vis-a`-vis abroad––which offers many advantages and constitutes a central pillar of the macroeconomic strategy the country has adopted in striving towards realizing the economy’s growth potential––combined with a low -interest rate and a low interest rate differential vis-a`-vis abroad, had the effect of creating the potential for realigning the public’s asset portfolio by increasing the foreign-currency and assets-abroad components, and creating heavy pressure on the demand for foreign currency. And indeed, in the first part of the year, continuing from 2003, there was evidence of a process of adjustment, especially in the household sector through the acquisition of mutual funds invested abroad. During the year, however, the acquisition of foreign assets diminished and even reached a complete standstill. The moderate level of activity and its lack of persistence can be explained by a long list of factors, at the head of which are global factors: uncertainty regarding global markets, and especially the US capital market which constitutes the major target market for Israeli investors––both households and institutions––against the backdrop of the “twin deficits” of the US economy (the trade deficit and the budget deficit). The major contributing factor was the uncertainty regarding the US bond market––namely, fears about interest rate hikes and long-term yields in the United States––which was meant to be the major channel of the expected adjustment process. The domestic factors that worked toward discouraging overseas investment were expressed by the low domestic exchange-rate risk, as opposed to the increasing risk of investing in dollar assets as a result of the processes mentioned, which together with the positive trends in the domestic capital market, tended to favor it. The major insights that emerge from these developments are that even if all the necessary conditions for significant change in the public’s asset portfolio are met, the sufficient conditions were not met this year; the adjustment process in the asset portfolio is not continuous nor even uni-directional. It is affected both by structural factors such as “home bias”––the tendency of domestic bodies to invest less in foreign assets than would be required in terms of an optimal portfolio allocation––and by short-term factors affecting its intensity in a given period, such as expectations regarding global marketing trends in comparison with the domestic market. |
| Additional aspects of the adjustment of institutional investors and households are connected to two policy issues: the first––in an attempt to encourage competition between the institutional entities and to increase their transparency, the Ministry of Finance publishes their yields monthly. It would appear that this step increases the weight of short-term considerations in the overall considerations affecting the composition of the portfolio, thereby distorting the allocation of an optimal portfolio based on long-term yield and risk levels of the economy vis-a`-vis abroad. The second concerns the issue of the centralization of the capital market––households’ marginal volume of holdings of exchange-traded funds (ETFs), which represent an investment in foreign shares indices, and which, in 2004, enjoyed a tax advantage as opposed to parallel investment mechanisms such as mutual funds, reflect the problems of conflicts of interest and a lack of unbiased advice given by the banks, which manage most of the mutual funds. |
| Another major insight that emerges from the development of the adjustment process this year, concerns the level of impact of the interest-rate differential on the stability of the exchange rate, against the background of widespread assessments by the public of the need to avoid contracting the interest-rate differential to a level that threatens the stability of the markets, and rather to preserve a certain “floor” of interest-rate differentials. Developments this year show that a fixed “floor” does not exist indefinitely, and that an interest-rate differential that is consistent with the stability of the market, changes according to changes in the background conditions and the domestic risk level––relative to the risks of alternative global assets. The continual improvement in these areas enabled the process of contracting the interest-rate differential to continue, as well as reducing their role as part of the overall forces affecting the exchange rate, and particularly the long-term forces that supported the stability of the NIS. As opposed to this, the impact of global processes has intensified in recent years, an expression of increasing integration of the domestic and the global financial markets, evidence of which can be found in the reduction of Israel's country risk in conjunction with the reduction of worldwide risks––with the ending of the Iraq war––and the diversion of capital flows to emerging economies, including Israel, and thus to increasing the correlation between changes in the exchange rate worldwide and changes in the NIS exchange rate during 2004. However, the low level of interest-rate differentials increases the sensitivity of the exchange rate to changes in the background conditions of the economy, especially to fundamental deviations from the accepted criteria in developed countries regarding the macroeconomic management of the economy, but also to sharp changes in world exchange rates, interest rates, and asset prices, as a possible consequence of the current global imbalance. |
| In 2004 the process of enhancing the NIS/foreign-currency market continued, expressed, inter alia, in the issuance of new financial instruments, against the backdrop of the contracting supply of foreign-currency assets as a result of the expiry of dollar-indexed government bonds (Gilboa), as well as the issuance of ETFs of a range of global assets. It does, however, appear that the expansion of this market, which is the deepest and most liquid of Israel’s financial markets, has been checked, after a gradual process of improvement and deepening in the past decade against the backdrop of the liberalization in foreign exchange control, flexibility in the exchange-rate regime, and the increased activity of foreign entities. The stability in the volume of currency conversions, and the decline referred to in the exchange-rate risk––even though an increase was recorded in these toward the end of the year––call into question the long-term path of the development of this market. While these factors may reflect the completion of the development process, they may also reflect structural problems, such as the level of development and the depth of the domestic capital market and discrepancies in trading patterns between domestic and foreign banks. These are characterized by a high degree of centralization––both regarding the number of active bodies as well as the limited number of shares and bonds with which they deal––by heterogeneity in their activities in the foreign-currency market and their considerable influence on the share market at certain periods. Particularly notable is the low level of exchange-rate risk, both by historical and by 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 in the context of monetary policy, because its decline offset the effect on the exchange rate of the marked interest rate cuts made during the year. |
| Against the backdrop of the growing openness of the economy and its integration in global economics, its greater sensitivity to external shocks, and the fact that it is subject to scrutiny by the global financial markets, special importance is attributed to responsible and prudent macroeconomic policy in accordance with the standards currently prevailing in developed economies, in addition to creating the conditions to enable the continued development and refinement of the market. In this context there is a need to remove the last remaining obstacle that prevents the economy from operating with a completely freely floating exchange rate and under conditions of full liberalization––the exchange-rate band. This band has widened over the past decade, but even though it is no longer effective, it still limits the potential range of mobility of the exchange rate, and embodies a potential distortion in the perception of risk by market players. Its annulment at a time that it is no longer effective and the transition to a completely floating exchange rate regime will prevent the generation of distortions of this kind and will enable the exchange rate to operate as a shock absorber, as is the norm in developed countries. |
| The private sector’s exchange-rate risk management is crucial for the process of market development in an era of transition to a floating exchange rate. In the long term, as a result of the convergence of domestic inflation rates in recent years to those in developed countries, the rate is expected to vary without a clear-cut trend––as opposed to the constant and ongoing 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 operate toward attaining price stability, which should serve to reduce the long-term volatility of the exchange rate, and the latter to manage risk thoughtfully and systematically in order to minimize the effect of the volatility on their business results. Despite the rapid development of the derivatives market, the increased volume of activity, and the development of a variety of instruments for different players and needs, 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. 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 for using them. The authorities thus need to take the initiative to regulate matters in order to bring about a more efficient distribution of risks, thereby contributing to the greater stability of both the business sector and the market as a whole. |
| Another phenomenon attesting to the public’s lack of internalization of the end of the process of disinflation and the transition to a floating exchange rate that is expected to fluctuate in both directions without a clear trend, is that of “dollarization”. Dollarization is expressed in the large component in the public’s asset portfolio of assets linked to or stated in foreign currency, in a large exposure to appreciation in the balance of assets and households’ foreign currency liabilities, and in a complete series of linkage arrangements and dollar payments. It can be assumed that in the long term the weight of the domestic dollar assets held with the motive of linkage to the exchange rate will decline, whereas the weight of the assets abroad, held for considerations of dispersal will increase. A contraction in linkage arrangements and dollar payments is likely to take place as an ongoing process, which the various authorities have a role in promoting, inter alia by legislative means. Thus, for example, the arrangement for determining the price of electricity in the economy embodies a linkage between the price of electricity and changes in the exchange rate––beyond that which is justified by the price of the inputs. Importance is attributed to diminishing dollarization in the economy in the context of consolidating price stability and weakening the transmission from the exchange rate to inflation, since in the current circumstances it would appear that a sharp and rapid devaluation of the NIS, as a result of an external shock, is the main factor endangering the price stability that has taken root in the economy. |
| In order to develop policy aimed at attaining the stability of prices and of the financial markets it is necessary to analyze the conditions for stability ––based inter alia on past experience––as well as the factors that create and increase vulnerability and the processes that undermine stability. Constant monitoring is required in order to identify such processes as early as possible, while distinguishing between temporary negative development and the onset of a damaging process. Special importance is attributed to the sectoral analysis of economic activity––identifying the behavior patterns of the various sectors, chief among them the major financial players and households, in times of calm and in times of crisis, and monitoring changes in their activity. The basis for monitoring and analysis of this kind is comprehensive, detailed, and up-to-date information. In the past few years, concurrent with the liberalization process, the Foreign Exchange Activity Department has constructed extensive and detailed information systems on economic activity vis-a`-vis abroad and in foreign currency. These systems make it possible to analyze monetary policy needs on an ongoing basis, to track the stability of the economy, and to identify focal points of vulnerability and processes in which stability is undermined. The information collected is processed within the Department and published regularly with a minimal lag, with the aim of improving the transparency, the quality, and the availability of the information in the hands of the players in the financial markets. The Department also publishes various reviews, press releases, and research studies in the area of its activity, and organizes meetings to create channels of direct communication between it and the various market players. This is done in the realization that transparency in the markets contributes to making them more perfect, thereby increasing financial stability. |
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| This report contains three parts. The first analyzes market developments within the accepted international framework of the balance of payments, that is to say, economic activity vis-a`-vis nonresidents in foreign and local currency, and includes the movements in both the current account and the financial account of the balance of payments and the asset surpluses and liabilities vis-a`-vis abroad, including the external debt. The unique nature of the Israeli economy and the prominent part played by the exchange rate in domestic activity requires a separate analysis enabling all the forces acting on the exchange rate to be identified. This issue is dealt with in the second part––NIS/foreign-currency activity––the activity of Israeli residents from the various sectors in foreign currency assets and liabilities (denominated and linked, vis-a`-vis nonresidents and between the sectors themselves) and the activities of nonresidents solely in NIS assets and liabilities (including NIS/foreign-currency forward transactions). The differences between the analytical frameworks are presented in the Department’s Internet site.
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| The liberalization process has exposed the Israeli economy to international capital movements and has made it more sensitive to external financial risks. It is thus necessary to continually monitor its external financial stability. Financial stability is analyzed in the third part of the report, in the context of activity in the NIS/foreign-exchange market and vis-a`-vis abroad.
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Foreign Exchange Activity Department
Chapter 1: Main Developments
Summary
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In 2004, as in 2003, the current account ended the year with a $ 0.5 billion surplus after deficits since the early 1990s (Table 1.1.1).1 The improvement in the past two years is especially conspicuous in view of the economic growth that occurred during this time; in the past, growth had been accompanied by current-account deficits. The positive level of the current account, coupled with price and exchange-rate stability, have made the opening conditions for 2005 among the best that the economy has ever known.
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The current-account improvement in 2004 coincided with an 18 percent expansion of activity on goods and services account of the balance of payments, surpassing the 2000 level. The goods account grew more vigorously than the services account. These growth performances were abetted by the continued global economic recovery but outperformed the recovery by a wide margin (Figure 1.1.1). The financial account also expanded for the second straight year. Foreign investment was $ 6.6 billion as against $ 6 billion in 2003 and resident investment (net of the change in foreign reserves) increased to $ 9.2 billion as against $ 6.1 billion a year earlier. In foreign investment, issues by technology companies on foreign exchanges increased perceptibly and direct investment declined significantly. In resident external investment, the increase in external deposits of the banking system stood out.
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The increase in exports of goods and services contributed to the upturn in imports because some imports serve as intermediates for exports. The expansion of imports in 2004 was also related to the increase in domestic demand. All types of imports (raw materials, consumption goods, and capital goods) increased, as opposed to the trend in 2003, when the economic slowdown held the increase in imports to a negligible rate while exports rose twice as rapidly. Notably, the rate of increase in exports of goods and services in the past two years surpassed that of domestic growth by far. As a result, the deficit on account of these two forms of activity fell to half its level in the preceding two years. It was this expansion that made a contribution to the change in the current account.
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Much of the increase in current-account activity during the past two years traces to high-tech industries, which account for nearly half of industrial exports, and software and R&D services, the exports of which are recorded in the services account. These industries together exported $ 15 billion in 2004. The regional geopolitical improvement in 2004 boosted inbound tourism by 40 percent. However, tourist arrivals remained 38 percent under the 2000 level and tourism revenue fell short of the 2000 level by $ 1.6 billion than in 2000.
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The upturn in global interest rates in the second half of the year was reflected in the factor- income account, raising the net interest income of the private sector (banking and nonbanking), whose external assets increased by $ 8 billion. The change in interest rates had hardly any effect on general-government expenditure because almost all general-government liabilities are long-term and at fixed interest rates. The wage-expenditure component has improved considerably in recent years because the population of foreign and Palestinian workers has declined. Since its peak in 2001, wage expenditure for foreign workers has fallen by $ 0.8 billion and that for labor from the Palestinian Authority areas by $ 0.7 billion, with the combined expenditure on both totaling $ 1.5 billion.
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The net financial account (foreign investment less resident external investment except for reserve assets), which had run a surplus for many years, recorded its first deficit in 2002, the crisis year, and the deficit increased to $ 2.6 billion this year (Figure 1.1.2).
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Turning to the distinction between capital instruments and debt instruments in the net financial account, the economy has had a surplus of capital instruments in all recent years. Thus, foreign investment in shares (direct and portfolio), a reflection of foreign investors' confidence in Israel, exceeds resident investments in these instruments abroad. In debt instruments (bonds, credit, and deposits), in contrast, the domestic economy is in deficit. This is a consequence of the surplus in capital instruments, since the typical level of the current account ranges from balance to a small surplus.
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The capital-instrument surplus declined from $ 4.3 billion in 1999-2001 to $ 2.2 billion in 2003 and 2004 (annual averages in both periods) as resident external investment expanded more quickly than foreign investment, and not due to a decline in Israel's attractiveness to foreign investors. Indeed, all factors that tend to attract foreign investment-the growth rate, technological innovation-which had an upward effect on investments in these industries (see box in the chapter on foreign investment)- the geopolitical situation, confidence in economic policy, greater efficiency in the capital markets, privatization, and the deregulation process-have shown signs of improvement in the past two years. However, the factors that encouraged residents to invest in foreign capital instruments were more intensive. Important factors of this type include the globalization process in which large Israeli firms are participating, reflected among other things in rather large acquisitions of production lines abroad, and the high-tech recovery, which has caused investments in these industries to rise.
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The net debt-instrument deficit climbed from $ 2.6 billion on average per year in 2001-2003 to $ 4.7 billion in 2004, largely due to an increase in the surplus of sources of the banking system, which the system invests abroad; the lowering of the liquidity ratio on commercial banks' deposits with the Bank of Israel; a decline in demand for forex credit, and the tax reform, all of which made foreign assets relatively more profitable for households and institutional investors to hold.
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In response to the factors that abetted change in the net financial account, the banking system, which operates mainly by means of debt instruments, transferred $ 7.3 billion (cumulative terms) in other sectors' excess forex sources out of the country in the past two years, including $ 2.7 billion in the last quarter of 2004. In contrast, the private sector and general government had surpluses (Table 1.1.1).
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Net direct investment flows turned around in 2004 and became negative for the first time in many years as foreign investment declined steeply and net portfolio investment became positive after three years of decline, largely due to an increase in Israeli high-tech issues on foreign exchanges (Figure 1.4). Some of the change traces to one large transaction that was recorded both as an increase in foreign portfolio investment and an increase in direct resident investment abroad.
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Foreign investment: In 2004, Israel maintained its share in the total capital inflow to emerging-market economies but the composition of the total, in terms of types of investments. changed sharply relative to these economies. As stated, direct investment declined steeply, from $ 4 billion in 2003 to only $ 1.6 billion in 2004, whereas portfolio investments climbed from $ 2 billion to $ 5.4 billion in the respective years (Table 1.1.2). The decrease in direct investment occurred despite the upturn in mergers and acquisitions around the globe and the improvement in Israel's macroeconomic fundamentals. However, it originated in the timing of a small number of large investment transactions and a technical shift from the direct-investment line to the portfolio-investment line, as opposed to a decrease in Israel's attractiveness to foreign investors. For example, nonresidents realized a $ 0.7 billion direct investment in a telecommunications company due to privatization processes in this industry that matured during the year. In the fourth quarter of 2004 and in early 2005, agreements were concluded for the performance of $ 1.9 billion in direct investments that will largely be reflected in the 2005 data, which are expected to show a large increase relative to the long-term average. Foreign direct investors in Israeli high-tech shares abroad sold $ 0.5 billion of their holdings to foreign portfolio investors in view of the relatively high prices that Israeli technology shares were commanding. Furthermore, capital raising by VC funds and investments in start-up companies, which reflect nonresidents' confidence in Israeli technology, increased vigorously even in American terms. The recovery of real global demand for high-tech products was accompanied in 2004, in contrast to 2003, by an upturn in international capital issues and led, as stated, to a rapid increase in Israeli technology share issues on American exchanges, at $ 2.8 billion as against $ 1 billion in 2003-a rate exceeding the upturn in issuing by domestic companies. In all, $ 5 billion was invested in shares (directly and for the portfolio) in 2004, the highest level in the past four years.
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The global uptrend in investments in emerging markets' stock exchanges in 2004, occasioned by poor yields on risk-free assets in developed countries and the decline in the riskiness of the emerging markets, was also evident on the Tel Aviv Stock Exchange and prompted nonresidents to invest $ 0.5 billion in shares, mostly in the fourth quarter of the year, as against negligible investment in the bond market. Nonresident activity in government bonds is expected to increase in 2005 as several reforms in this market go into effect.
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Resident investment: The worldwide high-tech recovery and the continued integration of Israeli firms into the globalization process acted to sustain the upturn in the direct investment flows of Israeli firms abroad and encouraged two changes in the patterns of investment-from the acquisition of marketing channels to the acquisition of production lines and from financing by means of loans to financing by equity investment. Investment flows in the portfolio assets of households and institutional investors slowed in the second half of the year, mainly due to the appreciation of the NIS and a decline in the prices of foreign assets, even though the January 2005 tax reform will make it relatively more profitable to hold assets abroad. (See box in the NIS-Forex Market section.) The business sector expanded its external depositing vigorously due to increases in exports and external issues and as hedging for the innovative financial instruments that financial companies in this sector issued to residents in 2004. As stated, the banking sector deposited much more money abroad than before, as the narrowing of the NIS-forex interest spread created surpluses of forex sources.
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Foreign Exchange Activity Department
Part II, The NIS-Forex Market
Summary
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The NIS exchange rate was notably stable in 2004 under the effects of mutually offsetting forces. Domestic factors that tended to weaken the currency were accompanied by a set of domestic and global factors that had the opposite effect. The domestic factors that favored a strong NIS include improvement in a number of long-term parameters in the forex market, the expansion of real domestic activity, and greater credibility in macroeconomic policy. In view of the global economic recovery including high-tech, these factors favored the continuation long-term foreign investment,1 largely portfolio and in small part direct. Long-term forex supply increased due to the perseverance of long-term foreign investment and the continued improvement in the current account. This supply generated underlying appreciation pressure and helped to ease the relative effect of short-term capital movements,2 which by nature are more volatile, on the changes in the exchange rate.
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Domestic factors that had a pro-depreciation effect included the tax reform, which reduced the relative attractiveness of NIS investments as opposed to those in forex, and the narrowing of the interest spread. During the period reviewed, the NIS-dollar interest spread narrowed by 2.25 percentage points and came to 1.45 percent. During the first few months of the year, these factors prompted households, which transact mainly by means of forex mutual funds, to adjust their portfolios. This process stopped later in the year, however, despite two factors that should have caused it to accelerate: an increase in certainty about the completion of legislation to advance the elimination of tax discrimination between domestic and foreign securities to the beginning of 2005 and the continued contraction of the interest spread. The process ended due to a series of factors, mostly global: slowdown and rising uncertainty in global stock markets, an increase in the dollar exchange-rate risk against main currencies, and an upturn in expectations of a rise in short-term yields in the U.S. bond market. These developments, coupled with the favorable trends in the domestic capital market, made investing in foreign securities relatively less advisable. The market's response to the narrowing of the interest spread was usually moderate during the year, since it was accompanied by a decrease in the exchange-rate risk of the NIS and an improvement in the underlying variables in the forex market.
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As the domestic economic environment remained relatively stable and the geopolitical situation improved, the global financial environment had a relatively greater effect on the NIS exchange rate. The effects of developments in exchange rates among main monetary blocs and the behavior of prices in global financial markets were especially important. The impact of the global financial environment was reflected in both the extent of long-term capital inflows and the extent and direction of short-term flows. The trend in nonresident portfolio investment, particularly that related to issues by Israeli firms abroad, usually moved in tandem with the trend in prices in main global financial markets. Thus, external issues by Israeli firms slowed after the NASDAQ market lost altitude in the second quarter and accelerated when the NASDAQ market recovered in the fourth quarter. The level and direction of short-term nonresident capital flows were also strongly affected by general global trends in investment in emerging-market economies. Thus, in the second quarter, as yields in the U.S. bond market climbed, international financial players became less willing to invest in emerging-market economies, including Israel. Consequently, the nonresident short-term NIS position fell to zero during the second quarter. As the dollar depreciated against the main currencies in the second half of the year and especially in the fourth quarter, due to factors including the American "twin deficits" (budget and trade), these institutions began to reinvest in emerging-market economies and helped to strengthen these countries' currencies against the dollar. As a result, nonresidents built up both their investments in shares on the domestic exchange and their NIS positions in short-term instruments during the last quarter. Notably, however, the NIS gained less against the dollar than other emerging-market currencies did.
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In one of the most conspicuous developments in 2004-one that helped to consolidate the financial stability in the forex market- the business sector reduced its liabilities surplus by $ 6.5 billion, to $ 0.7 billion at year's end. The reduction in the business sector's depreciation exposure traces to a buildup in forex assets, especially by companies that tend to have forex assets surpluses due to the nature of their activity. This abetted the consolidation of financial stability in the forex market since in past years the business sector's aggregate exposure to depreciation had been a potential threat to market stability due to concern that rapid closure of the exposure would make the exchange rate severely volatile. Importantly, however, even though its aggregate exposure to depreciation fell to low levels, the business sector is still badly exposed in both directions. Unlike the past, however, its exposure today is strongly heterogeneous.
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The relative stability that typified the forex market during the period reviewed was reflected in the continued downtrend of exchange-rate risk to a historic low at the end of the third quarter. During the last quarter, an upturn in exchange-rate risk came into sight, evidently due to increases in uncertainty about the exchange rate of the main monetary blocs and domestic uncertainty factors.
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Foreign Exchange Activity Department
Part III, External Financial Stability
Summary
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Israel's financial stability (FS) improved in external and forex activity in 2004 due to the more amenable financial environment in which the market operated and to a certain improvement in financial standing. An FS analysis is based on index monitoring and on an analysis of internal and external events and processes in Israel that have a potential effect on FS.
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The financial conditions under which the market operated in 2004 were more amenable than those of 2003: the indices show that the underlying conditions for global financial stability as well as that of Israel had improved. This was further bolstered primarily by global and domestic growth. A potential challenge to stability from the narrowed interest gap did not materialize. The external financial climate was responsive as a result of international investors' evident readiness to invest and the low cost of capital and debt financing. The economy operated in a climate of lower yields and risks than formerly and this contributed to economic activity. Trading on the NIS-forex market remained buoyant and heterogeneous in character. A further contribution to this stability resulted from reinforced credibility of monetary and fiscal policy. In 2004, no signs were discerned of any potential challenge to fiscal stability. Changes in the stability indices were minor compared to the previous year and changes during the year were more moderate than in 2002 and 2003.
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An analysis of Israel's external and internal resistance that derives from its balances and their components1 demonstrates the financial robustness of the economy in 2004 but a counter-development was also noted. On the one hand, Israel recorded a significant improvement in foreign currency activity as the business sector was no longer exposed to changes in the exchange rate. Furthermore, on the side of external liabilities, Israel was more resistant to a relative reduction in the extent of these obligations and an improvement in the short-term liquidity ratios. The continued upward trend of the net external debt assets improves Israel's standing in the eyes of foreign investors but exposes it to the risks of overseas investments. On the other hand, a deterioration was recorded in the economy on the liabilities and gross assets side because of their increase and a less favorable composition on the assets side. Furthermore, households hold a significant surplus of assets in forex and have a marked exposure to an increase in the value of the NIS. Non-residents short NIS position increased after it had closed during the year.
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A number of developments in 2004 had a significant impact on FS. After the last quarter of 2003 and during the first quarter of the year under review, considerable activity was discerned on the part of households to adjust their asset portfolios to changes in the relative external yields. This activity was inhibited by market forces. FS is sensitive to the households' activities because of potential of "herd" behavior patterns. Significant activity of non-residents was observed in two periods: in the months of April to June 2004 and September to December 2004. In the former period, an outward movement on the part of non-resident investors was noted. This corresponded to the capital outflow from emerging economies and a reduction in their short-term speculative positions. In the latter period, an increase in the in-flow of capital from non-residents was discerned against the backdrop of similar trends in other global economies. The heterogenic character of non-residents' activities in shares and derivatives was constant for most of the year but lessened in these two periods. The increased heterogeneity and spread of their activity will contribute to more robust FS. FS is sensitive to non-residents' behavior because of their financial strength and their behavior that is, at times, influenced by global trends.
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Global financial trends had an impact this year on the Israeli economy. The global volatility of financial assets lessened and credit gaps were reduced. Similar phenomena were noted also in Israel. The standard deviation inherent in options (the implied standard deviation) of the NIS-dollar exchange rate fell to a historically low level, but this was appreciably lower than the standard deviation inherent in other currencies; the exchange rate of the dollar-NIS was impacted by the weakening global trend of the dollar; the extent of the forex conversions recorded this year in Israel remained below record levels. However as a general rule, the increase in the extent of forex trading in recent years and its moderation this year are consistent similar trends in global money markets. A number of long-term processes were also noted this year that reinforce Israel's FS: reduced involvement of the public sector in economic and financial activity, increased activity of non-residents in the economy, the development of the NIS-forex market including the increased trading volume in recent years.
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Nevertheless, at the end of the period, Israel faced a lack of global balances externally and a low interest environment internally. The lack of global balances that derives mainly from difficulties in the US economy, contributed to financial stability denoted by Israel's interest reduction process but it embodies a potential for diverse exogenous crises in the absence of controlled and gradual regulation of the equilibration. The low level of interest in Israel was, from the aspect of the financial environment, unknown and increased Israel's vulnerability to crises. However the improvement in the financial strength of the economy in recent years and its characteristically low risk level do not necessitate maintaining a higher interest level than is required by considerations of monetary policy.
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Part III, External Financial Stability
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