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Bank of Israel Annual Report, 2007
Summaries
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Chapter 1
The Economy and Economic Policy
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Positive developments continued in many spheres in 2007: GDP rose by 5.3 percent; the rapid growth was led once again by the business sector, based on favorable background conditions; the rapid expansion of exports persisted; unemployment plunged to its lowest level in a decade.
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The ongoing improvement in the state of the economy was also reflected in decisions by external entities: the OECD organization invited Israel to embark on the procedure for joining it, and Israel's credit rating was raised.
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The character of Israel's economic expansion is changing: as the output gap narrows, growth is based to an increasing extent on an increase in factor inputs. Both employment and investment rose sharply in 2007. The expansion of private consumption also accelerated and demand pressures began to emerge, reflected inter alia in the contraction of the surplus on the current account and a surge in imports.
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The Consumer Price Index (CPI) rose by 3.4 percent in 2007, so that inflation exceeded the upper limit of the target range. Inflation accelerated in the second half of the year despite marked local-currency appreciation against the dollar. The acceleration was caused by the rise in world prices of fuel and food, especially in the last two months of the year, as well as by the expansion of domestic demand.
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Monetary policy acted to return inflation to the target range. In the first half of the year the Bank of Israel continued to reduce the interest rate in view of the low level of inflation and its deviation below the lower limit of the target range. In the second half of the year the central bank began to raise the interest rate as a result of the rise in inflation and inflation expectations.
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Until the end of 2007 the effect of the global financial crisis on Israel's economy in general, and on the financial system in particular, was moderate. But the global financial crisis is not yet over, and there are concerns that at a later date it will have a more significant impact on Israel's economy, impacting directly on the financial system as well as indirectly due to the slowdown in global economic activity.
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The government adhered to its growth-sustaining fiscal policy: the budget deficit was eradicated and the public debt/GDP ratio continued to contract. The expenditure target was maintained and tax rates were further reduced. Tax receipts rose as a result of economic growth, and the decline in public expenditure as a share of GDP persisted.
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The capital market continued to flourish and the resilience of the financial system improved. However, attention should be paid to the development of various risks in the financial system, inter alia against the backdrop of the boom and rapid structural changes. The regulatory and supervisory bodies should be adapted to these changes.
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Policy should persevere with measures that support sustainable growth, price stability and financial stability-also in view of the possible global economic slowdown and increase in risks. There should be a further reduction of the public debt/GDP ratio while steps should be taken to improve the level of the public services and reduce poverty. Policies aimed at allaying poverty should focus on a variety of measures designed to enable Israelis with a low level of education to find employment and increase their earning power.
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Chapter 2
GDP, Uses and Principal Industries
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GDP grew at a high rate in 2007, which was similar to that in the three previous years. The rapid process of growth, which continued throughout the year, was led by the business sector and was fully manifested in the labor market through the increase in employment and real wages and the steady decline in unemployment. |
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Though the growth rate was similar to that in previous years, its characteristics had changed: thus, in previous years, the growth process had been led by an increase in total factor productivity; in 2007, it was primarily the result of growth in production factors, particularly the major increase in labor input. Further, the growth process hitherto was spearheaded by exports; in 2007 it was also the result of a sharp increase in domestic demand. |
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The high rate of growth was the result of favorable background conditions: a boom in the global economy and in the hi-tech markets, improvement in the security situation and a supportive economic policy. |
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The improvement in background conditions and the continued growth led to a sharp increase in demand which elicited only a partial response in the supply of GDP. For the first time since the beginning of the accelerated growth process, there were signs of excess demand in the economy though only on a small scale. |
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Total uses increased at a much higher rate this year than GDP. As a result, imports grew sharply and exceeded exports, which resulted in a deficit in the trade balance. These developments were accompanied by a real appreciation and an increase in unit labor cost. |
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Private consumption grew rapidly this year. This was accompanied by a decline in private saving that was supported by a major increase in the public’s wealth, particularly in the value of its financial assets portfolio. |
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Despite the drop in the rate of national saving and the increase in the rate of investment, there remained a large surplus in the current account. |
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Manufacturing sector product grew as a result of the continuing growth in exports. The product of the transportation, commerce and service industries increased sharply due to the growth in private consumption and tourism. The construction industry grew but the stagnation in residential construction continued. |
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There is an urgent need for improvement in public transportation, primarily in the Tel Aviv metropolitan area, and for increased competition in the airline industry and ports. A reform of land ownership and land planning has become increasingly urgent. |
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Chapter 3
Inflation and Monetary Policy
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The Consumer Price Index (CPI) rose by 3.4 percent in 2007, above the upper limit of the inflation target. |
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The main forces affecting prices were the steep rise in world prices of inputs, the expansion of domestic demand, and the appreciation of the shekel during most of the year. |
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In the first half of 2007 real inflation was below the lower limit of the inflation target, while the effect of the forces exerting downward pressure on prices and influenced by local-currency appreciation predominated. During this period the Bank of Israel reduced the interest rate five times, by a cumulative 1.5 percentage points, so that in the middle of the year it stood at 3.5 percent. |
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Both real and expected inflation rose in the second half of the year, and the effect of the forces exerting upward pressure on prices resulting from both real economic activity and world prices of energy, goods, and food were predominant. In 2007:III the Bank of Israel raised the interest rate twice, to 4 percent, where it remained until the end of the year. |
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Chapter 4
The Financial System
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The positive trend in the financial markets and the stability of the financial system persisted in 2007. The global financial crisis that plagued the financial system in the developed countries during the second half of the year had only a moderate impact on Israel by the end of 2007. The direct effects of the crisis have been increased volatility and risk margins in the financial markets, and an end to the upturn in asset prices that was typical of recent years. |
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The financial system’s resilience––its ability to absorb shocks––increased in 2007. This improvement was reflected in a decline of banks’ credit risks, while their capital adequacy, and that of insurance companies, was maintained. The improvement was also reflected by the continued rise in liquidity in the financial markets, and by the greater diversification of credit risks in the economy. However, it appears that the financial institutions failed to exploit their high profitability in order to increase their capital ratios. |
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The structural reforms that were applied in recent years have helped to enhance the financial system: the banks’ share of business-sector finance decreased further in 2007, the corporate bond and ETF (exchange traded funds) markets expanded, the competition for the management of the public’s savings increased, and the banks began to develop a pension advice network. |
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Looking ahead, the risk of shocks in the financial system has increased due to the possibility of a slower rate of growth and a further expansion in risk margins as a result of the spread of the global crisis. The risk to the system also increased as a result of the rapid expansion in credit from institutional investors, which have less experience in monitoring credit risks and that are still subject to a lower level of supervision than the banks. |
| The measures initiated by the supervisory authorities regarding the management of risks and capital adequacy are helping to reduce the vulnerability of the financial system. In view of the prevailing risks however, greater enforcement and control are still necessary with respect to risk management and the actual positions taken at the financial institutions, principally the insurance companies. The supervisory authorities also need to cooperate in making the appropriate preparations for dealing with financial crises. |
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Chapter 5
The Labor Market
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The labor market was affected by the surge in demand in 2007 and was characterized by the marked expansion of employment, the significant contraction of unemployment alongside the reduction of its depth, and a rise in the real wage. |
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The improved chances of finding employment encouraged persons who had not been part of the labor force to join it; thus, the participation rate rose, and the number of discouraged workers fell. |
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Employment expanded this year in industries that are human-capital intensive as well as in those employing less-educated workers, and wages rose in almost all industries. The unemployment rate among educated workers neared its ‘natural’ rate, and the situation of workers with 11–12 years of education improved, although the unemployment rate remained high for persons with a low level of education. |
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Unit labor cost rose for the first time since the emergence from the recession at the beginning of the current decade. This was the result of the slowing of the growth rate of labor productivity, and attests to the fact that the economy is approaching capacity utilization of the factors of production. |
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After an extensive decline in the cyclical component of unemployment, most of the remaining unemployment reflects a mismatch between the level of human capital required and that offered. The employment rate of persons with less than 12 years of schooling rose slightly, but they continued to leave the labor force despite the policy measures adopted to encourage them to move ‘from welfare to work.’ |
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The government’s policy in the labor market focused on implementing the labor laws, subsidizing employment, and increasing remuneration for work through the long-term reform of income tax. At the end of the year the earned income tax credit reform legislation was adopted, and will initially be introduced in certain regions. On the other hand, the policy regarding foreign workers weakened, and the number of these workers even increased in 2007. In spite of the measures introduced, the rate of government expenditure on active labor market policy is only 0.21 percent of GDP, compared with an average of 0.7 percent in the OECD countries. |
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Chapter 6
General Government, its Output and its Financing
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Continued rapid growth and the composition of demand led to unexpectedly brisk revenues, resulting in favorable fiscal aggregates in 2007 as in 2006. The government deficit excluding net issue of credit was zero, the lowest in twenty years and far below the target ceiling. The general-government deficit, measured according to the National Accounts definitions used in developed countries, was 1.0 percent of GDP as against 1.2 percent in 2006. |
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The combination of a balanced budget, continuing growth, and currency appreciation caused the general-government debt/GDP ratio to fall even more precipitously than had been expected at the beginning of the year. The ratio at year’s end, 80.6 percent, remains high by the standards of developed countries but the gap has narrowed significantly in recent years. |
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The public expenditure/GDP ratio has been falling steadily since 2002 and ended 2007 at 44.9 percent, the lowest level since the late 1960s. Thus, Israel’s ranking among developed countries fell from the top of the scale at the beginning of the decade to the middle. Alongside the improvement in the fiscal aggregates, in the short and medium terms the drop in public expenditure resulted in a decline in the quality of civilian services, which also contributed to an increase in poverty and social inequality. |
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The public expenditure/GDP ratio fell in 2007 due to rapid growth of GDP, whereas expenditure rose swiftly in real terms. Additionally, the government made long-term decisions that augur an increase in expenditure in coming years at a pace that is not only inconsistent with continued significant reduction of the debt/GDP ratio but also surpasses the maximum rate of increase that current law allows. |
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Pursuant to the trend in recent years, government expenditure underperformed in 2007, chiefly in the outlays of civilian ministries, which were 2.3 percent lower than the budget. A large part of this underperformance derived from overbudgeting on certain items, on which there was underperformance in previous years too. |
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Even though statutory tax rates continued falling, the tax burden edged upward in 2007 due to the increase in activity and its changed composition. Israel’s ratio of taxes to GDP rests in the middle of the distribution of developed countries. |
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The budget policy in the years to come will be tested by its ability to strike a balance between two necessities: continued lowering of the public debt/GDP ratio and meeting of needs in both defense and social services, given the erosion of the latter in recent years. |
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By staying within the legislated ceiling of expenditure increase and implementing tax cuts already decided upon, it will be possible in coming years to lower the ratios of debt and deficit to GDP significantly if economic growth continues. As a result, however, civilian expenditure excluding interest will increase by less than 1 percent per annum during these years, making it difficult to respond adequately to society’s needs. |
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Chapter 7
The Balance of Payments
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The current account had a surplus of about 3 percent of GDP in 2007 ($5 billion), as compared to a surplus of 6 percent of GDP in 2006, which was an exceptionally high level. The reduction in the current account surplus is a result of the rapid and significant growth in imports and the worsening in the terms of trade. Alongside the reduction in the current account surplus, the surplus in net investment abroad also declined. From a longer-term perspective, the transition from an average deficit of about 3 percent of GDP during the period 1995–9 to a surplus of about 3 percent of GDP this year is a result of the reduced deficit in the goods and services account and the improvement in the income account, alongside a reduction in current transfers. |
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The reduction in the current account surplus was the result of a drop in private saving and an increase in investment in the economy. The drop in private saving was in response to the high increase in purchases this year and surprisingly high public saving during the previous two years (when the budget deficit was lower than planned). The increase in investment was the result of the continuing growth in the economy and the increase in employment. In addition to these forces, the level of the current account surplus contributed to a real appreciation which acted as a mechanism to balance the current account. |
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The investment in the economy by foreign residents and investment abroad by Israeli residents remained at high levels in 2007 and no major changes were observed in their characteristics or magnitudes. Since 2004 there have been signs of stability in gross and net investment, particularly in foreign direct investment (FDI). The financial crisis, which affected global markets this year, had only moderate effects on Israel’s financial account in 2007, which is evidence of the economy’s relative resilience to shocks. |
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The most significant changes in investment abroad by Israeli residents this year were the acceleration in direct investment in the real estate industry and the continued high level of investment by institutional investors in foreign securities. |
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This year was characterized by continued high levels of FDI in Israel and the growth of portfolio investment, against the background of volatility in international financial markets. On the other hand, foreign residents realized investments in government bonds this year against the background of the market-makers reform in 2006 and the financial crisis. |
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The lion’s share of investment in the economy by foreign residents during the period 2001–07 consisted of direct investment, while the share of portfolio and other investment declined. This may be partly explained by the ending of the US debt guarantees, the bursting of the hi-tech bubble and the global trend in investment via mergers and acquisitions (M&A). |
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Chapter 8
Welfare Policy Issues
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Israel had 1.7 million people living below the poverty line in the year ending June 2007. The poverty rate in that period amounted to 24.7 percent of the population, similar to that in the years 2005 and 2006. According to additional indices, which reflect the ability to purchase basic commodities or a fixed basket, the poverty rate has declined in recent years. The poverty rate is especially high in the Arab sector and in the ultra-orthodox Jewish (Haredi) sector. |
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Despite the stability and even slight improvement in the poverty rate as measured by certain indices, the poverty rates in the population in which not only income but also expenditure were below the poverty line continued to rise, indicating an increase in the proportion of the poor who have difficulty in maintaining a reasonable level of expenditure in the face of temporary reductions in their income. |
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Due to economic growth and the cuts in transfer payments during recent years, the weak populations have entered the labor market at an increasing rate. However, this trend has not been accompanied to an adequate extent by programs for encouraging employment and for increasing the remuneration for labor. As a result, entry to the labor market has been no guarantee for escaping poverty. |
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Over half of the ultra-orthodox population is poor. This is because of their low participation rates, relatively low wages, high birthrate, and education that is not directed at future income-earning ability. |
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During recent years policy-makers have shown a growing tendency to adopt an approach whereby the focus of support for the elderly population should be moved from universal support to selective support, where the most important criterion must be the level of need for assistance. |
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Since the beginning of the 1990s, a considerable improvement has been achieved in matriculation exam results (excluding adjustment in respect of the exams’ level of difficulty). The growing proportion of the Arab and ultra-orthodox educational streams has moderated the improvement, while the enhancement of the socioeconomic characteristics of the students within each of the educational streams has supported an increased level of achievement. |
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The gaps between the basic pattern of achievement in the matriculation exams among students from a weak socioeconomic background compared with those of students from a strong background contracted during the period, concurrent with an expansion of the gaps in achievements indicative of excellence. |
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The complementary insurance plans offered by the health funds contribute to the average level of health in the population and increasing the scope of them reflects in a large growth in private and national expenditure on health. |
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Seventy-seven percent of the population are covered by complementary health insurance. In the OECD countries excluding Holland and France, this ratio is lower. |
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