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Bank of Israel Annual Report, 2008
Summaries
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Chapter 1
The Economy and Economic Policy
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After five years of rapid growth, Israel's economy suffered a reversal in the second half of 2008,
and started sliding towards a recession, against the background of the increase in the severity
of the global crisis and its effects on the economy. Although GDP increased by an average of 4
percent over the year, in the fourth quarter it actually contracted.
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In the first part of the year, the trends that characterized the period of rapid growth continued–
–a high level of economic activity, low unemployment, a surplus in the current account of the
balance of payments, a high rate of saving, a significant cumulative reduction in the public debt/
GDP ratio, and a high level of profitability in the business sector.
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The effects of the crisis became more acute towards the end of the year, expressed in steep
declines in exports and tax revenues and a decline in private consumption. Employment stopped
rising, wages dropped, and unemployment started to climb.
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The turnaround was also evident in inflation: till September it was high, reflecting the increase
in global oil and commodity prices and the excess demand in the economy, and then it declined
sharply, in light of the fall in world prices and the moderation of excess demand. The CPI
increased by 3.8 percent in 2008, exceeding the upper limit of the inflation target range.
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Monetary policy in 2008 closely reflected the effects of global developments––the changes in
world prices and the changes in assessments of the seriousness of the crisis and its effects on
Israel. From September the interest rate was reduced significantly several times, and it reached its
lowest level ever. In 2008 the Bank of Israel bought considerable quantities of foreign currency
to increase the level of the reserves, and against the background of rapid appreciation of the
shekel.
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There was great upheaval in Israel's financial system, but it was moderate compared with the
situation abroad. Prices of shares and corporate bonds fell, and spreads in the credit market
widened considerably. The financial institutions, including the banks, exhibited resilience. The
strongest impact was on the nonbank credit market, which became the principal risk of the
financial system and the main cause of the contraction of the supply of credit.
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The public debt/GDP ratio declined further, albeit more slowly than before, and the deficit
increased, due to the continued cuts in tax rates, the slowdown in activity, and the falls in the
capital market, which had an adverse effect on tax revenues.
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The permeation of growth into the weaker sections of the population via the labor market was
evident in the increase in employment among the low-educated, and was reflected in a reduction
in the incidence of poverty in 2007 and the first half of 2008.
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There is a need for a policy to deal with the expected recession, aimed at minimizing its negative
effect on growth, employment and welfare. It will be judged not only in the light of the decisions
taken, but also in light of the ability to implement them quickly and on the required scale. In the
financial area it is important that lessons be learned and implemented. Moreover, the policy must
meet the long-term challenges facing the economy and society.
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Chapter 2
GDP, Uses and Principal Industries
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GDP grew by a somewhat lower rate in 2008 than in the previous years. In the first part of
the year, growth slowed as the economy approached full employment while in the latter part
of the year business sector product contracted as a result of the financial crisis and the global
slowdown that led to a drop in domestic and international demand. |
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Global economic developments dominated the Israeli economy this year. These included a
sharp transition from boom to recession in the developed countries, which was accompanied
by the collapse of several major financial institutions and the precipitous drop in asset values
worldwide. |
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Surplus demand, which first appeared in the previous year, began to grow during the first
part of the year. Employment and the capital stock grew rapidly, which was accompanied by
a slight drop in productivity, an increase in inflation and an appreciation in the real exchange
rate. Towards the end of the year, the trend was reversed with a sharp drop in demand and
an increase in the rate of unemployment, as well as a real depreciation and a decrease in
inflation.
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During the first part of the year, the shekel strengthened significantly, which was a continuation
of the real appreciation that began in 2007. The magnitude of the appreciation was larger than
could be explained only by economic developments and indeed there was a depreciation at the
end of the year which offset the over-appreciation.
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The rate of growth in private consumption slowed as a result of the uncertainty regarding the
future economic situation and the drop in the value of financial assets. Current consumption
grew moderately during the course of the year while the purchases of durable goods dropped
precipitously.
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Exports were significantly affected by the global slowdown. The export of services began to
contract already in the second quarter of the year while manufacturing exports fell only in
the fourth quarter. The increase in exports during the course of the year was primarily due to
the chemical and petroleum industry, while the other industries began to stagnate at an earlier
stage.
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The drop in manufacturing exports was the result of a number of domestic and international
economic developments: the decline in global demand, the continued worsening in the terms
of trade and the real appreciation.
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There was a slowdown in the rate of growth in the construction sector this year and residential
housing starts, though they stabilized this year, reflected a downward trend in public construction
since the beginning of the decade and stability in private construction. The stability in private
construction, together relative price stability until last year, reflected the balance between
demand and supply forces. This year saw a turnaround in the prices of rented and owned
housing, which increased following a prolonged downward trend.
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The slowdown in the economy, particularly during the second half of the year, was also
manifested in the commerce and service industries.
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Chapter 3
Inflation and Monetary Policy
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The consumer price index rose by 3.8 percent in 2008, the second consecutive year when it
exceeded the upper limit of the inflation target of 1-3 percent a year.
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Inflation did not follow a uniform path during the year: it was high during the first half of
the year, continuing the previous year’s trend, due to the large increases in world prices for
energy and food and to vibrant local activity. During the second half of the year the inflation
environment fell heavily as a result of the sharp drop in energy prices and worldwide commodity
prices, the slowdown in local real activity, and the worsening of the global financial crisis from
September onwards. In the fourth quarter, inflation expectations for twelve months ahead
actually fell to a negative rate. The accelerating housing item prevented a more substantial
decline in inflation during the second half.
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Monetary policy during the year was conducted against the background of the global crisis that
began in the summer of 2007 and worsened during 2008. Until September inflation was above
the upper limit of the targeted level concurrent with expectations of a recession in financial
and real activity. This background led to frequent changes in the direction of the interest rate,
because of frequent changes in the assessment of the scale and timing of economic risks: the
interest rate for January was increased by 0.25 percentage points, to 4.25 percent; in each of
the months March and April it was cut by 0.50 percentage points, and starting from June it
was increased by four consecutive steps of 0.25 percentage points each, back to a rate of 4.25
percent.
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From September onwards, in view of the worsening of the global crisis and growing signs of
a major downturn in real activity, all the considerations employed in interest rate decisions
supported sharp reductions in the rate, which was cut to a historically low level: at the end of
the year it stood at 2.5 percent. The rate cuts continued at the beginning of 2009 as well, and as
the rate approached its zero bound there was a need to employ additional policy tools. Thus, in
February 2009 the Bank of Israel announced it would start operating in the secondary market
of local government bonds, so as to directly influence long term interest rates.
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After more than a decade without intervention in the foreign-exchange market, in 2008 the
Bank of Israel began to purchase foreign currency, intending to increase the country’s foreign
exchange reserves. The timing of the purchasing program was picked according to the sharp
and continuous appreciation of the NIS, which supported the increase in the reserve in a
manner consistent with other monetary-policy objectives.
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Credit and liquidity data indicated that certain sectors were beginning to suffer from credit
difficulties, as was expected in view of the slowdown in real activity and the increased
perception of risk by the financial sector. Since mid-September, activity in the IPO market
for nonbanking credit was restrained. However, these developments were not indicative of a
liquidity problem that was prevalent in the American and European economies (mainly since
September).
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Chapter 4
The Financial System
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The global financial crisis worsened in 2008 and threatened to paralyze the
world’s financial system. As a result of the crisis, a serious liquidity shortage
developed in the global financial system, including at the very core of the
interbank money market. Many banks and financial institutions worldwide
collapsed or encountered serious difficulties, and an unprecedented level of
government injection was required in order to save them. The financial crisis
encroached heavily on real activity as well, and by the second half of the
year nearly all of the world’s countries were suffering from a considerable
downturn in activity and part of them had entered a recession. |
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The financial markets in Israel were hit by the crisis as badly as other
financial markets worldwide, and their reaction reflected concern over the
implications of the crisis for real activity in Israel: Prices of shares and
corporate bonds fell heavily, the volatility in the markets increased greatly
and the yield margins in the credit market rose sharply, thereby increasing
the cost of raising credit in the economy. In addition, the exchange rate of the
shekel appreciated sharply until June, followed by a large depreciation later
in the year. |
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The profitability of the banks and the insurance companies in Israel was
also badly hit in comparison with previous years, although despite the
deterioration in their position, the financial institutions in Israel remained
resilient compared with those abroad. This was due to their favorable situation
prior to the crisis, and because the banking system in Israel is conservative
and operates under comprehensive regulation and close supervision. Also
alleviating the adverse impact on Israeli compared with foreign institutions
were their limited exposure to toxic assets worldwide and their low reliance
on the local and international capital markets for raising sources. |
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The domestic corporate bond market was the center of risk for the local
financial system due to its rapid and unbalanced development during recent
years, which was reflected by the increasing amount of capital raised for
financing investments in real estate abroad—an industry that was initially at
the center of the financial crisis. |
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Growing uncertainty and savers’ desire to move to lower risk channels of
savings led to increased withdrawals from mutual funds specializing in
bonds and from the provident funds. These funds were compelled to
realize large volumes of assets, which spurred the rise in yields in the
corporate bond market.
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Due to the seriousness of the crisis, the Israeli government and the Bank
of Israel adopted a number of measures that were aimed at expanding
the availability of credit in the economy and reducing its cost, and at
encouraging real activity. The measures adopted included: the granting
of guarantees to local banks for raising capital, the establishment of
Manof (leverage) funds, large cuts in the interest rate, and intervention
in the foreign currency market and the government bond market. |
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Chapter 5
The Labor Market
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The labor market in 2008 generated more employment, suffered less
unemployment, and paid higher nominal wages; however, it also reflected the
reversal in the business cycle during the year.
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In the first half of the year, the labor market approached full employment,
reflecting the concurrence of rapid employment growth and a falling
unemployment rate. The participation rate leveled off after a protracted upturn
and nominal wage per employee post increased perceptibly.
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Indications of slowdown came into clear sight in the second half of the year.
Employment stopped growing and began to contract, unemployment increased
(especially among the high-skilled), and nominal wage per employee post
declined in most industries. The labor market seems to have responded to
recession more rapidly this time than in the past.
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In contrast to previous years, the growth of employment in the business sector
was driven by several industries that are intensive in low-skilled labor—lowtechnology
trade and services—and these industries made a salient contribution
to the decrease in the unemployment rate. The combination of stronger
demand for low-skilled labor and greater laxity in law enforcement caused the
employment of non-Israelis to grow swiftly.
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The effect of the global crisis was felt initially in high-tech industries. The
growth of employment slowed in high-tech services and stopped in hightech
manufacturing, and the increase in nominal wage in high-tech industries
slowed relative to the past and relative to other industries.
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In 2007, the Government set employment and poverty targets as part of its
socioeconomic agenda. An important goal of the “Agenda Forum” was to
boost the employment rate among sectors of the population that are prone to
especially low rates. The employment target will be harder to attain during the
impending recession than in 2007–2008.
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With the economy tumbling into recession, labor-market policy should strive
to minimize the blow to labor demand and invest in human capital, toughen
enforcement in regard to the employment of non-Israelis, and ease the qualifying
terms for unemployment compensation.
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Chapter 6
General Government, its Product and Financing
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The budget deficit excluding credit extended rose in 2008 to exceed the upper
limit of the target, and the general government’s deficit, which is measured
in accordance with National Accounts definitions, was 2.4 percent of GDP,
compared with 0.2 percent in 2007. The increase in the deficit this year was
due to a steep fall in tax revenues.
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After the sharp drop in the public-sector debt/GDP ratio in 2007, its rate of
decline slowed in 2008, and the debt reached 78 percent of GDP. This was
the result primarily of the stability of the exchange rate in relation to its rise
in 2007 and the marked expansion of the budget deficit. This ratio remained
higher than the accepted rate in the developed countries, but its contraction in
recent years has significantly narrowed the gap.
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The tax/GDP ratio fell by 2.6 percentage points in 2008—about 1 percentage
point of it due to tax cuts—to stand at 33.9 percent. Revenues were substantially
lower than forecasts made at the beginning of the year, mainly because of
the impact of developments in the capital market. Israel’s tax/GDP ratio is
currently lower than those of most of the developed countries, as is the tax
rate on wages. The progressive nature of taxes on wages has declined and has
begun to approach the rate accepted in the developed countries.
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The public expenditure/GDP ratio, which has declined consistently since 2002,
continued to contract by a similar rate in 2008, to reach 43.3 percent—placing
Israel at the midpoint of the distribution of developed countries, after being at
the top of the distribution at the beginning of the decade.
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The budget was fully utilized in 2008—the result of extensive under-utilization
from the middle of the year and the fact that a large part of budget expenditure
was brought forward in December.
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Because of the global economic crisis, its influence on Israel, and expectations
that it will persist in 2009, the government’s objectives in the next few years
are to ease the slowdown and prevent the ongoing damage which it could
inflict on the economy, minimizing the impact on the weaker segments of
the population, and creating the infrastructure for sustainable future growth.
The credibility the government has acquired in recent years—reflected in
the moderate rise in the yield on government bonds—enables it to allow the
automatic stabilizers to work, as well as to even stimulate economic activity
to some extent.
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If the crisis develops in accordance with current predictions, the debt/GDP
ratio is expected to grow in the next two years. The extent and duration of
this trend depends on the fiscal policy which the government adopts: a fiscal
rule based on increasing expenditure in accordance with the current upper
limit will enable the debt/GDP ratio to begin declining in 2011, and if the
slowdown is more protracted than forecast, in 2012. This policy, together
with its advantages in the financing sphere, will require decisions to be made
about marked reductions in the expenditure path to which the government
has committed itself in the next few years, making a very small increase in
civilian expenditure possible.
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A policy of increasing expenditure in line with the long-term plans adopted
by the government, without reducing other expenditure or increasing taxes,
will obviate returning to the declining debt/GDP path in the next few years,
and will even lead to its discontinuation, especially if the crisis deepens or
lasts longer than expected. As a result, the burden of future debt-servicing
payments and Israel’s risk premium are liable to rise.
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Chapter 7
The Balance of Payments
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The current-account surplus amounted to $1.6 billion in 2008, compared
with $4.5 billion in 2007.
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The development of the current account changed sharply during the year.
In the first three quarters imports and exports continued to expand, but
there was a turnaround in 2008:IV, as the real economic crisis worsened
globally: exports and imports fell by about 10 percent (in dollar terms)
from their average in the first three quarters of the year.
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The global economic crisis was exacerbated in 2008:IV and led to a $1.2
billion fall in exports (excluding seasonal goods, aircraft, and diamonds);
on the other hand, there was a $1 billion decline in expenditure on
imported fuel (compared with the average in the first three quarters of
the year).
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There was marked nominal and real local-currency appreciation in 2008
(relative to Israel’s trading partners), despite the moderation of economic
activity in Israel. This reason for this exceptional development, involving
the strengthening of the NIS alongside the moderation of economic
activity, was that the global economic crisis affected Israel’s economy
to a lesser extent than it did other countries, giving rise to heightened net
capital inflow in the first three quarters of the year.
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Against the backdrop of the global economic crisis, (gross) capital flows
in the trading portfolios abroad of residents and in Israel of nonresidents
diminished appreciably this year—in contrast with the long-term trends.
Direct capital flows into and out of Israel have not yet been affected by
the crisis, however.
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This year the Bank of Israel greatly increased its foreign reserves, and
this improved the economy’s resilience at the time of the global economic
crisis. An international comparison of reserves in 2007 shows that their
level in Israel is not exceptional relative to countries with a similar risk
level.
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Chapter 8
Welfare Policy Issues
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In 2007 and the first half of 2008, the extent of poverty was reduced according to most of the
accepted measures: the incidence of poverty, the SEN index and the proportion of the poor
consuming below the poverty line. However, the extent of poverty still remains high, both
in comparison to the OECD countries and in historical terms.
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The extent of poverty is especially high among the Arabs and the ultra-Orthodox, who are
characterized by low levels of employment and high birth rates.
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The incidence of relative poverty has declined despite a rise of 4.2 percent in the poverty
line. This was the result of an increase in per capita median income during the period, due
to the high rate of economic growth. This led to an even larger reduction in poverty in
absolute terms. (From 2006 until August 2007, the incidence of relative poverty fell by 1.5
percentage points, while it fell by 2.5 percentage points in absolute terms.)
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The reduction in the extent of poverty was primarily the result of an improvement in the
relative situation of weaker populations in the labor market, particular their increased rate
of employment, which reflects on the one hand the trickling down of growth to the weaker
populations during this period and on the other hand the effect of the cutbacks in welfare
benefits.
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The incidence of poverty before transfer payments and taxes fell to a level similar to
that during the late 1990s. However, the direct effect of welfare policy through transfer
payments remained limited in 2007, further to its continuous significant weakening since
2001. Therefore, the incidence of poverty after transfer payments and taxes was significantly
higher in 2007/8 than during the late 1990s.
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During the last decade, the extent of poverty has increased among households with at least
one income earner. This development reflects the entry of weaker segments of the population
into the workforce and the inability of the welfare policy to ensure a reasonable level of
welfare for workers. It is important to remember that the very entry into the workforce will
have additional positive effects in the long term which will intensify as the new workers
become better integrated in the labor market.
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In October 2008, an earned income tax credit was introduced in a number of locations in
Israel. This will work to increase the welfare of low-earning workers and thus is in line
with the overall policy of fighting poverty by increasing employment. The extension of the
earned income tax credit (EITC) program to additional locations is expected to increase its
positive effects.
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