CHAPTER 1 - The Economy: Developments and Policies (ch1.pdf - 120KB)

During 1999, there was a turnaround in economic activity, but the rate of GDP growth remained lower than that of the population, so that per capita GDP edged down by 0.2 percent, having declined at a similar rate in 1998. After falling in the first quarter of the year, GDP grew sharply for the rest of 1999. Accelerated activity was led by a recovery in domestic demand and export, and was accompanied by an increase in the current-account deficit. The acceleration was also reflected by a significant rise in overall employment, also in the business sector. Despite the increase in employment, unemployment rose during most of the year, as the labor force expanded even faster. It is too early to assess, however, the extent to which accelerated activity will continue, because, among other things, the rapid growth from the second quarter compensated in part for the reduction at the beginning of the year, and was affected by transient factors. The disinflation process continued in 1999, and the rate of price increases was below the inflation target. The annual rate reflected the price reductions in the first quarter—
which corrected the exceptional hikes at the end of 1998 in the wake of the rapid depreciation of the NIS in the last quarter of 1998—and the convergence of the inflation rate thereafter to the 1999 target rate of 4 percent.
The background to the turnaround in activity in 1999 was provided by long-term factors acting to return the economy to the path of sustainable growth, as well as short-term factors which boosted activity during the year. The main factors which supported recovery in 1999 included macroeconomic stability, the renewal of the peace process, the boom in world capital markets and hence in domestic share prices, the acceleration in world growth and trade, as well as calm on the security front, and the approach of the new millennium which had a beneficial effect on tourism. The recovery in exports was also helped by real depreciation, which mainly reflected the rapid nominal depreciation at the end of 1998. All the above contributed to the significant acceleration of exports and private consumption in 1999. Investment rose, too, mainly due to two special transactions (the purchase of equipment for an Intel plant, and the import of airplanes).
At the beginning of 1999, the tight monetary policy, reflected by the rise in short-term real interest, was intended to prevent the price increases at the end of 1998 from being translated into accelerated inflation. Thereafter, the policy was aimed at anchoring inflation at a level consistent with the target for 1999, and at creating the conditions necessary for the achievement of the annual target (3–4 percent) set for 2000 and 2001. In following this policy, yield differentials between Israel and abroad had to be taken into consideration. Net capital flows rose faster than the rise in the current-account deficit. Prominent among these flows were nonresidents direct investment, which rose slightly above its 1998 level, and nonresidents’ investment in equity portfolio, which went up again after declining steeply in 1998, with renewed buoyancy in world financial markets.
Fiscal discipline was maintained in 1999, continuing the restraint exercised in 1997–98. The budget deficit deviated only marginally from the target determined in the Budget Deficit Reduction Law, due to the fact that activity was below that assumed in the budget. The public debt, however, is still far higher than that considered acceptable in the industrialized countries. The composition of the budget and public expenditure did not change in 1999 as it should in order to support long-term growth: neither the tax burden nor its structure altered, and expenditure on infrastructure investment declined, while the shares of transfer payments and current public consumption remained unchanged. Nor was progress made in implementing structural reforms to encourage competition, which would help raise productivity and thereby support faster expansion of activity.



Chapter 2 - Output and Demand (ch2.pdf - 298KB)

GDP, which declined in the first quarter of 1999, began to rise steeply in the second, apparently indicating the economy’s emergence from the recession. As an annual average, however, GDP grew by only 2.2 percent, alongside a decline in per capita GDP for the second consecutive year. As there was a demand shift during the year, and it is not yet possible to assess to what extent it will persist, it was met by a marked increase in the average number of hours worked per employee together with the continued rise in the (average annual) unemployment rate. The revival of demand during 1999 was led by private consumption and exports, which were affected by the positive shift in tourism and the recovery of world trade.
After two years of stagnation, there was a notable rise in domestic demand in 1999, expressed in increased nonresidential and inventory investment, largely due to nonrecurring factors. The increase in demand was directed primarily to imports, which soared in 1999, alongside the expansion of the current deficit of the balance of payments.
On the demand side, total factor productivity and the rate of return on capital declined in 1999, the latter due to the effect of higher unit labor cost. Other factors influencing profitability in recent years include the high tax rate and the rise in the real interest rate.
Real appreciation, which has persisted for many years and was checked in 1998, became real depreciation in 1999 with a rise in the export/GDP price ratio. This development indicates inter alia a response with a lag to a process which had begun in mid-1996, namely, a marked slowing in the rate of expansion of domestic demand. Most of the nominal depreciation occurred in October 1998, and following fluctuations in both directions there was some real depreciation in 1999. Towards the end of the year and at the beginning of 2000 a trend of nominal appreciation could be discerned.
In recent years the growth rate of potential output—one of the estimates of an economy’s sustainable growth rate—has declined. Part of the fall is explained by the drop in total factor productivity (TFP, obtained after adjusting for the seasonal factors, which served to reduce it during the recession). In order to support the ongoing recovery of TFP and private-sector consumption, economic policy should maintain the positive developments in the area of inflation and the balance of payments. This ought to be done by adopting a strategy of long-term fiscal consolidation that includes reducing the share of current expenditure in GDP, thereby helping to ease the tax burden, enhance infrastructure investment—especially in mass transportation projects—and deepen structural reforms, including the reform of taxation.



Chapter 3 - Prices (ch3.pdf - 84KB)

The Consumer Price Index (CPI) rose by only 1.3 percent in 1999, significantly below the inflation target (4 percent) and similar to inflation rates in developed countries. The development of prices during the year shows that the inflation environment in Israel is still higher than in those countries, however. The first quarter should be regarded as an adjustment of the sharp depreciation and the Bank of Israel’s response to it at the end of 1998, with NIS appreciation and a 1.4 percent decline in the CPI. Developments in the other three quarters constitute a better indication of the inflation environment as there were no major exogenous shocks then although it was feared that they might recur, primarily in the second and third quarters. Uncertainty was reflected by expectations that there would be NIS depreciation towards the end of the year as well as by considerable fluctuations in inflation expectations, which fell to within the inflation target range only in the last two months of 1999. In the last three quarters of the year the CPI rose by an annual rate of 3.7 percent, slightly below the annual inflation target. Note that the moderate change in prices came in the wake of tight monetary policy and in the context of restrained economic activity. The principal achievement of monetary policy in 1999 was
to restore the path of moderate price increases which had characterized the economy in 1998 before the global financial shocks, expressed inter alia in the depreciation and steep price increases of the end of 1998.
The main challenge facing monetary policy in the next few years is to consolidate this achievement by attaining the inflation target for the years 2000 and 2001 of 3–4 percent, while gradually reducing the interest rate. Despite the slow rise of the CPI in 1999, the background conditions in 2000 appear to embody the danger of accelerated inflation, headed by the trend of narrowing the interest-rate spread vis-a-vis abroad, a rapid rise in the monetary aggregates, the recovery of domestic demand, and the expected increase in world merchandise prices.



Chapter 4 - Employment and Wages (ch4.pdf - 105KB)

In 1999, the average rate of unemployment rose to 8.9 percent, from 8.6 percent in 1998. The rise reflected a gradual increase in the first three quarters of the year, when demand for labor grew slowly while the expansion of the labor supply accelerated. The increase in employment accelerated during the year, and was reflected by a decline in the unemployment rate in the last quarter. Despite higher unemployment, unit labor cost in the business sector rose by 2.1 percent in 1999. The real wage in the business sector went up by 3.4 percent, while that in the public services edged down by 0.3 percent. Towards the end of the year, public service employees received a 4.8 percent wage rise in wage agreements for 1997 and 1998.
As in previous years, the main contribution to the rise in unemployment again came from the construction industry and related industries, but in 1999, for the first time, education-intensive industries also contributed. Despite the rise in unemployment, an increase in the number of workers from the Palestinian Autonomy and administered areas was evident, with just a small fall in the number of foreign workers.² Israel’s labor market was greatly affected during the 1990s by factors and events unique to Israel, the prime one being the absorption of the influx of immigrants, and also by structural, technology-oriented global trends and the opening of markets. Following a rise in the unemployment rate in 1990–92, GDP and employment started growing rapidly, reflected by a continuous decline in the rate of unemployment between 1993 and 1996. At the end of the decade, falling demand and a change in its composition led to a rise in and deepening of unemployment.
The rate of increase of the real wage in the business sector, which was quite slow in the early 1990s, accelerated from 1997 despite the slack in the labor market. The real wage in the public services, which hardly changed from 1988 to 1993, rose by 20 percent between 1993 and 1996, due to generous wage agreements, and remained more or less steady since then.



Chapter 5 - The General Government (ch5.pdf - 114KB)

The general government deficit,¹ public expenditure, the tax burden, and the public debt remained in 1999 at similar levels to those of 1997 and 1998. The central government deficit, measured according to the budget definition, exceeded the target, but was lower than in 1998. In view of the slow rate of GDP growth in 1998 and 1999, and the fact that 1999 was an election year, these developments indicate that fiscal discipline was to some extent becoming more firmly based, after the adjustment of the deficit path in 1997. The general government deficit adjusted for the output gap (the difference between actual and potential output) declined for the third successive year, and there are signs of tighter fiscal discipline not just in the central government, but also in the local authorities and the health funds. Nonetheless, in light of the increase in expenditure during past economic booms—both in Israel and in the OECD countries—
the real test of whether there has been a change in policy, and the key to realizing the potential reduction of the deficit/GDP ratio—i.e., the actual reduction of the deficit—lies in preventing a rise in general government expenditure as income increases after the recession. This is especially acute in view of the potential to increase central government expenditure since the central government deficit target for the next few years was raised as a result of the forecast, which turned out to be erroneous, of a large deviation from the 1999 target.
Despite tighter fiscal discipline since 1997, the general government deficit remained very high compared with levels in the developed countries, and public expenditure and the public debt in Israel are among the highest of those countries. Moreover, since 1994, after most of the direct budgetary expenditure arising from absorbing the influx of immigrants at the beginning of the 1990s had been incurred, progress towards reducing the share in GDP of the general government deficit, public expenditure, and the public debt was slow in relation to the OECD countries, even after allowing for the effects of the business cycle. Hence, fiscal policy made no significant contribution to bringing the economy to a sustainable growth path. Furthermore, the changes in the composition of the budget in the last few years, and in particular the fall in general government investment—including a sharp decline in road investment in 1999—did not support sustainable growth either. The central government announced that it intended to reform direct taxation in 2001. A comparison with the OECD countries shows that the tax burden in Israel is not exceptional. Taxation on individuals’ income in Israel has certain features which set it apart from the norm in industrialized countries, mainly the steep reduction in the marginal tax rate at high income levels, and the extensive tax exemptions on income from financial assets.


Chapter 6 - The Balance of Payments (ch6.pdf - 103KB)

The deficit in the balance of payments current account increased in 1999 to $2.6 billion. This is still lower than the deficits in 1995 and 1996, but it is higher than in most developed countries. The rise in the deficit in 1999 reflected an increase in investment, mainly due to two exceptional transactions, and a decline in the saving rate, reflecting a reduction in public saving. In foreign-trade terms, the increase in the deficit this year reflects a slight slowdown in export growth and a perceptible increase in imports. The downturn in exports, most of which occurred in the first half of the year, traces to the protracted slump in world trade and was attenuated by the real currency depreciation, which made exports more profitable. Imports expanded mainly because of two exceptional transactions but also in response to more vigorous domestic demand and a continued decline in import prices.
Net capital inflow (the financial account less the change in foreign reserves) was $3.1 billion in 1999 as against $1.5 billion in 1998. The most salient phenomenon this year was the recovery of nonresident investment (direct and in shares for trading) to the 1997 level. Events in world capital markets affected nonresident investment more strongly in 1999 than in past years; the impact of events related to the domestic economy was less conspicuous. Nonresident investment took place along two main paths—$2.3 billion in direct investment and $2 billion in acquisitions of shares issued abroad by Israeli companies, foremost in software and communications. Net direct and financial investment by individuals surpassed the current-account deficit in 1999, allowing Israel’s net external debt to decline.



Chapter 7 - The Money and Capital Markets (ch7.pdf - 109KB)

The main challenge facing monetary policy in 1999 was to return the economy to a low inflation environment in accordance with the government’s targets, after the global financial crisis in 1998 led to exceptional price increases at the end of that year. To meet the challenge, and in view of domestic and foreign developments during the year, a policy of cautious, gradual lowering of interest rates was adopted, commensurate with the government’s inflation targets of 4 percent in 1999 and 3–4 percent a year in 2000 and 2001. The Bank of Israel interest rate was lowered by 2.3 percentage points during the year and reached 11.2 percent at the end of the year.
The main reasons for the cautious and gradual approach were the risks of abrupt changes in the public’s portfolio of financial assets as the interest rate differential between Israel and abroad narrowed, uncertainties related to the change of government in Israel and concern about the millennium bug, an increase in prices abroad (especially those of oil and its derivatives), and the estimation (which proved false) that the government budget deficit would severely overrun its target. All these factors were reflected in one-year market-based inflation expectations, and inflation forecasts by economic forecasters, which were both higher than the inflation targets in most months of the year. Nevertheless, inflation expectations declined more quickly than the nominal interest rate, so that the average real interest rate in 1999 climbed to 7.5 percent.
A real increase of 60 percent in share prices in Israel’s capital market in 1999 led to a proportional increase in shares in the public’s financial-assets portfolio and caused the total value of the portfolio to increase. The share of short-term assets in the portfolio rose at the expense of long-term assets, in continuation of a trend that began in the late 1980s.
The strategy of monetary policy has undergone several changes in the past decade— the focus is on attaining inflation targets set by the government, and the exchange-rate regime has been made much more flexible, reflected in a widening of the crawling band and in a strategy of non-intervention in the foreign-currency market, against the backdrop of liberalization of foreign-currency control.



Statistical Appendix
   Appendix 2 (ap2.pdf - 143KB)
   Appendix 3 (ap3.pdf - 42KB)
   Appendix 4 (ap4.pdf - 43KB)
   Appendix 5 (ap5.pdf - 72KB)
   Appendix 6 (ap6.pdf - 70KB)
   Appendix 7 (ap7.pdf - 130KB)

Statistical Appendix (Excel files)
Main economic indicators of 1999