During 1999, a cautious and gradual reduction in the interest rate was a necessary component of monetary policy. A cautious approach was particularly important in view of past attempts at a rapid reduction in the interest rate that led to an upsurge in inflationary pressures, and to a rise in inflation expectations. The real interest rate, which is calculated on the basis of the Bank of Israel’s interest rate less inflation expectations derived from the capital market for the term of a year, was 1.4 percent higher in 1998 (7.4 percent compared with 6 percent) than the level considered acceptable in developed countries. This indicates that the disinflation process is not yet complete. (See Box A-3 in our survey for 1998.)

At the beginning of the year, the exchange rate fell, there was no rise in inflation and inflation expectations stabilized at 5.5 percent after reaching a level of 9 percent at the end of 1998. As a result of these developments and against the background of the recession in economic activity, the Bank of Israel began to cut the monetary interest rate in a gradual and cautious manner. During this period, the negative slopes of nominal yield curves (for T-bills and Shahar bonds) as well as the slope of the CPI-indexed bond yield curve were indicative of the public’s assessments that the decrease in nominal and real interest rates would continue. When the uncertainty in the financial markets increased during the months of April and May due to the approach of the elections, demand for foreign currency rose together with the exchange rate, and inflation expectations for a year exceeded 6 percent (according to forecasters and capital market data). The nominal and real yield curves became flat, a development indicative of a more severe monetary restraint as well as a decline in the real interest rate. The Bank of Israel decided not to continue with its reduction of the interest rate, due to the assessment that the actual level of the interest rate would in the final account make it possible to achieve the inflation target for 1999. The uncertainty in the markets continued until a new government was formed, a budgetary framework was determined, and an inflation target was set for 2000 and 2001.

Inflation expectations fell in the wake of the government’s decision to support the existing monetary policy by setting an annual inflation target of from 3 to 4 percent for the next two years, the lower than expected rate of price increases during the months September-November, and the moderate growth in the means of payment. The Bank of Israel cut the interest rate in the last quarter of the year to a level of 11.3 percent in December. At the end of 1999, inflation expectations for a year derived from the capital market reached 3 percent. Although expectations for longer terms exceeded 4 percent, this rate appeared to include a risk premium for investment in unlinked assets. At the beginning of January 2000, inflation expectations for long terms of up to five years stabilized within the targeted range of inflation. Following the 4 percent interest rate hike at the end of 1998, the Bank of Israel began to gradually cut the interest rate, by modest rates of between 0.3 percent and 0.5 percent. The interest rate was not raised even during periods when inflation expectations rose. This was due to the assessment that the policy that had been adopted in the past would in the future lead to a convergence of inflation expectations and actual inflation to within the targeted range.

The narrow money supply (M1) expanded by 9 percent during the first eleven months of 1999, following respective increases of 14 percent and 13 percent in 1998 and 1997. Estimated money demand as determined by the nominal GDP growth rate and interest rates was only slightly less than the actual amount during this period, and did not lead to a rise in prices. In December 1999, due to the liquidity fears associated with the Millenium Bug problem, the public temporarily increased their holdings of cash by NIS 1.5 billion (6 percent of the total means of payment). Credit to the public expanded by 12 percent in 1999. The proportion to total credit of foreign currency linked and dcredit was similar to that at the end of 1998 and amounted to 38 percent.

The exchange rate of the sheqel against the currency basket was located 12 percent above the lower limit of the band of mobility in the course of the year. This rate was subject to fluctuations of some 3.5 percent, without the Bank of Israel intervening in foreign currency trading. During the past two years, the exchange rate of the sheqel has risen by an annual average of 9 percent, compared with an increase of slightly more than 5 percent in the consumer price index and a 4.5 percent annual average dollar decrease in import prices. This indicates that the sheqel depreciated in real terms during those two years, a development that was to be expected in view of the slowdown in local activity and the rise in the unemployment rate.

Following a rapid 20 percent depreciation during the months August-October 1998, when the exchange rate moved away from the lower limit of the diagonal band, the rate fell again and a nominal appreciation of 3 percent was recorded during the whole of 1999. The only exceptional developments in the course of the year were a number of rapid depreciations during the months April-May that resulted from pre-election uncertainty, and depreciations in August that resulted from uncertainty over the new government’s fiscal policy and whether the policy of setting declining inflation targets would be continued. In the course of the year, the daily and monthly volatility of the exchange rate was less than that among the world’s major currencies (see Chapter 2).

The public’s risk assessment, as reflected by the premium on the dollar options issued by the Bank of Israel, rose sharply at the end of 1998 due to the large and unexpected fluctuations in the exchange rate of the dollar. This premium gradually fell in the course of the year and mainly at the end of the year, as the inflation rate fell and the foreign currency market became relatively stable. The developments in the foreign currency market during 1999 increased the public’s awareness of the risk premiums involved in foreign currency activity. As a result, the non-banking private sector’s purchases of instruments for hedging against financial and non-financial developments increased by 40 percent in 1999. Concurrently, the Banking Supervision Department imposed more stringent requirements on the banks with respect to the control of the risk exposure incurred by borrowers of foreign currency credit.

Foreign residents continued to invest in Israel during 1999 (a total of $4 billion), directly and by purchasing shares that Israeli companies issued abroad. At the same time, Israeli residents increased their investments abroad (to $1.6 billion) with funds deriving from issues abroad and as a substitute for deposits with banks in Israel. Liberalization measures appear to have increased the financial openness of the economy, which thereby increased the finance and investment opportunities available to Israeli residents. The growth in capital imports and exports reflects a healthy development of the foreign currency market. This development is particularly positive when we remember the large flows of capital in a single direction only, which prompted the public to sell or buy large amounts of foreign currency. Past experience of the proper functioning of the foreign currency market in the absence of Bank of Israel intervention within the limits of the diagonal band, supports the approach that the central bank adopted when the effect of the world financial crisis at the end of 1998 were apparent: a policy of non-intervention in trading following demand surpluses and a more rapid depreciation. (See Chapters 1 and 2 of our survey for 1998.) The liberalization of the foreign currency controls and the functioning of the market without central bank intervention are an important element in maintaining the structural stability of the money and capital markets.

The total budget deficit planned for 1999 was 2 percent of GDP. By April, it was assumed that the actual deficit and particularly the domestic budget deficit would be much higher. Accordingly, the government decided to amend the Law for the Reduction of the Budget Deficit for 2000 and the following years (the third upward adjustment since the initial legislation in this respect in 1992), and the deficit target for 2000 was raised from 1.75 percent to 2.5 percent of GDP. At the time, it did indeed appear that the deficit for 1999 would exceed 3 percent of GDP, while the proposed budget was not regarded as having a potentially expansionary effect on domestic demand. However, a change in a long-term target that is anchored in legislation, precisely when an effort should be made to adhere to the target, harms the government’s credibility.

At the end of the year, it transpired that the actual deficit was 2.25 percent of GDP, only 0.25 percent more than the targeted level, accentuating the fact that the total deficit planned for 2000 is higher than the actual deficit for 1999. This reveals the need to improve the methods used in planning and monitoring the management of the budget. Due to the growth in economic activity, it already became clear in 1999 itself that the decrease in tax receipts was less than the updated estimate, as was the case with the excess level of the total budget deficit. If this trend continues and the actual increase in tax receipts during 2000 exceeds the planned increase, the incremental revenue should be used to achieve a more rapid decrease in the deficit, in line with the government’s declared intention. This will contribute to a decrease in the debt and the interest burden, and will enable the budget to be more flexible in the future. Since Israel’s debt-GDP ratio is high by international standards, persistent progress in reducing the budget deficit is necessary. Among other benefits, this will make it possible to achieve the inflation target by means of a less restrictive monetary policy.

The decrease in public spending proportionate to GDP ceased in the second half of the 1990’s despite the continued decline in the defense burden. For this process to resume, a fundamental change in the composition of public spending in order to reduce the tax burden would appear to be necessary. At the end of 1999, a committee was appointed for the purpose of formulating recommendations for changes in all aspects of the tax system (labor and capital). The changes are intended to correct the distortions involved in the large number of individual tax exemptions and concessions, which have created relatively high tax margins on wages, on the one hand, and numerous discriminatory effective yields on different channels of saving, on the other hand. A reform in these areas is essential, and could enhance the functioning of the labor and capital markets.

In contrast to previous years when the inflation target was set for one year only, in 1999 the government set an inflation target for two years. This was an important step in consolidating the process of disinflation and in achieving the aspiration for price stability. The setting of longer-term objectives enhances the credibility of the government and the Bank of Israel in the eyes of the public, leads to increased certainty, makes it possible to sign long-term contracts based on nominal terms, and introduces an element of flexibility in the management of current monetary policy in order to accommodate deviations from the inflation target. This is a another key measure in the series of institutional changes that have occurred in recent years, and include the Law Prohibiting Monetary Financing of Budget Deficits, the Law for the Reduction of the Budget Deficit and the actual improvement during the 1990’s in the process of decision-making regarding the inflation target. In this respect, it is important to emphasize the need to update all of the provisions of the Bank of Israel Law in the spirit of the recommendations of the Levin Committee, namely the definition of the Bank of Israel’s function in achieving and maintaining price stability, enhancing the transparency of policy and tlevel of reporting to the public, independence in operating monetary instruments and the creation of a broader base for monetary policy decision-making, by establishing an independent monetary committee as is the practice in developed countries. Once low rates of inflation are achieved, the potential for divergent trends between the development of the exchange rate and the rise in local prices will disappear. This is in view of the broad diagonal band of exchange rate mobility and the free movement of the exchange rate, which obviate the need for administrative exchange rate adjustments, with all their potential for inducing destabilizing capital movements.

The GDP growth rate for 1999 is estimated at 2 percent. The second half of the year was notable for a 5.4 percent rate of growth that would appear to mark an end to the growth recession that has prevailed in the economy for the past three years. But despite this higher rate of growth, the unemployment rate continued to rise and reached a level of 8.9 percent in 1999, compared with an average of 8.1 percent in 1997 and 1998. The labor market is usually slow to respond to an upsurge in economic activity. This is because initially, until the growth in demand is sustained, employers fully utilize their existing labor force and do not recruit more workers. As stated, the second half of 1999 saw an upturn in demand, which was led by a rise in private consumption, exports, tourism and investment in machinery. Due to the depressed level of economic activity, the growth in demand did not lead to a more rapid pace of price increases, and the level of activity appears to be low relative to the economy’s growth potential. The growth in demand, which was centered in the second half of the year, led to a rise in imports and to an increase in the current account deficit, which reached $1.7 billion in 1999 compared with $0.7 billion in 1998. It should be noted that the decline in activity during recent years resulted from both a drop in demand and from structural factors on the supply side (see below). The extent of the inflationary pressures that might be caused by the beginning of the recovery is therefore uncertain. (See Chapter 1 of our survey for 1998.)

Two long-term phenomena apparent in the economy should be mentioned here: On the one hand, the rate of growth in investments in high tech industries increased greatly in 1999 as the world’s stock markets recovered. On the other hand, the economy’s continued exposure to competing imports had the effect of reducing activity in the traditional industries. Moreover, foreign currency investments in high tech companies held down the rate of increase in the exchange rate, requiring the traditional export industries to increase their efficiency. It should be noted that this structural change is not affected by monetary policy and is in fact inevitable in the long term. The structural change occurring in the economy, led by sectors where the economy enjoys a relative advantage, will make it possible to realize the economy’s growth potential. In the longer term, this will contribute to an increase in the welfare of the entire population.

1.2 DEVELOPMENTS IN THE CAPITAL MARKET

Long-term interest rates continued to rise in 1999 although to a lesser extent than in 1998, and reached a real average annual level of over 5 percent for a term of ten years a more. The high interest rates resulted from the growth in the domestic budget deficit and the financing requirements for it during the year, and from the continued policy of monetary restraint. The higher rates also derived from the reduced attractiveness of indexed assets as the inflation environment stabilized at a low level. The public’s penchant for holding indexed assets appears to have lessened, thereby requiring higher yields than in the past. The rise in indexed interest rates was also reflected by the higher interest rates in the mortgage market.

The rise in long-term interest rates, from 2-3 percent at the beginning of 1999 to 4-5 percent at the end of the year, is connected with the increased rate of return on capital. The increased rate of return accompanied the growth in demand for venture capital investments in new areas of technology and the new investment opportunities that became available in the world’s stock markets as the result of a progressive liberalization in the course of the decade. The increased rate of return on capital also derived from the expansion of the labor force and the stock of human capital that resulted from the wave of mass immigration at the beginning of the 1990’s. The ratio of capital to GDP has not yet returned to the levels prevailing prior to the onset of mass immigration.

The rise in interest rates during the 1990’s is also attributed to their low level at the beginning of the decade, a result of institutional investors’ (primarily the provident funds’) obligation to invest a large proportion of their assets in indexed government bonds and of the absence of investment alternatives abroad. As stated, the opening up of the markets led to a rise in the long-term yield in the indexed bond market, a rise that was supported by the large-scale move from the provident funds to other assets. In addition, the continued sale of earmarked bonds to the pension funds had the effect of diverting assets to them and reducing the accrual in other forms of indexed saving, primarily the provident funds. This led to an increased supply in the market for tradable bonds and to a continued rise in their yields. It should be noted that real long-term interest rates in Israel are little different from those in those in developed countries (approximately 3-4 percent).

The public’s financial asset portfolio grew by 19 percent in real terms during 1999 to a total of NIS 1,000 billion. A contributory factor was the increase in the weighting of shares from 16 percent at the end of 1998 to 22 percent at the end of 1999 that resulted from a rise of over 60 percent in their prices. Another major development was the decrease in the proportion of CPI-indexed assets from 46 percent at the end of 1998 to 39 percent at the end of 1999. This decrease was larger in 1999, a trend that has continued since the disinflation process began in 1985, and indicates that the public are now more convinced that the inflation environment has become established at a lower level. Unlinked sheqel assets continued to expand, albeit at a moderate rate, and their weighting in the portfolio reached 26 percent at the end of 1998 compared with only 11 percent at the beginning of the decade. The increase in the proportion of unlinked sheqel assets within the asset portfolio was centered in the second half of the decade and derived, as stated, from the high yield on them. Nineteen ninety nine was notable for a growth in deposits for terms of a year and more.

As stated, share prices rose by over 60 percent in 1999, in line with the upturn in prices on world stock markets and, following a break during the second half of 1998, in continuation of a trend that began in 1997. The rise in share prices appears to be connected with the decline in the inflation environment and the expectation of a cut in the interest rate, the assessment that the recession was ending, the renewal of the peace process and the resumption of growth in the economy. The rise in share prices (which occurred despite the rise in interest rates) did not lead to a growth in issues on the local market, and in 1999 as well the majority of stock issues by Israeli companies were floated on foreign stock markets. Some 80 percent of share issues were floated abroad, mainly in the United States, where the most notable issues were those by the software and communications industry (see Chapter 5). This is a further indication of the liberalization that has occurred in the economy and the financial markets, but does not explain why the volume of issues in Israel was so sparse.

The absence of long-term institutional investors appears to have been largely responsible for the low weighting of the local equity market in the allocation of capital in the economy,which is continuing to rely principally on sources of finance from the banking system. This phenomenon contrasts with the worldwide trend of a complementary relationship and competition between financial intermediation by banks and intermediation via the capital market, concurrent with an increase in the market’s sophistication and diversification, a situation that contributes to the immunity of the entire financial system. In the long run, the lack of reform in the capital market and the continued concentration in the banking system due to the banks’ control of the principal financial intermediaries will impair the development of the capital market, the development of the stock market and its ability to compete with worldwide stock markets, and the allocation of sources in the economy.

The government did not exploit the buoyant state of the equity market in order to continue the privatization process, from which receipts were NIS 2.5 billion less than planned in the budget. The government therefore increased its domestic borrowing to NIS 7.4 billion compared with the originally planned level of NIS 2.6 billion. Issues of tradable borrowing instruments were notable for an increase in the proportion of unlinked assets from 40 percent in 1998 to 57 percent in 1999. The cost of domestic borrowing rose by more than half a percent and reached 5.4 percent. This was due to the rise in yields on CPI-indexed bonds and to the increased cost of unlinked borrowing, which resulted from the decline in inflation and from the fact that this borrowing is for relatively short terms, on which interest rates are higher than on longer terms. In 1999 and in the previous year, the insurance companies initiated special arrangements whereby they agreed to redeem early part of the earmarked bonds issued to them in the past in return for waiving the right to purchase earmarked bonds in the future. The Finance Ministry accepted their proposal, and the arrangements were implemented in the form of a tender during the year. For the treasury, the main advantage is the increased number of players in the tradable bond market, which helps to expand the market (see also Box 4-2).

The government debt relative to GDP fell to 103 percent, following an exceptional increase at the end of 1998 that resulted from the faster pace of depreciation and inflation. The debt to GDP ratio is a particularly important indicator for assessing the market’s status, which affects the terms and opportunities for raising capital in international markets. Since 1995, the decrease in the ratio, which exceeded 130 percent at the beginning of the decade, has slowed appreciably. This development appears to have resulted from the slower rate of economic growth concurrent with a slower decrease in the total budget deficit and an increase in the cost of domestic borrowing. Apart from a resumption of growth, it is necessary to reduce the total budget deficit persistently and scrupulously. It would in fact be desirable to create a budget surplus in order to continue reducing the debt to GDP ratio and thereby also cut the cost of rolling over the debt.

As for the pension funds, reform must be implemented if financial savings are to be channeled into financing investments in the business sector via the equity market and the tradable bond markets. This is in order to ensure that the financing of private sector investment does not remain the almost exclusive preserve of the banking sector. The lack of long-term investors is also apparent in the mortgage market, and in the financing of long-term private investments in infrastructure and other industries.

The expansion of the scope of pension arrangements and a move from an unfunded pension to a funded pension concurrent with a decrease in the weighting of the provident funds, is turning the pension funds into long-term centers of saving. However, preventing the pension funds from participating in tradable markets is a regressive step in the reform process, which holds back a growth in the tradable debt at the expense of the non-tradable portion of the debt. This situation impedes the management of the current government debt and the construction of a tradable government bond market, which could serve as a benchmark and contribute to the development of the corporate bond market.

The trading methods on the Tel Aviv Stock Exchange were improved considerably during 1999 with the transfer of derivative assets to the TACT, Tel Aviv Continuous Trading System (the “Retsef” system in Hebrew). In the near future, this will make it possible to expand the range of contracts to additional underlying assets such as interest rates and the CPI, and will help to increase the sophistication of the money and capital markets.