Foreign Analysts’ Assessments Of Israel’s Economy -
What Do They Check, And What Have They Been Saying Recently?

Prepared by David Klein, Governor of the Bank of Israel
For the Annual General Meeting of the Association of Insurance Agents
and Brokers in Israel, 29 November, 2001

In the wake of the liberalization of the foreign currency market during the last decade, Israel’s economy has opened up to capital flows. Capital outflow reflects investments abroad by Israelis, both companies and individuals, and inflow reflects nonresidents’ investments and deposits in Israel and loans given by them mainly to the business sector in Israel, but also to the government. Capital inflow has increased gradually since 1993, and reached a peak of $ 11.2 billion in 2000. As is known, capital inflow has contracted in 2001, reaching just $ 4 billion in the first nine months of the year, less than half of the total in the equivalent period in 2000. Nevertheless, capital inflow over the last few years has accumulated to the extent that the stock currently exceeds Israel’s total GDP. Nonresidents’ total assets in Israel reached $ 111 billion in August 2001, about half in the private nonbanking sector, with the other half divided almost equally between loans to the government and foreign-currency deposits in banks in Israel.

This process of nonresidents’ exposure to Israel’s economy went hand in hand with a parallel flow of assessments of Israel’s economy by foreign analysts. Foreign investors’ demand for such assessments was strong enough for foreign investment banks to locate analysts here in Israel on a permanent basis, and for the rating companies to institute regular visits to Israel by their experts. The result is that for some time Israel has been assessed not only by Israeli economists and analysts, but also by foreign experts using their customary analytical methods. It is not only foreign investors who benefit from, or suffer from, these assessments, but Israelis who invest in Israel too, as well as public entities such as the government and the Bank of Israel.

The tragic attack on the Twin Towers in New York and the Pentagon in Washington on 11 September caused an economic shock which made it necessary to update the economic situation throughout the world, and Israel is no exception. The foreign analysts who observe Israel’s economic performance all participated in this process, and in the last ten weeks we have received a rich crop of external opinions on Israel’s economy. I will relate to these below, to emphasize what aspects interest foreign experts when they express their opinions on the economy’s performance and to summarize what they are currently saying about us.

We will distinguish between two types of analysts—those from the rating companies, and those from investment banks.

The public is more aware of assessments by the rating companies than of those by investment banks, so we will start with them. Among other things, these companies rank government debt, in other words, the risk that the government will be unable to meet its debt commitments. The lower the grading, the higher the risk incurred by giving the government a loan. In October 2001 S&P and Fitch both announced that they were not changing their ratings despite the events on 11 September in the US which affected the whole world. The risk entailed in advancing loans to Israel’s government remained at its previous relatively low level.

S&P came first, and it mentioned the negative effects of the intifada and the slump in the global economy, and bid farewell to the chances of economic growth reaching 4 percent in 2002. It forecast that the budget deficit would rise to between 2.5 percent and 3 percent of GDP in 2001–02, significantly higher, they mention, than the original targets. The downward trend in the debt/GDP ratio would also come to a halt.

On the other hand, the authorities succeeded in establishing fiscal and monetary credibility while implementing liberalization. S&P add that this is reflected in the relative stability of inflation expectations and the exchange rate. They are also of the opinion that the government will honor its commitment to fiscal discipline and structural reforms.

Fitch also kept its rating unchanged, giving as its reason the credible policy of inflation targets and flexible exchange rates. Public debt is at a high level, but the share in it of external debt, half of which is backed by US government guarantees, is not high. The opinion in Fitch is that as the US economy recovers, so will Israel’s.

The budget deficit, however, is expected to rise to 3 percent of GDP in 2001, or 5 percent if it is measured according to the normal definition used worldwide. Fitch’s opinion is that this is a temporary deviation from a long-term downward trend in the deficit and the government’s debt.

The Economist drew up a table of S&P ratings of 25 emerging economies, including Israel, comparing the ratings in October 2001 with those of October 1999. The table shows that Israel is among the group of ten countries (including Chile, China, the Czech Republic, Egypt, and India) whose rating did not change. The other countries divided equally between those whose ratings rose in the period (such as Hungary, Poland, and Russia), and those whose rating dropped (e.g., Argentina, Brazil, South Africa, and Turkey).

Foreign investment banks also have analysts located in Israel assessing the economy. Their recommendations serve foreign investors in financial markets—the securities market, and recently also the foreign currency market. Some of them summarized Israel’s position following the terrorist attacks in the US in September.

ING Barings were first; they predicted that Israel’s emergence from the recession would be delayed as a result of those attacks. Growth in 2002 would be 2.5 percent, and would exceed 4 percent only in 2003. They commented on the foreign currency market too, saying that there was depreciation due to nonresidents’ demand for foreign currency to hedge their investments in Israel, but that Israelis did not react the same way. The weakness of the NIS boosts inflation, and this will reach 2.6 percent in 2001, which in the opinion of the Baring analyst will prevent the Bank of Israel from lowering the rate of interest in the next few months. The bank sketches a scenario of a possible deterioration caused by a deviation of the budget deficit from its target. This deviation is already causing a rise in the yields on government bonds; it can raise the risk premium and the rate of interest on Israel’s borrowing from abroad, affect Israel’s foreign currency market, and feed inflation.

The second investment bank to publish its findings was Morgan Stanley. It estimated that the growth rate in 2001 would be only 0.2 percent, and that in 2002 it would rise to 1.7 percent. The budget deficit would reach 3 percent of GDP in 2001, compared with the original target of 1.75 percent. They added that the target deficit was based on an optimistic growth forecast, and it was more reasonable that the deficit would reach 3 percent, exceeding the 2.4 percent deficit in the revised plan. Morgan Stanley stress that this constitutes a major change in economic policy, which will have negative implications for the financial markets.

In a small open economy such as Israel’s, they argue, fiscal expansion rarely helps it recover from a slowdown. The correct policy is one of tax reform, and not of increased government expenses, when it is accompanied by monetary expansion, they conclude.

The next was Goldman Sacks. It advised its customers to reduce their exposure to Israel’s stock market because of the uncertainty deriving from fiscal policy. The 2002 budget, it explains, is based on the assumption that the law increasing benefits to large families will not become effective, but it turns out that the Prime Minister is about to yield on this issue, and has also agreed to reduce the cutback in the Ministry of Education budget. The revenue side is based on an optimistic growth forecast. The outcome will be that the actudeficit in 2002 will reach between 3 percent and 3.3 percent of GDP, or according to the definition used worldwide, between 4 percent and 4.5 percent. As a result, the curve of bond yields has become steeper.

The bank adds that it will be problematic to get the budget through the Knesset (Israel’s parliament) because of the claims put forward by the Shas, One Israel, and Am Echad parties. The government will face the choice of either coming to terms with an even higher deficit, or withdrawing the proposed budget. The result will be either a cut in the budget, or a dissolution of the Knesset, which would weaken the capital market even further and lead to Israel’s rating being reduced.

Finally, Salomon Smith Barney.

One of the indications that Israel has come of age is nonresidents’ speculative buying and selling foreign currency for NIS. This took place in 2001, but not in the naïve way which has been observed in other countries—in other words, converting foreign currency in order to invest in unindexed fixed-interest-bearing NIS, with the intention of benefiting from the interest differential between, say, the dollar and the NIS. Such speculation has never featured in the activity of nonresidents in Israel, because of the exchange-rate regime introduced which allows the exchange rate to move without central bank intervention. What occurred in 2001 for the first time was that nonresidents started buying foreign currency on a large scale via forward contracts for a period of a few months, assuming that the NIS was about to weaken, possibly due to the security situation. Recently they started selling their holdings of foreign currency, on the assumption that the foreign currency market was about to turn around and that the NIS was about to strengthen again. Part of the weakening and strengthening of the NIS was caused by the purchases and sales by nonresidents themselves, who account for a not inconsiderable share in the foreign-currency/NIS market.

Two weeks ago Salomon Smith Barney issued an update for its customers, advising them to prepare themselves for another round of purchases and then sales of foreign currency on the market in Israel. The analyst forecasts that the NIS will weaken again because:

Its latest strengthening is temporary, and is due to the closure of positions mentioned above;

The rate of interest is likely to continue falling because of the economic slowdown, and because of expectations that inflation will fall below the government’s target;

According to a model used by Salomon Smith Barney, the NIS is overvalued by about 20 percent, i.e., the potential for depreciation exists.

The conclusion of the Salomon analyst, who is actually located in London, is that an NIS/dollar exchange rate of 4.237 is a good one at which to buy dollars, and that the rate is likely to rise to 4.38, which could be a target rate at which to sell. The analyst also presents a technical analysis of the exchange-rate trend in support of this recommendation.

Assessments such as those described above indicate that nonresidents consider that Israel has a foreign currency market that reacts to the market forces which they recognize from other countries. They therefore attempt to act against the trend, thus helping to stabilize and develop the market.

Israel’s economy is sometimes referred to indirectly by foreign analysts. One topic of which has been of interest for some time is whether Argentina is going to declare a moratorium on its debts to some extent or other. The worldwide trauma caused by a similar occurrence with Russia in 1998 is still fresh in our memory, and everyone is asking who would be affected if Argentina defaults. The Economist published such an analysis in October, and Israel also features prominently in it.

The Economist addresses the question of which economies could suffer from such a situation, and it compiles a list based on the following relevant criteria:

Countries which need a significant amount of foreign-currency financing (to cover a balance-of-payments current-account deficit and foreign-currency debt servicing). Countries at or near the top of this list, apart from Argentina, include Brazil, China, Indonesia, Mexico, Poland, and Turkey, all requiring at least $ 10 billion of foreign currency a year. If the threshold is lowered to $ 5 billion, Chile, Colombia, the Czech Republic, Hungary, India, Israel, South Africa, and Thailand join the list.

Countries which require a significant amount of local-currency financing. The yardstick used is a government debt/GDP ratio higher than 80 percent. This list includes Egypt, Indonesia, Israel, Pakistan, and Turkey. The problem becomes more complex when part of the government debt is indexed to the exchange rate, as in the case of Israel.

The third criterion is the exchange-rate regime. The list includes countries whose exchange rate does not float, among them Argentina and Hong Kong (which have currency boards), China and Malaysia (with fixed exchange rates), Egypt (which has a horizontal exchange-rate band), and finally, Hungary, Israel, and Venezuela (with sloping exchange-rate bands). The assumption is that Argentina’s insolvency will create pressure on the currencies of these countries, attempts will be made to protect them by raising the domestic interest rates, which will harm growth and the governments’ debt repayment ability. Rapid depreciation would also have a negative effect on real activity, foreign-currency liquidity, and macroeconomic stability, which would cause a rise in the country risk.

There are two further criteria, in relation to which Israel is not mentioned: one is geographical proximity to Argentina, and the other is the ratio of the next 12-months’ payments on the external debt (principal and interest) to the foreign reserves. With regard to this last factor, Israel is in a favorable position due to the reserves that have been accumulated over the last decade.

At the end of a particular basketball game, one of the players came out with the words “we’re on the map.” It is not certain how this claim has withstood the test of time as far as Israeli sport is concerned. What is sure, however, is that it has applied for several years to Israel’s economy.

Investors who put money in Israel, about $ 110 billion to date, are very interested in how we manage the economy. They follow the government budget discussions in detail, are interested in the question of the independence of the Bank of Israel, make macroeconomic forecasts, closely watch developments in the stock exchange and in the foreign currency market, come forth with estimates regarding future movements of the exchange rate, inflation, and the rate of interest, read what the policymakers say, note possible effects of private legislation, and ask about the effect of the security situation on Israel’s economy. In other words, they act in just the same way as every local economist and analyst.

The weakening of fiscal discipline they list in the column of worrying signs to be watched carefully, and price stability and stability in the financial markets are included in the column of favorable points. This was reflected in an international survey published a month ago in the US, which graded the degree of economic freedom in a number of countries. Among the various elements of the grading, Israel scored poorly in its management of fiscal policy and the war on money laundering, and a very high rating on the maintenance of price stability. Foreign analysts do not expect the government or the Bank of Israel to act in the same way as the US, i.e., to cut taxes, increase expenses, and lower the rate of interest at a fast pace. As they know the relevant facts, they are aware of the differences between us:

In the US, the ratio of public spending to GDP is the lowest in the world; in Israel, it is the highest.

In the US, Congress sees to it that the administration does not squander money, and that the government remains small; in Israel, there is no upper limit to the increase in expenses or to the of revenues which Members of Knesset can initiate.

In the US, until a year ago the question was still being discussed of what would happen when the government debt disappeared as a result of budget surpluses; in Israel the enormous government debt has changed direction this year and started rising again due to the increase in the budget deficit this year and next. A growing share of tax revenue is pawned to the rapidly rising interest-payment account, and fiscal control is being significantly weakened.

The US has the most developed financial markets in the world despite the crisis in the stock market; in Israel financial reform is bogged down, banks hold a monopoly of financial intermediation, and the long-term-savings market suffers from major distortions.

In the US savings by households is low, and consumer credit high; in Israel the opposite holds, so that lowering the interest rate has a different effect on consumers’ behavior.

In the US indexation as a way of life is unknown; in Israel, despite the reduction in inflation, the debate is still continuing over whether financial statements should again be presented in nominal terms, attorneys and accountants quote their fees in dollars, housing rentals and real estate prices are quoted in dollars, certain tax rates are still based on calculations in real terms, and the attitude that inflation has left us never to return is far from being widespread.

In the US the Secretary of the Treasury traditionally supports a strong dollar and is not unduly concerned if there is a large balance-of-payments deficit; in Israel every Minister of Finance wants a weak sheqel. This is a by-product of the inflation culture, as a balance-of-payments deficit can cause a major crisis.

In the US, with a small public sector and general support for the rule of law, public-sector employees can very rarely paralyze essential services; Israel has a large public sector, and it is almost a case of catch-as-catch-can.

In the US the central bank’s commitment to price stability is supported by unconditional operational independence and is backed by the government; in Israel the central bank must improvise to be able to perform its task, it is often publicly under attack from governmental sources, and is threatened on a regular basis that it will be crippled by legislation which will harm its ability to function even further. The implications of this for the credibility of policy are self-evident.

The foreign analysts are aware of all the above. They know that they may expect positive surprises from us from time to time, but also, and at least to the same degree, negative surprises. That is why they do not compare us to the US, nor even to European countries. In their opinion, the closest to us are countries in South America, East Europe, and South East Asia, or as they are sometimes called “emerging markets” (one level above “developing countries”). And when they compile indices for investing in shares in the capital markets in these countries, they allot to us an appropriate position, something like 5 percent of the total portfolio. In their eyes, that is a correct assessment for us, about 5 percent of the emerging markets.

In other words, some among us believe that Israel is in the super league of the developed countries, so that what is good for America must be good for us too (of course only when the budget deficit rises and the rate of interest falls in the US). Foreign analysts, on the other hand, assess us by the standards of the emerging markets, more like the national league. Apparently what they see from over there cannot be seen from here.