By Amotz Asa-El
By sheer coincidence, the international economic downturn, sparked by the American sub-prime mortgage crisis and ongoing problems rattling global commodity markets, unfolded just when the Israeli economy’s performance had become the subject of universal admiration.
With GDP expanding for the fifth consecutive year at an annual pace of roughly five percent unemployment plunging from 11% in 2002 to 6.1% by early ’08, and the shekel shining as one of the world’s strongest currencies, Israel emerged as the developed world’s fastest growing economy. Now, Israel’s economic exuberance is clouded by the twin challenges of economic mayhem abroad and political uncertainty at home.
The causes of Israel’s economic success, two waves of ambitious reforms over the past generation, placed it in a good position to minimise the damage of the global crisis.
The first of these reform efforts came in 1985, when Israeli inflation exceeded 400% and the Jewish state came within a few months of seeing its foreign currency reserves vanish. Responding to that crisis, the government took some socially and politically daring action, as it abolished most food subsidies, froze all public-sector wages and hiring, slashed defence spending by 20%, froze by decree all retail prices, cancelled a slew of import tariffs and handed the Bank of Israel full independence in setting interest rates.
The result was a drastic decline in inflation and a gradual return to growth, as subsequent governments began to slowly privatise and break down assorted monopolies.
It was in that setting that Israeli hi-tech began to flourish, as engineers and technicians previously employed by the military-industrial complex lost their jobs and began setting up their own start-ups as well as research and development centres for multinational technology giants like Microsoft, Motorola and Hewlett Packard. Gradually, a new class of entrepreneurs saw their companies mature sufficiently to sell shares on Wall Street and even be fully bought by foreigners in multi-million dollar deals. Examples include AOL’s purchase in 1998 of software developer Mirabilis for US$407 million, or printing-technology developer Indigo’s purchase by Hewlett Packard for US$719 million in 2002, or disc-on-key inventor M-Systems’ purchase by SanDisc for US$1.5 billion in 2006.
The second wave of reforms came this decade, as former Prime Minister Ariel Sharon and his Treasurer, Binyamin Netanyahu, faced the severe recession that was fed by the one-two punch of the American NASDAQ meltdown and the Palestinian violence, both of which started in 2000 and were then exacerbated by the following year’s 9/11 attacks. The result for the Israeli economy was three consecutive years of negative growth, the worst recession in its history.
Netanyahu used that crisis, and the economic carte blanche he got from Sharon, to implement the Thatcherite economic reforms which he had preached for years. This meant trimming monthly payments to single mothers, the handicapped, the elderly, and all parents of minors.
Meanwhile, he cut taxes, raised the pension age, expropriated the pension funds from the unions that had mismanaged them, capped the public-sector’s long-term hiring, imposed on the government a 1% of GDP budget deficit cap, and decoupled Israel’s three seaports so that they would compete with each other. Finally, he sold almost any state asset he could, from the El Al airline and the ZIM shipping company to the national oil refineries.
All this happened while Israel sharply reduced the terror attacks that had previously raged in its big cities. The result was a major influx of foreign investment, which by 2007 as proportionately five times larger even than Russia’s, while industrial exports reached a record US$65 billion and GDP approached US$200 billion, well above most EU members’ per capita levels.
Even so, the Israeli economy could not remain fully insulated from the storms abroad.
On the plus side, the only local commodity producer, Israel Chemicals, which makes fertilisers out of Dead Sea minerals, has posted a second quarter net profit of US$709 million, the highest ever by any Israeli firm. Less happily, with food and energy prices rising worldwide, inflation rose in 2007 by 3.4% as opposed to the previous year’s 0.1% deflation. This year, as of July, prices are rising at an annualised pace of 6%.
Unlike in the 1980s, when price instability stemmed from regulatory problems at home, the current situation represents supply problems abroad. However, the current inflation level, the highest in six years, has alarmed the Bank of Israel, as has the shekel’s exchange rate. The steady inflow of foreign investments has seen the US dollar lose 15% of its shekel value between January and June, and 33% since 2002.
In many ways this is of course a happy development. Macro-economically, it means Israel has built the kind of financial depth its founders could only dream of. Micro-economically it means that the middle class’ purchasing power has grown considerably, and psychologically, Israelis are happy to see hotel bars, car dealerships and real estate agencies erase dollar price tags and replace them with shekel denominations.
But there has also been a downside, as an excessively strong shekel raised operational costs for exporters, who paid salaries in increasingly expensive shekels while their earnings came in increasingly cheap foreign currencies. Worse, some of the economies where Israeli exports are bound are already tipping into recession, which means, besides higher operational costs, also lower sales. Consequently, Israeli exporters have begun to lay off employees, a trend that economists say will soon impact unemployment data.
Faced with all this, the Bank of Israel set out to weaken the shekel – a priority that until recently would have sounded almost like science fiction.
Bank of Israel Governor Stanley Fischer, who happened to have played an important role in defeating Israel’s hyper-inflation as an International Monetary Fund executive back in 1985, now devised a policy whereby the central bank regularly buys dollars, thereby offloading shekels into the financial markets. Fischer announced early this year that the Bank of Israel would buy US$25 million daily. When that failed to dent the shekel, and the dollar plunged to NIS 3.2, Fischer raised the ante to a daily US$100 million. That worked. As of mid-August the shekel had depreciated some 12% and was trading at NIS 3.57 to the US dollar.
At the same time, to address the budding inflationary pressures, Fischer raised interest rates three times over three consecutive months by 0.25% and then again in mid-August, following the July Consumer Price Index’s rise of a relatively sharp 1.1%, bringing the central bank’s key lending rate to 4.25%.
All this firm management of monetary policy, which has so far proved as effective as it has been professional and impartial, is probably the best a central bank can do while compelled to manoeuvre in the face of a crisis it has not created and is in no position to undo. That is more than can be said of Israel’s politicians.
The good news about the economic situation has been that Ehud Olmert’s travails did not impact the markets, either when new corruption allegations emerged, or following his announcement that he will not be running for re-election. The reason for this is that on the economy Olmert displayed all the caution many feel he lacked on other fronts.
In all, despite his previous social critique of the Netanyahu reforms, Olmert left them intact. Olmert’s reforms added up to cutting the Value Added Tax from 16.5% to 15.5%, gradually expanding the minimum wage by some 30%, and increasing the budget-deficit limit from 1% to 1.7% of GDP. Overall, Olmert matched Fischer’s monetary prudence with a fiscal discipline that the markets appreciated.
Now, however, with Olmert on his way to early retirement and an early election increasingly likely, lawmakers are beginning to pressure the budget in an effort to impress various constituencies. A slew of private bills allocating funds for various purposes ranging from tax deductions on mortgage interest payments to expanded state-funding of medications have passed their first of three readings as the Knesset adjourned for the summer recess. Totaling NIS 40 billion, the Treasury says such bills are unaffordable and in fact dangerous, considering that the entire budget is NIS 315 billion, of which one third is automatically earmarked for debt service.
Meanwhile, of the leading candidates for Olmert’s succession, Transport Minister Shaul Mofaz says he will heed the ultra-Orthodox parties’ demand to undo Netanyahu’s cuts on child-rearing allowances. Foreign Minister Tzipi Livni, a corporate lawyer who back in 1996 was then-Prime Minister Netanyahu’s privatisation tsar, avoids discussion of the economy. The same is true for Internal Security Minister Avi Dichter. The fourth candidate, Interior Minister Meir Shetreet, a former finance minister, is economically knowledgeable and opinionated, but polls place him well behind the leading contenders.
Regardless of his or her views, Olmert’s successor is likely to lead a fragmented Knesset during an interim period of political instability, until a new election produces a new political map. It is during that interim period that some mistakes are likely to be made by politicians whose appreciation for the Bank of Israel’s monetary heroics may prove limited.
If it’s up to Finance Minister Roni Bar-On, who has endorsed Livni and came out forcefully against the populist trends in the legislature, the Knesset will approve his proposal for a trimmed budget ahead of the political commotion in the coming months. That way, the economy will not pay the price for the approaching political tempest.
Bar-On’s quest gains almost universal support from pundits and business leaders, but has yet to be adopted by his colleagues in the ruling Kadima Party, not to mention its coalition partners. To at least some of them, the new prime minister’s expected weakness represents opportunity. The ultra-Orthodox intend to demand increased funding for large families and religious seminaries, and Labor wants the deficit limit raised to 2.5% of GDP in order to finance more spending on education and welfare.
If any of this materialises, the already alarming inflationary pressures, which until now originated abroad, will likely be exacerbated by home-grown circumstances. In such a case, the shekel’s carefully fine-tuned readjustment can suddenly spin out of control and force the central bank to raise interest rates much more sharply than it would like to do, and thus bring about a recession that the Israeli economy could otherwise have avoided.