The Shekel, Inflation, and the 2002 Budget

What about the shekel?

The two percentage point cut in the Bank of Israel’s headline rate of interest, announced on 23 December 2001, led to a fairly rapid depreciation of the shekel; by close to 7% by early February. This weakening of the currency reflected shifts in the composition of financial asset portfolios, and was in line with previous large interest rate reductions carried out by the Bank of Israel during the 1990s. [1] The relatively high sensitivity of the CPI to fluctuations in the exchange rate, coupled with the fact that overall inflation levels used to be much higher in the 1990s, meant that the Bank of Israel tended partially to reverse such interest rate reductions within a few months.

Indeed, this partly contributed to high interest rate volatility, both in absolute terms and in relation to measures of volatility in other inflation-targeting countries. However, with inflation rates down to zero in 2000 and 1.4% in 2001, a sharp slowdown in the pace of economic activity last year, and aggressive monetary easing in the US, the authorities may well have felt that a large interest rate cut would pose no immediate risks to the achievement of the inflation target.

Furthermore, Israel’s external sector, a source of pressure on the shekel in earlier periods, is now in considerably stronger shape. The current account deficit is relatively small and easily financeable through non-debt capital inflows; net external debt levels remain manageable; and gross reserves at the Bank of Israel, at $23bn, are at close to historically high levels, equivalent to some eight months of imports. Other factors which we saw as eventually taking pressure off the shekel, once the round of financial assets adjustment had run its course, were: emerging signs of recovery in Israel’s main export markets; the likely beneficial effects on the tradeables sector of a one-time adjustment to the exchange rate; and incipient signs that capital inflows, which had peaked in 2000 and fallen sharply in 2001, had bottomed out. More importantly, the Bank of Israel was fairly explicit in conveying the message that it did not have an exchange rate target and that it would not hesitate to defend the government’s inflation target, were it to come under threat.

We were thus skeptical of the prevailing view in Israel in late January/early February which saw the shekel well above NIS5/$, within a relatively short-term horizon; this path for the exchange rate would have been inconsistent with achieving the inflation target (and data on inflation expectations for January provided strong backing for this view) and sharply increased the likelihood that the Bank of Israel would raise interest rates sooner rather than later.

In the event, on 25 February the Bank announced a 0.6% rise in interest rates, effective 1 March. In explaining its reasons, the Bank noted widespread skepticism in the market about the ability of the government to achieve the 3% of GDP budget deficit target in 2002 and, more generally, to steer the public finances back on to a path of medium-term downward adjustment. This, in turn, and notwithstanding the December rate cut, resulted in no change in the nominal interest rates on unindexed government bonds, and only a slight decline in long-term real interest rates, due to the rise in inflation expectations.

It is evident that the Bank will have no hesitation in raising rates further, as needed. Factors likely to play a role in shaping its decisions will be the actual and prospective evolution of prices, the behaviour of long-term interest rates (and thus, implicitly, the stance of fiscal policy), and the strength of the recovery in Israel’s export markets which will dictate the stance of monetary policies in the US and the euro area and, hence, the prospects for a sustained recovery in the domestic economy.

And the budget?

The Bank of Israel is certainly accurate in pointing out the market’s skepticism about the likelihood that the government will deliver a 3% deficit outturn in 2002. However, early in March and with the budget just approved, it is equally evident that overshooting of the target is not inevitable: it is well within the capacity of the government to deliver it, through additional measures, if necessary. Indeed, during the preparation of the revised 2002 draft budget last October, the government noted: “If it becomes clear in the course of 2002 that the deficit is deviating significantly fr om the target, changes in the budget will have to be considered in order to correct the deviation, making it easier to meet the declining deficit targets determined for 2003 and subsequently.”[2] The finance minister has recently confirmed the government’s commitment to this approach. Three factors could facilitate the achievement of the deficit target:

First, a faster recovery of exports, which the government has assumed (conservatively) would grow only by some 1.5% in real terms in 2002, compared with growth of 24% in 2000 and a drop of about 13% in 2001, the latter mainly reflecting the collapse of tourism in the course of the year.

Second, a more proactive approach to the elimination of some of the many tax exemptions long included in the budget. This could play a potentially important role, signaling structural improvements in the budget with positive medium-term implications.

Third, returning to the implementation of a more ambitious structural reform agenda would also help. One of the inevitable effects of the deteriorating security situation has been to divert the attention of senior government officials fr om structural reform issues. In this respect, the announcement this week of the creation of a high-level panel to issue tax reform recommendations for government consideration within a 90-day period is welcome. The requirements in this area are well-known and include the introduction of a tax regime for capital income that would treat all assets equally, and the need to broaden the tax base with particular reference to the relative taxation of labor and capital income. At present, the tax burden is concentrated on middle-income brackets, and this has contributed to perceptions of an inequitable tax burden.

We see no reason, at this early stage of the fiscal year, to revise upward our fiscal deficit forecast beyond the government’s own 3% of GDP target, while recognizing that we may have to come back to this issue later in the year, in the light of the record of budget implementation. For the time being, the credit agencies have confirmed existing ratings.

The security front: a glimmer of hope?

The establishment of credible and lasting security arrangements with its neighbors is crucial to Israel’s medium-term economic outlook. There would be at least five tangible benefits. First, with annual defense expenditures of the order of 10% of GDP, such arrangements would provide significant scope for a medium-term restructuring of budgetary expenditures, diminishing over time the burden of defense and the need to maintain a large military establishment. This would release resources which could be allocated to other more productive ends, such as upgrading the country’s infrastructure and boosting spending on education. Second, the further expansion of the tourist sector, wh ere activity has tended to reflect the underlying security situation and wh ere the potential for further development is vast. Third, the remarkable expansion of high-tech industries seen in recent years, coupled with Israel’s close trade links with the US and the EU, could position Israel to become a leading centre for a broad range of multinational corporations intent on expanding their activities in the region in a post-peace settlement environment. Fourth, the boosting of intra-regional trade and cross-border direct investment. Last, a permanent boost to confidence, reflecting diminished uncertainty about the political environment and increased stability of the country’s policies and institutions.

The recent Saudi-sponsored peace initiative involving the full normalization of Arab countries’ relations with the state of Israel in return for Israeli withdrawal to some modified version of its pre-1967 borders is being considered by the Israeli government, the Palestinians and the United States. The proposal, which has thus far received some important cautious endorsements, shares a number of features with the terms that Israeli and Palestinian negotiators were close to agreeing early in 2001, plus allegedly a few additional elements which suggest a new willingness on the part of Saudi Arabia to accept Israeli control over the Western Wall and certain neighborhoods in East Jerusalem.

Although there should be no illusions about the short-term prospects for a quick resolution of the underlying territorial (and other) issues, the very fact that there is a serious plan on the table (expected to be discussed at the Arab League summit in Beirut in late March) could contribute to damp the recent violence and open the doors for restarting much-needed peace negotiations.

[1] Three episodes, in particular, come to mind: January 1992, spring 1995 and mid-1996. The events on 11 September had no impact on the shekel; indeed the shekel strengthened in the period between the terrorist attacks on New York and the days preceding the interest rate cut.

[2] Quoted in The National Budget for 2002-2005, Ministry of Finance, Jerusalem, October 2001.