The Israeli Economy in 2002

Publication date
Tuesday, 15.01.2002

Augusto Lopez-Claros



2001: An Unusually Difficult Policy Environment

The pronounced deceleration of real GDP that took place in 2001 reflects several interrelated factors. The persistent weakening of the global economy (see the chart in the next page, which traces revisions to the consensus forecast for 2002 made in the course of 2001) and, more specifically, the collapse of asset prices in the international high technology sector in late 2000/early 2001, has clearly been a central factor. The evolution of the domestic security situation has likewise played a key role. The first of these has had an adverse impact on Israel through two interrelated channels. First, declining demand for Israeli exports, which grew by over 23% in real terms in 2000, but are estimated to have contracted in 2001 by over 10%. Second, a slowdown in the activities of start-up companies in the high-tech sector, which contributed a full 2 percentage points to the 6.4% GDP growth registered in 2000. [1]

The deterioration of the security situation has made itself felt through its impact on tourism, construction and agriculture, the latter two mainly as a result of labor shortages associated with the closure of the territories. Furthermore, the terrorist attacks on United States soil on 11 September contributed to an additional 50% drop in tourist arrivals, further dampening activity in a sector already reeling under the effects of the intifada.

Policy Responses

Against an otherwise complicated external environment, the authorities shifted the stance of fiscal policy in 2001. Faced with revenue shortfalls as a result of the much weaker pace of economic activity than originally assumed in the budget, and increased security-related expenditures, the government conceded, in connection with the preparation of the draft 2002 budget, that the 2001 deficit target of 1.75% of GDP would be overrun by about 1% of GDP. More recently, as a result of a sharp reduction in revenues linked to the deeper than expected slowdown of output during the last quarter of 2001, the authorities signaled that the budget deficit was likely to have overshot even this revised target.

Furthermore, because the revised deficit target for 2002 of 2.4% of GDP, if adhered to, would have implied a drop in real terms in per capita non-interest spending, the government revised upwards the target for 2002, to 3% of GDP. At the same time, it re-stated its commitment to a multi-year budget framework that envisages a medium-term path of fiscal adjustment, with the state budget deficit now projected to come down to 1.5% of GDP by 2004 and 1% by 2005 (see chart). In connection with this announcement the government has indicated that part of the projected rise in the deficit in 2002 is explained by a significant boost to capital spending for infrastructure projects. The inflation target has been tightened fr om 2.5-3.5% in 2001 to 2-3% in 2002, as approved by the previous government. The government had at that time indicated that, beginning in 2003, the annual setting of an inflation target for the following year would come to an end, with the introduction of a permanent definition of “price stability” which, henceforward, would mean a target range of 1-3%. Since the upper range in 2002 is already set at 3%, a case could be made that, de facto, monetary policy in 2002 is already operating in a framework of “price stability.”

The authorities’ response to the weakening of output growth in 2001 was broadly appropriate. Shortfalls in revenue and some pressures for additional security-related spending were met through a combination of expenditure cuts and a relaxation of the deficit target for 2001. While the initial revision to the deficit target was seen as justified, there are some concerns about a budgetary outturn in 2001 that might have exceeded the 2000 outcome by close to 3% of GDP and the difficulties that this is likely to entail as the government attempts to steer the public finances into what now appears, ex ante, a tough path of fiscal adjustment over the medium-term. Failure to adhere to the revised budget – which remains to be approved by the Knesset – could bring to a temporary end the trend reduction in the debt/GDP ratio seen in recent years, and could exert upward pressures on long-term interest rates.

A Change In The Policy Mix In 2002

To forestall some of these dangers the authorities announced in late December some changes to the economic policy mix for 2002. A 2 percentage points reduction in the Bank of Israel’s interest rate, to 3.8%, was the most noteworthy component of the package, a persuasive signal that the authorities remained concerned about the rapidly weakening growth performance. While large, this drop brought the interest rate differential with respect to the United States back to 2%, where it had been exactly a year before. This measure was accompanied by some expenditure cuts needed to bring the draft budget into line with the 3% deficit target for 2002.

In addition, the government agreed to a series of measures which are likely to enhance the policy flexibility of the Bank of Israel, including raising the share of investments which resident institutional investors may invest abroad, fr om 5% to 20%, to be followed by the removal of any restrictions by end-2002; the flattening of the lower lim it of the crawling band for the exchange rate (see chart); as well as other measures aimed at improved the money market infrastructure.

Nevertheless, the overall policy environment would benefit fr om acceleration in the pace of structural reforms. As in other countries, the agenda here is broad and could include: revisiting the tax reform proposals set out in 2000; formulating draft proposals for improvements in the efficiency of social spending wh ere the scope for progress is huge; and submitting to the Knesset the Levine Committee report on central bank independence. Another area wh ere the authorities could do more to improve the fiscal climate is through the elimination of a broad range of tax exemptions and benefits granted to various citizen groups or types of business. Detailed estimates carried out by the Ministry of Finance show that the revenue lost to the budget through such schemes in 2001 was equivalent to about 6.3% of GDP, a large sum by any measure. Even a limited elimination of some of the more costly exemptions could significantly improve the fiscal outlook and facilitate the achievement of the fiscal objectives contained in the medium-term deficit targets.

GDP growth in 2002 is projected to recover modestly. Our 1.9% growth forecast for 2002 is subject to more than the usual margins of uncertainty. Nevertheless, it assumes some recovery in GDP growth in the US during the second half of next year and a more robust performance in European markets. More importantly, it assumes that the domestic security situation will remain difficult but not substantially worse than what has been in evidence in recent months. We expect a strong rebound in 2003, with GDP growth in the region of 4-5%, much of it linked to a substantial recovery in foreign demand, with the US economy projected to grow by 3.5-4%.

The Security Situation

Due to significant improvements in the policy environment in recent years, the Israeli economy has shown considerable resilience during the period 2000-01. The shekel has shown remarkable stability and the authorities have met successfully their inflation targets, against a background of rapidly falling interest rates. Even after 11 September, at a time when global tensions, particularly in the Middle East, rose tangibly, inflation expectations remained subdued and the foreign exchange markets relatively unperturbed.

It is evident, however, that the unresolved security situation and the associated violence could remain an important drag on the economy. Tourism has been most directly affected, but a precarious security situation is surely having a restraining effect on foreign investment as well. While it is difficult to disentangle the concurrent effects of the U.S. recession and the associated weakening of activity in the information technology and telecom sectors from the direct impact of the intifada, it is clear that much would be gained by a resumption of negotiations aimed at a substantial reduction in the level of tensions. The Mitchell Report was thought to offer a promising framework for the implementation of measures intended to build mutual trust and confidence. While, in the short term, it may be extremely difficult to reach long-term understandings on some of the more intractable issues, such as the right of return of Palestinian refugees, or the status of Jerusalem, it remains desirable to actively pursue avenues of collaboration intended to substantially reduce the incidence of violence.

Chart 1: Growth forecasts for 2002
(% change)
  Chart 2: Actual and targeted deficits
(% of GDP)
Chart 3: NIS/Currency basket exchange rate   Table 1: Selected economic indicators 1/


[1] Investments by venture capital funds in Israel in the first three quarters of 2001 reached $1210m, down from about $2440m a year earlier. For an earlier review of economic developments see: “Israel: Striking the Balance”, Global Weekly Economic Monitor, 7 September 2001.



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