Bank of Israel : Macroeconomic survey by the Governor at the Knesset Finance Committee

BANK OF ISRAEL

Office of the Spokesperson and Economic Information

January 6, 2014

Press Release

Macroeconomic survey by the Governor at the Knesset Finance Committee

Governor of the Bank of Israel, Dr. Karnit Flug, provided a review of the state of the economy to the Knesset Finance Committee. The main part of her remarks is below.

A review of the Israeli economy must begin with the global macroeconomic picture. In 2013, the global economy was relatively restrained, with low growth in the US that was affected by budgetary restraints there, continued contraction in Europe and a slowdown in the emerging markets. Recovery is expected in 2014. In the US, with the easing of budgetary restraint, growth is expected to accelerate to 2.6 percent; Europe is expected to move to positive growth, and improvement is also expected in the emerging markets. From the standpoint of the Israeli economy, the most important global variable is global trade, which is an indicator of demand for Israeli exports. The rate of growth of trade is expected to accelerate from less than 3 percent in 2013 to almost 5 percent in 2014.

Against the background of improvement in the global economy, the Staff Forecast by the Bank of Israel's Research Department expects a growth rate of 3.3 percent in the Israeli economy in 2014, similar to that reported by the Central Bureau of Statistics in the preliminary estimate for 2013. But excluding the effects of natural gas production, growth is expected to accelerate slightly, from 2.6 percent to 2.9 percent.

The weak point in the Israeli economy in the past two years was exports, which has been stagnating with high volatility, and is impacted first of all by moderating global demand, but also by the appreciation of the shekel. In this context, it is worth noting that total exports are not highly sensitive to the exchange rate-estimated sensitivity is 0.2 (meaning that an appreciation of 1 percent leads to a decline 0.2 percent in exports, and the reverse in the case of depreciation)-but it is important to remember that the exchange rate also affects the competitive ability of industries that are competing with imports. Sensitivity to the exchange rate is higher in the low technology and mixed- low technology industries. While these (together) constitute just 20 percent of manufacturing exports, they comprise about 42 percent of manufacturing product (meaning they also manufacture alternatives to imports for the domestic market), and employ close to 60 percent of persons employed in manufacturing. This obviously has an impact on the sensitivity of employment to developments in the exchange rate, to which I will return when I relate to the Bank of Israel's policy.

The situation in the labor market, when looking at the aggregates, is positive: Participation and employment rates have stabilized at high levels (78.7 percent and 74.5 percent respectively among those aged 25-64 in the third quarter of 2013), and the unemployment rate reached a low of 5.3 percent. However, most new employee posts were created in the public services, while employee posts in the business sector are at a standstill (and according to employment data from manpower surveys, the growth in the number of employed persons in the business sector was moderate in the last year).

Looking long-term, I would like to present two worrisome trends:

The first is growth in productivity, meaning growth in product per hour of labor in Israel is slower than in most other developed countries, particularly that in the United States. The gap in labor productivity between us and the other developed countries is not closing, and we will need to work hard to close it. The explanation of the widening gap in productivity rests with a series of factors, including the quality of infrastructure, the rate of investment in the economy, the business environment, the low level of competition in some industries, and so forth.

The second phenomenon that I would like to mention is the trend of growth in the poverty rate among working people. The fact of growth in the participation rate and in the employment rate is welcome, and reflects a halt in the increase in the poverty rate among the general population. But poverty among families with one wage-earner, and even with two, presents us with a large challenge to raise the training and skills of those joining the labor force. One of the tools that can help in reducing poverty among workers is the expansion of the Earned Income Tax Credit (negative income tax).

I now move to macroeconomic policy, and I begin by outlining the Bank of Israel's policy.

As mentioned, according to the new Bank of Israel Law, the Bank of Israel operates with the aim of maintaining price stability as a central goal, and subject to this, supporting the government's economic policy, particularly growth, employment and the narrowing of gaps, as well as the stability and proper operation of the financial system. Within this framework, the Bank of Israel has recently used the variety of tools available to it-changes in the monetary interest rate, intervention in the foreign exchange market, and a series of macroprudential measures in the mortgage market.

Price stability has been maintained in recent years, with inflation remaining within the target range set by the government (1-3 percent) and expectations for coming years derived from the markets are that inflation will remain within the target range. Expectations for long-term inflation indicate the credibility of monetary policy, which is very important given the fact that players in the market act based on their expectations (for instance in wage agreements and a variety of long-term contracts).

In relation to the exchange rate, we are focusing on the effective exchange rate of the shekel vis-à-vis the basket of currencies representing Israel's trading partners. As we can see, following the depreciation of the exchange rate in the Summer of 2012 as a result of the increase in Israel's risk premium due to the geopolitical tension in our area surrounding the issue of Iran, there was a decline in tension after the Prime Minister's speech at the UN, which was joined by expectations of a marked improvement in the current account of the Balance of Payments as a result of the start of natural gas production. This was reflected in the rapid appreciation of the shekel. Over time, the reduction of the Bank of Israel interest rate together with the declaration of foreign exchange purchases to offset the effect of natural gas production on the current account have moderated these trends.

As to the housing market, since 2007 we have been witness to a rapid increase in home prices. This increase stems from a number of factors: a lack of residential homes, the decline in the attractiveness of alternative investment channels since the end of 2008, the low interest rates on mortgages (which are affected by long-term interest rates and the Bank of Israel interest rate), and particularly the slow response of the supply of homes to demand, due to the slowness in marketing land and granting building permits, inter alia due to insufficient planning stock.

Against the background of these developments-(1) inflation within the target range; (2) moderate growth and the weakness of exports; (3) pressures for appreciation of the shekel, inter alia against the background of near-zero interest rates and quantitative easing by leading central banks, and against the background of the natural gas production; and (4) the pressures in the housing market-the Bank of Israel adopted a policy through the use of the variety of tools: low interest rates that are intended to support growth and moderate pressures for appreciation of the shekel; a series of measures to limit the risks inherent in mortgages, chiefly limiting the portion of a mortgage that can be taken out at variable-rate interest, limiting the loan to value ratio in mortgages, limiting the rate of monthly repayment out of income, and increasing the capital buffers to absorb losses. In addition, the Bank of Israel directly intervened in the foreign exchange market. This intervention is intended both to moderate sharp fluctuations in the exchange rate that are not in line with the fundamental economic conditions, and to offset the exchange rate's overshooting due to the effect of natural gas production. In a small and open economy, the exchange rate also has an important function, as I noted earlier, on employment, and therefore, as we can understand from the policy that we have also recently adopted, we are not indifferent to developments in the exchange rate. While, the trend of appreciation reflects, among other things, the relative improvement in the Israeli economy compared to the other developed countries, a change that takes place sharply and rapidly, in contrast to changes in the fundamental forces that are by their nature gradual, makes it difficult for the commercial industries in the economy to prepare and adjust, particularly during a period when global demand is moderate. The Bank of Israel's policy in this area is intended to make the adjustment period easier, and even to prevent excessive harm in the commercial sector as a result of the exchange rate overshooting.

As to budgetary policy, following a sharp increase in the deficit, control has been returned to budgetary policy, and this is already being reflects in a decline in the cost the government is paying to finance its debt, and in the gap between this cost and the cost of financing in other advanced economies. In looking forward beyond this next year, the deficit targets set for the coming years will bring the public debt to GDP ratio to 60 percent by the end of the decade. We must emphasize the importance of meeting the deficit targets in order to strengthen the stability of the economy and its ability to withstand shocks, as well as in order to continue reducing the burden of financing the debt. It is important here to note that a significant adjustment will be required in order to meet the deficit targets that have been set, and the government will be required to choose how much of the adjustment will be made by reducing the expenditure growth rate-which will require minimizing the programs to which the government has committed-and how much will come from an increase in tax revenues, whether by way of cancelling exemptions and increasing the tax base, by way of tangible measures to improve enforcement and collection, or by way of increasing tax rates. We must also emphasize that under conditions of budgetary tightening, the order budgetary preferences takes on greater importance, both from the aspect of allocating resources to growth engines, and from social aspects.

As to financial stability, support of which is one of the goals defined in the Bank of Israel Law, we can sum up the financial situation through a radar diagram where the vertexes of the hexagon represent different groups of financial risks. We can see that compared to the height of the crisis, when all types of risks were at their apex, we are in a much better situation now. With that, the "macro-global" risk today-which stems mainly from the situation in Europe-is slightly higher than its historic value, and among other things due to the effect of the global macroeconomic situation, the domestic macroeconomic risk is also above its historic average (a value of 0.5 represents the value of the historic average for each of the types of risk). We got an illustration of the importance of maintaining financial stability during the last global crisis, when the crisis was much more difficult and deeper, and the recovery was much slower, for countries that experienced banking crises as part of the larger global crisis compared with countries where the crisis was not accompanied by a financial crisis. This is also the historic experience in Israel and abroad from crises that have a financial crisis component compared to crises that do not include such a component.

In this context I would like to emphasize a number of points concerning the banking system, the supervision of which is entrusted to the Bank of Israel:

- The banking system is strong, though we must continue strengthening capital adequacy and liquidity in accordance with the Basel III framework;

- The level of operating efficiency is low when compared internationally, and streamlining measures are required, including reducing salary expenses not just at the upper echelons, and balancing the compensation mechanisms;

- Measures for improving competitiveness and for transparency and fairness in the relations between banks and customers, particularly households and small businesses, have been formulated and advanced, and their implementation is an important element in maintaining public confidence.

In summation, I would like to clarify and emphasize the main challenges facing the economy:

In the short term, the main challenge is continued management of policy in a global environment of slow growth and near-zero interest rates, while striking a balance between support of growth and the commercial sector, and maintaining financial stability, including stability in the mortgage market.

In the long term, the challenge facing the government is encouragement of inclusive growth that integrates population groups with low participation levels, while increasing their human capital and earning power and increasing productivity.

In response to questions from members of Knesset, the Governor added:

Regarding the exchange rate, we are not indifferent to developments in the exchange rate. The action that we are taking and have taken is witness to this. At the same time, we must remember that in an economy the performance of which is good compared to other economies, there are fundamental forces acting for appreciation. We are trying to moderate these trends, and as I showed in the last half year, appreciation was much more moderate, among other things thanks to our actions.

Since foreign exchange reserves few, the weight we place on returns is higher, so that we invest some of the reserves in longer-term channels, which helps increase the return on the reserves. It is also important to remember that the Bank of Israel is not acting for purposes of profit, but rather for purposes of price stability and growth, even if there is a price for these actions.

Investors in the housing market- one of the directives of the Supervisor of Banks placed very heavy restrictions on the loan to value ratios of investors in the housing market compared to the restriction on young couples. The government has also taken measures in the area of taxation. It is important to note that if we were to leave the interest rate high, the damage to the economy as a whole, to exports and to employment, would have been much more serious. Therefore, the measures in the housing market are intended to reduce the effects of the interest rate on the risks in the housing market.

As to haircuts in the capital market-we published stress tests that related to the question of a threat to financial stability as a result of a situation in which a large business group collapses, or even two groups. These tests showed that such a scenario does not constitute a threat to stability on a macro level. The committee for debt arrangements that was established by the Minister of Finance and the previous governor is in advanced stages of formulating its recommendations.

In regard to the fiscal rule, a view forward gives us good reasons to assume that average growth in the last decade was higher than what is expected in the coming one. The rule should therefore have been adjusted in this context.