"The Israeli economy grew at a rapid pace (4.7%) in 2011 relative to other developed countries. The growth rate of per capita GDP was higher than the average over recent decades and the unemployment rate was the lowest since 1983." Thus the Bank of Israel opens its Annual Report for 2011, a year that began with rapid growth, "but in which growth, particularly of exports and private consumption, decelerated later on in the year as a result of the global slowdown."
The report points out one of the interesting changes that took place in the composition of GDP and growth: rapid growth in investment accompanied by a decline in unemployment, a decline in exports (as a result of the crisis in the US, and even more, the crisis in Europe), and a decline in private consumption.
According to the report, the growth rate started to moderate towards the end of the first half of 2011, as pessimism took hold around the world, affecting the capital market and private consumption, and as global demand slowed. These developments manifested themselves in a diversion of capital to countries considered safe havens, and in a change in the trend of the nominal and real exchange rates, from appreciation in the first half of the year, to depreciation in the second.
The report also states that, after seven years of surplus, the current account came into balance.
Real estate bubble fears recede
After two reports in which the Bank of Israel expressed concern that a bubble might be developing in the real estate market, the bank's economists have changed their tune. "Taking a long-term view, the latest boom in home prices was not exceptional," the current report states, describing 2011 as a "pivotal year" in the housing market. After three years of sharp rises, prices stabilized, and even fell towards the end of the year.
The bank's report goes on to say: "The housing market is cooling down. First, the number of transactions fell, and after that prices fell too." The report states that the social protest of last summer and the expectation of a decline in prices caused a dip in the number of transactions characteristic of previous recessions, but it points out that the main reason for the decline in housing prices was the raising of the nominal interest rate by the Bank of Israel in the second half of the year.
According to the report, prices moderated in other sectors too. "The slowing of the rate of economic expansion was one of the causes of a slowing in the rate of price rises," the report states, adding the social protest caused prices to moderate, because it acted as a brake on demand. "The protest demonstrated that consumers have not inconsiderable power," says the report, but it finds that it was more effective in concentrated markets, such as the milk and milk products market, and less so in competitive markets such as the housing market.
Price inflation amounted to 2.2% in 2011, in the middle of the government's price stability target range. Rents and energy prices were the main contributors to inflation.
An especially challenging fiscal year
Governor of the Bank of Israel Stanley Fischer sees an especially challenging fiscal year ahead following the social protest. Fischer suggests that government expenditure and tax revenues expected in the next few years will make it difficult to confine the fiscal deficit to the levels set by law, and that the budgetary implications of the recommendations of the Committee for Economic and Social Change (the Trajtenberg committee) will make expenditure cuts necessary.
Fischer says that the changes approved in taxation and expenditure are not fiscally balanced. He believes that it will be necessary to make decisions for the 2013 budget, which will start to be put together in the coming weeks, in order to prevent a breach of the budget framework. According to the report, the 2012 deficit will exceed the guideline because of the slowdown in growth and tax cuts, and will reach 3.2% of GDP.
In the light of these challenges, the Bank of Israel argues, the government will have to consider tax hikes, and a return to the tax burden of 2006-2007, a level similar to that in most of the developed countries. However, the Bank of Israel also points out that this year too, the indirect tax burden (VAT, fuel excise, and so on) in Israel is heavy compared with the level in the OECD countries, accounting for more than 50% of tax revenues. Although indirect taxation has a less adverse effect on growth, it widens social gaps.
Pressure from defense
The report states that the budget excess is partly due to the fact that the defense budget was in the end not cut in accordance with the Trajtenberg recommendations. "This year too, the process whereby the original defense budget is set billions of shekels lower than the amount eventually spent recurred," the report states. "The 2012 budget too has already been enlarged substantially beyond the original budget, by some NIS 3.6 billion… In the near future it will be necessary to deal with the fiscal pressures arising from security needs."
On the Trajtenberg recommendations, the report sharply criticizes one of the main measures intended to assist young families with children: tax benefits. According to the Bank of Israel's figures, these benefits, awarded to fathers of children up to three years of age, are ineffective for fully one third of the target population. Furthermore, the third in question is the weakest, not reaching the tax threshold, while the tax benefits are only of partial assistance to another 20% of the families concerned.
The Bank of Israel recommends expanding negative income tax and the tax credit points to the level customary in the OECD countries. In this way, the central bank believes, it will be possible to reduce the incidence of poverty among working families by about 13%.
According o the report, the deficit in the government's budget for 2011 was only a little higher than planned (3.4% of GDP). However, this level does not permit a further substantial reduction in the debt:GDP ratio, at least, not by the amounts seen in 2003-2007, when debt repayments were high in comparison with the developed countries. According to the Bank of Israel, the debt crisis in Europe "only highlights the importance of a continuing reduction in the debt and a decision on the order of priorities."
According to the report, the danger of contagion from the debt crisis has not yet by-passed Israel, and geo-political events such as the Arab Spring and the crisis with Iran "are liable to weaken Israel's relative status and lead to a decline in investment in the country."
The Bank of Israel report levels criticism at the two-year budget introduced by Minister of Finance Yuval Steinitz, claiming that it lacks the ability to predict economic variables. The bank hints that it will oppose this practice in the future.
Published by Globes [online], Israel business news - www.globes-online.com - on March 28, 2012
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