Economic review

The Israeli Economy in 2005 and 2006

Courtesy of Bank Leumi

Economics Department

Dr. Gil Bufman, Chief Economist

August 17, 2006

Economic growth in 2005

The improved trend in economic activity that commenced in 2003 continued in 2005. Economic activity in Israel expanded by 5.2 percent in real terms, exceeding the 4.8 percent increase recorded in 2004. Economic growth continued to be based on exports, even though the export growth rate slowed to some 5 percent. Particularly noteworthy was the rate of growth for exports of services (12 percent, partly reflecting the substantial rise in the export of tourist services), compared with the slower increase for exports of goods, which had been somewhat impacted by economic slowing in Israel's primary trading countries. Export-oriented growth persisted in tandem with an improvement in domestic demand in various fields, especially fixed asset investments and public consumption. It was actually private consumption that expanded at a lower rate than in 2004, even though background conditions, on the whole, supported acceleration. Unemployment, for example, was down in 2005 to 9 percent on average, compared with 10.4 percent in 2004.

Economic activity in early 2006

The Israeli economy expanded by an annualized rate of 5.9 percent in the first half of 2006, compared to the preceding half-year period. The business sector grew 7.4 percent during the same period. Within the business sector, financial and business services grew by 16.9 percent; trade, food and hospitality services expanded by 12 percent; and industry grew by 10.5 percent.

In the event that the UN-sponsored ceasefire agreement will bring sustained calm to the area, economic activity in most sectors could recover quickly. Government support for households, businesses, and municipalities that were hurt as a result of the fighting is likely to speed the recovery process. Despite an expected decline in third quarter GDP, the economy is still projected to return to an impressive growth rate during the fourth quarter of 2006, and to a 4 percent annual rate of growth of GDP in 2006.

The State Budget and its financing

In 2005, the State Budget deficit (exclusive of net credit extended) was NIS 11 billion (1.9 percent of GDP), compared with a planned deficit of NIS 18.9 billion (3.2 percent of GDP). The lower than planned actual deficit can be attributed mostly to underutilization on the expenditure side (i.e. Government ministerial spending and interest expenses were lower than expected). Government revenue, on the other hand, was slightly higher than expected, even though inland revenues, and particularly indirect taxes, such as customs duty and value added tax, fell short of forecast.

The State's income from taxes increased by 8 percent in real terms (net of the effects of legislation) in 2005, primarily due to a sharp rise in income from direct taxes (largely from an increase in economic activity and tax enforcement campaigns). Tax withholdings also increased, mainly due to the influence of the banking and insurance sectors. The Government deficit was financed for the most part by privatization revenues of NIS 8.6 billion from the sale of State shares in Bezeq and Bank Leumi.

In the first half of 2006, the government had a budget surplus of NIS 4.7 billion. This compares to a NIS 1.3 billion deficit registered in the first half of 2005, and a planned budget deficit of NIS 17.2 billion for all of 2006. The surplus is the result of a strong increase in State tax revenue growth and tight control of government spending, in part reflecting the lack of an approved budget framework for 2006. However, it is likely that a large portion of this year's revenue increase will not be permanent.

During the first half of 2006, the State budget was in good condition, enabling Israel to cope with an unexpected increase in budget spending and a temporary decline in state tax revenues related to the war. As a result, the budget deficit for 2006 is likely to be a modest 2 percent of GDP well within the 3 percent annual GDP target. The impact of the brief deterioration in the security situation will probably constrain the ability of the government to cut defense spending in the near future and will require an increase in spending in order to replenish inventories. Thus, the 2007 budget will be a greater challenge for Israel's economic policymakers and for financial market players who follow the policy steps of the government and try to translate these steps into expected changes in the value of financial assets.

Foreign trade, capital flows and exchange rate

In 2005, Israel's trade balance of goods and services resulted in a surplus of $300 million, a decrease of 22 percent, compared with 2004. The decrease mostly reflected the global rise in oil prices, whereas the surplus exclusive of energy materials increased significantly over last year. The principal import components, namely raw materials and investment assets, increased at a dollar rate of 4.4 percent and 3.3 percent, respectively, compared with an increase of 7.1 percent in the import of consumer goods.

Industrial exports (exclusive of diamonds) likewise expanded by a relatively moderate dollar rate of 7.2 percent. These developments reflect the slowing of the global growth rate, a phenomenon to which Israel is exposed.

Israel's balance of goods and services amounted to a surplus of $400 million (seasonally adjusted) in the first quarter of 2006, compared to a negligible surplus in the same period last year. Excluding the increase from the rise in global oil prices, there was a large increase in the trade surplus. This improvement is a result of a more rapid expansion in exports relative to imports of goods and services. Noteworthy is the rapid increase in exports of goods in the second quarter of the year (compared to the first quarter). A look at export growth on an annualized basis indicates a recovery and a return to a rapid rate of growth (in nominal US dollar terms). In particular, the increase in the high-tech sectors (primarily pharmaceuticals) and mixed high-tech sectors was striking. Alongside the growth in exports, there was an expansion in the import of raw materials, which supports expectations for an acceleration in industrial production (a portion of which is channeled towards exports). Against this backdrop, it appears as though the real growth rate of exports of goods and services from Israel will reach 7-8 percent in 2006. This export growth will consequently continue to support GDP growth.

In 2005, foreign currency activity in the non-banking private sector pointed to a considerable increase in both foreign resident investments in Israel and overseas investment by Israeli residents. Foreign resident investments in Israel amounted to $11.6 billion, with a conspicuous increase in direct investments to $5.6 billion (a significant upturn compared with the $5.1 billion in peak year 2000). Overseas investments by Israeli residents (non-banks) peaked at $12 billion, mainly reflecting a substantial increase in traded securities.

Investments by foreign residents supported the shekel exchange rate, moderating the strengthening of the dollar against the shekel, given the strong international showing by the US currency. The shekel depreciated against the dollar by 6.8 percent in 2005, compared with a depreciation rate of only 1.7 percent on the part of the shekel against the currency basket. Moreover, in the first half of 2005, the shekel/basket exchange rate remained stable. The difference is largely explained by the international strengthening of the dollar against other foreign currencies. Against the euro, for example, the dollar strengthened by 15.3 percent in 2005.

Obviously, the improvement in background conditions of the economy, with an attendant increase in the balance of payments current account surplus, and substantial capital inflows, constitute a convenient background for relative stability of the shekel against the currency basket. However, the rise in political uncertainty and the narrowing of the interest rate gaps between the shekel and the dollar operated to weaken the shekel. Thus, the weakening of the shekel against the dollar resulted mostly from influences extraneous to the economy (relations between various foreign currencies), while domestic influences were relatively moderate, being noticeable primarily in the second half of 2005.

The $4 billion sale of 80 percent of Iscar to Berkshire Hathaway (controlled by Warren Buffet) in May, 2006 was a major event for Israel’s industry and capital markets. The transaction is likely to have an effect on the Israeli economy on a number of levels. Tax revenues of $1 billion stemming from the deal have helped keep the budget deficit below the target of 3 percent of GDP.

Aside from the budgetary impact of the deal, there are likely to be effects on the capital flows of foreign investors. Foreign direct investment (FDI) is likely to reach a new peak this year. These investments amounted to $7.8 billion in the first seven months, while the previous peak was $5.6 billion in 2005.

During the fighting in Lebanon, Hewlett-Packard (HP) announced it had purchased Mercury Interactive Corporation, an Israeli IT and software company, for $4.5 billion. These developments indicate renewed interest in Israeli technology companies, specifically those that are R&D intensive.

The capital flows data are a clear indication of the complete openness of Israel's capital account and the degree of attractiveness of Israeli investment opportunities from the point of view of foreign investors, especially long-term strategic investors. The strong inflows are an expression of Israel’s lower country risk as perceived by foreign investors when considering investment alternatives both strategic and financial.

Inflation and monetary policy

In 2005, the Consumer Price Index recorded an increase of 2.4 percent within the Government's price stability target range (1-3 percent) following a 1.2 percent rise in 2004. A considerable portion of the rise reflected depreciation of the shekel against the dollar, which mainly affects housing, accounting for one-fifth of the CPI. (The shekel depreciated 6.8 percent against the dollar, mostly due to the strengthening of the dollar internationally, while the depreciation rate serving to calculate the housing item amounted to 6 percent.) The CPI was also influenced by the rise of oil prices worldwide. Price stability was reflected in the financial markets: inflation expectations for the upcoming 12-month period, which derive from capital market data, fluctuated between 1.5 percent and 2.5 percent, while inflation expectations commencing from the third year and thereafter fluctuated near the upper limit of the target range.

In July 2006, the year-over-year rate of inflation was 2.4 percent. The inflation forecast for 2006 is 2.0-3.0 percent near the middle of the target range. Price stability in 2005 enabled the Bank of Israel to reduce the interest rate at the beginning of 2005 to 3.5 percent, a level that was maintained from February to September. After October, the interest rate was raised to a year-end rate of 4.5 percent. The Bank of Israel explained that it had changed its policy on the basis of its assessment that a more restrictive international monetary policy was to be expected due to fears of rising inflation from higher prices of energy and goods. It also assessed that the real short-term interest rate in the economy was too low, given the increased rate of growth and the possible effect on inflation caused by the depreciation of the shekel against the dollar. The interest rate hike continued at the beginning of 2006, reaching 5.5 percent in August.

The capital market

The shares and convertible securities index rose 32.8 percent in 2005 following an upturn of 17.6 percent in 2004. Advances were recorded in every month of 2005, except June. The commercial bank index stood out with a 55.1 percent increase. Share prices were higher primarily due to improvement in the economic situation, that affected corporate profitability, an improved geopolitical situation, the conclusion of the Gaza disengagement process, and the relatively low short- and long-term interest rates. Average daily trading volume for shares and convertible securities on the Tel Aviv Stock Exchange was up sharply to NIS 895 million, compared with NIS 596 million in 2004. Trading volume was about four times higher than in 2002.

In 2005, The CPI-linked government bond index rose 6.5 percent, most notably in 7-10 year (8.4 percent) debentures. This rise is explained primarily by the low volume of long-term capital raising by the Government. Unlinked fixed-interest government bonds rose by 5.2 percent, while debentures with a term to redemption of more than five years posted a sharp 10.8 percent increase. There was a corresponding downturn in yields to maturity (eight to nine years) from 6.9 percent in January to 6.2 percent in December, 2005.

In April and early May 2006, clarification of the political picture and advancement in coalition negotiations on the composition of the new government combined to form a comfortable base for renewal of the stock market’s positive trend. The stock indexes once again climbed upwards, reaching new highs. However, the downward trend in global markets that began in mid-May 2006 cut short the run of gains on the local stock market and caused a 6 percent decline from the peak levels set on May 9th. Nonetheless, compared to developing markets that absorbed declines of 15-20 percent, the local market performed well. In this regard, the Israeli stock market resembled the developed markets and less so the emerging markets. However, the negative trend in the equity market continued in June and July against a backdrop of escalating violence in the Gaza Strip and Israel's northern region, and the TA-25 index briefly fell below 800 points after reaching close to 900 in May.

Financial assets of the public

The value of the financial assets portfolio in the hands of the public at the end of 2005 was NIS 1.8 trillion, an increase of 20.5 percent or NIS 311 billion from year-end 2004. A considerable proportion of the increase is explained by the effects of the revaluation of assets, particularly against the backdrop of the rise in debenture and stock prices on the Tel Aviv Stock Exchange. At the same time, 2005 recorded substantial inflows of new savings to households and companies, resulting from the improved economic situation, which were applied to the purchase of financial assets in Israel and elsewhere.

The rise in the value of the shares, accounting for about half the increase in value of the total portfolio, brought the balance of shares in Israel and abroad to 29.8 percent of the portfolio at the end of 2005 (compared with 24.9 percent at the end of 2004), while only in 1994 and 2000 was the weight of shares higher. By contrast, the unlinked and CPI-linked components slid in comparison with year-end 2004 and the foreign currency-linked component affected by currency depreciation and the increase in deposits rose.

The public's portfolio of financial assets amounted to NIS 1.92 trillion at the end of May 2006, representing an increase of 4.9 percent since the beginning of the year. The value of each component in the portfolio, except for non-linked shekel assets, rose since January.

The significant increase in the percentage of shares in the portfolio can be clearly linked to a number of events in recent years. Accordingly, it appears that part of the increase in market capitalization in Israel was affected by the completion of the merger (which included the distribution of shares) of Teva Pharmaceutical and IVAX in January 2006. An additional important factor that contributed to the increase in the proportion of shares in the public's portfolio of financial assets was the rise in overseas investments in shares (31 percent since the beginning of 2006) to 3.8 percent of the portfolio. This was a peak level except for the late 1999 through early 2001 period, and reflected a change in the public's preferences against the backdrop of a significant revision in tax policy (a reduction of the tax rate on overseas investments) and the understandable desire to improve risk diversification. In addition, pension reform is leading to a gradual decline in the proportion of government issued non-traded and designated bonds in pension investment portfolios, and a concurrent increase in the proportion of shares in these portfolios.

Israel: Main Macroeconomic Variables
Annual Rates of Change, Real Terms