Israel is one of the top five countries in the world in terms of high risk real estate prices, Canadian-born Organization for Economic Cooperation and Development (OECD) head of Country Studies Division 1 Peter Jarrett told "Globes." Jarrett has been following Israeli's economy since Israel joined the OECD. Jarrett is responsible for five teams of economists, each of which covers two countries; in other words, he is responsible for covering 10 of the 34 OECD members.
Jarrett will take part in the Aaron Institute for Economic Policy at the Herzliya Interdisciplinary Center in early May, under the arresting headline, "Does Israel's Government Have an Economic Strategy?"
"Globes": How would you describe the risk in Israel's real estate market?
Jarrett: "It's hard to say. According to our indices, housing prices in Israel are in a high risk group, especially for the existence of a bubble, together with New Zealand, and possibly Turkey and parts of Canada, my country, in the Toronto and Vancouver areas. These are the main concentrations of risk we see today in the OECD."
Israel is in the top five?
"Yes, but it's not necessarily unavoidable and really a bubble, with the only question when it will be deflated. Even if there's a risk that these housing markets will turn out to be bubbles, it won't necessarily happen. It's possible that none of these markets I mentioned will become a bubble, but we assess them based on prices over the past 5-10 years, after adjustments for inflation, and according to housing prices in comparison with per-household disposable income and rent. We have no data for the income ratio in Israel - only for the change in real prices and prices compared with rent. Israel is a leader in both categories, ahead of Canada and slightly behind New Zealand and Turkey."
Better transport infrastructure is needed
In recent years, the Ministry of Finance has been focusing mainly on demand side (taxation) solutions for the problem of real estate prices. Would it be better to focus on dealing with the supply?
"If you have to choose, we'd give more weight to the supply side. It's clear, however, that at some point in the development of a potential bubble, if the supply is incapable of meeting the basic demand, you find yourself with surplus demand from people who regard it as a possible channel for capital gains. You can call this demand from investors or speculative demand, so that in time, it's less clear. The fundamental source for the development of a bubble, however, is on the supply side.
"You (in Israel) didn't build fast enough to meet the basic demand. Pressures grew over the first decade of the 21st century, and then you started seeing a continual rise in prices. With time, the demand also became a problem, and so the authorities are trying to deter people from speculative activity in the market, because that only aggravates the situation, while at the same time, they are obviously trying to increase the supply in the market. When we conducted the previous survey in Israel just over a year ago, we said that you should focus on administrative requirements for planning and building homes. We also emphasized the need for better transportation infrastructure, so that people will be able to better utilize the available land, which in Israel is obviously quite limited, because you're a small country that is becoming more and more crowded. You have to enable people from areas that are not very crowded to reach workplaces in central employment areas, such as Tel Aviv."
In its most recent visit, the International Monetary Fund (IMF) criticized the high budget cost of the buyer fixed price plan, the Minister of Finance's pet project, which subsidizes land for building houses for people who do not own homes (who win lotteries) at a cost of NIS 2 billion a year.
What are your views about the buyer fixed price tenders?
"We have expressed no views publicly. The objective is of course legitimate - improving access to the market for young families, people buying their first home, because they're the ones being pushed out of the market in the case of a bubble.
"You should realize, however, that improving access to the market for them involves a price beyond the budget cost. When there are more people in the market on the demand side, the prices will rise. In other words, when you go in this direction, you're reinforcing the trend.
"But it's not all good news. There are still two prices: the budget cost, because the government represents the people and has to decide whether to invest tax revenues in this, and the price of reinforcing the trend, unless they succeed in making room by driving away investors. Investors are driven away only if they think that the overall demand will be less than the overall supply. Otherwise, they'll just smile and say, 'Good, buyer fixed price will make the previous investments, and maybe also my coming investments, even more attractive."
It has been said that the central bank can be a big help in halting the rise in housing prices by raising the interest rate. On the other hand, raising the interest rate is liable to cause a collapse. What effect are monetary tools likely to have on the risk that a bubble will form?
"It's certainly true that low interest rates are boosting asset prices all over the world, and real estate is only one of the types of assets whose prices have been inflated through surplus liquidity and low debt financing costs in general. One of the unknown variables is the assessment by investors of future interest rates during the life of the asset.
"If too many housing buyers assume that mortgage costs will remain at the current level during the entire life of the mortgage, and then the mortgage interest rate rises, they will be unable to pay the mortgage, and if too many people are too close to the (profit/loss) line, then it's obvious that the market will eventually suffer a substantial correction, and then we'll know that there was a bubble.
"The question is how the Bank of Israel, and other central banks in Washington, Frankfurt, Tokyo, etc., regard the need to raise the interest rate. People have differing views on this question.
"Optimists believe that inflation will never again be a significant problem, that the central banks are in control of the situation, that there's a large enough labor supply, and that enough people will return to the labor market in key countries. If you're also optimistic about all these aspects, you can imagine a soft landing scenario.
"Reduce leverage"
"There are many reasons, however, for thinking that people won't behave completely rationally, and that they have always been telling themselves, as they always do, 'I can leverage myself with all this liquidity available to me' - whether it's in housing, shares, bonds, or antique cars. The central banks are aware of this, of course, so it's not comfortable for them to keep interest rates low in the long term and see what happens. They realize that such low interest rates, which are apparently necessary in order to retain 1-2% inflation, are not preventing bubbles from being inflated. They are therefore using what we call macro-prudential measures - means of reducing the system-wide risk, in order to attempt to limit the volume of housing mortgages and other loans involving the household sector.
"I can't remember right now what Israel has done in this framework, but we usually encourage central banks to make extensive use of such measures in order to reduce leverage of loans."
The Bank of Israel is using macro-stabilization measures and imposing restrictions on mortgage banks, and the housing debt ratios of households are not increasing very quickly. The problem is that the planned reform in the financial sector will open many more channels for obtaining credit from what we call "shadow banks," for which regulation is less strict.
"Exactly. If you press the balloon from one side, it moves on the other side. You're not really making significant progress as a financial regulator, and in this case, it's clear that you want to reach uncovered areas, if that's at all possible."
For example, there is a capital adequacy (loan to value - LTV) limit of 75% on purchasers of a first home. In other words, people have to put up 25% in equity. The problem is that it is theoretically possible to obtain the equity through loans, say from parents or other financial institutions.
"Yes and no. You can ask people, especially if you see that their account has NIS 10,000, and several months before the mortgage request, the amount suddenly zooms to NIS 1 million, 'What happened here.' You can say, 'All right, this isn't equity.' In another case, you can detect in a bank account payment patterns likely to appear like repayment of some debt.
"What's important is that to some extent, the mortgage banks believe that it's in their interest to be cautious, and not merely for the sake of complying with the rules established by the central bank. Because if there's a significant correction, and someone you thought had 42% equity turns out to have had only 5% or 10% equity, because all the rest was camouflaged loans, what means of protection do they have? Who has priority concerning a property when its value plummets 20%, and the real equity is wiped out? Somebody's going to get hurt. Who will it be: the mortgage bank, or the shadow bank?"
From a broad perspective, how do you see Israel's economic development?
"The Israeli economy's performances have been very good. I started working with Israel before the global crisis and recession, and Israel certainly found itself in a good place in comparison with the OECD average.
"At the same time, the main problems are quite similar. The fact is that a large proportion of growth involves labor inputs, rather than productivity, which remains fairly weak. This is related to the dual nature of the economy; you have a very active high-tech sector, of course, and a lot of problems in services and protected sectors in industry.
"Another big problem is distributional - what we like to call the non-inclusion of certain population groups. There's nothing new in these areas, compared with several decades ago. In essence, the main new thing in recent years is the risk to the economy in housing, which didn't exist at the beginning. On the contrary - back then, housing in Israel lagged behind in activity for quite a long time, and has gradually become a top priority issue, step by step."
"There's no reason why the pension system should discriminate in favor of women"
The inflation rate in Israel in 2016 was minus 0.2%, the lowest among Western countries. Do you think inflation will rise later this year?
"In Israel's case, because the economy is quite small and open, the exchange rate is obviously an important factor. As you know, your currency was very strong, and exerted downward pressure on everything you import, but also on everything that competes with imports.
How unusual is the state of the shekel?
"To tell the truth, it's not unusual. Not so many years ago, you had a much stronger exchange rate than it is now - NIS 3.20/$. As of now, you are apparently close to a record against the euro and also the other main trading currencies. In any case, tourist services are definitely affected by the exchange rate.
"So where did inflation disappear to? I think it never disappears. It's there. When the central bank does good work, it's under control, and I think that the central bank in Israel did good work. I think a slight rise is likely, but there is no significant risk in this aspect on the horizon, except in case of a substantial global shock."
Several leading economists in Israel are criticizing the Bank of Israel's policy of buying dollars in order to weaken the shekel and help exporters. They argue that there is no advantage in giving exports preference over other sectors, and the central bank's subsidy is distorting investment decisions and resource allocation. What is your opinion?
"It's an interesting discussion, and Israel is not alone. The Swiss are doing the same thing, and the Czechs and Danes are doing the same thing, in a slightly different context. Quite a few countries have accumulated foreign currency reserves very rapidly in order to prevent their currency from reaching the point that the market apparently wants to take it, at least in the short term. The reason they're doing this is if they don't do it, they are liable to eliminate not only individual companies, but entire sectors, and that is liable to have irreversible effects.
"Even if we assume that the downward pressure on the shekel exchange rate will end when the central bank in Europe, say, starts raising the interest rate, something that could happen next year, at this stage, if the shekel were 10% or 15% stronger, several companies might already have gone bankrupt and closed down forever. If the currency depreciates again, these companies will not reappear.
"So it might be argued that this temporary situation is lasting a long time, and Israel therefore has such large reserves, but I think that now the end is in sight. The US central bank is on the way to higher interest rates in the next year or two. Where the euro is concerned, they're already starting to predict that the use of incentives by Frankfurt will be halted in early 2018."
So there's light at the end of the tunnel.
"I think that this is the Bank of Israel's philosophy, and it's more justified now than it was a year ago."
The OECD publishes a comprehensive report about Israel once every two years, and the organization's economists focus on two sub-topics each time.
What can you say about the organization's next report, which will be published in early 2018?
"It's too early for us to present good ideas that will undoubtedly appear in the next review, but it looks to me like you have taken the ideas in the last report to heart quite well. We didn't talk about the pension system. There are several simple ideas we still adhere to. For example, we think that the average retirement age should be raised throughout the OECD, because life expectancy is rising. It's better for it to be done automatically, instead of demanding that the government enact legislation in the matter each time. We unequivocally recommend that the pension age should be the same for men and women."
I think that our pension age for women is one of the lowest. This is a very politically sensitive matter here.
"Yes, all right, in general, women have a shorter career. The question is how to make sure that they have a fitting pension when they retire. That's a different question. On the average, however, women live longer, so their position is relatively not bad, because they receive a pension for a much longer time, even if their retirement age is the same. We regard this as a matter of equality. There's no reason for the system to discriminate in favor of women."
Published by Globes [online], Israel Business News - www.globes-online.com - on April 12, 2017
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