1. The Israeli Economy: Maintaining a Thriving Economy in the Shadow of Terror Prof. Zvi Eckstein Deputy Governor, Bank of Israel The Jerusalem Center for Public Affairs March 26, 2007

2. The Macroeconomic Picture

3. Real GDP per capita Israel vs. USA Source: BEA, PWT, OECD, BOI Israeli GDP per capita (left scale) Ratio of Israel to USA GDP per capita (right scale)

4. Running an Economy Under Terror In 2000-03) terror has become a part of every day life in Israel. –A continuous impact on GDP growth. –High level of defense consumption. –Larger impact on the weaker segment of the population. –Great impact on uncertainty, which influences economic activity in the macro and micro levels.

5. Implications of Terror (Eckstein and Tsiddon,2003) When the rate of terror incidents is high, output, consumption, investment and exports decline significantly. In times of terror, non-durable consumption and GNP per capita declined by about 3.2% annually, while exports and investments fell by 14%. GDP could have been 12% higher.

6. Defense Expenditure as percent of Total General Government Expenditure 2000 - 2006

7. Predicted GDP per capita under the existence of terror

8. GDP Growth and the Unemployment Rate Source: CBS and BOI*BOI Forecast

9. The Budget Framework Today Keeping public expenditure under 47% of GDP What is the desirable rate of public expenditure? Main services that we need to take into consideration: security, health care, education, etc. Decrease of the budgetary deficit to around 1%, so that the public sector debt would be about 60% of GDP. Fiscal stability supports financial stability, and both set the ground for annual GDP growth of 4-5% and more.

10. General Government Expenditure (% of GDP) Target: keeping expenditure under 47% of GDP Differences in expenditure components need to be noticed

11. Gross Public Debt (% of GDP, Maastricht terms) Target: below 60% of GDP *assuming adherence to expenditure target

12. Monetary Policy, and Inflation and Exchange Rate Evolution

13. Managing Monetary Policy : Bank of Israel Targets Achieving price stability, adhering to inflation target (1-3%). Promoting financial stability. Banking Supervision: Supporting the stability and the efficiency of the banking system Developing the capital market in a global economic environment ensures efficiency in consumption, investments and production. Short term interest rate

14. Monetary Policy in 2006 and 2007 Inflation in the past 12 month was below target (-0.8%). Main impact factors: depreciation of the $ and the falling of fuel prices in the past 6 month. Decrease of sovereign risk premium. Current account surplus.

15. The NIS/$ Exchange Rate During 2006 the US dollar depreciated against the NIS by about 8% and against the Euro by about 10%. The NIS/euro rate did not change much.

16. General CPI and CPI Excluding Housing and Energy Influence (rate of change, last 12 months) % General CPI General CPI excluding housing and energy

17. Nominal Yield Gap Between Israeli and US 10-year Government Bonds

18. Current Account and the Goods and Services Account right left The Current account surplus supports the interest rate gap and GDP growth.

19. The Importance of Transparency and Moderation in Monetary Policy Management Policy steps should be moderate in order to prevent panic in markets. Harsh decisions should be taken only in crisis times. Keeping policy transparent. Signaling agents in the markets regarding policy fundamentals.

20. Monetary Policy and Expected Inflation in 2007:  Private forecasters: 2.0%.  Capital market: 1.4%.  The economic atmosphere enables the BoI to operate at a low interest rate of 4%, while achieving the inflation target and financial system stability.

21. Inflation in the Past 12 Months and Expected (Breakeven) Inflation Gradual return to the target bound

22. Reforms

23. The Israeli Economy Weaknesses Financial markets: –Money markets are not at the world’s high standards –High centralization, low level of competition and efficiency in the banking system. –Banks are the main suppliers of financial services – change had begun in 2000 prior to Bachar reform.

24. The Israeli Economy Weaknesses Labor market: –High rate of poverty. –Low participation/employment rate. –Foreign workers. Education system. - Low levels of basic knowledge: Need to reform Low productivity in low-tech sectors. Infrastructures: –Low urban development in peripheral areas. –Lack of public transportation and low quality of roads in peripheral areas.

25. What needs to be done? Financial markets: –Enhancement of efficiency, competition and financial instruments: Following the world. Labor market: –Active Labor Market Policies: US/UK examples –Reduction of foreign workers –Compliance with labor laws Infrastructure improvement. More reforms …”Doing Business” by the World Bank.