Israel's economy was in deep recession in 2001. GDP fell by 0.6 percent, and business-sector product by 1.9 percent, alongside a deceleration in the rate at which output prices rose, an increase in the unemployment rate-to over 10 percent at the end of the year-and a widening of the current account deficit of the balance of payments. Most of the gap between actual business-sector product (which fell) and its growth potential, estimated at 4-5 percent, is explained by two significant demand shocks: 1. The intifada which erupted at the end of September 2000 and had an adverse effect on demand for tourism and exports to the Palestinian Autonomy, also had a serious impact on construction and agriculture; 2. The drop in world demand for the product of the high-tech industry and start-ups, which have been Israel's leading export in the last few years. Most of the effect of the demand shocks was expressed in exports, which declined by 11 percent, and in investment, all of whose components fell. Private and public consumption expanded by 3 percent each, however, thereby preventing the exacerbation of the recession in the short run.

Fiscal policy did not support a return to sustainable growth in 2001 because of the sharp rise in the share of public current expenditure in GDP, accompanied by the continued heavy tax burden-which had risen by 2 percent of GDP in 2000. Concurrently, the share of the public debt in GDP rose, and this trend is expected to persist in 2002 following the rise in the deficit target to 3 percent of GDP in that year. As regards monetary policy, the Bank of Israel gradually reduced nominal interest, and hence real interest followed suit. This gradual reduction, in the context of growing fiscal uncertainty, helped to maintain stability in the financial and foreign-currency markets, but due to the rise in uncertainty in the political-security sphere and decline in interest rates abroad it was not enough to significantly stimulate investment and create the conditions for real depreciation, which would stimulate exports. Ex post, it appears that the implementation of a more balanced policy mix, with a lower budget deficit and faster reduction of interest, would have led to real depreciation during the year. Notwithstanding, an estimate of the relative price elasticity of exports indicates that depreciation would have contributed only marginally to offsetting the decline in exports.

In the last few years profitability has weakened noticeably, as expressed in the lower return on capital and steep rise in unit labor costs. At the same time, the tax burden on non-wage income has increased, and the downward trend in the export/business-sector product price ratio has persisted. The steps taken at the end of the year, among them the government decision to restore the downward path of the deficit and the Bank of Israel's reduction of nominal interest by 2 percentage points, served to generate real depreciation in the short run, stimulating exports; the persistence of depreciation is contingent on slowing the real growth rate of public current expenditure, however.

An analysis of total factor productivity (TFP) from a long-term perspective shows that its growth rate has fallen every decade. This negative trend is notable in view of the apparent recovery of TFP in the OECD countries recently; it indicates that a substantial change is needed in fiscal policy trends, with a shift towards a composition that stimulates growth. This will be achieved by lowering taxes, reducing the deficit, and increasing infrastructure investment. These changes will help to raise TFP while creating the conditions for a return to a path of sustainable growth once foreign demand revives and the political-security situation is calmer.

Israel's labor market was affected by the deep recession in 2001, the first indications of which were evident in 2000:IV. The slump, which stemmed from the security crisis and the global slowdown, was expressed in a steep 3.5 percent drop in labor input in the business sector, reflecting a decline in both the number of persons employed (1.5 percent) and the average number of hours worked (2 percent). There was a lag in the response of the unemployment rate and business-sector wage to the slowdown, which came in the second half of the year, when the unemployment rate soared (reaching 10.2 percent in 2001:IV) and the rate at which the real business-sector wage rose moderated. The delayed reaction of unemployment and wages to the economic situation was due to several factors, among them the sharp shift to recession and uncertainty regarding its duration and intensity, the marked expansion of public-services employment, which offset 0.4 percentage points of the rise in the unemployment rate, and the notable reduction in the labor input of Palestinians. The recession and the security incidents impacted on most of the business sector especially on construction, which has been experiencing difficulties for several years, and on hotel and catering services, which in the past had served to offset the rise in the unemployment rate. Because of the relatively large share of Palestinians in employment in these industries, the marked contraction of their numbers moderated the effect of the slump on Israelis.

Average unit labor cost rose by 5.5 percent in 2001, due to the marked increase in wages, which was accompanied by a fall in the average number of hours worked and a slight increase in labor productivity. The real average wage per employee post (excluding Palestinians) rose by 2.5 percent-2.5 percent in the business sector and 2.7 percent in the public services. The wage increases were led by business services, where employment expanded, and by agriculture, where employment contracted considerably.

Fiscal policy in 2001 failed to create the conditions for a return to a sustainable growth path in the coming years, to say the least. The central government budget deficit was 4.6 percent of GDP (4.0 percent of GDP after adjusting for the effect of the delay in the transfer of US government aid)-up by 3.5 percent of GDP over 2000 and with a marked deviation from the target. The deficit thus rose even beyond the level at which it had stabilized prior to 2000, with a rapid real rise in expenditure, even though the share of public expenditure in GDP is higher in Israel than in any other advanced economy. The 2002 budget, which was approved by the Knesset in February, perpetuates these trends. The general government deficit, public expenditure, and the public debt were also appreciably higher in 2001 than in 2000, their share in GDP returning to the levels at which they had stabilized since 1994. The tax burden, which had risen sharply in 2000 after years of relative stability, remained high. Moreover, the composition of the increase in public expenditure was not in items that contribute to sustainable growth and productivity, most of it being in non-defense consumption and transfer payments to households that are not directly connected with the economic slowdown, i.e., items that are essentially permanent; only about one fifth of the increase is explained by the greater share in GDP of defense expenditure.

While the slower rate of GDP growth, which had an adverse effect on tax receipts, explains a large part of the rise in the deficit in 2001, the fact that the share of the deficit, public expenditure, and the debt in GDP has been constant since the mid-1990s indicates that the failure to make progress in these spheres is not a temporary result of the surprisingly severe slump in 2001. Israel's failure to make progress is particularly marked in view of the notable reduction of public expenditure and the deficit in the advanced economies in this period. This has enabled many countries to ease their tax burden in the framework of structural reforms, and some of them have even been able to accelerate its reduction in order to offset the effect of the recent drop in world demand. According to accepted international definitions, Israel's deficit in 2001 was 4.6 percent of GDP, and public expenditure totaled 54.9 percent of GDP. This may be compared with a budget surplus of about one percent of GDP, and public expenditure of 42.0 percent of GDP, on average, in the OECD countries. The slow expected decline in Israel's debt/GDP ratio, even if the government attains the declining deficit path in the coming years, will bring it to the ceiling adopted by the EU countries-60 percent of GDP- only in another 20 years.

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The consumer price index rose by 1.4 percent in 2001, one percentage point below the lower limit of the 2.5 to 3.5 percent inflation target for the year, and within the long-term target of price stability of 1 to 3 percent.

Monetary policy during 2001 must be seen against the background of two main forces that had totally differing effects on inflation. (1) The considerable slowdown in real activity and demand, which was mainly apparent in the second half of the year, held down prices. (2) The financial and security-related shocks at home and abroad and the growth in the budget deficit led to fears that financial stability would be undermined, thereby making it necessary to adopt a cautious and gradual approach to the implementation of interest-rate policy.

The year 2001 can be divided into three periods with respect to the development of inflation and inflation expectations: the first half of the year was notable for relative stability in prices, inflation expectations and the exchange rate. In the third quarter, the uncertainty in local and international markets increased, concurrent with a depreciation of the NIS and a rise in prices and inflation expectations, undermining confidence in financial stability. In the last quarter, the markets calmed down. This was apparent inter alia from the appreciation of the NIS and the low, even negative, price indices, and inflation expectations reverted to the range of the long-term inflation target. Also in the last quarter it became fully apparent that the recession was worse than forecast. In line with assessments regarding inflation and developments in the markets, the Bank of Israel reduced the interest rate by a cumulative 2.4 percentage points during 2001, consistently throughout most of the year, in cuts of 0.2-0.3 percentage points. Towards the end of the year, the Bank of Israel decided to make a one-time exception to its policy of gradual adjustment in the interest rate, and cut the interest rate by two percentage points. This decision was based on the assessment that it would be possible to lower the interest rate without endangering attainment of the inflation target. This was in view of the new trend in fiscal policy, and the decision to implement a number of economic measures and structural changes in the financial markets.

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The value of the public’s 1 portfolio of financial assets rose by 6 percent in nominal terms during 2001 to a total of NIS 1,187 billion. This followed an increase of 7.2 percent in 2000 and a large rise of 25.3 percent in 1999.

The weighting of unindexed assets in the asset portfolio continued to grow during 2001, a trend that began as far back as 1992. This was against the background of the disinflation process of the past decade, and low inflation that converged to price stability after 1998. As a result, the weighting of unindexed assets in the asset portfolio amounted to 31 percent at the end of 2001, compared with 25 percent in 1998 and only 10 percent in 1992. In contrast to this trend, CPI-indexed assets accounted for 36 percent of the portfolio in 2001 compared with 47 percent in 1998 and nearly two thirds of the portfolio in 1992. A particularly large increase was recorded during the last two years in the weighting of unindexed bonds due to the substantial accrual in the shekel mutual funds.

The development of the Bank of Israel’s interest rate during 2000 and 2001, and the public’s expectations regarding its further development were among the reasons for the changes in the internal composition of each channel of investment. These changes led inter alia to a growth in the weighting of tradable assets, including certain of these assets that bear interest.

The weighting of foreign currency denominated and foreign currency indexed assets (excluding shares abroad) rose from 10 percent in 1998 and 11 percent in 2000, to 12 percent in 2001 due to the relative stability of the foreign currency market and the considerable decrease in interest rates abroad during 2001.

The weighting of shares (including shares abroad) in the asset portfolio fell from 26 percent in 1999, which was a buoyant year in the equity market, to only 21 percent in 2001. This resulted from the crises in the high-tech industries and in other industries in Israel and abroad, which led to a large drop in share prices.

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During 2001, nominal and real yields-to-maturity fell in the treasury bill market and the government bond market, and inflation expectations stabilized within the range of the long-term inflation target. These developments occurred against the background of the continued reduction of the Bank of Israel’s interest rate and the continued recession in economic activity. The level of uncertainty as apparent from foreign currency derivatives was relatively low on average. In the equity market, returns on holdings fell concurrent with the downturn in prices in equity markets abroad, principally among the high-tech shares traded on the NASDAQ. The development of yields-to-maturity on financial assets was not uniform in the course of the year. Concurrent with other developments relating to inflation expectations, the year can be divided into three periods: the first half, the third quarter and the fourth quarter.

The downtrend in yields-to-maturity that has continued for several years now prevailed during the first half, and the negative slopes of the curves became more moderate. The uncertainty during this period mainly resulted from the worsening confrontation with the Palestinians (the intifada) that began in October 2000, but the level of uncertainty was lower than in the last quarter of 2000.

In the third quarter, the downtrend in yields ceased, and yields actually rose among all terms-to-maturity, especially among long terms, and inflation expectations rose with them. This was mainly due to expectations that the budget deficit would exceed its planned level, and that the supply of bonds issued by the government to finance the higher than planned deficit would increase. The rise in yields appears to have derived from uncertainty over the increase expected in the budget for 2002, in view of the reduced credibility in the government’s commitment to reducing the budget deficit during the coming years and reducing the public debt. As a result, the slopes of the yield curves became positive following a long period of negative or flat slopes. The increased uncertainty also resulted from the terror attacks in the USA in September, and was reflected inter alia by a large rise in turnover in derivatives on a variety of underlying assets.

In the fourth quarter of 2001, bond yields fell again and following the announcement of the one-time 2 percentage point cut in the Bank of Israel’s key interest rate at the end of the year, continued to fall, especially among short terms. As a result the slope of the yield curves remained positive. The interest rate cut, which came as a surprise to the market, led to a rise in uncertainty and to a continued growth in turnover in the derivatives market. The development of yields-to-maturity in 2001 was accompanied by a large rise in average daily turnover, particularly in Shahar fixed-rate unindexed bonds, due to the consolidation of inflation at a low level. Concurrently, turnover in the equity market fell considerably although it rose to some extent at the end of the year. A notable growth in activity was recorded in foreign currency derivatives at the commercial banks and on the stock exchange. As a result, demand for the shekel-dollar options issued by the Bank of Israel was higher than in previous years.

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The proportion of the public’s savings with institutional investors-provident and severance pay funds (henceforth, provident funds), advanced study funds, pension funds and life insurance plans-remained stable during 2001 at the levels of the previous two years, and amounted to 31 percent at the end of December 2001.

The proportion within the public’s asset portfolio of mutual fund holdings continued to rise and reached 5.3 percent in December 2001 compared with 4.1 percent in December 2000, mainly due to the positive accrual in them and especially in the shekel-oriented funds.

In 2001, the public chose to withdraw money from the provident funds-long-term channels of saving-and to direct most of it to short-term channels of saving-mutual funds and shekel deposits. This was a reflection of the public’s structural adaptation of their asset portfolio, a development that resulted inter alia from the increased risks in the market and particularly in long-term tradable saving instruments.

Despite the withdrawal of money from the provident funds, the proportion of institutional investors in medium and long-term saving is continuing to rise, mainly due to the increased proportion of profit-sharing type life insurance plans, advanced study funds and new pension funds, in which a positive accrual was recorded. It should be emphasized, however, that the proportion of institutional saving in the asset portfolio and in total medium and long-term saving is very low relative to its proportion in the middle of the previous decade.

Institutional investors directed their funds at unindexed shekel holdings during 2001, mainly at the expense of their investments in shares. The background to this adjustment process was the consolidation of the low inflation environment, the expectations of a reduction in the Bank of Israel’s interest rate and the actual reduction in the interest rate, which created expectations of high returns on tradable shekel investments, and the large drop in prices in the equity market.

A notable development in the regulatory procedures governing the institutional system in 2001 was the enactment of new investment regulations for the insurance companies (profit-sharing policies) and the provident funds. These regulations reflect a new concept of major liberalization, meaning everything is permitted except for what is expressly prohibited. This concept has led to the abolition of most of the quantitative restrictions alongside an increase in the stability-oriented restrictions or in other words, a move from direct and individual supervision to indirect supervision. Institutional investors have been given almost complete freedom in their investment decisions concurrent with minimal intervention by the supervisory authorities. New investment regulations for the pension funds are at an advanced stage of preparation at the Ministry of Finance. The prevailing concept in this respect is freedom in choosing the “unrestricted” part of the pension funds’ assets, as with the regulations applying to the provident funds. During 2001, a number of changes were made to the regulations for joint trust investments. These changes concern activity in derivatives, short sales and the leasing of securities.

A decision was taken within the framework of a joint Bank of Israel and Ministry of Finance program for structural changes in the financial markets to increase institutional investors’ permitted rate of investment abroad from the present level of 5 percent to 20 percent, and to remove this ceiling at the end of 2002. The change will enable institutional investors to disperse their assets more widely.

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The management of the foreign exchange reserves portfolio, whose average level in 2001 was $ 23.5 billion, is subject to the Bank of Israel Law, 5714–1954, and the relevant legal interpretations which have been added over the years, and a set of rules which reflect the Bank’s responsibility for the reserves (see Boxes 1.1 and 1.2). The holding-period rate of return on the foreign exchange reserves in 2001 was 6.4 percent, down from 6.8 percent in 2000, reflecting the significant decline in yield to maturity in the capital markets in 2001 which resulted from the expansionary monetary policy pursued in response to the slowdown in economic activity primarily in the US but also in Europe. In NIS terms, the holding-period rate of return in 2001 was 10.3 percent, compared to 1.6 percent in 2000, reflecting the weakening of the NIS against the currencies in which the reserves were invested in 2001.

The yield on the reserves is greatly affected by the composition of the neutral benchmark of the portfolio, due to the relatively small deviations from it. Much effort has been invested in the last few years in the areas of asset allocation (securities not in the benchmark) and security selection for the portfolio, hereafter referred to collectively as asset selection, while on the other hand the scope of positions in the areas of duration and currency management has declined, in accordance with the policy of reducing exposure in these fields. In 2001 the holding-period rate of return was 22 basis points higher than that on the benchmark; this yield differential reflects the contribution of all aspects of portfolio asset management.

Asset-selection decisions contributed 23 basis points to the yield differential in 2001. Most of this derived from investment in Treasury Inflation-Protected Securities (TIPS) (7 basis points), in Eurobonds and floating-rate notes (FRNs) (8 basis points), and securities-lending activities (5 basis points). In contrast, investment in mortgage-backed securities issued by the Government National Mortgage Association (GNMAs) reduced yield by 4 basis points compared to the benchmark, due mainly to the strategic decision to invest in this sector. The duration management contribution was a negative 1 basis point, and currency management made practically no contribution.

The exposure of the reserves to the banking system is limited to 25 percent of the value of the portfolio. In 2001 it averaged 23 percent, and much of it was used in securities-lending activities, which have a very short investment horizon. The exposure is managed under a system of quotas and rules which plays a central role in the credit-risk management of the portfolio.

The reserves had very high liquidity: about 90 percent was invested in very liquid assets, and the balance in less liquid assets. Given the high level of the reserves, the liquidity appears to be satisfactory.

The terrorist attacks on the World Trade Center and the Pentagon on September 11 caused shocks world wide. In the wake of the attacks, the US economic slowdown worsened, and the level of uncertainty in the markets rose. Activity in the financial markets, which was severely disrupted in the days following the attacks, recovered relatively quickly, largely due to the immediate steps taken by the US Federal Reserve Bank in cooperation with several other central banks.

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During the year 2001, the NIS (New Israeli Sheqel) depreciated against the currency basket by 7.0 percent and against the US dollar by 9.3 percent. The difference reflects the strengthening of the dollar against the other currencies in the basket-euro, sterling and yen. The exchange-rate band widened from 39.2 percent at the beginning of the year to 43.9 percent at the end (calculated in terms of the average of the band’s limits). This was partly due to the change in the lower limit of the band on December 24, whereby the lower limit was reduced by 1 percent and its slope was reduced to zero at a constant rate of NIS 4.1021 per currency basket. The slope of the upper limit remained unchanged at 6 percent, as in 2000.

The NIS weakened throughout the year as a result of the domestic economic slowdown, which began in late 2000 and intensified during the review period. The two main factors affecting domestic economic activity were the global high-tech crisis, which caused an economic slowdown in many countries, chief among them the United States, and the deterioration in the security situation caused by a renewal of the intifada. Against this backdrop, a sharp reduction in the level of capital imports to Israel in 2001 from their level in 2000 contributed to the weakness of the NIS.

The volatility of the NIS/dollar exchange rate was 4.0 percent in 2001, down from 5.1 percent in 2000. The volatility of the NIS has consistently been lower than that of other currencies, both of emerging and advanced economies. Probable reasons for this include minimal offshore trading, a low level of speculative activity, and the exchange-rate band, which imposes a limit on volatility.

The average daily turnover of foreign exchange in Israel’s foreign currency market reached $ 4.3 billion in 2001, representing a 59 percent increase over 2000 and an 88 percent increase from the 1999 level. Total turnover includes activity in the NIS/FX market as well the non-NIS sector (i.e. FX/FX) and the foreign-exchange-indexed sector of the market. The growth of the market in recent years may be attributed in large measure, although not exclusively, to the increased participation of foreign financial institutions, acting on their own behalf and on behalf of their clients.

Foreign exchange activity in Israel is small in comparison with global turnover, but it is comparable to that of other countries which are similar to Israel in terms of their levels of economic development, openness and international trade.

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Israel’s external activity contracted in 2001, as reflected in various components of the balance of payments. The current-account deficit worsened slightly and the financial account ended the year with a small net capital outflow. These developments occurred mainly under the influence of a severe domestic and global economic slowdown, especially in high-tech industries, that came about in the aftermath of security events and Israel’s strong external market openness.

The current account had a deficit of $ 1.7 billion in 2001. The deficit in terms of GDP, 1.6 percent, surpassed the 2000 deficit (1.3 percent of GDP) but was smaller than the average deficit in 1996-2000 (3 percent of GDP) (Table 1.1). The deficit increased relative to 2000 chiefly because the security events depressed tourism revenues severely. The global and domestic slowdown affected various components of the current account, especially in high-tech, in contrasting directions that canceled each other out; therefore, its effect on the deficit was scanty.

The financial account recorded a net capital outflow of $0.3 billion. The transition from inflow in 2000 to outflow this year was occasioned by a steep 60 percent decline in nonresident investment and a less acute contraction, 52 percent, in resident external investments. Both decreases were caused mainly by the abrupt changeover in high-tech industries from vigorous growth that crested in 2000 (the ‘bubble effect’) to a trough that was reflected in high-tech companies’ activities, earnings, and share prices. The effect of security events on the financial account was less severe; its main manifestation was a slight decline in nonresident deposits with Israeli banks. Notably, direct investments-of nonresidents in Israel and of residents abroad— were less affected by the adverse developments and maintained their long-term trend. The current and financial account developments described above took place in view of Israel’s strong openness to the global economy in its financial and nonfinancial activity, a state of affairs that gives external and domestic developments a greater impact than they would otherwise have. The nonfinancial openness of Israel’s economy surpasses that of similar economies elsewhere and has been rising since 1999 (Figure 1.1). Financial openness is also rising, although it still falls short of the level in similar countries (Figure 1.2). Even though Israel has a very open economy, its external financial vulnerability has decreased in the past three years.

Developments in the NIS-forex market in 2001 reflected the maturing of various processes in recent years. Since the middle of 1997, when the exchange-rate regime was eased, the rate has been set freely by market forces. This development, which along with the contraction of the NIS-forex interest spread led to an increase in exchange-rate risk, acted in concert with foreign-currency liberalization, globalization, and solidification of the credibility of macroeconomic policy to make the NIS-forex market more efficient. Additional progress was made in 2001: trading volumes increased substantially, the market became deeper, and a new class of players—foreign financial institutions—made their debut. The exchange-rate changes in 2001 led in two directions with no significant trend, due to equilibrium among market forces that made central-bank intervention unnecessary. The market did experience external and domestic shocks that, however, affected it for relatively short periods of time only. The forces at work in the market in recent years will probably remain operative in the near future and will allow the market to continue to perform soundly and without intervention—provided that the fiscal and economic policies not deviate from accepted international standards.

On December 25, the key rate was lowered suddenly and surprisingly, in conjunction with the announcement of related measures in regard to liberalization and the exchange-rate band. The rate cut had a substantial impact on the relative rate of return on assets, and immediately after it was announced households began to generate demand for forex. This demand lasted into January 2002 and caused the currency to depreciate steeply. The business sector, by engaging in net sales of foreign currency, countered the exchange-rate trend—much as it had during previous shocks .