BOI - The Governor's statement with the annual reports of the Bank of Israel

The President of the State of Israel
The Prime Minister and Members of the Government
The Chairman and Members of the Knesset Finance Committee
Jerusalem

It is with pleasure that I submit, in accordance with section 59 of the Bank of Israel
Law, 5714–1954, the Financial Statements for 1999 and three Annual Reports,
prepared by four departments in the Bank of Israel—the Comptroller’s, Foreign
Exchange Control, Monetary, and Research Departments. These reports document
yet another stage in the transition of Israel’s economy to the structure called for by its
integration into the global economy. This transition entails, on the one hand, a
redefinition of the role of the government and the central bank, from active
intervention in the management of the economy, to focusing on the creation of the
economic and social infrastructure required for sustainable growth, and on the other,
structural changes which correspond to the comparative advantages of an economy
open to international flows of goods, services, and capital.
Decisive management of the transition is therefore a joint objective of the
government and the private sector. In this connection, the government must resort to
several decisions:

* To correct the deviation from the deficit targets for the year 2000 and thereafter
which derived from a pessimistic assessment, during the planning of the budget for
2000, of the implementation of the 1999 budget and of the economy’s growth
capability. This correction must distinguish between the various components of the
surplus income, relative to the plan, expected for 2000—how much of it is due to
transient factors and how much to longer term causes—and must also take
advantage of any shortfall in expenditure that may occur. Such an analysis will
enable a decision to be made as to what share of the expected surplus income and
expenditure should be earmarked for further reduction of the large government debt
burden, which involves significant interest payments that greatly reduces the
government’s ability to meet current requirements, and what share should be used to
finance a cut in the tax burden, in the context of the tax reform now being formulated
by the committee appointed by the Minister of Finance.

* At the same time, the long-term horizon regarding the inflation target must be
maintained, so that the target is determined, in the middle of every year, for the next
two years at least, on a path reflecting the gradual convergence to price stability. In
this context, proper treatment should be afforded to the passing of a new central
bank law, based on the norms accepted world wide, taking a broad and
comprehensive view as that adopted by the Levin Committee appointed by the prime
minister to examine the Bank of Israel Law. The new Bank of Israel Law must
therefore incorporate all the components proposed in the Committee’s report, the
main ones being: defining the central target of the Bank of Israel as the achievement
of price stability and its long-term preservation; granting the Bank complete
independence to operate the instruments required; transparency and accountability
of the Bank to the government, the Knesset, and the public; the establishment of a
monetary committee, headed by the Governor, whose members would be
experienced professionals in the relevant spheres, unbiased and subject to no
conflicts of interests, and completely and solely committed to the Bank of Israel’s
objective. Any partial legislation which does not relate to all the above components
as one integral whole will adversely affect the Bank’s ability to function, will
unnecessarily lengthen the time required to achieve price stability, and will thereby
undermine the economy’s credibility in the eyes of Israeli and foreign investors.

* Improving Israel’s capital market must also be central to the government’s policy,
because otherwise full integration with international capital markets will be
incomplete. This requires a comprehensive policy of continued reform of the capital
markets, giving priority to reform in the area of pension funds. In this context it is
important to make progress in the various aspects that will increase competition in
the financial intermediation industry. These include ending the issue of earmarked
bonds, at the same time taking steps to minimize concentration in the management
of pension funds; significantly reducing banks’ holdings in provident and mutual
funds; abolishing the ceiling on the issue of Treasury bills while simplifying the
procedures for issuing commercial papers, in order to create a non-bank money
market to serve the business sector and households. Comprehensive reform of the
capital market is essential for changing the attitude of international financial markets
to Israel’s economy from that of an “emerging market” to that of a “developed
market,” and is vital to economic growth.

* Alongside all the above, it is necessary to examine the social implications of the
macroeconomic strategy adopted by the government. Such problems as the growing
polarization in income distribution and how to contend with it, the way the
government extends help to the weaker strata of the population in both the short and
the long run, the system of incentives for transferring from welfare to employment,
the efficiency of the social services, the way they are funded, and the division of
labor between the government and the private sector in providing them—these
issues and others must be subjected to debate and consideration that should
culminate in a special session of the cabinet on social policy in the framework of the
preparation of the Budget for the year 2001.

In 1999 there was a turnaround in Israel’s economy: economic activity rallied
together with a decline in inflation and progress towards its consolidation at a low
level, as well as relative stability in the domestic capital markets. From the second
quarter of the year GDP soared, not all of the increase being of a permanent nature,
reflecting the recovery of domestic demand and exports, and accompanied by a
significant growth in employment. At this stage, the increase in employment was not
expressed in a fall in the unemployment rate because of the rise in the number of
persons actively seeking employment and greater reliance on existing workers. At
the same time, inflation fell to a rate consistent with the government’s inflation target
for the years 2000 and 2001, after the steep price increases towards the end of
1998. There were further improvements in the foreign-currency market, greater use
was made of derivatives to hedge against exchange-rate risk, and the exchange rate
was determined, as it has been since the middle of 1997, by market forces without
Bank of Israel intervention. The inflow of investment and long-term loans from
abroad has reached an unprecedented level, and Israel’s financial standing in the
international capital markets has grown stronger. Note that these important
developments were influenced to a great extent by the economy’s success in coping
with the effects of the global financial shocks at the end of 1998, in the context of
marked progress in the liberalization of the foreign-currency market.
Developments in 1999 and 2000 are proving that the changes in the economy are
accompanied by a revival of the process of growth while keeping the inflation rate
low. This is a different kind of growth than the one we have known in the past, which
was characterized by transient factors, one that is in harmony with Israel’s
comparative advantages, and hence its durability and its contribution to the
expansion of employment appears more promising in the long run.

Yours sincerely,

David Klein
Governor, Bank of Israel