BOI - The Israeli Economy, 1990-2000: Strategy for Change And Recent Developments

Basic facts

The Israeli economy has undergone a major transformation in the last decade:

- GDP per capita, that stood at around US$ 11,000 in 1990, increased by more
than 50% to reach US$ 17,000 in the year 2000;

- The population of Israel increased in this decade by 35%, from 4.7 million in
1990 to 6.3  million in 2000, due mainly to a large wave of immigration following
the collapse of the Soviet Union.

- Despite the rapid increase in the labor force, the unemployment rate declined
from a peak of 11% in 1992 to less than 9% in 2000 while, at the same time, the
number of foreign workers has also increased to reach 15% of the business
sector employees, compared with 10% at the beginning of the decade.

- Foreign investors discovered Israel in the ‘90s - at a turning point in the peace
process in the region. External capital - a trickle before the ‘90s - started to flow
in towards the middle of the decade, mostly as direct investment and partly as
financial investment. It may reach a peak of some US$ 8 billion in 2000, roughly
7% of GDP.

- Foreigners invest in Israel not only in the high - tech industry, but also in the
so-called traditional industries like food and textile, and find active interest in
financial institutions. Altogether, Israeli assets held by foreign residents
amounted, at mid 2000, to US$ 123 billion, somewhat more than our GDP. Most
of it, 59%, reflects investment in the non-bank private sector; One quarter  - in
government of Israel foreign obligations; and the rest - in foreign currency
deposits in Israeli banks.

- In terms of international trade Israel is an open economy, and it has
become more so. Exports and imports amounted to 80% of GDP in 1990, and
88% in 2000. The deficit in the balance of payments has increased to reach a
peak of 6% of GDP at the middle of the decade but declined to roughly 1% at its
end.

- The nature of our manufacturing exports has changed dramatically in the
last decade. Out of the total increase in industrial exports, 88% were due to
advanced, high-tech industries.

- Foreign exchange reserves amount this year to some 40% of our imports,
compared to some 30% ten years ago, while the exchange rate regime has gone
most of the way from fix to floating rate. In addition, our short-term foreign assets
are almost twice the level of our short-term foreign liabilities - a vast
improvement over the surplus of some 20% that we had in the mid ‘90s, a
comfortable ratio by itself. Furthermore, the ratio of our net foreign debt to GDP
stood at 9% in mid 2000, compared with 25% in the middle of the ‘90s.

- The banking system is a solid and conservative one; the last crisis took
place 17 years ago. All Israeli banks weathered well the financial crisis that
swept South East Asia, Russia, Latin America and the hedge funds industry in
the second half of the ‘90s. Unlike some European and American banks, Israeli
banks did not lend to, or invest in emerging markets, and therefore did not incur
losses, due to their activity there.

- Inflation, endemic and unwielding for a quarter of a century, was brought
down to a low one-digit level, despite the persistent assertion of many Israeli
economists that the structure of the economy is too rigid to allow it.

Basic strategy

These results are not an accident or a result of sheer luck. They are due to a
long-term strategy, adopted by all Israeli governments, starting in the second
half of the ‘80s. The core of this strategy is, of course, neither new nor unique:
distance the government, as much as possible, from economic activity. In the
case of the government of Israel, that was an awesome agenda. We have not
yet finished the job, but we have gone a long way:

- A rather thorough change was implemented in our international trade area.
Customs and non-tariff barriers were abolished or reduced significantly, and free
trade treaties were signed with the EU and the US. That had an overwhelming
impact on the structure of the Israeli industry. It relies now more on advanced,
skilled labor based, technology and less on traditional, low wage labor,
industries.

- A similar change was effected in the financial area. The money and capital
markets were deregulated to a large extent, and almost all exchange controls
were lifted. At the same time, the exchange rate regime was gradually rendered
more flexible, and the daily rate is determined in the interbank market without
any involvement of the central bank. The foreign currency market thus created
attracts also foreign financial institutions, and its average daily turnover now
reaches US& 1.5 billion.

- At the beginning of the ‘90s the government embarked on the long-term
road of fiscal discipline. Each new government fixed a multi-year, declining,
deficit target. The most recent government decision will lead us to attain the
European standard, namely a general government deficit of 3% to GDP, by
2003.

Hence, it should not be surprising that after a decade of implementing that
policy, the government debt ratio declined from 132% to GDP in 1990 to less
than 100% at year-end 2000. We are all aware of the need to further reduce the
government debt burden towards the 60% Maastricht benchmark and
government policies ensure that we are heading in that direction.

- Apart from putting a declining cap on the relative size of its deficit, the
government has been engaged in privatizing its business corporations. A lot has
been accomplished already, and the government is weighing now the options of
privatizing the two remaining commercial banks it still partly owns, allowing also
privately supplied electricity, and opening the telecom business for additional
providers.

- Finally, the government decided, in August 2000, to adopt a price stability
target, and defined it to be at the range of 1% - 3%. We are already operating
within that range and our challenge is to maintain it, as we will.

- Based on this performance, the international credit-rating of Israel was
upgraded through the last decade.  S & P, for example, raised it from BBB- to A-.

Recent developments

A decade of structural changes and macro-economic strategy for stability,
resulted in the current year being one of the best in our recent history.

Until the third quarter of 2000 the economy was growing at an annual rate of
some 6%, led by the hi-tech sector. Exports are estimated to increase by 20%,
reflecting also the

acquisition of start-ups by foreign companies. Industrial exports are likely to increase this
year by 25%.

At the same time the standard of living also bounced. Private consumption per
capita is estimated to increase this year by 3% in real terms - compared with 1%
per-annum only in the previous two years.

Investment in equipment and machinery is increasing this year by 7%, indicating
positive prospects for further growth in the future.

The higher-than-expected growth of the economy increased government tax
revenues and reduced the budget deficit by more than 50% compared to the
planned one. As a result, the public debt burden will further decline, reducing
government interest payments.
The last quarter of this year, as we all know, is going to be different. However,
assessment of the likely repercussions, for the Israeli economy, of the rising
military tension in the area,

requires some perspective. Three comments are warranted here:

First, as far as one can tell, the recent tension is not going to lead to a reversal
of the peace process in our region. It is certainly a serious distraction, but
judging by the way the various sides handle it, they clearly are mindful of the
need to contain it.

Second, it affects the Israeli economy in a specific way. A decline in tourism is
clearly visible, and the absence of the Palestinian workers is affecting activity in
construction and agriculture. The implications for the rest of the economy are
indirect and a lot less significant. Tentative assessments, prepared by our
Research Department, talk about a one-time reduction of 1% - 2% of GDP from
the previous estimate for 2001, which was 5% - 6%. On the other hand the
unemployment rate is likely to decline because of the increased demand for
labor, especially low-skilled – most of the unemployed in Israel, to replace the
Palestinian workers.

Domestic financial markets, so far, lend support to the view that the Israeli
economy will return to normal operation after a while. In particular, the yield on
long-term government bonds hardly budged, and the reaction of the foreign
currency market was relatively benign. This may be a sign that our commitment
to maintain stability is still credible, but it should not be taken for granted.

Third, overall economic policy over the last decade resulted in a significant
improvement in the economy’s capability to compete on world markets. Hence,
its ability to weather a disturbance like the one we are experiencing now, was
greatly enhanced. After all, we know by now rather well that integration in the
global economy may also subject us to external shocks. We have learned, as a
result, that adjustments in our behaviour are called for from time to time.

That does not mean that our overall economic strategy should change. I believe that it
won’t. Based on our past performance it is very likely that any future government will
carry forward the economic strategy that proved to be so successful in the last decade,
namely:

* Fiscal discipline;
* Price stability;
* And structural reforms.

We know that this is the key to make progress in the global economy and,
hence, the road for a durable growth.