BOI - A Regional Perspective on Global Financial Issues

The Main Pillars of Macroeconomic Strategy

It is widely known that the government's macroeconomic strategy rests on
three basic elements:
* Fiscal discipline, which aims at adopting the European standard as regards the budget
deficit and the government debt;
* To attain and maintain price stability as defined in advanced economies;
* Enhancing the economy's competitive structure through structural changes.

These three, plus one other-opening Israel's economy to the free movement of goods,
without tariff barriers or non-tariff restrictions-were prescribed on the basis of the
assumption that the economic future of Israel lies in its integration within the global
market. This policy should serve to maximize Israel's growth potential on a sustainable
basis.
As this strategy has been adopted by all Israel's governments since the early 1990s, we
will assume here that it will also be affirmed by whatever government assumes office
after the elections of 6^t^h February 2001. It is on the basis of this assumption that we
refer below to the lessons of our experience in the year 2000 with regard to the further
implementation of each of those three basic elements.

Fiscal Discipline

The experience of the past year requires that we address two groups of topics
to strengthen fiscal discipline. The first group concerns the relations between
the executive (the government) and the legislature (the Knesset), while the
second group involves the government's work procedures.
With regard to the relations between the government and the Knesset, note the
following three features:
* It is not feasible to administer fiscal policy without the support of the Finance
Committee of the Knesset. This does not mean that the Committee should act as a
rubber-stamp, but rather that there should be agreement as regards the basic principles
of policy. If the composition of the Finance Committee is such as to prevent the
government from implementing its policy, one of the main pillars of macroeconomic
strategy is missing.
* On the other hand, the Finance Committee plays an important role, accorded it by
law, in monitoring the implementation of the budget on the basis of quarterly reports
from the Ministry of Finance. The quarterly reports are submitted, but there does not
appear to be any monitoring, i.e., they are not discussed and no operative conclusions
are drawn. The implementation of the budget for 2000 produced several surprises, and
there was certainly plenty to be discussed.
A discussion of that kind naturally is of value if-as noted earlier-there is consensus
between the Finance Committee and the government as regards the basic principles of
fiscal policy. In other words, the aspiration to attain the European standard with regard
to the budget deficit and the government debt. Otherwise it merely provides another
opportunity to undermine that policy.
* The subject of private legislation came to the fore in the past year, and it is evident
that the existing arrangements are no longer viable. Although section 39a of the Budget
Foundations Law states that "Regarding a proposal that is submitted to the Knesset and
whose implementation entails budgetary expenditure, or whose implementation involves
reducing government revenues…, the method of financing shall be noted," where "the
method of financing" is defined as either "reducing the amount of expenditure under a
given section of the National Budget Law" or "the imposition of a tax." This aspect of
the law is also addressed in that part of the Knesset rules of procedure (section 138a)
that refers to "legislation requiring a budgetary allocation," and which displays a similar
attitude.
This process does not appear to have been adhered to. Proposals are put on the agenda
without being accompanied by budgetary assessments, or there is a budgetary
assessment with no reference to the source of financing, or the source of financing is
defined as "reducing the budgetary reserve."
Since it is advisable, on the one hand, to maintain the possibility of private legislation,
but on the other, Knesset members cannot be expected to propose a source of finance,
the process should be changed. A basic law should be passed stating that a private law
may go into effect only:
* In the next fiscal year, and
* After the government has devoted a special discussion to it in the framework of the
budget proposal for that year, and has approved it.

The second group of subjects, relating to the government's work procedures, concerns
the way fiscal policy is formulated and implemented. Permit me to concentrate on two
subjects that I think are particularly important:
1. As is known, the government devotes several meetings to discussing the budget
proposal for the coming year. During this process, in the transition from the discussion
of the budgetary aggregates to the focus on the allocation of the budget to the various
ministries, the following three discussions should be added:
*A discussion of expenditure priorities.
Claiming that "education is our chief priority" and pointing to a proposed increase in
the Ministry of Education's budget may be a modest beginning, but it is no more that
that. It would be more useful to concentrate on the benefit accruing from this
expenditure in terms of output, in view of the targets and in comparison with other
countries. Similarly, to contend that "the infrastructure is our chief priority" and then to
vote in favor of increasing investment in it next year, compared to the current year,
cannot even be considered a modest beginning if no attempt is made to demonstrate
how to deal with the tremendous backlog we have accumulated in infrastructure
investment.

* A discussion of social policy.
Every government of Israel has had and will have a social policy. Expenditure in this
sphere is continually growing, both absolutely and relative to other public-sector
expenditure. On the other hand, it is doubtful whether anyone knows what the
objectives of the government's social policy are, and I am not referring here to general
aspirations but to goals that are measurable on a national level, what steps have been
taken by the government to reach its objectives, which goals have been attained, and
what progress is planned for the coming fiscal year? It is not entirely inconceivable that
certain measures that are currently being implemented in the framework of social policy
are in fact exacerbating poverty, making it more difficult to enter the workforce, and in
addition helping those who do not need help. A special discussion should be held on
these and other aspects of the subject.

* A discussion of tax policy.
An important part of the competition to which Israel's economy is subject in its course
to be integrated in the global economy lies in the sphere of taxes. A topic that has been
widely discussed in the past year is the high-tech industry with respect to such subjects
as raising capital, mergers and spin-offs, options, and income tax on companies and
individuals. A lengthy discussion has been held within the European Union on the
subject of taxing financial income, in view of the mobility of capital flows. In Israel
there is dissatisfaction with the way income from the labor of individuals and from
financial activity abroad is taxed. I do not think there is any need to cite more examples
(and there are plenty) to prove the importance of holding a special discussion each year
to review tax policy while the national budget is in preparation.

2. The second subject is connected with the question of the allocation of authority
between the Ministry of Finance and the other government ministries in implementing
the budget. As is known, control is quite centralized in this respect, with the ministries
having little flexibility in adapting the structure of their budgets to changing
circumstances. The Ministry of Finance claims that this centralized control is necessary
if the budget framework is to be maintained and taxpayers' money is to be utilized in an
efficient and appropriate way. The ministers feel that centralized control acts as a
disincentive to improving the service that is provided to the public.
This problem is not unique to Israel. Many countries have endeavored to resolve it by
reducing the number of budget items while improving reporting to the public and
parliament by ministries.
This subject, which is at the heart of public administration, should be reviewed
thoroughly by the next government as the budget for the year 2002 goes into
preparation. There is enough background material, conferences have been held (to a
great extent at the initiative of the Israel Institute for Democracy), proposals have been
submitted with regard to beginning slowly and on a modest scale, and conclusions
should be drawn while the process is ongoing. There is little danger and considerable
opportunity.

Striving to Attain Price Stability

In the sphere of monetary policy, the experience of the year 2000 requires us
to explain why actual inflation was zero while the target range set by the
government was 3–4 percent.
I will begin by saying that the development of inflation is not determined solely by
short-term nominal interest which is, as is known, the Bank of Israel's policy
instrument. Other important factors, such as fiscal policy, capital flows and the
exchange rate, import prices, and the extent to which the economy utilizes its
productive capacity, play a part. Underlying each of these factors are developments
whose trends and intensities it is extremely difficult to predict, if they can be predicted
at all, such as developments on the US stock markets, changes in world interest rates,
shifts in the security situation in the region, the stability of the government's political
base, the ability of the oil cartel to limit competition among producers, and the
deleterious effects of the financial crises that have hit the global economy in recent
years. Interest-rate policy should assess the effect of all these factors on the inflation
rate for a year or more, not merely in the coming month, and be adjusted to offset or
complement them so that the inflation target can be attained.
All this is relevant because the effect of the interest rate on inflation is not immediate,
and it takes months before the changes in it start to be effective, and a few more months
before that effect is realized to the full. Consequently, when we hold our monthly
interest-rate discussions we always look at least one year ahead. After the government
set our target as price stability from 2003 on, we extended our planning horizon to
three years.
The current interest-rate cycle in Israel and abroad began two years ago, at the
beginning of 1999, when the repercussions of the financial crisis in Russia (occasioned
by its debt default) and the US (near-bankruptcy of a major hedge fund) began to wane.
The average of twelve-month inflation forecasts declined during 1999 from about 5
percent to about 4 percent, and during 2000 from about 4 percent to about 3 percent.
Long-term capital-market expectations fell to a similar extent, while capital-market
expectations for one year dropped even more. We publish these data regularly, on a
monthly basis, and they provide the background to our interest-rate discussions.
In the wake of these assessments, and our estimates made on the basis of econometric
models developed over the years, a declining interest-rate trend began:
* In 1999 the Bank of Israel reduced its key interest rate by 2.3 percentage points in
five steps;
* In 2000 the Bank of Israel reduced its key interest rate by 3.0 percentage points in ten
steps.
Thus, in 2000 the expansionary monetary policy accelerated to some extent. This takes
on a special color when one examines the interest-rate spread between the shekel and
the dollar, both rates being set by the respective central banks. Against the backdrop of
rising US interest rates, the spread:
* Narrowed by 3 percentage points in 1999;
* And by another 4 percentage points in 2000.

At the end of 2000 the Bank of Israel's key interest rate was 1.5 percentage-points
higher than the Fed's, compared with 8.75 percentage points two years ago.
An interesting question to ask in this context is: has the narrowing of the interest-rate
spread affected the interest-rate-determined capital outflows of residents? The data in
our possession show the following:
* Relative to the total deposits of residents, the share of deposits indexed to and
denominated in foreign currency rose from 22 percent at the end of 1998 to 23 percent
in November 2000;
* On the other hand, relative to the total credit of residents, the share of
foreign-currency credit fell from about 38 percent at the end of 1998 to 36.5 percent in
November 2000. Moreover, the composition of foreign-currency credit changed, more
of it being in yen, because of the low interest rate, and less in dollars and the European
currencies, also in response to the narrowing interest-rate gap between the shekel and
the dollar.
In other words, interest-rate-determined capital flows did in fact react in the expected
direction-with greater demand for foreign currency-though not dramatically.
Notwithstanding, as is known, in the two years concerned there was no local-currency
depreciation, quite the contrary:
* In 1999 the exchange rate of the shekel against the dollar remained virtually
unchanged, and there was 3 percent appreciation vis-?-vis the currency basket;
* In 2000 the shekel appreciated by almost 3 percent against the dollar, and by 5.5
percent against the currency basket.
The reason is well known. Capital inflow for long-term nonfinancial investment, which
is not dependent on the short-term interest rate and is regarded as ‘autonomous' capital
inflow, more than offset the effect of the interest-rate-dependent capital flows on the
exchange rate. This occurred despite the fact that the shift in the Nasdaq began to be
apparent as early as the second quarter of 2000, and capital raised by Israeli companies
dwindled as the year progressed.
In addition, the current-account deficit also declined in 2000, contributing to the falling
demand for foreign currency.
Some of these developments, such as the size of the autonomous capital flows, were
not predicted. Others, such as the interest-rate-dependent capital flows, were expected
but we did not know enough-and still don't-to be able to assess either their expected
extent as a result of a given change in interest-rate spreads or the impact of their extent
on expected exchange-rate shifts.
We assess that this combination of capital flows and the exchange rate was the main
reason why the inflation rate fell short of the target despite the expansionary monetary
policy and its acceleration in the last two years.
If this assessment is essentially correct, this could also have implications for the
development of inflation in 2001:
* It is a common assumption today that the level of autonomous capital flows will be
lower in 2001 than it was in 2000;
* It is widely believed that the persistent narrowing of the interest-rate spread will serve
to further increase the demand for foreign currency. Nobody knows-and this should be
stressed-whether the moderate response that has characterized the change in the
composition of the public's assets and liabilities portfolios in the wake of the narrowing
interest-rate spread to date will also characterize it in the future, when the spread
between the interest rates on the shekel and the dollar falls below the current 2.0
percentage points, as compared with the decline from an 8.75 percentage-point spread
two years ago.
* It is also assumed now that the current-account deficit will be larger in 2001 than it
was in 2000.
* Thus, it is currently a reasonable assumption that the excess supply of foreign
currency that characterized the last two years will decline in 2001, and might even
become excess demand for it. However, we cannot estimate the expected extent of the
change or the implications of these quantitative changes for the exchange rate.
* None of the foregoing addresses other important factors which could impact on the
exchange rate and/or inflation in Israel in the coming year. These include the
development of geopolitical risk, the stability of the regime in Israel and its fiscal
repercussions, and the nature of the slowdown in the US and its implications for other
economies.
I would like to conclude this section, which focuses on the target of attaining price
stability, by making an additional remark. The (increasing) interest-rate cycle in the US
has come to an end. The (declining) interest-rate cycle of the Bank of Israel will also
reach completion when we attain our interest-rate target-though we do not know when
this will be or whether this will come with a bang (in the wake of some kind of shock)
or a whimper. We wish to avoid large interest-rate fluctuations which typically begin
with steep or sudden premature reductions, thereby creating uncertainty and
nervousness in the financial markets, leading to inflationary volatility, and unnecessarily
extending the period of adaptation to price stability. A period of this kind is required in
order to make it possible to deal with the institutional arrangements and practices that
have been built up over the years in order to enable us to live with inflation, and which
are responsible inter alia for the fact that the difference between high and low consumer
price indices during the year is still as great as it was-additional evidence of the fragility
of the process. As price stability starts to become a matter of routine and confidence in
it grows, it will be easier for us to maintain nominal and real interest rates which are
closer to those observed abroad, and this too will be a matter of routine. Meanwhile, it
is not unreasonable to assume that this basic approach has contributed to the restrained
response of the financial markets to the security events which we have witnessed for the
past three months, helping to buttress the assessment that the link between political and
economic risk is weakening.

Making the Structure of the Economy More Competitive

Finally, I would like to say a few words about structural reforms, referring only
to the financial markets.
There was progress in this area this year:
* The regulations for managing investments in life insurance portfolios were liberalized;
* Efforts were made to identify and deal with obstacles preventing the structure of the
pension industry from being more competitive;
* The process of relying mainly on unindexed bonds to finance the budget deficit
continued, while extending their term;
The Ministry of Finance should be given credit for its adherence to this difficult path.
On the other hand:
* The attempt to alter the ownership structure of the provident funds has not even got
off the ground;
* The reform of taxation of financial income was blocked before it could even get
started;
* The development of a corporate bond market, which is a crucial element of any
efficient capital market, is barely on the agenda;
* The non-banking money market is still as neglected as ever;
* The opportunity to completely abolish foreign-currency control was missed.

One of the most important lessons to be learned from our experience of the year 2000 is
that the efforts to make the financial markets more competitive have to proceed on
several fronts simultaneously, and hence require systematic and long-term management.
As we know, developed financial markets are a precondition for exhausting the
economy's growth potential and-equally as important-are necessary to enable it to
withstand the shocks that are liable to affect an economy that is part and parcel of the
global economy.
There can be no doubt that the next government should give careful consideration to
the question of how best to manage this sphere which is so vital for the future of the
economy, ensuring that change is continuous. The agenda for the required reform of the
financial markets is known; what is needed is that attention is devoted to the subject of
implementation.

Conclusion

The macroeconomic strategy adopted by all Israel's governments in the past
decade has prepared the economy to cope with the features characteristic of
the global economy, and to utilize its advantages. That is the route that is
appropriate for a small economy such as ours and, assuming that it is the one
we will continue to take, what is needed is to learn from our accumulated
experience in order to make the necessary adjustments.