Letter from Governor of the Bank of Israel on Submission of Bank of Israel Report 1999

(Communicated by the Bank of Israel Spokesman)

Jerusalem, 29 March, 2000
22 Adar 2, 5760

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

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

The first chapter of the Bank report in English is available on teh Bank of Israel website: http://www.bankisrael.gov.il.