ISRAELI OFFICIALS ON BUDGET, BACHAR COMMITTEE

C O N F I D E N T I A L SECTION 01 OF 02 TEL AVIV 006626

SIPDIS

NEA/IPA FOR BURNS/SATTERFIELD/DIBBLE
TREASURY FOR DOWNARD

E.O. 12958: DECL: 12/19/2014
TAGS: EFIN ECON PREL IS ECONOMY AND FINANCE GOI INTERNAL LABOR AND COMMERCE
SUBJECT: ISRAELI OFFICIALS ON BUDGET, BACHAR COMMITTEE
REFORMS, AND PRIVATIZATION

Classified By: ECONOMIC COUNSELOR WILLIAM WEINSTEIN FOR REASONS 1.4 (B,
D)


1. (C) Summary. Treasury Desk Officer for Israel Catherine
Downard discussed the budget, privatization, and other
subjects with Israeli officials on December 13. Her visit to
the Karni Industrial Zone will be reported septel. The
highlights of her discussions:
-- The GOI is committed to maintaining the 2005 budgetary
framework. Regardless of coalition negotiations, the 2005
budget deficit will not exceed 3.4% of GDP, including
disengagement;
-- The recent MoF-Histadrut labor agreement will not result
in additional 2005 expenditures;
-- The members of the Bachar Committee achieved consensus
that capital market reform required more than regulation but
rather a full separation between commercial and investment
banking;
-- As dramatic as the Bachar Committee reforms were, they
were only the first part of broader financial sector reform,
which still requires the creation of effective competition
within commercial banking;
-- Privatization is moving forward, but the low-hanging fruit
(El Al, Zim) has been picked.
-- Privatizing defense companies such as Israel Military
Industries (IMI) is the major challenge being faced by the
GOI. End Summary

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MOF BUDGET OFFICIAL: COST OF
COALITION WON'T BREAK BUDGET
--------------


2. (C) Deputy Budget Director Gordon said that he expected
the GOI to maintain the budget framework in 2005, with the
exception of disengagement funding. In large part as a
result of fiscal restraint in 2004, the major risks to fiscal
limits -- funding of local municipalities, wage costs, and
the new coalition's fiscal demands -- were under control.
Gordon went through a detailed analysis of the recent
MoF-Histadrut labor agreement, the bottom line of which was
that it would not influence 2005 expenditures. The 2005
budget's 1.2 billion reserve fund would cover the new
parties' fiscal demands, as well as pay for the cost of
increased local municipalities funding, the other major
unplanned expense for 2005:
UTJ: NIS 290 million
Local Municipalities: NIS 700 million
Labor: NIS 210 million.
Should Labor demand more than what the reserves could
cover, Gordon said the parties knew that would result in
across-the-board cuts in other budget areas.


3. (C) On disengagement, Gordon noted that, although
disengagement funding had not yet been finalized, it would
not cost more than 0.4% of GDP. He noted this had already
been communicated to the USG. As a result, the 2005 budget
deficit would come to no more than 3.4% including
disengagement and the real increase in expenditures compared
to 2004 would be no more than 1% excluding disengagement.

--------------
Central Bank Deputy Governor:
Amazing Consensus on Bachar Recommendations
--------------


4. (C) Deputy Bank of Israel (BOI) Governor Sokoler spoke
about his recent work as a member of the Bachar Committee on
capital market reform. He stressed that the various members
of the committee had quickly found themselves in consensus on
the substance and importance of the reforms. They believe
that the current structure of Israel's capital markets is not
suitable for such a vibrant economy. He stressed their view
that the GOI,s ability to address problems of conflicts of
interest through increased regulation is limited.


5. (C) Sokoler said the banks were fighting hard against the
reforms, saying that the solution was to bring in more
financial institutions, as opposed to divesting the existing
banks of their investment operations. Sokoler said such
argumentation made no sense in Israel: the two major banks,
which controlled upwards of 60% of the market, had shown
their ability to crush new market entrants. Moreover, "we
want our banks to be a place where one can receive neutral
recommendations on investments."


5. (C) Sokoler stressed that the Bachar Committee had only
begun the task of financial reform. Once the mutual funds
were hived off, who would purchase them? Sokoler hoped
"foreigners" would show an interest. Who would supervise
the new institutions? The GOI must also find a way to
increase competition within the commercial banking community
by making it easier for customers to change institutions.
Sokoler noted that these and other issues, such as
formalization of a deposit insurance scheme and development
of money market funds, will be addressed in a second phase of
recommendations to be formulated in the coming months.

--------------
Privatization Moves Forward
--------------


6. (C) Eyal Gabbai, Director of the Israeli Companies
Authority, said that the easy privatizations had been
completed and the GOI was now concentrating on the hard
cases.


A. El Al: Gabbai expected Knafaim to exercise its options
over El Al the week of December 20 and take formal control of
the company. Knafaim would probably make some initial
changes, including selling and leasing back fleet planes,
and engaging in more intense marketing. It was unlikely to
fly on the Sabbath.

B. Zim: The GOI had sold in 2004 its shares to the Israel
Corporation, which now owns 97.5% of the company. Zim, which
used to be one of the five largest shipping companies in the
world, is now likely to begin growing again.


C. Bezeq: Gabbai admitted that the GOI had priced Bezeq
shares too high in June, resulting in a disappointing lack of
interest by investors. Nonetheless, the GOI stands by its
commitment to sell all but 1.01% of the company, both
through the stock market, and through a "strategic block"
sale of 30-40% of the company to a private investor. As of
the end of October, eight companies had approached the GOI
regarding the sale. Gabbai expected this group to
consolidate down to no more than 2 or 3 purchasing groups.
The final sale would take place in the second quarter of

2005. Naturally, there were a number of conditions on the
sale, including that the bidding party must have at least 20%
of its capital in Israel.


D. Defense Companies: Gabbai said he had found the
privatization of Israel's defense companies to be the most
challenging part of his job, in large part because the
Defense Ministry and industry employees were utterly
opposed to it. That was why he was so pleased by plans to
privatize Ashot-Ashkelon Industries (AAI),which is part of
Israel Military Industries (IMI). He characterized AAI has
having 21st century technology held back by 1950s management.
Gabbai said the GOI plans to privatize AAI by the first
quarter of 2005 and hopes improved management after
privatization would show the wisdom of moving such firms into
private hands. He admitted that finding
investors would not be easy: "the employees are threatening
to set fire to the factory if privatization goes forward."
Selling the rest of IMI would be even more difficult: it Is
deeply indebted and faces large future pension liabilities.
The GOI had yet to agree on how to move forward.


E. Oil Refineries: The GOI had resolved in August, 2004 to
split the oil refineries into two companies to increase
industry competition. Gabbai said the GOI planned to sell
the smaller company, Ashdod, first. It would then sell
Haifa through the Tel Aviv Stock Exchange (TASE).


F. Banks: Gabbai noted that the process of privatizing
Discount Bank is very close to completion. Final proposals
from the two remaining interested parties are expected by
end-December. The release of the Bachar committee report on
capital market reform may result in some discounting in the
pricing of the sale of Discount Bank. Details of the Bank
Leumi privatization are still being formulated. Gabbai said
that the GOI is now considering distribute shares to the
public rather than stock options, as initially proposed.
Proper legislation to allow such a transaction has yet to be
passed.

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