Identifier
Created
Classification
Origin
05TELAVIV904
2005-02-15 12:15:00
CONFIDENTIAL
Embassy Tel Aviv
Cable title:  

NETANYAHU AS FINANCE MINISTER: CONFOUNDING THE

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C O N F I D E N T I A L SECTION 01 OF 05 TEL AVIV 000904 

SIPDIS

E.O. 12958: DECL: 02/10/2015
TAGS: ECON EFIN ELAB SOCI PREL EIND ENRG IS ECONOMY AND FINANCE GOI INTERNAL
SUBJECT: NETANYAHU AS FINANCE MINISTER: CONFOUNDING THE
SCEPTICS

Classified By: Ambassador Daniel C. Kurtzer for Reasons 1.4 (b,d)

C O N F I D E N T I A L SECTION 01 OF 05 TEL AVIV 000904

SIPDIS

E.O. 12958: DECL: 02/10/2015
TAGS: ECON EFIN ELAB SOCI PREL EIND ENRG IS ECONOMY AND FINANCE GOI INTERNAL
SUBJECT: NETANYAHU AS FINANCE MINISTER: CONFOUNDING THE
SCEPTICS

Classified By: Ambassador Daniel C. Kurtzer for Reasons 1.4 (b,d)


1. (C) Summary. Upon assuming office in 2003, Finance
Minister Benjamin Netanyahu implemented a series of
far-reaching economic reforms aimed at overcoming Israel's
economic crisis of 2001-2002, the worst in its history.
Originally drafted under Netanyahu's predecessor Silvan
Shalom, they encompass wage, welfare and social security
reform as well as significant changes in fiscal and tax
policy. Israeli economists, whether from the political left
or right, universally praise Netanyahu for the courage of his
reforms -- many of which actually reduced incomes at first --
and for the political canniness he showed in getting them
through the Knesset. As the Bank of Israel's chief economist
put it, "Netanyahu has done what he promised to do, and the
results are good." What these economists dispute, however,
is the effect of the reforms on poverty and income disparity
levels and how to help those hardest hit cope with what some
are beginning to call the "Netanyahu economy." This cable
examines the economic challenge Netanyahu faced when he
assumed office, outlines his programmatic response, and
assesses the extent to which this succeeded. For those who
want to know the punch line in advance: we think Netanyahu
made some tough, politically-unpopular decisions that have
paid off handsomely. The Israeli economy is better off than
it would have been had he not become minister. End Summary.

--------------

I. The Challenge
--------------


2. (SBU) Upon assuming office in March of 2003, Finance
Minister Netanyahu inherited an economy that had entered its
deepest recession ever. As a result of the Intifada and the
slowdown in the world economy, the Israeli economy contracted

0.9% in 2001 and 0.7% in 2002. This was a sudden and drastic
about-face for an economy that had ridden the high-tech boom
of the 1990s, leading to 8% growth in 2000. The decrease in
per capita income was particularly dramatic: 3.2% in 2001
and 2.7% in 2002. This combined drop of almost 6% brought
per capita income back to the level of 1996, the worst
decline in income in Israeli history. Unemployment levels
rose, consumption fell, and the Israeli public was becoming
increasingly pessimistic about the economic direction of the
country.

--------------
II. Netanyahu's Reform Program
--------------

--------------

A. Fiscal Responsibility
--------------


3. (SBU) In response to his country's economic malaise,
Netanyahu immediately implemented a reform program largely
developed under his predecessor, Silvan Shalom. His main
energy was focused on reducing public spending as a
percentage of GDP, which at 55% of GDP in 2002 was much
higher than that of other developed countries (including
Sweden). Netanyahu frequently regaled visitors at the time
with an image of the Israeli private sector as a marathon
runner hobbled by the necessity of carrying a much-heavier
man -- the public sector -- on the runner's back.


4. (SBU) Netanyahu reduced expenditures by making a number of
courageous and difficult policy changes. Perhaps the most
far reaching was his pension system restructuring. This
increased the retirement age and level of worker
contributions, took over bankrupt funds formerly managed by
the Histadrut (the national labor union),and introduced the
concept of investing a certain percentage of the funds into
Israel's capital markets. He took on Israel's huge public
sector by implementing a 4-6% average reduction in public
sector wages, a step that required reaching agreement with
the Histadrut to reduce workers' salaries by over NIS 2
billion. He cut ministerial personnel budgets significantly.
Less successful were Netanyahu's efforts to reduce the
number of government workers (other than in government
companies),which ran into fierce union resistance.


5. (SBU) Netanyahu's fiscal program was a success, with
general government expenditures falling to 51.1% of GDP in

2004. At the same time, the fiscal prudence he introduced
led to a significant reduction of the budget deficit, from
5.6% in 2003 to 3.9% in 2004. Netanyahu's fiscal moves have
elicited universal praise from Israeli economists, regardless
of their political stripe. They universally point to the
reduction in the deficit to 3.9% of GDP in 2004 as a signal
success. Even one of Netanyahu's fiercest critics, Professor
Momi Dahan of Hebrew University, points to Israel's newfound
fiscal prudence as essential for a small, open economy and
praises Netanyahu's moves in this area.
--------------

B. Tax Reduction
--------------


6. (SBU) During the 2003 and 2004 Joint Economic Development
Group (JEDG) meetings, Netanyahu repeatedly stressed the
importance he attached to "unleashing" Israel's potential for
growth by lowering the country's tax burden. He put his
political weight behind the implementation of a series of
far-reaching tax reforms outlined in the Rabinovitch
Committee tax reform plan, which went into effect in 2003.
Over time, Netanyahu actually accelerated implementation of
these measures, which reduced income taxes on the one hand
while imposing, for the first time in Israel, taxes on
capital gains to spread the tax burden more equitably.


7. (SBU) In 2004, Netanyahu introduced yet another series of
tax reforms, which he was able to implement because of
higher-than-expected governmental revenues. He accelerated
the decline in income tax, reduced VAT from 18% to 17%,
reduced purchase taxes on a number of consumer items, and
reduced tax rates further for middle and lower level wage
earners. He furthermore decided to reduce corporate tax
rates from 36% to 30% over the course of several years.
Netanyahu's changes measurably reduced the country's tax
burden, which fell from 40.1% of GDP in 2001 to 38.3% in 2004
(projected).


8. (C) The tax reforms have been controversial. The
Finance Ministry's chief economist, Michael Sarel, calls them
a "huge achievement," highlighting the cut in corporate taxes
from 36% to 30% as having the potential to increase long-term
growth rates. Professor Dahan, on the other hand, argues
that the tax cuts primarily helped the rich, and reduced the
GOI's ability in future years to increase support for the
poverty stricken. One other criticism, levied by the IMF, is
that the tax cuts prevented Netanyahu from taking advantage
of a potential revenue windfall to reduce Israel's high
debt/GDP ratio, which stands at 106.5% compared with the OECD
average of 80.2%. U.S. participants at the 2004 JEDG also
expressed concerns in this area.

--------------

C. Getting Israelis Back to Work
--------------


9. (SBU) At 54.5 percent, Israel's rate of labor
participation of those aged 15 and over is one of the lowest
in the developed world. Netanyahu and his Finance Ministry
colleagues believe that this statistic is in large part
grounded in simple economics: high levels of unemployment,
social welfare and other payments simply make it uneconomical
to work. Netanyahu has addressed this by systematically
reducing these payments while embarking on an effort to
increase demand for Israeli laborers. His primary effort in
this area is focused on reducing the number of foreign
laborers allowed to work in the country, which has fallen
from a high of 240,000 in 2002 to less than 200,000
currently. The minister also tried to make it easier for
Israelis to find work through implementation of a series of
measures that mimic the "Wisconsin Plan" pioneered in the
U.S. This initiative sets up "one-stop shops" where the
unemployed can receive job training, as well as increase
resume building and interviewing skills.


10. (SBU) Netanyahu,s reforms have helped reduce
unemployment. Bolstered as well by a resurgent economy,
unemployment fell from a peak of 10.9% in November 2003 to
10% one year later. Economists expect this trend to
continue. The MoF's Sarel points to a 100,000-person
increase in the labor force since Netanyahu assumed office as
proof that the "back-to-work" policy has been a success.
Nonetheless, labor participation has only inched up, with the
Finance Ministry's projections showing an increase of just
one percentage point from 2002 to 2005.

--------------
D: Structural Reforms
--------------

--------------
i. Privatization
--------------


11. (SBU) Netanyahu has implemented an ambitious
privatization program. This is not a new priority for the
minister, who as Prime Minister initiated Israel's most
successful privatization program up to that time in the
1990s, the highlight of which was Bank HaPoalim's sale to a
U.S.-Israeli investment group. He has so far had two major
successes in the current round, the privatization of El Al
and Zim (the Israeli shipping company),while some other
reforms (notably in the ports and in electricity generation)
have seen extensive delays.

-- Airlines: El Al. At the end of December 2004 the
Knafaim-Arkia group decided to exercise their options
increasing their holdings to around 40%, from 22%, turning El
Al into a private company.

-- Shipping: Zim. In February 2004, Israel Corp. bought out
the GOI,s 48.6% stake in Zim. Combined with the firm's
previous 48.9% holdings, this makes Israel Corporation
virtually the only stockholder in the firm.

-- Telecoms: Bezek. In July 2004 the Government decided to
sell 30% of Bezek, with the option to sell up to another 10%
of the State,s shares. A number of investors and investment
groups have shown interest. In 2003 the Government sold 9.1%
of Bezek in two trades, and another 3% of the Government's
shares were sold on the TASE in June 2004. Further movement
on Bezek's privatization is expected to be slow.

-- Banks: Israel Discount Bank. Agreement was signed with a
group headed by Matthew Bronfman for the purchase of 26% of
the Discount Bank, bringing the GOI's holdings down to 31%.
According to the agreement, Bronfman will pay NIS 1.3 billion
(approximately USD 300 million) for the shares. He has the
option to purchase an additional 25% of the bank's shares
within three years, which would give him majority control of
the company.

--------------
ii. Sectoral Reform
--------------


12. (SBU) Netanyahu has decided to inject competition into
a number of government-controlled industries in advance of
privatization. As Eyal Gabbai, Director of the Israel
Companies Authority notes, the GOI hopes to avoid simply
turning public monopolies into private monopolies. The
minister's reform of the financial services sector is being
led by his Director General, Yossi Bachar, whose reform plan
should see Knesset action in February, 2005. In addition,
Netanyahu is looking to reform Israel's sclerotic real estate
market (the state owns more than 90% of all land in Israel)
sometime in 2005.

-- Electricity/Oil Refineries: The GOI is preparing to break
up the oil refineries and electrical producers into a number
of entities which will compete with each other, hopefully
increasing competition and lowering prices. Privatization is
the eventual goal.

-- Ports: In order to bring competition to the port sector,
the Finance Ministry developed a plan to separate the Haifa,
Ashkelon and Eilat ports into independent, competitive
entities. Unionized port workers have fought hard, and
successfully to date, against this reform. According to the
MoF's Rani Loebenstein, who sits on the Ports Authority Board
of Directors, legislation implementing the competition plan
is scheduled to take effect February 27.

-- Bachar Banking and Capital Market Reforms: Netanyahu has
long made it his goal to reduce concentration in the Israeli
banking sector, which is overwhelmingly dominated by just two
banks, Leumi and Hapoalim. The reforms would remove banks
from the mutual fund and retirement fund businesses, while
compensating them with access to the insurance business. The
reforms have been approved by the government, and they are
expected to be brought to the Knesset in the spring of 2005.

-------------- --------------
III: The Reforms, Supported by U.S. Loan Guarantees and
Global Economic Resurgence, Reenergized Israel's Economy
-------------- --------------


13. (SBU) So, how did he do? An easy question, but one
that's hard to answer with precision. Unfortunately, it is
impossible to separate the effects of Netanyahu's reforms on
the Israeli economy from those of other factors such as the
U.S. loan guarantees, the improved world economy, a
rejuvenated Israeli high-tech sector, and decreasing number
of terror attacks. The U.S. willingness to provide $9
billion in loan guarantees, beginning in 2003, was crucial to
reestablishing Israel's international creditworthiness and
drove down borrowing rates significantly. The guarantees,
the release of which is conditioned on Israeli performance
against a series of economic metrics, also helped Netanyahu
prevail in numerous budget debates with Knesset members
interested in spending their way to continued electoral
success. As the MOF's Sarel has said, "We could not have
made all the economic changes we did without the guarantees."
Netanyahu has been forthright in crediting these factors as
a major element of his success over the past two years. The
resurgent international economy also helped through a 14%
increase in Israeli exports, particularly in the
high-added-value high-tech sector.


14. (U) Nonetheless, although many other countries were
exposed to the positive world economy, most performed less
successfully than Israel. Much of the difference can be
attributed to Israel's vigorous economic reforms.
Specifically, in 2004 GDP grew 4.2%, with per capita GDP
jumping by a real 2.4%. Business sector GDP increased by 6%
versus 1.7% for 2003. In comparison, OECD countries
experienced average growth of 3.6% in 2004. Even more
significantly, Israelis began to feel that their government
was on top of the situation and had a coherent, convincing
program to overcome the recession. Increasingly confident of
the future, Israelis increased their consumption by 5.3% in
2004, compared to a small increase of 1.3% the year before.
The government's fiscal restraint provided the Central Bank
the fiscal basis to embark on an expansive monetary program
of monthly interest rate reductions, which brought rates down
to 3.5% in January, the lowest level in Israeli history.

--------------
The Downside: Those Left Behind
--------------


15. (SBU) All has not come up roses, however. The downside
of Netanyahu's reforms, which the minister has himself
acknowledged, center around the plight of the poor. Although
economists quibble with the definition of poverty utilized by
the National Insurance Institute -- one-half of Israel's
median family income -- all take seriously the NII's most
recent annual report showing increasing income inequality and
poverty levels. As of 2003, the report says, more than 1.4
million Israelis lived below the poverty line. In a society
as child-oriented as Israel, the report's finding that
652,000 children were living under the poverty line -- equal
to 30.8% of all children -- was particularly shocking.
Professor Dahan argues that poverty is going to be the most
important, and disruptive, social policy issue over the
coming years. He believes that the improved security
environment has ironically allowed Israelis to begin focusing
on issues that had seemed secondary just a year ago -- such
as their personal economic situation.


16. (SBU) Dahan points to levels of income inequality, which
even the Ministry of Finance's figures show have increased
steadily since 2000, as particularly worrisome. Dahan
stresses the inordinate pain being born by the country's Arab
communities, noting that according to some estimates, poverty
among this group has reached 40%. He worries that such high
levels of poverty are particularly difficult to reverse --
families are forced to scramble for every shekel, preventing
many children from having the opportunity to attend
higher-level education. This can only lead to an increasing
divide, not only between rich and poor, but between Israeli
Jews and Arabs.


17. (C) Many Israelis blame Netanyahu and his economic cuts
for worsening poverty. The Bank of Israel's (BOI's) Flug
calls his cuts in unemployment and other benefits "too
brutal" and says he "half killed the patient" he was working
to cure. The BOI's Senior Social Policy Advisor, Daniel
Gottlieb, says the Finance Ministry has shown an
"insensitivity" to the plight of the poor and argues that
many policy decisions were taken without enough thought being
given to the real-world impact. He points to the fact that
old age support has been cut by 50% under Netanyahu, even
though these benefits represent a "small budgetary item."


18. (C) The question is where to go from here. Netanyahu
maintains that the solution is continuing to push people to
work by reducing unemployment benefits while increasing job
opportunities. He points to Israel's pilot "Wisconsin"
program as a significant initiative that will bear fruit.
The BOI's Gottlieb, however, calls the initiative a "flop"
and notes it encompasses just four pilot centers serving
14,000 people. Flug argues that much more needs to be done
with the tax structure to help the worst off, including
introducing a U.S.-like earned income tax credit.

--------------
Are Netanyahu's Reforms Permanent?
--------------


19. (C) Netanyahu has started the job of reforming the
Israeli economy, but his job is not over. Beyond the issue
of when and how he can complete his original reform agenda,
he needs to keep the reforms he has already made in place.
There has already been rollback on the fiscal front. In late
2004, the GOI requested USG approval to exceed the 3% target
for the 2005 deficit specified in the last JEDG to pay for
disengagement. The bill for disengagement is now destined to
go even higher: Legislation to provide compensation for
settlers leaving Gaza, which passed the Knesset Finance
Committee in early February, will cost up to NIS 4 billion,
at least NIS 1 billion more than originally planned. Other
disengagement costs, of which there are many, are equally
likely to increase over time. Of even greater concern, the
GOI has yet to craft a coalition to pass the budget as it is,
in large part because it has been unwilling to meet the
financial demands of Shas. In this environment, the Loan
Guarantee Agreement conditionalities assume even greater
importance in restraining GOI fiscal expansiveness.


20. (C) Yet even if there were no Loan Guarantee Agreement,
and even if Netanyahu were somehow replaced by an old-style
"tax and spend" politician, it seems unlikely that
Netanyahu's reforms would be fundamentally reversed. The
Israeli people see how Silvan Shalom's fiscal
irresponsibility in 2002-2003 had severe international
consequences that led directly to economic difficulties at
home. They see how Netanyahu's reforms -- no matter how
difficult and unpopular they were at first -- clearly helped
resurrect that same economy and allow it once again to
attract international respectability and capital. They
realize, in short, that Israel's economy is now closely
linked to the world economy and has to be managed
responsibly. Although solid proof for such an assertion is
inherently difficult to find, the fact that the Labor Party
made such relatively modest demands for fiscal change once
they entered the current coalition is telling. This change
in the economic debate is perhaps Netanyahu's most signal
achievement as Minister.

--------------
Comment: The Future
--------------


21. (C) Although we recognize his economic reform program
has not been marked by concern for the poor, we nonetheless
believe Netanyahu has been the right man in the right job at
the right time. Because of his political weight, he was able
to push difficult reforms through the Israeli political
system. His belief in U.S.-style free-market economics gave
his reforms a coherence and clear policy direction that
helped him sell them to an Israeli public worried about the
future. His program was also not a proverbial flash in the
pan. He has kept up momentum on some of the most difficult
aspects of his reforms, such as privatization and the
introduction of competition into various sectors of the
economy. His port reforms, fought tooth and nail by an
extremely powerful union, have continued to move forward
behind the scenes and may see implementation this month.


22. (C) From the viewpoint of 2005, what is perhaps most
remarkable is that Netanyahu came to the job with serious
reservations. Many at the time felt Sharon offered it to him
as a way to bury him politically, and Netanyahu at first
refused to accept it. Once he assumed the position, many
thought Netanyahu would live up to his reputation of bending
under pressure and would shrink from making hard choices, let
alone sticking to them. The fact is, however, that Netanyahu
has been steadfast and courageous in implementing his
ambitious reform program. He has helped change the face of
the Israeli economy.

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