ISRAELI ECONOMY HOLDING ITS OWN

C O N F I D E N T I A L SECTION 01 OF 03 TEL AVIV 003054

SIPDIS

NEA FOR FRONT OFFICE; NEA/IPA FOR WILLIAMS, WATERS, GREENE,
WAECHTER; NSC FOR ABRAMS, LOGERFO; TREASURY FOR HIRSON

E.O. 12958: DECL: 08/03/2016
TAGS: ECON EFIN PGOV PREL IS
SUBJECT: ISRAELI ECONOMY HOLDING ITS OWN


Classified By: Economic Counselor William Weinstein for reasons 1.4 b a
nd d.

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Summary
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1. (C) The Lebanon conflict war has negatively affected the
resurgent Israeli economy, but has not yet caused severe
damage. Governor of the Bank of Israel (BOI) Stanley Fischer
said at a press event on August 2 that by the end of its
first month, the war will have cut Israeli GDP growth by
between .7 and .9 percent, on an annualized basis. As long
as the fighting continues, it is difficult to accurately
assess the damage, but by all accounts, it has significantly
damaged industries, small businesses, and personal property
in the north. In addition to government compensation for
companies, workers, and individual property owners, the
defense budget -- which had been slated for substantial cuts
over the next few years -- will likely be increased.
Compounding the costs to the budget, tax revenues will
decline from the northern section of the country, which
accounts for about 20 percent of Israel's economic activity.
The tourism sector, which was experiencing a banner year
prior to the outbreak of the war, has been hit very hard.
While tourism in the north is now non-existent, tourism in
the rest of the country has slowed as well. Together with
the constant Qassam missile attacks from Gaza on towns and
kibbutzim in the western Negev, the war in the north has
convinced many potential tourists to stay away. Despite the
difficult situation, the GOI has announced its determination
to stick to the 2007 budget framework of a two percent
deficit target and a 1.7 percent increase in expenditures,
although taking recent events into account, there will
doubtless be changes in the way funds will be allocated. End
Summary.

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The North is Hit Hard
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2. (C) The Israeli economy has been hit hard by the war,
especially in the north. Many people have fled the areas
close to the border with Lebanon that have been experiencing
intense rocket barrages, and little economic activity is
taking place there. However, the slowdown is not limited to
the border, but reaches the entire northern section of the
country, where industry is working sporadically at best,
given that people are spending so much time in bomb shelters.
Since the region accounts for close to 20 percent of
Israel's total economic activity, the slowdown will have a
meaningful impact on Israel's overall economic situation. As
of July 26, the Manufacturers Association estimated that
damage had already amounted to about NIS 2.3 billion (about
USD 500 million). About 55 percent of factories in the north
are either closed or operating on a partial schedule.

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Tax Revenues Will be Down
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3. (C) The BOI expects the weekly damage to the economy to
be between NIS 750 million to 1.1 billion (USD 170 to 250
million),for as long as the fighting lasts. Tax revenues
will be down substantially (about .3 percent of GDP,
according to the BOI),and there will be a great demand for
government compensation for all of the sectors whose
activities were inhibited by the warfare. The government
will also be involved in compensating private property owners
who lack adequate insurance for the heavy damages they have
suffered as a result of the rocket attacks from Lebanon.
However, one bright spot looking towards 2007 is the
likelihood that the results of the war will provide momentum
for growth in a number of sectors, such as the defense
industries, and construction and development. This could
provide the stimulus the economy needs to get back on the
fast growth track and provide much-needed tax revenue. One
option being discussed widely in the press to raise more
revenue is the cancellation of the recent one percent cut in
the Value Added Tax, which went into effect on July 1,
reducing it to 15.5 percent. This would produce an
additional NIS 3.3 billion (about USD 750 million) in
revenue. Such a decision is unlikely, however, before an end
to hostilities, when an assessment can be made of the overall
impact of the war on the economy.

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Tourism in North Devastated
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4. (C) Most hard hit has been the tourism sector. While the
sector represents only about 1.5 percent of Israel's GDP, it
is particularly important in the north, where
bed-and-breakfasts and nature reserves predominate. 2006 had
been shaping up to be a banner year. Tourism officials
expected about 2.4 million visitors, on a par with 2000,
before the onset of the Intifada. However, tourism in the
north has come to a complete halt, and has slowed down
substantially in other parts of the country as well. Given
that rockets are falling both in the north from Lebanon and
in the south from Gaza, many potential tourists have
postponed or canceled their trips. One positive aspect for
the north is that much of the tourism there is local -- by
other Israelis. It is therefore likely that Israelis will
resume traveling there once the violence ends. If that
happens soon, there may still be time to salvage some of the
summer tourist season before the September 1 start of the
school year. The general expectation is that stability will
have been established in the area quickly enough for there to
be a relatively normal amount of tourism in the north during
the September-October Jewish holiday season.

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Interest Rate Hiked
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5. (C) On July 24, near the end of the second week of the
war, the BOI announced a .25 percent hike in the interest
rate to 5.5 percent. The Bank explained the move as
necessary due to the changed security situation, which could
result in capital outflows. Increasing the interest rate
reduced the impetus toward capital flight, strengthened the
shekel, and reassured investors that the BOI was keeping a
close watch on the impact of the violence on the Israeli
economy. Although the rate increase did generate some
criticism from the business sector for making it even harder
for businesses in the north to recover, the general market
reaction was positive. After a sharp drop at the beginning
of the war, the shekel has returned to its prewar levels
versus the dollar. The Tel Aviv Stock Exchange has also
recovered from its initial nine percent drop and is now only
about two percent lower than before the onset of the
violence. An additional impetus for increasing the interest
rate was that inflation was inching up, coming in at 1.6
percent for the first half of the year, and pointing to a
full-year inflation figure near the upper end of the GOI's
one to three percent target inflation range.

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War Will Cost About 1 Percent of GDP
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6. (C) Israel enjoyed a strong fiscal situation during the
first half of 2006. Since the 2006 budget was approved only
in June, spending in the first half of the year was extremely
restricted. Coupled with the increased tax revenues due to
more economic activity, the budget surplus for the first half
of the year reached about NIS 4.7 billion (just over USD 1
billion). Regarding the deficit, the widely held view was
that it would be close to zero for the year. Given these
strong pre-war conditions, it will not be particularly
difficult for the government to deal with the new demands for
spending spawned by the war in the short term. Pre-war
estimates of growth for 2006 ranged from 4.5 to 5.5 percent,
and Fischer's view that the fighting will cost the economy
close to one percent of GDP for the year is widely accepted.
If the war continues for a longer period, the cost will grow.
Regardless, plans for the 2007 budget will likely be
significantly affected, with rising demands for new spending
across the political spectrum on defense, social welfare, and
economic recovery for the north. The GOI has already decided
to delay budget discussion previously scheduled for August
until September.

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Sticking to the 2007 Budget Framework
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7. (C) The Prime Minister's office, the Ministry of Finance,
and the BOI all say that the GOI will stick to the agreed
2007 budget framework of a two percent budget deficit and a
1.7 percent increase in expenditures. (Note: The terms of
the U.S. - Israel Loan Guarantee Agreement of 2003 require
Israel to maintain a budget deficit of less than three
percent and to limit annual expenditure increases to one
percent or less. End Note) Plans to increase social welfare
spending, a hot-button issue in the recent elections, were
largely based on cutting the defense budget by about 500
million shekels per year over the next several years. The
defense budget, if anything, is now more likely to be
increased rather than cut, meaning that the money to pay for
reconstruction in the north and increased social spending
will have to come from elsewhere. Commentators are beginning
to discuss the possibility that the fight against poverty
will once again be de-emphasized in order to free up funds to
deal with the results of the war and to increase defense
spending. (Comment: Given that the Labor party only very
reluctantly agreed to accept a 1.7 percent budget expenditure
increase for 2007, there is little doubt that it will be
pushing for a much higher figure in future years -- and may
even demand a greater than 1.7 percent increase for 2007 as
well. Any insistence by PM Olmert on maintaining strict
budget discipline would be an additional destabilizing
element for a coalition that will be facing plenty of
post-conflict discord even aside from budget issues. If he
gives in and agrees to higher spending, it might endanger the
fiscal discipline that has made possible Israel's strong
recovery in recent years. End Comment)

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Rating Services Remain Positive
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8. (C) Despite the violence, the Israeli economy continues
to get high marks from international ratings services. Fitch
produced a positive report several days into the fighting,
saying on July 16 that "although confidence in Israel will
take a short-term knock from the recent escalation of
violence, the economy starts from a buoyant position, which,
together with a robust policy framework, will help limit the
economic fallout." Standard and Poor said on July 25 that
the fighting will have only a temporary and manageable impact
on the economy and public finances. They said that "it is
expected that continued strong diplomatic and financial
support from the U.S. will balance high strong external
security risks, which affect Israel more than any of its
category peers." They added that their positive rating
(A-/A for long term foreign and domestic debt) reflects the
"improved resilience of Israel's public finances and economy
to geopolitical shocks after a three-year period of fiscal
consolidation and strong economic growth." In a July 24
report, Dunn and Bradstreet noted that in contrast to the
Intifada, which occurred in a period of economic slowdown and
decline in global demand, the current fighting comes during
one of the brightest periods for the Israeli economy -- so
the GOI is in a much stronger position to deal with the
economic implications of the violence than it would have been
in the past.


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