ISRAEL LOOKS FOR SOLUTIONS TO BALLOONING LEBANON

S E C R E T SECTION 01 OF 03 TEL AVIV 003423

SIPDIS

E.O. 12958: DECL: 08/23/2016
TAGS: ECON IS
SUBJECT: ISRAEL LOOKS FOR SOLUTIONS TO BALLOONING LEBANON
CONFLICT COSTS


Classified By: Ambassador Richard H. Jones for reasons 1.4 (b) and (d)


1. (S) Summary. As projections of the fiscal impact of the
conflict in Lebanon grow, the Ministry of Finance (MoF) is
concerned that limited budget cuts alone will be insufficient
to cover longer term costs. Adding to the pressure, political
rivalries in the Knesset have stalled cuts in 2006 operating
budgets needed in the short term to fund Ministry of Defense
and rebuilding needs. While the MoF believes that they can
meet the demands for funds in 2006 without changing the
budget framework, there is growing concern that 2007 spending
will need to expand significantly. Without increasing taxes
or cutting social spending, the MoF will look to the capital
markets to fund increased defense spending and Galilee
development funds. This could force a loosening of the fiscal
discipline that has been the mainstay of recent economic
growth. Political tempers have already flared over the
initial round of budget cuts, with the real showdown expected
during the 2007 budget debate. End summary.

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Economic Climate
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2. (S) There is no broad consensus on the long-term impact of
the conflict in Lebanon on the Israeli economy. The strain
on the 2006 budget, which was only passed in June 2006, is
expected to be minimized by a large prewar revenue surplus
and the windfalls from taxes on the sale of Iscar and the
privatization of the Ashdod Oil Refinery. Investor
confidence in Israel remained high throughout the 33 days of
fighting with all three major rating agencies maintaining
Israel's high creditworthiness rating. Tax revenues fell in
July and are expected to remain suppressed in August. The
closure of Haifa Port during the conflict harmed Israeli
exporters' ability to make on time deliveries to
international buyers, and factories across the north have
sustained damage. The Tel Aviv Stock Exchange (TASE)
remained stable, and the value of the shekel appreciated
against the dollar when the Bank of Israel raised interest
rates by a quarter of a point in July. The ratio of
government debt to GDP fell in the first half of 2006 to a
low of 89%.

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Costs to the 2006 Budget
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3. (S) Though a grand total for war costs has yet to be
tallied, some immediate expenditures must be met. According
to MoF officials, approximately NIS 2 billion (USD 460
million) is needed for the resupply of armaments for the
Ministry of Defense. Of this amount, cuts to the 2006 budget
will provide NIS 1.5 billion (USD 345 million). In addition,
the Ministry of Finance will have to pay the salaries of
workers in the north who missed work because of Katyusha
attacks in the months of July and August. The GOI negotiated
an agreement with the Histadrut labor union to pay 52.5% of
wage compensation costs for employees who were unable to
work. The MoF and Histadrut are still negotiating the terms
of the agreement for lost work days in August, but if the
agreement is similar to the July package, total wage costs
could top NIS 3 billion (USD 690 million). Rebuilding of
infrastructure such as schools, roads, and private homes, and
the payment to reservists who were called to duty will also
come out of this year's budget. The 2006 costs have not been
finalized, but Deputy Director of the Budget Yossi Gordon
told EconOff on August 23 that the cost of rebuilding damaged
homes and schools might be less than the NIS 1.7 billion (USD
400 million) reported by many media sources. He also said
that the question of compensation and grants for reservists
has not been formally decided on by the Cabinet. Media
reports have speculated that this cost could soar to more
than NIS 3 billion (USD 690 million),but Gordon said that
normal compensation for reserve duty would cost less than NIS
100 million (USD 23 million). Assuming that Gordon's
calculations are correct, the total cost for the 2006 budget
will be in the range of NIS 6.8-9.7 billion (USD 1.6-2.2
billion) depending on the government's decision regarding
grants for reservists.

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Where will the money come from?
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4. (S) The Cabinet decided on August 13 that all ministries,
with the exception of welfare and local authorities, will
face a 6% across-the-board cut in their 2006 budget to help
finance the payments to the Ministry of Defense. (Note: The
exception to this rule is the Ministry of Internal Security
which will face only a 3% cut. End note.) The Knesset
Finance Committee has twice failed to approve the cuts, in
part due to political posturing by some Labor party members
of the committee. Treasury officials have cautioned that the
6% cuts, which would free up approximately NIS 1.5 billion
(USD 345 million),are only the initial request for
reductions in the 2006 budget. As damage assessments and
costs mount, deeper cuts could be requested.


5. (S) Prior to the outbreak of the war the Ministry of
Finance had a NIS 4.4 billion (USD 1 billion) surplus due to
stronger than expected tax revenues and the delay in passage
of the 2006 budget which forced ministries to spend at
subsistence levels through June 2006. Additional revenue
came from Seth Wertheimer's decision on August 8 to pay the
tax on the sale of Iscar to Warren Buffet in a single lump
sum payment valued at NIS 3.8 billion (USD 874 million). The
revenues from the privatization of the Ashdod Oil Refinery,
completed in a public tender on July 31 at a price of NIS 3.5
billion (USD 805 million),should bring additional revenue to
the Ministry of Finance. However, to date, income from
privatization has been allocated to debt repayment, not
current spending. Gordon told EconOff that an existing NIS
3.5 billion (USD 805 million) Tax Authority property tax
compensation fund, built up over the years from national
insurance payments, is in essence a "rainy day" fund designed
to respond to emergency situations like the conflict in the
north. However, Gordon was not able to estimate what
percentage of this fund had been spent in the course of the
war.


6. (S) To help compensate for future lower-than-expected tax
revenues, the Ministry of Finance has decided to put on hold
those infrastructure projects allocated for the 2006 budget,
but not expected to be competed for tender this year. On
August 23, Advisor to the Prime Minister for Planning and
Development Gabi Golan told EconCouns up to NIS 500 million
(USD 115 million) will be cut from road construction and
railroad expansion budgets, and that the tender for the
Hadera desalinization plant will be delayed.

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Costs to the 2007 Budget
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7. (S) Gordon confirmed that the GOI plans to delay many of
the defense related costs of the war, as well as the Galilee
development plan until 2007. Estimates of defense costs vary
wildly between NIS 5-9 billion (USD 1.5-2 billion). Gordon
said the bottom line is, "even defense does not have the
numbers yet." Media criticism of defense spending priorities
has grown in recent days as returning reservists complain
about outdated equipment and lack of supplies. Much of the
defense budget remains classified and it is regarded by
economic commentators as the least transparent part of the
GOI budget. Vice Prime Minister Peres' office is scheduled
to present to the Cabinet on September 3 a multi-year plan
for the redevelopment of the Galilee. No Israeli officials
were willing to estimate the cost of this plan prior to the
Cabinet presentation, but the media is estimating a cost of
at least NIS 3 billion (USD 690 million).

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And the money will come from?
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8. (S) The outbreak in hostilities in the north forced the
MoF to suspend planning for the 2007 budget. As part of the
coalition agreement between Kadima and Labor, the GOI agreed
to increase expenditures in 2007 to 1.7% to match the
increase in population growth. With the added defense costs
of the war, the GOI will have to decide between
re-prioritizing spending or increasing spending and deficit
targets upward. Most of the major political parties ran on
platforms of assistance to the poor and promised constituents
that they would raise social spending in the 2007 budget, as
there was little time to debate and pass the 2006 budget once
the new government took office. Defense cuts were assumed to
be the most likely way to finance increased social spending.


9. (S) Even before passage of UNSC 1701 Vice Prime Minister
Peres embarked on a fund raising campaign in the United
States to solicit donations from international Jewish
communities for rebuilding efforts. Commending his efforts
as a "sacred mission," Prime Minister Olmert told the
Ministerial Committee on Rehabilitating the North on August
23 "we are speaking of fundraising in the amount of hundreds
of millions of dollars." Hopes are high that private
donations for rebuilding efforts will exceed NIS 1.5 billion
(USD 345 million).


10. (S) PM Advisor Gabi Golan told EconCouns that some of the
money needed for reconstruction will be raised "off-budget."
Golan estimated that the GOI will need to raise between NIS
5-10 billion (USD 1.2-2.3 billion) to finance rebuilding
efforts across the north. Golan said the GOI plans to
finance at least 50% of this revenue for rebuilding costs
from the Israeli credit market. Under a new framework
agreement, the GOI will publicly offer bonds using the banks
as market makers. In exchange for the right to sell these
bonds, the banks have agreed to purchase any of the unsold
bonds. Golan said that the GOI will resist financing the
rebuilding efforts by increasing taxes - which would
"discourage inward investment and growth."

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Implications
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11. (SBU) On August 22, at the Knesset's Finance Committee
meeting, Labor Party members Avishai Braverman and Orit Noked
refused to vote in favor of the 6% across-the-board budget
cuts, which the Cabinet approved on August 13. This caused a
delay in the transfer of funds to the defense budget and in
paying salaries to workers from Northern Israel. In
response, Coalition Chairman Avigdor Yizhaki threatened to
dissolve the coalition, and said he cannot depend on the
Labor Party. According to press reports, associates of the
Prime Minister have said that changes will have to be made in
the coalition by mid-October, when the Knesset's winter
session begins. Among the parties mentioned as potential
coalition partners are the Likud, Yisrael Beiteinu, United
Torah Judaism, the National Union and Meretz. However, it is
unlikely that Olmert will have enough to offer Likud or
Yisrael Beiteinu to entice them to join the coalition.


12. (S) Acknowledging that Prime Minister Olmert was
"embarrassed" when the Labor MKs refused to vote for the
across-the-board cuts to the 2006 budget during the August 22
Finance Committee meeting, Golan said that these MKs would
soon return to the government's fold. Golan said these "MKs
who wanted to be Ministers" will end up voting for the cuts
because, "if the Prime Minister reshuffles the Cabinet their
positions will not be any better." Golan predicted that
United Torah Judaism (UTJ) will join the coalition government
after the September/October Jewish holiday season, but prior
to the October opening of the Knesset.

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Comment
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13. (S) Comment: The GOI appears unable to speak with a
unified voice on the cost of rebuilding and developing the
north or the financing of such development. Bringing new
political parties into the coalition will not ease the
demands for social spending, but could actually intensify the
conflict over child allowances and yeshiva subsidies. As
criticism of the conduct of the war grows, and if the Prime
Minister decides to appoint a state commission of inquiry on
the war, requests for increases in defense spending will face
greater public scrutiny. Treating the war as a one time
occurrence, while theoretically possible in terms of granting
compensation and rebuilding, will probably meet with
resistance from Ministry of Defense officials who will claim
the need to increase spending on defense in the north over
the long-term to ensure national security. The strains that
this will place on the coalition government and GOI fiscal
discipline will become immediately apparent once the Ministry
of Defense submits a revised 2007 budget request. End
comment.

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