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. -------------- Economic Climate -------------- ¶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%. -------------- Costs to the 2006 Budget -------------- ¶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. -------------- Where will the money come from? -------------- ¶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. -------------- Costs to the 2007 Budget -------------- ¶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). -------------- And the money will come from? -------------- ¶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." -------------- Implications -------------- ¶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. -------------- Comment -------------- ¶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. 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