ISRAELI FISCAL RESTRAINT FACES CHALLENGES

C O N F I D E N T I A L SECTION 01 OF 04 TEL AVIV 003669 SIPDIS NEA/FO FOR DANIN; NEA/IPA FOR WILLIAMS, WAECHTER; EB/OMA FOR GARRY; NSC FOR WATERS; TREASURY FOR HIRSON E.O. 12958: DECL: 09/13/2016 TAGS: ECON EFIN PGOV IS SUBJECT: ISRAELI FISCAL RESTRAINT FACES CHALLENGES Classified By: Ambassador Richard H. Jones for reasons 1.4 b and d -------------- Summary -------------- ¶1. (C) Chief Bank Leumi Economist Gil Bufman thinks that the Israeli economy can sustain increased spending in the short-term to cover war-related expenses without undermining investor confidence in the Israeli market or reversing the economic gains of the last few years. However, he is deeply concerned at the instability of the coalition and the possibility that the government will abandon established deficit and expenditure targets in favor of politically expedient increases for social welfare initiatives. He predicted (Note: correctly, as it turns out End Note) that the 1.7 percent target figure for year-to-year expenditure increases from 2007-2009 would be "irrelevant" in the upcoming 2007 budget negotiations, and characterized the coalition goal of achieving a ONE percent deficit by 2009 "mission impossible." In order to give the Ministry of Finance (MOF) more tools to maintain fiscal restraint, Bufman suggested that additional formal guidelines such as debt/GDP, deficit/GDP, and expenditures/GDP, be added to the ONE percent limit on year-to-year expenditure increases and three percent budget deficit currently enshrined in Israeli law as a result of the 2003 U.S.-Israel Loan Guarantee Agreement (LGA). He said that the memory of the 2002 recession, the discipline of the markets, and the strong bias of the Bank of Israel (BOI) in favor of fiscal restraint should help control the impulse to spend. End Summary. -------------- 1.7% Expenditure Increase "Irrelevant" -------------- ¶2. (C) At a September 5 meeting, Gil Bufman, the highly influential Chief Economist at Bank Leumi, ONE of Israel's largest banks, told Deputy Economic Counselor that the fiscally conservative approach taken by the prior Israeli government may be altered. While many "social issue" politicians acknowledge the importance of the Netanyahu economic reform program, some of them now say that the Israeli economy is strong enough to increase both defense and social spending, and that there is increasing pressure to do this since the end of the Lebanon War. In light of this, Bufman, who meets regularly with officials in the Prime Minister's office, called the coalition agreement to raise year-to-year expenditures from 2007-2009 by 1.7 percent "irrelevant." (Note: Even the 1.7 percent figure violates the terms of the 2003 U.S.-Israel Loan Guarantee Agreement (LGA) - which were enshrined in Israeli law - calling for ONE percent maximum annual expenditure increases. End Note). Bufman said that even before the war, limiting annual spending increases to only ONE percent was "not sustainable," because Israel's economic circumstances had improved dramatically since 2003, when the agreement was signed, and hewing to that low rate "ate into the level and quality of public services." (Note: On September 12, the Cabinet approved a 2007 budget which raised expenditures by about 3.3 percent over the prior year. End Note) -------------- Damage Management -------------- ¶3. (C) Bufman is "worried and alarmed" by the propensity to spend. While acknowledging that the Israeli economy had "passed a test" (and is now perceived to be stable and prosperous),he is concerned at possible government instability and the possibility that the PM will need to increase spending considerably to keep the coalition together. To respond to this challenge, Bufman called for the MOF to engage in "damage management" in order to prevent spending from spinning out of control. In his view, this means coming up with additional fiscal guidelines to constrain spending, in addition to the formal ones already delineated in the LGA. He said that increased transparency in financial matters is vital and suggested setting formal guidelines for debt/GDP, deficit/GDP, and expenditure/GDP, saying that this would give the MOF more tools to use to try to limit spending increases. Bufman acknowledged that the legal limitations already in place did not prevent politicians from exceeding the agreed ONE percent limit on budget increases for 2007, but said that additional formal limitations would make it somewhat harder for policymakers to ignore spending constraints in the future. -------------- Deal with Labor, Not UTJ -------------- ¶4. (C) In analyzing the future of the economy, Bufman said that the favorable background conditions -- the continuation of world growth and the successful policies of the previous governments -- are very important. Accordingly, the major risks to the Israeli economy now are a possible downturn in world economic growth and the adoption of unwise policies by the present government. He said that while MOF professional staffers will be very vigilant and want to control the fiscal appetites of government ministers, they are not as powerful now as they were in the past. The memory of the recession of 2002 and of the hyper-inflation after the 1982 Lebanon War will also temper some demands, and might help prevent the one-time expenditure shock resulting from the recent war from becoming permanent, as happened after the 1973 Yom Kippur War, for instance. Bufman suggested that it would be wise for PM Olmert to try to satisfy the "fairly reasonable" social demands of Labor Party leader Amir Peretz instead of turning to the ultra-Orthodox United Torah Judaism (UTJ) Party and its budget-busting demands to restore the large family allowances to their pre-reform levels. -------------- BOI Wants to Maintain Fiscal Restraint -------------- ¶5. (C) Regarding the stance of the BOI, Bufman said that Governor Fischer is unhappy with the pressure to increase spending and is strongly urging the government to maintain fiscal restraint. He said Fischer wants any expenditure increase beyond the 1.7 percent originally agreed to by the coalition to be offset by an increase in the VAT. A ONE percent VAT increase would generate about NIS 2.5 billion (USD 568 million). The recent strength of the stock market in the face of the war and the subsequent political fallout has been positive, but he expects the market to react quickly if it perceives a war of attrition developing in the north, or that government spending is getting out of control. He expects the BOI to raise interest rates in Israel slightly in the face of the upcoming spending increases and that a gap of 50-100 basis points would open between Israeli and U.S. rates in the coming year. Bufman expects Israeli interest rates to be about 5.2 percent in 2006, 5.4 percent in 2007, and then remain stable at 5.3 percent in 2008-2009. He is also assuming a stable exchange rate of about NIS 4.5 to the dollar. -------------- 1% Deficit in 2009 "Mission Impossible" -------------- ¶6. (C) Bufman stressed that any spending increases beyond the presently-agreed framework must be temporary -- for 2007 and possibly 2008 only, and be understood as such by the markets. While an expenditure "shock" of upwards of three percent is likely for 2007, it is important to make sure that the deficit remains under control and that the debt/GDP ratio continues to decline, or at least remain stable. It measured 89 percent at mid-year, and Bufman expects it to end the year at 91 or 92 percent. This is a sharp improvement from the 99 percent and 95 percent levels posted by the government in 2004 and 2005, respectively. He forecast that the debt would measure 91 percent of GDP in 2007, 89 percent in 2008, and 87 percent in 2009, based on his forecast of "moderate" year-to-year expenditure increases of about three percent in 2007, 2.6 percent in 2008, and two percent in 2009. Calling the coalition goal of reaching a ONE percent deficit by 2009 "mission impossible," even with only the moderate spending increases now being contemplated, Bufman forecast that the deficit would be in the two percent range in 2006, three percent in 2007, 2.6 percent in 2008, and 2.3 percent in 2009, all within the original three percent target range of the LGA. -------------- 4% Growth Rate Forecast -------------- ¶7. (C) All of these forecasts assume what Bufman called a "conservative" annual GDP growth rate of about four percent, that the cease fire in the north holds, and that there is no global economic shock -- although they allow for a mild economic slowdown in the U.S. Future Israeli growth will be fueled, in part, by domestic demand, led by investment in fixed assets, in construction, and in machinery and equipment. Fixed asset investment in Israel was negative during the 2001-2003 period, but has been growing since 2004. Machinery and equipment production capacity is near its peak, and unsold inventory is very low. He also noted that housing prices are starting to rise in central Israel. -------------- Infrastructure Spending Should Not Be Cut -------------- ¶8. (C) Bufman emphasized the importance of continuing to invest in major infrastructure projects in the coming years, saying that Israel's infrastructure needed upgrading for the country to remain internationally competitive. However, he noted that there has been much discussion among politicians and in the press about postponing important rail and road projects. He said that in order to finance increased spending, the GOI would likely postpone tax reductions and maybe increase the VAT (reduced from 16.5 to 15.5 percent in July). The higher budget deficit will be financed by raising more debt in the bond market. -------------- GOI Very Inefficient - Needs to Outsource -------------- ¶9. (C) Regarding the issue of where the GOI can get the money it needs for new financing initiatives, Bufman said that the government operates very inefficiently and that there is much room for severe cost cutting. He advocated outsourcing many government functions. However, in describing an effort he was involved in some time ago to try to do just that -- which went nowhere -- he acknowledged that a serious outsourcing program at this point is not realistic. He added that throughout the government, particularly in the military, health, and education sectors, no real cost-benefit analysis is being done, so no ONE has ever seriously examined if money is being spent properly. He said that it is reasonable to assume that it is not. -------------- Comment -------------- ¶10. (C) Bufman alternated between hope and despair during the course of the conversation. He expects the government to muddle through the crisis brought on by the Lebanon war with moderate spending increases that will allow the military to prepare properly for the possibility of a further round of warfare, while giving people the feeling that social problems have not fallen off the national agenda. However, he is skeptical that the supposedly one-time spending increases will really be temporary. He therefore sees the need to equip the MOF with as many tools as possible to constrain politicians' spending habits - thus his attempts to enumerate additional "official" guidelines such as the expenditure, debt, and deficit to GDP ratios. ¶11. (C) In our view, his fears are reasonable. The Olmert coalition government is weakened as a result of the war, but managed nonetheless to secure Cabinet approval for the 2007 budget by a vote of 19 for, 4 against, and ONE abstention (Defense Minister Amir Peretz of Labor). Knesset deliberations on the budget will be more contentious and will present the next major obstacle to the survival of the coalition in its present form. Polling indicates that, were elections to be held now, neither Kadima nor Labor would do as well as they did last time, so politicians from both parties probably will want to make sure to pass a budget by year end to prevent having to hold new elections early next year (as required by Israeli law if the budget is not passed by December 31). Therefore, there does not seem to be any immediate threat to the coalition, as long as the budget passes. ¶12. (C) The possibility of the ultra-Orthodox UTJ party joining the government also looms as a potential threat to fiscal restraint. However, an Olmert insider has assured us that there is little likelihood that the coalition would invite UTJ in for this very reason. Moreover, the government has so far succeeded in responding to the post-war trauma and increased spending pressures with moderation. However, at a time when social issues are once again a priority and demands from the military will only increase, it is easy to envision one-time spending increases becoming permanent, and more increases following. If this happens, and other unfavorable factors, such as renewed violence in the north, and/or a major world economic slump kick in, Israel could once again face a difficult economic situation which would require a new reform program to alleviate. End Comment. ********************************************* ******************** Visit Embassy Tel Aviv's Classified Website: http://www.state.sgov.gov/p/nea/telaviv You can also access this site through the State Department's Classified SIPRNET website. ********************************************* ******************** JONES