BOI OPTIMISTIC ABOUT ISRAEL'S POST-WAR ECONOMIC

C O N F I D E N T I A L SECTION 01 OF 03 TEL AVIV 004033

SIPDIS

NEA/FO FOR DANIN; NEA/IPA FOR WILLIAMS, SHAMPAINE; EB/OMA
FOR GARRY; NSC FOR WATERS; TREASURY FOR HIRSON

E.O. 12958: DECL: 10/12/2016
TAGS: ECON EFIN IS PGOV
SUBJECT: BOI OPTIMISTIC ABOUT ISRAEL'S POST-WAR ECONOMIC
PROSPECTS


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) Bank of Israel (BOI) Research Director Dr. Karnit Flug
voiced optimism about the health of the Israeli economy,
citing the various political and security shocks weathered
over the last year as proof of the economy's resilience.
Flug indicated that she thinks the GOI responded to post-war
calls for increased spending as conservatively as possible.
As a result, the 2007 budget as passed by the Cabinet was
reasonable. Flug suggested that the GOI's austerity measures
over the past few years with regards to child allowances were
perhaps too severe. She also defended the government's
decision to change the annual expenditure increase cap to 1.7
percent from the original 1 percent. In Flug's opinion, the
BOI will not have trouble working with the new economic
advisory council established by Prime Minister Olmert, but
she lamented the BOI's lack of progress on its internal
reform initiative. End Summary.

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ECONOMY RESILIENT, EMPLOYMENT INCREASING
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2. (C) Dr. Karnit Flug, Director of the Research Department
at the BOI, on September 21 told Deputy Economic Counselor
and Economic Officer that she is optimistic about the overall
health of the Israeli economy. She cited the success with
which the economy has weathered the various political and
security shocks of the last year (such as former Prime
Minister Sharon's illness, the formation of the new
government, and the Lebanon war) as proof of the economy's
resilience. She noted that Israel is continuing to reduce
its unemployment rate, which measured 8.9 percent in the
second quarter of 2006, and labor force participation is
improving. She raised concerns, however, about data
indicating that despite these improvements in the employment
rate, wages are not increasing. Despite this, Flug echoed
the BOI's opposition to a minimum wage increase on a
condensed schedule, but she said raises in small increments
would be acceptable. She confirmed that the BOI would prefer
to implement an earned income tax program, instead of
increasing the minimum wage, to address Israel's poverty
problem.

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NOT TOO WORRIED ABOUT 2007 BUDGET
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3. (C) Flug considers the 2007 budget passed by the Cabinet
acceptable, in light of the heavy pressure put on the
government to increase spending after the Lebanon war. In
her view, the biggest threat to the budget and its framework
as it enters the Knesset approval process will be additional
pressure for increased defense spending. The BOI estimates
the Lebanon war caused about NIS 5-6 billion (USD 1.2-1.4
billion) in indirect and direct civilian damage, which should
be covered entirely by Israel's Property Tax and Compensation
Fund. (Note: This fund, financed by the revenues from a
national property tax levied on businesses, pays claims on
property damage that is the direct result of a hostile
terrorist attack. End Note.) However, the account only
contains about NIS 3.5 billion (USD 814 million),so the GOI
must transfer an additional NIS 1.5-2.5 billion (USD 386-586
million) to it. These transfers will be accounted for in the
budget as lower tax revenues and, therefore, will not
increase expenditures on the books. Flug confirmed that the
GOI in 2006 will meet the 1 percent expenditure increase
constraint required under the 2003 U.S.-Israel Loan Guarantee
Agreement, even with the war-related spending increases.
This is because the government ministries before the war were
forecast to spend only 97 percent of their budgets by
year-end. As a result, the GOI has an additional 3 percent
across-the-board to redirect to war-related needs.

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SOCIAL SPENDING CUTS TOO SEVERE
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4. (C) In general, Flug endorses the GOI's pre-war plans to
increase social welfare spending. She said those plans only
became a problem this year when the government no longer was
able to free up the funds for the increases by cutting
defense spending. According to Flug, the GOI was forced to
freeze child allowances in 2007 in order to add NIS 1 billion
(USD 430 million) to the base defense budget without breaking
the budget framework. While the allowances technically will
not be cut (they will not be increased in line with inflation
next year, as is the normal practice),the policy is severe,
in Flug's view. She also favors restoring the child
allowances to their previous schedule of increases, as the
Olmert government promised it would do in its coalition
agreements with the Shas party. (Note: During former Finance
Minister Netanyahu's tenure, the GOI changed the mechanism
for increasing child allowances. Under the original scheme,
a family with several children would receive a larger
increase to their child allowance with the birth of an
additional child than they received for the birth of the
previous child. Under Netanyahu, the GOI changed the
schedule, so that a family received a flat increase for the
birth of each child. End Note.) Flug said the changes in
some cases led to a 75-percent cut in an allowance that
comprised 50 percent of a family's income.


5. (C) Flug echoed BOI Governor Fischer's comments in favor
of increasing the expenditure growth cap to 1.7 percent per
year, in line with Israel's population growth. She said that
when the economy is growing and the standard of living is
improving, there is more "room" for additional government
spending. She noted the GOI's continued ability to reduce
Israel's debt levels as a share of GDP at the 1.7 percent
spending increase level. In Flug's view, the 1 percent cap
was excessively constraining once Israel's economic fortunes
improved, though she acknowledged that the target helped
force the GOI to make what she called "the big shift" in its
fiscal policymaking. Flug cited the adoption of several
policies, such as linking increases in allowances to
inflation instead of the average wage and delaying the
retirement age, as evidence of Israel's successful completion
of "the big shift."

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BOI CAN WORK WITH OLMERT'S NEW ECONOMIC GROUP
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6. (C) The BOI does not view the new economic advisory
council (EAC) organized by Olmert under the leadership of
Professor Manuel Trajtenberg as a threat. According to Flug,
the Prime Minister's office established the EAC to help
balance the very-powerful Ministry of Finance, not to reduce
the influence of the BOI. Though there presently is a lot of
overlap between the EAC and BOI's areas of responsibility,
Flug thinks the two groups' expertise will evolve, such that
both groups will be relevant. In Flug's view, there is room
for both the BOI and the EAC at the Prime Minister's table of
economic advisors.


7. (C) According to Flug, the MOF is very powerful. This
concentration of power is helpful when the government is
trying to maintain a budget framework, but it is not good
when the MOF is able to make individual ministries' funding
priority decisions for them. Flug said the MOF should allow
each ministry the flexibility to modify its funding
priorities within the budget framework. The Budget Director
at the MOF, Kobi Haber, is the most powerful figure within
the Ministry, Flug said. According to Flug, Haber was
instrumental in securing the Cabinet's approval for the 2007
budget that stayed within the government's framework.

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LITTLE PROGRESS ON BOI REFORM
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8. (C) Fischer's efforts to implement reforms at the BOI have
been hamstrung by disagreements with the MOF over Bank
workers' wages. Until these disagreements are resolved, Flug
said, the workers' union is unwilling to let the rest of the
reforms move forward. In Flug's opinion, this uncertainty
has reduced morale among the employees and encouraged some to
leave the Bank. She said many had hoped Fischer, who came to
the Bank from outside the government, would have more success
reforming the Bank than his predecessors. Flug offered her
opinion that that MOF may be responsible for some of the
difficulty by preventing forward movement on the reforms.
(Note: Fischer, upon becoming Governor of the BOI, made it a
priority to secure Knesset approval of a new law governing
the activities of the BOI. This law, presently in draft
form, will standardize the way the Bank makes interest rate
decisions and its internal management practices.
Negotiations on the law were progressing successfully earlier
this year, until press reports exposed the results of some
internal BOI studies on the very high levels of compensation
received by some Bank employees. End Note.)

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COMMENT
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9. (C) Flug offered a rather optimistic assessment of the
state of the Israeli economy even after the Lebanon war. In
her view, there is little reason to be worried about Israel's
future economic growth prospects being significantly damaged
by the Lebanon conflict. She also did not seem to think that
spending increases made in the 2007 budget as a result of the
war mark a permanent end to the policy of fiscal restraint
that the government has pursued over the last few years. In
fact, Flug's comments suggest the BOI might favor a more
liberal approach by the government in its efforts to combat
poverty in Israel, a sentiment evidenced by her vigorous
defense of the GOI's plans to modify the annual expenditure
increase cap to 1.7 percent from its original 1 percent. End
Comment.

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