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 -------------- SUMMARY -------------- ¶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. -------------- ECONOMY RESILIENT, EMPLOYMENT INCREASING -------------- ¶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. -------------- NOT TOO WORRIED ABOUT 2007 BUDGET -------------- ¶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. -------------- SOCIAL SPENDING CUTS TOO SEVERE -------------- ¶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." -------------- BOI CAN WORK WITH OLMERT'S NEW ECONOMIC GROUP -------------- ¶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. -------------- LITTLE PROGRESS ON BOI REFORM -------------- ¶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.) -------------- COMMENT -------------- ¶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. ********************************************* ******************** 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. ********************************************* ******************** CRETZ