Israel's Technology Sector: The Future at Risk

UNCLAS TEL AVIV 000653

SENSITIVE BUT UNCLASSIFIED
SIPDIS

DEPT FOR OES/STC, NEA/IPA and EEB/OIA
USDOC FOR FCS - Wiegler and Loustaunau
DOE FOR EERE - Chalk
AMMAN FOR ESTH-Bhalla

E.O. 12958: N/A
TAGS: TSPL EINV ECON ENRG PINR IS
SUBJECT: Israel's Technology Sector: The Future at Risk

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Introduction and Summary
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1. (U) Israel's economy was fundamentally altered by the rise of a
robust high-technology innovation sector over the past twenty years.
The key factors contributing to its formation were strong national
intellectual capital resources, state-supported innovation programs
in the defense and non-defense sectors that generated tangible and
intangible spin-offs, and an abundance of private sector capital
resources (much of it foreign) speculating on Israeli ingenuity
under pressure. The technology innovation sector now accounts for
20 percent of industrial output, directly engages over 10 percent of
the workforce, and is responsible for a large share of economic
growth. GOI ability to cultivate high-tech innovation growth and
broaden it to other sectors was due to an effective national science
policy, strong government investment in education, and fortuitous
circumstances. Israel's economic future is now intertwined with the
health of this major component of the economy, but is increasingly
at risk from an eroding education system, underinvestment in
intellectual capital, and growing competition from lower-cost R&D
centers. Given the long lead-time education investments take to
yield results, Israel's next government faces critical decisions
with pivotal long-term consequences. End Summary.

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The Data and the History
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2. (U) Israel's success in the global high technology innovation
market is remarkable: After companies based in the United States and
Canada, Israel has more NASDAQ-listed companies than any other
country. Israeli developers pioneered the technology that led to
the internet, and several Israeli companies (Amdoxs, Comverse,
Checkpoint) have become global names in their fields. Many major
high-tech corporations (Motorola, IBM, Phillips, Cisco,
Microsoft...) have big R&D divisions based in Israel. Intel employs
over 6,400 Israelis at its research center in Israel, one of only
three such centers worldwide. The technology innovation sector
counting software, computer and IT components today accounts for 20
percent of industrial output, directly engages over 10 percent of
the workforce, and is responsible of a large share of Israel's
economic growth. High-tech industry exported $15 billion in
products and services in 2006, accounting for nearly half of all
export earnings. Israel records the fourth greatest number of
patents per capita in the world, and claims to have the world's
highest percentage of broad-band internet connection per population
(30%). An analysis of global innovation centers in the Harvard
Business Review of March 2009 ranked Israel third in the world,
trailing only the US and Finland.


3. (U) The country's success in high technology, including
microelectronics, bioengineering, software development, and
telecommunications, is more assumed than analyzed. However, its
advent was far from accidental. Until the 1990s Israel's economy
relied on agricultural exports, the diamond industry, and a small
but growing arms and defense equipment export sector for revenue.
These were heavily supplemented by a tourism industry - subject to
the vagaries of regional political tensions - and direct assistance
from the USG and the global Jewish diaspora through Israeli bonds
and other investment vehicles. During the 1990s, the advent of
subcontracts to export civilian technology products forced companies
to offer shares to the public in order to raise the funds for
expanding production -- first in the small Tel Aviv capital market
and later in New York. This drew the attention of emerging market
specialists, who recognized the potential of the country as a
civilian technology producer.

4 (U) What allowed Israel to make the transition from military
technology innovation to civilian high-tech R&D was a fortunate
combination of extraordinary intellectual capital resources, and a
business culture that rewarded success against daring odds and did
not punish failure. This fostered an entrepreneurial culture that,
according to a 2008 OECD study, has become a principal factor in
Israel's innovation economy. A 2007 global competitiveness survey
ranked Israel first in terms of new business start-ups.

A Well-Tuned Science Policy
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5. (U) The key ingredient that helped combine the intellectual
resources and entrepreneurial business culture was a strong
government science policy. This was composed of (1) heavy
investment in the country's human capital, particularly during the
mandatory military service of both men and women, (2) facilitating
the spin-off of ideas and highly-trained personnel from the military
into the civilian sector and academia, and (3) using
publicly-supported incubators and other mechanisms to channel
venture capital to innovative applications, resulting in a very high
rate of business start-ups.


6. (U) Israel's intellectual capital derives from both official
structures and cultural tradition. Academic study has long been an
esteemed Jewish cultural value, and Jewish history is filled with
icons of learning. Some attribute it to the minority status which
often led to the persecution of Jews in diaspora society for 2000
years - intellectual property, unlike physical property could never
be confiscated by expulsion or edict. Referring to themselves as
"the people of the Book", Jewish tradition honors scholarship and
the learned professions. This high cultural value placed on study
provided a good foundation for a knowledge-based economy. Even
before the state was created in 1948, Jews returning to British-held
Palestine had made the country's educational institutions a
priority, founding Hebrew University in 1918, with Albert Einstein
delivering its first science lecture. Recognizing a dearth of civil
engineers and architects to design and build a modern country, in
1923 the Technion-Israel Institute of Technology was also founded by
early Zionist leaders.

Human Capital Paramount
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7. (U) Government investment in the country's intellectual capital
continues to play a critical role. Israelis place a high priority
on education, which as a sector accounts for 10 percent of GDP.
Education is one of the key responsibilities of the government,
taking about 9 percent share of Israel's domestic budget, some 28
Billion NIS in 2008. Israeli secondary and tertiary education
received enormous investments from 1960 through 1990, as the country
built four new universities, to supplement the four existing ones,
and expanded its capacity to meet the demands of a doubling
population. Today, Israel has the third highest tertiary education
attainment ratio in the world, after Norway and Canada.
Significantly, nearly a quarter of all Israeli graduates are in the
fields of science and engineering.


8. (U) Government investment in intellectual capital is strikingly
demonstrated in Israel's military training programs. GOI military
service is one of the unifying elements of Israeli society. Between
the ages of 18 and 22, men and women are expected to serve in the
military (men for three years, women for two),and may remain on
reserve duty for up to 20 years thereafter. It is an equalizer in
society, obliging both rich and poor, native-born and immigrant, to
serve the state - the major exceptions being the ultra-orthodox
Jewish sector, which is now under increasing pressure to serve, and
the Arab sector, which is also being pressed to perform some type of
national service. Although it imposes a common obligation on
Israelis, the GOI does not treat all recruits identically, using the
opportunity to troll for the most academically talented youth and
channel them into selective training programs.


9. (U) The Talpiyot program is the most elite of these, selecting 50
recruits per year for intensive three-year training in physics,
computers and other sciences with an eye to cultivating tech-savvy

officers for the Israeli military. The graduates then serve six
years in the military, not in combat but rather in roles tailored to
meet the technological challenge of improving the Israel Defense
Force's (IDF) effectiveness. Spurred by the shock of heavy losses
in the October 1973 Yom Kippur War, the Talpiyot program was
established with the recognition that each IDF soldier must be equal
to seven of the enemy if the country is going to meet the challenges
presented by its more numerous enemies. Since its creation thirty
years ago, graduates of this program have contributed to Israeli
security through innovations such as improved propulsion systems,
better missile guidance systems, life-saving technologies such as
drone aircraft and stronger vehicle construction. Beyond Talpiyot,
the IDF also offers a more general university education option to
IDF soldiers in exchange for an extended service commitment, and
offers an impressive array of technical training programs to
cultivate the skills it needs to win wars, from piloting fighter
aircraft to repairing engines to designing advanced
telecommunications systems.


10. (U) Although its primary mission was to create a techno-savvy
future officer corps, the Talpiyot program's inadvertent secondary
effect has been to feed a stream of high-powered engineers and
innovators to the private sector. After finishing military service,
Talpiyot graduates are snapped up by technology firms. Of the
nerly 600 graduates over the life of the program, onl 25 have
stayed in the IDF to attain its highestranks, while most move into
commercial R&D and fund companies working on new technology. These
irms benefit from both the personnel and the ideasthey bring with
them. Anecdotal evidence points o a high percent of Israeli
high-tech corporatios counting Talpiyot grads among their
leadership An added benefit is the Talpiyot alumni connection,
that encourages communication and cross-fertilization of hatching
ideas among young companies, avoiding the stove-piping that hinders
creative problems solving.

Channeling Capital Resources
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11. (U) A second key method through which GOI science policy fosters
innovation is facilitating the spin-off of ideas from military and
academia into the commercial world. The government supports a
series of incubator programs that help individuals with ideas
develop them further into commercially viable applications.
Principal among these is a program run by the Office of the Chief
Scientist (OCS) of the Ministry of Industry, Trade and Labor, though
other ministries have their own Chief Scientist offices with smaller
research support budgets. Since 1991 the Trade and Industry OCS has
funded technological incubators in Information and Communication
Technology, life sciences, medical devices, water technology, and
clean-tech that support fledgling entrepreneurs trying to turn
innovative ideas into exportable commercial products and viable
business ventures. These incubators provide physical premises,
financial resources and professional and business guidance during
the initial and most risk-prone phase of a start-up's business
cycle. The OCS claims that after a year or two with state support,
over 60 percent of the 11,000 projects it has assisted have
successfully attracted private investment, and 55 percent of
assisted projects were still active in R&D three years after
"graduating." About 200 projects are currently in the program,
which yields about 80 new start-up companies annually. Over the
life of the program the OCS has cumulatively invested over $500
million, but has leveraged nearly $2.2 billion in private sector
funds for these companies.


12. (U) To fully draw on the potential from its investment in
tertiary education, the GOI also encourages universities to assist
their professoriate in converting new knowledge into marketable
products. This assistance usually takes the form of a separate
company, with the university as the unique shareholder, which offers
incubator-type assistance to the institution's researchers, both
professors and students. This assistance may include financial
assistance, equity investment, and guidance on patent and copyright
issues and business strategy. These companies, such as Hebrew
University's Yissum, Technion's Yazamut, Tel Aviv's Ramot, and the
Weizmann Institution's Pamot, operate independently of their parent
university, but channel their financial proceeds to the
institutions. Hebrew University claims such returns now account for
about 10 percent of its R&D investment budget, and many of Israel's
tertiary education institutions hope the licensing rights,
inventions, and equity investments from their professors' and
students' research will help cover the budget shortfalls of the
future.


13. (U) Leveraging the private sector's resources through initial
public offerings evolved as another facet of official science
policy. In 1992, to help structure the emerging private venture
capital market in Israel, the GOI created the Yozma Venture Capital
Fund. Yozma (which is Hebrew for "initiative") was the tool for
organizing and expanding the first stages of Israel's young venture
capital market. One of Yozma's major purposes was to encourage
local and foreign multinational investors to join forces in
financing young, high risk Israeli firms. These early venture
capital investments combined financial means with post-military
Talpiyot talent, and resulted in companies such as Elbit Vision
Systems-EVS (Elron),Gilat Satellites (AAV),Logal (Veritas),and
Mercury Interactive (Athena). Cultivating and channeling capital to
promising start-up companies was undertaken as a national policy,
recognizing that fully utilizing Israel's intellectual capital can
generate the exports, jobs and income of the future.


14. (U) Between government investment, investments by Israeli
venture capital firms, and existing private sector R&D budgets,
Israel records the world's highest R&D intensity at 4.65 percent of
GDP, over twice the OECD average of 2.26 percent. According to the
2008 OECD Science, Technology and Industry Outlook, Israeli private
sector R&D at 3.64 percent of GDP also outpaces all OECD countries.


A Future at Risk
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15. (SBU) Despite its present image of strength, Israel's high-tech
sector faces considerable challenges in maintaining its position in
the future. The education budget has been cut in recent years, both
in nominal and relative terms, due to the need to rein in government
expenditures. This has aggravated a system already under strain,
with the large impact on primary and secondary education visible in
standardized test scores. In the 1960s Israeli students scored
among the top in the world in science and mathematics testing; in
2006 Israeli pupils ranked 39th and 40th out of 57 countries in math
and science. Israeli middle and high school teachers were on strike
for about two months in 2007 over working conditions and pay; they
earn half of the average OECD teacher's pay, and have over 30
students per class. So many teachers have left the profession that
the GOI, trying to capitalize on the global high-tech downturn,
signed up 1,000 unemployed engineers for a course of study to turn
them into science and math teachers. Estimates of the need for new
teachers to fill gaps and replace retirees in coming years range up
to 10,000. Critics say the Education Ministry is a dysfunctional
bureaucracy grossly inefficient at utilizing its massive budget;
ironically this led to further budget cuts by the Knesset, rather
than a serious attempt to fix the administrative problems. The
persistent under-investment in basic education may have long-term
ramifications on the country's competitiveness.


16. (SBU) Universities have also not been spared budget cuts, which
have significantly reduced faculty size at most universities.
Academic sources say one-third of all Israeli doctoral-level
professors have chosen to teach abroad rather than accept the low
salaries paid by the government-funded universities in Israel. In
2007-8 university professors and instructors went on strike for
three months to protest low salaries and cuts in government support.
Tighter budgets also have resulted in less prepared entering
students. Without a stream of top-notch students from secondary
schools, universities fear that scholastic standards will fall, and
the brainpower to fuel Israel's high-tech economy into the future
will not be there.


17. (SBU) Another bad omen is a marginal drop in national R&D
spending. OCS support for R&D was cut back in 2007 and 2008.
University R&D investment dropped almost 2 percent across 2006 and
2007, as GOI funding for universities was cut back in the quest for
a balanced national budget. The global economic recession also has
severely impacted donor contributions to and the endowments of
Israeli universities, and struck simultaneously with the substantial
damage to Jewish philanthropy caused by the Bernard Madoff scandal.
The Technion, for example, lost $25 million directly, and the
American Technion Society (its alumni and benefactor arm) lost $72
million. Because government support for the universities covers
only faculty salaries and overhead, most research and capital
construction costs must be covered by corporate and alumni
donations. As a consequence, numerous academic investment projects
are being delayed or cancelled.


18. (U) Coincident with the self-inflicted blows to its long-term
innovative capacity, Israel faces the new and immediate challenge of
growing foreign competition from new research centers in the
developing world. The capacity of India, China, and Brazil dwarfs
that of Israel; over 800,000 engineers finished university in India
and China in 2007, compared to only 8,000 in Israel. The ability of
competitors to throw huge numbers of developers into a project poses
a daunting challenge to Israel. Even smaller competitors like
Singapore and Ireland are a threat, with their assured access to
larger regional markets (China and the EU respectively),while
Israel remains a virtual island. Just as the global economic center
of production may be shifting toward Asia, so Israeli analysts say
the globe's R&D capacity may be shifting away from the West.
Employment costs, a key component, may be half as high in Asia as in
Israel. Israelis also fear the strengthening of Israel's currency,
the shekel, which in 2007-8 strengthened by 22 percent before
falling back, and caused high-tech exporters a reported $690 million
in lost orders during that period.


19. (SBU) Although the new government of prime minister-designate
Benjamin Netanyahu may not be able to control the international
competition the country faces, it will need to acknowledge and act
on the great pressures building up in Israel to fix an
under-performing education system and promote national R&D
competence. Netanyahu's reputation as a serious financial manager -
a legacy of what is widely considered to be his successful term as
Finance Minister earlier in this decade -- may help him recognize
the value of long-term investment in human capital and the
short-term importance of pro-investor tax incentives to encourage
competitiveness. Without serious attention to strengthening
Israel's commitment to science education and investment, the
country's future as a locus of diverse high-technology innovation
will be endangered.

Cunningham