BOI PROPOSED SPENDING INCREASE TO COMBAT RECESSION

UNCLAS SECTION 01 OF 04 TEL AVIV 000725 SIPDIS NEA/IPA FOR GOLDBERGER, SACHAR; EEB/IFD FOR JACOBY; TREASURY FOR BALIN E.O. 12958: N/A TAGS: ECON EFIN PGOV ELAB IS SUBJECT: BOI PROPOSED SPENDING INCREASE TO COMBAT RECESSION -------------- Summary -------------- ¶1. The Bank of Israel (BOI) presented a plan of modest spending increases to combat Israel's economic downturn. The cost is about NIS 4.4 billion (USD 1.1 billion),designed to offer incentives for the labor market, for infrastructure investment and for exporters. Implementation would raise the deficit, but the BOI says that, given Israel's excellent record of fiscal responsibility over the past five years, the markets should understand the need for these one-time spending measures. If the downturn turns out to be harsher and longer than expected, the BOI said it might be necessary to implement a variety of spending cuts to maintain fiscal discipline, including delaying or canceling certain aspects of its plan. It also strongly recommended that the new government come up with a comprehensive and credible economic program based on multi-year fiscal targets to enable it to focus on longer-range goals and priorities beyond the immediate necessity of dealing with the financial crisis. Israel's unexpectedly successful bond offering on the international market last week is an indication that the Israeli economy is perceived as relatively strong compared to many others. -------------- NIS 4.4 billion Spending Plan -------------- ¶2. The Governor of the Bank of Israel (BOI) Stanley Fischer recently proposed modest increases in spending to combat Israel's economic downturn. The BOI's latest 2009 growth forecast projects 1.5 percent negative growth for the year, following growth of 4 percent in 2008. The cost of implementing the BOI's proposed steps is NIS 4.4 billion (USD 1.1 billion). The plan offers incentives for the labor market, and for infrastructure investment and exporters. -------------- Plan Would Raise Deficit -------------- ¶3. Implementation of the proposal would raise the deficit in 2009 to 5.8 percent, higher than the BOI's earlier deficit forecast of 5.2 percent. However, the BOI said that as long as it is understood that its proposal includes one-time, temporary measures to deal with an extreme situation -- a global crisis that could cause a sharp increase in unemployment and poverty -- the increased spending will likely not damage Israel's credit rating or raise the risk premium �A;on its debt. The BOI noted that this is due to the GOI's stringent policy of fiscal restraint since 2003, and its success in dramatically lowering Israel's debt to GDP ratio. The "very moderate" expenditure increase the BOI is proposing will not have much impact on that ratio. The BOI is recommending that the government prepare a comprehensive multi-year fiscal plan, similar to that presented by then Finance Minister Netanyahu in 2003. It strongly emphasized the importance of credibly maintaining a declining debt to GDP path, despite the current difficulties. -------------- Labor Market Incentives -------------- ¶4. The BOI plan calls for a total of NIS 1,790 million (about USD 450 million) for labor market relief. NIS 750 million (USD 188 million) would be used to implement a long-planned Earned Income Tax Credit nationally. NIS 555 million (USD 140 million) would go towards increasing unemployment benefits, particularly extending the period of eligibility for receiving payments. For example, those 45 and older would be eligible to receive benefits for 200 days in place of the present 175. Those aged 28 to 35 with fewer than three children would receive benefits for 138 days instead of the present ¶100. The number of months of work needed to be eligible for unemployment benefits would also be reduced from twelve months out of the last eighteen, to nine. ¶5. The BOI proposal also calls for spending NIS 200 million (USD 50 million) to extend the "welfare to work" Wisconsin Training and Employment Plan beyond the current pilot areas nationwide. It envisions spending NIS 185 million (USD 46 million) on a program to reduce the number of foreign workers in the country. Finally in the area of labor market incentives, the plan would provide NIS 100 million (USD 25 million) to finance temporary leave for employees at factories that are experiencing difficulties. -------------- Infrastructure Investment -------------- TEL AVIV 00000725 002 OF 004 ¶6. The second tranche of the program allots NIS 1.5 billion (USD 375 million) for infrastructure investment. This includes NIS 500 million (USD 125 million) for infrastructure projects, particularly public transportation. It also includes a similar amount for projects such as rehabilitating city centers and neglected tourist areas, and for moving IDF bases to the Negev. This part of the program also calls for moving forward on projects in the education sector, and for investment in other one-time projects such as new computer systems for the government. -------------- Industry and Export Incentives -------------- ¶7. The NIS 1.15 billion (USD 288 million) allotted for industry and export incentives includes NIS 750 million (USD 188 million) for increasing R & D budgets, NIS 600 million (USD 150 million) of which is targeted for the office of the Chief Scientist. NIS 400 million (USD 100 million) would also be used to provide increased levels of risk insurance for companies involved in international trade. -------------- Quick and Easy to Implement -------------- ¶8. According to the BOI, the plan should be easy and quick to implement. The bank stressed the importance of moving quickly to ensure that its impact be apparent in 2009. It said that it is preferable to increase expenditures that do not require long-term planning - while infrastructure investment is always touted as a tool to stimulate economies, the benefit of such expenditure is often felt only over the long-term. The BOI also suggested that the government attempt to reach agreement with the Histadrut Labor Federation to delay public sector wage increases scheduled to go into effect this year. -------------- Soften the Blow of the Recession -------------- ¶9. As the BOI's economic forecasts have become more pessimistic with time, the hope is that this relatively modest plan will slightly soften the blow of the recession in terms of growth, unemployment, and the number of people falling under the poverty line. Following four years of greater than five percent growth, the Israeli economy grew by four percent in 2008, despite the onset of the worldwide financial crisis in the second half of the year. This attests to the continued strong fundamentals of the economy. The global slowdown took time to actually impact on Israel, which registered 0.9 percent growth in the third quarter of 2008, followed by a negative growth of 0.5 percent in the fourth quarter. Exports alone declined by 43.6 percent in the fourth quarter, although the Central Bureau of Statistics notes that export figures are given to volatile swings from quarter to quarter -------------- - 2009 Negative Growth of 1.1 Percent with Plan -------------- - ¶10. While explaining the BOI's economic proposal, Fischer also presented the bank's most updated forecasts for 2009 and 2010. These include negative growth of 1.5 percent in 2009, which would make this year even worse than the recession years of 2001 and 2002, when growth was negative 0.4 percent and negative 0.7 percent, respectively. At that time, the recession was due to a combination of factors, including the Intifada, the bursting of the high-tech bubble and the NASDAQ downturn. The BOI says that the implementation of its proposed economic plan would marginally ease the present downturn by increasing growth 0.4 percent in 2009, bringing the overall negative growth for the year to 1.1 percent. -------------- Unemployment Up Sharply -------------- ¶11. The BOI forecast an unemployment rate of 7.8 percent by the end of 2009, but added that implementation of its plan could reduce this to 7.3 percent, resulting in 15,000 fewer unemployed and 4000 fewer people living in poverty. These numbers stand in marked contrast to the 2008 unemployment figures of six percent in the second and third quarters and 6.3 percent in the fourth quarter. The daily press is filled with reports about layoffs in all sectors of the economy, with growing numbers of people applying for unemployment benefits, 20,000 in January alone. Labor Participation, which increased over the last few years to 52.9 percent in 2008, was also forecast by the BOI to decline to 51.8 percent in 2009. The BOI claims that implementation of its plan would halt the decline at 52.1 percent. TEL AVIV 00000725 003 OF 004 -------------- Increased Deficit and Debt to GDP Ratio -------------- ¶12. While preventing spiraling unemployment is viewed as one of the major goals that will face the new government, the BOI plan has a price. It will increase the deficit which is already expected to be high, and the debt to GDP ratio as well. The general view among economists is that the deficit in 2009 will be over 5 percent as a result of the sharp decline in tax revenues. The BOI 2009 deficit forecast is now 5.2 percent. The BOI assesses that implementing its economic plan would raise it to 5.8 percent, if no cuts are made to offset the spending increases. ¶13. This contrasts starkly with 2007's almost-balanced budget and the 2008 deficit of 2.1 percent. The 2008 figure was 0.5 percent higher than originally forecast due to the Ministry of Finance's (MOF) decision to stimulate the economy towards the end of 2008 by spending in advance NIS 4.4 billion that had originally been slated for spending in 2009. ¶14. The debt-to-GDP ratio has been on a steady and significant decline since the implementation of the 2003 Economic Recovery Plan under then-Finance Minister Netanyahu. It declined from about 103 percent at its height to 79.6 percent in 2007 and 78.1 percent in ¶2008. The BOI forecasts that it will increase to 85.7 percent in ¶2009. Implementation of the BOI's plan would increase it slightly more -- to 86.2 percent this year. -------------- BOI Favors Anti-cyclical Intervention -------------- ¶15. At the end of 2008, before the BOI had adopted its more pessimistic growth and deficit forecasts for 2009, Fischer publicly called for a very cautiously expansionary fiscal policy based on the "automatic stabilizer" of an increase in the deficit resulting from increased government expenditures - on unemployment payments, for example - at the same time that tax revenues are reduced by the slowdown. Now, hit by the reality of a deeper-than-forecast downturn, the BOI thinks that the time has come to implement anti-cyclical intervention beyond the automatic stabilizers. Their plan, which aims to increase demand, is much preferable, in the BOI's view, to raising taxes or significantly cutting the budget, as these measures would deepen the slowdown. Forecasting a 0.5 percent reduction in private consumption in 2009, compared to a 3.9 percent increase in 2008, the BOI's assessment is that adoption of its plan would enable private consumption to grow by 0.1 percent in 2009. In the central bank's view, an increase in the deficit is mitigated by the temporary nature of the plan and the extreme circumstances dictating its implementation. The judgment is that this will not have a large influence on the cost of financing debt. -------------- Low Debt-to-GDP Vital in Long Run -------------- ¶16. The BOI replied to criticism that the plan's NIS 4.4 billion in expenditures is too little to have any real impact on the economy by saying that any spending increase needs to be moderate, in order to minimize the increase in the deficit and the cost of financing the growing debt. In addition, the BOI stressed that the government must reaffirm its commitment to significantly reduce the debt-to-GDP ratio in the medium term. Excessive expansion of expenditures without a credible plan that includes medium term fiscal targets and eventual budget cuts would harm the GOI's fiscal credibility and endanger its credit rating. -------------- Ideas on Offsetting the Cost of the Plan -------------- ¶17. Numerous commentators criticized the BOI for not suggesting enough offsets to pay for the costs of its plan. Many note the need for expenditure cuts which would not affect domestic activity, implying a reduction in the defense budget. (Note: Dr. Karnit Flug, the Chief of Research at the BOI and one of the chief authors of its economic plan, was a member of the Brodet Committee, which decided in 2007 that the defense budget needed to be increased while at the same time calling for the military to implement efficiency measures to reduce its budget. End Note). -------------- Sharper Cuts May be Needed -------------- ¶18. The BOI notes that based on decisions made by the outgoing TEL AVIV 00000725 004 OF 004 government on expenditures in the coming years, implementing these plans will require offsetting measures in order to maintain the 1.7 percent annual expenditure ceiling, committed to by the GOI to the USG according to the 2003 Loan Guarantee Agreement. The BOI's assessment is that if the government does not offset the increases in expenditures, some of which have been agreed to by the current government, and the economic situation is severe and continues for longer than anticipated, the deficit in 2010 could reach 7.4 percent and debt to GDP could increase to more than 90%. ¶19. The BOI suggests that in such a scenario, in which the 2010 deficit will be even higher, the tax reductions planned for the last year of Netanyahu's five year tax reduction plan - presented when he was Finance Minister and estimated to cost about NIS 2.5 billion (USD 625 million) - should be delayed. In such a case, it also suggests cancelling certain tax exemptions, increasing the VAT, curbing the increase in other government expenditures, and even delaying or canceling certain aspects of its proposed plan. The BOI noted that in any case, large cuts will be necessary in 2010 in order to meet the expenditure ceiling. -------------- One-Time Increases OK -------------- ¶20. The BOI noted that the fiscal consolidation that took place in the last five years reduced yields on government debt and improved Israel's credit rating. Given the shakeup in the global economy, it thinks that it is worth risking a temporary increase in the deficit despite of the uncertainty regarding the markets' reaction. The BOI also noted that similar policies have been undertaken in other countries. As long as the new government presents a comprehensive and credible economic plan that will be based on multi-year fiscal targets, the risk of the BOI plan is minimal. -------------- Most Successful Ever Bond Issuance -------------- ¶21. With all of its problems, the Israeli economy is relatively healthy in comparison with many others around the world. On March 19, the GOI successfully floated Israel's largest-ever bond issuance on the international markets. The MOF had originally intended to test the waters with a USD 500 million ten year-issuance, but tripled the amount to USD 1.5 billion after receiving indications that the market demand for the GOI bonds could reach as high as USD 12 billion. The rate of interest was 5.19 percent. -------------- Comment -------------- ¶22. It is not at all clear what impact the BOI's plan will have on whatever government is ultimately formed in Israel. It is likely that, during this interim transaction period, the BOI wanted to reassure the public and the markets that someone was paying close attention to the country's economic problems and formulating practical plans to deal with them. Fischer's moderate plan serves as a warning to the new government that, while action is called for, so is prudence and responsibility. It remains to be seen what the final costs of the coalition agreements will be and how much money will be left for further discretionary spending to stimulate the economy. In any case, the success-beyond-expectation of last week's bond offering indicates that, with all its problems, the Israeli economy is still perceived as among the healthiest in the world. CUNNINGHAM