JEDG MIDTERM REVEIW - ISRAEL ON TARGET FOR FY2010 LOAN

UNCLAS SECTION 01 OF 06 TEL AVIV 000194 SIPDIS SENSITIVE NEA/IPA FOR GOLDBERGER,FRELICH; EEB/IFD FOR PERDUE; EEB/OMA FOR ENGLE; TREASURY FOR BALIN E.O. 12958: N/A TAGS: ECON EFIN PGOV ELAB IS SUBJECT: JEDG MIDTERM REVEIW - ISRAEL ON TARGET FOR FY2010 LOAN GUARANTEES AND EAGER FOR HIGH-TECH COLLABORATION REFS: A) 09 STATE 76107; B) 09 TEL AVIV 653 -------------- Summary -------------- ¶1. (SBU) At the December 15 mid-term review of the U.S.-Israel Joint Economic Development Group (JEDG) held in Jerusalem, the GoI clearly demonstrated that it is meeting, and may well surpass, the calendar year 2009 conditionality required to release the FY2010 tranche of loan guarantees. The GoI focused JEDG discussions on its positive economic performance, despite the global financial crisis, and on its desire to engage the U.S. in a high-tech dialogue. The U.S. delegation, led by Treasury Acting Assistant Secretary for International Affairs Andy Baukol, presented the outlook for the U.S. economy, and offered its views on a future Israeli fiscal rule. While expressing willingness to explore avenues of high-tech cooperation, the U.S. delegation remained non-committal citing funding constraints and consideration of the proper government role. The Director General of the Ministry of Finance, Haim Shani, led the Israeli delegation, with Governor Fischer presenting Bank of Israel's monetary outlook. Shani spearheaded the push for robust USG involvement in promoting the high-tech dialogue and a variety of Israeli officials underscored the call, including the head of the Economic Council, Dr. Eugene Kandel and the Chief Scientist of the Ministry of Industry, Trade and Labor, Dr. Eli Opper. End Summary. -------------- A Tale of Two Economies -------------- ¶2. (SBU) At the JEDG mid-term review held on December 15, 2009 in Jerusalem, Acting Treasury Assistant Secretary for International Affairs Andy Baukol began the meeting by providing a sobering update on the U.S. economy. From negative GDP growth until the third quarter of 2009 and an unemployment rate at a 26-year high, Baukol looked to the positives of improving financial conditions and a stabilization of the housing market. He shared Treasury Secretary Geithner's goals for financial sector reform: 1) avoiding regulatory arbitrage 2) increasing accountability by regulators, 3) increasing the resilience of the financial sector and 4) avoiding the "too-big-to-fail" enterprises. ¶3. (SBU) The outlook of a return to growth in 2010 and solid growth thereafter was moderated by the assessment that unemployment will remain high through 2010 and the federal budget deficit will remain at roughly 10 percent of GDP. Fiscal projections from the Office of Management and Budget (OMB) show publically held debt-to-GDP rising through 2019 and mandatory spending on Social Security, Medicaid and Medicare increasing to 60 percent of the federal budget by 2080 on the current trajectory. Baukol underscored the current administration's belief that spending on entitlement programs and healthcare will be the biggest economic problems the U.S. must address in the next four years. Baukol also stressed the danger of snowballing interest payments on debt if the U.S. does not return to deficits under 3 percent of GDP (the long-term average U.S. growth rate) once private sector growth returns. ¶4. (SBU) Ministry of Finance Director General Haim Shani offered a largely positive macroeconomic overview of the Israeli economy, spotlighting the role of the high-tech industrial sector as a key engine of Israeli economic growth. Shani commented that Israel suffered less in the global crisis due to the financial nature of the fully external shock. Exporters of financial goods and sophisticated markets such as derivatives experienced the worst of the crisis. However, the relative lack of sophistication in Israel's banking sector and its status as a high-tech goods exporter, a sector which saw only moderate decline following the crisis, allowed its economy to rebound quickly. The MoF estimated that Israeli GDP grew by a conservative 0.3 percent in 2009 and forecasts 1.5 percent growth in 2010. The second quarter of 2009 showed the first evidence of recovery in Israel, and DG Shani emphasized Israel's improved position relative to other countries. Focusing on exports, Shani cited a small increase in exports to the U.S. in 2009 (whereas exports to all other markets decreased),and credited the resilience of Israel's exports in part due to the opening of a major Intel fabrication plant in Kiryat Gat, north of Beersheba. From 2002 to 2008, high-tech exports doubled, and now comprise 12 percent of GDP and over 30 percent of total exports. Shani did note, however, that Israel is still vulnerable to a high-tech downturn similar to the one experienced in 2001-2003, a period of slow growth and increasing fiscal deficits. ¶5. (SBU) Shani also highlighted labor market statistics, noting TEL AVIV 00000194 002 OF 006 the downturn in unemployment in the 3rd quarter (7.8 percent down from 8 percent in the 2nd quarter),the nominal freeze in wages, and signaling the government's interest in reversing the trend of decreasing labor participation among the ultra orthodox and the Arab minorities. Capital markets and credit conditions improved dramatically from December 2008 to November 2009. Corporate bond issuances and prices have shown significant improvement since April 2009 after a period of stasis during the financial crisis. Shuki Oren, the Accountant General at the MoF, noted his concern that the mood may be too exuberant and cautioned that Israel and the global economy are still in crisis. ¶6. (SBU) On fiscal matters, Shani again emphasized Israel's progress relative to other OECD countries. Stronger spending controls in Israel's budget since 2002, supported by conditions on U.S. loan guarantees, brought Israel's public expenditures down to 42.9 percent of GDP in 2008, lower than the OECD average. With Israel's high military expenditures and high interest payments, civilian expenditures rank among the lowest of industrialized countries, a matter of concern for some at the Bank of Israel and elsewhere in the GoI. Shani expected the actual budget deficits for 2009 and 2010 to be one percentage point less than the 6 percent and 5.5 percent of GDP deficit ceilings agreed to at the June JEDG meeting -- about 4 percent in 2009 and 4.5 percent in 2010. He added that Israel's increase in public debt due to the economic crisis is one of the lowest among advanced economies, estimated at 80 percent of GDP in 2010. ¶7. (SBU) Shani shared the IMF's advice from its recent mission to Israel that the increase in global debt-to-GDP ratios relative to that of Israel may not be beneficial to Israel's cost of funding. An increased supply of high-grade American and European debt may crowd out Israeli international debt and raise its cost of financing. As such, Shani reiterated Israel's commitment to further lowering its debt-to-GDP ratio in the near term. He cautioned, however, that current projections do not anticipate Israel's debt load decreasing until 2012. ¶8. (SBU) When asked about 2010 debt management plans, MoF Accountant General Shuki Oren stated that Israel plans to issue $1.5 billion in international bonds in the first quarter of 2010 and is contemplating at least one other large external offering in 2010 to finance Israel's budget deficit and reduce crowding-out pressures on Israel's domestic corporate debt market. At least one offering will be Euro-denominated while the others will likely be dollar-denominated. Oren added that Israel expects to raise a maximum of $1 billion from the Diaspora community in 2010, and said that U.S. guarantees remain a "backstop" that Israel will not likely utilize unless the Ministry deemed other sources of financing too costly. He did, however, note the importance of the guarantees to investor confidence in Israeli debt. -------------- Bank of Israel on Monetary Policy -------------- ¶9. (SBU) Bank of Israel Governor Stanley Fischer gave JEDG participants an overview of BOI growth forecasts, monetary policy, and assessment of health of the banking system. He noted that the Bank would likely revise 2010 growth rates upwards, but currently forecasts 2.5 percent. He underscored the openness of the Israeli economy and the current account surplus of 3.6 percent of GDP in 2009, expected to decline slightly in 2010 to 2.3 percent of GDP. ¶10. (SBU) Fischer explained the BoI's recent monetary policy measures, including interventions in the foreign currency markets, as the need to increase reserves and improve currency dynamics in the face of a looming recession and a 20 percent appreciation of the shekel. While noting that the exporter's ideal shekel/dollar exchange rate would be around 4, he said the Bank started intervening with U.S. Treasury bill purchases when the shekel was at 3.3 to the dollar. Daily purchases of $25 million per day started in March 2008 and increased to $100 million per day in July 2008. In August 2009 the BoI enacted an exit strategy that called for an end to daily purchases and continue to use ad-hoc interventions to guide exchange rate expectations and guard against movements deemed to be out of synch with Israel's economic fundamentals. Fischer noted that he did not want to spur excessive currency market volatility and an unchecked appreciation of the shekel and therefore is pursuing a slow exit from daily interventions. ¶11. (SBU) By November 2009, foreign exchange reserves amounted to $61.5 billion, up $32.9 billion from March 2008. Fischer noted that since 70 percent of Israel's exports are listed in U.S. dollars, and an even larger amount are incorporated into final goods sold in the TEL AVIV 00000194 003 OF 006 U.S. markets, the BoI concentrates largely on the shekel-dollar exchange rate in its evaluation of Israel's real effective exchange rate. The BoI also began purchasing government bonds through open market operations in February 2009, stopping in July 2009 as it became clear that Israel was coming out of a short recession. In all, the BoI purchased 3 percent of GDP in bonds, markedly less as a percentage of GDP than the Bank of England or the U.S. Federal Reserve. ¶12. (SBU) When asked about the outlook of Israel's foreign exchange intervention policy, Fischer explained that he disagreed with the IMF recommendation to publically announce an end to interventions as he believes reserving the right to intervene will help guide market expectations to avoid excessive appreciation speculation. He said that most private trading on the currency market does not follow long-erm trends and most actors do not employ sophistcated hedging techniques. As such, he sees a cotinued, but gradually diminishing, role for the Ban in managing Israel's currency market. ¶13. (BU) Fischer presented interest rate policy by firt noting Israel's history of high inflation and the Bank's focus on controlling inflation expectations. To counter rising 12-month inflation expectations above the Bank's 3 percent upper target, the BoI raised Israel's benchmark rate from 0.5 percent to 1 percent between September and the time of the December 15 JEDG midterm review. (Note: An additional increase at the end of December brings the current rate to 1.25 percent.) Governor Fischer explained that inflation expectations remain at the upper end of the BoI's 1-3 percent price stability range, and inflation momentum from the rise in Israel's value-added tax along with anticipated growth will likely precipitate further rate hikes. Fischer commented that his ability to raise rates is somewhat constrained by interest differentials with the U.S. and European Central Bank, which may increase if developed market central banks do not raise rates while the BoI feels compelled to do so. Regarding the banking system, Fischer noted that Israeli banks were able to raise funds on the capital markets and did not require government assistance. The Supervisor of Banks exerted consistent pressure on banks to maintain capital requirements. Although Israel has seen a contraction in credit growth in 2009, Fischer said, it need not return to 2006-09 levels, which he deemed "overly aggressive." ¶14. (SBU) When asked about the applicability of Israeli-style currency intervention policy to other countries, he stressed that few other countries could successfully mimic Israel's actions. A small open economy, Israel enjoys a broad base of domestic investors with a strong home bias (creating inflows during the most recent crisis)as well as an open currency market that is small enough not to attract overly excessive speculative trades by large hedge funds. This combination, along with a well-respected and credible Central Bank, is not easy to duplicate, said Fischer. He did note, however, that BoI policies during the crisis may have also spurred the beginning of bubbles in Israel's housing, equity and bond markets. He will be paying close attention to these markets in the coming months, he said. ¶15. (SBU) Fischer also emphasized that the GoI must continue to focus on boosting economic growth. The 3-3.5 percent growth predicted by the IMF for 2010 is too low to sustain current military spending levels, maintain social equity, and continue to raise the standard of living for most Israelis, he said. He argued that Israel must concentrate on three main issues: 1) increasing the size of the workforce, especially among religious and Arab communities, 2) boost competitiveness of the high-tech sector and its links to minority communities and 3) enact real estate market reform to make land ownership and transfer easier. He also noted that Israel could see a large influx of foreign direct investment if a peace settlement were enacted. (Note: Treasury reports that most major rating agencies cite conflict/political risk as a primary constraint to Israel's credit rating and investment climate.) -------------- The Fiscal Framework -------------- ¶16. (SBU) Eyal Epstein, Deputy Budget Director at the Ministry of Finance, described the history of Israel's fiscal framework from no fiscal rules prior to 1992 to 2005 when pro and a-cyclical limitations were introduced - a deficit ceiling and an expenditure limitation. (See ref A for current targets agreed to in June 2009 JEDG meeting in Washington). Epstein argued that decreases in expenditures and debt (as a percentage of GDP) since 2003 demonstrate the ability of the current arrangement to restrain spending. (Note: Although spending controls aided fiscal TEL AVIV 00000194 004 OF 006 retrenchment, a large increase in tax revenues from high economic growth during 2003-2007 served as the primary reason behind Israel's declining debt levels.) The ceilings have contributed to conservative budgeting practices by the Ministry of Finance, which Epstein believes have now been internalized throughout the Israeli government. ¶17. (SBU) Epstein cited three risks to the current framework: 1) the lack of sustainability of current expenditure ceilings given an anticipated rise in mandatory spending along with social spending that is already quite low compared to most OECD countries; 2) planned tax cuts; and 3) military and other spending commitments already written into the budget that are not obliged to conform to Israel's future fiscal targets. Epstein noted that the GoI will face difficulty in reaching the targets in 2011, when many budgetary obligations will be coming due. He also said that the GoI is considering another two-year budget, in the hopes of retaining political stability and locking in multi-year budget commitments. ¶18. (SBU) A new fiscal rule is under discussion among the Bank of Israel, the National Economic Council and the Ministry of Finance, but discussions are not likely to yield a unified proposal until the end of the first quarter of 2010, as the new rule will be the basis for structuring the next budget. While there was no firm decision that the next budget would be another two-year budget, Eugene Kandel of the NEC noted that a two-year budget lessens political bickering and assists with long-term planning. Epstein demurred on specifics of the fiscal rule options under discussion, but noted that the challenge for the future is to further reduce the debt-to-GDP ratio over the medium term under the appropriate size of the public sector and the tax level. ¶19. (SBU) Acting A/S Baukol inquired about whether escape clauses would figure into the new framework, and if there would be sufficient accountability or enforcement mechanisms. Previous fiscal rules, he said, had often proved ineffective in preventing creative accounting that led to overspending in strong economic times, and in allowing additional spending in sharp downturns. Baukol also asked, per the IMF's recommendation, if Israel is looking to change from real to nominal figures for its budget ceiling, to increase transparency and the budget's anti-cyclicality. He queried as to whether the new fiscal rule might force medium-term spending plans to follow the rule's expenditure caps, noting that the current rule fails to guide medium-term spending, causing rapid increases in planned expenditures each year. While non-committal on the new rule's escape clauses and enforcement mechanisms, Epstein explained that the MoF had recently consulted with Sweden and the Netherlands on the nature of their fiscal rules and policymaking. He also confirmed that Israel is investigating the use of nominal budget figures and the creation of long-term budget projections that would allow spending plans to fit into the fiscal framework. -------------- GoI Prioritizes Expanded High Tech Dialogue -------------- ¶20. (SBU) DG Shani introduced the discussion of the proposed high tech dialogue by providing an overview of the sector's significance to the Israeli economy. In addition to the exports the sector generates, the Information, Communication and Technology (ICT) industry employs 14 percent of Israelis, according to Shani. He pointed to the ICT sector's roots in the Israeli military and emphasized the heavy state involvement in its development, especially the strong government science policy. Eli Opper, the Chief Scientist housed in the Ministry of Industry, Trade and Labor, participated in the JEDG discussion. (See Ref B for description of the technology sector's history and challenges.) ¶21. (SBU) Citing the many U.S. technology companies with facilities or other ties to Israel, including Intel, Microsoft, IBM, Motorola, and Cisco Systems, Shani brought the focus to areas of strategic cooperation that would address national priorities of both Israel and the U.S. He introduced short presentations by two Israeli software companies that had recently participated in a high tech conference in New York organized by the Israel-America Chamber of Commerce. The first, dbMotion, specializes in healthcare software which aggregates health information and creates virtual patient records. The second, Time to Know, creates integrated educational software. Both companies are actively engaged in both the Israeli and U.S. markets. ¶22. (SBU) Chemi Peres, a well-known Israeli venture capitalist and President of the Chamber, told participants that Israel and the U.S. are missing major opportunities to address problems on a national TEL AVIV 00000194 005 OF 006 level with advanced technological solutions. He called for a "binational stimulus package" in which the two countries would act like venture capitalists by elevating 2-3 projects to address national priorities such as healthcare, education, alternative energy and homeland security. Israel, he proposed, could act as a test bed for implementation of high-tech solutions in the U.S. ¶23. (SBU) Following the private sector presentations, DG Shani asked what government could bring to the table to promote this binational alignment. He argued that the U.S. and Israel are not competitors but natural partners with complementary business cultures, and that both countries seek to maintain a slipping edge in the face of growing competition from China, India, etc. The GoI participants urged the establishment of a bilateral government structure to manage expanded high-tech cooperation that could prioritize projects with critical, strategic potential and help generate more resources for them. The form such an organ would take was open for discussion, but generating new funding was essential, said Shani. He also noted the potential to target the involvement of Israel's Arab minority and create linkages to Palestinian entities. ¶24. (SBU) Providing preliminary feedback, the U.S. delegation questioned the proper role of government in this sphere, and emphasized a reticence to "pick winners" among private sector participants. Addressing areas of policy coordination, resource allocation, and best practices discussions were all potential foci but required the involvement of varied government agencies and the private sectors on both sides. U.S. delegates noted the possibility of wider forums, such as the OECD, to initiate discussions that might lead to a more considered binational objective. U.S. delegates also raised the success of established binational foundations such as BIRD, BARD, and BSF and expressed a desire, in principle, to expand funding for the foundations. However, they reported, initial attempts to identify funds had not yielded any positive results. ¶25. (SBU) Acting A/S Baukol stressed that the Commerce Department has the lead in the USG on high-tech issues, and noted the importance of linking the private sector into any future dialogue. He amplified DG Shani's message regarding the inclusion of Israel's Arab minority by noting the possibility of high-tech cooperation with the PA and Israel's other Arab neighbors. He stated his desire to continue dialogue on macroeconomic, fiscal and monetary issues as the main focus of the JEDG, regardless of where any future high-tech collaboration may be discussed. ¶26. (SBU) Chief Scientist Eli Opper agreed that existing mechanisms could be utilized to address the areas of strategic bilateral concern, citing BIRD Energy as a successful example. In May 2009, BIRD Energy garnered $2 million in funding from both the U.S. Department of Energy and the Israeli Ministry of National Infrastructures to pursue renewable and energy efficiency projects. He urged increased funding for the foundations along with continued discussion of focus areas to be recommended to the foundations. ¶27. (SBU) Director of the National Economic Council, Eugene Kandel, argued that governments can act as facilitators of "equilibrium-changing" solutions and hasten progress by providing evaluations of strategic proposals by drawing on a range of subject-matter expertise. This, he noted, would require collaboration from many governmental bodies as well as a managing mechanism to ensuring success. DG Shani noted the possibility of harnessing the academic and research capabilities of the two countries as well. However, he agreed that the matter required further deliberation. Again, he emphasized the importance of funding, noting that the GoI was ready to commit resources, and encouraged the U.S. delegation to identify a counterpart to further develop the proposal. (Note: Post will report septel on prospects for furthering the high-tech dialogue proposed by the GoI.) -------------- Progress on Loan Guarantee Conditions -------------- ¶28. (SBU) Both Israel and the U.S. expect the calendar year 2009 conditions for release of the FY 2010 tranche of the loan guarantees agreed at the June 2009 JEDG (see ref A) to be met. The Israeli delegation confirmed that final statistics for 2009 would be compiled and reported by March 2010 to allow for the USG's written determination and subsequent formal release of the FY2010 tranche of guarantees. GoI delegates briefly described Israel's progress toward structural reforms in the 2010 conditions, including privatization in electricity, ports and land reform. They stated that reform was proceeding, albeit with certain snags including IEC TEL AVIV 00000194 006 OF 006 pensions and certain legal requirements of reorganizing the land administration and zoning systems. Baukol noted that the spending targets agreed for 2010 differ from those specified in the 2009-2010 budget. GoI officials, however, reported that lower than expected social and other spending combined with higher than expected inflation will likely allow the GoI to meet 2010 fiscal conditionality. ¶29. (SBU) While IPR negotiations continued in other fora and were not discussed in detail, the U.S. delegation requested the Ministry of Finance's flexibility regarding a bottleneck in the progress of negotiations: MoF's concern that longer patent terms would negatively impact the GoI's finances. The U.S. delegation also reiterated the appeal for application of international sanitary and phytosanitary standards, and promised to submit questions regarding the GoI's procedures regarding food safety by the end of 2009. (Note: Post subsequently relayed food safety questions to GoI and responses are expected by December 2010.) Regarding the GoI's evaluation of long term social expenditures, the Israeli delegation reported that development of an action plan is underway and recent discussions with Swedish and Dutch counterparts on forecasting had informed the process considerably. The GoI is currently devising estimates of the demographic pressures the country will face over the medium term, and do not foresee difficulties in the next 20 years. ¶30. (SBU) Acting A/S Baukol stressed to the Israeli delegation the timelines for the required reports and action plans upon which release of the loan guarantees are contingent, including an action plan for a new fiscal rule due by the next JEDG meeting (tentatively scheduled for June 2010) and a long-term budget analysis of Israel's future social expenditures due by December 2010. ¶31. (U) This message was cleared by Treasury. MORENO