Author: David Lipkin

A STUDY IN CONTRADICTIONS


By David Lipkin

Geopolitical and fiscal uncertainties are having an impact on Israel's growth prospects, but the country is benefiting from development of its natural gas reserves.

300 Features_17 Country Report_Israel_01

Although its export-oriented economy and high-tech sector are not immune to the global economic uncertainty, Israel is showing some positive signs. On the one hand, the Israeli economy is undoubtedly slowing down as a result of decreased exports—particularly to Europe and the US. GDP growth declined from 4.8% last year to 3% this year. In fact, there is a risk of recession, according to economists, as Israel deals with the repercussions of the global slowdown.

On the other hand, Israel has some distinct advantages that partially offset external challenges. For example, the country has been developing its natural gas resources. With growing capacity in the sector, Israel will become a gas-exporting country in the coming years. Meantime, Israeli companies already have more natural gas than they need—keeping costs low.

Nonetheless next year will be an extremely challenging one for the Israeli economy, predicts Leo Leiderman, professor at Tel-Aviv University and chief economic adviser for Bank Hapoalim. He expects the growth rate of the Israeli economy will fall to 2.5% in 2013—primarily owing to the drop in exports to Europe, which have declined by more than 10% since the end of last year.

The slowdown has also led to a fall in state tax revenue. To deal with the drop, the government of Benjamin Netanyahu increased the state budget deficit from 2.5% to 3%—a measure that infuriated Stanley Fischer, governor of the Bank of Israel, who warned that raising the budget deficit in 2013 could have "disastrous consequences" for the Israeli economy.

The stern warning hastened fiscal reforms—including an increase of both value-added tax and income tax by 1% each. In addition, budget cutbacks were instituted to ministries other than those of defense, education and welfare.

Over the next few weeks the government will have to deal with the budget for 2013, which has a hole of ILS13 billion ($3.3 billion). It will need to incorporate new spending to meet demands from the ministry of defense for a budget increase—in part to equip the Israel Defense Forces for the possibility of a military conflict with Iran—and to implement recommendations of the Trachtenberg Committee on social equality, including free education from the age of 3 and increased tax benefits for parents.

The impact of the external slowdown has shown up in Israel's labor market, notes Leiderman. The unemployment rate rose to 7.1% in June but dropped again in July to 6.5%. However, efficiency measures (staff cuts) by different companies and slower growth could translate into higher unemployment rates in the coming months.

The Israeli housing market continues to rally. Purchases of new units rose by 12% in the second quarter of 2012 over the first quarter, and housing prices are rising. New mortgages increased by 20% in July as compared with June. As a consequence, the Bank of Israel is likely to take some measures to avoid overheating in the housing market.

Leiderman says: "Considering the external conditions of slower global economic growth, I must say that the performance of the Israeli economy has been pretty good, with a relatively stable GDP growth rate of 3.0% over the last four quarters." He adds that he expects the administration will continue to show fiscal responsibility, as in recent years, but says that Bank Hapoalim has reduced its GDP growth forecast to 2.5% for 2013, citing the general increase in uncertainty on the geopolitical front, the fiscal front, and the regulatory front.

BUSINESS RISKS

But from the standpoint of Israel's business sector, the fact that concrete plans on adjustments in taxes and government spending have not yet been defined leaves considerable risks for those who need to reach decisions now about business plans for next year.

Case in point: Israel is at risk of losing its place as one of the leading technological nations in the world as there has been a decline in the scope of foreign investments in its high-tech sector. Israel's most important growth engine may start to suffer.

"Considering the external conditions of slower global economic growth, I must say that the performance of the Israeli economy has been pretty good"

– Leo Leiderman, Tel-Aviv University

This is also in part the result of a regression in government investments in high-tech research and development. Economist Shlomo Maoz, a former economic adviser to the finance minister, points out that the share of the government's involvement in R&D expenditures declined from 8% of the total cost in 1995 to 3.7% in 2010. As a result, Israel is losing its competitive edge worldwide and is not encouraging new investments. In the first half of 2012 only 29% of venture capital investments were in the preliminary stages of start-ups.

Against the background of a possible recession, Israel is stepping up plans to become a natural gas exporter in the next few years, following the discovery of natural gas fields in the Mediterranean Sea. Israel has the potential to exploit as much as 800 billion cubic meters of gas. A government study has recommended that Israel export around 50% of its natural gas capacity, but before starting to do so, it must overcome bureaucratic hurdles and establish infrastructure to handle the gas.

STRONG BANKING SECTOR

The Israeli banking sector—dominated by banks Hapoalim and Leumi—circumvented the debt crisis in Europe without major shocks. But they must now deal with a slowdown in the Israeli economy. David Zaken, Israel’s supervisor of banks, says that negative developments in the global financial system have resulted in much greater risks for banks in Israel. Local factors include an increase in risk margins, a decline in the ability to recycle debts in the banking market—predominantly of large commercial enterprises and real estate companies—and increasing regional geopolitical concerns.

Alon Glazer, the research deputy CEO of Leader and Associates Investment, points out that in the past few years Israeli banks have improved their credit portfolios. But they have also vastly increased their housing market exposure, so if house prices collapse, bank balance sheets could suffer.

A recent report commissioned by the Bank of Israel and the finance ministry evaluated measures needed to increase competition between existing banks in Israel, reduce information barriers and enhance transparency and fairness. It recommended the entry of new players into the banking sector, such as Internet banks or credit unions, to increase competition.

GFmag.com Data Summary: Israel

450 Features_17 Country Report_Israel_02