Author: Joel Bainerman

ISRAEL


Past wars and threats of future ones just can’t stop Israel’s economic engine plowing ahead.


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Past wars and threats of future ones just can't stop Israel's economic engine plowing ahead.

During the past year, Israel’s economy grew by 5.1%, the shekel appreciated substantially—not only against the dollar but against other leading currencies—share prices on the Tel Aviv Stock Exchange soared about 40%, and foreign investors sank a record $21 billion into Israeli real estate, shares and bonds. All of this happened despite a war in Lebanon, a shaky government coalition and a four-month stretch without a full-time finance minister. If anything, events such as the continuing regional turmoil have served to show investors how strong Israel’s economy is, given that such upheaval has failed to derail the national economy.

“The potential reward conferred by Israel’s robust, stable economy overrides the concern about the risks of its political and security situation,” says Reinhard Cluse, senior Europe, Middle East and Africa (EMEA) economist at Swiss banking giant UBS. “That background noise gets lost,” he adds.

Israel’s economy appears to be in remarkably good shape. It is the only non-oil-based EMEA economy projected to experience a current-account surplus in 2007—even after accounting for US aid transfers. The country’s public debt burden has dropped to 85% of GDP, down from 100% of GDP a decade ago. Inflation for the first half of 2007 came in below the Bank of Israel’s 1%-3% target range. Israel is now a net external creditor on debt securities (24% of GDP) although still a net debtor on equities (34% of GDP). Analysts believe that this rising stock of equity assets will tip the income balance into positive territory during the coming two years.

A recent country report by Deutsche Bank concludes: “We continue to view Israel as one of the most robust economies in EMEA. The growth picture is solid, the debt burden has declined, and the currency is competitive.” Morgan Stanley predicts that, given the lagged effects of monetary easing and the strength of the global economy, Israel’s real GDP growth will likely accelerate to around 6% this year and show no major correction in 2008.

Another positive factor is that, while export growth remains robust, private consumption is expanding at an accelerating pace—up from 4.8% in 2006 to 11.8% in the first quarter of 2007. High-tech industries are still Israel’s top exporters and generators of growth as they account for half of total exports, while the share of low-technology industries has fallen to 7%.

A Stable Currency
With the economy firing on all cylinders, all the indicators—domestic as well as global—call for monetary tightening. In late July the Bank of Israel responded, nudging rates up by 25 basis points and hinting that further rises might be on their way. Morgan Stanley agrees, noting recently: “Currency fluctuations always play an important role in shaping inflation trends in Israel, largely because of historical linkages between domestic prices and the dollar. For that reason, it was not surprising to see the shekel’s appreciation leading to a wave of deflation since last October. The shekel’s strength was the one and only factor behind deflation and now its recent depreciation leads to a sudden, but unsurprising, jump in inflation. We believe Israel already has ‘hidden’ inflation and will experience a sustained increase once the shekel stabilizes. In our view, the strength of domestic demand will intensify inflationary pressures.”

In its recent country report on Israel, ratings agency S&P; confirmed its A- long-term foreign currency, A+ long-term local currency and A-1 short-term ratings for both foreign and local currency. The agency cites strong GDP growth, the credibility of the Bank of Israel, structural reform, long-term fiscal consolidation, macroeconomic stability, declined government deficit and stronger external solvency indicators as factors behind the solid credit ratings.

Not everyone agrees that the central bank will continue with a tightening program. Cluse predicts that the shekel will remain strong and that the Bank of Israel won’t change interest rates any more this year but will start raising them in early 2008, although not dramatically.

Economy on Autopilot
Israel’s economy has faced some unusual political challenges recently. During the first quarter of 2007, finance minister Avraham Hirchson suspended himself for three months while the police pursued an investigation into alleged embezzlement from a non-profit organization. Prime minister Ehud Olmert took over as acting finance minister and only in late June did he appoint a new finance minister. Darren Shaw, analyst at UBS Israel, remarks that Israel has an “economy on autopilot,” pointing out that even without a finance minister it continued to grow. Shaw says that even if new elections in Israel take place in the coming 12 months—two years ahead of schedule—it shouldn’t have any major impact on the economy. If opposition leader Benjamin Netanyahu does come to power, many analysts believe it will only help the Israeli economy. Netanyahu is popular abroad and is considered the main architect of Israel’s economic turnaround starting in 2003 after three horrific years following the outbreak of the second Intifada in September 2000.

Speaking at a recent conference in Israel, Netanyahu emphasized his belief that tax cuts are an important growth engine, adding: “In 2003 57% of GDP went to the public sector, and we were on the brink. The percentage is now 43%.”

Netanyahu said: “I believe we can achieve GDP per capita of $45,000 within 10 years, a growth rate of 8% a year. This will put us among the top-10 wealthiest countries in the world and will make money available for both social needs and defense.”

Says Yaacov Fisher, CEO of I-Biz, a Tel Aviv-based consultancy firm that conducts research on the Israeli economy: “Netanyahu’s forecasts of 8% average growth rates are completely unrealistic. For the past four years from mid-2003 to mid-2007 Israel’s growth has averaged 5% a year. Every Western country other than Ireland is a bit jealous of Israel.”

Bloated Budgets Threaten Stability
Much of the confidence foreign investors have in Israel’s economy is based on the fact that its number-one banker is Stanley Fischer, an economist of international standing and reputation. Never afraid to court controversy, the Bank of Israel governor has accused the government of threatening the stability of the economy with its “bloated budgets.” He is urging the government to reduce spending because he believes that increasing expenditure in the 2008 budget could impede the market’s momentum.

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Towering achievement: Israel's economic future remains bright, despite continuing regional turmoil.

Fischer attributes much of Israel’s recent economic success to the government’s reduction of expenditures as a proportion of gross domestic product from 52% in 2002 to 47% in 2006, but he also warns that its ratio of debt to GDP of 88% is higher than the standard for most member countries in the Organization for Economic Cooperation and Development (OECD.) His focus on the OECD is particularly pertinent as Israel may be invited to join the organization’s ranks in the near future. Israel has participated in the OECD’s activities since 1996 and is already involved with more than 50 committees, working groups, networks, task forces and schemes.

However, not everyone is enthusing about Israel’s imminent admission to the OECD. Merrill Lynch research analyst Haim Israel warns of the negative impact of the move: “Israel’s admission to the community of developed markets may be cause for celebration for the politicians, but it will be a mortal blow to the Israeli capital market.” Addressing the annual forum of CFOs in Israel, he said that the local economy accounts for just 2% of the MSCI Emerging Markets Index, and its share in the global investment pie would fall to 0.2% if Israel is admitted to the developed markets index. “The moment Israel is defined as a developed rather than an emerging market, not one foreign investor will invest time and resources here, and this will herald the end of the era of foreign investment in Israel,” he predicted, adding that the switch to the developed market category would be a “disaster” for Israel.

Capital Markets

One of the pillars of the robustness of the Israeli economy is the Israeli capital markets. A recent country report by banking giant Citi states that Israel stands out as attractive in terms of earnings trends. “Here, inflation is practically nonexistent; interest rates are very low, and valuations have not stretched enough to negate the benefits of this low-interest-rate environment,” the report notes.

Locally, Israeli companies are benefiting from the added liquidity. Israeli companies traded on the Tel Aviv Stock Exchange (TASE) raised a record 15.6 billion shekels ($3.6 billion) in equity in the first half of 2007 as 64 firms held IPOs. In the full-year 2006, companies raised just 11.9 billion shekels. A total of 85 companies issued shares and convertible bonds in the first six months of this year. In the bond market alone, companies issued 53.1 billion shekels in the six months through June, compared with 47.3 billion shekels during all of 2006.

Securities offerings have grown in Tel Aviv as the stock exchange’s benchmark TA-25 index has risen four-fold in the past four-and-a-half years, reaching a record high on June 17. Many companies have turned to the bond market for debt financing as lower government deficits have reduced the state’s borrowing needs.

Abroad, the Israeli government will issue up to E1 billion in bonds by the end of 2007. Most of the issue is due to be in the European market, denominated in euros, and 20% of the offering may be held in the US market. For the first time, 15% of the issue—up to E150 million—is slated to be placed in the Chinese, Hong Kong and Singapore markets.

The planned bond issue is part of accountant general Yaron Zelekha’s bond-raising reform aimed at building an independent fundraising capability of $2.5 billion to $3 billion a year through issues on capital markets and through Development Corporation for Israel/State of Israel bonds. Earlier this year he approved the fourth and final stage of the reform. The plan focuses on increasing Israel’s foreign currency reserves in order to lower risk and dependence on the dollar and euro.

While the recent turmoil in global markets has knocked Israel’s stock market and currency back from their mid-2007 highs, the prospects for the economy continue to look good. And as it has shown before, the country’s economic growth may be robust enough to shrug off significant external upheaval.

Joel Bainerman