MAJOR ECONOMIC DEVELOPMENTS

Growth
1997 saw continued recession in economic activity. This reversal of the growth trend of the economy, which began in the second quarter of 1996, is manifest in a slowing of the rate of expansion of most of the economic indicators, for instance: a steep decline in investments, decline in the number of employed persons (increase in the unemployment rate since the second half of 1996), slowing of imports of raw materials and slowing of private consumption.
The factors contributing to slowing of the rate growth include the following:
The economic influences of immigrant absorption have almost reached their conclusion.
Natural transition to a stage of depression in the business cycle. The substantial investments in the economy, which accompanied the high growth rates of recent years, led to a considerable increase in the capital stock and a decrease in the need for rapid renewal of the stock.
The policy of high interest has an adverse effect on the profitability of production in general and of exports in particular.
The sharp 15% decline in tourism since the second quarter of 1996, in comparison with parallel months in 1995, and stabilization at this low rate throughout 1996 and the first half of 1997.
A certain decree of uncertainty in the market, which influences investments by the business sector and private consumption.
Changes in the market's production structure, which in the transition stage is manifest in contraction of certain branches.
The real GDP growth rate fell from an average of 6% yearly in 1990-1995 to 4.5% in 1996, and further (estimated) to about 2.5% in 1997.
Despite the sharp decline in the GDP growth rate, 1997 is characterized by an encouraging change in the form of economic growth. While the growth rate of the domestic product demands has fallen steeply and imports have stagnated, exports of goods and services increased in the first half of 1997 by 7.8% in comparison with the corresponding period in 1996. This transition from GDP growth to export-based growth derives from the structural change in the composition of industrial production occurring in the economy in recent years, with a shift from the traditional labor intensive branches to the advanced high-tech branches.
The serious slowing in the growth rate of domestic demand in the first half of 1997 and the rising unemployment rate illustrate the increasing gap between potential growth and the actual GDP growth. The growth potential, which is estimated at about 5% yearly, is made up of the anticipated growth rates of capital stock and labor inputs (hours of local work), and of the overall productivity growth rate (GDP growth by work unit beyond the capital stock growth by labor unit). Overall productivity is expected to increase in the next few years following adapting of the human capital of the immigrants to the job requirements in Israel, and following the relatively high investments of recent years, which have not yet yielded their full fruits.

Branches of the Economy

The first half of 1997 was characterized by low economic activity, a trend which commenced in the second quarter of 1996. The national accounting data show that the business GDP for the first half of 1997 (without seasonal fluctuations) increased by 1.7% against the parallel period last year, compared with an annual growth of 5.2% in 1996 and 8.7% in 1995.
In investment assets imports, a specific marker of business sector expectations, the decline has continued for over a year. It should be noted that in the months of June-July this year, there was a substantial increase in these imports, but it is still too early to determine whether this signifies a change in the trend.

Industry

1997 is marked by a recession in industrial production (except for diamonds), a recession which dates from the second quarter of 1996. The industrial production index rose in the first six months of the year by 2.3% in comparison with the corresponding period last year, and after growth rates of 5.3% in 1996 and 8.6% in 1995.
Breakdown of industrial production to its branches shows an annual increase of 5% - 7% in the high-tech branches, for instance: electricity and electronics, plastics and chemicals; and a fall, on the other hand, in the traditional labor intensive branches.
The increase in exports of goods and services in the first half of 1997 derives from the structural change in industrial production in the economy. In 1997 the upward trend continued in exports in advanced high-tech. In the first half of the year, on the one hand, there were impressive increases compared with the first half of 1996 in the communications, equipment, control and medical equipment (34.4%), in the chemicals and oil refinery (20%) and in the electronic components, office machines and computers (16%). On the other hand, the growth rate in traditional industry is far lower and some of them showed a decline.

Construction

The data for the first six months of the year show a slackening of activity in the construction, both in supply and demand, even beyond the slackening attributable to the abating of the waves of immigration and the stabilization in the household growth rate.
Marketing of lands: In the first seven months of the year, approximately 15.8 thousand housing units were marketed by the Ministry of Construction and Housing and the Israel Lands Administration. This is a far lower rate than in 1996 (37.6 thousand housing units), and may lead to an inability to guarantee routine housing needs and demands from 1998 onwards.
Building starts: The number of building starts, according to the Ministry of Housing evaluation, is expected to reach about 44,000 apartments in 1997, compared to 52,870 building starts in 1996. This is a decrease of about 17%, in addition to an identical decrease in the number of housing starts in 1996.
The sharp decline in activity in this activity was accompanied in the first months of 1997 by a decreased demand for housing, and thus by a real increase of one percent only in apartment prices. Property Tax data show a decline of approximately 22% in the number of apartment sales in the first half of 1997 in comparison with the parallel period last year. Notwithstanding, updated data for the months of May, June and July 1997 indicate a recovery in apartment sales. The mortgage market shows a trend similar to that discerned in relation to apartment sales.

Tourism

From 1993 to 1995, with the progress of the peace process, there was a constant average annual rise of about 10% in incoming tourism to Israel. In the course of 1996, this trend changed, with a decline of about 15% in the level of incoming tourism compared with the parallel months in 1995, and stabilization at this low level throughout 1996 and the first half of 1997.
As against the sharp decline in incoming tourism, domestic tourism increased. In 1996 about 7.2 million overnight hotel stays by Israelis were registered in comparison with 6.5 million in 1995. This 11% increase is partially explained by attractive marketing campaigns carried out by the local hotels with a view to attracting Israelis, in order to compensate for the decrease in incoming tourism to Israel.

Private Consumption

The accelerated growth in the first half of the 1990's was accompanied by a rapid increase in per capita private consumption, about 5% yearly on average. In 1996, the slackening in economic activity was paralleled by a considerable decrease in private consumption. Private consumption increased in 1996 by 5.2%, or about 2.8% in terms of per capita consumption. In the first half of 1997, the moderation trend in private consumption grew, with an increase of 2.1% in the first half of the year as against the corresponding period last year. In terms of per capita private consumption, this is an absolute decrease.
The main factors leading to moderation in private consumption are:
Conclusion of the influence of the waves of immigration. The rapid increase in private consumption at the beginning of the decade derived inter alia from purchase of durable products by new immigrants.
The depression in the business cycle after the high level reached by private consumption in the first half of the decade.
Slackening of economic activity which led individuals to evaluate their economic status in the present and in the near future.

Investments

The moderate decrease in investment in fixed assets, which began in the second quarter of 1996, continued also in the first quarter of 1997, when a fall of 4.8% was registered, as compared with the corresponding half in 1996. In contrast to the freeze in the growth rate of investments in residential building, investment in the economic sector fell by about 6.7% in the first half of the year, as compared with the corresponding period last year.
From the beginning of the decade, the investments in the economy grew by an average yearly rate of about 14%. The large scope of investment was accompanied by a rapid expansion of economic activity, and was motivated principally by the need to adapt the capital stock to the rapid growth in the number of employed persons. With a downslide in this trend, this year has seen, for the first time, a fall in investments.
The main factors which led to this decline are:
The need to adjust the capital stock, which grew substantially in the last few years.
Slowing in real estate investments for commercial and industrial objectives, as a reaction to surplus building in previous years.
A sharp decline in investment in residential building, due to a scarcity of lands marketed and to the uncertainty which has prevailed for over a year.
The economic environment is characterized by growing uncertainty in the economy.

Productivity

The second half of the 1980's saw a process of increasing efficiency in the business sector. This was manifest in the growth of overall productivity. Overall productivity, defined as a rise in real GDP per weighted unit of capital and labor input, increased in the years 1986-1990 by an average annual rate of 3.2%.
In the first half of the 1990's the accelerated economic activity was manifest in the business sector data. The business sector GDP increased in the years 1990-1995 by an average annual rate of 7.3%, on a parallel to the growth rate of the factors of production, capital and labor. Accordingly, the overall productivity remained unchanged.
Economic activity decreased in 1996. The business sector GDP increased by 5% in comparison with 7.3% in the years 1990-1995. Labor productivity (the rate of change in the real GDP per unit of labor) showed an increase of 1.3% in 1996 in comparison with the annual average of -0.3% in the years 1991-1995. The main increase in labor productivity is explained by adapting of the human capital of the immigrants to the job requirements in Israel. On the other hand, capital productivity (rate of change in real GDP per unit of capital) fell by 3.3% in 1996 in comparison with an average annual increase of 0.5% in the years 1991-1995. This sharp decline is explained by the excess investments which were planned in previous periods, when there was still considerable growth in business sector activity.
In the next few years the growth rate of the factors of production in the business sector is expected to decrease. At the same time, an increase in immigrant productivity is anticipated, together with an increase in the contribution of the capital stock which accrued in the last few years. As a result of these trends, productivity is expected to increase. This anticipated increase will lead to improved profitability in the business sector and gradual accelerating of its growth rate.

Employment

From the second half of 1996, the influence of the general economic recession made itself felt also in the labor market, and this after years of rapid growth in the number of employed persons. Initial data for the first half of 1997 indicate a continued recession in the labor market.
In the first and second quarters of the year the upward trend in the unemployment rate continued, with unemployment figures in the second quarter of the year reaching 7.6% as compared with 7.4% in the first quarter of last year, and 7.1% and 6.6% in the fourth and third quarters of last year respectively. Increased unemployment is caused by the economic recession which leads to a freeze in the number of employed persons. The transition from activity in traditional labor-intensive branches to high-tech branches also contributed to the situation.
Unemployment this year is of a different nature to the employment which characterized the economy in previous years. Formerly, there was a rapid growth rate in the number of employed persons accompanied by an even more rapid growth rate in the labor force, The overwhelming majority of the unemployed in the first half of the 1990's were new immigrants who joined the labor market. Today the unemployment derives from the slow pace of creation of new jobs and the higher number of dismissed workers among the unemployed. This difference means that the return to lower unemployment rates of about 6%-6.5% will be slower than in the years 1993-1996.
It should be noted that after the long stability in the number of employed persons from the middle of last year, their numbers rose in the second quarter this year. This increase in the number of employed persons in the second quarter was accompanied by an increase in the unemployment rate (from 7.4% in the first quarter of this year to 7.6% in the second quarter), due to new unemployed persons who joined the labor force reserve.
In the first half of the year, the number of unemployed persons rose by 27% in comparison with the parallel period last year, reaching 143,400. This upward trend, which has continued for the last two and a half years, brings the number of unemployed back to the high level which prevailed in the economy four years ago.
Unemployment mainly affects unskilled workers who are identified with the traditional industries. For instance, the number of employed persons in the textile branch decreased by 15% in the first five months of 1997 in comparison with the first five months of 1996.

Wages

In the first half of 1997, there was a real 1.3% wage increase for paid employees compared with the corresponding period last year. This is made up of a real wage increase of 2.1% in the business sector and an 0.5% decline of wages in the public sector.
The wage agreements signed with the trade unions in 1993 and 1994 gave exceptionally large pay rises to the employees, and led to a real annual 6% wage increase in the public sector in 1995 and a 9.8% increase in 1994. The slower wage increase rate in the public services in 1996 (real increase of 1.9%) and in the first half of 1997 (-0.5%) is a result of those wage agreements, since most of the high pay rises were given in the first two years of the agreements. In conclusion, despite the aforesaid wage erosion in the public sector in 1997, over the entire period of the agreement from 1993 to 1997 there was a sharp and exceptional rise in public sector real wages of about 18%. This increase, in addition to its negative influence on the labor market, greatly raised the rigidity in the State Budget, and made it difficult for the Government to set budget priorities.
Against the substantial wage increase in the public services, the stability of the real wage in the business sector was conspicuous in this period. The real business wage increase last year derives at least partially from technical factors - on one hand the growth of the high-tech branches, in which the wage levels are relatively high, and on the other the weakening of traditional branches in which the wage levels are low.

Balance of Payments and Foreign Trade

In the first half of 1997 the balance-of-payments current account deficit fell to $2.3 billion compared with $3.6 billion in the same period last year. The improvement in the current deficit stems from the fall of the commercial deficit by about $900 million, and an increase of approximately $400 million in the total unilateral transfers.
The improvement in the balance of payments is characteristic of periods of economic recession, which lead to a sharp decline in imports of goods and services. An encouraging sign this year, which perhaps also indicates to what extent the recession is continuing, is that the improved trade deficit derives mainly from an increase in exports in general and in industrial exports in particular. In the first half of 1997 exports of goods and services rose by 7.8% compared with the first half of last year, while imports of goods and services showed a moderate increase of 2.6%.
Another development which helped to reduce the trade deficit is the improvement in trading conditions, stemming inter alia from the strengthening of the dollar relative to other currencies in the world markets in the first half of the year.
Short term capital imports (net) rose in the first half of the year by $6.1 billion in comparison with $2.1 billion in the same period last year. The exceptional increase derives from the increased foreign currency credit taken by the business sector, inter alia on account of the high shekel interest rate.
In June this year, the change in the exchange rate band was accompanied by the announcing of a series of liberalizing steps in relation to foreign currency control, designed to give greater freedom of foreign currency movements outside Israel. The process will be gradual, with removal of most of the restraints on foreign currency transactions over the next year.

Monetary Policy

The means of payment (M1) rose in the course of the first eight months of the year by about 15.3%, and by about 18% in the course of the last 12 months (August 1996 - August 1997). This is considerably in excess of the rate suited to the inflation targets and the GDP growth, which is estimated at about 12%.
Unrestricted credit increased in the last 12 months (August 1996 - August 1997) by about 17.9%; shekel credit (unlinked and index-linked) increased by about 11.2% whereas unrestricted foreign currency credit and foreign currency-linked credit increased by 38.4%. The weight of foreign currency credit out of the total credit increased from 17.8% in January 1995 to about 29% in August 1997. This exceptional increase derived principally from the change of the credit mix by the business sector due to high shekel interest.
The capital imports led to pressures for revaluation, and in order to prevent the exchange rate from falling below the bottom of the band, the Bank of Israel purchased some 7 billion dollars of foreign currency from the public during the first eight months of the year. On a parallel, in order to meet the monetary goals, the Bank of Israel absorbed the injection created, principally through tenders for interest-bearing deposits with it by the banks.
The cost of this sterillization policy (injection of shekels and purchase thereof at a higher price) in 1996, according to the Bank of Israel estimates, was 3/4 - 2/3 of a percent of the GDP, namely about 2 billion shekels. In 1997, as can be seen from the following graph, this trend intensified.

The Budget Deficit

In 1997 the Government decided to amend the Deficit Reduction Law, with setting of an total deficit target rather than a domestic deficit target, as was the case in the preceding five years. The multiannual deficit target set by the Government places the total deficit, without allocation of credit, at 2.8% of the GDP in 1997, at 2.4% of the GDP in 1997 and at 1.5% of the GDP by the year 2001.
In order to arrive at the 1997 deficit target, the Government had to cut about 7 billion NIS in the budget.
In 1996 the domestic deficit, without allocation of credit, rose to 4.7% of the GDP, as against a planned deficit of 2.5%, principally because of the recession which began at that time, and which led to a sharp decline in Government revenues. In 1997, however, as a result of the restraining policy adopted in the 1997 State Budget, including a further cutback in the basic budget of 600 million shekels in the middle of the year, we expect to meet the deficit target set, despite the recession, which continues even beyond the estimates on which the budget was based,.
In the months of January to August of this year, the domestic government deficit (without allocation of credit) totaled NIS 3.3 billion against NIS 8.2 billion in the corresponding period last year.
Inflation
The consumer price index rose in the first eight months of the year by 6.4%, i.e. by about 9.8% in yearly terms. In the course of the last 12 months the index rose by 9.3%. These rates remain within the inflation target of 7% - 10% set by the Government.
The consumer price index shows an exceptional rise in fruit and vegetables prices, 14% in the first eight months of 1997 and 13% in the last 12 months. This is attributable to the warm weather at the beginning of last winter and the ensuing cold spell, which damaged the crops.
A noticeable increase was also registered in housing prices. The owned apartment price index rose in the first eight months of the year by 9.2%, or by 14% in yearly terms. In the course of the last 12 months the owned apartment price index rose by 12.6%. Apartment prices rose principally in June and July of this year, due to renewed demand for housing after a prolonged decline from the middle of last year, and due to the accelerated devaluation of the dollar rate in June of this year.
Basic inflation (the index without fruit and vegetables and without housing) rose in the last 12 months by 7.7% and the wholesale price index of industrial output rose in the last 12 months by 6.9%.


Exchange Rate

During most of the first half of 1997 the pressures for revaluation of the dollar exchange rate continued, as a result of the following factors: differences in interest rate between Israel and abroad, which led to a sizable increase in capital import, particularly by the business sector; a substantial reduction in the balance-of-payments deficit and the continued growth of incoming capital movements by foreign investors.
As a result of these revaluation pressures, in the first eight months of 1997 the Bank of Israel purchased nearly 7 billion dollars from the public in order to prevent a fall below the lower limit of the exchange rate band. With the strengthening of the dollar in the first quarter of the year, relative to other currencies in the world markets, the exchange rate in relation to the dollar rose faster than the curve of the floating band.
In June the Government decided to make several changes in the parameters of the exchange rate floating band. This decision included upward extension of the band by about 15% and reducing of the curve of the lower limit from 6% to 4%, while maintaining its location. At the same time, a series of liberalizing steps were announced in foreign currency control, designed to give greater freedom to outgoing capital movements.
Prior to the government decision, many speculators had wagered on downward extension of the band, and this had led to increased capital imports. Announcement of the changes, which put an end to speculation, was followed by rapid devaluations, to a cumulative scope of 5%. In the following months the exchange rate was revalued against the currency basket. In mid-September it had fallen to only a few-tenths above the lower limit of the diagonal band.