A. ECONOMIC DEVELOPMENTS IN 1998¹

	Major developments
	Private consumption
	Gross domestic investment
	The labor market
	Fiscal developments
	Prices
	The balance of payments
	Monetary developments

Major developments
In 1998 Israel was confronted by far-reaching international developments, characterized by instability in the financial markets, a marked slowing of the growth rate of the world economy and trade, and the sharp contraction of capital flows to developing countries, and to emerging economies in particular. In view of Israel's accelerated integration in the world economy in the last few years, these developments-which were exacerbated in August and September, as reflected by the volatility of capital and foreign-exchange markets worldwide-required a responsible and cautious macroeconomic policy aimed at preventing a financial crisis from emerging in Israel. Crises of this nature, which are characterized by a steep drop in economic activity and difficulties in meeting external obligations, have developed in several countries since July 1997 as a result of macroeconomic imbalance and the weakness of the financial system. Developments in 1998 indicate that the progress towards macroeconomic stability of the last two years while maintaining fiscal and monetary restraint, together with economic robustness-expressed in a relatively small short-term external debt, efficient banking supervision, and increased flexibilty of the exchange-rate regime-has helped to reduce the impact on Israel of the global financial crisis.
Against the backdrop of international developments, GDP growth continued to be sluggish in 1998, even falling below the slow 1997 rate and significantly below the potential rate derived from the increase in capital stock and the labor force. GDP growth was also slower than the rate predicted in the National Budget for 1998, most of the departure being explained by the slower than predicted rise in exports, due to the crisis that erupted in East Asia after the forecast was made and its effect on the global economy. The slowdown in growth in 1998 caused the unemployment rate to rise, there was a negligible increase in business-sector employment, and total factor productivity in the business sector declined by about one percent. Nonetheless, the positive trends evident in 1997-mainly the reduction of the balance of payments current-account deficit-persisted in 1998. The CPI rose slowly until August, reflecting more rapid progress than expected towards the long-term inflation target set by the government. Although the accelerated local-currency depreciation since August is expected to lead to a significant acceleration in the rate of price increases in the last quarter, the annual rate of price increases is expected to be lower than the 1992-96 average; this will also depend on exchange-rate developments during the rest of the year.
Macroeconomic developments in 1998 are explained by trends in the global economy, foremost among them the sharp slowdown in the growth rate of world trade and the decline in prices of tradables, especially commodities, as well as by the persistently slow rise in domestic demand-primarily the decline in investment-affected inter alia by the maintenance of cautious macroeconomic policy. Global developments led to the slowing of export growth (excluding diamonds) and the acceleration of import growth (excluding defense imports, diamonds, and ships and aircraft), on the one hand, and to a decline in domestic production costs and price increases and an improvement in the terms of trade-significantly reducing the current-account deficit-on the other. The growth rate of domestic demand remained lower than at the beginning of the decade and than the growth rate of potential GDP, though accelerating slightly over 1997. This rate of growth reflects the continued adjustment of the level of domestic demand, both endogenously and as a result of policy, particularly in view of the steep decline in 1998 in international capital flows to developing countries in general, and foreign investment in Israel in particular. This year, too, the main factor behind the persistently slow growth rate of domestic demand was the continued decline in investment at a rate similar to that in 1997, reflecting the protracted convergence of the growth rate of capital stock to Israel's long-term potential growth rate. The growth rate of private consumption slowed slightly from 1997, but remained higher than that of GDP, while that of public consumption accelerated, and was in line with the population growth rate.
GDP rose by a real 1.6 percent in 1998, a lower rate than that of the population, so that per capita GDP fell by 0.8 percent. The growth rate of business-sector product slowed more sharply, falling from 1.9 percent in 1997 to 0.9 percent in 1998-significantly below its potential. As a result of the deceleration, the growth rate of labor inputs fell, and the average unemployment rate rose to 9.1 percent. The number of Israelis employed in the business sector did not increase at all in 1998, while the real wage in this sector rose by 5.5 percent in the first seven months of the year. Domestic demand (derived from domestic uses, excluding defense imports) rose more slowly than GDP, even though it increased faster than in 1997, so that the import surplus (excluding defense imports) fell by 0.3 percent of GDP (at constant prices). In addition, Israel's terms of trade improved significantly in 1998, helping to reduce the current-account deficit to $ 2.2 billion.
The object of monetary policy in 1998 was to consolidate the decline in the rate of price increases, while preventing the development of a financial crisis similar to those seen in some Asian and South American countries. From the beginning of the year to the end of September the Bank of Israel's key interest rate declined gradually by 3.9 percentage points. However, because of the rapid fall in the rate at which prices rose and of inflation expectations, in the first nine months of the year the effective expected average real interest rate was 6.5 percent-1.5 percent higher than in 1997. Parallel with this increase, medium- and long-term real (indexed) interest rose, expressed inter alia by a steep rise in mortgage interest. These trends moderated in August and September, following the reduction of the Bank of Israel's key interest rate by 1.5 percentage points at the beginning of August, along with the determination of the inflation target for 1999 and a change in the slope of the exchange-rate band. The latter also led to a change in the yield curve on Treasury bonds, so that short-term and long-term yields were equalized, after the short-term yield had been significantly higher in the first seven months of the year. Share prices rose by 8.4 percent from the beginning of the year to the end of July, after which the general share-price index fell by some 17 percent until mid-October, as share prices plummeted in the US and Europe.
The relaxation of foreign-exchange controls continued in 1998. Restrictions on households and the business sector were removed, though some remained in force for transactions abroad by institutional investors and local-currency futures transactions by nonresidents. Until the end of July the exchange rate remained near the lower limit of the band for most of the time, but local-currency depreciation accelerated significantly in August, and by mid-October (the time of writing) the NIS had depreciated by 22 percent against the currency basket, and by 19 percent against the dollar, substantially more than the rate at which the Consumer Price Index (CPI) rose in the same period. Capital inflow dropped substantially in 1998, principally due to the cessation of short-term net borrowing in the wake of the slower expansion of foreign-currency credit to residents, but also because of the sharp contraction of foreign-primarily financial-investment.

Private consumption
Private consumption growth moderated in 1998, to 3.6 percent (1.2 percent per capita). Although the growth rate of durable goods consumption slowed most sharply, to a rate below that of population growth, the consumption of other goods also decelerated. The continued sluggishness of private consumption in 1998 may have been due to the tapering-off of the expansionary effect of purchases by immigrants who had arrived in the early 1990s (also reflected this year for the first time by a decline in residential construction), a rise in unemployment-increasing the uncertainty of many households regarding future income-and high real interest rates, possibly causing them to postpone purchases. Despite the slowdown in the growth rate of consumption, it still rose faster than disposable income, so that the net private saving rate fell.

Gross domestic investment
Gross domestic investment fell by 5.9 percent in 1998, continuing the 6.6 decline of 1997. Nevertheless, the level of investment remained high, and business-sector gross capital stock will be 6.3 percent greater at the beginning of 1999 than at the beginning of 1998-less than the equivalent rate (7.5 percent) last year, but more than the rate of growth of business-sector product and of capital stock in the past. The decline in gross domestic investment encompassed all its components. Residential investment fell by 8.5 percent (after remaining stable in 1997), reflecting the adjustment of construction activity to the decline in demand following the waning of the expansionary effects of the influx of immigrants of the early 1990s, as the proportion of immigrants from that period who are home-owners equalled that of the established population. The erosion of subsidized mortgages for eligible persons also appears to have had a restraining effect on demand, as did expectations that they would be adjusted and the higher interest rate on nondirected mortgages. However, despite the slowdown in 1998, per capita construction output was 50 percent higher in 1998 than in 1989, just before the influx of immigrants began. Nonresidential investment (excluding ships and aircraft) went down by 1.8 percent in 1998, a more moderate decline than in 1997 (4.8 percent). This moderation appears to reflect the convergence of the growth rate of capital stock to a sustainable path that fits the rate of expansion of potential GDP in the long term. Factors accounting for the continued decline in investment in 1998 include the rise in the real long- and medium-term interest rate, the persistent fall in the return on capital-because the increase in real wages outstripped that in labor productivity, along with the higher capital/GDP ratio-and uncertainty regarding the continuation of the peace process in the region. Foreign direct investment also fell in 1998, after rising in recent years.

The labor market
The slowdown in economic activity was also reflected in the labor market: the number of employed persons rose by only 1.1 percent, compared with a 1.9 percent increase in 1997 and higher rates in previous years. The number of Israelis employed went up slightly more slowly-by 0.9 percent-due to the greater proportion of foreign workers and Palestinians from the territories who were employed². As a result of this slowdown, and because the growth of the labor force did not slow, the rise in the unemployment rate, which had begun in the second half of 1996, accelerated in 1998, and the unemployment rate reached an annual average of 9.1 percent. While public-services employment rose by 3 percent in 1998³-similar to its growth rate in 1997, and exceeding that of the labor force-business-sector employment increased by only 0.2 percent. This was the result of the decline in the number of persons employed in the traditional industries and construction, and the rise in those in high-tech industries and the services. Beyond the cyclical change, the shift in the composition of business-sector employment reflects trends similar to those in many advanced economies, as income levels rise.
The growth in the number of foreign workers in Israel was checked in 1998. This appears to have been the result of the slowing of activity in the industries in which they are employed as well as of the efforts to reduce their number. However, the fact that the number of foreign workers did not fall even when unemployment rose significantly indicates how difficult it is to reverse the rising trend in their number. The number of Palestinians from the territories in employment rose by some 12 percent in 1998, as a result of which the share of non-Israelis employed in the business sector rose from 11.4 percent in 1997 to 11.6 percent in 1998.
The average real wage per employee post was about 4 percent higher in the first half of 1998 than in the same period in 1997. This represents a one percent increase in real wages in the public services (excluding the one-time grant paid to many public-services employees in their September 1998 wage-packet) and a significant 5.7 percent rise in real business-sector wages. The latter rise encompassed most of the business sector, reflecting an acceleration of the 3.5 percent wage rise in 1997, even though the acceleration of prices towards the end of 1998 may moderate the annual average rise in real wages. There were particularly prominent wage increases in manufacturing (7 percent, and a sharper increase in terms of producer prices), agriculture (4.7 percent), construction (4.4 percent), and business services (6.5 percent). The steep wage increase in the business sector is surprising in view of the continued increase in unemployment, although it can be partly explained by: a. an inflation rate that was lower than that expected at the time the wage agreements were signed, explaining about one percentage point of the rise in the real wage; b. the one percent rise in labor productivity due in part to the shift in industry composition and dismissals of low-wage workers; c. excess demand for workers in high-tech and other industries. Nonetheless, without a more comprehensive explanation of the rise in the real wage it is difficult to say whether it contributed significantly to higher unemployment. Although the direct contribution of the 8.5 percent increase in the minimum wage in April 1998 to the total rise in the average real wage was small, because of the small proportion of employees earning a minimum wage, it had a greater effect on real wages in those industries where the share of employees earning a minimum wage is relatively large. It is reasonable to assume that in those industries the rise in the minimum wage served to reduce employment.
In the first seven months of 1998 immigrant arrivals were 10 percent below the figure in the equivalent period in 1997. The decline was due mainly to the contraction of the pool of potential immigrants, but may also have been the result of the rise in unemployment in Israel. The unemployment rate among immigrants rose from 10 percent in 1997 to 12.2 percent on average in the first half of 1998. Nonetheless, the unemployment rate among immigrants who reached Israel in 1990-91 was similar to that of the general population.

Fiscal developments
The overall public-sector deficit reached 3.5-4 percent of GDP in 1998, compared with 2.5 percent in 1997. This rise reflects mainly the rapid increase in National Insurance transfer payments, as well as the more rapid growth of public-sector expenditure than of GDP. Public investment also rose markedly this year, particularly that of the local authorities. On the other hand, the tax burden (including National Insurance payments and municipal property taxes) remained unchanged in 1998. The overall deficit (excluding credit extended) of the government, the main component of the public sector, stood at NIS 8.2 billion at the end of September, and the domestic deficit was NIS 4.6 billion⁴. The development of the budget until the end of September appears to enable the overall deficit, as calculated with reference to the Budget Deficit Reduction Law, to stand near the government's target of 2.4 percent of GDP. While the domestic deficit is expected to be significantly higher than predicted in the 1998 budget-primarily because real revenues fell below the original estimate-a substantial foreign surplus, rather than the predicted deficit, is expected, largely due to greater than expected revenues in the category of the Bank of Israel's realized profits (reflecting mainly interest receipts and realized capital gains on the foreign exchange reserves).
The negotiations on the public-sector wage agreements, which expired towards the end of 1997, continued during the year. Wage agreements were signed with the teachers, airport workers, and university teachers. The negotiations with the unions organized within the General Federation of Labor (Histadrut) were only partly concluded in the agreements signed at the beginning of September, however⁵. According to these agreements, a lump-sum wage increment will be paid for 1998 without adjusting the wage schedules, and the parties went on record as limiting their demands and pledging to continue negotiating while refraining from taking industrial action before the end of the year.
Prices
From the beginning of the year until August the CPI rose by an annual rate of 3.9 percent. This rate, the lowest since 1969, brought Israel close to the inflation rates accepted in developed countries and to the price stability that is a long-term goal set by the government. However, the rapid local-currency depreciation evident since mid-August (about 14 percent against the dollar and 17 percent against the currency basket by mid-October) was expressed by a 1.4 percent rise in the CPI in September and is expected to cause prices to accelerate in the last quarter.
The sudden slowing of the rate of price increases at the end of 1997 encompassed most of the components of the CPI, as well as the indices excluding items which are characterized by wide fluctuations in the short term: both the CPI excluding housing, fruit and vegetables, and clothing and footwear, and the CPI excluding those items as well as goods whose price is controlled or monitored by the government, rose by about 4 percent in the twelve-month period to August, while the wholesale price index hardly rose at all. Inflation expectations for the next twelve months, as derived from the capital market (on the basis of the gross yield gap between indexed and unindexed bonds), fell during the period reviewed to their lowest level since they were first calculated in the early 1990s-6 percent on average-compared with 9.3 and 12 percent in 1997 and 1996 respectively. However, there was some acceleration of the rate at which the adjusted indices rose during the year, and these went up by 3, 4.4, and 6.1 percent in the first three quarters respectively. Since August there has also been a marked increase in expected inflation (see below). In view of the acceleration expected in the rate of price increases following the shekel depreciation since August, Israel is returning to the inflation environment that prevailed previously, and its consolidation depends on the resolution with which policy is maintained, the development of prices abroad, and other fundamentals in Israel and abroad.
The decline in inflation until August was assisted by monetary policy, which served to consolidate the lower rate of price increases, and by the fiscal discipline introduced during 1997 and maintained in the first half of 1998. Together with other weighty factors, policy contributed to the slowing of domestic demand, which was a major determinant of the decline in the rate of inflation, as well as to the lowering of inflation expectations. The decline in inflation was also due to exogenous factors, including the persistent fall in import prices (in dollar terms), since the beginning of 1996, of both manufactured goods and raw materials and fuel. This decline is part of the process of the moderation of global inflation rates in the last decade, and also expresses the effect of the recent crises in East Asia, Russia, and South America, contributing to the dampening of global demand. The structural reforms that served to increase competition also brought about a reduction in the rate of price increases.
Among the components of the CPI, housing stands out, rising by 1.3 percent in the twelve months to August 1998-about one tenth of its average rate of increase in 1992-97. This reflects a sharp drop in excess demand for housing, due to a decline in demand and a significant rise in supply. The rise in export prices, as derived from National Accounts data, outstripped that of GDP prices, reflecting the change in the trend of real appreciation that has prevailed for a long time. Import prices continued to rise more slowly than GDP prices in 1998, due to the steep fall in the dollar price of imports, but the real appreciation in import terms moderated significantly in comparison with the previous two years.

The balance of payments
The balance of payments current-account deficit contracted to$ 2.2 billion (2.2 percent of GDP) in 1998, continuing the declining trend that has been evident since 1997, from its peak of $ 5.1 billion (5.6 percent of GDP) in 1996. In 1998, too, the main cause of the fall in the deficit was the improvement in the terms of trade (with a decline, in dollar terms, in the prices of imports and exports). An analysis of the improvement in the trade balance-1.4 percent of GDP-in terms of investment and saving explains this improvement as a decline in investment of 1.9 percent of GDP and a reduction in the gross saving rate of 0.5 percent of GDP. In quantitative terms the rate of growth of exports (excluding diamonds) fell-from 9.1 percent in 1997 to 6.1 percent in 1998-reflecting mainly the abrupt slowing of the expansion of international trade, from 9.7 percent in 1997 to 3.7 in 1998, in the wake of the crises in East Asia, Russia, and South America. In addition, exports were adversely affected by the continued contraction of incoming tourism, further exacerbated at the beginning of the year by the tension in the Persian Gulf, and by the continued fall in commerce with the territories. The volume growth rate of imports (excluding defense imports, diamonds, and shipping and aircraft) accelerated to 4.7 percent (compared with 3.1 percent in 1997)-despite the slowdown in GDP growth-apparently reflecting the effect of the relative decline in import prices.
Manufacturing exports continued to expand rapidly in 1998-by 7.7 percent in volume terms-albeit more moderately than the 12 percent growth rate of 1997; the trend change in the structure of manufacturing exports persisted, those of the human-capital-intensive high-tech industries expanding rapidly while those of the traditional industries stagnated. The rise in services exports (excluding capital services and tourism) also moderated in 1998-to 5.4 percent, compared with 9.9 percent in 1997-but the decline in exports of tourism services decelerated, to 2.3 percent, compared with 8.5 percent in 1997. Diamond exports plummeted in 1998 as a direct result of the crisis in East Asia-a major market for Israel's diamond trade-but net exports (excluding diamond imports) actually rose, apparently because of a decline in inventory. As an annual average, exports were up over 1997, but in May-September there was a trend decline in their dollar value.
Imports fell in dollar terms in 1998, with a moderate increase in imports of intermediates and consumer goods alongside a decline in imports of capital and durable goods, albeit at a more moderate rate than in 1997. These data continue to reflect the slowdown in investment. Services imports (excluding capital and labor services) rose by 2.8 percent, along with an increase in expenditure on tourism (3.5 percent, or 9.8 percent in volume terms).
Capital inflow plummeted in 1998, continuing the trend that had begun in the second half of 1997. In the first half of the year capital inflow amounted to $ 2 billion, compared with $ 8.7 billion in the equivalent period in 1997, principally because net short-term borrowing abroad stopped, alongside the slower rise in foreign-currency credit to residents. This trend reflected developments on the foreign-exchange market and the narrowing of yield gaps, the result inter alia of the internalization of exchange-rate risk by economic agents, making this credit less attractive. Other causes of the fall in capital inflow in 1998 were the decline in nonfinancial investment in Israel by nonresidents, which was down by about $ 240 million in the first eight months of the year over the same period in 1997, and a sharp drop in nonresidents' investments in Israeli shares.
The Bank of Israel's foreign-exchange reserves reached $ 21.7 billion in September 1998, compared with $ 20.3 billion in December 1997.

  Monetary developments
The object of monetary policy in 1998 was to consolidate the lower inflation environment, in accordance with the long-term goal of price stability set by the government; the rate at which prices rose until August reflected more rapid progress than planned towards this goal. In 1998 special caution was required in implementing monetary policy because of the need to reduce the risk of a crisis in domestic financial markets, in view of the economic and financial crises and instability in many developing countries. The experience of these countries shows that the damage inflicted by a financial crisis is not restricted to price stability, and can extend to the real sector, too.
Consequently, and considering the inflation environment, the Bank of Israel gradually reduced its key interest rate, which is the principal monetary instrument, during most of the year until August. The interest rate was reduced from a nominal 13.7 percent at the end of 1997 to 11 percent at the beginning of August 1998, in several stages of between 0.3 and 0.5 percentage points. The adjustment of nominal interest was slower than the decline of the rate of price-increases and expected inflation-a development that was expressed in the rise in the real interest rate from an average of 5 percent in 1997 to about 7 percent in July 1998.
At the beginning of August three measures were introduced: an inflation target of 4 percent was set for 1999, the slope of the lower limit of the exchange-rate band was moderated from 4 to 2 percent, and the Bank of Israel's key interest rate was reduced by 1.5 percentage points.
The exchange rate of the NIS against the currency basket remained close to the lower limit of the band for most of the first half of 1998, but without any need for the Bank of Israel to intervene in trading (except for a few days at the beginning of the year). In April, because of the uncertainty that accompanied the announcement of a new stage in the relaxation of foreign-exchange controls, the NIS depreciated by 3.6 percent against the currency basket but, as in the previous episode (June 1997), it appreciated again by about 1.7 percent in May. From August to mid-October (the time of writing), after the policy changes had been announced, and together with the emergence of the global economic crisis accompanied by considerable volatility in the financial markets, the NIS depreciated by some 18 percent against the currency basket. This depreciation expresses the response of the business sector (including foreign investors) to shocks to the world economy, the internalization of greater exchange-rate risks, and expectations of depreciation.
In the wake of the deceleration of the rate of price increases since the end of 1997, inflation expectations (derived from the capital market) declined, too, falling from 9 percent to less than 5 percent in May-July 1998. Developments on the financial markets in August and September were also expressed in a steep rise in inflation expectations (as measured from the capital market), to over 6 percent in September and over 10 percent at the beginning of October. This rise seems to reflect assessments of the increased probability, inter alia due to the rapid depreciation, that the inflation rate will accelerate in the next few months (even though not necessarily in the long run), but it probably also reflects a rise in the risk premium required by investors in unindexed assets, because of increased uncertainty as to price developments. As a result, the derived expected real interest rate fell from 7 to 2.7 percent in September.
M1 expanded by 16 percent in the twelve months to September, outstripping the growth rate of nominal GDP and even those of prices and potential GDP. Note, however, that some increase is in line with the decline in nominal interest, which serves to raise the demand for money at all levels of activity. Short-term (less than a year) interest-bearing local-currency deposits expanded in 1998 (until September, in annual terms) by a relatively rapid 19 percent, expressing a steeper increase in time deposits and of only 16 percent in SROs. Deposits denominated in and indexed to foreign currency expanded in the first nine months of the year by 24 percent in annual terms (11 percent in dollar terms).
Nondirected bank credit expanded by 16 percent (up to September, in annual terms)-a slightly slower rate than in previous years but faster than that of nominal GDP. Since the second half of 1997 the expansion of credit denominated in and indexed to foreign currency has slowed sharply (after rising at an annual rate of over 40 percent in dollar terms in the first half of 1997), and in the twelve months to end-September 1998 its share of credit has remained stable. Nevertheless, the rise in its share of total credit in the last few months increases the exposure and vulnerability of the private sector (and hence also of the banking system) to exchange-rate risk, especially at a time of increasing financial instability and exchange-rate volatility worldwide.