BANK OF ISRAEL
Office of the Spokesperson and Economic Information
July 7, 2014
Press release
Remarks by the Governor of the Bank of Israel at the Knesset Finance Committee
The Governor of the Bank of Israel spoke today to the Knesset Finance Committee. The
following are the main points of her remarks.
My lecture will cover the macroeconomic environment, monetary policy and our
considerations when formulating it, and I will refer as well to the foreign exchange
market, to financial stability, and to the fiscal situation.
A macroeconomic survey of Israel’s economy begins naturally with the global economic
situation, because as a small and open economy we are very affected by the economic
situation worldwide. World trade is the most important global variable in terms of the
impact on Israel’s economy, because it reflects the demand for Israel’s exports. In 2012–
13, world trade increased at a relatively low rate of 3 percent and below, and in 2014 a
recovery is expected, though we still don’t see it in the data. From the perspective of our
major export markets, the situation in Europe still reflects an expectation for very
moderate growth, and in the US, despite expectations for recovery, the first quarter was
marked by negative growth, and we still don’t see a full recovery.
GDP in Israel grew by 2.7 percent in the first quarter of 2014. This is a low rate relative
to the past, but is higher than the growth rate we see in major advanced economies. In the
first quarter we saw a troubling development of moderation in private consumption,
which was a stabilizing component of growth throughout the years of the crisis, in
contrast to exports which suffered from the moderation in world trade. We assess that the
weakness in private consumption is temporary, but it is nonetheless troubling when we
examine the recent period’s data. In the past two years, exports, in particular goods
exports, were disappointing. This is of course related to sharply declining world trade, but
also to exchange rate developments. Services exports continue to increase over the course
of the period, and this is definitely an encouraging development.
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Labor force data are good, both compared to the past and compared to the global
environment. The unemployment rate, which increased for a relatively short period at the
worst part of the global crisis, is in a trend of decline, which has drawn out despite the
labor force participation rate continuing to increase, and thus the employment rate has
increased. It should be noted that this is a very different development than in major
advanced economies—in the US we saw a decline in unemployment with a sharp decline
in the participation rate—people left the labor force after assessing that their chances of
finding work are small. By us, people are joining the labor force, a phenomenon which
also includes relatively weaker populations—these people join the labor force at a low
wage, of course, but the result is an increase in household income, as I will show in a bit.
In the housing market, we have seen a sharp increase in prices since 2007, after an
extended decline in real prices in the decade prior to the current rising cycle. At the
beginning of the process, home prices increased in line with rents, though in recent years
rents have increased at a much more moderate rate than home prices. The most direct
route to moderating home prices is, of course, increasing the supply. In recent years there
has been an increase in the rate of building starts, and we assess that should construction
continue at its current rate of over 40,000 new homes per year—a rate which is greater
than the increase in number of households—with an emphasis on areas in high demand,
we will be able to see a change in the trend in home prices. The decline in building starts
in the recent quarter is certainly troubling in this regard.
Monetary policy works, as its central goal, to achieve price stability, and subject to that,
to support economic policy and financial stability. The tools at our disposal are the Bank
of Israel interest rate, direct intervention in the foreign exchange market, and since the
Banking Supervision Department is part of the Bank of Israel, we also have a range of
macroprudential tools that the Supervisor of Banks can utilize. Inflation over the previous
12 months was 1 percent, at the bottom of the target range, and no less important are
inflation expectations, both short term and long term, which are within the target range,
indicating that the Bank of Israel’s monetary policy is relied on by the public, which
believes that the inflation target will be maintained over time.
In the past decade the Consumer Price Index has increased by about 25 percent—that is,
an average rate of about 2.07 percent per year, very close to the midpoint of the target
range. Various components of the CPI increased at a more rapid pace, which lead to the
public’s sense that the cost of living increased during those years. We are of course very
aware of the price increases of certain components, such as food and housing, though less
attention is paid to the more moderate increase, and even decline, in components such as
clothing and footwear, education, and communications. Such a detailed analysis indicates
where it is nonetheless important to focus our efforts, and it is clear that promoting
competitiveness can impact on the cost of living—in the area of food, for example.
Furthermore, the salary per employee post increased only slightly relative to the CPI over
the course of the period, though net household income increased more, very similar to the
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rate of increase in per capita GDP. The implication is that the benefits of growth trickled
down to households, whether that is due to more people joining the workforce or is the
result of a decline in taxes.
Getting back to monetary policy, the Bank of Israel interest rate is currently 0.75 percent,
slightly higher than interest rates in major advanced economies, and much lower than
interest rates in emerging markets, some of which still have problems of inflation, and
some of which experienced sharp depreciations. We saw a relatively rapid appreciation of
the shekel in the first half of 2013, in light of relative geopolitical calm and, at the same
time, the beginning of natural gas production. Since then the pace of appreciation has
moderated. In 2013 many currencies strengthened against the dollar, while the shekel’s
appreciation against the dollar was relatively atypical. In 2014, the shekel has
strengthened by about 1.6 percent against the dollar, but we are not atypical in this
regard, and in many countries, such as New Zealand, Australia, and the UK the
currency’s appreciation against the dollar was much sharper.
What is behind the appreciation in Israel? Israel’s economy is in a relatively good
situation. We have a continuing current account surplus, and net foreign direct investment
by nonresident investors who see Israeli companies as attractive for investment. This all
means that there are basic forces which are leading to an inflow of foreign currency into
the economy, and these are forces which policy does not attempt to offset. In addition, in
the period up to the first quarter of 2013, nonresidents sold foreign exchange, and this
contributed to shekel appreciation. Since then, there is no real trend in nonresidents’
activity in the foreign exchange market; that is, we can’t say that it is nonresidents who
are leading to the prolonged appreciation. In recent weeks, we again see nonresidents
selling more foreign currency, but it is still difficult to establish that this is a change in the
trend. In contrast, in 2011, when the Bank of Israel interest rate was much higher than
that in the US, we saw the entry of nonresidents into short term investments, and at that
time we also took steps that stopped that trend.
Institutional investors invest part of their assets under management abroad, which should
have contributed to weakness of the shekel. However, institutional investors hedge their
investment abroad against currency appreciation, an activity that involves selling foreign
currency, and thus we don’t get the support such activity could have given us toward
weakening the exchange rate.
As I noted, the policy does not attempt to act against the basic macroeconomic forces
which lead to the appreciation of the shekel. In March 2008, the Bank of Israel began to
increase the foreign exchange reserves to a level in line with the needs of the Israeli
economy. In retrospect, the lessons of the financial crisis indicated that countries with
high levels of foreign exchange reserves were more resilient in the face of the effects of
the crisis. There are currently two components of the Bank of Israel’s policy in the
foreign exchange market. Beginning in August 2009, the Bank has intervened in the
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market when there have been unusual fluctuations in the exchange rate that are not in line
with fundamental economic conditions, or when the foreign exchange market has not
operated in an orderly manner. In May 2013, the Bank launched the “natural gas plan”,
which is intended to moderate the pressure on the exchange rate as a result of the
production of domestic natural gas (“Dutch disease”), and within this framework the
Bank of Israel began to purchase foreign exchange on the market, and committed to do so
at least until a sovereign wealth fund is established in 2018.
Among the Bank’s objectives, we also deal with financial stability. A radar diagram can
show that the risks in the domestic and global financial systems are markedly lower than
the level they were at during the global financial crisis. Specifically, domestic financial
market risk is very low, but it should be remembered that it measures the risk as reflected
in the market, and to the extent that the risks are underpriced, a chart like that would not
show it. In general, the domestic financial market continues to display stability despite a
challenging global environment, and low interest rates in Israel and abroad. The main
risks to the system are the high exposure of households to the housing market, which is
liable to present a risk should there be changes in market conditions, including
employment and the interest rate, and the underpricing of risks in the corporate bond
market, which is liable to impact on the allocation of resources in the economy and on
pension savers.
In the housing market a rapid increase in outstanding mortgages over time can be seen, in
parallel with an increase in the share of housing credit in the banks’ overall credit
portfolio. This is a risk that we are aware of, and also act to reduce, and the steps taken by
the Supervisor of Banks have markedly reduced the risk characteristics of new
mortgages, as reflected in, for example, the loan to value ratio and the payment to income
ratio.
In the corporate bond market there has been a decline in spreads against the background
of accelerated net investment in corporate bond mutual funds, which are buying bonds
that don’t necessarily meet all the standards met by bonds that are purchased by
institutional investors. This is definitely a component of risk that we must be aware of.
The banking system remains robust. The core capital ratio is about 9.4 percent, and the
return on equity is around 8.7 percent. The system continues to increase the volume of
credit to households, in parallel with continued contraction of credit to the business
sector. As we published last month, operating efficiency in the banking system is low in
international comparison, and steps are needed to improve efficiency, including reducing
salary expenses and balancing the remuneration mechanisms for senior executives. In this
regard, I will note that the Supervisor of Banks was the first regulator to issue guidelines
with regard to senior executive salaries, which are intended to ensure that the senior
executive remuneration structure does not provide incentives for taking on excess risks,
and the banks, of course, implemented the Supervisor’s guidelines. The Minister of
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Finance is promoting a bill that would affect the norms for senior executive salaries. I am
definitely of the opinion that there is a place for that, and I believe that norms need to be
broad, and not focused on a specific sector, such as the financial sector, in light of the fact
that this sector manages other peoples’ money. I think that these norms should apply as
well to companies which benefit from monopolistic power, on those that have purchased
assets from the state, that manage natural resources, that have benefited from
concessions, and so on—I believe that the norm should be extended to all public
companies, and I am sure that as the norm expands, the banks will also meet it.
The Banking Supervision Department is very diligent in promoting competitiveness and
fairness in the banking system, and in the past year it dealt with several main issues in
this regard: managing a current account through various fee tracks, dealing with fees
(cancelling, reducing, repricing, increasing transparency), making it easier to transfer
payment orders between bank accounts, opening bank accounts over the Internet,
formulating a framework for bringing in a new player—credit union, and more. There are
important issues that are still being dealt with, such as a periodic comprehensive report to
the customer (banking ID), a system to identify dormant accounts, publishing
comparative data on interest rates, and more.
The government budget deficit is expected to meet the target this year, but it is important
to note that in light of the relatively good macroeconomic state of the economy, it is a
relatively high deficit by international comparison. The debt burden is in fact low
compared with previous years, but the burden of interest payments is high by
international comparison, due to the risk premium that the Israeli economy must pay. I
want to explain why I think that we need to continue to work to reduce the debt burden.
In 2002, the debt was about 100 percent of GDP, and when the economy was hit by a
recession and the deficit soared due to the macroeconomic situation, yields jumped to 12
percent. This was a signal to the government that it must reduce the budget, and it was
forced to do so at the height of the recession, thus making it sharper. In contrast, in 2009
we were forced to again increase the deficit, when faced with the global economic crisis
and its effect on the growth of the economy, but yields did not rise because it was clear
that we were after a prolonged effort to improve the fiscal situation, and that the increase
in the deficit was temporary in light of the crisis. When the government acts in a manner
which indicates fiscal reliability, investors show the readiness to finance a deficit to the
extent it occurs as a result of an unexpected shock.
In response to Knesset members’ questions, the Governor added:
As far as the impact on the economy of the geopolitical situation, there is no doubt that an
improvement in the geopolitical situation will positively impact on the economy. At the
same time, the Israeli economy displayed resilience in the face of previous geopolitical
events, such as Operation Cast Lead and the Second Lebanon War. Now, as well, we do
not see an increase in the perception of the economy’s risk. In light of the events of recent
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days, I will perhaps note that I hope that we succeed in getting back to restraint and
maintain the delicate fabric of Israeli society with all its sectors.
As far as the proposed zero VAT on homes law, as I noted in the past, I believe that the
proposal is likely to fan home price increases in the short term, in light of the fact that
what is required in the market is increased supply. The proposal also refers to tight
supervision of prices and specifications, and I believe that it will be very difficult to apply
this supervision. Thus, I am concerned that the benefit is liable to mainly reach the
pockets of the contractors and not those of households, perhaps through informal
arrangements between buyers and contractors, and thus it will not achieve its goal.
Likewise, despite the proposal being changed since it was first presented, it still does not
provide a response for the weakest population groups. Another issue is the permanent
effect of the proposal on the tax system: the proposal is brought to deal with a problem
which exists today but it is not clear if it will still exist in the distant future, but in the
future it will be difficult to forego the exemption, and we know many exemptions which
were granted in the past and are difficult to cancel today.
As far as employing Arab and ultra-Orthodox employees at the Bank of Israel: There are
currently eight Arab employees at the Bank of Israel, as opposed to two a few years ago,
and nine ultra-Orthodox employees have joined, though it is not clear if we can always
identify who is ultra-Orthodox. In any case, the percentage is still low relative to the
share of these sectors in the overall population, and I believe that we need to continue to
make efforts in this area.
As far as credit to small businesses: The volume of bank credit to small businesses
increased by 7 percent in 2013, to a level of NIS 70 billion, and the increase is partly the
result of banks’ efforts in this area. Progress in the area of securitization will also help to
expand the supply of credit to small businesses.
As far as the exchange rate: I noted the issues that we are working on, including dealing
specifically to offset the effect of natural gas production on the exchange rate. There are
also some issues that are not in our court, such as cancelling the tax exemption for
nonresidents in bond investments. We follow the developments in the exchange rate, and
also study the policy measures adopted in other countries. As I noted, the developments
this year in the exchange rate are not atypical when compared with other countries.
As far as the economy in the Arab sector: There is no doubt about the importance of
economic activity in the Arab sector to the overall economy. This is an area in which the
Bank of Israel does not have policy authority, except for my role as economic advisor to
the government, in the framework of which we conduct research and publish policy
recommendations.
As far as credit unions: Setting up credit unions was one of the recommendations in the
report issued by the team to increase competitiveness, headed by the Supervisor of Banks.
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We believe that it is appropriate to provide the conditions for setting up these unions, we
recently published a draft document that describes the credit union licensing process, and
we requested responses from the public to the document. The last thing we want in this
regard is to allow the setting up of credit unions that will not be stable. We studied the
issue and the models around the world, and in our assessment the capital requirements we
presented are those that will ensure that unions such as these that are set up will be stable
and will be able to operate for a long time.
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