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WorldOctober 1 2014

Israel CBG: Interest rate cuts target weak economy

A year into Karnit Flug’s tenure as governor of the Bank of Israel, James King looks at the impact of her stewardship on the broader economy.
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Israel CBG: Interest rate cuts target weak economy

When Karnit Flug was appointed governor of the Bank of Israel in October 2013, the export-intensive Israeli economy was grappling with the effects of diminished growth in the US and Europe. The slowdown in exports ultimately hit the country hard as gross domestic product growth for the year reached a lower-than-expected 3.3%.

Nevertheless, in the first year of her role, Ms Flug has been widely praised for her stewardship of the Israeli economy. Under her guidance, the Bank of Israel has maintained a loose monetary policy, while taking action, when needed, to promote stability and diversity in the country's economy.

Interest rate cut

This year export growth in Israel has remained relatively muted. The appreciation of the shekel has not helped, with elevated levels of foreign investment into the country’s hi-tech sector and rising natural gas production both pushing the currency higher. Yet, the decisive intervention of the Bank of Israel over two consecutive months to cut interest rates to 0.25% has gone some way to improving this situation.

“The two interest rate cuts in August and September this year were motivated by low inflation and declining inflation expectations, as well as the weakness in economic activity. We are quite pleased with the effect on the exchange rate and we have seen some weakening of the shekel since. Continued depreciation should support the tradable sector. This is particularly important given the nature of the weak global environment,” says Ms Flug.

Recent data covering the second quarter of 2014 points to a similar set of challenges this year, although the slowdown is likely to be more pronounced. Based on current estimates, GDP growth in Israel is expected to hit 2.3% for the year, with the effects of the recent hostilities in Gaza playing a small but notable role in denting short-term growth.

“We do expect some further slowdown in the third quarter as a result of the recent hostilities in Gaza. However, most of this impact will probably be over the short term, especially the effect on private consumption,” says Ms Flug.

Hi-tech sector

Despite these sizeable challenges, Israel’s economy remains broadly resilient in terms of longer term potential. Moreover, positive growth indicators have emerged from some sectors, particularly those driven by Israel’s world-beating hi-tech industry.

“If we look a bit deeper into the export sector, what we see is that exports of services have continued to grow quite strongly, even above the trend of world trade in services,” says Ms Flug. “The service sector is more hi-tech oriented and seems to be less affected by the weaknesses in the global economy as well as the strengthening of the shekel.”

Moreover, the prospects for the development of Israel’s massive natural gas reserves are presenting opportunities for the country’s economic growth. Here, the Bank of Israel is playing a crucial role by executing a foreign exchange purchasing programme to maintain balance in the domestic economy.

“The Bank of Israel has introduced a programme to purchase foreign exchange in order to offset the effect of any excess in foreign exchange resulting from the country’s natural gas hitting the market,” says Ms Flug. “This is to alleviate the potential emergence of the so-called ‘Dutch disease’ as a result of that gas production. And we will continue this policy, at least until an Israeli sovereign wealth fund is established. The fund will start operating around 2018 and will invest tax receipts coming from the natural gas production overseas.”

Meanwhile, an agreement over Israel’s macroeconomic priorities in the 2015 budget was reached in late September. Prior to this, there had been a degree of conflict over demands by the ministry of defence for a NIS11bn ($3bn) increase in spending on the armed forces. While this demand was being opposed by the finance minister and treasury, a number of leading figures in the governing coalition ultimately secured a NIS6bn increase. The challenge, however, is that Israel is aiming for a longer term deficit target of no more than 3%.

“There are obviously additional defence needs that would have to be included in the budget but, as it is, our civilian spending is relatively low compared to other advanced economies. So to accommodate these defence needs and civilian expenditure would mean that in order to meet the deficit target of no more than 3% we would have to increase revenues either by reducing tax exemptions or by increasing some tax rates. In policy terms, this will be a difficult path to follow,” said Ms Flug before the budget had been approved.

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Read more about:  Middle East , Israel