Turning the Corner: Israel’s Economy Looking at A Sustainable Recovery

By Scott B. MacDonald

NEW YORK (KWR) The last few years have been difficult for the Israeli economy. The ongoing media show of terrorist attacks, fractious public debates about settler colonies, and the construction of a wall to separate Israelis and Palestinians have conveyed the image of an economy in shock. Indeed, the combination of difficult global economics and local problems overshadowed the Israeli economy and created a somewhat pessimistic outlook. It now appears that the tide is turning and prospects for 2004 look better.

Although the 2000-2003 period witnessed one of the most difficult economic downturns in the Israeli economy, credit should be given to the important transformation that occurred during the 1980s and 1990s. Throughout much of the pre-1980 period, the Israeli economy was considerably more statist in orientation, given to regulatory and bureaucratic intervention. While the state sought in a fashion to control the commanding heights of the economy, labor laws were rigid and a sizeable amount of the work force was unionized. Although there was a degree of job security and a considerable focus on national security (with major conflicts fought in 1948, 1956, 1968 and 1973), the cost was felt in slow growth and high inflation.

During the 1980s and 1990s, economic reforms liberalized labor markets, reduced the state's role in the economy and provided a stimulus for private sector development, especially in the high-tech sector. This resulted in rapid, yet balanced, economic expansion, rising per capita incomes and employment generation. The development of the high tech sector was able to take advantage of one of Israel's major strengths, its highly educated and skilled labor force.

In 2000 the tide turned against the Israeli economy. From 2000 to 2003, a combination of Middle East violence (a second Iraq war and an upswing in tensions with the Palestinians) and a global decline in orders for computer parts and telecom equipment resulted in a sustained economic downturn, with high unemployment (10.7% at year-end 2003). Middle Eastern violence hurt tourism and foreign direct investment as well as forcing the government to spend more money on security (swelling the fiscal deficit to 7.5% of GDP in the first half of 2003). The global decline in high-tech orders had a heavy impact on the export sector. Complicating matters, the country's politics have been far from stable. While Ariel Sharon has managed to maintain his position as prime minister, his coalition has been fractious and scandals (one of which included the Prime Minister's son) have undermined confidence in the government. Real GDP in 2003 was a disappointing 1.3%, helped along by marginal consumer demand of 2%.

Despite the difficulty of the last three years, conditions for a sustainable economic recovery are now in place. In the fourth quarter of 2003, real GDP growth was 2.6%. The main drivers were growth in private consumption of 7.2% and export expansion. We expect these trends will continue in 2004. Real GDP for this year should be in the 2.6-3.1% range. The Bank of Israel (the central bank) has been accommodative, recently dropping interest rates to close the gap with the United States. In addition, key global markets for Israeli products are once again expanding. In 2003, the high-tech sector's output was 5.3%, the first positive numbers since 2000. The sector was clearly helped by a depreciation of the shekel against the currency basket in 2003 and 2003. Indeed, high-tech exports were up in 2003 to $10.2 billion, accounting for 25% of goods & services exports (up from 2002's $8.8 billion).

Based on data from a range of Israeli tech companies, 2004 is looking like it will only be better. Export expansion is expected to be a healthy 7% (up from last year's 3.3% and a dismal 1.5% in 2002). Private Israeli economists are also looking for further expansion of consumer spending. Consensus puts consumer growth at 2.8% for 2004, after 2.0% in 2002 and 0.1% in 2002.

Israel’s economy is also likely to continue benefiting from a healthy flow of foreign direct investment (FDI). FDI peaked in 2000 at $5 billion, much of it going into the high tech sector, including start-ups. Although 2001 saw an additional $3.5 billion of FDI, 2002 saw it fall to $1.6 billion, roughly the same level as in the mid-1990s. Although 2003 was a difficult year for the economy, filled with uncertainty, FDI bounced back to $3.6 billion. Once again Israeli high-tech was an attraction. That trend is expected to continue in 2004.

Israel is also set to maintain control of the fiscal imbalance in 2004. Last year, the fiscal deficit was as wide as 7.5% of GDP, but ended the year at 3.9%. The target for 2004 is 4%, which barring any major unforeseen expenditures (which can never be ruled out in the Middle East), should be attainable.
To be certain, Israel still faces considerable challenges. The highly fragmented nature of the political system constantly makes for difficult-to-hold together coalitions. Domestic debt remains high and there is a need to reduce public sector debt (standing at year-end 2003 at 106% of GDP). Last, but hardly least, terrorism remains a strong negative factor. Part of the problem is directly linked back to the ongoing challenge from the Palestinian Authority, which is supported to varying degrees by regional governments. There are other more radical Palestinian groups, Hamas and Hezbollah that represent terrorist threats as well. Without the deadly and disruptive nature of terrorist attacks, the Israeli economy would be far more geared for growth. All this being said, Israel still has considerable strengths, which outweigh the negatives.