Country Report Israel
The Israeli economy is likely to continue to grow at a moderate pace, while the strong growth of mortgage debt and the rise of housing prices pose risks. Meanwhile, the latest round of peace talks with the Palestinians collapsed in late April.
Strengths (+) and weaknesses
(+) Strong institutions
Israel has strong institutions and a well-developed education system, which have contributed to a high level of human development and a high GDP per capita.
(+) Diversified and advanced economy
Israel has a modern and advanced economy and a business environment that promotes innovation. The economy is relatively open and the agricultural, industrial and services sectors are all well-developed.
(-) Conflict with Palestine to continue
The territorial dispute over the West Bank and Gaza Strip between Israel and the Palestinians is unlikely to be resolved soon after recent peace talks collapsed (see key development 3).
(-) Heightened geopolitical risks
Tensions with Iran over its nuclear proliferation program and with Syria over alleged armaments to Hezbollah are expected to remain high.
1. Economy likely to continue to grow at moderate pace
Israel’s economy grew by 3.4% in 2012 and 3.3% in 2013, which are moderate growth rates by recent Israeli standards. In both years, growth was primarily driven by private consumption (see figure 1). Private consumption is likely to remain the main driver of growth in 2014, as inflation has remained low and unemployment was 5.8% in the first quarter of 2014 and is thus at a historically low level. However, a weakening of the housing market (see key development 2) would lower consumption growth. Meanwhile, fiscal policy is likely to have a negative impact on near-term growth, as the government imposed tax increases and spending cuts in the two-year 2013-2014 budget. This helped to bring the fiscal deficit down from 3.9% of GDP in 2012 to 3.2% in 2013 and this improvement is expected to continue in 2014. Export growth is likely to benefit from the recovery in the United States and the European Union, which are both important export markets for Israel. This, together with the growth of domestic gas production, are likely to result in a further widening of the current account surplus (see figure 2). Overall, we expect the Israeli economy to continue to grow at roughly 3.5% in 2014.
2. Housing market risks
In recent years, house prices and mortgage debt have risen rapidly in Israel. Between 2007 and late 2013, house prices rose by 80% in nominal terms and 50% in real terms. This strong increase can be explained on the one hand by favourable lending conditions, as low interest rates on the back of the monetary easing implemented in response to the global financial crisis boosted demand for housing. On the other hand, supply constraints in the form of a lack of land of which houses can be built and a long approval process - it is estimated that there are 11 year between the moment that land is converted into land for development and the moment that a building permit is granted - also played an important role. According to a recent IMF analysis, house prices in Israel are 25 percent higher than medium-term fundamentals would suggest and that they are also high by international standards. Also, given the fact that the mortgage debt to GDP ratio has increased rapidly, there is the risk of a price correction, which could lead to a weakening of consumption. In response to strong increase of house prices, the central bank has taken several macro-prudential measures in recent years. It, for example, capped the loan-to-value (LTV) ratio at 75% for first time buyers and at 70% for all other buyers. Furthermore, capital requirements for banks on mortgages were increased for mortgages with a relatively high LTV. However, the IMF has stated that a further tightening of macro prudential regulations might be necessary if house prices continue to rise rapidly.
3. Peace talks collapse
In late April 2014 the latest round of talks between Israel and the Palestinians, which had started in July 2013, collapsed. There have been several rounds of talks on an Israeli-Palestinian peace since the Madrid conference in 1991, but none of them has resulted in a major breakthrough. This time, John Kerry, the US secretary of state, invested a lot of time in the talks between the Israeli government and the Palestine Authority (PA). However, during the talks, the positions of both parties hardened. The Palestinians lost trust in the process as Israel continued the expansion of its settlements on the West Bank. In the last stage of the talks, Israel declined to negotiate with the PA when a reconciliation agreement between the PA, which controls parts of the West Bank and Hamas, which controls Gaza, was announced. It has yet to be seen though whether the PA and Hamas will be able to reach the goal of having a unity government within six months, given the deep divisions between both movements. Meanwhile, Israel has condemned the interim deal concluded in November 2013 between Iran and the UN Security Council members of the and Germany over Iran’s nuclear programme. Nevertheless, this agreement seems to have reduced the likelihood of an Israeli military strike on Iran’s nuclear facilities.
Israel has a multi-cultural society. A large part of the population is of Palestinian background, the dominating Jewish population is a heterogeneous melting pot of mainstream ‘Jews from everywhere’. This has led to a highly fractious political landscape, in which several parties form a coalition but have very little common ground. As a result, coalitions seldom last a full term, which makes it difficult to implement meaningful socio-economic reforms. At the same time, Israel is the only (more or less) democratic state in the Middle East. The continuing construction of settlements on the West Bank, which Israel has (largely) held under its control since the 1967 war, has resulted in a lot of international criticism. Inequality remains an issue in Israel, as the Israeli Arab and the ultra-Orthodox communities are much poorer than the rest of the population. Both communities grow much quicker than the rest of the population. Israel has a technologically advanced market economy with substantial, though diminishing, government participation. Due to limited natural resources (apart from new finds of huge gas reserves and some potash), Israel has intensively developed its agricultural, industrial and service sectors over the past 20 years. The economy is open and flexible and exports are oriented towards advanced economies. Israel imports substantial quantities of grain, but is largely self-sufficient in other agricultural products. Israel spends a higher proportion of its GDP on private research and development than any other country in the world. The high-tech nature of the economy is to a large extent driven by military security needs, but has had significant spill-over effects to civilian industrial applications.