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Country Report Israel

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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, a new round of peace talks with the Palestinians is not obvious under a new government that is dominated by nationalists and ultra-Orthodox parties.

Author: Jan-Willem van Tongeren (trainee)

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.

(-) Heightened geopolitical risks

Tensions with Iran over its nuclear proliferation program and with Syria over alleged armaments to Hezbollah are expected to remain high.

Key developments

1. Economy likely to continue to grow at moderate pace

Israel’s economy grew by 3.4% in 2013 and 2.8% in 2014, 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 2015, as inflation has remained low and unemployment stood at a historically low level of 5.4% in the first quarter of 2015. However, a weakening of the housing market (see key development 2) could lower consumption growth. The budget deficit (2.7% of GDP) and public debt level (66% of GDP) stabilised in 2014. Monetary policy acted to support activity, exports and the exchange rate, and the return of inflation to the target range. After a depreciation of the Shekel in the second half of 2014, there were renewed appreciation pressures in recent months in light of monetary easing in many of Israel’s main trading partners. 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, is 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 2015. Although Israel has a sound and well capitalised banking sector, it is increasingly exposed to the risks of rising house prices and expanding housing credit (see key development 2).

2. Housing market risks

In recent years, house prices and mortgage debt have risen rapidly in Israel. Between 2007 and late 2014, house prices rose by about 90% in nominal terms and 60% 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 years 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 (2013), 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 and economic growth. Although this will have serious effects, the impact on Israel’s banking sector will be relatively limited as the sector is underpinned by strong and intrusive supervision and a sound loan to deposit ratio (approximately 85%). 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 / 70% for all other buyers and introduced debt-service to income limits. Furthermore, capital requirements for banks on mortgages were increased (again) 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.

Figure 1: Economic growth
Figure 1: Economic growthSource: EIU
Figure 2: Current account balance
Figure 2: Current account balanceSource: EIU

3. New government with small majority and conflicting interests

Since May 2015, Israel has a new right-wing government led by Prime Minister Benjamin Netanyahu (Likud party). The new coalition consists of 5 parties and has only a small majority with 61 of the 120 Parliamentary seats. Because of the small majority, the conflicting interests between the coalition parties and the domination of nationalist and ultra-Orthodox parties, Netanyahu was forced to make major concessions (e.g. repealing laws passed by the previous government to expand the military draft to include ultra-Orthodox men). It is expected that this leaves little room for manoeuvre nor for a revival of peace talks with the Palestinians. Especially as the nationalist and ultra-Orthodox parties have a clear view on the construction of new settlements in the occupied West Bank (pro) and the establishment of a Palestinian state (contra). Therefore a slowdown of the peace talks and a growing negative opinion towards Israel is feared.

Meanwhile, Israel has condemned the framework agreement of April 2015 between Iran and the UN Security Council members over Iran’s nuclear program. As the involved parties still have to work out significant details, Israel declared that it will exert itself to get more severe restrictions for Iran’s nuclear program introduced. Nevertheless, this agreement seems to have reduced the likelihood of an Israeli military strike on Iran’s nuclear facilities.

Factsheet of Israel
Factsheet of IsraelSource: EIU, CIA World Factbook, UN, Heritage Foundation, Transparency International, Reporters Without Borders, World Bank.

Background information

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.

Economic indicators of Israel
Economic indicators of IsraelSource: EIU
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