Despite 'tremendous strides,' bumps seen on the road ahead

Clouds gather as Israel emerges from economic ‘golden decade’

After April elections, the new government must set out long-term policies to curb the shekel’s rise, boost education and infrastructure, and trim bureaucracy, economists say

Shoshanna Solomon is The Times of Israel's Startups and Business reporter

Illustrative. Clouds on the horizon. (SARINYAPINNGAM; IStock by Getty Images)
Illustrative. Clouds on the horizon. (SARINYAPINNGAM; IStock by Getty Images)

In the past 10 years, the Israeli economy has enjoyed what some economists are calling a “golden decade” of strong growth, mainly due to a global tech boom and the impact of older reforms that is now being felt.

Yet, economists warn as national elections approach in April, no incoming government will be able to rest on the laurels of past successes. Clouds in the shape of lower economic growth and higher government spending are already on the horizon. The nation still lags sorely behind the average of other advanced economies in the ease of doing business; infrastructure needs a significant upgrade; and the public sector is still inefficient, leading to ballooning government costs, according to the OECD international economic organization.

Housing prices remain high; financial inequality, though shrunken, is still a problem; and the education system is failing to deliver the skilled workers the country needs to ensure the continued success of its high-tech-led economy.

“Despite the tremendous strides made over the past decade the nation still lags in certain key areas such as infrastructure — mainly roads, public transportation, hospitals and fiber optic cables” for fast internet services, said Terence Klingman, chief investment officer at the Heritage Family Office Partners Ltd., which advises wealthy families on where to invest their funds. Klingman is also a former head of sell-side research at Psagot Investment House, and has worked as director of equity research at the chief investment office of UBS Wealth Management.

View of the Azrieli towers in Tel Aviv at night, June 15, 2017. (Mendy Hechtman/Flash90)

The next government, economists say, must set out long-term policies, including making sure the currency doesn’t continue to appreciate — in order to keep exports competitive — increasing spending on infrastructure and education, and drastically cutting back on bureaucracy.

Israel is holding national elections on April 9 in a heated race in which incumbent Prime Minister Benjamin Netanyahu, head of the ruling Likud party, is facing indictment for bribery and fraud along with the challenge of the new Blue and White party led by former army chief of staff Benny Gantz.

The good years

The past decade has seen Israel’s economy boom, possibly beyond the wildest dreams of the founding fathers who established a state 70 years ago in an arid land amid hostile neighbors.

The country, widely referred to as the Start-Up Nation, has become a global center for high tech and innovation, with multinational corporations flocking to its shores to snap up tech firms and set up research and development centers. Last week, an annual survey by US News & World Report ranked Israel as the eighth most powerful nation in the world for the third consecutive year.

The country’s almost nine million citizens enjoy record low unemployment levels, low inflation and economic growth higher than the average of the world’s richest economies. Living standards in Israel are higher than in France, Japan, the UK and Italy.

Terence Klingman — the Chief Investment officer at the Heritage Family Office Partners Ltd. (Courtesy)

“Between 2009 and 2019, the Israeli economy has enjoyed a golden decade, post crisis,” said Heritage’s Klingman in an interview. “In contrast to the 2000 high-tech boom, which was mainly concentrated in communications, technology has expanded to many industry verticals and we have seen startups flourish and record exits in areas such as cybersecurity, autonomous vehicles, navigation, software, fintech.”

Unemployment in Israel is at around four percent, inflation is at the lower edge of the nation’s target of 1% to 3%, and the increase in gross domestic product (GDP) in 2018 was 3.3% over the previous year, according to data compiled by the Central Bureau of Statistics and published on March 10. This is lower than the 3.5% growth Israel posted in 2017, but still higher than the average growth in 2018 for OECD nations — the world’s richest — forecast to be 2.37%.

The economy has not faced a recession in the last 15 years, and GDP in dollar terms has increased by over 55% since 2010, international ratings firm Standard & Poor’s said in its February 2019 research update on the nation. The S&P reaffirmed its AA- investment grade rating, one of its highest ratings, saying it expects Israel’s economic growth “will remain resilient in the face of softer global growth.”

On March 5 Moody’s, too, reiterated its A1 investment grade rating for the nation, its fifth highest ranking. Sovereign credit ratings give investors insight into the level of risk associated with investing in a particular country, including political risk. The higher the risk, the lower the rating.

GDP per capita in Israel was $40,270 in 2017, up from just $1,229 in the 1960s, and is now “firmly in line with high income nations,” said Klingman. The 2017 GDP per capita figures for France, Japan the UK and Italy, were $38,477, $38,428, $39,720, and $31,953, respectively. The average GDP per capita for developed OECD countries was $38,151, according to World Bank data for 2017. In the US, GDP per capita that year was $59,532.

Thousands of Israelis dance at a beach party at the annual gay parade in Tel Aviv on June 7, 2012 (Matanya Tausig/Flash90)

Over the past 20 years, government debt has shrunk to around 60% of GDP from around 90% in 2000, whereas it has ballooned in other developed countries, reaching an average of 103.8% in 2018 after governments worldwide injected huge amounts of money into their economies to promote growth following the 2008 financial crisis.

A number of domestic reforms have also laid the ground for success, Klingman said. One key move was a decision in 2003 by then-finance minister Benjamin Netanyahu to slash welfare payments, in particular child allowances, to incentivize a higher level of participation in the workforce.

A second significant reform started after the 2011 social protests, in which citizens took to the streets to protest the rising cost of homes and dairy products such as cottage cheese. The unrest caused the government to set out policies to increase competition – including in the telecommunications and financial sectors – and break up large highly leveraged conglomerates that owned large pieces of the economy through pyramid corporate structures.

“The net result of these reforms has led to an improvement in Israel’s income inequality,” Klingman said. “These domestic reforms, coupled with higher economic growth, have led to higher employment, a decrease in inequality and rising real wages, as wage growth has outstripped inflation.”

Young israelis seen near tents set up on Rothschild Avenue in Tel Aviv. Fed up with high housing prices around the country, thousands set up a tent city, vowing to stay until the government presents a solution. August 10, 2011. (Liron Almog/Flash90/File)

The Gini coefficient, which measures this inequality, has been declining steadily, after having been one of the most unequal economies among the world’s industrialized nations.

According to OECD data, in 2016 the Gini coefficient for Israel was 0.35 — with zero being complete equality and 1 complete inequality — compared to 0.371 in 2011. The Slovak Republic with 0.24 led the 2016 ranking, while South Africa was the most unequal society, with a coefficient of 0.62 that year. Even so, income inequality in Israel is still higher than the OECD average, according to figures compiled by the organization.

Israel has also benefited from relative quiet on the geopolitical front in the past decade, Klingman added.

Following the Arab Spring — anti-government protests and uprisings that spread across the Middle East starting in late 2010 protesting oppression and the low standard of living – “the Arab world has been involved in internecine struggles and civil war between Shia and Sunni and Islamists and moderates, which ensured that periodic flareups in the Palestinian-Israeli conflict remained largely contained,” he said.

Clouds on the horizon

Yet going forward, the Israeli economy will face a number of challenges, and the nation is already beginning to feel the pinch of a slowdown and higher government debt levels.

Economic growth is expected to be flat at 3.2% in 2019, according to S&P, as exports and government tax revenues decline due to the global slowdown, a decrease in technology sales, and the threat of trade wars and protectionism globally. The Finance Ministry forecast economic growth of 3.1% for 2019, while the Bank of Israel revised its growth forecast for 2019 to 3.4% from a previous forecast of 3.6%.

Illustrative image of dark clouds (dwleindecker; iStock by Getty Images)

The debt-to-GDP ratio — an indicator of a country’s ability to pay back its debt — rose for the first time in a decade to 61.2% according to Finance Ministry data after reaching a record low of 60.5% in 2017, having dropped every year since 2009, when it was 74.6%.

The higher debt stems from increased government expenditure as ministers caved to demands for higher wages in the public sector, including for police officials, or spent money on projects to make housing cheaper for consumers.

Yaniv Pagot, an economist and head of strategy for the Ayalon Group. (Courtesy)

“It is clear to all that the days of declining debt-to-GDP ratio are over for this year and for years to come,” said Yaniv Pagot, an economist and head of strategy at the Ayalon Group, an institutional investor.

A flagship housing program promoted by Finance Minister Moshe Kahlon, who won public approval as communications minister for bringing down the price of cellular calls, is one of the key reasons for the rise in government debt, said Gil Bufman, the chief economist of Bank Leumi.

“The debt-to-GDP ratio is a data point that you can’t fudge,” he said. “Kahlon’s program gives government-owned land to residential developers almost for free.” The government would otherwise have generated privatization revenue from the sale of the land at market prices, which would have helped repay some of its debt, he explained.

The budget deficit — the difference between a government’s income and how much it spends — is also expected to rise in 2019, in breach of a government target of 2.9% of GDP. The deficit for January and February 2019 came in at NIS 5.6 billion ($1.545 billion), or 3.5%, on an annualized basis, the Finance Ministry said last week, well above the 2.9% annual target and the highest ever for those two months. If a budget deficit is too high, it gives the government no room to deal with a potential economic slowdown through even greater spending, economists and analysts have warned.

In 2018 the budget deficit came in almost miraculously within the target set by the government, exactly at 2.9% of GDP, according to Finance Ministry data. Most analysts had predicted the deficit in 2018 would also breach the target, based on preliminary data that showed there would be a shortfall of income.

On February 12, the State Comptroller said it would examine if there were any improprieties in the way the government managed to meet its budget deficit target in 2018, Reuters reported.

The low debt-to-GDP ratio and a budget deficit that is within target are two indicators of fiscal restraint and responsibility, data on which international ratings agencies such as Standard and Poor’s and Moody’s decide how to rate credit-worthiness.

The ratings provided by these agencies determine how easily and cheaply Israel and other nations can raise funds on international debt markets. A lower rating means that countries need to pay higher interest rates on the money they borrow.
For now, Standard & Poor’s has kept its rating for Israel at AA- but has warned that this could change if the nation’s fiscal performance “weakened markedly” beyond S&P’s forecast. Moody’s and Fitch have Israel’s rating one notch lower than S&P, at A1.

The challenges ahead

“One of the challenges facing the new government will be to re-establish the declining trajectory of public debt, while at the same time keeping cost containment measures growth-friendly,” S&P said in its report.

“Any new government that comes in will have to set up a program to lower the deficit,” said Bank Leumi’s Bufman.

Amir Kahanovich, chief economist for Excellence Investment House (Oded Karni)

Amir Kahanovich, chief economist for Excellence Investment House, said  the deficit and the higher debt do not mean the government “has lost control” on costs.

Even so, the next finance minister “will have a less comfortable job,” he said. Instead of handing out higher salaries or other benefits, “he’ll have to tighten the belt.” To keep the deficit and debt in line, the next government will have to either cut costs or take the unpopular step of raising taxes, he said.

The new government will have to focus on setting out a long-term economic vision, which the governments headed by Netanyahu have failed to do in recent years, opting instead to put out fires and address more immediate aims, economists say.

“We should take advantage of the Israeli economy’s good situation in order to require handling the long-term challenges, which will contribute to growth that is more balanced, that is sustainable and inclusive,” former Bank of Israel governor Karnit Flug said last year.

“There are so many long-term projects the government should be undertaking, but these have been sidelined as it deals with shorter-term and more immediate aims,” such as creating affordable housing, Bufman said.

Counterbalancing the negative impact of the strength of the shekel, which has appreciated some 30% from 2007 to 2017, is one of the key long-term issues the government will have to tackle, he said.

“The decade-long appreciation of the shekel has been specially damaging for industrial firms that export their products,” he said, especially for low-tech or mid-tech firms that currently don’t or only partially use technologies to increase productivity.

Gil Bufman, the chief economist of Bank Leumi (Bank Leumi)

The government should also set up national innovation programs to help these low- to mid-tech firms modernize their manufacturing infrastructure with new technologies, Bufman said, and train workers with the required technical skills to enable the upgrade, he said.

In addition, bureaucracy must be reduced, the economists said. Ease of doing business in Israel is still pretty abysmal. Israel is ranked 49th out of 190 in a 2019 global Doing Business report by the World Bank. It takes four procedures and 12 days to open a business in Israel, and it takes six procedures and 37 days to register a property. This compares to 1 procedure and half a day to start a business in New Zealand, which topped the ranking, and two procedures and one day to register a property.

Even as the boon of offshore natural gas resources is enabling Israel to cut back on imports of coal for fuel and will eventually cut electricity costs and yield export income from sales to neighboring countries, not all firms can access the gas to lower their energy costs. “Connecting to the gas infrastructure is bureaucratically still difficult,” Bufman said.

Employee productivity continues to be low compared to developed nations. According to Bank of Israel data, productivity per hour in Israel in 2017 was just under $40, compared to almost $60 in the US and almost $70 for an average of 21 rich countries.

Spending on infrastructure projects is also below par, with disadvantaged areas and demographics, especially Arab Israelis, suffering from inadequate services such as road upkeep, green areas and garbage collection.

Garbage piled up on the streets of Jerusalem, January 3, 2015. (Times of Israel)

“Poverty remains widespread,” a 2018 OECD report said, particularly among Arab Israelis and ultra-Orthodox Jews, which it says will represent half of the population by mid-century. The integration of these sidelined populations “is crucial,” the report urged.

On Wednesday, a damning report on transportation infrastructure was issued by the state comptroller, which found that lackluster planning over years was the cause of heavy congestion on roads and overcrowding on trains and buses — with the situation only expected to get worse.

Increased road traffic has resulted from a lack of viable public transportation alternatives and because car ownership is relatively affordable since government disincentives have not been imposed, the report said. Delays in completing public transportation projects have caused poor bus and train services and “intolerable” overcrowding for passengers, it said.

Housing prices remain high, well above OECD averages, and the price-to-income ratio of homes was among the highest in those countries, according to OECD data. These high prices, said Heritage’s Klingman, “have the potential to cause political tensions” since Israel, “unusually for a developed economy, has a high birthrate and a growing population of young adults who are struggling to get a foot on the housing ladder and who have shown that they are willing to get politically active.”

The high price of housing puts an “excessive burden” on household finances, particularly if the economy enters a recession at some later date, he warned.

The nation’s education system is also failing to provide the skilled workers Israel’s tech industry, the nation’s main growth engine, needs to grow. The industry has a shortfall of 12,000 to 15,000 skilled workers each year, according to Start-Up Nation Central, a nonprofit that tracks the industry. Israeli students score below OECD averages in mathematics, science and reading scores, according to 2015 data published by the OECD. The nation spends below OECD averages per student at secondary school level, OECD data shows.

The upcoming elections, said Klingman, pose an even greater danger to the nation’s finances as whoever heads the new government will likely find it expensive to woo potential coalition partners.

“We might land up with unwieldy coalitions which will be tempted to engage in fiscal largesse and populistic policies, handing out money to appease coalition partners — rather than address the key challenges that need to be tackled,” he said.

The key to Israel’s continued economic success, he said, will be in the new government’s ability to “tackle long-term challenges like bureaucracy, infrastructure spending and improving education and productivity levels.”

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