$Unique_ID{bob00272} $Pretitle{} $Title{Israel Chapter 4D. Industrial Policy and Development} $Subtitle{} $Author{Richard F. Nyrop} $Affiliation{HQ, Department of the Army} $Subject{exports israeli foreign imports billion government industrial defense percent equipment} $Date{1979} $Log{} Title: Israel Book: Israel, A Country Study Author: Richard F. Nyrop Affiliation: HQ, Department of the Army Date: 1979 Chapter 4D. Industrial Policy and Development The War of Independence destroyed any possibility for Israel to become a regional manufacturing center with markets in nearby Arab areas. The Arab boycott, which was still active in 1978, went further than just refusing to buy Israeli goods. Sanctions were also applied to firms doing business with Israel that wanted to trade with Arab countries. Arab sanctions had varying effectiveness, but they created problems for marketing arrangements, production licenses as a means of acquiring foreign technology, and direct investment relationships between Israeli firms and international companies. The Arab boycott increased the difficulties of overcoming the constraint of Israel's small domestic market. The small size of the domestic market affected Israeli industrial development in several ways. The most obvious and perhaps most important impact involved economies of scale; many modern industrial processes require a high level of production to achieve low unit costs-often a production level considerably higher than could be sold in Israel. Thus investment in modern technology frequently meant that investors had to build a plant large enough to achieve economies of scale but with part of production to be marketed abroad, thereby facing the competition from established, international companies and the risks of penetrating foreign markets largely in industrialized Western Europe. Less obvious were the small firms' inability to maintain marketing and research staffs, the effect of small-scale production on allocation of resources in Israel, and the difficulty of finding appropriate government policies to achieve rapid and rational industrialization. In the years immediately after independence the flow of immigrants was extremely high, and a shortage of goods existed. The government therefore intervened directly to foster rapid development of manufacturing. Many inducements were introduced, but commercial policy was very important. Local manufacturing was completely protected from foreign competition by high tariffs and quantitative restrictions on foreign imports, resulting in rapid growth primarily among numerous small industrial concerns. Production was on a small scale, managerial and skilled labor were spread thin, and costs tended to be high. By the mid-1950s government officials recognized that this excessive level of protection was causing distortions in the economy. Quantitative restrictions on imports were removed, and a commitment was made to gradually reduce import duties. Liberalization of commercial policy was slow. By 1978 domestic manufacturing still enjoyed substantial protection although an Israeli agreement with the European Common Market countries, signed in 1975, committed the government to continual, gradual reduction of tariff duties on industrial products in return for duty-free entry of Israeli manufactured exports to Common Market countries starting in July 1977; free trade in industrial products between the two areas was scheduled for the late 1980s. In the late 1970s some foreign firms were interested in establishing plants in Israel to benefit from the duty-free access to the European Common Market. In the early 1950s a major focus of government policy was to create jobs for the huge flow of immigrants and provide goods that were in short supply. A highly protectionist policy was adopted in support of these goals. For some officials, the increasing numbers of local manufacturers and growing competition between them would mitigate the harmful effects of excessive protection from the outside. It soon became apparent, however, that one or only a few domestic producers of a specific product could supply the small internal market. Since the mid-1950s the country's balance of payments dominated government policy. Stimulating local manufacturing toward import substitution and development of industrial exports became more important than excessive concentration in domestic industry. Mergers were promoted to expand the size of economic units in order to increase exports. The size of manufacturing plants and industrial exports increased, particularly in the 1960s and 1970s, but accompanied by the growth of cartels and monopolies in the domestic market even though no Israeli firm was large by international standards. There was some concern about the lack of internal competition. An effort toward regulating cartels and restrictive trade practices became law in 1959, for example, but legislation in 1969 removed obstacles and encouraged mergers in a single line of production. Some economists commended government policy for its flexibility and accomplishments, noting that reduced tariff protection and liberalized imports would counteract the excessive concentration in domestic industry over the long run although acknowledging that costs and prices in the home market were higher than would have been the case with greater internal competition in the short run. Since the mid-1950s industrial development policies have concentrated largely on science-based industries, such as metal products, chemicals, plastics, and electronics, because they best suited the country's endowments. A substantial inflow of foreign capital permitted development of advanced technology and capital-intensive industries. Policy attention and investments concentrated on manufactured components or high-quality special products, such as scientific instruments and minicomputers, requiring a large amount of precision per unit and high value added, rather than mass produced items requiring large production runs to be economical. Growth of productivity per worker has been at a sustained high rate since independence. The skills in the labor pool added to the country's comparative advantage in modern industries. The proportion of well-educated scientists and engineers, skilled workmen, and able managers in the Israeli work force was unrivaled in young, developing countries, even though Israel's development efforts required still more. Educational and training programs for both the already skilled and the unskilled immigrants enlarged and added to the pool of skills. The country's defense needs reinforced development of science-based industries. Facilities that originally began as repair and maintenance shops for imported military equipment, developed competence to make substantial modifications and adaptations on equipment and subsequently to produce Israeli versions of guns, planes, missiles, armored vehicles, and electronic equipment. Development of defense and related civilian products was particularly stimulated after the 1967 war when France, a major military supplier at the time, embargoed armaments. By 1978 Israel's defense industries were producing for their own needs more than what they used to buy from the French, and exports of military and related products were becoming major foreign exchange earners. The government used a variety of means to influence the peace and direction of industrial development. Availability of low interest credit, tax incentives, tariff protection, export premiums, export insurance, and marketing assistance were part of the policy arsenal. Legislation protected and encouraged investment by foreigners. Foreign investments in Israel remained low in the 1950s but became substantial in the 1960s (until the six-day war) and in the early 1970s (until the 1973 war). The government sponsored and promoted research and development for some products and lines because the size of most Israeli firms was too small to support the necessary staff. The government encouraged private investment in industry through incentives and assistance rather than by creating a large public sector. Government ownership of industry was primarily in defense, utilities (water and power), fuels (refining), and chemicals and petrochemicals (primarily related to processing particular refinery products, phosphate rock, and Dead Sea brine). The government sold its shares in various industrial plants on occasion in order to raise funds for investment in new plants. By 1978 industrialization had progressed rapidly and become much more sophisticated, but major problems remained. Continuing large investments in industry still depended heavily on an inflow of capital from world Jewry and other sources. Manufacturing was very dependent on imported materials, requiring more imports for further growth. The large number of industrial establishments, frequently with nonspecialized production and underutilized capacity, kept production costs high and dispersed skilled labor and managerial talent. Labor's mobility proved inadequate particularly since the 1973 war; manufacturing for the domestic market encountered a slump and underemployment, but by 1977 too few workers had moved into export industries, which were short of labor. Strikes and disruptions by labor interfered with production. Industrial wages were related to the cost of living and not productivity, undermining the competitiveness of industrial exports. The technical efficiency of many branches of industry was below international standards, increasing production costs. Maintaining research and development work ahead of huge international companies and major industrialized nations in such products as weapons, instruments, optics, and selected electronics would remain a serious challenge to continued industrialization and export growth. Diamond Industry The Israeli diamond industry is an exotic but representative example of the country's industrialization effort and export drive. From exports of US $5 million in 1952, the industry grew and by 1977 accounted for more than half of the world trade in cut and polished diamonds, and exports exceeded US $1 billion. Diamonds were by far the country's largest export. The industry employed about 25,000 people in all aspects of the trade. Rough diamonds were purchased from an international cartel that controlled marketing of the bulk of all rough diamonds. Israeli dealers handled gemstones almost exclusively and specialized in medium sizes (approximately one-fortieth to one-half a carat). A skilled worker determined the cuts to achieve the best possible refraction of light and the least loss to the original rough stone. Actual cutting required several hours, usually by a machine using a diamond for a cutting edge. Polishing and removing impurities to obtain as near as possible a blue-white color involved about six separate steps. Cutting and polishing in Israel had been streamlined, using automated equipment and assembly-line techniques as much as possible to reduce costs. The polished gems were sold to international dealers primarily at the Israeli Diamond Exchange in a suburb of Tel Aviv that had become the largest center for gem diamonds. The United States was the largest market, accounting for about one-third of exports in 1977. Other major markets included Hong Kong and the industrialized countries of the world. About one-fifth of the value of diamond exports represented foreign exchange earnings after paying for the import of rough stones. In 1977 the net added value was estimated at US $275 million. The Israeli diamond industry began in the 1930s when a European Jewish cutter immigrated. More cutters and dealers arrived in the 1940s and formed the nucleus for the industry. Expansion since the 1950s required extensive training of many additional cutters and substantial investments in buildings and equipment. By 1977 there were about 750 factories and workshops. The Israeli industry surpassed Antwerp as the largest wholesale diamond center in the 1970s, accounting for more than 50 percent of all cut and polished gem diamonds by 1976. Diamonds were the only export product in which Israel was more than a marginal supplier in any market. The growth of the industry to its present eminence in the world diamond trade partly reflected the specialization and concentration on technical efficiency. Defense Industries Given the country's national security requirements and continuous balance-of-payments problems, it was natural to develop defense industries. Domestic production would reduce foreign exchange costs for imports, would ensure control of supply, and would permit adaptations of equipment to meet Israeli requirements. A substantial number of well-qualified scientists, engineers, and technicians and a growing industrial base facilitated increasing reliance on local production of military equipment. Defense industries led the growth in the manufacturing sector. The military industrial complex was dominated by government-owned plants under the Ministry of Defense (see Economic Impact, ch. 5). The largest was a conglomerate, the Israeli Aircraft Industries (IAI), employing about 20,000 workers in 1977. The IAI and its subsidiaries serviced and refurbished civilian and military aircraft, produced airplanes (civil and military), sophisticated electronic equipment for civilian and military use, missiles, missile-carrying patrol boats, and components for equipment in the Israeli inventory. Other industrial facilities directly under the Ministry of Defense supplied small arms and ammunition, some cannon and shells, ships, tanks and parts, and major maintenance and modification of a variety of foreign equipment. There were, in addition, private firms with varying proportions of output sold to the Ministry of Defense, the country's largest buyer. The government released little data on defense industries, and most information came from press interviews with officials. In 1977 there were reportedly about 150 private and public firms producing military and related products. Direct employment in defense industries was estimated at about 30,000 with perhaps another 30,000 workers in firms related to military production, such as parts manufacturers and subcontractors. Basic defense industries (small arms, uniforms and related equipment, and maintenance facilities) were constructed in the 1950s and early 1960s, but rapid expansion and development of advanced, complex products came after the 1967 war. The sudden imposition of the French arms embargo at that time spurred officials to achieve greater self-sufficiency. With the introduction of the high-quality, Israeli-designed Galil assault rifle in 1973, local industries completely outfitted the infantry soldiers and probably supplied almost all of the country's needs for small arms and ammunition. By the mid-1970s the bulk of electronic gear was domestically produced. In 1976 the country reportedly manufactured about one-third of its overall defense requirements; although Israeli officials did not indicate how this was measured, budget data suggested a greater dependence on foreign supplies. Defense authorities hoped eventually to receive half of the country's military equipment needs from domestic manufacturing. Even with the rapid growth of the armaments factories, the country remained heavily dependent on imports, primarily from the United States, for a number of advanced weapons systems and key components for those produced locally. Moreover the costs of these imports kept escalating, increasing the burden of defense. In the mid-1970s nearly half of the military budget was for purchases abroad. In 1976 Israel spent about US $2.3 billion for foreign armaments, fifteen times what was imported a decade earlier. Although more could be produced at home than ever before, the pressure on the balance of payments had increased because of the rising force levels and the greater sophistication of each new piece of equipment obtained by the Arabs and the Israelis. Growth of defense industries was achieved by a mixture of imported technology and Israeli innovation. Israeli firms purchased production rights and entered into joint ventures with foreign companies to produce some products and components. Nearly all manufacturers of electronics had links of one sort or another to American firms. Purchase agreements for foreign military equipment frequently specified data and design information and coproduction rights whenever possible. The IAI tried to obtain rights to produce a portion of the F-16s it had ordered, for example, but the United States government rejected the request in late 1977. Experience and necessity led to Israeli innovation. Tank maintenance shops, as an illustration, performed major modifications of basic American armored vehicles, such as larger guns, improved armor, and higher powered engines with more reliability. The shops also modified and improved the large number of Soviet tanks captured from the Arabs and incorporated them into their inventory. In the mid-1970s an Israeli tank (the Chariot) was designed and built (see Size, Equipment, and Organization, ch. 5). Some equipment, such as compact, lightweight special purpose radar for Israeli patrol boats and planes, was locally designed to meet specific military requirements because it was not available elsewhere. By 1978 research and development of new products for military and civilian use was a major activity in most defense industries. The technical level of Israeli military products was high, production costs were low, and foreign sales were a natural outlet for battle-proven equipment to supplement the short production runs required to meet Israel's own requirements. In 1977 labor costs were reportedly 40-percent lower than in American aerospace industries, and reported export prices for various sophisticated equipment were considerably less than for comparable items from other countries. The sea-skimming Gabriel missile, which was so successful against Arab shipping in 1973 and was being exported to eight countries in 1977, was priced at less than half that of a similar French missile, for example. Exports grew rapidly. From about US $25 million in 1966, exports of military and related equipment reached about US $60 million in the early 1970s and US $320 million in 1976. Exports of US $400 million were expected in 1977. The sharp rise in the value of export earnings, to a considerable extent, resulted from the sale of higher priced equipment reflecting an overall industrial policy to concentrate on science-based products in which there was a high value added by local manufacturing. The emergence of Israel as a significant exporter of military equipment produced new problems. Its modern fighter-bomber, the Kfir, for example, was based on the design of the French Mirage 5, used an American General Electric J79 engine, and had domestically designed and produced components for the flight control and weapons delivery systems. Some parts of the J79 engine were produced under license in Israel. Most experts rated the Kfir superior to the French original and in a class with the Soviet MiG 21, but it was priced at only US $5 million each. In 1977 the United States government halted the initial foreign sale of Kfirs to Ecuador by refusing to permit reexport of the General Electric engines. It was uncertain whether the United States would permit shipment of the planes to other countries that had ordered them. Governments and companies were disturbed by the country's growing competition in arms exports, and by early 1978 some American companies appeared to be diminishing production help to Israeli military industries. Techniques used in defense industries should have beneficial ripple effects in other branches of manufacturing. Firms and shops producing for the military worked to maintain good labor relations and had far fewer strikes and disruptions, an example that could profit the rest of industry. Ministry of Defense orders required a high degree of reliability imposing much more attention on quality control than was common in Israeli industry. The recent addition of many of the defense facilities permitted installation of the most modern equipment, such as the latest computer-controlled machine tools, a large vacuum furnace, special plating facilities, computer aided design equipment, and computers in a number of other functions to improve efficiency, which could serve as examples and directly aid other industrial branches. The heavy reliance on research and development for advanced weapons made direct and indirect contributions to civilian products. Israel's military-industrial complex had made significant contributions to the country's defense and to the economy. There was a potential for further expansion of exports and a substantial rise if sales of Kfir fighters were allowed in the next few years. But there was a question of how much further growth was possible in defense industries; the small production runs required for Israeli forces, the escalating costs of each new system, and the limited supply of investment funds placed the same barriers in front of Israel that restrained the military industrial complexes in Western Europe. In 1978 the Israeli aircraft industry and government leaders faced the difficult decision of whether to gamble on investments to develop a new fighter plane for the 1980s with the possibility of few orders. The problem for Israel's defense industries was no longer industrial capability but economic viability. Foreign Trade The limitations of water and arable land, the lack of natural resources, the need for industrial development, and the Arab threat to the country's survival made Israel heavily dependent on imports for food, materials for processing, machinery, and defense equipment. The need for imports was always high; the problem was obtaining the foreign exchange to pay for imports. Continuous pressure existed to develop exports, reinforced by numerous government policy measures to induce the private sector to look to foreign markets (see Role of Government, this ch.). The currency was depreciated by 75 percent between late 1974 and early 1978 partly to encourage exports. Imports increased from US $300 million in 1950 to US $4.1 billion in 1976, an average increase of 10.6 percent a year. Imports grew at about the same rate as the economy as a whole partly because of the preponderance of material for processing-77 percent in 1976 (see table 16, Appendix A). Many settlers just before and after independence were accustomed to an urban European standard of living. In the 1950s the government channeled the demand for European kinds of goods toward import substitution by domestic manufactures. Because of the lack of natural resources, local industry had to import many materials for processing to meet domestic consumer wants. As manufacturing expanded in range and depth, the expansion was largely based on imported materials. The link between imports and industrial and economic growth should remain for the foreseeable future. In 1977 imports amounted to US $4.8 billion, a 16-percent increase over the previous year. The bulk of Israeli imports came from industrialized countries. The Common Market countries of Western Europe supplied most, 43 percent in 1976, and all of Western Europe accounted for 51 percent of imports. The European communist countries, primarily Romania, furnished only 1 percent of imports. The Americas, primarily North America and essentially the United States, accounted for nearly 23 percent (the United States 21 percent) of imports in 1976. Asia and Africa supplied only 6 percent of imports. Japan was by far the biggest supplier in the Asia and Africa group, but it had a small share in the Israeli market. The remainder of imports came from a number of countries. Exports increased from US $35 million in 1950 to US $2.4 billion in 1976, an average increase of nearly 18 percent a year, a rate of growth higher than the rest of the economy, and reflecting the government's efforts (including many tax advantages, adjustments of exchange rates for a wide range of export goods, and a series of currency devaluations) to stimulate exports. The growth of exports accelerated, and the rate reached 21 percent a year between 1970 and 1976. By the mid-1970s export oriented industries were primarily the ones retaining dynamism in a generally stagnating economy. In 1977 exports reached US $3.1 billion, an increase of 29 percent over the previous year. Citrus fruits, essentially oranges for Western Europe, were the basic export in the early years after independence. Later many additional products found markets abroad. Citrus fruits lost importance even within agricultural produce as foreign markets for other fruits, nuts, vegetables, and cut flowers were developed (see table 17, Appendix A). More importantly, the growth of domestic manufacturing led to a preponderance of industrial products in exports. Government policy strongly supported industrial development with an export orientation to ease the country's continual balance-of-payments problems. Emphasis was given to science-based industries with a large value added by domestic manufacturing, particularly since the 1960s (see Industry, this ch.). This was the kind of export (e.g., chemicals, metal products, machinery, and electronic equipment) that, along with polished gem diamonds, grew most rapidly in the 1970s. Diamonds were by far the only product in which Israel had more than a peripheral share in any foreign market, but only about one-fifth of the value of polished diamonds exports represented foreign exchange earnings after paying for imports of rough stones. Net value added by diamonds in 1977 was estimated at US $275 million. Even though government policy had stimulated growth of exports at a rate substantially ahead of the rest of the economy, the day when exports began to equal imports appeared far distant. There were about 3,000 exporters, but 300 firms handled about 90 percent of all exports. About 100 large plants, employing more than 300 workers, accounted for more than 80 percent of industrial exports in 1977. The remainder of industrial exports were almost completely from medium-sized plants. Small plants and shops played a negligible part in sales abroad. The foreign markets for Israeli products, and even the pattern of industrial growth, were shaped by the Arab boycott instituted after formation of the state. The Arab boycott of Israeli goods, which was still in effect in 1978, precluded the possibility of Israel developing close links to the economies of its Arab neighbors. Instead the country had to seek more distant markets. West European countries brought most of Israel's exports, 48 percent in 1976. The European Common Market countries were the principal buyers (37 percent in 1976), pointing up the significance of the 1975 agreement whereby Israeli industrial products began to enter the Common Market area duty free after mid-1977. Economists expected increasing direct investments in Israel by non-European international companies seeking this duty-free entry to the Common Market. Israel's trade with communist countries, essentially those in Europe, was small, amounting to 1 percent of exports in 1976. North and South America (20 percent) and Asia and Africa (20 percent) were the other principal areas for Israel's exports. The United States (18 percent) and Hong Kong (6 percent) were the main markets in these areas, partly because of diamond sales. The United States and the Federal Republic of Germany (West Germany) were the most important individual countries in Israel's export trade. Tourism was a more important net earner of foreign exchange than such commodity exports as diamonds or citrus fruits. There were 620,000 tourists in 1975 and about 1 million in 1977. Painstaking efforts over two decades built up a variety of facilities to broaden the appeal and lengthen the stay of visitors. Ski slopes, beach resorts, and archaeological and historic sites added to Israel's biblical and religious attractions. In 1977 foreign currency receipts from tourism exceeded US $400 million and probably exceeded US $500 million if air fares on national carriers were included. Earnings from tourism were strongly affected by the security situation in Israel, however. Balance of Payments By the late 1970s Israeli leaders were extremely concerned about the country's balance-of-payments difficulties. A very large inflow of foreign funds, especially American aid, had been required since 1973 to finance the level of imports needed by the economy and national security, and a financial crisis was avoided in 1974 and 1975 only by heavy use of short-term financing. Many officials expected the flow of aid to diminish in the near future. Preparations had to be made for that eventuality to avoid a reduction of imports, which would starve the economy and weaken the country's defenses. Since independence imports have substantially exceeded exports creating most of the balance-of-payments problem. Balancing international transactions was not necessary before independence because the local currency in the Palestine Mandate was tied to and as good as English pound. The Israelis have been able to finance a continuous import surplus, the magnitude of which increased tremendously over time, by a large inflow of foreign funds. The inflow of contributions, grants, and loans from major sources exceeded US $32 billion between 1950 and 1977, over half of which required no repayment. The most stable source of foreign funds has been world Jewry, whose members supplied about US $11 billion between 1950 and 1977. The two major fund raisers among Diaspora Jews, the United Jewish Appeal (in the United States) and Keren Hayesod, collected more than US $5.7 billion between 1948 and 1978, about two-thirds in the United States. Government bonds (Independence and Development Bonds) sold overseas since 1950 (largely in the United States) had yielded US $4.2 billion by the end of 1977, although US $1.7 billion had been repaid. The remainder of the funds came from other fundraisers and unilateral transfers by institutions and individuals, including immigrants transferring their capital to their future home. Only a small part of the funds from world Jewry, essentially that invested in bonds, had to be repaid. An unusual aspect of the flow of funds from world Jewry was the increase in times of trouble for Israel, such as the Arab-Israeli wars, which was the reverse of most capital movements. This source of funds reached a peak of about US $1.5 billion in 1973 and was providing nearly US $900 million a year in the mid-1970s. The United States government provided Israel with the most assistance over the years, totaling nearly US $13 billion between 1948 and late 1978. Before the 1970s financial assistance averaged less than US $75 million a year and consisted essentially of economic help. In the 1970s and particularly after 1972, American aid increased sharply, averaging over US $1.5 billion a year between mid-1973 and late 1978. Although economic assistance, primarily help to finance balance-of-payments deficits, increased by large absolute amounts, the focus of American aid shifted toward military equipment. By the late 1970s military aid amounted to US $1 billion annually out of total American aid of US $1.8 billion. Between independence and late 1978 total American military assistance had reached US $7.9 billion, US $6.5 billion of which had been provided since the 1973 war. At the end of 1977 Israel's debt to the United States government amounted to US $3.7 billion. Over US $4 billion had been received from West Germany by 1978. The West Germany government provided US $836 million in reparation payments to the Israeli government, but this program was completed in the 1960s. The reparation payments were significant in Israel's development effort in the late 1950s and early 1960s. Personal restitution payments to Israeli citizens for acts during Nazi rule were continuing in the 1970s, amounting to US $314 million in 1976. The West German government also provided development loans, amounting to about US $50 million in 1976 and slightly more in 1977 and 1978. Reparations and restitution payments, the bulk of capital imports from West Germany, required no repayment. More than US $4.5 billion was received from a variety of sources between 1950 and 1977. These other sources included credits from West European governments, loans from financial institutions, such as the International Bank for Reconstruction and Development (IBRD, also known as the World Bank) and the International Monetary Fund, and some other private and government borrowing on long and medium term. Short-term loans provided an additional emergency source of funds, but they were not included in this survey of Israel's capital imports. Although a large part of capital imports required no repayment, the increased borrowing during the 1970s rapidly escalated the obligations owed abroad from US $3 billion in 1970 to US $9.3 billion at the beginning of 1977. At that time the external public debt amounted to US $7.4 billion, including US $2.1 billion for the government's Independence and Development Bonds. At the beginning of 1977 private indebtedness abroad was US $1.6 billion. Interest payments on the public and private debt were US $523 million in 1976, and total debt servicing amounted to US $1.1 billion, 25 percent of the export of goods and services. In 1977 the external debt increased by 15 percent to US $10.7 billion, but debt service as a percent of goods and services continued the decline begun in 1975 because of increased exports; in 1977 the debt burden amounted to 23 percent of the exports of goods and services. At the end of 1977 over 55 percent of the country's foreign debt was owed to the United States government and Israeli bond holders. Deterioration of the balance of payments after the 1973 war was the result of several factors. The major ones were the high level of defense costs, sharply rising prices for imported commodities between 1973 and 1975, and an economic recession in industrialized countries in the mid-1970s that contracted Israel's export markets. The interaction of these factors greatly increased the excess of imports over exports that had to be financed by foreign funds. The trade deficit amounted to US $232 million in 1960, US $326 million in 1965, US $1.1 billion in 1970, and US $3.5 billion in 1975. Capital imports, including private and government transfers, also increased nearly doubling between 1972 and 1973. Capital imports amounted to US $2.4 billion in 1974 and US $3.3 billion in 1975 and 1976. In 1974 and 1975 the usual sources of capital imports were insufficient, and foreign exchange reserve and other short-term financing were used, amounting to nearly US $2 billion. In 1976 the balance of goods and services improved primarily because of increased exports, partly resulting from economic recovery in industrialized countries and currency devaluation, and a reduction of imports, almost exclusively for defense (see table 18, Appendix A). Direct military imports amounted to US $1,846 million in 1975 compared with US $1,603 million in 1976. The reduced trade deficit accompanied by a shift of American aid from loans to grants (from US $642 million in 1975 to US $1.2 billion in 1976) reduced the amount of foreign borrowing and eliminated the need for additional short-term financing. The improvement in 1976 eased the near crisis of 1974 and 1975. Foreign exchange reserves had increased by nearly US $200 million by the end of 1976, and they rose another US $200 million by January 1978 as exports of goods and services increased more than imports. The country's foreign exchange reserves amounted to nearly US $1.6 billion by January 1978, the highest level since the end of 1973. Israeli officials had no hopes for rapidly reversing the traditional import surplus. They had labored for many years to reduce imports by encouraging local manufacturing and to stimulate export industries through numerous policy measures. The best they could hope for was a gradual improvement, such as that in 1976 and 1977, meanwhile continuing to rely on a flow of foreign funds. Nonetheless there was strong motivation to reduce the need for future borrowing and particularly to reduce the dependence of the country's economy and defense posture on direct financial assistance from another government. Moreover the important flow of funds from Jews in America hinged partly on the tax treatment afforded contributions to Israel. By 1978 projections of export growth and reductions of the trade imbalance in future years were optimistic, but realization depended on adjustments in domestic industry that would improve its competitive position in foreign markets and, above all, on peace and a reduction of the level of military imports.