$Unique_ID{bob00273}
$Pretitle{}
$Title{Israel
Chapter 4E.   Banking and Monetary Policy}
$Subtitle{}
$Author{Richard F. Nyrop}
$Affiliation{HQ, Department of the Army}
$Subject{government
percent
new
israel
prices
policy
economic
housing
bank
banks}
$Date{1979}
$Log{}
Title:       Israel
Book:        Israel, A Country Study
Author:      Richard F. Nyrop
Affiliation: HQ, Department of the Army
Date:        1979

Chapter 4E.   Banking and Monetary Policy

     The beginnings of the banking system extended back to the mid-nineteenth
century when Palestine was part of the Ottoman Empire. Several banks were
established, but the most important for the Jewish communities was one formed
in 1903 and subsequently named the Anglo-Palestine Bank. It was active in
financing the new town of Tel Aviv, for example, after it was founded in 1904.
Under British rule after World War I, the Anglo-Palestine Bank considerably
expanded its operations, and a number of other Jewish banks and credit
societies were formed. By 1948 the banking system in what became Israel was
well developed and heavily involved in mobilizing finances for development.

     At independence the Anglo-Palestine Bank became the banker for the
government and issued the new currency, the Israeli pound (see Glossary). It
also expanded its commercial operations, meanwhile changing its name to Bank
Leumi Le Israel in 1951. In 1978 Bank Leumi remained the largest of the
commercial banks and was ranked among the 100 largest in the world with assets
of US $10 billion. In 1954, however, its central bank functions were turned
over to the newly created Bank of Israel after legislation was passed creating
a central bank.

     The Bank of Israel has exclusive right of note issue and the authority to
regulate and stabilize the currency. It also acts as the government's fiscal
agent, licenses and regulates commercial banks, and controls the amount and
directs the flow of credit in accordance with the economic policy of the
government. The head of the bank acts as chief economic adviser to the
government. The bank is required to prepare an annual report on the country's
economic and financial situation (a very valuable and extensive source of
information).

     By the late 1970s there were more than twenty commercial banks with an
extensive network of branches and offices throughout the country and several
branches or subsidiaries abroad. Commercial banks primarily handled short-term
financing such as loans for trade and working capital. A trend toward
consolidation and large banks existed before and after independence. The
number of banks has been shrinking, and many of the cooperative societies were
taken over by the banks. The three largest banks, all established before 1935,
handled the bulk of the commercial banking business.

     Medium- and long-term financing came from specialized banks to serve
industry, agriculture, shipping, and housing and other building. These
institutions were government owned or jointly owned by the government and
others, particularly the large commercial banks. The Industrial Development
Bank of Israel (IDBI), for example, was formed in 1957 by the government, the
three major commercial banks, Histadrut, the Manufacturers Association of
Israel, and foreign investors, and was the major source of funds for
industrial development. The IDBI, directly or through its subsidiaries,
provided loans, equity capital, and fund administration. It borrowed abroad
and at home, although the latter was minor; the government or the commercial
banks provided most of the local currency needed.

     There were a number of other financial institutions engaged in mobilizing
funds for investment. Social insurance and pension funds, particularly the
country's equivalent of the American social security system, were a major
source. General commercial insurance companies provided some investment
financing, but life insurance was not extensively used by Israelis, limiting
the collection and long-term use of insurance money. Investment companies also
collected and channeled investment funds into economic expansion. The
forerunner of the Tel Aviv Stock Exchange was established in 1934, but stock
or bond issues were a minor source of development financing after the 1950s
because institutional investors, the usual major source of financing, had to
hold a large percentage of funds in government bonds or government approved
issues.

     The Israeli financial system was comprehensive and efficient in
collecting funds and providing services, but the government played a decisive
role in both mobilization and allocation of financial resources. The
government received a substantial portion of capital imports and borrowed
extensively in the domestic market, which along with tax collections, passed
a substantial part of the country's financial resources through the budget.

     The government controlled allocation of financial resources through a
variety of measures. Direct allocations from budget expenditures to
investments or to the specialized lending banks, which in a sense acted as the
government's agent, for onlending to desired projects was one method. A
substantial part of short-term credit was so-called directed credit that the
commercial banks supplied, according to government guidelines, to businesses
considered essential. The government, through the central bank, also regulated
the amount and terms of credit from financial institutions. The interest rate
was controlled, and subsidized in many cases, so it had little allocative
function. The extensive government role in finance contributed to the rapid
economic growth that provided a rising standard of living for an expanding
population, but it was less successful in controlling inflation.

     Inflation was a constant characteristic of the economy. Inflationary
forces were especially strong from independence until about the mid-1950s.
Price controls and rationing suppressed the upward pressures on prices at
first, but prices rose rapidly between 1951 and 1954, contributing along with
a greater availability of goods to the elimination of numerous black markets.
From 1955 to 1965 rapid expansion of output, monetary and fiscal policy, and
other factors diminished the pressure on prices, and they rose an average of
5.9 percent a year.

     Toward the mid-1960s officials became concerned about the growing deficit
in the balance of payments. Policies were instituted to reduce aggregate
demand and the level of imports. The currency was devalued in 1964 to make
imports more expensive and to stimulate exports. Between 1965 and 1967 growth
of output slowed considerably, unemployment increased, and underutilized
capacity developed. After the 1967 war, policy reverted to economic
stimulation, and a period of high economic growth continued until the 1973
war. A new factor contributing to economic expansion was an increase in
private consumption; after years of austerity and concern with survival, the
victory in the 1967 war prompted Israelis to think more about personal goals,
resulting in a buying spree for things such as housing, furniture, appliances,
and cars. Defense costs and other public consumption also increased, and
investments expanded. The increased demand had little effect on prices at
first because of the slack in the economy. Between 1965 and 1970 the consumer
price index increased only about 4 percent a year although prices began edging
upward by 1969.

     By 1970 the demand on resources became excessive, and prices began to
rise more rapidly. Domestic factors of production were fully employed.
Monetary policy had not fully neutralized the large inflow of foreign funds,
increasing the liquidity in the economy. Restrictions of private consumption
were not effective. Surcharges on imports and a currency devaluation started
import prices upward in 1970, and the rise of fuel prices in 1973 and 1974 and
the inflation in industrialized countries in the 1973-75 period further
increased import prices. The wage-price agreement, which had kept wages stable
for several years, broke down before the 1973 war, and wage costs began
rising. A wage-price spiral was in motion. The average yearly change in the
cost-of-living index was 12 percent in 1971, 13 percent in 1972, and 20
percent in 1973.

     Inflation continued to worsen after the 1973 war in spite of efforts to
contract aggregate demand. Between 1973 and 1976 real GNP growth slowed to
about 3 percent a year with investments suffering the most; real gross capital
formation in 1976 was less than the 1972 level. Real public consumption slowed
and fell in 1976, but private consumption continued to increase except for a
slight decline in 1975. The change in average prices of the cost-of-living
index was 40 percent in 1974, 39 percent in 1975, and 31 percent in 1976.
Prices rose 42 percent in 1977 (the increase in average prices was 35 percent
over 1976), much of it late in 1977 after institution of the new government's
New Economic Policy.

     Factors on the cost side contributed to the rising prices. Currency
depreciation, including a series of minidevaluations (totaling 43 percent),
raised import prices between late 1974 and October 1977 when the currency was
devalued by a nominal 47 percent and allowed to float. Government subsidies
were cut, and prices for services were raised several times after 1973 to ease
the problem of budget financing. Wages rose twice each year just from the
cost-of-living clause in labor agreements, and unemployment barely increased.
Imposition of the VAT in 1976 and the higher rate in late 1977 further
increased the costs of goods and services.

     By 1978 efforts to halt inflation had failed. Institutional arrangements
were partly at fault. Such policy measures as currency depreciation, reduced
subsidies, and higher taxes increased prices, which then pushed up wages
through the cost-of-living clause and negotiated salary increases. Higher wage
costs increased the prices of goods and services in a vicious circle. The
major cause, however, was the reluctance to cut budget expenditures. More
emphasis was given to increasing revenues, restricting credit expansion, and
other indirect measures to contract demand than the more efficient and
necessary reduction of government spending. The FY 1978 budget was prepared
under the New Economic Policy of the Likud government and proposed a reduction
of expenditures by 5 percent in constant prices, but the Bank of Israel and
other observers criticized the proposed budget for its optimistic forecasts
and high level of spending. Many economists predicted that the budget would
inject too much liquidity into the economy and continue the high rate of
inflation.

Other Economic Sectors

     Construction has always been of exceptional importance in the economy,
but in the 1970s housing became a social and political problem. One facet of
the problem was that the standard of housing that could be provided immigrants
in the early years was lower than current standards. Another facet was the
very rapid rise in the cost of housing after the 1967 war, placing the
purchase of housing out of the reach of young couples and many others. The
older immigrants and their grown children believed that they deserved housing
equal to that provided new immigrants. There were several squatters' strikes
at housing units for new immigrants in the 1970s. The government feared,
however, that diminution of the standard of housing offered new immigrants
would adversely affect the immigration rate. Moreover, since the 1973 war,
budget constraints hobbled the government's ability to increase its help on
housing.

     Residential construction is both a public and private sector activity.
Since 1948 the government has built more than 400,000 units of permanent
housing as well as undertaking slum renovation and providing help in various
forms to individuals to find their own housing. Expenditures on housing have
been an important drain on the budget. About 67 percent of Israelis own their
own housing, largely condominium apartments. A substantial number of the
existing residences were seriously substandard. Housing taken over from the
Arabs who left at independence and some of the low-cost units built during the
1950s had deteriorated by the 1970s. This was the kind of housing the older
immigrants, particularly the poorer, Sephardic (see Glossary) families, were
disturbed about.

     In the 1970s the government planned programs to ease the housing problem,
but officials continuously encountered a shortage of funds to implement the
programs. In 1978 the goal was to eradicate slums in five years as part of a
war on poverty. It was not certain what success this program would have in the
face of probable future budget constraints. Residential construction by both
the public and private sector fell sharply after 1973 partially in response
to restrictions on government expenditures. Housing construction in progress
dropped from 100,000 units in 1974 to only 54,000 units in 1977. Building
starts had also fallen, and the construction industry was in difficulty,
partly because completedhousing units were not selling as a result of high
prices. A continuation of the low level of immigration in recent years would
help reduce the housing problem, but a solution would also require a high
rate of construction for several years.

     The transportation system was well developed, partly because of defense
needs. Considerable expansion took place after independence as new areas were
settled in an effort to produce a national system in contrast to the much
larger area that was the focus of the British transportation development
under the Mandate. Since independence about one-quarter of Israeli investments
in the economy went into the transportation sector, and about one-tenth was
largely for the roads network.

     By the mid-1970s (the latest data available in mid-1978) there were more
than 20,000 kilometers of roads, providing a relatively dense network. Road
surfaces varied from high speed interurban highways (at least 3,300
kilometers) to dirt and gravel surfaces in isolated areas. The bulk of the
freight (close to 90 percent) and passenger traffic moved by trucks and buses.
In 1976 there were 484 kilometers of standard-gauge railroad line, connecting
Haifa, Tel Aviv, and Jerusalem, and linking the Negev phosphate deposits with
the port of Ashdod (see fig. 1). The railroad was used primarily for bulk
cargo, particularly phosphates.

     There were three major deepwater ports-Haifa, Ashdod, and Eilat. In 1976
these ports handled 8.8 million tons of cargo (excluding bulk oil transport),
nearly 60 percent via the port of Haifa. At the beginning of 1977
Israeli-owned shipping amounted to 4.4 million deadweight tons, two-thirds of
which were oil tankers. About 44 percent of imports and 26 percent of exports
were carried by Israeli ships in 1976.

     The communications system was modern and highly developed and one of the
best in the Middle East. In 1977 there were nearly 800,000 telephones and
several television, fourteen AM, and ten FM stations. Links to foreign
countries were by submarine cable and satellite stations.

The New Economic Policy of 1977

     Since the mid-1970s economists have pointed out the need for structural
changes in the economy. The size of defense costs, investments, and welfare
measures could no longer be handled as they had been since independence
largely by increasing available resources through greater capital imports. The
new arithmetic required curtailment of growth if not actual reductions of some
uses of resources. A start in that direction had begun after 1973 with
reductions of subsidies, devaluation, and even a decline of defense
expenditures (in constant prices), but investments suffered most, the area
needing augmentation if more resources were to be available in the future and
continued improvement in the balance of payments was to be achieved.

     The May 1977 elections brought the first change of the ruling party since
independence (see Political Setting: Elite, Values, and Orientations, ch. 3).
The moderate socialist, prolabor Israel Labor Party was replaced by the
nationalistic, free-enterprise oriented rightist Likud Party as the head of a
coalition government. The new government announced a new economic policy on
October 28, 1977, and the FY 1978 budget was prepared under the new
guidelines.

     The major provisions of the New Economic Policy were: freeing the Israeli
pound and allowing it to float; abolition of most foreign exchange
restrictions; elimination of the system of export rebates, surcharges on
imports and some invisible payments, and taxes on foreign travel; unlimited
travel allowances for business trips abroad and more liberal allowances for
tourists; and reduction by 21 percent of import duties about 12 percent. Other
provisions included an increase of the VAT (from 8 to 12 percent for most
commodities); reduction of purchase taxes on raw materials; gradual reduction
of budget subsidies; and immediate increase of fuel prices by 25 percent and
later increases for electricity and water.

     Although the new policy partly aimed at control of inflation, the main
focus was the balance of payments. The value of the Israeli pound depreciated
immediately after the removal of controls by a nominal 47 percent (from
10.40 Israeli Pounds to 15.25 Israeli Pounds to US $1). This occurred after the
pound had already depreciated by 43 percent under the policy of creeping
minidevaluations in effect from late 1974. By the end of March 1978 the pound
had declined further to 16.42 Israeli Pounds to US $1. The actual currency
devaluation was substantially less than the nominal value, however, because
of the elimination of the multiple exchange rate system that resulted from
the surcharges on imports and rebates on exports. Some estimates indicated the
devaluation for imports was on the order of 20 percent and somewhat less for
exports.

     The devaluation made imports more costly and exports more competitive
even with virtual abolition of export promotion payments of past years. The
expected result was a structural shift in the economy and a flow of resources
moving toward export industries and the production of substitutes for imports.
The policy anticipated that the structural change would follow and
automatically continue from the economic pressures of the free floating
currency. The policy change from government interference to market forces in
the allocation of resources appeared to be the most innovative and unusual
aspect of the new policy. The change was also expected to stimulate an inflow
of direct investment in Israeli industries, a source of capital imports that
had virtually dried up after 1973.

     The new policy would likely hurt numerous firms and force some to close,
but it would take a period of time to determine the impact and success of the
new policy. Moreover sharp increases in such domestic costs as wages would
nullify the gain from devaluation. Furthermore it was not even certain that
the government would stick with the new direction-much depended on the amount
of unemployment that resulted.

     An announced aim of the Likud Party was to lower the rate of inflation to
about 30 percent in 1978, and the New Economic Policy continued the policy
efforts of recent years. Part of the effort focused on contracting aggregate
demand, particularly the 50-percent increase in the VAT. The more interesting
aspect was the effort to reduce government spending. The FY 1978 budget
expenditures declined about 5 percent in terms of constant prices, largely
because of cuts in subsidies and defense purchases abroad. A greater reduction
was precluded by the substantial jump in debt repayment and government wage
costs caused by the record jump in the cost-of-living index resulting from the
imposition of the new policy.

     The devaluation accompanying the new policy automatically increased the
costs of servicing the foreign debt and jumped up the prices of imported
goods. The increase in VAT raised domestic prices. The cost-of-living index
increased by 11.8 percent in November 1977 after introduction of the new
policy, the highest monthly rise in the country's history; the index rose by
42.5 percent over the whole year. There were a number of wildcat strikes and
disruptions after introductions of the new policy.

     The government's changes posed some risks. The most risky was the
declared intention to rely on the private sector for investments in industry.
A period of low investment because of uncertainty or reluctance by private
investors, coming after several years of slow investment by both government
and private sector, could seriously undermine future industrial and export
growth.

     The other major risk was that labor discipline and productivity would
break down because of increasing unemployment and falling real wages. The
amount of unemployment would depend on the government's ability to reduce
expenditures and the mobility of labor to shift from the service sector and
uneconomical manufactures to export industries. Any real slowing of inflation
would require belt tightening, but labor felt the new government was placing
all of the burden on them and the poor. Their argument had merit because the
bulk of the new measures increased living costs, affecting those in lower
income ranges more than those with higher salaries. The government has
promised help to the very poor, however. It was unclear what the outcome would
be. In April 1978 an informal agreement was reached between the government and
the Histadrut for a freeze on prices of government services and subsidized
basic necessities in return for restraint in wage negotiations by the trade
unions. It was uncertain whether the agreement would hold up or what workers'
reactions would be.

     By early 1978 a start had been made toward reducing inflation and
restructuring the economy. The success in 1978 would probably be limited
because it was a transitional period. The incursion into Lebanon and wage
agreements already negotiated would likely raise expenditures above the
budgeted level and keep the rate of inflation quite high. What would happen
in subsequent years was anybody's guess. Government officials were
optimistic, and critics, and there were many, were pessimistic. Much would
depend on variables in countries other than Israel. A peace settlement and a
reduction of the defense burden would immeasurably improve chances for
adjusting the economy toward rapid growth again.

                                    * * *

     Information on the Israeli economy is extensive, and any short listing
is bound to exclude many of the informative books and articles available.
Basic data are contained in the annual Statistical Abstract of Israel
published by the Central Bureau of Statistics and the Annual Report published
by the Bank of Israel. The Ministry of Finance's annual Budget in Brief
provides considerable data and text on the budget. Additional data and text
are included in the Bank of Israel's Economic Review and Recent Economic
Developments, and the Central Bureau of Statistics' Monthly Bulletin of
Statistics. Other sources covering a wide range of economic subjects include
the monthly Israel Economist and Kidma: Israel Journal of Development.

     A handy broad survey covering the Palestine economy and Israeli
development up to the 1970s is contained in the Israel Pocket Library-Economy.
Several books cover the subject of foreign trade and economic development
including Michael Michaely's Foreign Trade Regimes and Economic Development:
Israel and Richard Pomfret's Trade Policies and Industrialization in a Small
Country: The Case of Israel. Harold Greenberg and Samuel Nadler's Poverty in
Israel: Economic Realities and the Promise of Social Justice reviews economic
development in terms of income distribution and social problems. A number of
books treat agriculture and its cooperative organization-one of the most
recent is Haim Barkai's Growth Patterns of the Kibbutz Economy. The Arabs in
Israel by Sabri Jiryis looks at land acquisition by the government from the
Arab point of view.

     A very useful survey of the country's capital imports is contained in an
article by Michaely entitled "Israel's Dependence on Capital Imports." Nadav
Halevi's article "The Economy of Israel: Goals and Limitations" briefly sums
up how Israel reached its present difficulties. The Number 11/1977 issue of
Kidma: Israel Journal of Development was largely devoted to the country's
water problems and solutions. Information on defense industries is included in
Edward Glick's Between Israel and Death, Anthony Sampson's The Arms Bazaar,
Louis Kraar's "Israel's Own Military-Industrial Complex," Charles Holley's
"Israel After Agranat," Clarence A. Robinson's "Israel Arms Exports Spur
Concern," and Charles Gilson's "Israel's Aerospace Industry." Information on
the economies of the occupied territories is contained in the Statistical
Abstract of Israel, the Bank of Israel's The Economy of the Administered
Areas 1974-75 (and reports for other years), and Brian Van Arkadie's Benefits
and Burdens: A Report on the West Bank and Gaza Strip Economics Since 1967.
(For further information see Bibliography.)