Cablegate: Israeli Economic Growth Slows in Third Quarter

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1. (SBU) Summary. Although the economy slowed in the third
quarter, it will grow close to 4% for the year as a whole.
The deficit is likely to come in under the targeted level of
4% as a result of the GOI's lid on spending and a positive
revenue picture. The Bank of Israel (BOI) took advantage of
a low-inflation environment to cut interest rates 0.2% in
November, providing monetary policy support for continued
economic expansion in 2005.

2. (SBU) Growth has yet to result in a significant reduction
in unemployment, which remains at 10.2% as of the third
quarter. The picture is unlikely to improve in 2005. The
poor unemployment numbers increased the political impact of
the "poverty report," issued annually in November by the
National Insurance Institute, which claimed that almost 30%
of all Israeli children live under the poverty line.

3. (SBU) Economic stability has not been affected by Likud's
ongoing efforts to form a coalition with Labor as well as
with at least one religious party. Within the context of the
coalition negotiations, economic commentators believe Labor
will use the poverty report to push for changes to the GOI's
economic program, including possible delays in implementing
the Bachar Committee's capital market reforms, approved by
the Government on November 14. Finance Ministry officials
claim Labor's participation will have only a minimal impact
on the budget, which is likely to be submitted quickly to the
Knesset once the new coalition is in place. Although the GOI
continues to move towards Gaza disengagement, it has yet to
finalize budgetary numbers. End Summary

Third Quarter Growth Slows

4. (U) Although the Israeli economy continued to expand in
the third quarter, it did so at a significantly slower pace
than earlier in the year. This was due to a contraction in
personal consumption, the port strike of July-August, which
restricted both imports and exports; and a decline in
international demand for Israeli exports.

5. (U) According to initial Central Bureau of Statistics
figures based on partial statistics, the economy grew by 3.7%
on an annualized basis in the third quarter, following
annualized growth of 4.3% in each of the first two quarters.
Private consumption expenditure, which had been showing signs
of improvement earlier in the year, also contracted; in
particular, consumption of durable goods per capita declined
by 20% in the third quarter, following growth of 10.5% in the
second quarter of 2004. Per capita private consumption
declined by 1.8% in the third quarter, compared with an
increase of 1.1% in the second quarter of 2004, and increases
of 2.3% both in the first quarter of 2004 and the fourth
quarter of 2003.

6. (U) Business sector GDP growth moderated to 3% in the
third quarter from 6% in the second quarter. The third
quarter was the first quarter since the third quarter of 2003
in which business sector GDP was lower than GDP. The slower
growth in the business sector reflects the significant
reduction in export growth from 23% in the first quarter, to
13% in the second quarter, and 4.2% in the third quarter.
The lower export figures are due in large part to the port
strikes during July and August. Imports of goods, also
negatively affected by the port strike, grew by just 1.8% in
the third quarter, compared with 12% in the second quarter
and 24% in the first quarter. The main indication of
investment, fixed capital formation, declined by 14.3% in the
third quarter, compared with a decline of 3.2% in the
previous quarter.

CBS: Overall 2004 Growth Close to 4%

7. (SBU) On October 18, the Central Bureau of Statistics
reported that their preliminary growth estimates indicated
that growth would be 4% in 2004. A CBS contact told us this
view obtained in spite of the decline in most major
components in the third quarter. He cited positive trend
data, which indicated an increase in imports of raw
materials, durable goods and consumer durables in October.
Industrial production also showed a positive trend in each of
the last three months.

2004 Deficit Below Target

8. (U) GOI and other private forecasts indicate that the 2004
deficit will be in the 3% to 3.5% range. The cumulative
deficit for the first eleven months of 2004 totaled NIS 11.4
billion, which is only 55% of the NIS 20.6 billion deficit
target for the entire year. By comparison, the deficit for
the first 11 months of 2003 stood at NIS 21.2 bio. A Bank
Leumi economist told us that in his estimation the deficit
will be somewhere between 3% to 3.5% for the year, as the
government is likely to increase expenditures in December.
The reduction in the deficit to less than 3.5% from a deficit
of 5.6% of GDP is primarily a result of the GOI,s success in
curbing expenditures, as evidenced by cumulative expenditures
for 11 months of NIS 175 bio, or NIS 46 billion less than the
expenditure target of NIS 221 billion. Although there has
been a slowing down in tax revenues in recent months, the GOI
is likely to meet the tax target of the 2004 budget.

BOI Reduces Rates by 0.2% in November

9. (U) On November 22, the Bank of Israel announced a 0.2%
interest rate reduction to 3.9% from 4.1%. This was the
first change in interest in seven months, since the BOI
reduced rates by 0.2% at the end of March. In its press
release, the BOI indicated that the reduction was based on
the very low level of inflation in the past few months, as
well as the assessment that inflation will be within the
range of price stability (current inflation rate for the year
is 1.2%). The Central Bank also cites the slower economic
recovery and weaker dollar as reasons for lowering interest
rates without concern that it would cause economic or
financial instability.

Unemployment High but Declining

10. (U) The Central Bureau of Statistics reported on November
24 that unemployment declined to 10.2% in the third quarter
of 2004, from 10.5% in the second quarter. There was an
increase of 3.3% in the number of employed persons in the
first 9 months of 2004 compared with the comparable period in
2003, representing an increase of 76,000 people. After the
release of the unemployment data, Finance Minister Netanyahu
expressed satisfaction with the consistent and continuous
decline in unemployment during the last year, and said that
this supported the efficacy of the government,s economic

--------------------------------------------- -
Poverty Report Sparks Discussion on Bibinomics
--------------------------------------------- -

11. (U) The publication of Bituach Leumi,s (National
Insurance Institute) &poverty report8 in November led to an
intensification of Israel,s debate over combating poverty.
Finance Ministry officials believe in using a range of
economic incentives, including the reduction of transfer
payments, to induce more people to enter the workforce.
Other observers, including the Bank of Israel and Bituach
Leumi (BL), believe the GOI has reduced government support to
the poor and unemployed too far too fast, thereby
unnecessarily increasing poverty levels.

12. (SBU) The report indicates that there was an 8% increase
in the number of people living in poverty to more than 1.4
million people in 2003, an increase of more than 100 thousand
compared with 1.3 million in 2002. The 2003 statistics
indicated that 29.4% of children and 19% of families were
living below the poverty level, even after receipt of
transfer payments. In view of the proposed inclusion of the
Labor party in the Government, it is likely that the poverty
report and its findings will remain an important part of the
economic debate in 2005.

Bachar Capital Market Reforms Move Forward

13. (SBU) The Bachar capital market reform recommendations,
which are intended to increase competition in the very
centralized and concentrated banking sector, were approved by
the Government on November 14. The main aspects of the
reforms include removing Provident funds (private retirement
funds) and mutual funds from the banks, ownership and
management over the next few years. In return, the banks
will be able to enter the insurance market, and sell life
insurance. The banking community has strong reservations
about the reforms and is seeking to delay their

14. (SBU) Debate over the Bachar reforms is taking place
against the background of increased &bank bashing8
resulting from perceptions these institutions have taken
advantage of their strong position to leverage outsized
customer fees. The reforms have also become something of a
bargaining chip in coalition talks between the various
parties. As one Central Bank official told us, it is
impossible to predict whether the Bachar recommendations will
have a fate any more successful than other (unimplemented)
financial reform plans introduced over the past twenty years.
She nonetheless finds them appropriate and necessary for
reforming a hidebound financial services sector.

Gaza Disengagement

15. (SBU) A range of GOI officials have told us that PM
Sharon is committed to implementing his Gaza Disengagement
plan on time ) at the latest. Fast-paced legislative
movement reflects this commitment. On November 3, the
Knesset approved the first reading of the Disengagement
legislation. On November 15 the Knesset Finance Committee
approved the transfer of NIS 35 million for the Disengagement
Plan: NIS 30 million for prepayment of compensation to
Settlers who agree to leave their homes, and NIS 5 million
for the cost of the Justice Ministry to prepare Compensation
) Evacuation legislation. On November 16 the Disengagement
Administration officially commenced its operations, with the
inauguration of its website including information and forms
regarding compensation calculations and maps showing
re-settlement possibilities.

16. (SBU) The Israeli media estimates disengagement will cost
more than NIS 5 billion (USD 1.1 billion). The Finance
Ministry plans to apportion payment over two years in the
2005/2006 Budgets. For 2005, the MOF has proposed
accommodating disengagement-related spending by raising the
deficit target to 3.4% from the original 3%, as well as by
increasing real expenditure growth above the 1% target. As
these targets form a core element of Loan Guarantee Agreement
economic conditionality, the MOF has requested USG views on
the changes. Although the Israeli press has reported the GOI
will request U.S. assistance to pay for at least a part of
disengagement, no formal request has been made to date.

The 2005 Budget ) Temporarily Tabled

17. (U) The GOI will likely begin 2005 without a new budget.
Although PM Sharon had waited a number of months to submit
the budget in the hope of finding the necessary votes, he
finally decided that the cost of losing was less than not
forcing a decision. In the end, only Sharon,s own Likud
party and United Torah Judaism supported the NIS 264.5
billion (approximately USD 60 billion) bill in its first
reading on December 1. Sharon fired ministers from the
Shinui party who voted against the budget, an action which
reduced his coalition to a party of one and set the stage for
ongoing coalition negotiations with the opposition Labor
party, United Torah Judaism and Shas. Sharon has threatened
to call early elections if he cannot build a coalition with

18. (SBU) According to contacts at the Ministry of Finance,
Labor will make a big show of obtaining changes to the 2005
budget once it is in the coalition. In reality, these
changes will probably center on a fairly modest increase in
transfer payments to the elderly, which can be accommodated
within the budgetary framework. Even if Labor achieves more
significant budgetary changes, these will be paid for out of
across-the-board reductions in ministerial budgets, not
through additional spending, according to our Finance
Ministry contacts. The result: a 2005 deficit that should
not exceed 3.4% of GDP (disengagement expenses included).

19. (U) Assuming the budget does not pass before the end of
the year, the Government will begin operating on a monthly
appropriations based, per line item, on the lower of either
the 2004 actual or 2005 proposed budgets. In accordance with
Israeli law, if the Budget is not passed by March 31, 2005,
the Government would fall, and new elections would be called
in 90 days.

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