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Cablegate: Jedg Midterm Reveiw - Israel On Target for Fy2010 Loan

VZCZCXRO9194
RR RUEHROV
DE RUEHTV #0194/01 0271158
ZNR UUUUU ZZH
R 271158Z JAN 10
FM AMEMBASSY TEL AVIV
TO RUEHC/SECSTATE WASHDC 5191
INFO RUEHXK/ARAB ISRAELI COLLECTIVE
RHEHNSC/NSC WASHDC
RUEATRS/DEPT OF TREASURY WASHDC

UNCLAS SECTION 01 OF 06 TEL AVIV 000194

SIPDIS

SENSITIVE

NEA/IPA FOR GOLDBERGER,FRELICH; EEB/IFD FOR PERDUE; EEB/OMA FOR
ENGLE; TREASURY FOR BALIN

E.O. 12958: N/A
TAGS: ECON EFIN PGOV ELAB IS
SUBJECT: JEDG MIDTERM REVEIW - ISRAEL ON TARGET FOR FY2010 LOAN
GUARANTEES AND EAGER FOR HIGH-TECH COLLABORATION

REFS: A) 09 STATE 76107; B) 09 TEL AVIV 653

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Summary
-------

1. (SBU) At the December 15 mid-term review of the U.S.-Israel
Joint Economic Development Group (JEDG) held in Jerusalem, the GoI
clearly demonstrated that it is meeting, and may well surpass, the
calendar year 2009 conditionality required to release the FY2010
tranche of loan guarantees. The GoI focused JEDG discussions on its
positive economic performance, despite the global financial crisis,
and on its desire to engage the U.S. in a high-tech dialogue. The
U.S. delegation, led by Treasury Acting Assistant Secretary for
International Affairs Andy Baukol, presented the outlook for the
U.S. economy, and offered its views on a future Israeli fiscal rule.
While expressing willingness to explore avenues of high-tech
cooperation, the U.S. delegation remained non-committal citing
funding constraints and consideration of the proper government role.
The Director General of the Ministry of Finance, Haim Shani, led
the Israeli delegation, with Governor Fischer presenting Bank of
Israel's monetary outlook. Shani spearheaded the push for robust
USG involvement in promoting the high-tech dialogue and a variety of
Israeli officials underscored the call, including the head of the
Economic Council, Dr. Eugene Kandel and the Chief Scientist of the
Ministry of Industry, Trade and Labor, Dr. Eli Opper. End Summary.

-----------------------
A Tale of Two Economies
-----------------------

2. (SBU) At the JEDG mid-term review held on December 15, 2009 in
Jerusalem, Acting Treasury Assistant Secretary for International
Affairs Andy Baukol began the meeting by providing a sobering update
on the U.S. economy. From negative GDP growth until the third
quarter of 2009 and an unemployment rate at a 26-year high, Baukol
looked to the positives of improving financial conditions and a
stabilization of the housing market. He shared Treasury Secretary
Geithner's goals for financial sector reform: 1) avoiding
regulatory arbitrage 2) increasing accountability by regulators, 3)
increasing the resilience of the financial sector and 4) avoiding
the "too-big-to-fail" enterprises.

3. (SBU) The outlook of a return to growth in 2010 and solid
growth thereafter was moderated by the assessment that unemployment
will remain high through 2010 and the federal budget deficit will
remain at roughly 10 percent of GDP. Fiscal projections from the
Office of Management and Budget (OMB) show publically held
debt-to-GDP rising through 2019 and mandatory spending on Social
Security, Medicaid and Medicare increasing to 60 percent of the
federal budget by 2080 on the current trajectory. Baukol
underscored the current administration's belief that spending on
entitlement programs and healthcare will be the biggest economic
problems the U.S. must address in the next four years. Baukol also
stressed the danger of snowballing interest payments on debt if the
U.S. does not return to deficits under 3 percent of GDP (the
long-term average U.S. growth rate) once private sector growth
returns.

4. (SBU) Ministry of Finance Director General Haim Shani offered a
largely positive macroeconomic overview of the Israeli economy,
spotlighting the role of the high-tech industrial sector as a key
engine of Israeli economic growth. Shani commented that Israel
suffered less in the global crisis due to the financial nature of
the fully external shock. Exporters of financial goods and
sophisticated markets such as derivatives experienced the worst of
the crisis. However, the relative lack of sophistication in
Israel's banking sector and its status as a high-tech goods
exporter, a sector which saw only moderate decline following the
crisis, allowed its economy to rebound quickly. The MoF estimated
that Israeli GDP grew by a conservative 0.3 percent in 2009 and
forecasts 1.5 percent growth in 2010. The second quarter of 2009
showed the first evidence of recovery in Israel, and DG Shani
emphasized Israel's improved position relative to other countries.
Focusing on exports, Shani cited a small increase in exports to the
U.S. in 2009 (whereas exports to all other markets decreased), and
credited the resilience of Israel's exports in part due to the
opening of a major Intel fabrication plant in Kiryat Gat, north of
Beersheba. From 2002 to 2008, high-tech exports doubled, and now
comprise 12 percent of GDP and over 30 percent of total exports.
Shani did note, however, that Israel is still vulnerable to a
high-tech downturn similar to the one experienced in 2001-2003, a
period of slow growth and increasing fiscal deficits.

5. (SBU) Shani also highlighted labor market statistics, noting

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the downturn in unemployment in the 3rd quarter (7.8 percent down
from 8 percent in the 2nd quarter), the nominal freeze in wages, and
signaling the government's interest in reversing the trend of
decreasing labor participation among the ultra orthodox and the Arab
minorities. Capital markets and credit conditions improved
dramatically from December 2008 to November 2009. Corporate bond
issuances and prices have shown significant improvement since April
2009 after a period of stasis during the financial crisis. Shuki
Oren, the Accountant General at the MoF, noted his concern that the
mood may be too exuberant and cautioned that Israel and the global
economy are still in crisis.

6. (SBU) On fiscal matters, Shani again emphasized Israel's
progress relative to other OECD countries. Stronger spending
controls in Israel's budget since 2002, supported by conditions on
U.S. loan guarantees, brought Israel's public expenditures down to
42.9 percent of GDP in 2008, lower than the OECD average. With
Israel's high military expenditures and high interest payments,
civilian expenditures rank among the lowest of industrialized
countries, a matter of concern for some at the Bank of Israel and
elsewhere in the GoI. Shani expected the actual budget deficits for
2009 and 2010 to be one percentage point less than the 6 percent and
5.5 percent of GDP deficit ceilings agreed to at the June JEDG
meeting -- about 4 percent in 2009 and 4.5 percent in 2010. He
added that Israel's increase in public debt due to the economic
crisis is one of the lowest among advanced economies, estimated at
80 percent of GDP in 2010.

7. (SBU) Shani shared the IMF's advice from its recent mission to
Israel that the increase in global debt-to-GDP ratios relative to
that of Israel may not be beneficial to Israel's cost of funding.
An increased supply of high-grade American and European debt may
crowd out Israeli international debt and raise its cost of
financing. As such, Shani reiterated Israel's commitment to further
lowering its debt-to-GDP ratio in the near term. He cautioned,
however, that current projections do not anticipate Israel's debt
load decreasing until 2012.

8. (SBU) When asked about 2010 debt management plans, MoF
Accountant General Shuki Oren stated that Israel plans to issue $1.5
billion in international bonds in the first quarter of 2010 and is
contemplating at least one other large external offering in 2010 to
finance Israel's budget deficit and reduce crowding-out pressures on
Israel's domestic corporate debt market. At least one offering will
be Euro-denominated while the others will likely be
dollar-denominated. Oren added that Israel expects to raise a
maximum of $1 billion from the Diaspora community in 2010, and said
that U.S. guarantees remain a "backstop" that Israel will not likely
utilize unless the Ministry deemed other sources of financing too
costly. He did, however, note the importance of the guarantees to
investor confidence in Israeli debt.

---------------------------------
Bank of Israel on Monetary Policy
---------------------------------

9. (SBU) Bank of Israel Governor Stanley Fischer gave JEDG
participants an overview of BOI growth forecasts, monetary policy,
and assessment of health of the banking system. He noted that the
Bank would likely revise 2010 growth rates upwards, but currently
forecasts 2.5 percent. He underscored the openness of the Israeli
economy and the current account surplus of 3.6 percent of GDP in
2009, expected to decline slightly in 2010 to 2.3 percent of GDP.

10. (SBU) Fischer explained the BoI's recent monetary policy
measures, including interventions in the foreign currency markets,
as the need to increase reserves and improve currency dynamics in
the face of a looming recession and a 20 percent appreciation of the
shekel. While noting that the exporter's ideal shekel/dollar
exchange rate would be around 4, he said the Bank started
intervening with U.S. Treasury bill purchases when the shekel was at
3.3 to the dollar. Daily purchases of $25 million per day started
in March 2008 and increased to $100 million per day in July 2008.
In August 2009 the BoI enacted an exit strategy that called for an
end to daily purchases and continue to use ad-hoc interventions to
guide exchange rate expectations and guard against movements deemed
to be out of synch with Israel's economic fundamentals. Fischer
noted that he did not want to spur excessive currency market
volatility and an unchecked appreciation of the shekel and therefore
is pursuing a slow exit from daily interventions.

11. (SBU) By November 2009, foreign exchange reserves amounted to
$61.5 billion, up $32.9 billion from March 2008. Fischer noted that
since 70 percent of Israel's exports are listed in U.S. dollars, and
an even larger amount are incorporated into final goods sold in the

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U.S. markets, the BoI concentrates largely on the shekel-dollar
exchange rate in its evaluation of Israel's real effective exchange
rate. The BoI also began purchasing government bonds through open
market operations in February 2009, stopping in July 2009 as it
became clear that Israel was coming out of a short recession. In
all, the BoI purchased 3 percent of GDP in bonds, markedly less as a
percentage of GDP than the Bank of England or the U.S. Federal
Reserve.

12. (SBU) When asked about the outlook of Israel's foreign
exchange intervention policy, Fischer explained that he disagreed
with the IMF recommendation to publically announce an end to
interventions as he believes reserving the right to intervene will
help guide market expectations to avoid excessive appreciation
speculation. He said that most private trading on the currency
market does not follow long-erm trends and most actors do not
employ sophistcated hedging techniques. As such, he sees a
cotinued, but gradually diminishing, role for the Ban in managing
Israel's currency market.

13. (BU) Fischer presented interest rate policy by firt noting
Israel's history of high inflation and the Bank's focus on
controlling inflation expectations. To counter rising 12-month
inflation expectations above the Bank's 3 percent upper target, the
BoI raised Israel's benchmark rate from 0.5 percent to 1 percent
between September and the time of the December 15 JEDG midterm
review. (Note: An additional increase at the end of December brings
the current rate to 1.25 percent.) Governor Fischer explained that
inflation expectations remain at the upper end of the BoI's 1-3
percent price stability range, and inflation momentum from the rise
in Israel's value-added tax along with anticipated growth will
likely precipitate further rate hikes. Fischer commented that his
ability to raise rates is somewhat constrained by interest
differentials with the U.S. and European Central Bank, which may
increase if developed market central banks do not raise rates while
the BoI feels compelled to do so. Regarding the banking system,
Fischer noted that Israeli banks were able to raise funds on the
capital markets and did not require government assistance. The
Supervisor of Banks exerted consistent pressure on banks to maintain
capital requirements. Although Israel has seen a contraction in
credit growth in 2009, Fischer said, it need not return to 2006-09
levels, which he deemed "overly aggressive."

14. (SBU) When asked about the applicability of Israeli-style
currency intervention policy to other countries, he stressed that
few other countries could successfully mimic Israel's actions. A
small open economy, Israel enjoys a broad base of domestic investors
with a strong home bias (creating inflows during the most recent
crisis)as well as an open currency market that is small enough not
to attract overly excessive speculative trades by large hedge funds.
This combination, along with a well-respected and credible Central
Bank, is not easy to duplicate, said Fischer. He did note, however,
that BoI policies during the crisis may have also spurred the
beginning of bubbles in Israel's housing, equity and bond markets.
He will be paying close attention to these markets in the coming
months, he said.

15. (SBU) Fischer also emphasized that the GoI must continue to
focus on boosting economic growth. The 3-3.5 percent growth
predicted by the IMF for 2010 is too low to sustain current military
spending levels, maintain social equity, and continue to raise the
standard of living for most Israelis, he said. He argued that
Israel must concentrate on three main issues: 1) increasing the size
of the workforce, especially among religious and Arab communities,
2) boost competitiveness of the high-tech sector and its links to
minority communities and 3) enact real estate market reform to make
land ownership and transfer easier. He also noted that Israel could
see a large influx of foreign direct investment if a peace
settlement were enacted. (Note: Treasury reports that most major
rating agencies cite conflict/political risk as a primary constraint
to Israel's credit rating and investment climate.)

--------------------
The Fiscal Framework
--------------------

16. (SBU) Eyal Epstein, Deputy Budget Director at the Ministry of
Finance, described the history of Israel's fiscal framework from no
fiscal rules prior to 1992 to 2005 when pro and a-cyclical
limitations were introduced - a deficit ceiling and an expenditure
limitation. (See ref A for current targets agreed to in June 2009
JEDG meeting in Washington). Epstein argued that decreases in
expenditures and debt (as a percentage of GDP) since 2003
demonstrate the ability of the current arrangement to restrain
spending. (Note: Although spending controls aided fiscal

TEL AVIV 00000194 004 OF 006


retrenchment, a large increase in tax revenues from high economic
growth during 2003-2007 served as the primary reason behind Israel's
declining debt levels.) The ceilings have contributed to
conservative budgeting practices by the Ministry of Finance, which
Epstein believes have now been internalized throughout the Israeli
government.

17. (SBU) Epstein cited three risks to the current framework: 1)
the lack of sustainability of current expenditure ceilings given an
anticipated rise in mandatory spending along with social spending
that is already quite low compared to most OECD countries; 2)
planned tax cuts; and 3) military and other spending commitments
already written into the budget that are not obliged to conform to
Israel's future fiscal targets. Epstein noted that the GoI will
face difficulty in reaching the targets in 2011, when many budgetary
obligations will be coming due. He also said that the GoI is
considering another two-year budget, in the hopes of retaining
political stability and locking in multi-year budget commitments.

18. (SBU) A new fiscal rule is under discussion among the Bank of
Israel, the National Economic Council and the Ministry of Finance,
but discussions are not likely to yield a unified proposal until the
end of the first quarter of 2010, as the new rule will be the basis
for structuring the next budget. While there was no firm decision
that the next budget would be another two-year budget, Eugene Kandel
of the NEC noted that a two-year budget lessens political bickering
and assists with long-term planning. Epstein demurred on specifics
of the fiscal rule options under discussion, but noted that the
challenge for the future is to further reduce the debt-to-GDP ratio
over the medium term under the appropriate size of the public sector
and the tax level.

19. (SBU) Acting A/S Baukol inquired about whether escape clauses
would figure into the new framework, and if there would be
sufficient accountability or enforcement mechanisms. Previous
fiscal rules, he said, had often proved ineffective in preventing
creative accounting that led to overspending in strong economic
times, and in allowing additional spending in sharp downturns.
Baukol also asked, per the IMF's recommendation, if Israel is
looking to change from real to nominal figures for its budget
ceiling, to increase transparency and the budget's anti-cyclicality.
He queried as to whether the new fiscal rule might force
medium-term spending plans to follow the rule's expenditure caps,
noting that the current rule fails to guide medium-term spending,
causing rapid increases in planned expenditures each year. While
non-committal on the new rule's escape clauses and enforcement
mechanisms, Epstein explained that the MoF had recently consulted
with Sweden and the Netherlands on the nature of their fiscal rules
and policymaking. He also confirmed that Israel is investigating
the use of nominal budget figures and the creation of long-term
budget projections that would allow spending plans to fit into the
fiscal framework.

-------------------------------------------
GoI Prioritizes Expanded High Tech Dialogue
-------------------------------------------

20. (SBU) DG Shani introduced the discussion of the proposed high
tech dialogue by providing an overview of the sector's significance
to the Israeli economy. In addition to the exports the sector
generates, the Information, Communication and Technology (ICT)
industry employs 14 percent of Israelis, according to Shani. He
pointed to the ICT sector's roots in the Israeli military and
emphasized the heavy state involvement in its development,
especially the strong government science policy. Eli Opper, the
Chief Scientist housed in the Ministry of Industry, Trade and Labor,
participated in the JEDG discussion. (See Ref B for description of
the technology sector's history and challenges.)

21. (SBU) Citing the many U.S. technology companies with
facilities or other ties to Israel, including Intel, Microsoft, IBM,
Motorola, and Cisco Systems, Shani brought the focus to areas of
strategic cooperation that would address national priorities of both
Israel and the U.S. He introduced short presentations by two
Israeli software companies that had recently participated in a high
tech conference in New York organized by the Israel-America Chamber
of Commerce. The first, dbMotion, specializes in healthcare
software which aggregates health information and creates virtual
patient records. The second, Time to Know, creates integrated
educational software. Both companies are actively engaged in both
the Israeli and U.S. markets.

22. (SBU) Chemi Peres, a well-known Israeli venture capitalist and
President of the Chamber, told participants that Israel and the U.S.
are missing major opportunities to address problems on a national

TEL AVIV 00000194 005 OF 006


level with advanced technological solutions. He called for a
"binational stimulus package" in which the two countries would act
like venture capitalists by elevating 2-3 projects to address
national priorities such as healthcare, education, alternative
energy and homeland security. Israel, he proposed, could act as a
test bed for implementation of high-tech solutions in the U.S.

23. (SBU) Following the private sector presentations, DG Shani
asked what government could bring to the table to promote this
binational alignment. He argued that the U.S. and Israel are not
competitors but natural partners with complementary business
cultures, and that both countries seek to maintain a slipping edge
in the face of growing competition from China, India, etc. The GoI
participants urged the establishment of a bilateral government
structure to manage expanded high-tech cooperation that could
prioritize projects with critical, strategic potential and help
generate more resources for them. The form such an organ would take
was open for discussion, but generating new funding was essential,
said Shani. He also noted the potential to target the involvement
of Israel's Arab minority and create linkages to Palestinian
entities.

24. (SBU) Providing preliminary feedback, the U.S. delegation
questioned the proper role of government in this sphere, and
emphasized a reticence to "pick winners" among private sector
participants. Addressing areas of policy coordination, resource
allocation, and best practices discussions were all potential foci
but required the involvement of varied government agencies and the
private sectors on both sides. U.S. delegates noted the possibility
of wider forums, such as the OECD, to initiate discussions that
might lead to a more considered binational objective. U.S.
delegates also raised the success of established binational
foundations such as BIRD, BARD, and BSF and expressed a desire, in
principle, to expand funding for the foundations. However, they
reported, initial attempts to identify funds had not yielded any
positive results.

25. (SBU) Acting A/S Baukol stressed that the Commerce Department
has the lead in the USG on high-tech issues, and noted the
importance of linking the private sector into any future dialogue.
He amplified DG Shani's message regarding the inclusion of Israel's
Arab minority by noting the possibility of high-tech cooperation
with the PA and Israel's other Arab neighbors. He stated his desire
to continue dialogue on macroeconomic, fiscal and monetary issues as
the main focus of the JEDG, regardless of where any future high-tech
collaboration may be discussed.

26. (SBU) Chief Scientist Eli Opper agreed that existing
mechanisms could be utilized to address the areas of strategic
bilateral concern, citing BIRD Energy as a successful example. In
May 2009, BIRD Energy garnered $2 million in funding from both the
U.S. Department of Energy and the Israeli Ministry of National
Infrastructures to pursue renewable and energy efficiency projects.
He urged increased funding for the foundations along with continued
discussion of focus areas to be recommended to the foundations.

27. (SBU) Director of the National Economic Council, Eugene
Kandel, argued that governments can act as facilitators of
"equilibrium-changing" solutions and hasten progress by providing
evaluations of strategic proposals by drawing on a range of
subject-matter expertise. This, he noted, would require
collaboration from many governmental bodies as well as a managing
mechanism to ensuring success. DG Shani noted the possibility of
harnessing the academic and research capabilities of the two
countries as well. However, he agreed that the matter required
further deliberation. Again, he emphasized the importance of
funding, noting that the GoI was ready to commit resources, and
encouraged the U.S. delegation to identify a counterpart to further
develop the proposal. (Note: Post will report septel on prospects
for furthering the high-tech dialogue proposed by the GoI.)

-------------------------------------
Progress on Loan Guarantee Conditions
-------------------------------------

28. (SBU) Both Israel and the U.S. expect the calendar year 2009
conditions for release of the FY 2010 tranche of the loan guarantees
agreed at the June 2009 JEDG (see ref A) to be met. The Israeli
delegation confirmed that final statistics for 2009 would be
compiled and reported by March 2010 to allow for the USG's written
determination and subsequent formal release of the FY2010 tranche of
guarantees. GoI delegates briefly described Israel's progress
toward structural reforms in the 2010 conditions, including
privatization in electricity, ports and land reform. They stated
that reform was proceeding, albeit with certain snags including IEC

TEL AVIV 00000194 006 OF 006


pensions and certain legal requirements of reorganizing the land
administration and zoning systems. Baukol noted that the spending
targets agreed for 2010 differ from those specified in the 2009-2010
budget. GoI officials, however, reported that lower than expected
social and other spending combined with higher than expected
inflation will likely allow the GoI to meet 2010 fiscal
conditionality.

29. (SBU) While IPR negotiations continued in other fora and were
not discussed in detail, the U.S. delegation requested the Ministry
of Finance's flexibility regarding a bottleneck in the progress of
negotiations: MoF's concern that longer patent terms would
negatively impact the GoI's finances. The U.S. delegation also
reiterated the appeal for application of international sanitary and
phytosanitary standards, and promised to submit questions regarding
the GoI's procedures regarding food safety by the end of 2009.
(Note: Post subsequently relayed food safety questions to GoI and
responses are expected by December 2010.) Regarding the GoI's
evaluation of long term social expenditures, the Israeli delegation
reported that development of an action plan is underway and recent
discussions with Swedish and Dutch counterparts on forecasting had
informed the process considerably. The GoI is currently devising
estimates of the demographic pressures the country will face over
the medium term, and do not foresee difficulties in the next 20
years.

30. (SBU) Acting A/S Baukol stressed to the Israeli delegation the
timelines for the required reports and action plans upon which
release of the loan guarantees are contingent, including an action
plan for a new fiscal rule due by the next JEDG meeting (tentatively
scheduled for June 2010) and a long-term budget analysis of Israel's
future social expenditures due by December 2010.

31. (U) This message was cleared by Treasury.

MORENO

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