over the last two weeks panic has taken hold around the weakening shekel, now bumping against five to the dollar after a near 20% drop in its value since the end of last year.
Israelis have moved some $1.5 billion of their money abroad so far this year -- not a huge amount, but enough to knock the fragile currency off balance -- and the reason isn't the unending "cycle of violence" or the collapse of the peace process. Palestinian unrest exploded nearly two years ago and after a half-century in a continuous state of war or near-war, Israeli investors have developed a thick skin for geopolitical risk. Rather, the reason Israelis are taking out their cash is because they're distressed at the state of the economy, and more specifically with economic policy.
Israel's economy is in a particularly bad state even by the standards of the global slowdown. Gross domestic product fell 0.6% last year, the first such decline since 1953, and is widely expected to show further contraction this year. Foreign investment fell 60% last year from its 2000 peak of $11.9 billion. Inflation, which was nil two years ago, is likely to reach 6-7% this year. Unemployment is 10.6%.
Part of the blame rests on three events Israel could not control: (1) the collapse of the global high-tech industry after Nasdaq's crash in March 2000; (2) the outbreak of Palestinian unrest six months later; and (3) the world economic slowdown in 2001.
But Rosenberg says Israel made its plight worse through bad economic policy choices:
The Israeli Treasury planned the 2002 budget on the politically convenient but economically unfounded assumption the economy would grow 4% this year. It revised its estimates lower until it stopped making any estimates at all, and adjusted spending accordingly -- but nothing it has done seems to be in tune with the real state of affairs. The Treasury's latest budget revision, approved by the Knesset earlier this month, calls for higher taxes at a time of deep recession. Government borrowing has become so heavy that long-term interest rates have soared.
The Bank of Israel, once regarded as a bastion of economic discipline, blundered into making a hefty two percentage point rate cut last December, inadvertently setting off the depreciation of the shekel. In doing so, it managed to re-ignite inflation at a time when the economy is slack. To rectify its mistake, the central bank has since reversed course and raised interest rates 5.3 percentage points. Its zig-zagging does not inspire confidence that the bank has a firm grip on how the economy is functioning or what it needs.
... Even though Israel shoulders heavy defense and debt-repayment burdens, welfare spending is slated to grow to 31% of the budget this year from 25% in 2002 and is now the single biggest part of the budget. The percentage of GDP going to taxes, always a high figure, has been going up since 2000.
So investors are headed for the hills because of problems that began some time ago. While Israel's economy was soaring in the 90's, its economic reform movement sputtered and stalled. In the booming 90's this was fine. Israel could get away with it. But Rosenberg says that now that high-tech, a big part of Israel's economy, has sputtered, there ain't much left to power the economy.
Israel's capital market is small and inefficient. Telecoms deregulation is stuck in a twilight zone between a free market and a state monopoly, creating a knot of regulatory idiocies. No one has touched the power-generation industry or the government's near-monopoly on land. The state-owned telecoms company, many of the banks and a host of other companies have been in the "process" of being privatized since the early 1990s. Social welfare policy has created such negative incentives to work that Israel has one of the lowest labor force participation rates in the industrialized world.
Oops. Now what? Rosenberg thinks the immediate future is bleak unless Israel kicks its economic reforms into high gear:
The global high-tech recovery is likely to be slow in coming and Israel's industry has become so thoroughly internationalized that entrepreneurs and investors need not commit their resources to Israel if the economic and political environment is so insecure. They can do what they need to abroad. No one is expecting Palestinian unrest to wind down anytime soon or for the peace process to return to its pre-Intifada momentum. Without high tech and without peace, Israel will end up becoming the economic basketcase it was in the 1970s and 1980s. That is, unless it can liberate its human and financial resources by freeing its economy.
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