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ISRAEL and the ISRAEL and the Globalized World Globalized World

EconomyEconomy

Prof. Assaf RazinProf. Assaf Razin

July, July, 20022002

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What Is Globalization ?What Is Globalization ?

• Globalization is an opening process of domestic Globalization is an opening process of domestic markets to the world markets, for trade of markets to the world markets, for trade of inputs, goods, services, capital, labor and inputs, goods, services, capital, labor and finance.finance.

• Benefits: Risk diversification; Better Benefits: Risk diversification; Better resources allocation.resources allocation.

• Costs: Increased wage volatility; Risk Costs: Increased wage volatility; Risk of financial crisis contagion; of financial crisis contagion; Exacerbating business cycles; Exacerbating business cycles; Constraints on the conduct stabilizing Constraints on the conduct stabilizing macro economic policy.macro economic policy.

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• The Information and The Information and Communication Technology sector Communication Technology sector (ICT)grew from 5% of GNP in (ICT)grew from 5% of GNP in 1990, to 14% in 2000. GNP 1990, to 14% in 2000. GNP fluctuations became linked with fluctuations became linked with the ICT fluctuations.the ICT fluctuations.

• Duality between the economic Duality between the economic activity and the performance of the activity and the performance of the capital market.capital market.

ImplicationImplications:s:

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• Economic Activity: Structural Economic Activity: Structural Indications-Indications-oGDP rose at annual rate of 2.4% in GDP rose at annual rate of 2.4% in

2002/1, after a continuous decline in 2002/1, after a continuous decline in 2001/2 (-3.2%), 2001/3 (-5.2%) and 2001/2 (-3.2%), 2001/3 (-5.2%) and 2001/4 (-6.6%).2001/4 (-6.6%).

oCurrent account deficit is 3% of Current account deficit is 3% of GNP.GNP.

oNet external debt is 2 billions $ Net external debt is 2 billions $ (gross debt is 65 billions $; external (gross debt is 65 billions $; external assets are 63 billions $), about 2% of assets are 63 billions $), about 2% of GNP.GNP.

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• Capital Market Indications:Capital Market Indications:

oTop 25 index went down by 20%, Top 25 index went down by 20%, from Jan. 1, 2002 to July 10, from Jan. 1, 2002 to July 10, 2002.2002.

oExchange rate depreciated by Exchange rate depreciated by 13% in Jan. 1 - June 30, and 8% 13% in Jan. 1 - June 30, and 8% in Jan. 1 – July 10, 2002.in Jan. 1 – July 10, 2002.

The remains of this presentation The remains of this presentation consists of 4 parts: technology consists of 4 parts: technology transmission, constraints on macro transmission, constraints on macro policy, international trade and labor policy, international trade and labor mobility.mobility.

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Part I: Adaptation and Exports of New Technologies.

MOORE’S LAW: The number of MOORE’S LAW: The number of transistors on a chip doubles every transistors on a chip doubles every 18-24 months (Pentium 4, released 18-24 months (Pentium 4, released 20.11.2000, has 42 million 20.11.2000, has 42 million transistors).transistors).

The ICT sector is characterized The ICT sector is characterized by rapid technological changes by rapid technological changes and corresponding price decline.and corresponding price decline.

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Technology is mobile across countries Technology is mobile across countries through Multi National Firms (MNF). through Multi National Firms (MNF). The origin of 90 out of the 100 largest The origin of 90 out of the 100 largest MNF worldwide, is US, EU and Japan.MNF worldwide, is US, EU and Japan.

The size distribution of firms in the The size distribution of firms in the high-tech sector in Israel, is very high-tech sector in Israel, is very skewed: there are barely handful of firms skewed: there are barely handful of firms above $100 millions, with the vast above $100 millions, with the vast majority of medium size firms either majority of medium size firms either stagnating or disappearing after a while.stagnating or disappearing after a while.

The high-tech sector in Israel seems The high-tech sector in Israel seems unable to go beyond the “glass-ceiling” unable to go beyond the “glass-ceiling” of $100 millions, thereby forfeiting the of $100 millions, thereby forfeiting the opportunity to establish a firm opportunity to establish a firm stronghold in international markets.stronghold in international markets.

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Policy ImplicationsPolicy Implications

Israeli MNF are scarce, mainly Israeli MNF are scarce, mainly because they are lacking because they are lacking strategic management, long strategic management, long term outlook.term outlook.

Need to provide policy support Need to provide policy support in setting up headquarters, R&D in setting up headquarters, R&D and management units in Israel.and management units in Israel.

Tax Policy and Competition Tax Policy and Competition PolicyPolicy can can facilitate M&A of facilitate M&A of Foreign firms by Israeli firms.Foreign firms by Israeli firms.

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Part II: Constraints on Part II: Constraints on Stabalizing Macro PolicyStabalizing Macro Policy

• Capital market liberalization 1985 – 2002:Capital market liberalization 1985 – 2002:– Deregulating Israeli banks credit policy, Deregulating Israeli banks credit policy,

abolishing “directed” credit.abolishing “directed” credit.– Permission to private sector to invest abroad.Permission to private sector to invest abroad.– Trust funds are allowed to invest in dollar Trust funds are allowed to invest in dollar

assets.assets.– Household deposits in foreign currency is Household deposits in foreign currency is

allowed.allowed.– Rescinding foreign currency allocation limit Rescinding foreign currency allocation limit

for traveling abroad.for traveling abroad.– Permission for financial savings and Permission for financial savings and

investments in real estate abroad.investments in real estate abroad.– Institutional investors can invest abroad.Institutional investors can invest abroad.

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Proposed Framework for Proposed Framework for Conduct of Monetary Conduct of Monetary

PolicyPolicyObjectivesObjectives::

• Main objective: price stability.Main objective: price stability.• Secondary objective: mitigating Secondary objective: mitigating

business cycles fluctuations.business cycles fluctuations.

PolicyPolicy::

• Main instrument: short term Main instrument: short term interest .interest .

• Framework: inflation target.Framework: inflation target.

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BenefitsBenefits:: Price stability over time contributes Price stability over time contributes

to the stabilization of economic to the stabilization of economic activity. In its absence, expansionary activity. In its absence, expansionary monetary policy leads to inflationary monetary policy leads to inflationary pressures, which leads to tight pressures, which leads to tight monetary policy, which generates monetary policy, which generates recession, and soon.recession, and soon.

In recessions the monetary policy In recessions the monetary policy has a significant role, as exemplified has a significant role, as exemplified by the 11 interest cuts by the FED, by the 11 interest cuts by the FED, during 2001-2002.during 2001-2002.

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Monetary Policy Conduct in Monetary Policy Conduct in Israel:Israel:

• In the 1990s the central bank In the 1990s the central bank managed to move down managed to move down inflation to western countries inflation to western countries level; at the cost of increased level; at the cost of increased recession in the late 1990s.recession in the late 1990s.

• The short term interest rate The short term interest rate path is shown in the following path is shown in the following chart: chart:

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0

2

4

6

8

10

12

14

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Source: Bank of Israel

Short Term Interest RateShort Term Interest Rate

9.1%

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Deviations from inflation targets: Deviations from inflation targets: ProblemsProblems

• Inflation Target serves as a Inflation Target serves as a coordinator of private sector’s coordinator of private sector’s inflation expectation.inflation expectation.

• In 1999, 2000 and 2001, inflation fell In 1999, 2000 and 2001, inflation fell bellow the target; real wages and real bellow the target; real wages and real interest went up sharply, and the real interest went up sharply, and the real exchange rate went down.exchange rate went down.

• In 2002, the inflation realized above In 2002, the inflation realized above the target, due to sharp depreciation; the target, due to sharp depreciation; economic activity is moderate; economic activity is moderate; overshooting in interest rate policy overshooting in interest rate policy can contribute to recession.can contribute to recession.

18Source: Bank of Israel

actual

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ConclusionConclusion::• Discrete jumps in interest rate can Discrete jumps in interest rate can

lead to loss of credibility. October lead to loss of credibility. October 1998 (interest cut by 1.5%) and 1998 (interest cut by 1.5%) and December 2001 (interest cut by December 2001 (interest cut by 2%), caused waves of capital 2%), caused waves of capital market instability and market instability and depreciations.depreciations.

• Loss of credibility required sharp Loss of credibility required sharp interest rate increase.interest rate increase.

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We propose to stick to interest We propose to stick to interest

smoothing policy, so as to achieve smoothing policy, so as to achieve

medium terms inflation targets, medium terms inflation targets,

without overreaction to transitory without overreaction to transitory

shocks.shocks.

Monetary Policy Monetary Policy ImplicationImplication

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Budget PolicyBudget Policy

Current budget policy should Current budget policy should create credibility concerning create credibility concerning future budget discipline, by future budget discipline, by adapting rigid rules.adapting rigid rules.

The Maastricht rules are not The Maastricht rules are not suitable to Israel for two reasons:suitable to Israel for two reasons:They do not include anti-cyclical They do not include anti-cyclical

elements;elements;They treat public investment on They treat public investment on

equal footing as public equal footing as public consumption.consumption.

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Balanced budget rules that allow Balanced budget rules that allow for cyclical fluctuations in tax for cyclical fluctuations in tax revenue, and treat capital revenue, and treat capital expenditure according to user expenditure according to user costs, could enhance fiscal costs, could enhance fiscal credibility, while permitting credibility, while permitting government investment in government investment in infrastructure.infrastructure.

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Government DebtGovernment Debt• Government debt as a strategic (long Government debt as a strategic (long

term) target has to be structured so as to term) target has to be structured so as to take into account that:take into account that:o Gross debt is partially matched by Gross debt is partially matched by

government assets (lands, banks, government assets (lands, banks, telecom.).telecom.).

o Debt reduction through privatization Debt reduction through privatization does does notnot affect net debt, whereas debt affect net debt, whereas debt reduction via budget surplus, reduces reduction via budget surplus, reduces net debt.net debt.

• Given that OECD countries have different Given that OECD countries have different stocks of public owned assets than Israel, stocks of public owned assets than Israel, the adaptation of the 60% debt/GNP rule the adaptation of the 60% debt/GNP rule to Israel is not relevant.to Israel is not relevant.

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Reintroducing Stabalizing Reintroducing Stabalizing Elements Into Budget Elements Into Budget

PolicyPolicy Establishing an a-political Fiscal-Board, Establishing an a-political Fiscal-Board,

which shall determine future long-term which shall determine future long-term growth forecast, as a benchmark to the growth forecast, as a benchmark to the budget.budget.

The growth forecast will be the base for The growth forecast will be the base for the a-cyclical tax revenue projections.the a-cyclical tax revenue projections.

Public capital spending accounting will Public capital spending accounting will be in accordance to “resource be in accordance to “resource accounting”. The board will determine accounting”. The board will determine the types of public investment in the types of public investment in infrastructure that shall be part of the infrastructure that shall be part of the resource accounting.resource accounting.

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0.0

1.0

2.0

3.0

4.0

5.0

6.0

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

* 2002

*על פי יעד הגירעון החדש של הממשלה.Source: Bank of IsraelSource: Bank of Israel

Total Public Sector Deficit 1991-2002Total Public Sector Deficit 1991-2002 ((GNP PercentageGNP Percentage))

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0.48

0.68 0.690.73

0.80 0.82 0.830.89

0.96 0.96

1.04 1.071.10

1.191.22 1.24

1.34

1.54

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

רקנמ

ד ווןי

יהרק

טו

יהטל

אי

נדול

ה

אלשר

י

נדרל

אי

יהבג

ורנ

יהלג

ב

יהטנ

ברי פתצר

OEC

D

נדנל

פי

יהמנ

גר

רגמבו

קסלו

יהבד

ש

רדספ

יץשוו

Gross Infrastructure Investment (GDP %)Gross Infrastructure Investment (GDP %){{OECD at 1994-95; Israel at 2001OECD at 1994-95; Israel at 2001}}

Source: bank of IsraelSource: bank of Israel

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Tax Reforms (June 2002)Tax Reforms (June 2002)

• Capital income taxation.Capital income taxation.• Alleviating labor income taxation.Alleviating labor income taxation.• International taxation.International taxation.

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Direct Tax Rates Following the Direct Tax Rates Following the ReformReform

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Estimated Net Income Increase Estimated Net Income Increase Following the ReformFollowing the Reform

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2012 2011 2010 2009 2008 2007 2006 2005 2012 2011 2010 2009 2008 2007 2006 2005 2004 20032004 2003

Budget Balance Prior to the Budget Balance Prior to the Reform Commencement (2002 prices)Reform Commencement (2002 prices)

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• The fundamentals of opening an The fundamentals of opening an economy for international trade:economy for international trade:oCompetition; Price reduction.Competition; Price reduction.oChanneling production into relative Channeling production into relative

advantage sectors.advantage sectors.oCanceling trade deviation/distortion.Canceling trade deviation/distortion.oReduction of imports license rents.Reduction of imports license rents.

Part III: International Part III: International Trade Trade

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• The liberalization in Israel since 1991:The liberalization in Israel since 1991:oCanceling purchase tax, thereby Canceling purchase tax, thereby

exposing the textile, furniture, shoes exposing the textile, furniture, shoes etc. industries.etc. industries.

oGradual reduction of custom Gradual reduction of custom regarding “third countries” import.regarding “third countries” import.

oNarrowing down shielding regulations Narrowing down shielding regulations regarding import, reciprocity regarding import, reciprocity acquisitions, tenders etc.acquisitions, tenders etc.

oExposing the agriculture industry Exposing the agriculture industry (since 1996).(since 1996).

oAbolishing depreciation substitutes.Abolishing depreciation substitutes.

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• Results of the exposure:Results of the exposure:oDuring 1983-1999 the non-During 1983-1999 the non-

trade goods’ prices increased trade goods’ prices increased 56% higher than the traded 56% higher than the traded goods.goods.

oMarket centralization declined, Market centralization declined, import and efficiency increased.import and efficiency increased.

oTrade distortion reduced, and Trade distortion reduced, and import from “third countries” import from “third countries” went up.went up.

oEmployment declined in the Employment declined in the exposed industries.exposed industries.

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Policy ImplicationsPolicy Implications

Retracting liberalization in goods, Retracting liberalization in goods, will inflict substantial macro damages will inflict substantial macro damages – price increase, efficiency loss, trade – price increase, efficiency loss, trade distortion etc., without real distortion etc., without real employment improvement.employment improvement.

Exposure achievements should be Exposure achievements should be maintained, and measures like import maintained, and measures like import levy shall be used only in proved levy shall be used only in proved market flooding situations.market flooding situations.

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Part IV: Labor MobilityPart IV: Labor Mobility

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The total number of foreign workers The total number of foreign workers in Israel in 2001, including in Israel in 2001, including Palestinians and illegal workers, is Palestinians and illegal workers, is estimated as 250,000, which is 13% estimated as 250,000, which is 13% of the total labor force in the private of the total labor force in the private sector.sector.

The increase in the total foreign The increase in the total foreign workers corresponds to the workers corresponds to the reduction of Palestinian workers in reduction of Palestinian workers in Israel (from 120,000 to 14,000).Israel (from 120,000 to 14,000).

Almost half of the foreign workers Almost half of the foreign workers are in the construction industry. are in the construction industry. Many employed in agriculture and Many employed in agriculture and food services industries.food services industries.

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• AdvantagesAdvantages::– Essential labor force in construction, Essential labor force in construction,

agriculture...agriculture...– Reciprocity with countries which employ Reciprocity with countries which employ

Israelis.Israelis.• DisadvantagesDisadvantages::

– Delaying technological innovations.Delaying technological innovations.– Wages reduction and the crowding out of Wages reduction and the crowding out of

Israeli employees in those industries.Israeli employees in those industries.– Establishing immigrants communities.Establishing immigrants communities.– Social rights violation, poor medical Social rights violation, poor medical

services rendered, low standard services rendered, low standard accommodation.accommodation.

– Asymmetric power between employers and Asymmetric power between employers and employees.employees.

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Taxation of Israeli employers, thereby Taxation of Israeli employers, thereby equalizing foreign and domestic equalizing foreign and domestic employment remuneration.employment remuneration.

Enforcing employees shielding rules.Enforcing employees shielding rules.Granting the visa to the worker, not Granting the visa to the worker, not

her employer.her employer.Establishing authority that will Establishing authority that will

regulate the number of foreign regulate the number of foreign employees.employees.

Policy ImplicationsPolicy Implications