The almost two-year-long Intifada and the recent Israeli operation in the occupied territories has hit hard nearly all sectors of the Israeli economy, writes John Sfakianakis* There is little doubt that the Israeli economy has been facing a serious downturn, if not a recession for more than a year and a half. The economy shrank 0.6 per cent last year, after seeing 6.2 per cent growth in 2000. On the employment front, too, things have worsened, with the unemployment rate now exceeding 10 per cent. The budget deficit is expected to widen from three per cent to 3.9 per cent. On 22 May, the cabinet endorsed a $2.7 billion emergency plan to prevent a fiscal crisis, caused in part by increased defence spending after Israel's offensive. It included Shk6 billion ($1.25 billion) in cuts and $625 million in tax rises (mainly in indirect taxation such as diesel oil and cigarettes), public wage freezes and a four per cent cut in social security payments. Although the economy has experienced in its history a much higher budget deficit -- in 1984/85 the budget deficit hit an all-time high of 13.2 per cent of GNP. For today's global economy, such a deficit is alarmingly steep. Additional fiscal measures are awaiting parliamentary approval. These include raising sales taxes by one per cent and increasing the tax on diesel oil and cigarettes. Such measures are not growth-oriented, but only temporary fixes. Additional fiscal gaps will be covered with deficit spending, a standard practice that the country has heeded since its inception. Strong growth in the first quarter of 2002 can be attributed to government spending, mainly on defence, which accounts for 20 per cent of GDP. This kind of state-sponsored growth should not be favoured by any economy. These and other developments led Standard & Poor's international rating agency to reduce Israel's rating outlook from 'stable' to 'negative.' Following the cabinet's decision Israel's business leaders launched an attack on the government's emergency plan and warned that the programme could lead to a financial catastrophe. Undoubtedly the economy is faced with two major problems: a global slowdown and increased defence and security spending as a result of the recent Israeli offensive and the Palestinian Intifada. The economic aftershocks of the recent violence have been felt throughout the Middle East, as international investors gauge the region with a higher risk premium. The Intifada as well as the recent Israeli offensive have not been good for the Israeli economy. The Bank of Israel (BOI) reported on January 2002 that the Intifada had cost Israel some Shk13 billion, or four per cent of GDP. The Intifada has a direct effect on tourism and the construction sector. The slump in tourism is particularly grave. It began at the end of 2000, with the eruption of the Intifada, and was exacerbated by the 11 September attacks in the US. Tourist arrivals in 2000 grew by three per cent while the following year fell by more than 50 per cent. In December-February the number of tourist entries by air into Israel was down by 37 per cent from the equivalent period last year. Vacancy rates in Israeli hotels amount to 90 per cent, according to a recent article in the Wall Street Journal. Construction has also been affected since approximately one-third of the sector's total workforce had until recently been Palestinian. Notwithstanding increasing interest rates by the BOI, consumer spending has also plummeted over the past few months as a result of the ensuing violence in Israel. Israel is facing a new obstacle in its attempt to develop its gas distribution network. Tractebel SA of Belgium recently pulled out of a consortium to build a distribution network in Israel due to political pressures to cancel projects with the country. The Intifada as well as the recent Israeli offensive have impacted the much-respected Israeli high-tech sector. Many high-tech companies provided employment to Palestinians engineers from the occupied territories, although on a less equitable basis than to their Israeli colleagues. However, the Israeli economy has not been dependent on the Palestinian, the relationship is, in fact, the inverse. Pre-Intifada 2000, Israel annually sold about $25 million in goods to Palestine, while some 25 per cent, or $2 billion, of the Palestinian GDP, came from its trade with Israel. Palestinian exports to Israel accounted for 60 per cent of all Palestinian sales. Increasing violence has exacerbated troubles in high-tech industries since customers and investors are more reluctant to travel to Israel. During the tech boom, Israel gained acclaim as one of the most vibrant breeding grounds for technology outside the Silicon Valley -- a status it shares with India and Ireland. Certainly Israel's IT boom is attributed to, among other things, a large domestic market, a large defence industry which has been so vital in nurturing talent, a well-developed capital market to back its genuine entrepreneurs, highly skilled engineers, aggressive global marketing strategies and last but not least ties with various Wall Street investment houses. Israel has more than one hundred companies on Nasdaq, the US technology-focused exchange. The global slowdown is also a cause for a loss of momentum by Israel's high-tech sector. The global technology slump, along with the violence of the past year and a half, made raising funds abroad difficult. Israeli venture capital funds forecast a recovery in fund-raising abroad only in 2003 or 2004, with just $250 million raised this year compared with $1.4 last year and a record $3.7 billion in 2000. As a result, venture capitalists in Israel are targeting local pension funds and insurance firms, with an estimated $75 to $100 billion in assets. In currency terms, the shekel has fallen by 16 per cent since the end of December 2001. Several of the above factors have combined to weaken Israel's currency. Many companies have suddenly stopped borrowing dollars from the banks, after taking out massive forex credit in recent years. Households have also started shifting shekel deposits into dollar or dollar-related investments. The fall in tourist receipts and foreign investments, particularly in high-tech companies has been dramatic. Foreign direct investment fell from $1.1 billion in 2000 to $761 million in 2001. A sudden drop in interest rates created a wave of fleeing capital, especially in the form of financial institutional and retail investors. According to a recent report by Bank Leumi, the second largest commercial bank in the country, Israelis -- both institutional and retail investors -- had about $16.4 billion in holdings abroad at the end of 2000. In April interest rates on unindexed 10-year government bonds rose to seven per cent -- about one percentage point higher than at the beginning of the year -- and interest on indexed debt rose by a similar amount in that period to 4.8 per cent. The increases in these interest rates cause a parallel rise in other interest rates and depress investment and employment. Stock market activity has not been very promising either. The fall in the share price index in Israel is a reflection of the low level of profitability of Israeli companies. The 25 largest quoted companies on the Tel Aviv Stock Exchange (the Tel Aviv 25 Index), made a cumulative loss of about $330 million in 2001, compared to a profit of around $730 million in 2000. Banking has been facing tough times recently. In March 2002, Bank Leumi announced that net profits plunged 46 per cent last year as provisions for doubtful debts jumped sharply amid an economic slowdown and violence. The drop in profits, Leumi's first in seven years, followed a 45 per cent fall in annual net profits at Bank Hapoalim, the country's biggest banking group. The two banks together control about two-thirds of the Israeli banking sector. Leumi said the slowdown had adversely affected the ability of companies in hard-hit sectors (telecommunications, construction, real estate and tourism) to repay loans. Israel also has a reputation for suffering financial scandals for which the banking sector will have to pay the bill. The latest such scandals hit the Trade Bank, which was defrauded of around $45 million by an employee. * The writer is a research fellow at Harvard University's Centre for Middle Eastern Studies.
