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Senior banking sector sources expect a downturn in economic activity in 2005 due to a series of developments including political instability, difficulties in ratifying the state budget, George W. Bush's reelection which could increase U.S. pressure on Israel, and a substantial slowdown in investment.

The sources told Haaretz that the political-diplomatic situation has led to the rosy economic projections of just a few months ago being replaced by far less pleasant scenarios. This is evident in lowered economic growth forecasts, including from Bank Hapoalim chief economist Leo Leiderman, who cut his projection for 2005 to 3.5 percent growth from 4 percent.

One worrisome factor is the small dribble of foreign investment or any investment. The small quantity of investment funds has caused a drop in demand for bank credit, meaning the banks cannot expand their financing operations.

The infrastructure sector is also beset by many delayed projects and, despite endless plans, only one major project has completed its financing - the Ashkelon desalination facility. The rest of the projects that rely on private sector financing along BOT (build-operate-transfer) models, are stuck.

The banks have also identified increased movement of businesspeople transferring operations abroad. Senior bank executives, who attribute the trend to higher yields, tax considerations and Israel's burdensome regulation, also project the slowing of economic recovery will result in the unemployment rate remaining steady at 11.5 percent.

The banking sector also believes the U.S. economy is not in good shape, calling the current situation "a false sense of wealth". The comments related in particular to the U.S. property market where prices have risen tens of percent in the past two years.

Bank of Israel Governor David Klein's interest rate reduction to 3.9 percent, which takes effect today, created a small interest rate gap between the U.S. and Israel of 1.9 percent, which worries some macroeconomists and banking executives.

They are concerned about shekel depreciation against the U.S. dollar. Those concerns are growing with the certainty of a U.S. interest rate hike in December, which will further reduce the gap, apparently to only 1.7 percentage points.

Financial markets responded positively to the interest rate cut with gains in stocks and bonds and a stable currency market. Even the dollar's global weakening helped markets here and yesterday the representative dollar exchange rate closed lower than it has been in almost a year at NIS 4.372.

Bank Leumi chief economist Gil Buffman warned yesterday in a report that such low interest rate gaps have not lasted long in the past due to weakening financial market stability in Israel. Buffman said this process has always been accelerated by the dominant presence of serious economic and political problems.

He mentioned that after the interest gap was decreased in 2002, there was substantial shekel depreciation.

"Reduction of the interest rate gap at this time does not have to weaken the shekel, but maintaining stability will require a series of positive conditions: continued expansion of Israeli exports, continued foreign investment in Israel and even an increase, successful ratification of the 2005 state budget, stability on global financial markets and Israel's successful integration of impending tax parity with investments abroad," Buffman writes.

Traders in U.S. treasury bonds estimate the Federal Reserve will raise interest rates in its December meeting by 0.25 percent to 2.25 percent. Twenty of the 22 firms that trade directly with the central bank called the rate hike a certainty. The U.S. Federal Reserve began raising rates on June 30, 2004, after they had not budged from 1 percent in a year.

U.S. employment figures, the consumer and producer price indexes, as well as October retail sales were all higher than analysts had predicted, boosting expectations of a rate hike. A month ago, just six of those 22 traders said in a survey they expected to see U.S. interest rates rise.

In the most recent survey, investment bank Merrill Lynch stated there will be no rate hike and Dresdner Bank refused to participate.

Major traders including Citigroup, HSBC, and JP Morgan projected interest rates would climb to an average 3.5 percent by the end 2005.