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Bank of Israel governor David Klein has become one of the most ubiquitous speakers in Israel's economic circles. He's given five lectures in the last month alone, skipping from conference to seminar. If you keep track, you'll find that he has a new agenda.

Before, he used to focus on inflation, the budget, the deficit and the reforms the capital market so urgently needed; lately, you get all that garnished with dollops of social conscience and similar topics that the central bank had generally sidestepped.

Another repetitive element in his speeches is praise, sometimes spontaneous and sometimes less so, for Finance Minister Benjamin Netanyahu and his policy.

Klein granted this interview to Haaretz late last week, the day after Netanyahu was forced to withdraw his budget proposal for 2004, after his coalition partners put forward extra demands totaling billions of shekels. Yet Klein seemed unperturbed by the rending of the budget, and evinced heavy optimism in most areas.

What do you say about the trouble the treasury's been having in pushing through its budget proposal?

"It may attest to the intensity of the change. [The treasury] is attempting to introduce a policy of growth, which is evident in the nature of the budget. Therefore, despite the increase in tax revenues, government expenditure must be curbed, and this weighs heavily on the ministries.

"One of the ways to restore economic expansion is to change fiscal strategy, prevent expenditure from growing while reducing the tax burden. That requires restraint in spending.

"It's been tried before, yet the budget sailed through Knesset. Knesset debate on the budget seems to have regressed three years in time.

"It's true that attempts were made, but they may not have actually been implemented. In 2001, despite the efforts, expenditure grew. It did again in 2002. The years 2003 and 2004 are the first real attempt to reduce government spending in real terms, and it isn't easy."

Do you believe that Netanyahu erred by saying the recession is over, which Knesset members may have understood as a possibility to stop exercising restraint?

"No, for two reasons. Clearly, this year developed differently from the preceding two years. The economy contracted in the last two years, but grew a little in this one, so we can define it as the end of the recession. Factually speaking, the trend has been correctly identified. Did that have a deleterious effect on the public and its elected representatives? Could they think the problems have been solved? I don't think so.

"The intensity of the changes the treasury proposes teaches that shoals still lie ahead; and the changes the treasury is making in 2004 aren't the end of the story - they're just the beginning. We would like a lot more than the treasury is proposing.

"Obviously the process of getting the budget approved isn't smooth. A consensus has to be created that would enable its passage, which will require more effort."

Has the treasury capitulated to coalition extortion?

"If the changes are marginal, it's completely routine. If the framework is violated, obviously that isn't good. I assume that's what the finance minister had in mind when he withdrew the budget."

What are your estimates for the deficit?

"When 2003 began, we assumed the deficit would run at 6 percent. The way things look now, it will be lower, 5-5.5 percent. The margins could be determined by two or three special events, for instance whether the U.S. special aid will arrive by the end of December or not. That alone could account for 0.5 percent of the deficit. Then there are the sanctions at the ministries that invite the question of whether tax refunds are being made or not, and that's another NIS 2 billion.

"The main point is that adherence to the 2003 budget looks better, thanks to improvement during the year. Since we estimate the situation will continue to improve during 2004, a deficit target of 4 percent is certainly attainable."

So everything's going well?

"I don't understand your umbrage, as though something is wrong if the tone is upbeat. This is a beginning and the results attest that there is a resolute attempt to institute change. It isn't the idyll we'd like, but we're improving. There is more to be done, but I appreciate what has been done.

Just a year ago, you were talking about the possibility of a big bank collapsing.

"A year ago, the forecasts were far from optimistic. There was no light evident at the end of the tunnel. But the horizon is totally different today. I suggest you look at the shades of gray. There is a process of improvement; there is a different economic policy that can serve as a basis for restoring economic growth. I can't think of another major thing that needs doing and is not being done, though I do think we aren't at the end of the road. Some things remain to be done."

For instance?

"Investment in infrastructure. There is a long list of investments that should total some NIS 100 billion over five years. Today, that issue is being handled separately. Different people are handling different projects, while the approval processes have a lot in common - committees, obtaining financing, publishing tenders and so on.

"Since it is so complex, there should be a single address in government for implementation. Just as there's a single team of experts at the White House whose job is to study government policy and advise, Israel should do something like that for infrastructures - establish an interdisciplinary team led by a mover and shaker that would be answerable to cabinet. The team's mandate would include breaking through obstacles to get the project moving. Meanwhile, we don't even have quarterly data on investment in infrastructure."

What else?

"Employment policy. The treasury plan offers a lot of tools, but lacks focus. We know employment here runs lower than elsewhere in the world, by almost 9 percent, or 350,000 potential workers. That's more than the number of job-seekers. We need to set a goal or eradicating that gap - meaning, add 120,000 people to the workforce each year. Then all government plans should be judged by the criteria of promoting that goal. For instance, the Employment Service budget should be judged by the service's contribution to achieving the goal."

That's self-evident.

"Yes, but there are other more controversial elements. Take the Investments Encouragement Law that some want to amend to pin aid on exports as the sole criterion. They examined how the change would affect industry in rural areas, and found that many would not be eligible. Exporters aren't located in the periphery; there, you have manpower-heavy industry. So the Investments Encouragement Law should be examined through the lens of job creation, not exports. Our exports-imports balance is different today. Export doesn't need stimulation any more. The same is true of sundry tax benefits. Ones that encourage job creation should be encouraged."

Is there no need to encourage exports?

"I don't think we need government policy to encourage exports. We have a general open market policy, and stable prices, which is key to stimulating exports. Israel has high foreign currency reserves and export-import is almost at equilibrium. That is totally different from the situation 30 years ago."

We can guess whether you think interest rate policy should be designed to help exporters.

"Encouraging exports through exchange rates is to adopt a policy of a weak shekel. One has to ask how it would be done. Some say talk is enough to weaken the shekel, but I don't believe that. The only tool I know is to lower interest rates, which has been mentioned often enough in the discussions of the [central bank's] advisory council."

By its chairman, Aharon Fogel?

"More than one committee member has talked about it. I don't believe that's how the goal could be achieved. First of all, a nominal devaluation is not good, because it leads to price rises; so you need a real devaluation, and that can't be achieved by lowering interest rates."

Can't a real devaluation be achieved under conditions of deflation?

"My experience is from 2002, and it taught me that even under the current recessive conditions, lowering interest rates can trigger inflation. I'm not saying interest rates shouldn't be cut, but doing so just to devalue the currency is risking inflation, and exporters don't want that at all.

"Aside from that, designing interest policy just to weaken the shekel requires a target range for exchange rates to be set. What should it be - 2 percent devaluation, 5 percent in a month, in a year? The suggestion of governing exchange rates through interest isn't feasible. In an open market like Israel's, it is impossible."

Israel's ratio of GDP to debt is 108 percent, and its deficit is 6 percent. Without the guarantees, wouldn't we be spiraling out of control and unable to raise debt?

"What the budget has accomplished is to halt the trend of losing control over it. The behavior of the markets shows that danger is nonexistent at the moment because of the global rally, the non-escalation of hostilities with the Palestinians, the guarantees, the path we've taken, which the markets expect us to continue pursuing. If we stop at a deficit of 4 percent of GDP, that isn't good; but there is a long-term policy about budget management from 2005 to 2010 - an annual increase of 1 percent in government expenditure.

"That isn't enough, and the question is how the gap will be bridged. The goal is a highly ambitious one. It isn't clear how it can be achieved. There has been no precedent in Israel's economic history. It will be hard, because the population is growing by more than 1 percent a year. But if it is achieved, and so far the market believes it will be, debt will start to decline.

"We know that because of changes in the government's accounting, the status of the debt is not immediately apparent."

Now that there are guarantees, will all the wrong conclusions be drawn, and will all the actions to pull the economy out of the recession be halted?

"The guarantees were given for a period of three years, and we must ask whether that time will be utilized to return the economy to a path of growth. I do not see that we are falling asleep on the job, in the sense that nothing is being done to encourage growth. If the economic program moves forward, we will be reasonably prepared for the period after the guarantees. The guarantees provide a time out; and if it is utilized in order to continue to progress in the right direction, it will be an effective time out."

What is the effect of the guarantees on the economy this year?

"Mainly that of providing a time-out, since the problems do not have to be solved immediately. The government is using this time-out via the budget plans. This has engendered willingness in the market to lend money to the government at lower interest rates than prevailed at the beginning of the year. This is the main influence of the guarantees on the economy."

Without the guarantees, would we be able to raise capital abroad?

"We know that without the guarantees we were unable to raise money abroad before."

Does this mean that all our fundraising now has to be attributed to the guarantees, not to the finance minister's touted program?

"I do not think that that is the case. One of the important things in the government's program is its long-range perspective. The plans are not for immediate steps, but rather long-term processes, and that is very important to the financial markets. Were it not for the faith in the long term, it would be much harder to obtain financing - and that is not the result of guarantees, but rather of the economic program and the political backing it has been given. The economic program was sufficient to open the markets to us, but it is also clear that the guarantees lowered the cost of the financing."

Are the markets euphoric?

"The answer needs to be divided into three parts - foreign currency, bonds and shares. What happened this year in the foreign currency market is not euphoria. This is a market that drew its conclusions from the character of the economic policy and the external changes. What happened in the economic and security arenas contributed positively to the stability of the foreign currency market. We have even witnessed a return of long-term foreign investments. The investments by foreign residents in Israel have doubled from $2.5 billion to $5 billion. At the same time, the Israeli investments abroad have remained unchanged - $3 billion. There has therefore been a net growth in imported capital."

Does this mean that there is no fear of a depreciation in the shekel under today's conditions?

"I am not afraid of any instability in the foreign currency market. I do not see the shekel changing its direction."

Even if interest rates continue to go down?

"There is a balancing mechanism. The interest rates are being managed in keeping with assessments of inflation. If we reach a situation in which the balance in the foreign currency market changes, and as a result inflation increases, it is clear that interest rates will follow suit."

Does the steep drop in interest rates not bring us closer to the dangerous range of overly low interest spreads?

"What determines currency stability is not only the shekel/dollar interest rate spread. One has to look at the differential and the risk of capital movements in its wake. Since there has been a drop in Israel's risk premium, thanks to the guarantees, the improving security situation and the economic program, we can live today with narrower spreads without triggering an upheaval in the foreign currency market."

What will stop the process of lowering interest rates?

"A series of things - the extent to which the public continues to have faith in the government, the situation in the world, the preservation of political stability in Israel and the interest differential.

What is your opinion of the condition of the bond market?

"In order to judge whether there is euphoria in the market, one has to look at the irregular interest rates. The answer is no. There have been similar rates in the Israeli economy for long periods, and they are appropriate for a period of budgetary control and price declines. Perhaps they have not yet exhausted their downward momentum - although they are nearing the end of this process - so I do not think there is any instability here.

What do you think about the increase in bond issues?

"We are only at the beginning of this trend, which is the market's initial reaction to the improvement in the economy. The quantities are not exaggerated, but rather have a positive effect of varying the financing sources in the business sector."

Do you have any apprehensions regarding the entry of the pension funds as buyers in the market? Could they repeat the disaster scenario of the provident funds reform in the 1990s?

"I think that the pension funds will have to make extensive investments in bonds. The question is how they can do so differently than was done via the reforms in the provident funds a decade ago. One of the lessons I learned from handling changes is that it is hard to do so in a controlled manner. Changes are made when an opportunity presents itself, and then they happen faster than in theory. I hope that the lessons of the provident funds have been learned, that the market has developed since then, and that anyone embarking today on the management of a large asset portfolio has some experience, is not a greenhorn, as happened in the 1990s."

What about the stock market?

"The stock market has come a very long way, so the question of euphoria regarding it is more relevant. The answer is that it depends: If our economic assumptions prove true, then what happened in the stock market is a kind of adjustment. There is a big difference between that and euphoria. Still, this adjustment has to be backed up by the performance of the companies.

"The business sector has gone through a tough period. It has become more efficient, and if the economy also expands, the condition of the business sector can be expected to improve.

If this is what has happened in the stock market, it is perfectly normal and is another aspect of the faith in the government's policy."