Outgoing Central Bank Chief: Israel's Fiscal Situation Is Economy's Main Problem

As the end of his term drew near Bank of Israel Governor Stanley Fischer on Monday praised Israel's economic performance while defending his monetary policy.

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But unveiling the bank's 2012 annual report Fischer also produced a long list of challenges ahead, starting with what he said was an urgent need to create a sovereign wealth fund for the state's future natural-gas profits, and warned against trying to close the yawning budget deficit with tax hikes alone.

Speaking a day after Lapid provoked controversy by referring to a hypothetical Israeli woman, "Riki Cohen," who together with her husband earns NIS 20,000 a month, as "middle-class," Fischer said the interests of the poor had to be defended.

"I’m confident the government will continue to do that and that the finance minister, who has made an excellent impression on me, will address the problems of all socioeconomic classes," Fischer told a press conference. "I have met with the finance minister few times and my initial impressions are excellent, that he is a serious man."

But Fischer didn't discount the challenges Lapid faces in trying to close a budget gap of some NIS 30 billion. Fischer called Israel's fiscal situation the economy's "main problem."

Israel's gross domestic product is forecast by the Bank of Israel to grow 3.8% this year. While one percentage point of that growth will come from the start of natural gas production from the Tamar field, Fischer noted that at 6.5% unemployment is at its lowest in three decades, while the workforce participation rate is rising. Israel's current account will be in balance, while inflation is forecast to remain within the target range, he noted.

But Fischer signaled that Israel remains exposed to a troubled world economy and that the budget deficit is structural, meaning that is cannot be reduced simply by increasing economic growth. Moreover, the target for this year's deficit, which is 3.6% of GDP, is by no means a sure thing, he said.

"Although we're talking about a low rate relative to other countries, it is less than desirable," he said. "If you recall what happened in 2003, when as a result of a recession the deficit rose to 6% with virtually no increase in spending, we can see that if, heaven forbid, we enter into a recession, the deficit could easily be bigger than in 2003."

On that account, Fischer said Lapid would have a difficult time avoiding tax increases without cutting deeply into the defense budget. But the governor avoided making a specific policy recommendation.

"If we need to keep defense spending at current levels, or even raise it, we need as a country to pay the cost of security," he said. "But I also believe that it would be wrong to shoulder the entire cost of reducing the deficit with higher taxes. We have to preserve the ability of the business sector to operate and contribute to economic growth."

Addressing another area of difficulty, Fischer defended the Bank of Israel's policy of keeping interest rates so low that home buyers were encouraged to take out loans, fanning demand and boosting prices. The central bank has taken steps to cool demand for mortgages, but Fischer said the government should also look at ways to deter people buying homes as speculative investments, including by extending the exemption for the property improvement tax to seven years from four.

The bank's base interest rate fell to as low as 0.5% in 2009 at the height of the financial crisis, rose to as much as 3.25% in the middle of 2011 as Israel's economy recovered and has since been cut to 1.75%.

"A low interest rate was necessary to protect the economy against the impact of the global financial crisis," Fischer said, urging the government to take the lead by taking steps that would lead to increased home-construction starts and lower prices. "We can't use the interest rate tool just for this purpose. We have to remember the impact of interest rates on the exchange rate."

The interest rate issue came as the dollar weakened to a Bank of Israel rate of NIS 3.61, its lowest since October 2011, prompting speculation that the central bank would intervene in the market to prevent the shekel from strengthening further.

Currency dealers said the shekel's strength might be derived in part from the start of gas deliveries this week from the Tamar field.

The Bank of Israel estimated that domestic gas production will save Israel's $2 billion to $3 billion in imported-energy bills while improving its balance-of-payments situation. The Bank of Israel took issue with how much gas Israel should export, saying that the Tszemach committee's estimates of reserves appeared overly optimistic.

Gas exports also could lead to a strengthening of the shekel, undermining the country's other export industries. To prevent that from happening, Fischer urged the Knesset to approve legislation creating a sovereign wealth fund that would invest the government's natural-gas profits abroad, spending only the returns accrued.

"Setting up a fund like this can be justified on the ground that it shares the resources between generations," Fischer told the press conference. "It's important to preserve the resource for generations to come and not exploit it simply for ourselves."

Among other reforms the governor urged were the creation of a financial stability committee together with improved regulation.

"Every few months we witness the damage wrought by the financial system in another country," Fischer said.

The Bank of Israel estimated in its annual report that since 2009 some NIS 26 billion in bonds have been subject to restructuring because borrowers couldn't meet repayments. It estimated that the rate of problematic debt in the bond market at 2.5% to the total, versus 1.96% for the banking system, although it said making the comparison was difficult because of the different natures of the markets.

Fischer also defended the central bank against charges that it is more concerned about the stability of the banking system than in encouraging competition in the industry or protecting consumers.

"We see what's happening in Cyprus and what happened in Ireland - countries where the banking system grew to be many times bigger than the economies themselves," Fischer said. "We can't allow a bakning crisis to occur in Israel."

Ital Trilnick contributed to this report.