Economic Research:

A Strong Shekel And A Weak

Construction Sector Are Holding Back
Israel's Economy
Economist:
Sophie Tahiri, Paris 33 1 44 20 67 88; sophie.tahiri@standardandpoors.com
EMEA Chief Economist:
Jean-Michel Six, Paris (33) 1-4420-6705; jean-michel.six@standardandpoors.com
Table Of Contents
A Strong Shekel Has Been Curbing Foreign Trade Growth
Housing Market Uncertainty Is Holding Back The Economy
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Economic Research:
A Strong Shekel And A Weak Construction Sector
Are Holding Back Israel's Economy
Israel's economic growth momentum has been slowing since the second quarter of 2011. On a quarter-on-quarter
annualized basis, real GDP growth in the business sector slowed to 1.5% in first-quarter 2014, from 1.8% in the first
quarter of 2013 and 2.5% in first-quarter 2012, according to Central Bureau of Statistics (CBS). Exports and
manufacturing production have been under pressure since the end of 2011 because of the soft global economic
recovery and the strong appreciation of the shekel. Since the middle of last year domestic factors--especially a
slowdown in housing demand--added to this loss of momentum. Real fixed investment declined sharply by 14.3%,
quarter on quarter, during the first quarter, owing to a decline in residential and non-residential private construction.
Meanwhile, private consumption dropped 0.6%, mainly owing to a fall in spending on durable goods.
Overview
Economic growth has been slowing in Israel because of tepid global growth, a strong currency, and softness in
housing market activity.
The strong shekel has hurt competitiveness, and the recovery in Israel's key foreign markets is likely to be
slow.
The central bank and the government are seeking to cool the booming housing market, but with the side effect
of slowing domestic demand growth.
Cyclical indicators continue to suggest a slowing trend in the business sector at the beginning of the second quarter.
The composite state-of-the-economy index has been indicating a slowdown in activity. The index remained unchanged
in April for the second month in a row and only grew by 2.1% year on year--the lowest growth rate since December
2009, when the Israeli economy was recovering from the recession that resulted from the 2007-2008 financial crisis
(see chart 1). The more recent decline in activity is related to weakness in exports of goods, industrial production, and
housing starts.
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Chart 1
Reflecting the reduced pace of economic activity, April inflation was only 1%--at the lower limit of the central bank's
price stability target range of 1%-3%. This moderate inflation is in line with the trend that started at the end of 2011.
Nonetheless, the Bank of Israel (BoI) left its policy interest rates unchanged at 0.75% at its last meeting on May 26.
Israel's central bank has gradually turned its attention to declining inflation trends and appreciation of the shekel since
mid-2011. Since September of that year, the policy interest rate has declined by a cumulative 250 basis points (bps).
The BoI has a delicate task ahead. On the one hand, the weaker economy combined with stronger currency will keep
inflation at the low end of the central bank's target range. We expect inflation to average 1.0% this year, down from
1.5% last year. On the other hand, inflation in real and financial assets remains a concern. Home prices continue to
climb, and housing loan growth remains elevated, while corporate and government bond yields are approaching
record lows. We think that foreign-exchange pressure and low inflation will continue to pose a constraint on the BoI's
normalization of its monetary policy and may lead to further easing in 2014, before the BoI gradually starts to increase
policy rates in 2015.
Moreover, uncertainty remains as to the extent of the moderation in economic growth because forward-looking
indicators, such as consumer or business tendency surveys, are improving. The difference between negative and
positive respondents to the consumer confidence survey declined from 26% in March to 21.6% in April, in
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Economic Research: A Strong Shekel And A Weak Construction Sector Are Holding Back Israel's Economy
continuation of a positive trend since the start of the year. Furthermore, the April CBS Business Tendency survey
showed that businesses are reporting improved conditions in all sectors except for construction. We think these
positive survey results are likely to be reflected in a rise in private consumption and investments in the second half of
the year.
Meanwhile, the situation in the labor market has been improving. The number of jobs in the economy increased by
50,000 in the first four months of the year, in seasonally adjusted terms, reflecting an increase of 0.9% compared with a
rise of only 0.2% in the last four months of 2013. However, because the participation rate in the economy rose slightly
in the first four months of 2014, from 63.6% to 64%, the unemployment rate only decreased by 0.3 percentage points
to 5.6% in April, in line with a gradual decline in the unemployment rate since the middle of last year. According to the
BoI, this positive trend is mainly due to increased public sector employment, while business sector employment
remained stable. The number of employees in the public sector increased by 2.8% in the 12 months to February and
by only 1% in the business sector, reflecting moderate growth in Israel's economy. We think that hiring in the
corporate sector will remain subdued this year, owing to the moderate GDP growth rate, and we expect the
unemployment rate to average 6.0% this year.
A Strong Shekel Has Been Curbing Foreign Trade Growth
The shekel has appreciated by around 10% in nominal trade-weighted terms over the past few years and by nearly
20% since 2007. It is now 7.4% above its long-term average and has been one of the strongest performing currencies
globally, ahead of the euro, the British pound, and the Swiss franc since June 2012 (see chart 2). This appreciation has
occurred despite active intervention by the BoI in the foreign exchange markets in 2010-2011, as well as since March
2013. In real terms, the appreciation of the currency has been of the same magnitude, indicating that prices and wages
in Israel have not grown faster than in other trading partner countries.
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Economic Research: A Strong Shekel And A Weak Construction Sector Are Holding Back Israel's Economy
Chart 2
Several factors have contributed to the shekel's performance. The interest rate differential with the U.S has been fairly
significant over the past three years following the central bank's rate hikes in 2010 and in the second half of 2011 and
has contributed to the exchange rate appreciation. However, we think that strong foreign direct investment (FDI)
inflows on the back of promising prospects of large-scale natural gas production and foreign purchases in Israel's
robust high-tech start-up sector have been the biggest contributor to higher demand for the shekel. In fact, despite the
narrowing of the interest rate differential as the BoI has cut rates by 250 bps to 0.75% since 2011, the shekel has
resumed its appreciation since mid-2012.
The strong currency appreciation has hurt competitiveness, causing sluggish export growth and a protracted decline in
manufacturing production. Merchandise export volumes have been falling continuously since mid-2011, despite stable
global demand, before rebounding somewhat in the last quarter of 2013 (see chart 3). More recent data from the CBS
show that Israeli exports of goods (in nominal terms)--excluding ships, aircraft, and diamonds--dropped by 12.9%
annually during the three months to April, compared with an increase of 1.3% in the previous three months.
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Economic Research: A Strong Shekel And A Weak Construction Sector Are Holding Back Israel's Economy
Chart 3
In contrast, services exports remained high, up 6.8% quarter on quarter in the first quarter of 2014. The steady rise in
the export of services, primarily software and other business services, has been the key factor behind the swing from a
sizable current-account deficit prior to 2002 to a succession of large surpluses over the past 12 years.
Export weakness in recent years has also partly reflected the Israeli economy's strong links to the U.S.--a top export
market and a significant source of investment--and Europe. For now, continued export growth will depend on the pace
and strength of economic recovery in both economies. While we expect U.S. GDP growth to strengthen from 1.9% last
year to 2.5% this year and 3.2% next year, we forecast eurozone growth to remain sluggish, rising by 1.1% this year
and 1.6% next year. Hence we believe goods and services export growth will stay below trend given the still strong
currency and as the pace of recovery in the U.S. and the eurozone remains moderate this year, before strengthening
somewhat next year.
In the longer term, because Israel's trade is shifting more toward emerging markets, export growth should benefit from
stronger growth in those markets. Israel's exports of goods to the U.S. fell to 26% of total exports in 2013 from 38% in
2006, according to IMF data (see chart 4). Meanwhile, export shares to the EU remain stable (at 28% of total exports).
By contrast, Israel's exports of goods to emerging economies jumped from 17% to 27% of its total over the same
period. Its exports to the Asian continent, excluding Japan, doubled to 12% in 2013 from 6% in 2006.
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Economic Research: A Strong Shekel And A Weak Construction Sector Are Holding Back Israel's Economy
Chart 4
Housing Market Uncertainty Is Holding Back The Economy
We believe soft housing demand is weighing on private consumption and investment in the construction sector.
Activity in the housing market has been slowing since October of last year. According to data from the CBS, home
sales dropped 9% in April compared with March and 15% compared with April 2013 (see chart 5). The decline reached
10% on an annual basis. Meanwhile, housing starts fell 26.4% year on year in February and were down by 2.2% in
cumulative terms for the last 12 months. However, home price growth remained high, with the average price rising by
7.1% year on year in February down from double-digit numbers last summer.
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Economic Research: A Strong Shekel And A Weak Construction Sector Are Holding Back Israel's Economy
Chart 5
The weakness in the construction sector is primarily due to heightened uncertainty among households about the
potential impact of two major government reforms that aim to curb house price inflation. Low borrowing costs and
tight supplies of new homes have led to a surge in prices since 2007 (+87% between October 2007 and February
2014). Recent research from the BoI confirms that market affordability declined between 2004 and 2012. An additional
one to three years of average household income are now needed to purchase a home, depending on the district.
To address the systemic risks emanating from rapid house price increases, the BoI has introduced various types of
macroprudential measures since 2009. These include capital surcharges and additional provisioning, aimed at reducing
banks' incentives to extend mortgage loans. These measures have certainly increased the resilience of the banking
system but were hardly successful in containing house price increases. More recently the BoI has put in place other
measures, such as loan-to-value and debt-service-to-income limits, which are more likely to curtail house price
inflation, in our view.
Rental and house prices increases resulted in social protests in summer 2011. In response, the government is exploring
housing reforms aimed at lowering costs for home buyers and renters. One key proposed reform includes a
value-added tax (VAT) exemption on home purchases for first-time homebuyers who fit certain criteria. Under this
reform, buyers would enjoy an 18% discount off the purchase price. The aim of the reforms is to make the market
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Economic Research: A Strong Shekel And A Weak Construction Sector Are Holding Back Israel's Economy
more affordable for this category of buyers. A second reform seeks to set target prices through land subsidies for
contractors, as long as contractors agree to sell housing units at predetermined prices (20% lower than current prices).
The long-term effect of these reforms is uncertain. For instance, the VAT break could increase housing demand and, in
a context of a supply shortage, might eventually inflate prices. An inelastic response of supply to increasing demand
diminishes the effectiveness of fiscal policies aiming to support housing through targeted subsidies. And the
government subsidy could benefit contractors more than homebuyers. The second reform would only bring down
prices if the inventory of state-owned land available for residences is substantial, which hasn't been established yet.
Meanwhile, uncertainty about the implementation of these reforms is likely to continue to weigh on the home sales
market, contributing to the slowdown in investment in residential construction. The standstill is likely to continue in
the second and third quarter, until reforms are implemented and legal problems are solved. In the longer term, we
think residential investment will rebound because government reforms are unlikely to bring down prices significantly.
Similarly we think that weakness in housing demand has contributed to the weakness in private consumption since the
last quarter of 2013. Spending on durable goods such as electric appliances and other household equipment has
declined by 4.3% quarter on quarter in the last quarter of 2013 and by 0.2% in the first quarter of 2014, weighing on
private consumption as a whole. There is a relatively strong and positive correlation between housing sales and
demand for durable goods. Similarly we expect the weakness in durable goods consumption to continue in the
following two quarters. The weakness in consumption has also stemmed from rising housing expenditures in recent
years, including rental prices and mortgage payments, as well as an only moderate rise in real wages.
More generally, we expect real activity in the second quarter will increase moderately, before growth accelerates in the
second half of the year, led by global demand and, possibly, less uncertainty about the housing market. We lowered
our growth estimate for 2014 to 2.9% from 3.3%, but we project growth will accelerate to 3.5% in 2015, owing to a
stronger global trade recovery.
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Economic Research: A Strong Shekel And A Weak Construction Sector Are Holding Back Israel's Economy
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