Fischer: War could cost economy NIS 5b.

Says gov't would not necessarily have to raise taxes though household incomes could take a hit.

By DANIEL KENNEMER
August 3, 2006 06:54
stanley fischer 88

stanley fischer 88. (photo credit: )

The war in the North would most likely cost the Israeli economy between 0.7 percent and 0.9% of gross domestic product, or up to about NIS 5 billion, assuming the fighting lasts roughly one month in total, Bank of Israel Governor Stanley Fischer said Wednesday, estimating the conflict was costing the country between NIS 750m. and NIS 1.08b. each week, or the equivalent of about 0.2% of GDP. Loss of tax revenues will come to about 0.3% of GDP, while direct and indirect compensation payments - expected to total NIS 2b. to NIS 3b. - would be paid from the Tax Authority's Compensation Fund "and therefore will not affect the budget deficit," he said. Increased defense spending also would come to about 0.3% of GDP, assuming the fighting ends by mid-August. The total increase of the budget deficit stemming from the conflict in the North then would come to "only" 0.6% of GDP - keeping the year's total deficit beneath 2% of GDP - as based on the net tax revenue surplus built up in the first half of the year. Boosted industrial activity among defense contractors was not factored into the calculations, nor was a probable rise in business stemming from post-conflict building repairs or the possibility of a drop in investments. In such a situation, the government would not necessarily have to raise taxes to cover expenses, he said, though household incomes could take a hit from the private sector. "We were in a very good situation on the eve of fighting," Fischer said, citing a surplus in the balance of payments in the current account, a "near 0%" fiscal deficit and a healthy private sector. "We have a strong economy that is capable of covering the costs of the fighting," he added, noting that the first priority of the government is necessarily the physical defense of the country and its inhabitants and that "at this stage," at least, Prime Minister Ehud Olmert need not seek his counsel on whether economic constraints should be factored into decisions such as how long the war should take. Fischer said that though Israel didn't want to fight, the confrontation was forced on the country, necessitating certain economic costs. Boosted industrial activity among defense contractors was not factored into Fischer's calculations, nor was a probable rise in business stemming from post-conflict building repairs or the possibility of a drop in investments. Although investor reaction to the outbreak of fighting with Hizbullah led to a 3% devaluation of the shekel and a 12% drop on the Tel Aviv Stock Exchange, "once they understood that we would continue to pursue [the government's] macroeconomic policy, the markets began to recover," Fischer said, adding that "This is not coincidental, but the result of decisions made by the government and the Bank of Israel." Daily volumes of trade on the bourse have increased significantly since fighting began - once even hitting an all-time record of $3.4b., far above last year's average daily trade rate of $1b. - which, he said, "reflects a market working well with high numbers of sellers and buyers." "Despite the particularly high increase in spreads and volatility, trade continued normally and continuously throughout the trading hours," and the market has since regained stability in any event, he said. The shekel is back to about NIS 4.40 per dollar, as it was on the eve of the outbreak of violence, and share prices have risen to the extent that the total drop in indices since the outbreak has contracted to about 2%, he noted. Over the same period of time, several other countries' currencies and bourses dropped more than those of Israel, Fischer added, citing the currencies of Sweden, Japan, Korea, Switzerland, Chile and the Czech Republic, and the bourses of Taiwan and Australia, among others. "Relative to the average [drop in world bourses] we dropped somewhat more, but not much more," he said, but added that uncertainty would continue for as long as the fighting lasts. Manufacturers' determination to maintain production levels and fill clients' orders are also helping to maintain foreign investors' confidence in the Israeli economy, Fischer said. "All of them know that they are now being tested ... All of them understand that they have to supply [clients' orders] as if nothing happened," he said. Confidence among foreign investors is also seen in Israel's risk premium, stable announcements of credit rating agencies and foreign acquisitions of Israeli companies during the fighting, he added. Israel's overall risk premium, as measured by the 5-year credit default swap (CDS), is currently at 0.35%, a "moderate" 0.05 percentage points higher than before the crisis, having dropped somewhat since an initial 0.08 point rise to 0.38% during the first three days of fighting. Fischer attributed the recovery to investors' confidence that macroeconomic policies would be maintained, particularly price and financial stability, "necessary monetary policy" and the 2006-2007 budget framework. "I am optimistic that we'll be able to continue meeting our fiscal and monetary obligations," Fischer said. "The fact that the situation is so stable is affected by our [August interest rate] decision and by the investors' confidence that neither the Bank of Israel nor the government will allow the macroeconomic situation to deteriorate." Speaking of the July 24 decision to raise the shekel interest rate by 0.25 percentage point to 5.5%, Fischer said that - beyond inflationary pressures - the hike was necessitated by a higher level of financial risk, and that it demonstrated "that we are ready, and [will] take the decisions [needed] to protect the economy's stability. Stability is very, very important in this situation. Therefore we decided what we decided." Federation of Israeli Chambers of Commerce President Uriel Lynn, however, on Wednesday, called on Fischer to bring the interest rate back down. "There is no economic justification for burdening the economy further, seeing the slow-down in business activity in the North and the heavy economic costs on households and businesses in that region, and it would be preferable to relieve the market as long as there is no risk of damaging stability," he said. "Furthermore, one must remember that the Bank of Israel will maintain a degree of freedom to raise the interest rate again if the war expands beyond its current dimensions or if a change occurs in the economy's stability." Fischer, meanwhile, told reporters tourism most likely would be affected throughout the country to some extent "and recovery will be gradual." While most industries are expected to bounce back more quickly once fighting ceases, tourism will continue to suffer negative effects even after hostilities end, bringing total damage to the industry to about NIS 1b., he estimated. Due to an apparent need to either raise defense spending - "or at least not cut the defense budget" - the State will have to make decisions based on priorities, Fischer said, reiterating the need to meet fiscal targets, in any event. Social spending increases, for instance, would likely either have to be reduced somewhat or spread over a longer term but not canceled entirely, he said. "If defense spending is needed, then we will have to cut in other places." Given the 6% annualized GDP growth rate in the first and second quarters, even if economic growth stalls, averaging 0% for the second half of 2006, the economy still will have grown about 4.5% for the whole year, he indicated, but added that it was "reasonable to expect" that the economy would do better than that despite the war. On assumption that global growth continues and the fighting stops soon and with an outcome benefiting Israel's geopolitical standing, the economy likely will resume its fast rate of growth "well before" the end of the year, in which case there should be no fears about the 2007 budget and fiscal discipline for next year, Fischer said in response to reporters' questions. Effects related to the level of confidence in the economy depend on how the fighting ends, he stressed, noting that it appeared that not all of Israel's objectives in the conflict would be achieved, increasing the importance of achieving an improved geopolitical situation nonetheless. A worsening of the geopolitical situation following the war, he said, could cause an outflow of capital abroad by both Israelis and foreign investors, depreciating the shekel and boosting the risk premium further. Yet, positive macroeconomic and fiscal figures in the first half of the year, alongside the weakening dollar, suggest that the shekel will keep getting stronger, the governor noted. The conflict area is home to 17.2% of Israel's employees, earning 15.5% of the country's total wages. In a separate report released Wednesday, Fischer said the crisis in Gaza and subsequent outbreak of fighting in the North were expected to push short-term inflation above its previously expected level. "The Bank of Israel, in conducting monetary policy in the coming months, will need to take into account both the possible rise in inflation and the likely slowdown in activity," he said in the report. To reporters, Fischer explained that in a situation of simultaneous inflation and falling output - typically encountered during a "supply shock" scenario - decision makers are required to "choose [their] trade-offs," with the knowledge that any decision would hurt either the demand side or supply side of the economy. "This is the difficult part of economic policy," he said. The consumer price index (CPI) rose 1.6% in the first half of the year, bringing inflation over the past 12 months to 3.5%, in excess of the price stability target range of 1%-3%.


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