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Israel: Country outlook(EIU Viewswire Via Thomson Dialog NewsEdge)COUNTRY VIEW FROM THE ECONOMIST INTELLIGENCE UNIT OVERVIEW: Kadima (Forward), the new centrist party founded by the former prime minister, Ariel Sharon, and now headed by the acting prime minister, Ehud Olmert, is poised to head a new coalition government following its emergence as the largest party in the March 28th general election. However, the party's comparatively modest showing will make for a relatively unwieldy coalition government. Healthy real GDP growth will be supported by a strong domestic performance and steady export growth. The budget deficit will widen in 2006-07, but, despite a modest increase in social spending, improved fiscal management will keep the deficit at around 3% of GDP. Interest rates have begun to rise as the Bank of Israel (the central bank) responds to rate hikes in the US and to increased domestic demand. Average inflation will rise in 2006 but stay low overall in 2006-07. The current-account surplus will contract in 2006, before rising in 2007. Domestic politics: Kadima is poised to lead the next coalition government following the March 28th general election, when it won the most seats (29 of 120) in the Knesset (parliament). The party, which was formed by the now incapacitated Mr Sharon, benefited from his popular, unilateralist approach to the Israeli-Palestinian conflict as well as from the weakness of the other main parties. However, a low voter turnout hurt its showing at the polls, broadening the number of parties that would be required to ensure a comfortable majority in the Knesset. As anticipated by the Economist Intelligence Unit, the proposed coalition partners include the centre-left Labour, which held steady to win 19 seats, and Shas, a religious party, with 12 seats. The coalition will also include the new pensioners advocacy party, Gil, with seven seats. This will give the new government control of at least 67 seats. The major political realignments in recent months, which have included the implosion of the right-wing Likud, disaffection with other large parties including Labour, the creation of Kadima and Mr Sharons incapacitation, have added uncertainty over subsequent government policy and composition. International relations: With the new Israeli administration inclined to continue the unilateralism of its predecessor (a policy that remains broadly popular in Israel) and Hamas, a radical Islamist group, forming the new Palestinian government, the long-stalled Israeli-Palestinian peace process is unlikely to be revived any time soon. Israel will continue to act against perceived threats emanating from the Palestinian Territories. Israeli has long argued that any restoration of the peace process will be dependent on the ability of the Palestinian president, Mahmoud Abbas, to deliver enhanced security. However, his position has been further weakened by the formation of a Hamas-dominated government. Nevertheless, Hamas has largely complied with the ceasefire agreed in February 2005, mindful of the unpopularity of actions that provoke Israeli reprisals. However, without substantive changes to Hamass stance towards the Jewish state and existing agreements, negotiations are unlikely to happen, other than possibly over practical and humanitarian issues. Even if bilateral talks in some form are conducted, a proper resumption of formal negotiations towards a final settlement of the conflict is unlikely. The political and practical difficulties for any Palestinian leadership in preventing attacks on Israelis, and the likelihood that Israel will not wish to make significant concessions to a Hamas-led government, could even lead to a resumption of sustained confrontation. Policy trends: The outgoing government was active in promoting economic liberalisation, setting realistic fiscal and other policy targets, and restarting a stalled privatisation programme. In addition, financial market reforms have provided greater financing options for businesses. Further fiscal consolidation will move at a slower pace under the new government, given the prominence that some of Kadimas coalition partners have placed on improving welfare provision. However, given that many of the most important measures have already been implemented, or have progressed too far to be easily rolled back, and coupled with Mr Olmerts insistence that the Ministry of Finance remain under Kadimas control, we do not expect a major reversal. Other reforms will move forward, albeit at a modest pace, particularly in the financial sector. These will include some privatisations. The institution of a compulsory (but not state-funded) universal pension system will also be on the agenda. Further tax reforms were legislated on by the previous government, including cuts to sales, corporation and income taxes, offset by broadening capital gains tax. The new government may give these measures lower priority, and a tax-credit system to encourage employment among low earners may be introduced. International assumptions: World GDP growth (at purchasing power parity exchange rates) is expected to slow modestly from 4.6% in 2005 to 4.3% in 2006 and 4.1% in 2007, as the impact of a slowdown in the US is partly offset by stronger performance in the EU, Japan (in 2006) and elsewhere. US growth will fall to an average of 2.7% a year in 2006-07, as fiscal and monetary policy becomes less accommodating to growth. Real GDP expansion in the EU25 will strengthen but remain modest, at 2.2% in 2006 and 2.3% in 2007. Israels two main export destinations are the US and the EU, but it has increasingly diversified its markets. The Economist Intelligence Unit expects the high-tech export sector to continue to expand--global demand growth for these products will remain fairly healthy--and foreign direct investment to stay high. The three-month target rate at the US Federal Reserve (the central bank) will continue to trend upwards in 2006, as will rates in the euro zone, which will continue to rise into 2007. With oil prices now likely to rise further in 2006 and slacken only slightly in 2007, there will be some pressure on consumer prices, particularly in 2006, which will increase the likelihood of further interest rate rises in Israel. Economic growth: With global demand growth easing slightly since 2005, economic expansion will continue to be more evenly distributed than during the initial export-led economic recovery in 2003-04. A stronger recovery in the domestic economy will mitigate the impact on exports of more modest global demand, although growth in exports of goods and, particularly, services will remain robust. Private consumption will continue to rise. Moreover, gross fixed capital formation will expand strongly. Inflation: A weakening of the shekel against the dollar and surging oil prices have seen consumer price growth strengthen overall in recent months, but at a modest pace, helped by sluggish wage growth. Despite rising interest rates, domestic demand will stay relatively strong throughout 2006 as unemployment falls further and the output gap narrows. Global commodity prices will continue to rise this year, adding to supply-side pressures. A recovery in house prices will also feed into consumer price growth, although the recent strengthening of the shekel against the US dollar (housing is dollar denominated) should help offset some of the impact of this trend. Nevertheless, after climbing to 3.6% year-on-year in March, consumer price inflation will return to within the central banks 1-3% price-stability target range over the forecast period. Average annual inflation will rise slightly in 2006 to 2.6% (little changed on the end-2005 figure of 2.4%), before slowing to 2.1% in 2007 as the weakening in global commodity prices helps offset continued strong domestic demand. The main risk to our central forecast will remain shekel volatility, with the currency vulnerable to poor economic policy decisions and political events. Exchange rates: Strong export growth and capital inflows are likely to help anchor the exchange rate during the forecast period, despite the end of the differential tax treatment of domestic and overseas assets from 2005. The shekel will remain sensitive to political and security developments, but such concerns, along with other worries over fiscal policy or further reform of the tax rules, should only have a short-term impact on the currency, unless there is a major change in policy. A reversal in the current trend of strong net capital inflows is the biggest threat to our main scenario of a relatively stable currency. As it is, we expect a modest fall in these inflows, as well as the maintenance of a fairly narrow differential between Israeli interest rates and those in the US and the EU, to offset the impact of a weakening of the dollar against other major currencies. The shekel has made significant gains against the US dollar in recent weeks as election-related jitters have passed. However, given its weakness earlier in the year, we expect the shekel to depreciate to an average of NIS 4.58:US$1 in 2006. The currency will continue to strengthen in the latter part of 2006 and in 2007, averaging NIS 4.53:US$1 that year as the dollar weakens further on global markets and Israeli interest rates trend upwards, although by end-2007, with the dollars decline halted, the shekel will be marginally weaker. Despite these later gains against the dollar, the shekel will stay relatively competitive against its main trading partners, in particular the euro zone economies. External sector: Israel registered a record current-account surplus of US$2.4bn (1.9% of GDP) in 2005, owing to rapidly rising services and income credits. These have offset the pick-up in import spending stemming from rising consumer and business demand and the surging price of imported commodities. In 2006-07 export earnings will remain fairly robust. Capital goods imports will also rise, however, and the recovery in demand for imported consumer goods will continue, albeit at a gentler pace. Record oil prices will also keep import costs high in 2006, although weaker non-oil commodity prices and a fall in oil prices in 2007 will help limit the expansion in the import bill. We expect the trade deficit to widen to US$4.8bn in 2006 before easing to US$3.8bn in 2007. |