This annual report to the Congress of the United States describes the economic situation in Israel that led to the 1985 Economic Stabilization Program, the reforms that have taken place since then and their impact, the current state of the Israeli economy, the current external debt situation, prospects for continued reforms and the need for continued economic assistance from the United States.

The most salient points of the report are:

The economic reform program has been successful in the
sense that inflation has been greatly reduced, the
budget restrained, unemployment is lower than it had
been for several years, and, in 1987, economic growth
was at the highest rate for the decade.
Continued reform is necessary, especially in the areas
of capital markets, taxation, privatization and the
pricing system.

The momentum in economic reforms has diminished,
somewhat.

To capitalize on progress made to date, Israel will
have to fully implement anticipated structural reforms.
The trade deficit will worsen in 1988.

Israel's external debt has grown slowly and its debt burden has declined.

Israel's debt service should remain manageable over the next three years.

If Israel can successfully implement structural reforms, extraordinary foreign assistance should not be needed.

As long as the country's security needs continue to demand a large share of the country's domestic resources as well as its foreign exchange, continued foreign assistance at current levels will be necessary.

II.

BACKGROUND AND RECENT ECONOMIC PERFORMANCE

Background

Israel experienced rapid economic growth until the early 1970s. Fueled by very high levels of investment, at times exceeding 30% of GDP, real GDP grew at an average rate of 98 p.a. between 1950 and 1972. At the same time, prices were relatively stable and private capital inflows easily covered balance of trade deficits. By the mid-1970s, Israel's economy turned sluggish. By the early 1980s, the economy was only growing at an annual rate of 1.4%. Much of the slowdown was brought on by the rapid escalation in oil prices after 1973 and 1979. Also, the war of 1973 diverted a major share of national

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resources to defense. The GOI, in trying to maintain civilian expenditures in the face of slower economic growth and greater security needs, financed growing budgetary deficits with private domestic savings. With the growth in budget deficits and concomitant money supply growth, inflation roared. Productive private sector investment declined in the face of uncertain real returns. Gross domestic investment declined from 31% of GDP in 1972 to only 18% in 1985.

During this period of slow growth and rapid inflation, personal consumption was maintained through indexation of welfare payments, wages, interest income and taxation. High levels of personal and government civilian and military consumption were induced through large and growing budget deficits and other expansionary aggregate demand policies. Over the 1971-1984 period, labor demand was strong as reflected in the low rates of unemployment, between 2.5% and 5.0%, and real wages rose more rapidly than did labor productivity. The expansion in government spending and aggregate demand led to money creation, domestic borrowing and current account deficits. The current account deficits were financed by increased U.S. assistance flows, private donations, other transfers and by foreign borrowing (concessional and commercial). The trade deficit on the civilian goods and services account rose from $600 million in 1972 (8.6% of GDP) to $4 billion in 1983 (16.7% of GDP). External foreign debt (net of foreign assets of Israeli commercial banks) rose from $4 billion in 1972 to $23.7 billion at the end of 1984.

To stem foreign exchange outflows, reduce inflationary pressures, restore growth and, in general, stabilize the economy, the coalition government (National Unity Government NUG) in 1984 devised a stabilization program. It included:

reduction in government expenditures;

- increase in prices of subsidized goods and services;

- imposition of foreign exchange and import

restrictions; and

- freezing or controlling many prices, wages and
interest rates.

Initially the program had some positive impact. Inflation had slowed by the beginning of 1985 and the overall balance of payments moved into surplus. However, it soon became apparent that the underlying pressures, which had created the earlier economic instability, were still in place. The need for more comprehensive reform was recognized. In July of 1985, the NUG initiated a new Economic Stabilization Program (ESP),

comprising:

price controls
wage restraints

Many achievements have been attained by the ESP since its initiation, although significant problems remain to be confronted. Despite continuing difficulties, the Israeli economy has taken great steps forward. Reforms initiated in 1987 include the de-indexing of bonds, deregulation of the capital market, preliminary research into the divestiture of public sector corporations, and a review of tax policy.

Recent Economic Performance

In 1986 and 1987 the Israeli economy made considerable gains in combatting balance of payments difficulties and reducing inflation. This progress began haltingly in 1986 but in 1987 Israel may have experienced the highest rate of growth since 1979. As indicated in Table II.1, which provides the major economic indicators, GDP in 1987 was expected to grow by 4 4.5%.

Current security concerns notwithstanding, the present business climate in Israel is perhaps the most favorable in many years. Israel's economy expanded rapidly for the first three quarters of 1987, and probably continued to expand in the last quarter of 1987. By the end of 1987, the industrial sector may have grown by 5.6%. Unemployment has dropped from 7.1% in 1986 to an average of 5.7% for 1987.

In 1987, the banking sector has returned to earning profits after a disastrous performance in 1986. Part of the increase in net profits directly resulted from a decrease in corporate tax rates introduced in the beginning of the year. Additionally, the return to economic growth and business expansion engendered strong demand for financial services.

Sources: IMF, Ministry of Finance, Bank of Israel

A great deal of the improvement in the national economy can be traced to policy reforms and fiscal restraint. In particular, lower inflation and the return to confidence in the Shekel are the major results of government policy and impact on national economic performance, business confidence and expanded private investment.

The economic stability now enjoyed in Israel will evolve into