This week, the Bank of Israel published its first economic forecast for an economy under fire. The picture that emerges from the forecast by the Bank of Israel Research Department is one of some degree of damage to Israel’s macro numbers, but no major change. The fiscal deficit is expected to rise, but not a great deal; growth will decline, but will remain positive in the coming two years; and the unemployment forecast is actually better than in the central bank’s last forecast.
It’s not just the numbers that radiate optimism. Throughout the press conference that he held after the announcement of the bank’s interest rate decision two days ago (the rate was left unchanged at 4.75%) Governor of the Bank of Israel Amir Yaron kept repeating the message that "the Israeli economy is strong and stable." According to him, even in extreme scenarios that were tested, "the banking system in Israel remains stable and sound."
Not every metric was tested in the extreme scenarios, however. As far as the rest of the macro metrics are concerned, the Bank of Israel’s assumptions about the future course of the war were fairly optimistic. In the preamble to its forecast, the Research Department states: "The basic forecast we present estimates the costs of the war on the assumption that it will mostly be on one front against the terrorist organizations in the Gaza Strip and will be concentrated in the current quarter, the fourth quarter of 2023. Any change in the duration, scope, and intensity of the war will of course have a material impact on actual economic developments." In other words, the forecast rests on the expectation that the war will be over by the end of the year, and will be limited to the Gaza front.
Trusting the government to change the budget
Even more optimistic assumptions are made about the financing of the war. Where will the money come from? The central bank’s basic scenario rests on the government cutting its other expenditure, and on most of the defense expenditure in 2023 being covered by reallocations within the existing budget, and US aid. Or as Yaron put it: The government will change the state budget.
Since the outbreak of war, many economists have called on the government to shelve the 2024 budget, but, so far, there has been no response from the government side and no known measures have been instituted in this direction. This week, Yaron called on the government "to change the priorities within the budget, to make an effort to find the required budget sources through a change in priorities within the existing budget framework, including priorities reflected in the coalition agreements." So far, however, no-one in the government has officially signaled any change in the state budget or in the coalition agreements.
"Every month of reserve duty equals 1% of GDP"
The Research Department’s optimism is mainly expressed in its forecast for the fiscal deficit. It sees this year’s deficit coming out at 2.3% of GDP, which represents a substantial increase over the previous forecast, released in July, of 1.3%, but nothing extraordinary. Even before war broke out, the Ministry of Finance estimated that the annual deficit would grow to 2%.
Bank Hapoalim chief financial markets strategist Modi Shafrir says that even before October 7, the Bank of Israel’s deficit forecasts were on the optimistic side. "The bank’s basic scenario (before the war) was optimistic in comparison with our previous forecasts, and the deficit we forecast now is higher than the Bank of Israel’s estimates," he says.
"It’s not certain that the government will in fact rein in its spending and make dramatic changes within the current budget framework. State spending will rise, the declining trend in tax revenues will worsen, and in our view the deficit will grow by much more than the Bank of Israel forecasts," he adds.
Yoni Penning, chief market strategist at Mizrahi Tefahot Bank, believes that the deficit will grow substantially. "If we take the estimated deficit in terms of percentage of GDP, every month of reserve duty at the current level of manpower is estimated to cut 1% off growth. So even on the assumption that the war will be over by the end of the year, as in the Bank of Israel’s forecast, the deficit will be deeper."
Penning says that the most relevant forecast is that of the Ministry of Finance. "In the end, it’s the Finance Ministry that signs off on spending and expanding the deficit," he says.
Meanwhile, some investment houses have published their own estimates. Meitav sees the cost of war damage amounting to NIS 25 billion, more than double the cost of the Second Lebanon War, which translates into a 2.5% loss of GDP. Meitav sees a deficit in 2023 of 3% of GDP, which compares with a pre-war estimate of 2%, and 2.3% in the Bank of Israel’s updated forecast. Meitav’s basic scenario also assumes two months of fighting, but it expects the deficit next year to climb to 4% of GDP, which compares with 3.5% in the Bank of Israel’s forecast. Meitav’s chief economist, Alex Zabezhinsky, stresses that in any event it will be possible to estimate growth for 2023 only once the growth figures for the third quarter are released.
Not all the war expenditure will come out of the state budget, however. "We assumed that the Ministry of Finance would use about NIS 10 billion from its reserves," says Zabezhinsky. "It’s likely that the ministry will try to reduce the amount it raises through spending cuts, such as freezing the coalition money, but it will still have to raise some NIS 37 billion within two months. It will be hard for the market to digest such large sums. The ministry will therefore probably raise lower amounts, and the remainder will be rolled over to be raised next year." Either way, he says, "the rise forecast by the Bank of Israel itself regarding debt in 2024 looks too high in relation to their forecast for the deficit."
How is it that the unemployment forecast has improved?
As far as the unemployment forecast is concerned, it seems that the Bank of Israel does not expect the labor market to deteriorate, but rather the opposite. The bank now sees unemployment among people aged 25-64 averaging 3.2% in 2023 and 3.6% in 2024, which compares with previous forecasts of 3.7% and 4.1%. Despite thousands of people being placed on unpaid leave, and despite fears that the trend will broaden, the Bank of Israel actually sees an improvement in participation in the workforce.
Economists to whom we spoke are unanimous in saying that the Bank of Israel has underestimated the expected unemployment rate. "Tax revenues have declined sharply in the past year, and the trend will yet worsen, partly as a result of a rise in unemployment," says Shafrir. "In addition, the Ministry of Finance will not pay full compensation to everyone impacted by the war, and that will find expression in personal spending capacity." Despite this, he does not believe that we will see a return to the high levels of unemployment of the Covid pandemic period, when large parts of the economy were in lockdown.
Published by Globes, Israel business news - en.globes.co.il - on October 25, 2023.
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