Once 'Best in the West', Israel's Economy Shows Cracks

Jerusalem: For more than a decade, Israel's high-tech-fuelled economy has weathered the global financial crisis and several military conflicts with little impact on growth or the free flow of foreign investment.

But its strong run, which led former finance minister Yuval Steinitz to coin its justifiably upbeat tag as the 'Best in the West', may be coming to an abrupt end, with the era of sustainable high growth rates consigned to history.

The war against Hamas in Gaza, which ran into a 50th day on Tuesday, has taken a heavy toll, hitting tourism, slowing consumer spending as people stay indoors and denting manufacturing, especially in plants close to Gaza.

Even before the conflict began on July 8, growth was weakening. A preliminary estimate showed the economy grew an annualised 1.7 percent in the second quarter, down from 2.8 percent in the first, while unemployment inched above 6 percent from 5.7 percent in late 2013.

With a concerned central bank expecting the war to knock around half a percentage point off output, forecasts for growth of around 3 percent this year now look wildly optimistic, and the budget deficit is likely to exceed its 3 percent target.

After a decade of growth of 3-5 percent a year - during which Israel's economy has nearly tripled in nominal terms to $300 billion - some are even predicting a complete reversal.

"We might have a recession," said veteran Israeli economist Ayelet Nir, although she adds it wouldn't be a deep one.

Prospects of a sharp downturn, coupled with near zero inflation, prompted a second surprise interest rate cut in the past month on Monday, when the Bank of Israel trimmed its benchmark rate to an all-time low of 0.25 percent.

"We are definitely in a slowdown in activity," said central bank governor Karnit Flug.

Economists point out that the economy - 40 percent dependent on exports, mostly high-tech goods and software - is still looking solid compared with much of Europe and the West.

But like most developed economies, Israel is becoming more services-oriented, which means growth depends on its major trading partners buying its high-value services.

With the largest, Europe and the United States, both struggling and the shekel currency strong, Israel has to work even harder to be competitive and grow its exports.

Add to that war-weary consumers who are growing fed up with the high cost of living -- even if inflation is stable -- and the days of Israel posting up to 5 percent growth may be over.

"Our growth potential is not as high as before," said Nir, who projects long-run output of around 3 percent.

"The population growth is not as high as in the past, investment is not as high as in the past, productivity is very low ... and Israel is transitioning from manufacturing to services," she said. "It is happening very fast."

SQUEEZED ON ALL SIDES

Mai Doan, an emerging markets economist at Bank of America Merrill Lynch, said many of Israel's problems stem from the fact that the world has changed: Global trade has slowed, while fiscal restraint has weighed on growth, especially in Europe.

"Israel is a developed country so we are not talking high single digits (anymore). So 2-1/2 or 3 percent is a decent rate of growth," she said.

Once the Gaza conflict ends, the next problem Israel faces is the 2015 budget and the risk of missing fiscal targets. Finance Minister Yair Lapid has said the 3 percent deficit goal for 2014 will likely be breached.

A 2015 target of 2.5 percent of GDP is also in jeopardy due to a likely jump in the defence budget. At the same time, Lapid had promised not to raise taxes or limit social spending.

"There is some room for manoeuvre but not much," Nir said. "It can be 3 to 3.5 percent but not 5-6 percent again."

One perennial bright spot for Israel has been more than $10 billion a year in foreign direct investment as global companies such as Apple and Google snap up Israeli tech firms. In 2013, Israel was ranked fourth among the OECD -- a club for rich countries -- for foreign direct investment.

The country has also seen heavy investments in developing its natural gas sector, although investment in residential building and industries has declined over the past year.

Nir fears that the current round of fighting could dent inflows as companies take a wait-and-see approach.

Such flows have also been an Achilles heel for Israel's economy, prompting the shekel to appreciate sharply and making exports relatively more expensive. As a result, the Bank of Israel has bought more than $55 billion of foreign currency since 2008 in a bid to weaken the shekel.

It now stands at a nearly one-year low of 3.58 versus the dollar, after a 4.5 percent depreciation in the past month.

But in historical terms it remains strong. Only a month ago, it stood at a three-year high of 3.40, having appreciated 20 percent since 2009.

"What's hurting Israel now is the tradeable sector due to the strong shekel," Doan said.

Analysts doubt the Bank of Israel will push its key rate to zero but if it does, the next step would be to buy bonds, following the pattern of 'quantitative easing' adopted in the United States.

"There is a good chance that Israeli rates will stay low even when the United States starts to raise them," Nir said.