US embassy cable - 04TELAVIV1336

C O N F I D E N T I A L SECTION 01 OF 07 TEL AVIV 001336 
 
SIPDIS 
 
STATE FOR E, NEA/IPA AND EB/IFD/OMA; 
TREASURY FOR U/S TAYLOR 
PLEASE PASS USTR FOR SAUMS 
NSC FOR EDSON 
USDOC FOR 4520/CLOUSTANAU/TSAMS/NWEIGLER 
 
E.O. 12958: DECL: 03/04/2014 
TAGS: EFIN, ECON, ETRD, BEXP, IS, ECONOMY AND FINANCE, U.S.-ISRAEL RELATIONS 
SUBJECT: ISRAEL'S ECONOMIC POLICIES GET HIGH MARKS AT THE 
2004 JEDG 
 
REF: TEL AVIV 1033 
 
Classified By: Ambassador Daniel C. Kurtzer for Reason 1.4 (B) and (D) 
 
 
 
 1.  (C)  Summary.  The U.S. delegation to the 2004 
U.S.-Israel Joint Economic Development Group meeting in 
Jerusalem (JEDG), led by Under Secretary Larson and Treasury 
Under Secretary Taylor, expressed satisfaction with the steps 
the Government of Israel has taken to implement the 
government's economic reform plan.  The JEDG endorsed the 
release of the 2004 tranche of loan guarantees (up to $3 
billion), noting that the GOI had met its commitments under 
the terms of the U.S.-Israel Loan Guarantee Agreement (LGA). 
Although the U.S. team praised the GOI for meeting the 2003 
expenditure targets outlined in the LGA 2003 terms sheet, it 
urged heightened vigilance in meeting the GOI's expenditure 
and deficit targets in 2004. 
 
2.  (C)  The U.S. and Israeli JEDG delegations drafted a new 
terms sheet detailing LGA commitments for 2005 (text in para. 
19).  This terms sheet will be annexed to the agreement 
pending approval by Minister Netanyahu.  Especially notable 
is a commitment to meet expenditure targets in 2004 and to 
limit real expenditure growth to 1% per year from 2005-2010. 
Finance Minister Netanyahu said the only circumstances 
wherein Israel might miss the spending commitments were 
related to extraordinary costs associated with a Gaza 
withdrawal or an emergency plan to revamp Israel's education 
system.  The draft LGA terms sheet outlines new planned 
reforms, including restructuring Israel's financial sector, 
ports and electricity markets, as well as continued 
privatization efforts.  It also stresses the importance of 
intellectual property protection and notes the need to 
resolve procurement problems affecting U.S. companies doing 
business in Israel.  Other issues discussed at the JEDG and 
in related meetings with GOI officials included: 
-- the "Land Bridge" between Eilat and the Mediterranean, 
which Netanyahu said would cost $500 million and provide an 
alternative to the Suez Canal for cargo shipping.  (Note: 
Netanyahu did not ask for U.S. financial support and none was 
offered by the U.S. side); 
-- an update on Israel's improved growth prospects and 
pension reforms; 
-- a U.S. call for heightened GOI steps to improve the 
Palestinian economy; 
-- Israel's request for U.S. support regarding OECD 
accession, an issue which U/S Larson said involved reform of 
the organization's organizational structure as a prerequisite; 
-- a review of Bank of Israel (BOI) monetary policy by 
Governor Klein; 
-- a U.S. call for cooperation between the BOI and the 
Palestinian Monetary Authority, which Klein said he welcomed. 
 End summary. 
 
------------------------------------- 
Meeting with Finance Minister 
Netanyahu - Expenditures and Tax Cuts 
------------------------------------- 
 
3.  (C)  In a small-group meeting to kick-off the JEDG on 
February 23, Netanyahu reviewed the main goals of Israel's 
economic plan: 
 
--freezing government expenditures; 
 
--using excess revenues to lower taxes and the deficit; 
 
--moving from welfare to work; 
 
--stimulating exports; 
 
--breaking monopolies; and 
 
--building infrastructure. 
 
The Minister said his recent decision to cut Israel's 
value-added tax from 18% to 17% and reduce purchase taxes on 
consumer durables was meant to help Israel's poor, since most 
of the economic reform program was "skewed to the top" (i.e., 
tended to benefit middle and upper income Israelis).  This 
move, he said, was also consistent with his desire to cut 
both taxes and government spending and was affordable in 
light of expectations that 2004 revenues would come in above 
previous estimates.  Netanyahu said he hoped to devote about 
half of any such excess revenue to deficit reduction and 
about half to tax cuts.  Netanyahu said Israel would 
definitely keep to its 2004 expenditure commitment of NIS 226 
billion, as it had in 2003, as well as to a budget deficit 
target of 4%.  Exceptions to this policy would be allowed 
only if major, exceptional events forced the GOI's hands. 
Such events might include withdrawal from Gaza, unforeseen 
defense needs, and/or a major restructuring of Israel's 
education system, an issue currently being discussed in the 
government.  This reform would result in lay-offs of many 
under-performing teachers and would costs hundreds of 
millions of shekels, he said.  U/S Larson noted that, in view 
of these potential expenditures, the GOI might be 
well-advised to dedicate a higher portion of unforeseen tax 
revenues to deficit reduction.  Netanyahu took this 
suggestion on board.  Turning briefly to economic prospects, 
the Minister noted that world growth was likely to boost 
Israel's export-led recovery.  He specifically mentioned the 
BOI's interest rate reduction policy as likely to promote 
economic growth. 
 
----------------------- 
Structural Reform Goals 
----------------------- 
 
4.  (C)  Netanyahu said the government would focus on four 
structural reforms in the coming year: 
 
--restructuring Israel's inefficient ports, 
 
--increasing competition in the financial markets, 
 
--real estate reform, and 
 
--easing red-tape and regulations that impede economic 
development. 
 
The port reform, said Netanyahu, would almost certainly lead 
to labor conflict - possibly as early as late February. But, 
he continued, "reform has to be done, no matter what the 
cost."  He furthermore noted that "the measure of a minister 
is his ability to fight the unions."  He said the GOI would 
sell the port of Eilat, and would allow the Haifa and Ashdod 
ports to compete with each other on price and service.  The 
two latter ports, he explained, would each be a separate 
company, with 51% government-ownership and the remainder sold 
off to private investors.  The Minister of Transportation, 
Avigdor Lieberman, is fully supportive of the effort, he said. 
 
5.  (C)  Netanyahu said that MOF Director General Yossi 
Bachar would lead an effort to create more competition in the 
financial markets by increasing transparency, adding new 
financial instruments, and reducing the strangle hold on the 
banking sector held by Israel's two largest banks - Hapoalim 
and Leumi.  He said the privatization of Discount Bank would 
be a big part of that effort.  He welcomed foreign banks into 
Israel as a way to increase competition.  Real estate reform 
will be very difficult to implement, given the power held by 
the Israel Lands Authority, but Netanyahu said he would try 
to make changes.  The Minister characterized the current land 
system, wherein 93% of land is state-owned (long lease 
contracts), as combining the worst elements of Ottoman, 
British, and Israeli bureaucracies.  He noted that there were 
currently three overlapping land planning systems - the 
local, regional and national planning boards.  One of these 
three planning boards, he said, must be eliminated to cut 
back on red tape.  In fact, unnecessary regulation in many 
areas has held the economy back: "we need to move to a 
culture of regulation by exception."  To change the 
regulatory culture, he said, was one of his largest and most 
difficult challenges.  The Minister said the GOI was looking 
at Britain's regulatory reform as a possible model for GOI 
action. 
 
--------------- 
The Land Bridge 
--------------- 
 
6.  (C)  Minister Netanyahu reviewed some of Israel's 
transportation initiatives, but focused on the proposed rail 
link between the Red Sea and the Mediterranean.  He estimated 
the total cost of this "Land Bridge" at USD 500 million.  A 
rail link between the center of the country and Eilat was 
"definitely going to happen," he said.  This link would set 
the stage for creating a rail-based cargo link between Eilat 
and Israel's Mediterranean ports that would provide shippers 
an alternative (if much smaller capacity) route to that of 
the Suez Canal.  Preliminary studies by a consulting firm 
looking into the project had determined, he said, that the 
best port to serve as the Red Sea terminal would be Eilat, 
not Aqaba.  Despite this surprising finding, Netanyahu said 
he continued to believe that Aqaba should be the terminus, 
because it was important to bring Jordan into the project and 
make it beneficial for the entire region.  He mentioned 
several other projects which could be combined with the 
"land-bridge," including an amusement park and casinos on the 
Jordan-Israel border.  Netanyahu said that no final decision 
had been made on the project, but that PM Sharon might 
discuss it with President Bush in his upcoming trip to 
Washington.  (Note: As reftel notes, Embassy sources in the 
PMO discount the likelihood of the PM raising this issue in 
Washington.) 
 
--------------- 
Business Issues 
--------------- 
 
7.  (C)  Under Secretary Larson raised three business issues 
with Netanyahu, noting that he and Under Secretary Taylor had 
met with the representatives of U.S. firms just before their 
meeting with the minister.  U/S Larson expressed concern that 
proprietary pharmaceutical data was not protected in Israel, 
that the bilateral agricultural agreement remains unsigned, 
and that U.S. firms often feel they are not given a fair shot 
at government and parastatal procurement.  In reaction to the 
data issue, Netanyahu turned to his Director General and said 
"This data isn't protected?  That's a dirty trick!  We need 
to fix this."  On agriculture, Larson stressed this issue had 
come to the attention of the Chairman of the House Ways and 
Means Committee, and that there was no reason it should take 
so long to conclude a reasonable agreement.  The Minister 
promised to look into this and into procurement issues. 
 
-------- 
The JEDG 
-------- 
 
8.  (C)  The formal session of the JEDG covered Israel's 
economic growth prospects, budgetary issues, Israel and the 
OECD, and ways in which Israel could help the Palestinian 
economy.  On the economy, the MoF's Research Director said 
that a number of factors are pointing in the direction of 
strengthened Israeli growth.  These include the global 
economic recovery, which is absorbing increased quantities of 
Israeli exports; decreasing Israeli interest rates; and 
continued improvements in Israeli productivity.  These 
factors have led the MoF to increase its predicted 2004 
growth figure from 2.5% to 3% or more.  The GOI was also 
taking steps to increase Israel's labor participation rate, 
through measures aimed at making work more attractive.  In 
this regard, he expressed concern at suggestions aimed at 
increasing Palestinian employment in the Israeli economy. 
Although this was a laudable goal, employment in sectors such 
as construction came directly at the cost of Israeli 
employment.  Rather, the GOI should focus its efforts on 
increasing Palestinian employment in tradable goods sectors, 
where the employment pie could grow and accommodate both 
increased Israeli and Palestinian participation. 
 
9.  (C)  The budget discussion focused on establishing a 
mutually-acceptable definition of expenditures.  Both Under 
Secretaries said the USG required a detailed explanation of 
 
SIPDIS 
the NIS 228 billion expenditure figure for 2003 referred to 
by Minister Netanyahu.  MoF DG Bachar promised to provide 
whatever information the USG required.  He furthermore 
confirmed that the GOI uses this number as the basis of its 
new budgetary legislation limiting expenditure growth to 2010 
to 1% a year in real terms.  (Note: In subsequent, 
staff-level meetings with GOI budget experts, the USG side 
outlined exactly what information it required for reference 
in the terms sheet and received a promise that this 
information would be provided promptly.  End Note.) 
 
10.  (C)  The GOI officials also outlined pension reform and 
privatization programs. On pension reform, the Commissioner 
of Capital Markets, Insurance and Savings, Eyal Ben-Chlouch, 
highlighted the increase in the retirement age, 
contributions, and the amount of funds to be directed to the 
capital markets.  The Director of the Israel Government 
Companies Authority, Eyal Gabbai, outlined achievements in 
privatization including the successful El Al IPO, the sale of 
majority ownership in Bezeq (telephones) and Zim (shipping), 
and the plan to introduce more competition in the electricity 
sector.  There was also a brief discussion of monetary policy 
by the Bank of Israel's Deputy Governor, in which the current 
low-inflation environment and recent reductions in both short 
and long-term interest rates were highlighted. 
 
11.  (C)  During a JEDG lunch hosted by Finance Ministry 
Minister without Portfolio Meir Sheetrit, Under Secretaries 
Larson and Taylor noted GOI efforts to improve Palestinian 
economic conditions and urged it to do more.  Under Secretary 
Larson noted the importance of the GOI continuing its 
transfers of Palestinian tax revenues to the PA, as well as 
addressing the issue of revenue attachments.  Under Secretary 
Taylor cited the importance of reducing impediments to the 
free movement of goods and people within the West Bank and 
Gaza.  Both officials noted they had pushed PA officials hard 
to improve performance in fighting terror, but also urged the 
GOI to think about constructive ways it could respond to 
positive PA moves should such occur.  Sheetrit did not 
respond directly to these concerns, but rather stressed ways 
in which the Palestinians had undermined the peace process. 
He expressed his strong personal opposition to PM Sharon's 
ideas on unilateral disengagement, noting the issue could 
break up the coalition while bringing little or no 
improvement in security.  In response to Sheetrit's statement 
that the best solution would be to "kill Yassir Arafat," 
Under Secretary Larson pushed back strongly, noting there was 
no way Israel could predict the consequences such an act 
could have.  Sheetrit said he recognized Israel could take no 
steps against Arafat. 
 
12.  (C)  Sheetrit urged the U.S. to support Israeli 
accession to the OECD.  Under Secretary Larson said the U.S. 
wanted to enhance Israel's relationship with the OECD, but 
noted the complicated state-of-play on OECD enlargement. 
Before the organization increased its size, it was essential 
it implement extensive institutional reform aimed at 
streamlined decision making.  He also noted that the 
composition of the next enlargement required extensive 
groundwork aimed at assuring regional balance in the 
organization.  In the meantime, he urged the GOI to continue 
its efforts to work in whatever ways possible with OECD 
bodies. 
 
13.  (U) JEDG Participants: 
 
U.S. 
Alan Larson, Under Secretary of State for Economic, Business 
and Agricultural Affairs 
John Taylor, Under Secretary of Treasury for International 
Affairs 
Daniel Kurtzer, Ambassador 
Theodore Mann, Economic Counselor (Notetaker) 
Adnan Kifayat, Director, National Security Council 
Dayna Cade, Special Assistant to Alan Larson 
Tom Engle, Deputy Director, EB Office of Monetary Affairs 
David Greene, NEA Office of Israel and Palestinian Affairs 
Catherine Downard, Office of Near Eastern Affairs, Department 
of Treasury 
Clark Price, Deputy Economic Counselor (Notetaker) 
 
Israel 
Benjamin Netanyahu, Minister of Finance 
Meir Sheetrit, Minister in the Ministry of Finance 
Joseph Bachar, Director General, MOF 
Yaron Zelekha, Accountant General, MOF 
Eyal Gabbai, Director Israel Government Companies Authority, 
MOF 
Eyal Ben-Chlouch, Commissioner, Capital Market, Insurance and 
Saving, MOF 
Michael Sarel, Head of Economics and Research Department, MOF 
Dan Catarivas, Deputy Director General, International Affairs 
Elded Fresher, Senior Deputy Accountant General, MOF 
Boaz Raday, Economic Minister to Washington 
Rani Loebenstein, Senior Advisor to the Director General, MOF 
Yossi Gordon, Deputy Director, Budget Department, MOF 
Meir Sokoler, Deputy Governor, Bank of Israel 
Michel Strawczynski, Assistant Director, Research Department, 
Bank of Israel 
 
--------------------------------------------- ----- 
BOI Governor Klein Gives Netanyahu A Passing Grade 
--------------------------------------------- ----- 
14.  (C)  In a meeting held after the conclusion of the JEDG, 
Bank of Israel Governor Klein reviewed GOI fiscal and 
monetary policy with U/S Larson and U/S Taylor.  He said that 
the Bank had been able to bring down short-term rates 
relatively quickly - from 9.1% in the beginning of 2003 to 
4.5% a year later - without igniting inflation.   Markets had 
responded very positively, he said, to the fiscal restraint 
shown by the GOI, and long-term rates had also dropped. 
Finance Minister Netanyahu, he said, had convinced the 
markets that he is serious about economic reform, no small 
achievement. Klein expressed skepticism, however, about the 
government's ability to hold to a 1% per year expenditure 
increase until 2010, as stated in the JEDG.  Such a 
commitment, which would require cuts in per capita spending 
every year, will be very hard to keep, he said.  Klein also 
said that cutting taxes was no substitute for keeping 
spending in check.  It is sometimes stated that the best way 
to control spending is to cut taxes (and so make less money 
available to the government).  That is not true in Israel, he 
emphasized.  Strict spending commitments are the only way to 
keep budgets under control. 
 
15. (C)  The government's newfound fiscal responsibility, 
continued Klein, remains constantly under pressure.  He 
recounted a recent conversation with the Minister of Health 
(Danny Naveh), in which the minister asked him how could it 
be that acceding to a NIS 500 million increase the ministry 
was asking for would really threaten the Israeli economy. 
Klein responded by saying that the notion that "small 
deviations" were acceptable was precisely how Israel's public 
sector grew to be "the largest in the world."  Markets, 
continued Klein, were a little nervous about the Bank of 
Israel's willingness to continue reducing interest rates in 
light of spending pressures.  In fact, long-term rates had 
risen in recent weeks, a sign that the markets are unsure the 
Bank will keep reducing short-term rates.  Klein made it 
clear, however, that he believed there was still some room 
for further rate cuts while keeping within the 1-3% inflation 
target for 2004.  He noted that rate would be cut later on 
February 23 (BOI cut the interest rate by 0.2% to 4.3%). 
Klein said that BOI's rates, after the pending cut, would be 
very close to rates in some European countries and noted that 
interest rates in the UK were at 4%. 
 
--------------------------------- 
Central Bank Regional Cooperation 
--------------------------------- 
 
16.  (C)  Klein said the recent meeting of central bankers 
from the Mediterranean region in Naples was unprecedented. He 
noted that he had talked to the central bank governors of 
Morocco, Egypt, Libya and the PA, among others, during the 
meetings.  Klein said there was plenty of issues of common 
interest to talk about in meetings like this, no matter what 
the political differences between the countries represented. 
Possible topics might include, he said, central bank 
independence, and the various stages of capital market 
development.  In response to a question from U/S Taylor, 
Klein said he would be happy to work with Amin Haddad, 
Governor of the Palestinian Monetary Authority, to help 
further cooperation on terrorist financing. This was an 
issue, he said, that he and Haddad had discussed in Naples. 
 
---------------------- 
Comment and Next Steps 
---------------------- 
 
17.  (C)  This JEDG accomplished a number of important goals. 
 It recognized Minister Netanyahu's and the GOI's significant 
progress on economic reform over the past year while urging 
continued fiscal restraint, and did so both in private and in 
a number of press appearances.  The meeting also underlined 
the close attention the USG is paying to the GOI's budget and 
how it is calculated.  The draft 2004 terms sheet 
incorporates the issue of restraining GOI expenditures and 
meeting its deficit target for 2004. 
 
18.  (C) According to our MoF contacts, Minister Netanyahu is 
now reviewing the terms sheet draft and will respond to it as 
soon as possible. 
 
---------------------- 
Draft 2004 Terms Sheet 
---------------------- 
19.  (C)  Modifications to and Determinations of Specific 
Reforms Details in Annex II of the Loan Guarantee Commitment 
Agreement 
The Joint Economic Development Group (JEDG), as the joint 
consultative mechanism referred to in Section 5.03 of the 
Loan Guarantee Commitment Agreement, and proceeding under 
Section 4.02 of the Loan Guarantee Commitment Agreement, 
determines and modifies the &specific reforms8 referred to 
in Section 4.02 by appending the following as Appendix 4 of 
Annex II. 
 
CONDITIONS FOR DISBURSEMENT OF THE SECOND TRANCHE OF 
SUPPLEMENTAL ASSISTANCE 
 
The second tranche of bond guarantees in the amount of up to 
$3.0 billion will be released on determination of completion 
of the following: 
 
1.  Progress on Reform Plan: Progress on the main measures of 
the GOI economic reform plan.  This plan includes, among 
other things, reforms related to: 
-- Acceleration of tax reform: Continued progress on final 
implementation of tax reforms (legislated in the Knesset in 
2002) by January, 2006; 
-- Pension Reform: Continued long-term reduction in issuance 
of special government bonds for pension funds; 
-- Wage reforms: Continued reduction of public sector's 
budgetary expense on the wage bill as a percentage of GDP, to 
be achieved by cutting wages and/or benefits and/or reducing 
public sector employees. 
 
2.  Meet Spending and Budget Deficit Targets 
-- Commit to expenditures (defined in Appendix X) in 2004 of 
no more than 226.1 billion New Israeli Shekels, with the firm 
goal of keeping the budget deficit to 4.0 percent of GDP or 
less. 
 
-- Public dissemination and GOI commitment to a detailed, 
multi-year fiscal plan, including a commitment to limit real 
expenditure growth (defined in Appendix X) to 1 percent per 
year from 2005 to 2010.  Furthermore, commitment to maintain 
budget deficits to a level of less than 3 percent of GDP and 
aim to implement further reductions in the operational 
deficit of at least 0.5 percent of GDP every year until the 
deficit reaches 1 percent of GDP. 
 
-- Any revenues in excess of those foreseen in the 2004 
budget would be allocated to deficit and tax reduction.  Due 
emphasis should be given to deficit reduction. 
 
3.  Proceed with Privatization Plan 
-- Further progress on the main measures of the Israeli 
government's privatization plan.  Future privatization steps 
should focus on the twin goals of increasing competition as 
well as reducing government involvement in the economy. 
 
4.  Implement Structural Reforms 
-- Increase competition in the economy by: 
A. Implementing liberalization of the domestic 
telecommunications market through a regulatory environment 
that facilitates the introduction of competitive local 
landline services within the timeframe of this agreement; 
B. Working to increase competition within the ports, 
financial markets, and electricity sectors; 
C. Reduce governmental regulation with the aim of promoting 
economic growth. 
-- Continue efforts to further strengthen IPR protection in 
Israel. 
 
5.  Undertake Infrastructure Investments 
-- Commitment to, and progress on $1 billion in 
infrastructure spending as discussed in the GOI,s economic 
reform plan. 
 
6.  Other 
-- The amount of guarantees that may be issued shall be 
reduced by an amount equal to the amount extended or 
estimated to have been extended by the GOI during the period 
from the last deduction to the date of issue of the 2004 
guarantee, for activities which the President determines are 
inconsistent with the objectives and understandings reached 
between the United States and the Government of Israel 
regarding implementation of the loan guarantee program. 
-- Commit to working with the U.S. Government to resolve 
outstanding procurement issues. 
SUBSEQUENT DISBURSEMENTS 
 
Subsequent disbursements of bond guarantees will be 
conditioned upon determination and implementation of the 
GOI,s macroeconomic, structural and other targets developed 
through the USG-GOI joint consultative mechanism.  Fiscal 
deficit targets and implementation of the reform plan will be 
the main foci.  In particular, disbursements of the third 
tranche of bond guarantees will be conditioned on achievement 
of the spending and budget deficit targets for 2004 and 2005. 
 The extent to which other commitments made for the 2004 
disbursement are met will also be an important consideration. 
 
20. (U)  This message was cleared by Under Secretaries Larson 
and Taylor. 
 
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