US embassy cable - 05TELAVIV904

C O N F I D E N T I A L SECTION 01 OF 05 TEL AVIV 000904 
 
SIPDIS 
 
E.O. 12958: DECL: 02/10/2015 
TAGS: ECON, EFIN, ELAB, SOCI, PREL, EIND, ENRG, IS, ECONOMY AND FINANCE, GOI INTERNAL 
SUBJECT: NETANYAHU AS FINANCE MINISTER: CONFOUNDING THE 
SCEPTICS 
 
Classified By: Ambassador Daniel C. Kurtzer for Reasons 1.4 (b,d) 
 
1.  (C) Summary.  Upon assuming office in 2003, Finance 
Minister Benjamin Netanyahu implemented a series of 
far-reaching economic reforms aimed at overcoming Israel's 
economic crisis of 2001-2002, the worst in its history. 
Originally drafted under Netanyahu's predecessor Silvan 
Shalom, they encompass wage, welfare and social security 
reform as well as significant changes in fiscal and tax 
policy.  Israeli economists, whether from the political left 
or right, universally praise Netanyahu for the courage of his 
reforms -- many of which actually reduced incomes at first -- 
and for the political canniness he showed in getting them 
through the Knesset.  As the Bank of Israel's chief economist 
put it, "Netanyahu has done what he promised to do, and the 
results are good."  What these economists dispute, however, 
is the effect of the reforms on poverty and income disparity 
levels and how to help those hardest hit cope with what some 
are beginning to call the "Netanyahu economy."  This cable 
examines the economic challenge Netanyahu faced when he 
assumed office, outlines his programmatic response, and 
assesses the extent to which this succeeded.  For those who 
want to know the punch line in advance: we think Netanyahu 
made some tough, politically-unpopular decisions that have 
paid off handsomely.  The Israeli economy is better off than 
it would have been had he not become minister.  End Summary. 
 
---------------- 
I. The Challenge 
---------------- 
 
2.  (SBU) Upon assuming office in March of 2003, Finance 
Minister Netanyahu inherited an economy that had entered its 
deepest recession ever.  As a result of the Intifada and the 
slowdown in the world economy, the Israeli economy contracted 
0.9% in 2001 and 0.7% in 2002.  This was a sudden and drastic 
about-face for an economy that had ridden the high-tech boom 
of the 1990s, leading to 8% growth in 2000.  The decrease in 
per capita income was particularly dramatic:  3.2% in 2001 
and 2.7% in 2002.  This combined drop of almost 6% brought 
per capita income back to the level of 1996, the worst 
decline in income in Israeli history.  Unemployment levels 
rose, consumption fell, and the Israeli public was becoming 
increasingly pessimistic about the economic direction of the 
country. 
 
------------------------------ 
II.  Netanyahu's Reform Program 
------------------------------ 
 
------------------------ 
A. Fiscal Responsibility 
------------------------ 
 
3. (SBU) In response to his country's economic malaise, 
Netanyahu immediately implemented a reform program largely 
developed under his predecessor, Silvan Shalom.  His main 
energy was focused on reducing public spending as a 
percentage of GDP, which at 55% of GDP in 2002 was much 
higher than that of other developed countries (including 
Sweden).  Netanyahu frequently regaled visitors at the time 
with an image of the Israeli private sector as a marathon 
runner hobbled by the necessity of carrying a much-heavier 
man -- the public sector -- on the runner's back. 
 
4. (SBU) Netanyahu reduced expenditures by making a number of 
courageous and difficult policy changes.  Perhaps the most 
far reaching was his pension system restructuring.  This 
increased the retirement age and level of worker 
contributions, took over bankrupt funds formerly managed by 
the Histadrut (the national labor union), and introduced the 
concept of investing a certain percentage of the funds into 
Israel's capital markets.  He took on Israel's huge public 
sector by implementing a 4-6% average reduction in public 
sector wages, a step that required reaching agreement with 
the Histadrut to reduce workers' salaries by over NIS 2 
billion.  He cut ministerial personnel budgets significantly. 
 Less successful were Netanyahu's efforts to reduce the 
number of government workers (other than in government 
companies), which ran into fierce union resistance. 
 
5.  (SBU) Netanyahu's fiscal program was a success, with 
general government expenditures falling to 51.1% of GDP in 
2004.  At the same time, the fiscal prudence he introduced 
led to a significant reduction of the budget deficit, from 
5.6% in 2003 to 3.9% in 2004.  Netanyahu's fiscal moves have 
elicited universal praise from Israeli economists, regardless 
of their political stripe.  They universally point to the 
reduction in the deficit to 3.9% of GDP in 2004 as a signal 
success.  Even one of Netanyahu's fiercest critics, Professor 
Momi Dahan of Hebrew University, points to Israel's newfound 
fiscal prudence as essential for a small, open economy and 
praises Netanyahu's moves in this area. 
----------------- 
B. Tax Reduction 
----------------- 
 
6. (SBU) During the 2003 and 2004 Joint Economic Development 
Group (JEDG) meetings, Netanyahu repeatedly stressed the 
importance he attached to "unleashing" Israel's potential for 
growth by lowering the country's tax burden.  He put his 
political weight behind the implementation of a series of 
far-reaching tax reforms outlined in the Rabinovitch 
Committee tax reform plan, which went into effect in 2003. 
Over time, Netanyahu actually accelerated implementation of 
these measures, which reduced income taxes on the one hand 
while imposing, for the first time in Israel, taxes on 
capital gains to spread the tax burden more equitably. 
 
7. (SBU) In 2004, Netanyahu introduced yet another series of 
tax reforms, which he was able to implement because of 
higher-than-expected governmental revenues.  He accelerated 
the decline in income tax, reduced VAT from 18% to 17%, 
reduced purchase taxes on a number of consumer items, and 
reduced tax rates further for middle and lower level wage 
earners.  He furthermore decided to reduce corporate tax 
rates from 36% to 30% over the course of several years. 
Netanyahu's changes measurably reduced the country's tax 
burden, which fell from 40.1% of GDP in 2001 to 38.3% in 2004 
(projected). 
 
8.  (C)  The tax reforms have been controversial.  The 
Finance Ministry's chief economist, Michael Sarel, calls them 
a "huge achievement," highlighting the cut in corporate taxes 
from 36% to 30% as having the potential to increase long-term 
growth rates.  Professor Dahan, on the other hand, argues 
that the tax cuts primarily helped the rich, and reduced the 
GOI's ability in future years to increase support for the 
poverty stricken.  One other criticism, levied by the IMF, is 
that the tax cuts prevented Netanyahu from taking advantage 
of a potential revenue windfall to reduce Israel's high 
debt/GDP ratio, which stands at 106.5% compared with the OECD 
average of 80.2%.  U.S. participants at the 2004 JEDG also 
expressed concerns in this area. 
 
---------------------------------- 
C. Getting Israelis Back to Work 
---------------------------------- 
 
9. (SBU) At 54.5 percent, Israel's rate of labor 
participation of those aged 15 and over is one of the lowest 
in the developed world.  Netanyahu and his Finance Ministry 
colleagues believe that this statistic is in large part 
grounded in simple economics: high levels of unemployment, 
social welfare and other payments simply make it uneconomical 
to work.  Netanyahu has addressed this by systematically 
reducing these payments while embarking on an effort to 
increase demand for Israeli laborers.  His primary effort in 
this area is focused on reducing the number of foreign 
laborers allowed to work in the country, which has fallen 
from a high of 240,000 in 2002 to less than 200,000 
currently.  The minister also tried to make it easier for 
Israelis to find work through implementation of a series of 
measures that mimic the "Wisconsin Plan" pioneered in the 
U.S.  This initiative sets up "one-stop shops" where the 
unemployed can receive job training, as well as increase 
resume building and interviewing skills. 
 
10. (SBU) Netanyahu,s reforms have helped reduce 
unemployment.  Bolstered as well by a resurgent economy, 
unemployment fell from a peak of 10.9% in November 2003 to 
10% one year later.  Economists expect this trend to 
continue.  The MoF's Sarel points to a 100,000-person 
increase in the labor force since Netanyahu assumed office as 
proof that the "back-to-work" policy has been a success. 
Nonetheless, labor participation has only inched up, with the 
Finance Ministry's projections showing an increase of just 
one percentage point from 2002 to 2005. 
 
---------------------- 
D: Structural Reforms 
---------------------- 
 
---------------- 
i. Privatization 
---------------- 
 
11. (SBU) Netanyahu has implemented an ambitious 
privatization program.  This is not a new priority for the 
minister, who as Prime Minister initiated Israel's most 
successful privatization program up to that time in the 
1990s, the highlight of which was Bank HaPoalim's sale to a 
U.S.-Israeli investment group.  He has so far had two major 
successes in the current round, the privatization of El Al 
and Zim (the Israeli shipping company), while some other 
reforms (notably in the ports and in electricity generation) 
have seen extensive delays. 
 
-- Airlines: El Al. At the end of December 2004 the 
Knafaim-Arkia group decided to exercise their options 
increasing their holdings to around 40%, from 22%, turning El 
Al into a private company. 
 
-- Shipping: Zim. In February 2004, Israel Corp. bought out 
the GOI,s 48.6% stake in Zim.  Combined with the firm's 
previous 48.9% holdings, this makes Israel Corporation 
virtually the only stockholder in the firm. 
 
-- Telecoms: Bezek.  In July 2004 the Government decided to 
sell 30% of Bezek, with the option to sell up to another 10% 
of the State,s shares.  A number of investors and investment 
groups have shown interest. In 2003 the Government sold 9.1% 
of Bezek in two trades, and another 3% of the Government's 
shares were sold on the TASE in June 2004.  Further movement 
on Bezek's privatization is expected to be slow. 
 
-- Banks: Israel Discount Bank.  Agreement was signed with a 
group headed by Matthew Bronfman for the purchase of 26% of 
the Discount Bank, bringing the GOI's holdings down to 31%. 
According to the agreement, Bronfman will pay NIS 1.3 billion 
(approximately USD 300 million) for the shares.  He has the 
option to purchase an additional 25% of the bank's shares 
within three years, which would give him majority control of 
the company. 
 
------------------- 
ii. Sectoral Reform 
------------------- 
 
12.  (SBU)  Netanyahu has decided to inject competition into 
a number of government-controlled industries in advance of 
privatization.  As Eyal Gabbai, Director of the Israel 
Companies Authority notes, the GOI hopes to avoid simply 
turning public monopolies into private monopolies.  The 
minister's reform of the financial services sector is being 
led by his Director General, Yossi Bachar, whose reform plan 
should see Knesset action in February, 2005.  In addition, 
Netanyahu is looking to reform Israel's sclerotic real estate 
market (the state owns more than 90% of all land in Israel) 
sometime in 2005. 
 
-- Electricity/Oil Refineries: The GOI is preparing to break 
up the oil refineries and electrical producers into a number 
of entities which will compete with each other, hopefully 
increasing competition and lowering prices.  Privatization is 
the eventual goal. 
 
-- Ports: In order to bring competition to the port sector, 
the Finance Ministry developed a plan to separate the Haifa, 
Ashkelon and Eilat ports into independent, competitive 
entities.  Unionized port workers have fought hard, and 
successfully to date, against this reform.  According to the 
MoF's Rani Loebenstein, who sits on the Ports Authority Board 
of Directors, legislation implementing the competition plan 
is scheduled to take effect February 27. 
 
-- Bachar Banking and Capital Market Reforms:  Netanyahu has 
long made it his goal to reduce concentration in the Israeli 
banking sector, which is overwhelmingly dominated by just two 
banks, Leumi and Hapoalim.  The reforms would remove banks 
from the mutual fund and retirement fund businesses, while 
compensating them with access to the insurance business.  The 
reforms have been approved by the government, and they are 
expected to be brought to the Knesset in the spring of 2005. 
 
--------------------------------------------- ----------- 
III:  The Reforms, Supported by U.S. Loan Guarantees and 
Global Economic Resurgence, Reenergized Israel's Economy 
--------------------------------------------- ----------- 
 
13.  (SBU) So, how did he do?  An easy question, but one 
that's hard to answer with precision.  Unfortunately, it is 
impossible to separate the effects of Netanyahu's reforms on 
the Israeli economy from those of other factors such as the 
U.S. loan guarantees, the improved world economy, a 
rejuvenated Israeli high-tech sector, and decreasing number 
of terror attacks.  The U.S. willingness to provide $9 
billion in loan guarantees, beginning in 2003, was crucial to 
reestablishing Israel's international creditworthiness and 
drove down borrowing rates significantly.  The guarantees, 
the release of which is conditioned on Israeli performance 
against a series of economic metrics, also helped Netanyahu 
prevail in numerous budget debates with Knesset members 
interested in spending their way to continued electoral 
success.  As the MOF's Sarel has said, "We could not have 
made all the economic changes we did without the guarantees." 
 Netanyahu has been forthright in crediting these factors as 
a major element of his success over the past two years.  The 
resurgent international economy also helped through a 14% 
increase in Israeli exports, particularly in the 
high-added-value high-tech sector. 
 
14.  (U)  Nonetheless, although many other countries were 
exposed to the positive world economy, most performed less 
successfully than Israel.  Much of the difference can be 
attributed to Israel's vigorous economic reforms. 
Specifically, in 2004 GDP grew 4.2%, with per capita GDP 
jumping by a real 2.4%.  Business sector GDP increased by 6% 
versus 1.7% for 2003.  In comparison, OECD countries 
experienced average growth of 3.6% in 2004.  Even more 
significantly, Israelis began to feel that their government 
was on top of the situation and had a coherent, convincing 
program to overcome the recession.  Increasingly confident of 
the future, Israelis increased their consumption by 5.3% in 
2004, compared to a small increase of 1.3% the year before. 
The government's fiscal restraint provided the Central Bank 
the fiscal basis to embark on an expansive monetary program 
of monthly interest rate reductions, which brought rates down 
to 3.5% in January, the lowest level in Israeli history. 
 
------------------------------- 
The Downside: Those Left Behind 
------------------------------- 
 
15. (SBU) All has not come up roses, however.  The downside 
of Netanyahu's reforms, which the minister has himself 
acknowledged, center around the plight of the poor.  Although 
economists quibble with the definition of poverty utilized by 
the National Insurance Institute -- one-half of Israel's 
median family income -- all take seriously the NII's most 
recent annual report showing increasing income inequality and 
poverty levels.  As of 2003, the report says, more than 1.4 
million Israelis lived below the poverty line.  In a society 
as child-oriented as Israel, the report's finding that 
652,000 children were living under the poverty line -- equal 
to 30.8% of all children -- was particularly shocking. 
Professor Dahan argues that poverty is going to be the most 
important, and disruptive, social policy issue over the 
coming years.  He believes that the improved security 
environment has ironically allowed Israelis to begin focusing 
on issues that had seemed secondary just a year ago -- such 
as their personal economic situation. 
 
16. (SBU) Dahan points to levels of income inequality, which 
even the Ministry of Finance's figures show have increased 
steadily since 2000, as particularly worrisome.  Dahan 
stresses the inordinate pain being born by the country's Arab 
communities, noting that according to some estimates, poverty 
among this group has reached 40%.  He worries that such high 
levels of poverty are particularly difficult to reverse -- 
families are forced to scramble for every shekel, preventing 
many children from having the opportunity to attend 
higher-level education.  This can only lead to an increasing 
divide, not only between rich and poor, but between Israeli 
Jews and Arabs. 
 
17.  (C) Many Israelis blame Netanyahu and his economic cuts 
for worsening poverty.  The Bank of Israel's (BOI's) Flug 
calls his cuts in unemployment and other benefits "too 
brutal" and says he "half killed the patient" he was working 
to cure.  The BOI's Senior Social Policy Advisor, Daniel 
Gottlieb, says the Finance Ministry has shown an 
"insensitivity" to the plight of the poor and argues that 
many policy decisions were taken without enough thought being 
given to the real-world impact.  He points to the fact that 
old age support has been cut by 50% under Netanyahu, even 
though these benefits represent a "small budgetary item." 
 
18.  (C) The question is where to go from here.  Netanyahu 
maintains that the solution is continuing to push people to 
work by reducing unemployment benefits while increasing job 
opportunities.  He points to Israel's pilot "Wisconsin" 
program as a significant initiative that will bear fruit. 
The BOI's Gottlieb, however, calls the initiative a "flop" 
and notes it encompasses just four pilot centers serving 
14,000 people.   Flug argues that much more needs to be done 
with the tax structure to help the worst off, including 
introducing a U.S.-like earned income tax credit. 
 
---------------------------------- 
Are Netanyahu's Reforms Permanent? 
---------------------------------- 
 
19.  (C) Netanyahu has started the job of reforming the 
Israeli economy, but his job is not over.  Beyond the issue 
of when and how he can complete his original reform agenda, 
he needs to keep the reforms he has already made in place. 
There has already been rollback on the fiscal front.  In late 
2004, the GOI requested USG approval to exceed the 3% target 
for the 2005 deficit specified in the last JEDG to pay for 
disengagement.  The bill for disengagement is now destined to 
go even higher: Legislation to provide compensation for 
settlers leaving Gaza, which passed the Knesset Finance 
Committee in early February, will cost up to NIS 4 billion, 
at least NIS 1 billion more than originally planned.  Other 
disengagement costs, of which there are many, are equally 
likely to increase over time.  Of even greater concern, the 
GOI has yet to craft a coalition to pass the budget as it is, 
in large part because it has been unwilling to meet the 
financial demands of Shas.  In this environment, the Loan 
Guarantee Agreement conditionalities assume even greater 
importance in restraining GOI fiscal expansiveness. 
 
20.  (C) Yet even if there were no Loan Guarantee Agreement, 
and even if Netanyahu were somehow replaced by an old-style 
"tax and spend" politician, it seems unlikely that 
Netanyahu's reforms would be fundamentally reversed.  The 
Israeli people see how Silvan Shalom's fiscal 
irresponsibility in 2002-2003 had severe international 
consequences that led directly to economic difficulties at 
home.  They see how Netanyahu's reforms -- no matter how 
difficult and unpopular they were at first -- clearly helped 
resurrect that same economy and allow it once again to 
attract international respectability and capital.  They 
realize, in short, that Israel's economy is now closely 
linked to the world economy and has to be managed 
responsibly.  Although solid proof for such an assertion is 
inherently difficult to find, the fact that the Labor Party 
made such relatively modest demands for fiscal change once 
they entered the current coalition is telling.  This change 
in the economic debate is perhaps Netanyahu's most signal 
achievement as Minister. 
 
-------------------- 
Comment:  The Future 
-------------------- 
 
21.  (C) Although we recognize his economic reform program 
has not been marked by concern for the poor, we nonetheless 
believe Netanyahu has been the right man in the right job at 
the right time.  Because of his political weight, he was able 
to push difficult reforms through the Israeli political 
system.  His belief in U.S.-style free-market economics gave 
his reforms a coherence and clear policy direction that 
helped him sell them to an Israeli public worried about the 
future.  His program was also not a proverbial flash in the 
pan.  He has kept up momentum on some of the most difficult 
aspects of his reforms, such as privatization and the 
introduction of competition into various sectors of the 
economy.  His port reforms, fought tooth and nail by an 
extremely powerful union, have continued to move forward 
behind the scenes and may see implementation this month. 
 
22.  (C) From the viewpoint of 2005, what is perhaps most 
remarkable is that Netanyahu came to the job with serious 
reservations.  Many at the time felt Sharon offered it to him 
as a way to bury him politically, and Netanyahu at first 
refused to accept it.  Once he assumed the position, many 
thought Netanyahu would live up to his reputation of bending 
under pressure and would shrink from making hard choices, let 
alone sticking to them.  The fact is, however, that Netanyahu 
has been steadfast and courageous in implementing his 
ambitious reform program.  He has helped change the face of 
the Israeli economy. 
 
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