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July, 2002 ISRAEL and the Globalized World Economy Prof. Assaf Razin 1 What Is Globalization ? • Globalization is an opening process of domestic markets to the world markets, for trade of inputs, goods, services, capital, labor and finance. • Benefits: Risk diversification; Better resources allocation. • Costs: Increased wage volatility; Risk of financial crisis contagion; Exacerbating business cycles; Constraints on the conduct stabilizing macro economic policy. 2 Implications: • The Information and Communication Technology sector (ICT)grew from 5% of GNP in 1990, to 14% in 2000. GNP fluctuations became linked with the ICT fluctuations. • Duality between the economic activity and the performance of the capital market. 3 • Economic Activity: Structural Indicationso GDP rose at annual rate of 2.4% in 2002/1, after a continuous decline in 2001/2 (-3.2%), 2001/3 (-5.2%) and 2001/4 (-6.6%). o Current account deficit is 3% of GNP. o Net external debt is 2 billions $ (gross debt is 65 billions $; external assets are 63 billions $), about 2% of GNP. 4 • Capital Market Indications: o Top 25 index went down by 20%, from Jan. 1, 2002 to July 10, 2002. o Exchange rate depreciated by 13% in Jan. 1 - June 30, and 8% in Jan. 1 – July 10, 2002. The remains of this presentation consists of 4 parts: technology transmission, constraints on macro policy, international trade and labor mobility. 5 Part I: Adaptation and Exports of New Technologies. MOORE’S LAW: The number of transistors on a chip doubles every 18-24 months (Pentium 4, released 20.11.2000, has 42 million transistors). The ICT sector is characterized by rapid technological changes and corresponding price decline. 6 7 8 Technology is mobile across countries through Multi National Firms (MNF). The origin of 90 out of the 100 largest MNF worldwide, is US, EU and Japan. The size distribution of firms in the high-tech sector in Israel, is very skewed: there are barely handful of firms above $100 millions, with the vast majority of medium size firms either stagnating or disappearing after a while. The high-tech sector in Israel seems unable to go beyond the “glass-ceiling” of $100 millions, thereby forfeiting the opportunity to establish a firm stronghold in international markets. 9 10 Policy Implications Israeli MNF are scarce, mainly because they are lacking strategic management, long term outlook. Need to provide policy support in setting up headquarters, R&D and management units in Israel. Tax Policy and Competition Policy can facilitate M&A of Foreign firms by Israeli firms. 11 Part II: Constraints on Stabalizing Macro Policy • Capital market liberalization 1985 – 2002: – Deregulating Israeli banks credit policy, abolishing “directed” credit. – Permission to private sector to invest abroad. – Trust funds are allowed to invest in dollar assets. – Household deposits in foreign currency is allowed. – Rescinding foreign currency allocation limit for traveling abroad. – Permission for financial savings and investments in real estate abroad. – Institutional investors can invest abroad. 12 Proposed Framework for Conduct of Monetary Policy Objectives: • Main objective: price stability. • Secondary objective: mitigating business cycles fluctuations. Policy: • Main instrument: short term interest . • Framework: inflation target. 13 Benefits: Price stability over time contributes to the stabilization of economic activity. In its absence, expansionary monetary policy leads to inflationary pressures, which leads to tight monetary policy, which generates recession, and soon. In recessions the monetary policy has a significant role, as exemplified by the 11 interest cuts by the FED, during 2001-2002. 14 Monetary Policy Conduct in Israel: • In the 1990s the central bank managed to move down inflation to western countries level; at the cost of increased recession in the late 1990s. • The short term interest rate path is shown in the following chart: 15 Short Term Interest Rate 9.1% 16 Source: Bank of Israel Deviations from inflation targets: Problems • Inflation Target serves as a coordinator of private sector’s inflation expectation. • In 1999, 2000 and 2001, inflation fell bellow the target; real wages and real interest went up sharply, and the real exchange rate went down. • In 2002, the inflation realized above the target, due to sharp depreciation; economic activity is moderate; overshooting in interest rate policy can contribute to recession. 17 actual Source: Bank of Israel 18 Conclusion: Discrete jumps in interest rate can lead to loss of credibility. October 1998 (interest cut by 1.5%) and December 2001 (interest cut by 2%), caused waves of capital market instability and depreciations. Loss of credibility required sharp interest rate increase. • • 19 Monetary Policy Implication We propose to stick to interest smoothing policy, so as to achieve medium terms inflation targets, without overreaction to transitory shocks. 20 Budget Policy Current budget policy should create credibility concerning future budget discipline, by adapting rigid rules. The Maastricht rules are not suitable to Israel for two reasons: They do not include anti-cyclical elements; They treat public investment on equal footing as public consumption. 21 Balanced budget rules that allow for cyclical fluctuations in tax revenue, and treat capital expenditure according to user costs, could enhance fiscal credibility, while permitting government investment in infrastructure. 22 Government Debt • Government debt as a strategic (long term) target has to be structured so as to take into account that: o Gross debt is partially matched by government assets (lands, banks, telecom.). o Debt reduction through privatization does not affect net debt, whereas debt reduction via budget surplus, reduces net debt. • Given that OECD countries have different stocks of public owned assets than Israel, the adaptation of the 60% debt/GNP rule to Israel is not relevant. 23 Reintroducing Stabalizing Elements Into Budget Policy Establishing an a-political Fiscal-Board, which shall determine future long-term growth forecast, as a benchmark to the budget. The growth forecast will be the base for the acyclical tax revenue projections. Public capital spending accounting will be in accordance to “resource accounting”. The board will determine the types of public investment in infrastructure that shall be part 24 of the resource accounting. Total Public Sector Deficit 1991-2002 (GNP Percentage) 6.0 5.0 4.0 3.0 2.0 1.0 25 Source: Bank of Israel .של הממשלה * 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 0.0 *על פי יעד הגירעון החדש )Gross Infrastructure Investment (GDP % }{OECD at 1994-95; Israel at 2001 1.54 1.6 1.34 1.4 1.24 1.22 1.19 1.10 1.2 1.07 1.04 0.96 0.96 בריטניה בלגיה 1.0 0.89 אירלנד ישראל הולנד 0.73 0.8 0.69 0.68 טורקיה 0.82 0.80 יוון 0.83 0.6 0.48 0.4 0.2 שוויץ ספרד שבדיה לוקסמבורג גרמניה פינלנד צרפת נורבגיה איטליה דנמרק OECD 0.0 26 Source: bank of Israel Tax Reforms (June 2002) • Capital income taxation. • Alleviating labor income taxation. • International taxation. 27 Direct Tax Rates Following the Reform 28 Estimated Net Income Increase Following the Reform 29 Budget Balance Prior to the Reform Commencement (2002 prices) 2003 30 2004 2005 2006 2007 2008 2009 2010 2011 2012 Part III: International Trade • The fundamentals of opening an economy for international trade: o Competition; Price reduction. o Channeling production into relative advantage sectors. o Canceling trade deviation/distortion. o Reduction of imports license rents. 31 • The liberalization in Israel since 1991: o Canceling purchase tax, thereby exposing the textile, furniture, shoes etc. industries. o Gradual reduction of custom regarding “third countries” import. o Narrowing down shielding regulations regarding import, reciprocity acquisitions, tenders etc. o Exposing the agriculture industry (since 1996). o Abolishing depreciation substitutes. 32 • Results of the exposure: o During 1983-1999 the non-trade goods’ prices increased 56% higher than the traded goods. o Market centralization declined, import and efficiency increased. o Trade distortion reduced, and import from “third countries” went up. o Employment declined in the exposed industries. 33 Policy Implications Retracting liberalization in goods, will inflict substantial macro damages – price increase, efficiency loss, trade distortion etc., without real employment improvement. Exposure achievements should be maintained, and measures like import levy shall be used only in proved market flooding situations. 34 Part IV: Labor Mobility 35 The total number of foreign workers in Israel in 2001, including Palestinians and illegal workers, is estimated as 250,000, which is 13% of the total labor force in the private sector. The increase in the total foreign workers corresponds to the reduction of Palestinian workers in Israel (from 120,000 to 14,000). Almost half of the foreign workers are in the construction industry. Many employed in agriculture and food services industries. 36 • Advantages: – Essential labor force in construction, agriculture... – Reciprocity with countries which employ Israelis. • Disadvantages: – Delaying technological innovations. – Wages reduction and the crowding out of Israeli employees in those industries. – Establishing immigrants communities. – Social rights violation, poor medical services rendered, low standard accommodation. – Asymmetric power between employers and employees. 37 Policy Implications Taxation of Israeli employers, thereby equalizing foreign and domestic employment remuneration. Enforcing employees shielding rules. Granting the visa to the worker, not her employer. Establishing authority that will regulate the number of foreign employees. 38