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Israeli Election Winner Faces Souring Economy

The Israeli election campaign that drew to a close on Feb. 9 paid little attention to the faltering state of the country's economy. The main focus has been on the aftermath of Israel's 22-day military operation in the Gaza Strip. That skirmish turned out to be a godsend for hawkish former Prime Minister Benjamin Netanyahu, who is tapped in the latest polls as front-runner to become Israel's next Prime Minister.

Having served as the country's Finance Minister from 2003 to 2005, Netanyahu is blamed at least partially for the big hit pension funds have taken in recent months and for a huge income gap between Israel's rich and poor—the widest of any Western country. But economic issues have taken a backseat to national security during the electoral campaign.

If Netanyahu wins, though, experts say he'll have to take swift action to deal with a deepening recession in Israel. After five years of rapid economic growth, averaging around 5% annually, the local economy came to a standstill in the fourth quarter of 2008. The Bank of Israel now forecasts the economy will contract by 0.2% this year. Others say that prediction is far too optimistic: On Feb. 8, UBS (UBS) slashed its 2009 gross domestic product estimate to -0.8%. "Slower global growth will impact Israeli exports and consumer confidence," predicts Reinhard Cluse, a UBS analyst.

The slowdown in major Western economies is already taking a heavy toll. Exports from Israel fell by more than 20% on an annualized basis in 2008's fourth quarter. "High tech is extremely vulnerable in the current situation, as most exports go to the U.S. and Western Europe," notes Karnit Flug, director of research at the Bank of Israel.

Unemployment on the Rise

There's plenty of negative news on the home front, too. Industrial production dropped 6%, and retail sales suffered their first decline in years during the last quarter of 2008 as consumer confidence plummeted. Unemployment, which bottomed out last year at 5.9%—its lowest level in nearly two decades—is now on the rise and could hit 8% by the end of 2009.

The Bank of Israel and the Finance Ministry have been criticized for a slow response to the mounting crisis. "The Bank of Israel started to act late and at a slower pace than other countries, while the Finance Ministry has failed to include the banks and the business sector in discussions on stimulus plans," complains Zvi Ziv, chief executive of Bank Hapoalim (POLI.TA). The Bank of Israel has lowered its base rate to 1%, the lowest in the country's history, and expectations are for another half-percentage-point cut on Feb. 23. In addition, the government approved a $5.5 billion economic stimulus plan along with a limited safety net for pension holders.

Netanyahu argues the government hasn't gone far enough. "We are in a very deep crisis, and there is a danger of tens of thousands being fired," the Likud leader told a gathering of industrialists in Tel Aviv last month. His remedy: lowering the top personal tax rate from 46% to 35% and the top corporate rate from 27% to 18% over a four-year period.

The free-market champion campaigned on the strength of his reputation for having pulled the economy out of the 2001 recession and into a period of unprecedented growth and stability when he served as Finance Minister under Prime Minister Ariel Sharon. But many doubt the wisdom of cuts at a time when collections are declining sharply. In January the Finance Ministry reported tax revenues were down by 16% over the same month a year earlier.

Deficit Drama

The Likud party leader also wants to increase spending on infrastructure as part of a proposed $7.5 billion stimulus plan. Yet economists are predicting the government's budget deficit will rise to more than 4% of GDP this year even before any stimulus measures are taken. "Israel does not have a lot of room to play with because of the high ratio of debt to GDP," says Ori Greenfeld, chief macroeconomist at Clal Finance & Investment Management (CLFN.TA), a Tel Aviv-based investment house. Although the debt ratio has been falling steadily in recent years—to around 80% of GDP now, vs. 95% in 2005—it remains high by Western standards.

Potentially an even larger problem is the credit crunch. The local economy weathered the initial phase of the global economic crisis because Israeli banks were only marginally exposed to the U.S. subprime mortgage market, but the country now faces a crisis in the local corporate bond market, which has all but dried up over concerns the global financial freeze will make it harder for companies to repay their debt.

In recent years billions of dollars in bonds were issued by nonbanking institutions, accounting for about half of all credit to the business sector. Companies such as Africa-Israel Investments (AFIL01.TA) and Delek Real Estate (DLKR.TA) used corporate bonds to finance ambitious expansion plans in the U.S., Europe, and other overseas markets. "We will not be able to get out of the economic crisis unless we solve the problem of the bond market," says Zohar Goshen, chairman of the Israel Securities Authority.

The Bank of Israel and the Finance Ministry are considering measures to help the bond market. Netanyahu has vowed to use $4 billion in U.S. government loan guarantees that are still available to ease credit.

But even with his plans for tax cuts and stimulus, Netanyahu faces an uphill battle if elected. Most economists are predicting a local recovery won't get under way before 2010 at the earliest. And even then, the consensus is that a turnaround will depend on economic developments in the U.S. and Western Europe.

Sandler is a correspondent for BusinessWeek in Jerusalem .

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