Israeli Economy Shrugs Off Scandals

Enjoying record foreign investment and healthy growth, business has been able to ride out a deluge of sleaze and corruption in government—so far

by Neal Sandler

An unprecedented wave of scandals and corruption involving senior public officials is shaking Israel's political establishment. Police are investigating President Moshe Katsav, Prime Minister Ehud Olmert, two cabinet ministers, the police commissioner, and the Income Tax Authority director, on allegations ranging from rape and sexual harassment to breach of trust and political cronyism. (Both the tax director and police commissioner have stepped down.) The latest scandal to hit the headlines concerns Finance Minister Avraham Hirchson, who is suspected of involvement in an embezzlement case.

The political turmoil doesn't yet appear to be affecting Israel's four-year-long economic expansion. Fueled by a solid flow of foreign investment, which hit a record $22.5 billion last year, the economy continues to thrive. Indeed, on Mar. 20, the same day Hirchson was grilled for the first time by the police fraud unit, the Bank of Israel raised its 2007 economic forecast to 5% growth. The only negatives cited by the central bank were fears about a slower-than-expected recovery in Israeli tourism and moderating U.S. economic growth. There was no mention of the local political situation.

But among businesspeople there's growing concern that the scandals could start to bite. "There is no guarantee the economy will continue to perform over time totally detached from the events," says a worried Jacob Perry, board chairman of Mizrahi Tefahot Bank, the country's fourth largest. Adds Lev Leviev, chairman of Africa Israel Investments, a leading real estate and construction company, "Israel's image has been tarnished and we are trying hard to minimize the damage."

"Atmosphere of Sleaze"

So far, so good. The Tel Aviv stock market continues to trade at near-record levels. Israel's current account surplus widened to a record $6.8 billion last year, due largely to the export boom led by the country's high-tech industry. Local high-tech startups raised $1.62 billion in 2006, their best showing in five years. Even unemployment, which hovered at double digit levels only a few years ago, dropped to 7.6% in February, the lowest level in nearly a decade.

"It's remarkable how resilient the economy and financial markets have been, given the current political atmosphere of sleaze," says Richard Gussow, senior analyst at Nessuah Zannex, a Tel Aviv investment bank.

That's true at a macro level, too. The shekel is at its highest level against the dollar in over five years. Attempts by the Bank of Israel to stem the currency's growing strength by cutting interest rates to their lowest levels in the country's history have so far met with little success. The government also reported a budget surplus in the first two months of this year, as tax receipts continue to run at record levels. The sharp upsurge in the fourth quarter of 2006 all but erased the negative effect of last summer's war in Lebanon.

Prime Economic Climate

The steady stream of positive news seems to be keeping damage from the political fracas to a minimum. "Investors are continuing to focus on the strong fundamentals, and as long as the government sticks to sound fiscal policies, they remain on board," says Leo Leiderman, chief economist at Bank Hapoalim, the country's largest.

Even better, foreign investors who have traditionally shied away from Israel in times of instability appear to be taking little notice of the political developments. "There has never been a better economic climate here for investment," says Stanley Gold, president of Shamrock Holdings, the Disney family investment fund. According to Gold, Shamrock's Israeli portfolio had a return of 31% last year. Shamrock Holdings is reportedly planning a third fund of at least $250 million for further investments in Israel.

Still, the high-flying economy has done little to help the waning popularity of Prime Minister Olmert, who has seen his support dwindle to single digits over the handling of last summer's war in Lebanon and because of the allegations against him of influence peddling and shady real estate deals. Most analysts believe that his days in office may be numbered. Though his cabinet is still intact, a report on the war due out this summer from a government-appointed panel could bring down Olmert's coalition and lead to early elections. The latest polls show that former Prime Minister Benjamin Netanyahu would likely be returned to power if elections were held today.

Widening Income Gap

Few would dispute that it was Netanyahu's policies as finance minister under former Prime Minister Ariel Sharon that laid the foundation for the current boom. But at the same time there is concern that Netanyahu's trickle-down economics have increased poverty and widened the income distribution gap. Some 20% of Israel's population is living below the poverty level, the highest percentage of any Western country.

"The trickle-down theory has failed everywhere in the world, including the U.S.," argues Labor Party Knesset Member Avishai Braverman. The renowned economist-turned-politician believes the policy has done well by Israel's growing class of super-rich but has only served to widen the gap between rich and poor in a society which once prided itself on equality.

With many of Israel's top leaders under investigation and the Olmert government increasingly fragile, it could be just a matter of time before political instability starts to take a toll on the economy. If that happens, Israelis could pay a heavy price for the transgressions of their leaders.

Sandler is a correspondent for BusinessWeek in Jerusalem .