Israel's Economy Is Back on Track

Thanks to foreign investment, fiscal stability, and high-tech exports, the country is enjoying solid growth after the Lebanon war hiatus

by Neal Sandler

Less than three months after a costly war in Lebanon, investors have quickly regained confidence in the Israeli economy, driving the Tel Aviv stock market to all time highs. On Oct. 31 the key TA-25 index of the largest companies traded on the exchange broke through the 900 threshold, and it's now trading at 910. The index has gained 22% since its mid-July low when the war broke out.

The war temporarily put the brakes on growth, but the Israeli economy is now back on track. "We're not only witnessing a recovery but an across the board strengthening in nearly every sector of the economy," says Gil Bufman, chief economist at Bank Leumi.

The sole exception is the tourism industry, which is still suffering the impact of the month of fighting. Even retail sales that fell during the war have rebounded. Fears that a protracted conflict would hit the economy hard have not materialized, and economists are now predicting growth of 4.5% for 2006, only half a percentage point down from pre-war estimates. The consensus is that growth next year will be around 4%, buoyed by exports as well as strong domestic demand.

Capital Flow Continues

The quick return to growth has contributed to the upbeat mood on the bourse. Capital continues to flow into Israel at record levels, with direct foreign investment expected to top $12 billion this year. In May Warren Buffett jumped on the bandwagon when his Berkshire Hathaway ponied up $4 billion to take an 80% stake in Iscar Metalworking Company (see BusinessWeek.com, 9/18/06, "Buffett Tours Plant in War-Scarred Tefen").

Exports are also up sharply. The country's high-tech sector continues to lead the way, with sales abroad up 20% this year. The inflow of foreign investments coupled with the export boom will translate this year into a $6 billion balance of payments surplus.

The flood of cash also has led to an unprecedented strengthening of the shekel. The Israeli currency has appreciated by nearly 8% against the dollar since the beginning of the year, much of this occurring since the end of the Lebanon war. The strength of the currency and negative inflation in recent months led the Bank of Israel on Oct. 23 to reduce its key lending rate by a quarter of a percentage point, to 5.25%.

High Productivity, Low Inflation

"The current interest rate environment is fueling the market upwards," says Richard Gussow, senior analyst at Nessuah Excellence, a Tel Aviv-based investment bank. Analysts are predicting that the central bank will cut rates by a further half a percent in the coming months.

To be sure, the strong shekel could have a negative impact on exports. But economists say that rising productivity and very low inflation will offset the appreciation. In addition, high value-added tech exports, which account for about half of the $40 billion in foreign sales, are far less sensitive to currency fluctuation than commodities.

There is also continued confidence in the Israeli government's fiscal policy. Despite an increase in government spending to pay for the war, the budget deficit is expected to remain at around 2% of gross domestic product. The recent broadening of the government coalition is likely to help the finance ministry stick to its budget targets. Israel's fiscal responsibility has not gone unnoticed by international credit agencies. In recent weeks, both Moody's and Fitch Ratings issued positive outlooks on the government's long-term debt.

Foreigners in the Bourse

Foreign interest in the Tel Aviv market remains keen. Until recent years, most of the foreign interest in Israeli companies was limited to those traded on U.S. markets, where over 100, mostly high-tech, firms are listed. But foreigners are now playing a major role in Tel Aviv as well. "They account for about 20% of trading volume, though in the major blue chips it's much higher," says Yaron Bloch, head of equities for UBS Securities Israel.

The Switzerland-based investment bank was the first to buy a seat on the Tel Aviv Stock Exchange nearly 10 years ago.