OECD Economic Outlook, Volume 2023 Issue 2

Israel

The economic impact of the evolving conflict following Hamas’ terrorist attacks on Israel on 7 October is highly uncertain and depends on the duration, scope and intensity of the conflict. The projections assume that the impact will be largely concentrated in the last quarter of 2023, leading to a temporary but pronounced slowdown. GDP growth is projected at 2.3% in 2023 and 1.5% in 2024 before recovering to 4.5% in 2025. Supply side disruptions due to the security situation and the significant decline in the civilian labour force, together with weakening economic sentiment, will mainly affect private consumption and investment. A drop in tourism will weigh on export growth.

Monetary policy accommodation in the near-term will depend on uncertain exchange rate and inflation developments. Fiscal space built up after the pandemic can help provide temporary support to households and firms affected by the war and meet spending needs for defence, security and reconstruction. This should be accompanied by reprioritising permanent expenditure, while safeguarding growth-enhancing spending on infrastructure and skills provision. In the medium term, labour market and educational reforms are needed to address demographic challenges and reduce wide labour market disparities.

The war is having a significant impact on the economy

The economy was performing robustly before the war. GDP grew by about 3% in the first three quarters of 2023 (average annualised quarterly rate) and the labour market was close to full-employment. Following the terrorist attacks on 7 October, the shekel initially depreciated markedly but recovered to pre-war levels in nominal effective terms by mid-November. The stock market was still around 6% below its pre-war level in mid-November and risk premia are elevated. Consumer and business confidence plummeted in October. Labour shortages in the economy are severe due to the call of reservists into service, evacuation of the population close to the border with Gaza and Lebanon, absences of parents from the workplace due to the closure of the educational system, lack of Palestinian workers and exit of many foreign workers from Israel. Moreover, the number of furloughed workers, for instance due to temporary business closures, increased markedly and vacancies dropped sharply in October. Parts of the educational system and retail shops, bars and restaurants have gradually reopened in November. Credit card data suggests a partial recovery of spending in November. Consumer price inflation, at 3.7% in October, remains above the central bank’s 1-3% target range.

Israel: Inflation and fiscal indicators

1. The trend is based on data from January 2016 to September 2023. Underlying data is seasonally adjusted (7-day moving average), index January 2020=1.

2. Data for 2022 is an OECD estimate.

Source: Bank of Israel; OECD Economic Outlook 114 database; and OECD calculations.

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Israel: Demand, output and prices

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The authorities are responding to ensure economic stability

On 9 October, the Bank of Israel announced a programme to sell up to USD 30 billion in foreign exchange (about 15% of total foreign exchange reserves or 6% of GDP) and provide swap facilities of up to USD 15 billion in order to moderate exchange rate volatility and to provide the necessary liquidity for the continued proper functioning of financial markets. A credit facility for SMEs via banks was established in early November. By the end of October, the central bank had sold USD 8.2 billion of foreign exchange. On 23 October, the central bank left the policy rate unchanged at 4.75%. In early November, parliament approved a NIS 15 billion (0.8% of GDP) business support package, including grants for firms near the borders with Gaza and Lebanon, and firms in the rest of the country based on their revenue losses. Other support measures include support to households who were evacuated, easier access to unemployment benefits, as well as business liquidity measures including the postponement of VAT payments and loan guarantees. Part of the substantially higher spending on the military and security, reconstruction and support to households and firms affected by the war will be financed by cuts to other spending, extra‑budgetary funds and US defence aid. Nevertheless, the projections assume a marked fiscal expansion of around 4% of GDP over 2023-25. Public debt is set to increase to slightly above 65% of GDP in 2025.

Economic growth is projected to slow markedly in 2024 but uncertainty is large

The uncertainty about the duration, scope and intensity of the conflict, and hence its economic impact, is large. The projections assume no further regional escalation of the conflict, with the main economic impact confined to the last quarter of 2023 and to a lesser extent the first quarter of 2024. Government consumption will rise but falling economic sentiment, high uncertainty, temporary business closures, in particular in the retail, food services and construction sectors, a significant temporary reduction in the civilian labour force and transport disruption will markedly reduce private consumption and investment growth. A drop in tourism (about 5% of total exports) will also weigh on export growth. The projections assume that economic activity will start to recover in 2024 and growth will rise above the potential rate in 2025. Inflation developments will depend on the interplay of supply and demand disruptions. The projections assume that supply disruptions will add some inflationary pressure in the near term. With supply restrictions easing and demand only gradually recovering, inflation will abate in the medium-term. A further escalation into a regional conflict or a more prolonged conflict could lead to more severe supply disruptions, plummeting sentiment and higher risk perceptions, with much more pronounced effects on economic growth and public finances. After the conflict, domestic political tensions (including around the judicial reform) could re-intensify and lead to higher uncertainty.

Policies should mitigate the economic repercussions of the conflict

In the near-term, the scope for monetary policy accommodation may be constrained by exchange rate developments and above-target inflation. Fiscal space built-up after the pandemic can be used to support the economy. Planned temporary income and liquidity support measures to households and firms can cushion the impact of the war. The authorities could also consider refining the furlough scheme by allowing for a partial adjustment of hours in addition to full furloughs and introducing a small co-financing requirement for employers. With increased spending on defence, security, reconstruction and interest payments in the medium term, some re-prioritisation of permanent expenditure, based on spending reviews, will be needed to mitigate the impact on the public finances. Growth-enhancing spending, including for infrastructure investment and to improve educational outcomes, should be safeguarded. In addition, revenue could be raised, including by reducing inefficient tax expenditures. In the medium-term, structural reforms to strengthen work incentives and improve skills at all stages of the learning cycle are needed to address demographic challenges related to the rising share of population groups with weak labour market attachment. Preserving the rule of law is essential to maintain robust economic performance.