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Leza L Olson  09/05/2006 01:06:05 PM  From  DB/Inbox:  Leza L Olson

Cable 
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C O N F I D E N T I A L        TEL AVIV 03501

SIPDIS
CXTelA:
    ACTION: ECON
    INFO:   FCS IPSC SCI IMO CONS RES POL DCM AMB AID ADM
            PD

DISSEMINATION: ECON
CHARGE: PROG

APPROVED: ECON:WEINSTEIN
DRAFTED: ECON:JNWITOW
CLEARED: ECON: WWEINSTEIN

VZCZCTVI569
OO RUEHC RUEHXK RHEHNSC RUEATRS
DE RUEHTV #3501/01 2441158
ZNY CCCCC ZZH
O 011158Z SEP 06
FM AMEMBASSY TEL AVIV
TO RUEHC/SECSTATE WASHDC IMMEDIATE 6095
INFO RUEHXK/ARAB ISRAELI COLLECTIVE IMMEDIATE
RHEHNSC/NSC WASHDC IMMEDIATE
RUEATRS/DEPT OF TREASURY WASHDC IMMEDIATE

C O N F I D E N T I A L SECTION 01 OF 03 TEL AVIV 003501 
 
SIPDIS 
 
NSC FOR WATERS; TREASURY FOR HIRSON 
 
E.O. 12958: DECL: 08/31/2016 
TAGS: ECON EFIN IS
SUBJECT: DANGERS LOOM AS GOI DEALS WITH ECONOMIC EFFECTS OF 
WAR 
 
 
Classified By: Economic Counselor William Weinstein for reasons 1.4 b a 
nd d. 
 
------- 
Summary 
------- 
 
¶1.  (C)  The former Chief of Economic Research at the 
Ministry of Finance (MOF), Michael Sarel, says that the 
Lebanon War will have negative short-term consequences for 
the Israeli economy, but that the economy will resume its 
strong growth over the longer term.  Despite his skepticism 
that the GOI will be able to reverse a "temporary expenditure 
shock," Sarel recognized that some additional spending is now 
necessary.  Expenditures through 2007 will rise, but the 
deficit will stay close to the three percent range.  Defense 
spending will increase significantly, but not by nearly as 
much as the defense establishment is requesting.  Social 
spending will be sidetracked as will spending on education 
and major infrastructure projects, and "Negev development is 
off the map."  Taxes will not be raised, but the reductions 
envisioned by the tax reform program which is now in progress 
will be delayed by a year or two.  However,  Sarel said that 
if the cease fire in the north does not hold, the resulting 
deterioration in the security situation will likely result in 
significant negative changes in the reformist policies that 
have helped the Israeli economy to prosper in recent years. 
End Summary. 
 
---------------------------------------- 
Economy Will Recover if Cease-fire Holds 
---------------------------------------- 
 
¶2.  (C)  In an August 30 meeting, Michael Sarel, former Chief 
of Economic Research at the MOF and now Chief of Economic 
Research at Harel Investments - a top Israeli investment 
firm, discussed two possible scenarios for the near-term 
economic future with the Deputy Economic Counselor.  In the 
optimistic scenario, the cease fire in the north would hold 
and the security situation would return to something 
approximating what it was before the outbreak of the war.  In 
this case, Sarel said that the economy would recover very 
quickly.  There would still be a major impact on near-term 
spending, and more spending on defense in the intermediate 
and longer terms.  The tourist sector will not recover 
quickly, but the need to rebuild and rearm will spur growth 
in construction, military industries, and other areas.  In 
such a case, 2007 would be a good year, and steady growth 
would resume.  Growth for 2007 will likely look even more 
impressive when compared to 2006, with its artificially low 
growth rate because of the war. 
 
---------------------------------------- 
Deterioration in Security Spells Trouble 
---------------------------------------- 
 
¶3.  (C) In the negative scenario, Sarel described a situation 
of continued low-level warfare in the north, with a rocket 
being fired in from Lebanon once or twice a week, and people 
unable to fully return to life as they had lived it before 
the war.  The long-term economic implications of this type of 
situation are extremely negative.  Tourism would not revive 
at all in the north, and only slowly in the rest of the 
country.  More ominously, there may be some hesitation on the 
part of foreign investors to continue to invest in the many 
hi-tech companies that are located in that part of the 
country.  This would seriously affect the growth rate both in 
the short-term and long-term. 
 
¶4.  (C)  Sarel went on to say that there were two main 
reasons for Israel's excellent economic performance in recent 
years.  The first was the dramatic improvement in the 
security situation, and the second was the government's 
decision to change its economic policies.  Regarding 
security, investors used to be jittery at the news of every 
terrorist attack or military operation.  In recent years, 
they have come to believe that the country is essentially 
stable and the economy solid.  The number of terrorist 
attacks and civilian casualties is still very important, and 
Sarel stressed the need to maintaining vigilance.  However, 
since 2002, the sharp drop in the number of attacks and the 
almost inconsequential impact of terrorism at the present 
time has dramatically improved the economic climate.  A 
long-term deterioration in the security situation would be 
severely negative for the economy. 
 
------------------------------- 
Some Reforms May Be Rolled Back 
------------------------------- 
 
¶5.  (C) The other major factor which contributed to the 
economy's dramatic improvement was the change in the 
government's policies and the implementation of the economic 
reform plan in 2003, which is still in progress.  The "very 
positive policies for growth and investment," such as the 
reduction in expenditures as a percentage of GDP, and the 
reduction in the deficit and taxes have all contributed to 
the decrease in the risk premium for investing in Israel. 
 
¶6.  (C) Sarel noted that, in the post-Lebanon War situation, 
both of these factors are at risk.  There will likely be 
economic policy changes as a result of the security 
situation.  Most important is the push to increase the 
defense budget by NIS 30 billion (about USD 6.8 billion) over 
the next three years.  Sarel said that there was no chance 
whatsoever that the Ministry of Defense would receive such an 
increase.  However, even a fraction of that amount - he 
thought a figure in the NIS 5 billion range likely - would 
have a big fiscal impact.  On the need for additional defense 
spending, Sarel noted that there is room for some savings in 
the defense establishment.  The army has an extremely 
generous pension system, which was not reformed several years 
ago when the GOI reformed the equally generous pension plans 
enjoyed by most other government employees.  Regardless of 
the amount that defense spending is increased, this new 
situation represents a drastic change from pre-war plans for 
major defense cuts (about NIS 500 million per year for three 
or four years) to finance social spending. 
 
¶7.  (C) In addition, some other reformist policies will be 
"reversed a bit."  The deficit ceiling will be raised, as 
will expenditures and taxes.  However, on taxes, Sarel said 
that rates would not increase, but rather that the reform 
under which corporate and personal income taxes have been 
slowly declining would be postponed for a year or two, 
bringing in an additional NIS 2 billion in revenue to the 
government in 2007 and 3.5 billion in 2008.    He also 
expected that the government would not change the 15.5 
percent VAT rate. 
 
---------------------------------- 
Temporary Expenditure Shock Needed 
---------------------------------- 
 
¶8.  (C) Sarel said that the right thing to do in the present 
situation was to allow for a "temporary expenditure shock," 
which would sharply increase expenditures and the budget 
deficit now on the understanding that they would be brought 
back into line in 2008 and 2009.  However, he expressed 
skepticism that these increases would be reversed later.  He 
said that the revenue side will not be much affected by the 
war - the reduction in tax payment will only amount to about 
NIS two or three billion.  However, the compensation packages 
for businesses and individuals who suffered damage during the 
war and the increase in defense spending will have a big 
effect on the expenditure side.  Sarel noted that by law, the 
budget deficit is set at three percent.  The coalition 
agreement calls for it to be reduced to one percent by 2009, 
and the Prime Minister and Defense Ministers had agreed that 
it should be set at two percent for 2007.  Sarel suggested 
that it would be prudent to allow for a reasonable three 
percent deficit in 2007, and to plan to go back to reducing 
it gradually after that. 
 
--------------------------------------------- --------- 
Only Fiscal Tricks Can Maintain the Expenditure Target 
--------------------------------------------- --------- 
 
¶9.  (C) As for 2006, Sarel said that it will require some 
"fiscal tricks" to keep expenditures from rising by only one 
percent over those in 2005, as required by law.  One 
possibility is that additional expenditures be handled 
"off-budget."  He said that new legislation is needed to 
raise the expenditure ceiling, adding that since the deficit 
will likely stay in the three percent range, no new 
legislation will be needed to raise that ceiling. 
 
----------------------------- 
Negev Development Off the Map 
----------------------------- 
 
¶10.  (C)  As for the impact of the new situation on social 
spending, Sarel noted that much had already been done to undo 
the damage caused by some of the more drastic cuts in 
allowances over the past few years.  He said that the 
restoration of some cuts in the child and old age allowances 
was done in a very modest and reasonable way that did not 
threaten to explode the budget.  Regarding the increase in 
the minimum wage, he called it harmful to those it was 
intended to help, but economically not significant.  Planned 
increases in education spending will likely be postponed, as 
will work on major infrastructure projects such as the NIS 
eight to ten billion allotted for road and railway projects 
over the next five years.  He added the "Negev development is 
off the map," and that there will be another -- probably 
failing -- effort to get rid of many of the "exemptions" 
allowed in the tax system, such as the tax-free money in 
funds allotted for training courses, and the exemption on 
paying VAT in the southern port and resort city of Eilat. 
 
-------------------------- 
Deficit Will Stay on Track 
-------------------------- 
 
¶11.  (C)  When pressed, Sarel said he thought that while the 
war has caused real - but temporary - economic damage, the 
more optimistic scenario would ultimately play out.  The 
increase in the deficit and fiscal targets is a negative as 
will be the change in the internal composition of the budget 
towards more defense spending.  However, he expressed 
confidence that the deficit will remain in the three percent 
range, noting that the Bank of Israel, the USG, and 
international rating agencies will all be exerting a lot of 
pressure to keep the deficit under control. 
 
 
 
 
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