III. ECONOMIC TRENDS AND OUTLOOK Major Trends and Outlook ------------------------ The current positive trends in Israel's economic growth are expected to continue in the medium term. Israel is in the midst of a three year economic expansion, fueled mainly by the entry of approximately one half million new immigrants since 1989 (largely from the former Soviet Union as well as from Ethiopia), and strong export growth. Unemployment has fallen from a 1992 average of over 11 percent to 7.8 percent for the second quarter of 1994. Inflation remains a concern, however, and the rate for 1994 is likely to be 12 or more percent. In recent years, the Bank of Israel successfully set inflation targets that influenced expectations and exerted a moderating influence on price increases, which registered in the range of 18-20% in the late 1980's and early 1990's. For 1994 the Bank targeted inflation for 8% but it will be higher, due to the effects of large public sector pay increases and higher than expected increases in housing prices (In the first five months of 1994, housing prices increased 13%). The Bank of Israel will likely continue to use monetary policy to dampen inflation, i.e. the central bank has raised interest rates five times in the first eight months of 1994. Housing remains a major bottleneck in the economy, with an estimated current shortfall in affordable or low cost housing of 30,000 units. Housing starts for new homes have continued to fall in the first quarter of 1994, following the end of direct government housing construction and as builders delay building to profit from expected appreciation in land values. The government has recently announced a new set of initiatives to increase the supply of affordable housing, but the business community and the public remain skeptical. In 1994 Israel's stock market experienced extreme volatility, reflecting past over-valuation of shares, charges of insider trading, and the emotional ups and downs of the peace process. The government has begun the process of improving regulation of the market. The Ministry of Finance has decided to start imposing taxes on stock market capital gains beginning in 1995. A so-called emerging market for capital investment, the Israeli bourse lacks the depth of an American stock-exchange, which inherently increases the volatility of the market. Nonetheless, plans are well underway for the establishment of a second stock exchange. Trade continues to grow at double digit rates, a peace dividend attributable to expanding trade ties with Asian, African and other countries that only recently began trading with Israel following the de facto erosion of the secondary and tertiary Arab Boycott. Israeli appetites for imported goods (especially imports from the European Union and long-denied products from Japan), result in persistent trade deficits. Israel blames its large and growing trade deficit with Europe ($7 billion in 1993) on an unbalanced free trade agreement and is now negotiating to improve market access to Europe. The overall growth rate for 1994 is projected to be 5-6 percent. With continuation of current trends, the outlook is good for a long and steady continued expansion. Maintaining discipline on public sector spending, continued economic deregulation, and reducing inflation will be key to stable and sustainable growth in the long- term. Principal Growth Sectors ------------------------ For the remainder of 1994 and 1995 construction will be the leading growth sector in the economy due to a number of large infrastructure projects. Investment in infrastructure remains a high priority, especially in such sectors as power, ports/airports, housing, transportation and water. With the expected liberalization of the banking and insurance sectors and their enhanced integration with international markets, it is expected that these sectors will also show significant growth during 1995. The industrial manufacturing sector is expected to maintain a 7-8% real growth rate, led by the chemical and electronic industries. Non-defense commodity imports are also expected to maintain an average growth rate of 10%. There was a striking increase during the first half of 1994 in capital goods imports in the form of machinery and equipment, indicating further economic growth. The steady, ongoing rise in incoming tourism is driving growth in hotel services and tourism infrastructure. It is expected that the number of tourists will double during the next decade. Government Role in the Economy ------------------------------ Despite a commitment to reduce the government's traditional, interventionist role in the economy, involvement remains high. In the trade area, the formation of three Free Trade Area Agreements (FTAA), including one with the U.S., has greatly reduced government involvement, although government-imposed quotas and duties still heavily influence food and agricultural imports. The Government of Israel (GOI) continues to set sourcing requirements (eg. country of origin) on the procurement of certain commodities such as wheat, feedgrains, and soybeans, although it has recently relinquished its monopoly on the importation of meat. The GOI has announced plans to sell off most of its holdings in government companies, including government shares in commercial banks. Privatization plans are, however, progressing at a much slower pace than expected. El-Al (the national airline), Zim Maritime (national shipping company), Bezek (national telecommunications company), Tahal (national water planning company), Israel Electric Company (IEC) and the Port and Railway Authority are all still owned by the GOI. There has been a steady liberalization of the capital and foreign exchange markets. Balance of Payments Situation ----------------------------- Despite annual trade deficits, the government's balance of payments deficits are significantly ameliorated by unilateral capital flows from the U.S. and other sources. In recognition that the U.S. indirectly finances Israel's trade deficit with Europe and Japan, the Prime Minister has called for a reorientation of Israel's trade relations in favor of the U.S., which offers better market access for Israeli goods and services, while continuing to seek increased market access with the European Union. Trade and Investment Barriers ----------------------------- Trade: Under the U.S.-Israel FTAA all duties on manufactured goods and some agricultural products are scheduled to be phased out on January 1, 1995. Although Israel is converting all agricultural non-tariff barriers (NTB's) into tariffs as a result of the GATT Uruguay Round Agricultural Agreement, high tariffs will replace NTB's, and will provide continued protection for the domestic agricultural market. Other NTB's remain, including purchase taxes, uplifts, standards, and kashrut restrictions. Purchase Taxes: Ranging from 25-95%, purchase taxes are applied on so-called luxury goods, including automobiles, consumer electronics, wine, and products containing alcohol. Purchase taxes apply to both domestic and imported goods. In the absence of local production, a purchase tax is an equivalent to a duty. The GOI has recently announced its intention to lower purchase taxes on many appliances and some consumer electronics. Uplift: An increase on import invoice prices which are then assigned duties and other taxes on the basis of the higher value occurs because Israel determines import value according to the Brussels Definition of Value (BDV), which permits uplifts of invoice prices. In practice, the Israeli Customs Service typically uplifts by 2-5% the value of most products imported by exclusive agents, and by 10% or more the value of other products. The GOI has agreed to use only actual wholesale prices by 1995. Israel is not a signatory to the GATT Valuation Code. Port Procedures: Israel agreed in 1993 to streamline customs regulations by providing leading U.S. exporters with a blanket certification procedure and eliminating certain other notarization requirements for all U.S. exporters. These changes should facilitate the flow of goods between the U.S. and Israel. Israel's port system discriminates against imports by levying a 1.5% CIF value port fee on imports, but not on exports. Standards: Israel agreed in late 1990 to harmonize standards treatment to eliminate discrimination against imports. Progress to date has been slow. Recently, Prime Minister Rabin called for a reorientation of standards to provide greater access for U.S. goods rather than Japanese or European imports, although no concrete steps have been taken as yet. In May 1993, the GOI said that package size standards would be revised in a manner that would facilitate entry of some U.S. (non-metric) packages. This has not yet been completed. Israel has agreed to notify the U.S. of proposed new, mandatory standards to be recorded under the GATT. The Standards Institute of Israel is proposing a bilateral Mutual Recognition Agreement of Laboratory Accreditation with the United States which could result in the acceptance of U.S.-developed test data in Israel. The proposed program would eliminate the need for redundant testing of U.S. products in Israel to ensure compliance with mandatory product requirements. Kashrut Restrictions: Despite limited agricultural liberalization through the Uruguay Round, Israel has actually expanded Kashrut import restrictions, and now requires a local kashrut certification for all imports of frozen meat. In general, U.S. kosher certifications are not recognized for purposes of import into Israel, and kosher certification by Israeli rabbinical authorities is required. Kashrut is not a formal requirement for other food imports, but lack of certification significantly reduces product marketability. Investment: The GOI actively solicits foreign private investment, including joint ventures, especially in industries based on exports, tourism, and high technology. Foreign firms are accorded national treatment in terms of taxation and labor relations, and are eligible for incentives for designated approved investments in priority development zones. There are generally no ownership restrictions, but the foreign entity must be registered in Israel. Profits, dividends, and rents can generally be repatriated without difficulty once an investment has been executed through a licensed bank. About 100 major U.S. companies have subsidiaries in Israel, and some 170 Israeli companies have subsidiaries in the United States. Investment in regulated sectors, including banking, insurance, and defense industries, requires government approval. Israel's small market and certain non-transparent regulations have hindered both foreign and domestic investment. Although the impact of the secondary and tertiary Arab Boycott has dissipated, the primary boycott remains in force, and continues to impede foreign investment in Israel. The U.S. Government continues energetic efforts to end the primary boycott. Labor Force ----------- Israel's 1993 labor force numbered 1.96 million. The labor market has successfully absorbed a significant portion of the over 500,000 immigrants who arrived between 1989-1993, many of them scientists, physicians, and academics from the former Soviet Union. Much of the growth in the labor force was in high-technology and export oriented sectors with a lesser degree of unionization. This has helped to restrain private sector wage growth. Wages in the public sector, however, have been rising due to generous public sector wage agreements and some analysts fear this may spill over into the private sector, reversing the current trend. Strikes and labor actions in the private sector are relatively rare, but occur more frequently in government companies, including many defense firms, as well as, as companies owned by the National Labor Federation. Highly skilled and well-educated, the Israeli labor force continues to be a major asset to the economy. Those working in professional, technical, scientific, and academic positions account for 25% of the workforce. Skilled workers make up another 24%. Approximately 38% of the workforce have more than 13 years of education and over 17% have 16 or more years of education. Israel experiences labor shortages in unskilled labor, particularly construction and agriculture, but is relying increasingly on imported labor from the Far East and Central Europe, as well as Palestinian labor from the Palestinian autonomy and the West Bank area. Major Local and Third Country Competitors ----------------------------------------- U.S. exporters face strong competition from European, Far Eastern, and local suppliers in the consumer goods sector. Israeli companies continue to dominate the housing and basic construction sectors, although elimination of remaining duties under the FTAA may make U.S. suppliers more competitive in this area. U.S. companies involved in the manufacturing and high-tech sectors face competition from European and local counterparts. U.S. companies, in particular Motorola and AT&T, have a strong position in the telecommunications sectors. Several major U.S. companies - Bell South, Fairchild, McCaw, Southwestern Bell, Sprint, Vanguard - bid on a recent second cellular telephone system tender: a conglomerate including Bell South won the tender. There is no comparable competition from Europe or the Far East. In the power sector the major U.S. suppliers have been G.E., Westinghouse, Combustion Engineering (ABB), and Babcock & Wilcox. Major third-country competitors include: Siemens, Steinmuller (German) and ABB (German-Swiss). U.S. companies have been the traditional suppliers to the IEC, although recently this trend has started to change with IEC diversifying its purchases. One reason for this may be that Israel is, itself, making strong attempts to penetrate the European energy market with its locally produced equipment (Elco transformers). The U.S. position in the transportation sector has traditionally been weak. The major competitors are European: Siemens and Mercedes Benz (German) are both strongly represented in the country with an eye towards upcoming railway, lightrail/underground transit, and port projects. The French National Railroad Company has hosted several Ministry of Transport delegations, and their representatives have made repeated offers to perform pre- feasibility studies for major railroad projects. Infrastructure Situation ------------------------ The Government of Israel is making large investments in infrastructure projects. One of the top priorities is the improvement of public transportation, from the expansion of Israel's neglected railway system to the development of municipal lightrail/mass transit systems in Tel Aviv, Haifa and Jerusalem. After years of neglect of the national road system, funds are now available for the construction of new roads. Expansion of Israel's air and sea ports is continuing and will receive additional impetus as a result of the peace negotiations. In the energy sector, the country's total generating capacity is to be increased by around 4,000 MW (almost 60%) by the end of the decade, in order to meet the needs of industry and a growing population. The GOI is also showing increasing interest in environmental projects, from the development of regional sanitary landfills and recycling systems to air pollution and waste water treatment. Major Infrastructure Projects ----------------------------- The following projects offer the best opportunities for U.S. companies at the present time: Rutenberg Power Station "Project C": In 1992 the Israel Electric Corporation (IEC) prepared an operational plan for the construction of two 550MW units at the Rutenberg power station, located some ten miles north of the Gaza Strip. Requests for proposals (RFPs) for the turbine generator, the steam generating unit and the main cooling water piping system were sent to prequalified suppliers in 1992 and 1993, and in the next three years RFPs will be issued for many of the major systems. The most recent tenders have been awarded to Babcock & Wilcox, ABB and Siemens. Electrical Power (other projects): "Project C" is only one of IEC's many projects. The company plans to invest over $1 billion annually in generating, transmission and distribution systems over the next six years. Planned investments include: Generating systems: 6 X 550 MW units (power stations) $2.7 billion 75 MW oil shale-fired $250 million 800 MW pumped storage $550 million 300 MW compressed air $180 million 1340 MW gas turbines $400 million Existing power stations $360 million Transmission systems: 400 KV project $650 million High tension lines $200 million Substations $670 million Mobile substations $ 15 million Distribution systems: Low and high tension lines and distribution transformers $ 2 billion Meters $100 million Improvements in distribution system $600 million Airport Expansion: In 1993 the GOI approved the construction of a new international terminal for the Ben Gurion Airport. The project design has been completed by a U.S. company. Another U.S. firm has been awarded the project planning contract. Construction is expected to begin upon completion of the diversion of the Ayalon River, probably at the end of 1995, and is targeted for completion in May 1998, the 50th anniversary of the State of Israel. Total costs involved: $850 million ($500 million in stage A, $350 million in stage B). Port Expansion: The GOI has plans to expand both the Ashdod and Haifa ports. Projects currently under development include: the construction of the coal pier near Ashkelon Power Station ($100 million) and the Ashdod expansion ($250 million). Carmel Tunnel: BOT tenders for the construction of the 4.8km Carmel Tunnel in Haifa were issued in February 1994. Estimated cost of the project is $105-120 million, with a 25-28 year concession for the operator. The tunnel, targeted for completion by 1998, will be the first highway in Israel to be operated as a toll road. Several U.S. companies and other foreign companies have submitted bids. Trans-Israel Highway: Legislation to pave the way for the construction of a 270km Trans- Israel Highway, which may be developed as a toll-road, is expected to be passed in the next several months. Estimated cost of the project is $2 billion. Metropolitan Mass Transit System: Tel Aviv Municipality and GOI Ministry of Transport are cooperating in the development of Tel Aviv's Metropolitan Mass Transit System. This is to be an integrated system of railway, lightrail, buses and an underground for Tel Aviv's inner-city. The municipality has awarded two companies (one U.S. and one French) the contract to prepare the feasibility study for the Tel Aviv underground. The study is expected to take about a year. The total estimated cost of the project including the Ports and Railways Authority's plans to expand the railway system to establish a suburban commuter rail service to the north and south of Tel Aviv, connecting Ben Gurion Airport and modernizing the Tel Aviv-Jerusalem and Tel Aviv-Beersheva lines are as follows: Tel Aviv lightrail transit system -$600 million 160km double track railroad Beer Sheva-Eilat -320 million Rapid electric rail system Tel Aviv-Jerusalem -$145 million Electrification of railroad Nahariya-Lod -$55 million New railroad Tel Aviv-Lod-Ben Gurion Airport - $60 million 155 wagons for transport of goods - $12 million Four diesel locomotives and 20 passenger coaches - $13 million Environment: International tenders for two major sanitary landfills, Dudaim and Talia, each with an estimated value of $100 million, were issued in the first half of 1994.