Israel Country Profile
“The Banking Industry and Government in the Economy”
for Comparative Political Economy of Globalization, GOV 390L, MES 381,
1998
Dr. Clement Henry and Dr. Catherine Boone
The Early Years
In the formative years of the state of Israel, capitalism was not
actively promoted because all attention and resources were turned over
to the state in order to unify the citizens for the dual goals of
survival and prosperity. This was the case despite the fact that there
was already a large private sector in place that had developed during
the British Mandate period (Ben-Porat, p45). Since 1948, Israeli the
government has actually participated in the economic development of the
country by way of direct investments and by providing capital to public
and private investors (Weingeist, p12). First Israeli Prime Minister
David Ben-Gurion’s process of intense state-building was designed to
ensure that each citizen pledge loyalty to the state above all else. No
aspect of Israeli society escaped his attention. And in economic
affairs, the state was the agent, initiator and promoter of economic
development and of capitalism (Ben-Porat, p46). Capitalism in Palestine
began with the Mandate in 1920, but Eastern European Jewish immigrants
brought the spirit of capitalism beginning in 1880. They set up banks
and businesses and operated them on the economic principles they had
used in their former countries. After Israel’s independence, there were
three agents of entrepreneurship available: the Histradrut, the private
sector and the state (46). This paper will focus on the dominating
position the government has had in directing the economy since 1948.
The state controlled much of the land in the country after 1948,
claiming ownership of property previously inhabited and owned by Arabs
(Ben-Porat, p49). “The allocation of such land cost the state
practically nothing”, and after independence Israel owned 90% of the
land and gave much of it to kibbutzim and moshavim (p66). The state
also began to accumulate industries such as the Dead Sea Potash Company,
El-Al Airlines, and the water company. “This was not merely a
temporary, ad-hoc intervention, but a basic policy for enlarging the
state regulation of the economy” (p67). There was also the
establishment of special banks to maintain the development of industry
and agriculture, like the Bank for the Development of Industry in 1958
and the Bank for the Development of Craft in 1954 (p67). The state also
owned certain public services that in capitalist countries are usually
owned by private individuals or corporations, like radio and TV stations
(p68).
Two key parameters for deciding the position of the state as agency in
the early period were immigration and capital (Ben-Porat, p50-51). The
state could maintain its position in shaping the economy because “the
import of [mainly unilateral] capital enabled the state to carry out the
absorption of immigration and to encourage essential economic
development” (p56). “New capital came mainly from Jewish communities in
Europe and N. America, in the form of grants and government bond
purchases. The United States government support from 1952-1956 was
$327.4 million, 85% as grants to the Israeli government” (p53). The
more foreign aid Israel received, the more dependent on outside sources
it became, however (Weingeist, p5). “From the end of the 1960’s onward,
the US government support for Israel became essential for the
development and even survival of Israel” (Ben-Porat, p54).
“The most important source of unilateral capital in the first decade
was German reparations,” and over a twelve-year period, German
reparations paid for 9% of the import of goods and services and covered
17% of the current deficit of Israel’s balance of payments. The Bank of
Israel suggests that reparations added 15% to the capital stock and 10%
to the net national product in 1964 (p55). Israel’s capital stock grew
by 50% from 1949-1952 and continued to grow after that; the GNP grew by
57% for the same period. The annual growth of GNP was about 10% and
although the Israeli economy was expanding, the growing population
stressed it (p52). To expand the new state’s income, it collected
income tax and used internal borrowing by means of selling government
bonds, for example. “The lack of capital for investment and, no less
important, the regime’s tendency to consolidate its grip on the inflow
of capital and its allocation, were the prime reasons for state
intervention in the economy by means of banking” (p68).
Capitalist ventures began well before Israel’s independence and four of
the largest and most important commercial banks were created between
1903 and 1935 footnotehere A fifth bank, the Central Bank of Israel,
was created in 1954 as a government institution to regulate the activity
of all banks. Its functions are “to administer, regulate and direct the
monetary system as well as to regulate and direct the banking credit in
Israel in accordance with economic policy of the Government” (Weingeist,
p16). The Central Bank can issue currency and regulate the liquidity
and holding the reserves of banking institutions. It holds the nation’s
foreign exchange reserves, rediscounts notes to regulate the volume,
price and destination of bank credit, and buys and sells securities in
the open market (p16). Banks wishing to establish branches abroad must
obtain a permit from the Central Bank (p19). When Israel was created,
banking institutions owned nearly three-quarters of the total assets of
all of the financial intermediaries of the country. Banking institutes
serve two functions as financial intermediaries. The first is the
raising of demand deposits, time deposits, savings schemes and the
granting of credit to the various economic sectors. These operate
within a relatively competitive market. The second function is to
provide financial intermediation services for other sectors of the
economy (p18). Commercial banks are organized as privately owned public
corporations. The main source of credit for banks is deposits from the
public, which includes demand and time deposits, and savings and foreign
currency deposits (p21).
Approximately one-half of the credit granted by the banks is directed
credit from deposits earmarked for loans (Weingeist, p24). Since 1979,
the Central Bank of Israel has required that banks taking loans from
abroad deposit 20% of the sum in a special, closed account, which cannot
be opened until the loan matures (p26). Approximately two-thirds of the
income of banking institutions is interest income from loans and
discounted bills in local currency; the other two sources of income are
the net income from securities and interest on deposits held with the
Central Bank (both in local and foreign currency).
Israel is currently in a state of transition, attempting to restructure
its financial system to fit a more privatized and eventually liberalized
model. With the continued sale of majority shares of banks by the
government to the public, a process that began in the early 1990’s,
Israel will perhaps over time distance itself from the French model that
it most closely resembles now. Traditionally capital has been allocated
by the government to projects it endorsed, a product of Ben-Gurion’s
state-building, and the government limits capital movement by
restricting the capacity and type of external investment. The
structural power of private capital “lies in its ability to invest or
withhold financing of projects of its choice” (Henry, p2). Thus we can
say that the structural power of private capital in Israel has
historically been weak. In the early years, the state allocated money
to projects it deemed important for the unity and well-being of the
state. However, the sale of state assets, including banking
institutions, has been a priority of Benyamin Netanyahu’s government and
privatization has progressed rapidly under him (EUI, p1). In 1998, the
government announced plans to sell near-majority and majority shares in
several banks and companies, including El-Al Airlines, Israel Electric,
and Banks Ha’Poalim, Leumi, Mizrachi and Israel Discount Bank (p1-2).
Over time, this should increase the structural power of capital as bank
investors find ways to invest in areas where they had previously been
denied access.
The Need for Reform
Consumers in Israel enjoy a standard of living that can in no way be
supported by what they produce (Plessner, p80). The government has a
prominent role in financing the high rate of public consumption, and
this can be dangerous because excessive government financing of
consumption gives people a sense of security that the government will
take care of them in financial troubles. As mentioned above, when the
state of Israel gained independence, it embarked on a vigorous and
comprehensive plan to settle the Jewish citizens of Israel in the areas
formerly occupied by Arabs. To expedite this process of settlement, the
government offered subsidized home loans that effected low-cost
housing. By the early 1970’s, however, the demand for housing
outweighed the supply, and market prices soared. The government was in
large part essentially underwriting the cost of the new housing through
subsidies. Incredibly, the government allowed the borrowers, most of
whom were farmers and individual homeowners, to escape their obligation
of repaying the loans when the payments increased beyond what the
borrowers could manage with their incomes (Plessner, p91).
The absolution of this responsibility by the government proved
disastrous in 1983, when the banks in Israel basically collapsed from
lack of reserve capital, and the government had to bail them out. Years
earlier, the banks had begun the practice of buying their own stock when
they perceived that the share values were dropping. They did this
partly in an attempt to mobilize financial resources that would not be
subject to governmental control (p92). But the banks ran out of
reserves, partly because the reserves were not being replenished by
borrowers. The banks were trying to get themselves out of a bad
situation caused in part by low capital reserves, which in turn was due
partly because borrowers were allowed to default on their loans with no
penalty. If the government hadn’t allowed the people to default, the
banks might have had enough money to remain stable during the period of
their own shares’ depreciation.
In the 1990’s, several shifts occurred on the international scene
regarding capital inflows to industrialized and middle-income nations.
Industrial countries, not developing countries, were the main recipients
of capital inflow. The main type of capital flows were direct
investment and portfolio investment, replacing commercial bank credit as
the major type of capital flow (Griffith-Jones, p6). As international
pressures promote more liberal reforms in trade and banking systems,
Israel has begun to change its financial structure under the present
government’s rapid liberalization, privatization, and currency
deregulation processes.
Israel could be characterized as a high consumption society that does
not export much capital, and which receives a high amount of foreign
capital, whether or not for investment purposes. Currently Israel has
free trade agreements with both the European Community and the United
States characterized by unrestrictive policies and exchanges in
manufacturing and agriculture. However, the agreements that Israel has
with these communities do not include capital movements (capital
markets) or financial services (banking and insurance) (Assaf & Efraim,
179). Israel does not act on the EC reciprocity principle whereby an
EC and non-member country agree that they will not restrict each other
in the maximum controlling share of banks they can purchase in the
other’s country (p179). As an associate member of the EC, Israel does
not have member status that would allow it to purchase majority share of
stocks and bonds in EC countries. Israel can only deal in capital
movements if it reciprocates and adopts the same liberal policies as the
EC countries (p180). Israel has found itself unable to invest in these
communities because of its own restrictions on this type of capital
flows into the country. With the rest of the industrialized world
diversifying and deepening their investment in other countries, Israel
is being left behind.
Though data is generally absent regarding the breakdown of the types of
capital inflows for Israel, it is possible to make a few small
assumptions. For example, we might not expect to see an increase or
depth in Israel’s portfolio arrangement vis-a-vis the EC, even though
portfolio investment to industrialized countries was double what direct
investment was in the early 1990’s. The Economic Intelligence Unit
reports that foreign direct investment inflows into Israel totalled an
estimated $3.4 billion, which is a 42% increase over the 1996 total of
$2.4 billion (p2). This might suggest that Israel is receiving a very
healthy amount of direct investment, possibly even unilateral funds.
Summary
The post-independence Israeli capital market was traditionally
characterized by heavy government involvement, expressed on several
levels (Assaf & Efraim, p186). For example, the government funneled
long-term savings, including institutional retirement savings, into its
budget. These savings included pension funds and life insurance funds,
and the government required that the holders invest in government bonds
(p187). The government now had a steady and dependable supply of
capital and it also directed investments of the business sector toward
favored geographical locations and types of industry.
Corporations and businesses have been restricted in the kinds of
transactions that they can participate in, including global long-term
capital market transactions and direct borrowing and investment by
individuals and businesses (p187-88). The capital went into the
government treasury, leading to a situation in which the government was
the primary provider of capital for business growth (p189). As a result
of these and other restrictions, the banks had only an internal source
of generating capital, the government, and this led to a somewhat inbred
practice in the late 1970’s and early 1980’s of the banks regulating the
price of their own shares in an attempt to “raise” capital. When the
bank shares collapsed as a result of overvaluation, the banks could not
stabilize the situation for lack of capital. Similar situations
occurred in 1989 and 1991, though they were not as devastating as the
1983 fiasco. These too occurred as a result of relaxed payback and
penalty schedules (Plessner, p93-94)
This set the stage for reform in the mid-1980’s and the government
began to permit the transfer of funds from savings schemes to
private-sector borrowers, allowing the government to be bypassed (Assaf
& Efraim, p191). “The reform’s main goal was to reduce the level of
government involvement in financial intermediation and to rid the
markets of excessive regulations” (p191). Highlights of the reform
include greater freedom for private-sector firms in the choice of
investments; a reduction in government direct or indirect financing of
investments; and relaxation of the supervision of international capital
movements; (p191-92). And though significant controls still remained
over these capital movements, positive effects of deregulation of
financial markets could be seen in the early 1990’s (p194-195).
Conclusions
Israel seems to be privatizing state-owned industries and increasing
access to internal and external capital flow for a few different
reasons. Through ownership of state enterprises, the government is
ultimately responsible for the welfare and performance of these
industries. The government had to bail out many banks because of poor
management and oversight in 1983, and so this push for privatization may
be seen as a way of ridding itself of a near-constant liability. In the
global context, such reform is also beneficial if Israel expects to be
able to trade competitively with other countries in the financial
market, increasing its potential to gain capital inflows via return on
investments. A third consideration for why the present government would
be rapidly liberalizing its economy involves the political situation
with the Palestinians, which will be dealt with in detail in the final
paper. The Palestine region is viewed as very unstable and unattractive
to outside investors, so making up for that lack of capital inflow by
liberalizing its economy and increasing its ability to trade on global
financial markets seems wise. There have been moves by the Israeli
government to expand trade between Israel, Jordan and the territories
(EUI, 2). A potentially more profitable avenue, however, would be to
stabilize the region through political concessions to the Palestinians
which would create an enduring economic stability in Israel.
BIBLIOGRAPY
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“Israel”, The Economic Intelligence Unit, April 1998 Updater
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Journal of Interamerican Studies and World Affairs, vol 37, 1995
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Prepared for International Conference: The Role of the Business Sector
in Economic and Political Change, Tunis, 30 August-2 September 1998
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Stagnation
(New York Press, 1994 )
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Promise
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