September 3, 2006

The economic motor will steam ahead and the smart money is getting on board now. Before Hizbullah terrorists brazenly crossed an internationally recognized border, killed several Israeli soldiers, kidnapped two others, and fired a flurry of missiles into northern Israel, the Israeli economy was steaming ahead. In the first half of the year, it was enjoying 6% growth, low inflation, falling unemployment, a budget surplus, a balance of payments surplus, a shrinking national debt, and record levels of foreign investment – an economic picture that was accurately described by one international analyst as “nearly perfect.”

Though five weeks of war struck a blow to Israel’s economy, it is strong enough to absorb it. Indeed, Israel’s economy remains strong, and it will only get stronger in the future.

Recognizing this, none of the major ratings agencies lowered Israel’s credit rating during the war. Those who have been paying attention to the recent transformation of the Israeli economy understand why.

First, Israel’s fiscal policies are sound. Three years ago, finance minister Binyamin Netanyahu put Israel’s fiscal house in order, and his successors have maintained that order. Faced with a deep recession, a bloated public sector (55% of GDP), exploding deficits (6% of GDP), a high debt burden (106% of GDP) and sky-high tax rates (64% marginal rate), the government drastically cut the budget and sharply reduced taxes. Moreover, abiding by conditions set forth in a 9 billion dollar loan guarantee program with America, Israel capped spending growth at 1% per year, and has maintained that budgetary framework for the last three years.

The results have been dramatic. While still high, the public sector now accounts for less than one-half of GDP, tax revenues have skyrocketed, and debt ratios have dropped to under 90% of GDP, bringing them close to the ratios maintained by the leading industrialized nations.

Second, a number of important structural reforms were implemented in the last three years. The government sold off its stake in the country’s second and third largest banks, and privatized a number of state-owned companies including EL AL, the national airline, and Bezek, the national phone company. In addition, Israel overhauled the government pension system, restructured the ports, modernized the country’s rail and road systems, and, perhaps most important, reformed the country’s capital market, forcing what was effectively a banking duopoly to sell off its exclusive control of most of the country’s financial assets.

The new government, led by Prime Minister Ehud Olmert, and Finance Minister Avraham Hirschson, has said that it is committed to continuing these prudent fiscal policies and to pressing forward with reform. Just three weeks ago, in the middle of the war, the government sold one of Israel’s two oil refineries for $800 million, a sum nearly triple what it had been expected to fetch.

Sound fiscal policy is buttressed by sound monetary policy. Now that Alan Greenspan has retired, Israel can justifiably boast of having the finest central banker in the world in Stanley Fisher. With investors confident in his steady hand navigating Israel’s economic ship, both the Israeli stock market and the shekel have essentially maintained their pre-war values.

But beyond the personalities or the policies of its government lies the real key to Israel’s future – its people. With more scientists, engineers, high-tech start ups, and research & development spending per capita than any country in the world, Israel will continue to provide investors with access to human capital that is second to none.

That is why companies like Hewlett Packard and Sandisk acquired Israeli firms and technology in billion dollar deals after the war had already started, and why Greylock Partners just launched a $150 million venture capital fund to invest in early stage Israeli technology. That is also why it was no surprise when Intel announced last month that its Israeli R&D facility in Haifa developed a new chip that will form the core of the company’s new mobile and desktop production line, and why Warren Buffet said that the war would not have dissuaded him from his recent purchase of a four billion dollar stake in Iscar, an international metal works company based in northern Israel.

To be sure, in addition to the scores who have lost their lives and the hundreds who have been injured, the war has caused significant economic damage. With missiles raining down on Israel’s northern cities, the thousands of companies located there were either closed or forced to operate at only a fraction of their capacity. Tourism in the country as a whole, and in the north in particular has been hit hard, and will surely take many months to recover.

But tourism represents less than 2% of Israel’s GDP. The heart of Israel’s economy remains the export of high-technology goods and services and its pulse remains the highly skilled, dynamic, and entrepreneurial workforce that creates those goods and services.

Smart investors see beyond the sound and fury of the moment and focus on fundamentals that pay huge dividends over time. As the Jewish state emerges from this latest round of violence, and as security is once again restored, Israel’s economic motor will steam ahead. The smart money is getting on board now.

(Originally appeared in the New York Sun)

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Jason Harris

Jason Harris

Executive Director

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