Bank of Israel Governor: "There’s an economic price for the changing sentiment in the world towards Israel"

"It is clear to us that some of the sentiment in the world towards Israel is currently much more challenging. Israel is still seen as a productive, entrepreneurial economy, with good academia, and that is the good part. But as the sentiment erodes, then this intangible capital may be damaged, and if it is damaged, it could potentially hurt how investors see us and our capabilities. And the more there is such an erosion, the better we will have to be, and work harder to compensate for it," says Bank of Israel Governor Prof. Amir Yaron in a conversation with Calcalist.

Yaron is a careful and experienced governor. He recognizes pitfalls from a distance and feels uneasy when the conversation moves away from monetary issues. But even beyond the walls of politeness and restraint, he succeeds in conveying to the government the message that it must make decisions regarding the integration of the ultra-Orthodox, and realize that there is an economic price for the ever-changing sentiment in the world towards Israel.

What are the economic implications of Israel's international status these days?

"Israel is an open economy, we depend a lot on exports, imports, and not only on the high-tech worlds, it goes a long way. Therefore, the openness of the economy and relations with the rest of the world are very important. But beyond the economic level, there is something that is difficult to quantify and put a finger on. I would call it Intangible Capital. Just as companies have intangible capital, so does the economy of countries. And this intangible capital is related to the sentiment towards Israel."

Can you already identify this erosion in sentiment towards Israel?

"I am very cautious. At the macro level, we do not see this. We see an increase in exports, in the survey of trends in business we see improvements, in purchase orders we see an improvement, and even in high-tech we saw improvement in the first quarter. But we see the news in the world, and the discourse may affect the sentiment of people, entities and countries that work with us."

"Impressive ability to recover from crises"

Let's talk about the Americans, whom you know well and who are especially important to Israel.

"The USA is a great and loyal friend of Israel, it has helped and continues to help us for years and certainly during the current war. That is why it is important to maintain this sentiment as well. I say again, in the business world we are seen as a strong, entrepreneurial, productive, dynamic country and we don't want to erode that. Around events like the ones that are happening now, we have to work even harder to preserve it, and certainly with regard to the U.S. when the power relations between us and them are different and we depend on aid. It is important that the decision makers in Israel seriously listen to what the Americans say and offer."

Political and security conduct also has an economic aspect, and the question is do you alert and touch on these issues as an economic advisor to the government, or say "this is not my responsibility"?

"There are things that are in the immediate range, and we at the bank reflect the costs. The costs in the various stages of combat had a different structure, because there were different forms of combat. The decision makers know what the economic costs are, but they have a broader scope. We at the bank are not security personnel, and it is clear that the issues, the policy, and certainly the security, has a much wider canvas than the economic number we reflect."

According to the governor, "there are long-term effects that are more processual, for example, the issue of the Palestinian workers. It is true that it has an immediate effect, but the issue will remain with us even into 2025. We know that in 2001-2002 it took almost five quarters to bring in about 25,000 workers , so it is clear that the talk of bringing in 100,000 foreign workers will probably take a long time. We also reflect in the 2025 forecast that there will be more people in reserves, and that the construction industry will take more time to recover, even though the forecast remained at 5%, and in the long term we have the potential for growth. The sentiment for the Israeli economy, how Israel will be seen in the world."

And what do you think will happen after the war economically?

"There are ebb and flow cycles in the economy, and I hope it will be the same the day after. There will be a restoration of the towns, villages and kibbutzim and the businesses that were damaged and even a jump in investments in the region, around a regional security arrangement that will be the final chord of the state of war. In the past we have seen that our economy demonstrates an impressive ability to recover from crises. Unexpected rapid growth, as in the exit from the coronavirus crisis, was accompanied by high global growth, but I believe that we will see a gradual return to Israel's long-term growth rate. Our forecast for growth in 2025, assuming that there will be no additional direct effects of the war, is 5%."

How afraid are you of a scenario of a boycott of Israel, especially after Turkey's recent decision?

"We saw Turkey's step, but we know that Turkey is not like other countries. Anyone who reads the international news knows that a problematic sentiment has been created towards Israel. If at the beginning of the events we were at one point, today we are at another point. The decision makers have security considerations first, but it is clear that if the negative sentiment develops and translates into a boycott of Israel, it will have effects on the Israeli economy."

The issue of integrating the ultra-Orthodox into the economy, which you at the bank see as a long-term issue, has not disappeared either, perhaps on the contrary.

"From day one I have been talking about the ultra-Orthodox issue in the most professional and clear way, it is of the utmost importance. We know that in politics the year 2060 seems very far away, but is isn't in the demographic hourglass. In 2019, I talked about the importance of ultra-Orthodox men and women in Arab society entering the labor market. I want them to earn, to have good salaries. And for high productivity, you need core studies."

According to Yaron, already in 2019 he presented that if Israel does not implement an action plan in ultra-orthodox society, there is a possible damage of 6-7% to the GDP per capita. "It's a lot, it brings us below Poland," he explains. "I also said that if we want to give the public the same government services, and there is no doubt that these strata receive a lot of government services, then we will have to raise taxes by 16% in the future. But now there is a difference, we are after October 7th, and we have what the Israeli security establishment is saying. It demands doubling the reserve days, increasing regular service from 32 to 36 months, that's about 10 billion shekels per year, and it has immediate implications, and it can have implications of attrition of factors that work in the economy, and result in the erosion of growth potential."

Therefore, Yaron clarifies, the economic implications of the ultra-orthodox continuing as they have will not become critical in 2060, but far sooner. And so now the necessity to deal with this issue is much greater.

Regarding the IDF recruitment of the ultra-Orthodox, you procrastinated, the Ministry of Finance released studies and reviews long before you.

"The issue of recruitment has clear economic aspects, which we focused on. We had our own internal process, we don't compete. Of course, there are also normative aspects to recruitment, but we, as an economic consultant, do not get into that."

You talk about the need for ultra-Orthodox integration and the assimilation of core studies, but it seems that you do not make concrete recommendations.

"Among the components of the last budgets there are components that took us backwards in terms of growth engines, and precisely in these areas (Orthodox and infrastructure) we know that there are incentives that keep people away from the labor market such as receiving allowances and property tax discounts. With this issue of entering the labor market, they will probably have to resort to tools that encourage them to enter the labor market and place more barriers for those not entering the labor market."

The governor likes to compliment the original fiscal framework before the war - the budget passed in May 2023 - because the planned deficit was low. But it turned out that even without the war, the deficit kept expanding. "They made a cyclical first budget and it was correct, and I, together with the Minister of Finance, stood on our feet, because there were forces here that wanted otherwise," explains Yaron. "The conservative deficit served us in light of all the uncertainty created in the nine months of the legislative changes, and it also served us at the time of the war. In May, we were on the path of public debt decreasing to 57%. Then a few more things happened here and this has been reflected, certainly in the financial markets."

How did you feel about the components of the budget?

"The framework was good, but the components were problematic, the coalition, and the core studies, and we said it was not good. As an economic advisor to the government, we constantly talk about these issues, but some things are accepted and some things are not accepted. We spoke about a negative income tax and in the end it was accepted. It's not like the monetary field where we are independent and operate as we determine."

And what about the updated war budget?

"I think that the Bank of Israel made an important and great contribution to understanding the framework thinking of 'how to think about the 2024 budget.' We brought this thinking that there is a one-time cost of NIS 250-240 billion and if it stopped there and we were without scars, then debt would go up to 67% and then go down. But because of the requirement to add to the security system money, and the money required for rehabilitation, so we said that this is a macro event. Therefore, first of all, we need to think about the minimum that is needed under each scenario. And after that, we can decide that the strategy should change. But this should be examined in the same committee I'm talking about, and it should be with professional parties, civilian professionals and security and economic experts, and it should be established as soon as possible."

It is difficult to understand whether you are at peace with the current fiscal situation.

"I didn't say I was at peace. We ended up raising the deficit forecasts for the years 2024-25 by almost 2%, however, we see a recovery of the economy that is stronger than we anticipated at the beginning, higher revenues, and as long as American aid arrives we are in a 6.6% deficit scenario at the end of the year. In the scenario of no deviation, we are at best stabilizing the GDP debt. Saying that, all the pressures we are under could result in the rising of the debt-to-GDP ratio, so I am not calm. We are in a world where most of the risks are on the negative side."

You are talking about raising taxes, which taxes are you talking about?

"There are all kinds of things. You can consider changes in tax brackets. The issue of taxation is a heavy one, it's not just that they went for a VAT increase in 2025 because given the timetables, this is the tax they know how to collect and are sure will arrive. If more adjustments are needed, then we will have to discuss broader tax issues together with the Treasury and the Tax Authority."

You criticize the members of the Knesset who did not approve all the taxes, but you appeared in the Knesset and opposed taxing the banks.

"Perceptually, we do not support a sectoral tax, and certainly when this tax does not apply to the entire sector. We said that if it needs to be done, then it should be done for the entire financial system as a whole. At the same time, we said that we understand the need of the hour, and if that's what's needed, then that's what will be."

And the budget that was passed following the war provided improvements in terms of growth engines?

"No, not at all, not on the issue of infrastructure, education, and incentives to go to work, there was no progress on these issues."