Archive for November, 2009

Obamanomics: Reaganomics in reverse?

November 23, 2009
Source: Google Images Source: Google Images

A central challenge of our times:  America, Europe, and countries the world over will have to figure out a way to staunch the hemorraging red ink we are currently sustaining.   As a result of fiscal stimulus packages and bank bailouts, in addition to the standard generous provision of guns and butter, we will be talking a lot more about fiscal policy in the years to come.  The Economist produced three nice, analytically meaty articles on the subject in its Nov. 21-27 edition — not yet emailed to me electronically, but I will post them in this blog when available.

In the 1980s, in a moment of candor, Reagan’s Director of the Office of Management and Budget, David Stockman, said that the intent of the Reagan administration was to cut taxes so that deficits got so big that the government would be forced to cut spending so dear to liberals.  That was Reaganomics, smash liberalism not directly through spending cuts, but through tax cuts.  Publicly, however, we were sold some snake oil called Supply-side economics that purported to yield a higher tax intake because tax cuts would spur growth.  We would grow our way out of Reagain’s gaping deficits.  Not so.  George H.W. Bush had to raise taxes during his term, which arguably cost him re-election, the two-term Gipper safely back on his ranch in California.

Is Obamanomics the reverse?  We’re told that health care reform will yield cost containment, which will ensure that government spending on health care will not grow dramatically.  Many doubt the current packages in Congress will do that.  So, in effect, Obamanomics argues that by raising spending, we will reduce deficits through cost containment.  Reaganomics in reverse?  H.W. called this Voodoo Economics before he became the Gipper’s VP.

In any event, have a read of the Economists articles.  The Economist briefing on America’s fiscal deficit argues that in addition to spending restraint — including later retirement ages for baby-boomers and winding down soon our two wars in Iraq and Afghanistan —  tax hikes will be needed.  The article recommends tax reform, which will either close income tax loopholes favoring the rich and impose carbon taxes, or launch a Federal value-added tax, such as all other OECD countries have.  These decisions will be politically agonizing because they affect both economic efficiency and fairness.  The VAT discourages consumption, which we need to do, but is regressive, affecting the poor more than the rich.  Our current reliance on an income tax that has more holes in it than Swiss cheese — for wealthy mice to scamper through — provides disincentives to growth.  More importantly, if we don’t take these decisions — to raise taxes and cut spending, the Economist argues, the bond markets will punish us with higher interest rates and the rating agencies with a loss of our AAA credit rating.

Get used to it:  fiscal policy will become a critical kitchen-table issue in the years to come…

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Brazil: So you finally noticed?

November 20, 2009
Brazil's crown jewel, Rio, will get the World Cup in 2014 and the Olympics in 2016.  Hope the lights work!  Source: The Economist
Brazil’s crown jewel, Rio, will get the World Cup in 2014 and the Olympics in 2016. Hope the lights work! Source: The Economist

The Economist this week (Nov. 14-20) featured a mediocre special report on Brazil.  Its message:  Brazil is a good investment.  So, you finally noticed!  Better to have invested in late 2002, when Brazilian assets were selling at prices implying a sovereign default (which didn’t happen).

Some good points were made though, notably how this is the first global crisis in over thirty years which was not magnified in Brazil.  Brazil’s strong external balance sheet (the public sector is a net creditor to the rest of the world), sound macro policy framework, and well-capitalized banks moderated the shocks coming from the U.S.  The report featured a nice, though superficial, box on past financial crises in South America’s largest economy. 

In an article called “The Self-harming State,” the Economist highlighted how Brazil’s large, cumbersome state gets in the way of the private sector.  It’s no joke.  Very hard to open a business down there.  The report also noted that Brazil will likely grow nicely (4-5% per year) and could become one of the five biggest economies by mid-century.  Our poster child of a rising power.  Nothing to sneeze at, but China is set to become the number one economy on Planet Earth even earlier, perhaps in the 2020’s.  The Economist report, not characterized by analytical depth, does note that what Brazil has over China is its stable democracy, and over India, is relative social peace (despite high crime, there are no ethnic or border conflicts in Brazil). 

Yet the article fails to mention one of Brazil’s critical weaknesses:  fiscal policy.  Most of Brazil’s economic problems in the last half century can be traced to a mismanagement of public finances.  Government debt will represent about 70% of GDP this year, which is very high for an emerging market country.  Given that most of this debt is borrowed domestically — a good thing in that this limits Brazil’s exposure to currency shocks — the private sector is consequently crowded out of the credit markets, which constrains GDP growth.  China and Russia have much, much lower government debt burdens.  Further, the Lula administration, which should be praised for its general adherence to sound policies and a market orientation, as well as for its substantive efforts to reduce income inequality, has gotten cocky and reduced its commitment to restraining government spending.  The Economist should have told us more about that…

A link to the report follows, as does an excerpt:

http://www.economist.com/specialreports/displayStory.cfm?story_id=14829485

From the Economist:

“BRAZIL has long been known as a place of vast potential. It has the world’s largest freshwater supplies, the largest tropical forests, land so fertile that in some places farmers manage three harvests a year, and huge mineral and hydrocarbon wealth. Foreign investors have staked fortunes on the idea that Brazil is indeed the country of the future. And foreign investors have lost fortunes; most spectacularly, Henry Ford, who made a huge investment in a rubber plantation in the Amazon which he intended to tap for car tyres. Fordlândia, a long-forgotten municipality in the state of Pará, with its faded clapboard houses now slowly being swallowed up by jungle, is perhaps Brazil’s most poignant monument to that repeated triumph of experience over hope.

Foreigners have short memories, but Brazilians have learned to temper their optimism with caution—even now, when the country is enjoying probably its best moment since a group of Portuguese sailors (looking for India) washed up on its shores in 1500. Brazil has been democratic before, it has had economic growth before and it has had low inflation before. But it has never before sustained all three at the same time. If current trends hold (which is a big if), Brazil, with a population of 192m and growing fast, could be one of the world’s five biggest economies by the middle of this century, along with China, America, India and Japan.”

China’s History Lessons

November 19, 2009
Presidents Hu and Obama in Beijing Tuesday.  Source:  www.lepoint.fr
Presidents Hu and Obama in Beijing Tuesday. Source: http://www.lepoint.fr

Presidents Hu and Obama finished their summit in Beijing and issued a joint statement.  Below, Christiaan Tuntono of CSFB notes that President Obama didn’t get a commitment from China to revalue the RMB against the U.S. dollar, which would effectively increase Chinese demand for U.S. exports.  As RMB undervaluation is a key focus of such Congressional China-bashers as Senator Chuck Schumer, President Obama may return home perceived as being soft on China.

As caretakers of not only the planet’s most populous nation (and third largest economy), but also of a 5000-year old civilization, China’s leaders study history.  Not that they always learn the right lessons.  What they learned from the Asian financial crisis of the late 90’s was that a country must hold a fortress of foreign exchange reserves, so as not to be at the mercy of international capital.  The likes of Korea, Thailand and Indonesia were made to grovel at the feet of the IMF because they ran out of fx reserves. 

Likewise, Tuntono suggests that what China learned from 1985 Plaza Accord on exchange rates was not to give in to pressure to revalue your currency.   At that time, the U.S. economy was floundering in part due to a strong U.S. dollar.  So, Japan agreed to bolster the yen, allowing a depreciation of the dollar, in order to reduce the U.S. trade deficit and jumpstart the U.S. economy.  Consequently, recessionary conditions in Japan led to a loose monetary policy, sparking Japan’s asset price bubble and ultimately a decade of stagnation.  China hopes to avoid the same by resisting calls to strengthen the RMB.  With so many U.S. treasuries in the bank, China is in a good position to just say no.

From CSFB November 19, 2009:

Christiaan Tuntono
+852 2101 7409
christiaan.tuntono@credit-suisse.com
The China-US joint statement mentioned neither the RMB exchange rate nor China’s commitment to purchase US Treasury securities, suggesting that the two sides may not have reached consensus on these contentious issues. US President Obama concluded his visit to China on 18 November and released a joint statement with China President Hu Jintao the day before to highlight the consensus reached during this visit. The statement under the “economic cooperation and global recovery” section seems to be in line with the existing economic policies pursued by the two sides, but the lack of mention of the RMB exchange rate seems to suggest that the two sides continue to disagree on this issue. Under the economic section, China promises continued adjustment on economic structure and to raise the contribution of domestic demand to its growth. The US pledges it will increase national saving, promote non-inflationary growth, and return the federal budget to a sustainable level. In our view, the promises suggest that China will gradually decrease its reliance on exports, while the US will protect the safety of China’s investments. The lack of reference to the RMB, despite what was widely considered to be the focus of this meeting, reflected China’s refusal to identify it as the tool to rebalance its economic structure. The Chinese also refrained from making any statement to suggest its support for US Treasury securities, as it would like to see how the US manages its fiscal account and inflation, in our view.
We think the statement is positive for China, but Obama may face pressure back home from critics accusing him of being soft on China. We think Obama may face criticism from the conservative wing in Congress and the general public for sidelining the issue of the RMB exchange rate in the joint statement. In our view, the US may have a higher priority now in cementing China’s support for US Treasury debt, and is in a weak position to push on the exchange rate front. We believe China will appreciate the RMB at its own pace and do not anticipate major move in the near term. The recent statement in the PBoC’s 3Q09 monetary policy report already revealed Beijing’s changed attitude in benchmarking the RMB more against other global cross rates, which may achieve a better balance against the EUR and JPY as the USD weakens. With the memory of the 1985 Plaza Accord and its impact on the Japanese economy in mind, we believe China’s policymakers would opt to boost private consumption and domestic demand as the means for global rebalancing, rather than a sharp rise in the RMB. We also think that this could be a better solution for the rest of the world.

Obama in China: Who’s the Superpower?

November 17, 2009

Presidents Obama and Hu (cartoon).  Source:  Google Images

President Obama did a good job this week in China.  Goodwill is a valuable intangible in politics, and he engendered some on his Asian trip.  Still, the gloss is off the family car — the superpower with hat in hand is an oxymoron.  The spectacle of the United States having to go to Beijing to explain health care reform, the biggest expansion of American entitlement spending in years undertaken in a year when government debt is skyrocketing, reminds one of Jimmy Carter’s infamous “Carter bonds.”  This embarrassing episode in U.S. economic history occurred in 1979, when U.S. government bonds were to be issued in deutchemarks in order to shore up the sagging U.S. dollar. 

C’mon, America, you can do better than that! 

Instead of having to explain America’s faltering public finances to our Chinese bankers, the administration should be planning a medium-term deficit and debt reduction strategy.  The financial relationship with China echoes too much of the relationship in years past between the IMF and the likes of Argentina and Turkey, Mexico and the Ukraine, periodically having to explain their messy public books.

The NYTimes reported this week that the Chinese grilled the president’s budget director, Peter Orszag, on health care reform — not on the public option, not on universal coverage, but on its impact on the budget deficit.  These are the kinds of questions the IMF asks countries with serious fiscal problems. 

President Obama is impressive on the world stage.  He did well in China this week, as he has done giving speeches across the globe.  On Iran, the impressive stance his administration has taken — tough, though measured, and thus far, persistent (see NYTimes article) — is to be praised.  He emphasized this issue with the Chinese this week as well.  But, let us not forget the view of international relations “realists,” that relative power remains the foundation of a country’s security, and in the case of a superpower such as the U.S., the pillars upon which important global institutions rest (the U.N., the IMF, the WTO, the World Bank, NATO, the G-20, etc.).  America should stick to its knitting, by enhancing internal sources of power — a strong economy, sound public finances, a sound currency,  a healthy banking system — as a counterpart to external sources of power — good relations with other great powers, alliances. 

It is understandable that the Democrats would undertake an expensive health care reform this year.  They want this legislation.  It has its merits in terms of fairness in our society.  They have the majorities in Congress and control over two branches of government.  If they don’t do it now, they may miss the opportunity, when the Republicans have their inevitable electoral surge.  Witness the losses of two governers’ mansions this month in New Jersey and Virginia, despite the president’s active campaigning.  So, health care reform now is understandable from a political perspective.  It just remains fiscally irresponsible, as government debt moves toward 90% of GDP.

Granted, a fiscal tightening right now would be premature, would take away the only stimulus active in the U.S. economy.  But, a plan, a program, to restore fiscal health — in a word, credibility — would reassure not only America’s foreign investors, but Americans themselves, uneasy over the management of the economy.

This was the 800-pound gorilla in the Forbidden City this week.  Sure, staunching a trade war between the U.S. and China is arguably as important as improving America’s finances.  Sure, working diligently on climate change is probably the issue most critical to our planet in the long run.  And, cooperating on policy toward Iran and North Korea is a very high priority, as is human rights, a cornerstone of America’s mission in the world.  Nevertheless, all of these issues can be advanced more effectively by a United States more in control of its destiny.

Medvedev: Glasnost and Perestroika all over again?

November 13, 2009

Russian President Medvedev and his mentor, Vladimir Putin.  Note: this is not a photo from Medvedev's speech this week.  Source: www.russiablog.org

Not so fast.  President Medvedev has resounded the main themes of reform for some time now, without his government (or, rather, Putin’s) following through.  See a NYTimes article from yesterday on President Medvedev’s annual address to the Russian nation, as well as a report on the matter below in a CSFB Emerging Markets report.

Reducing Russia’s humiliating dependence on energy exports and the role of state enterprises in the economy, and adding flexibility to labor markets and greater pluralism to Russia’s proto-democracy were all laudable goals mentioned in his speech, delivered at the Kremlin with Putin in attendance.  Mere platitudes devoid of concrete measures, critics say.  Maybe so, but the first step toward change is talking about it openly. 

Russia may have a positive future and a greater potential to join Fukuyama’s end of history in terms of being a functioning liberal democracy and market economy than other authoritarian countries, such as China, Saudi Arabia, Iran, to mention a few, where the lack of nascent democratic institutions distinguishes them (though Iran has a few).  Russia looks a bit like the Iberian, Greek and Latin American authoritarian regimes just before their transitions to democracy in the 1970s-80s; these societies yearned for the freedoms and prosperity of the West.  One day, Russia will join Europe and the West, if Europe and the West will have them.  Institutions such as the EU and NATO remain closed to Russia.  Remember what Kissinger said about NATO expansion — alliances have to be against somebody.  That way of thinking has to change in the West, and then maybe Russia will accelerate Medvedev’s reforms.    

From CSFB today:

Sergei Voloboev
+44 20 7888 3694
sergei.voloboev@credit-suisse.com
President Medvedev’s annual state of the union address yesterday contained criticism of past economic policies and some specific economic and political reform proposals. With a reference to his “Russia, Forward!” article published on 10 September, Medvedev has called for the country’s comprehensive modernization, based on democratic principles. Referring to the reasons for Russia’s particularly painful economic contraction during the recent economic crisis, the president mentioned the economy’s primitive structure, “humiliating dependency” on raw materials and general reliance on export receipts, appallingly low competitiveness of Russia’s manufacturers, as well as insufficient efforts to adopt a new growth model. Medvedev stated that even though the situation in the banking system has stabilized, it remains weak and insufficiently capitalized.
Medvedev mentioned the following specific directions for economic reform:
– further reform of the financial sector, which needs to be brought in line with the modernization requirements;
– a long-term reduction in the size of the state sector (from about 40% at present);
– transformation of state corporations operating in competitive environments into joint stock companies and liquidation or sale of all other such corporations by 2012; and,
– introduction of tax benefits for innovation-related activities and of a transition period to higher levels of mandatory insurance contributions.
– The president has offered a detailed view of the needed technological modernization, including the following:
– urgent commencement of technological modernization of the entire manufacturing base;
– creation of a modern technological centre – a Russian Silicon Valley;
– introduction of energy-saving equipment, bulbs, meters for use by utility services;
– wider application of space technology in the telecommunication industry;
– introduction of supercomputers;
– universal access to broadband Internet;
– development of strategic information technologies; and,
– a three- to four-month limit on granting approvals for new investment projects.
Encouragingly, the address contained specific proposals aimed at easing access to Russia’s labour market for qualified foreign workers, including a simplified visa regime and issuance of long-term visas, adoption of a more uniform approach to recognising foreign higher education diplomas and other educational degrees. Medvedev also mentioned certain measures in the area of political modernization, including a gradual phasing out of constraints on activities of small political parties and allowing such groups to occasionally participate in parliamentary meetings.
Overall, Medvedev’s policy address was fairly robust in criticising Russia’s recent economic policies, but it was predictably short on specific details on how to implement and observe the proclaimed reform objectives. It should nevertheless encourage the liberal-oriented part of Russian public that became very concerned about Russia’s democratic principles in the aftermath of the flawed municipal elections in early October. Representatives of the business/ investor community have likely noted the commitment to streamline the tax system further but were probably disappointed about the lack of more specific details.
October fiscal data points to rebalancing of revenue sources. This morning’s regular set of monthly fiscal data (for October) contained few surprises. There was another large monthly deficit (RUB179bn, 4.9% of monthly GDP, after 4.6% of GDP in September), taking the 12-month deficit to 6.5% of GDP from 5.5% in September. The monthly revenue/GDP ratio edged up to 18.4% of GDP from 18.3% in September on the annual basis; revenues fell to 17.5% of GDP from 18.0% in the previous month. Total expenditure was 23.3% of GDP, up from 23.0% in September and rose to 24.0% of GDP on the 12-month rolling basis from 23.4% in September.
An interesting observation on the composition of revenues in October: the data shows a weaker energy component of revenue (8.1% of monthly GDP, vs. 9.6% in September), while non-energy revenues (which have been declining progressively since June) jumped to 10.4% of monthly GDP from 8.7% in September. Overall, the data continue to point to a very large deficit for the full-year 2009, but its magnitude now looks likely to be materially lower than the government had anticipated (close to 7% of GDP rather than 8.3% assumed during the drafting of the 2010 budget).
The first official estimate for Q3 2009 GDP was better than the government’s provisional estimate. Rosstat reported yesterday that Q3 2009 GDP fell 8.9% yoy (after Q2 GDP was down 10.9%). This was better than the Economy Ministry’s previous 9.4% estimate for Q3. The statistics office has not provided a seasonally adjusted QoQ growth estimate, saying only that growth was 13.9% qoq in volume terms. Any seasonal adjustment would not be very reliable this year because of a structural break in series, but it is now clear that the original government estimate of 0.6% qoq SA growth in Q3 will be surpassed significantly (not adjusting for working day differences, we would estimate that qoq SA growth in Q3 was close to 3% – a very strong result, just slightly weaker than the 3.5% qoq growth in early 1999, after the economy bounced back from the H2 1998 meltdown).

Photo above:  Russian President Medvedev and his mentor, Vladimir Putin.  Note: this is not a photo from Medvedev’s speech this week.  Source: www.russiablog.org

Colombia/Venezuela: What would Simon Bolivar say?

November 10, 2009
Colombian President Uribe and Venezuelan President Chavez hug, as Latin American Independence hero, Simon Bolivar, looks on.  Source: Google Images
Colombian President Uribe and Venezuelan President Chavez hug, as Latin American Independence hero, Simon Bolivar, looks on. Source: Google Images

Latin America is not usually high on the list of hotspots for geopolitical analysts.  Yet Hugo Chavez is threatening war against neighboring Colombia.  (See the note below from a JPMorgan publication today.)  Venezuelan President Chavez is America’s nemesis in the hemisphere, and Venezuela shares a long border with Colombia in the north of South America, facing the Caribbean.  The word is that Chavez is on friendly (financial) terms with the FARC, the murderous, drug-dealing insurgency that has plagued Colombian society for decades.  Yet Venezuela and Colombia are also important trading partners, though this trade has suffered amid recent tensions.  Chavez doesn’t like the close military ties Colombia has fostered with the United States, quietly intensified by the Obama administration earlier this year.  Meanwhile Chavez buys arms from US global competitor, Russia.  Conflict in Latin America has been rare in recent years, though there was a cross-border flare-up in early 2008 between Colombia and Ecuador, currently led by Chavez’s nationalistic ally, Rafael Correa, who won a second term earlier this year.  Apparently Correa allowed the FARC to operate across the border from Colombia, prompting the government of Alvaro Uribe to launch a raid against a FARC camp in Ecuador. 

Like Iran in the Persian Gulf, Venezuela wishes to be a regional power countering local U.S. allies, wielding its oil wealth to make arms purchases.  The best the U.S. could do to counter Venezuela’s threats is to move ahead with the Colombian free trade agreement, pushed aggressively by George W. Bush and scuttled by Democrats in Congress, including then Senator Barack Obama.  See a note on this I penned a year and a half ago.  President Bush openly talked about America’s strong alliance with Colombia.  It might be worthwhile for President Obama to do the same.

From JPMorgan’s Emerging Markets Today, 11/10/09

Colombia/Venezuela: Escalating political noise

Julio CallegariAC (55-11) 3048-3369 julio.c.callegari@jpmorgan.com

Ben RamseyAC (1-212) 834-4308 benjamin.h.ramsey@jpmorgan.com

Over the weekend, Venezuelan President Hugo Chavez told

his military and civil militias to prepare for a possible war

with Colombia, saying that “the best way to avoid a war is

to be prepared for one.” Chavez has been saying that the

military co-operation pact signed in October between

Bogota and Washington could set the stage for a US

invasion of Venezuela. The Colombian government, in turn,

has been highlighting that the agreement with the US is

intended to fight drug trafficking and insurgents within

Colombia, and responded to Chavez’s threats in a statement

saying “Considering the threats of war enunciated by the

government of Venezuela, the government of Colombia

proposes going to the Organization of American States and

the Security Council of the United Nations.” We remain of

the view that an actual armed conflict will not ensue,

particularly because the Venezuelan military would be

reluctant to actually fight Colombia (indeed, Chavez

would be entering dangerous territory if he sought to force

them). However, the threat of further deterioration of the

bilateral trade relationship is real. Indeed, we highlighted

last week that total Colombian exports decreased 11%oya in

September (the latest official figure available) while exports

to Venezuela dropped 50%. Moreover, partial data from

Customs, suggest that while total exports fell about 15%oya

in the first three weeks of October, exports to Venezuela

plunged 80%oya. The ongoing deterioration in Colombia’s

relationship with Venezuela should hurt bilateral trade even

more in the coming months.

Israel’s economy: weathering the storm

November 10, 2009
Source: Google Images
Source: Google Images

Much news and commentary you hear about the State of Israel has to do with geopolitics and the Arab-Israeli conflict (see my colleague Ben Moscovitch’s blog on this site for a nice selection.)  Settlements, will Abbas run or not, Iran’s plans to wipe Israel off the map, Israel’s thoughts about taking military action against Iran, the Goldstone Report on the war in Gaza, films about the war in Lebanon, and on and on. 

Not that this hyper-news about Israel is not important and interesting.  But, let’s step back and look at Israel from a “rising power” perspective — half highly indebted socialist country/half cutting-edge hi-tech and health sciences capitalist upstart.  Its economy has proven itself resilient to the intifada, to the tech bust of nearly a decade ago, and now to the US-led global meltdown. 

How so?  It’s about policy, stupid.  Sound economic policy, begun in the 1980s with a classic monetary stabilization program that reduced inflation, and deepened only a few years ago, by none other than Benjamin Netanyahu, as finance minister, with his Thatcherite restructuring of the economy (e.g., increasing the labor force participation rate by creating incentives for the religious to work) and his shift to a rules-based fiscal policy.  Israel still has a high government debt burden — above 80% of GDP.  But that is down from above 100% not long ago.  Meanwhile the rest of the world has caught up to Israel’s debt levels (with the U.S. now surging higher). 

On the external front, the country couldn’t look better — $60 billion in foreign exchange reserves, a current account surplus, and “net external creditor” status, that is, Israel’s claims on foreigners exceed foreigners’ claims on Israel (oh, how the U.S. would love to have that balance sheet!)

So, in spite its modest size, constrained by the country’s small population, the Israeli economy dwarfs those of many of its much poorer and poorly run neighbors.  Have a look at the Fitch press release below referencing a recent report on Israel and its sovereign credit outlook.

Fitch Affirms State of Israel at ‘A’/’A+’; Outlook Stable   
06 Nov 2009 8:22 AM (EST)


Fitch Ratings-London-06 November 2009: Fitch Ratings has today affirmed the State of Israel’s Long-term Foreign and Local Currency Issuer Default Ratings (IDR) at ‘A’ and ‘A+’ respectively with Stable Outlooks. The Short-term Foreign Currency IDR is affirmed at ‘F1’ and the Country Ceiling at ‘AA-‘.

“Israel has fared better than many other small, open economies in the recent global economic and financial downturn, suffering only a mild recession compared to rated peers in Europe and Asia,” says Paul Rawkins, Senior Director in Fitch’s London-based Sovereigns team. “Nonetheless, the downturn has exposed Israel’s key vulnerability to shocks, namely a high public debt ratio that looks set to exceed 80% of GDP in the wake of wider fiscal deficits in 2009-10.”

Fitch says an improved macroeconomic policy framework, coupled with structural reforms since the last recession in 2001-02, laid the foundations for strong growth in 2004-08, in line with the ‘A’ median of 5%, rendering the economy markedly more resilient to shocks. With the exception of Bahrain, China and Poland, Fitch expects Israel to be the only country in the ‘A’ range to escape an outright recession in 2009. This performance is attributed largely to aggressive monetary and exchange rate policies, aided by a relatively trouble-free banking sector and an absence of asset price bubbles. Structurally, Israel’s high-tech manufacturing and services sectors have proved unexpectedly resilient to declining global investment demand, presaging a near record current account surplus in 2009.

Israel’s high public debt ratio remains the key constraint on its sovereign ratings. The adoption of rules-based fiscal policy in the wake of the last recession has served Israel well; limits on the growth of public expenditure and a ceiling on the state (i.e. central government) deficit facilitated a contraction in general government debt to 78% of GDP at end-2008 from a peak of 100% in 2003. Even so, this ratio remains high relative to the peer group median of 37%, although it is not the most extreme (‘A-‘ rated Greece exceeds 100% of GDP). Moreover, considering the mildness of its recession and an absence of financial sector-related support, the current external shock has taken a heavy toll on the public finances, chiefly on the revenue side. Fitch expects Israel’s general government deficit to widen to 6%-7% of GDP in 2009-10, on a par with rated peers Malaysia and the Czech Republic, which have experienced much steeper recessions, while pushing general government debt up to over 84% of GDP by end-2010.

While Israel’s experience with fiscal rules has been mixed, the current framework has entrenched fiscal discipline and together with signs of a strong economic recovery, suggests Israel’s powerful public debt dynamics could reassert themselves by 2011, forestalling any further deterioration in the public debt/GDP ratio. The government envisages a sharp narrowing in the state deficit to 3% of GDP in 2011 (from 6% in 2009), but still hopes to adhere to tax cuts over the medium term. Fitch expects some revision to the fiscal rules, with greater prominence being given to the Maastricht public debt/GDP ratio of 60% of GDP. From a rating standpoint, a positive rating action would require a decline in the debt/GDP ratio to a level nearer to the ‘A’ median. Conversely, a prolonged rise in the debt/GDP ratio and/or sustained fiscal easing would prompt a negative rating action.

Externally, the Government of Israel became a net external creditor for the first time in 2008, although it still falls short of ‘A’ norms on this measure. Burgeoning international reserves – these have more than doubled to USD60bn since end-2007 – have been the key factor behind this status change for the sovereign, facilitated by a strong current account surplus and buoyant net capital inflows. The economy as a whole also passed a new milestone in 2008, registering a surplus of external financial assets over liabilities for the first time. Israel expects its standing on the international stage to be further enhanced by OECD membership in the near future.

Contact: Paul Rawkins, London, Tel: +44 (0) 20 7417 4239; Richard Fox, +44 (0) 20 7417 4357

Media Relations: Peter Fitzpatrick, London, Tel: + 44 (0)20 7417 4364, Email: peter.fitzpatrick@fitchratings.com.

Additional information is available on http://www.fitchratings.com.