ISRAEL: BALANCE OF PAYMENTS AND THE ROLE OF US AID

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• Content Type: REPORT

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STAT
Israel: Balance of Payments
and the Role of US Aid
State Dept. review completed
Confidential
NESA 82-10576
November 1982
Copy 2 7 4
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Israel: Balance of Payments
and the Role of US Aid
Confidential
NESA 82-10576
November 1982
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Confidential
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Israel: Balance of Payments 25X1
and the Role of US Aid
Key Judgments Israel faces a large and growing financial gap over the next several years,
Information available the more so if Finance Minister Aridor attacks triple-digit inflation at the
as of I October 1982
was used in this report. expense of the country's balance-of-payments position. The civilian goods
and services deficit will widen dramatically under present government
policies. The problem will be exacerbated by slow growth in exports since
manufacturers are finding a growing domestic market for their goods.
Even under Israel's present procurement plans, the military deficit will also
grow as defense imports outstrip US military aid; this deficit could grow
substantially if the Israelis move to replace equipment lost or damaged
during the invasion of Lebanon.
US financial assistance has been and will continue to be vital to Israel.
Even if US aid continues at present levels, the Israeli Government will be
forced by dwindling foreign exchange reserves to take austerity measures
by 1986. If US aid were cut off, austerity would probably have to be
introduced as early as next year, at the cost of economic growth. If the
United States took less drastic action, for example, eliminating economic
aid and grants on military assistance, Israeli officials could probably put
off such measures until 1984.
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iii Confidential
NESA 82-10576
November 1982
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Confidential
Israel: Balance of Payments
and the Role of US Aid F_
We have used the CIA econometric model of Israel to
project the financial gap-the sum of the civilian
goods and services deficit, self-financed military pay-
ments, and debt repayment-likely to face the Israeli
Government under various scenarios.' A baseline sce-
nario was generated assuming that the Israeli Govern-
ment continues current economic policies and US aid
remains at current levels. We then looked at several
alternative scenarios, comparing them to the baseline.
Baseline Scenario
With the help of the econometric model, we project
that the financial gap could easily increase from $4
billion this year to $7.5 billion in 1985, barring
changes in Israeli economic policies or external
shocks. We have assumed that the government will
increase real domestic military spending over the next
few years as a result of the invasion of Lebanon, while
domestic nonmilitary expenditures will be cut in
1982-83 to help keep the budget deficit from increas-
ing, and then rise slowly in 1984-85. Economic growth
in the OECD countries, which is a factor in determin-
ing Israeli exports, is assumed to be a moderate 2 to 3
percent per year.
Traditional sources of financing-private transfers,
bond sales, and US economic aid-are unlikely to
keep pace. Thus, we believe Israeli officials will be
forced to rely even more heavily on foreign bankers-
primarily in the United States-for short- and
medium-term loans if they want to avoid drawing
down foreign exchange reserves
Israel has had little difficulty managing this year's
financial gap. The trade deficit has widened by $150
million so far this year, according to available data.2
Export receipts through the first eight months are
6 percent below the same period last year due princi-
pally to growing domestic demand, although recession
' A discussion of the Israeli econometric model and the effect of
several possible economic policies appears in the appendix.
Z Due to a strike at the Central Data Processing Office earlier this
year, import data for February and March are unavailable
Civilian goods and -1,671 -2,718 -2,214 -2,219
services balance
Exports 6,841 8,289 10,119 10,841
Goods 4,075 4,717 5,800 5,929
8,512 11,007 12,333 13,060
5,282 6,916 7,454 7,459
Services 3,230 4,091 4,879 5,601
Self-financed military 293 250 250 497
imports
Military import 1,690 1,420 2,018 2,404
payments
Debt repayment
900
893
1,025
Financial gap
2,864
3,861
3,489
Sources of financing
3,968
4,299
3,777
Unilateral transfers
1,229
1,400
1,471
US economic
assistance
875
980
785
Other capital
including short-
term borrowing
1,327
1,501
1,064
1,730
4,446
4,591
1,521
785
1,799
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in Europe and the United States and temporary
disruptions caused by the invasion of Lebanon are also
factors. Tourism Ministry officials estimate that tour-
ist receipts will be reduced by at least $100 million-
because of the fighting, the number of visitors to 25X1
Israel this summer has dropped sharply, compared
with the same period last year.
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Table 2
Israel: Baseline Financial Gap a
Civilian goods and -2,471 -3,458 -4,519 -5,471
services balance
11,739 12,981 14,248 15,651
Self-financed military -66 224 696 606
imports
Upper range of
projection
Lower range of
projection
Foreign exchange reserves-$3.5 billion at the end of
June-have held steady so far this year, implying that
the Israeli Government has been able to find the funds
to cover the financial gap. No capital flow data for
this year are available; thus, we do not know the
extent to which the Israelis have had to resort to
commercial bank borrowing. Aridor said he hopes to
raise an additional $200 million in bond sales-
roughly equivalent to the increase after the 1973
war-in the wake of the Israeli invasion of Lebanon.
The projected average annual real GNP growth rate
of 4 percent through 1985 will boost civilian imports
by nearly 5 percent a year in real terms. At the same
time, exports will be held to only a 2.4-percent annual
growth. Because Israeli producers can switch rapidly
between the domestic and foreign markets and plants
are running at about capacity, export growth tends to
be sluggish when domestic demand is buoyant. As a
result, the civilian goods and services deficit could
reach $5.5 billion by 1985
According to the weapons procurement schedule out-
lined in the aid request the Israelis presented last
year, foreign exchange expenditures for weapons will
outstrip US military aid by $1.5 billion in 1983-85.
We are assuming that scheduled drawdowns of Sinai
redeployment aid and Foreign Military Sales (FMS)
credits will be continued at $1.4 billion a year-the
level Congress approved for FY 1982. The adminis-
tration has proposed FMS credits of $1.7 billion for
FY 1983. The Israelis may revise their procurement
plans, particularly if they want to replace equipment
lost or damaged during the invasion of Lebanon.
We believe Israeli officials will find it difficult to
avoid drawing down reserves before 1986. Unilateral
transfers and Israeli bond sales, which covered almost
half of last year's financial gap, are unlikely to
increase much faster than the 6-percent annual
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Million Us $ Figure 1
Israel: Projected Traditional
Capital Inflowsa
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Confidential
Since 1962 the United States has provided $20 billion
in financial assistance to Israel; military aid totaled
$14.3 billion, while economic support amounted to
$5.7 billion. US military and economic assistance
was $2.7 billion last year-$1.6 billion was grant aid.
Israel last year garnered nearly half as much foreign
exchange from US aid as from its commodity ex-
ports. Israel will receive $2.9 billion this year-$1.3
billion as grants-the single largest recipient of US
aid. Because almost half of the aid Israel has
receivedfrom the United States since 1962 has been
in theform of grants rather than loans, debt servicing
costs are much lower than they otherwise would have
been, thus narrowing the financial gap.
The administration has proposed that Foreign Mili-
tary Sales (FMS) credits be increased by $300 mil-
lion to $1.7 billion in FY 1983. In addition, a Senate
subcommittee has passed legislation increasing eco-
nomic aid by $125 million to $910 million-equiva-
lent to the principal and interest payments owed on
debt to the US Government. A recommendation was
made that future economic aid be at least equivalent
to the debt service owed to the United States.
growth rate recorded since 1978. Contributions from
Jews living abroad do not respond to economic crises;
donations soared in 1974 after the October 1973 war
but fell back to traditional levels in 1975 and 1976
when Israel was in a severe foreign exchange crunch.
Aridor's goal of increasing bond sales by $200 million
may not be met if Jews abroad who do not support
Begin's policies in Lebanon choose to withhold contri-
butions. US economic aid is scheduled to remain at
$785 million.
The Israeli Government will be looking to commercial
bank borrowing over the next few years to provide
funds to cover a growing portion of the financial gap
at a time when bankers are becoming increasingly
concerned about international lending. We believe
that bankers think the US Government and foreign
Jews, Israel's two largest creditors, would not press
for payment in a squeeze; thus, the bankers are
willing to carry more Israeli debt than they would
normally consider prudent. Nevertheless, bankers
may be unwilling to increase their lending to Israel by
the amounts that would be needed to avoid foreign
exchange reserve drawdowns in 1984 and 1985.
Anti-Inflation Program
According to the US Embassy, Aridor plans to an-
nounce a new program to bring the inflation rate
down to 85 percent within a year-consumer prices
for the first eight months of the year rose at an annual
rate of 135 percent. The major element of the pro-
gram is a limit on the depreciation rate of the shekel
to between 4 and 5 percent per month to restrain the
rise in prices of imported goods. Since taking office,
Aridor has advocated using exchange rate policy to
fight inflation. He now has a governor of the Bank of
Israel-Moshe Mandelbaum-who we believe will go
along with this scheme because he has supported 25X1
Aridor's policies across the board; Mandelbaum's
predecessor opposed such a policy because of the
damage it would do to exports and refused to imple-
ment it. 25X1
The gains on the inflation front will come at the
expense of Israel's balance of payments. Using our
econometric model, we project that by 1985 the
financial gap would be $2 billion larger- than under
the baseline scenario. We used the same assumptions
as in the baseline except that we limited the deprecia-
tion rate of the shekel to 4.5 percent per month from
October 1982 to December 1983-the time period in
which Aridor wants to meet his inflation goal. In
addition, the annual average real GNP growth rate
would be a percentage point lower.
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Figure 2
Israel: Financial Gap Under Various Scenariosa
Assuming Eliminsdion Assuming No US Aid
of Grants and Economic
Assistance
Assuming Shekel
Depreciation Policy
Slowing the depreciation rate will reduce the competi-
tiveness of Israel's exports, resulting in export volume
declines of 1 percent annually compared with growth
of 2.4 percent in the baseline scenario. According to
US Embassy reporting, officials of the Manufactur-
ers' Association have criticized the plan because of its
detrimental effect on exports; the Association, howev-
er, does not have much political clout and probably
would not be able to dissuade Aridor. Although lower
prices will increase demand for imported goods, this
will be offset by the impact of lower growth, and the
real annual growth of civilian imports will be a
percentage point lower than in the baseline case. The
greater impact on exports, however, will increase the
civilian goods and services deficit
If the depreciation rate is reduced, we believe Israel
would probably have to start drawing down reserves
as early as next year, when most of the impact of the
shekel depreciation policy would be felt. The financial
gap would be $1.5 billion larger in 1983 than in the
baseline scenario. Commercial bankers may be reluc-
tant to extend additional financing if they perceive
that the Israeli Government is deliberately pursuing
policies that are exacerbating its balance-of-payments
situation. In addition, Aridor may need to use some of
the $3.5 billion in reserves to defend the exchange
rate.
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Confidential
Using our econometric model, we have estimated the
tremendous impact of US military and economic aid
on the Israeli economy. Assuming the absence of all
US aid this year and no Israeli policy adjustments,
the financial gap would have been $2 billion, or
almost 50 percent, larger than in the baseline case.
Foreign exchange reserves could have been depleted
to cover the larger gap, but policy adjustments would
have quickly become necessary. If the Israeli Govern-
ment had tried to protect its foreign exchange posi-
tion-we assumed government spending was reduced
to offset the decline in revenues-real GNP would
have declined by nearly 4 percent instead of growing
by the 3.6 percent projected in the baseline case.
The impact would have been less if for example, the
United States had continued to provide military
aid-but totally in the form of loans-and no eco-
nomic aid. Economic growth this year would have
been 0.2 percentage point lower than in the baseline
scenario, and the financial gap would have been $40
million larger. Since economic aid is used to cover
the gap, the Israeli Government would have had to
use some of its foreign exchange reserves to cover the
financial gap unless commercial borrowing was
arranged.
The impact would be much greater than implied
above, however, because US assistance has a cumula-
tive impact on the Israeli economy over time. If for
example, US aid were totally cut off through 1985,
the financial gap in that year could reach $9.3 billion,
compared with $7.5 billion in the baseline case.
Although real GNP in this scenario would grow
faster than in the baseline, this would result from
lower inflation due to higher imports. The Israelis,
however, could not afford the resulting deterioration
of their balance of payments.
Foreign exchange reserves would quickly be depleted,
forcing Israeli officials to take action. If government
spending were reduced to offset the decline in reve-
nues, the financial gap in 1985 would be $3.3 billion
lower than in the baseline scenario, but real GNP
would decline at an average annual rate of 5 percent.
compared with average annual growth of 4 percent in
the baseline.
Moreover, commercial credit has probably been more
generous as a result of the financial resources provid-
ed to the Israeli Government by the United States.
We believe bankers would probably interpret any
kind of aid reduction as a sign of US displeasure with
Israel and, depending on the severity of the US
action, limit their own lending or charge higher
interest rates.
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Likely Adjustments to Government Policy
The financial gap implied by these scenarios will force
the Israelis to press for additional US aid or to
implement austerity. We believe the Israeli Govern-
ment would only resort to a major austerity program
to deal with its balance-of-payments problems if there
were no other options. Israeli officials are reluctant to
incur the political costs involved in a meaningful
austerity plan. These officials have also publicly stat-
ed that they have a moral obligation to provide a
healthy economic climate for foreign Jews taking up
permanent residence in Israel.
Instead, Israeli policymakers would prefer to make up
the difference between the financial gap and tradi-
tional sources of funds through increased US aid or,
alternatively, commercial borrowing. The Israelis
have enough foreign exchange reserves-$3.5 billion
is sufficient to cover more than five months of civilian
commodity imports-to cushion the impact of Ari-
dor's exchange rate policy or potential US aid cut-
backs for a time.
At some point-by 1985 in our baseline scenario and
even sooner under Aridor's exchange rate policy or in
the event of reductions in US aid-dwindling foreign
exchange reserves will force the Israeli Government to
implement austerity measures. If this became neces-
sary because of lower amounts of US aid, particularly
if aid was completely cut off, we believe the Israeli
Government would attempt-probably successfully-
to generate public support for austerity by claiming
the measures were necessary in order to demonstrate
its independence from the United States.
25X1 r
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Conf dendai
Appendix
The Israeli Econometric Model
and Various Scenarios
The CIA econometric model of Israel is designed to
make forecasts of Israeli economic performance. Us-
ing exogenous variables ranging from Israeli fiscal
policies to OECD growth rates, the model projects
various endogenous variables. These variables include:
? Measures of Israel's real domestic economic per-
formance, including GNP, private consumption, and
private investment.
? Israeli inflation as measured by the GNP deflator.
? Measures of Israel's balance-of-payments position,
including imports and exports and the exchange
rate.
Using the model, we have developed several scenarios
to measure the impact of Israeli policy changes or
external shocks. We started with a baseline scenario
that assumes that the Israeli Government continues to
pursue current economic policies and that US aid
Table 3
Israel: Baseline Scenario
remains at present levels. We then looked at what
would happen if Finance Minister Aridor follows
through on his plan to reduce inflation by slowing the
depreciation rate of the shekel. The average exchange
rate for 1982 and 1983 was set at the. level that would
result if the shekel depreciates by 4.5 percent per
month from October 1982 to December 1983.
We then tried to measure the impact of US aid on the
Israeli economy by eliminating all US military and
economic aid. In addition, we ran a scenario in which
Israeli officials reacted to the cutoff of revenues by
cutting government expenditures by the same amount.
To analyze the impact of US measures less drastic
than an aid cutoff, we ran a scenario in which only
economic aid is cut off and military aid is totally in
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Table 4
Israel: Shekel Depreciation Policy
Table 5
Israel: Eliminate Grants and Economic Assistance
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Table 6
Israel: No US Aid
Million US $
Civilian goods and services deficit
2,328
3,752
4,820
5,786
Self-financed military payments
2,055
1,958
2,133
2,014
Financial gap
5,928
7,180
8,333
9,255
Real government consumption
-5.6
-9.7
22.7
-6.9
Domestic nonmilitary
-5.0
-2.0
1.0
1.0
Domestic military
3.0
3.0
2.0
1.0
Foreign military
-16.5
-37.1
110.1
-22.8
Real civilian exports
1.1
3.9
2.8
2.3
Real civilian imports
1.9
12.4
6.0
3.9
GNP deflator
147.1
152.3
173.5
194.3
Table 7
Israel: Policy Adjustment to No US Aid
Civilian goods and services deficit
Self-financed military payments
Financial gap
Million US $
2,178
1,255
906
780
2,055
1,958
2,133
2,014
5,778
4,683
4,419
4,249
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Confidential
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