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The Middle East politically hobbled but with major potential

A sustainable peace agreement between Israel and Palestine will be one of several important keys to achieving long-term stability in the Middle East and increasing the chances of developing the regions economic potential. Unfortunately this novices conclusion is that the near-term prospects for a peace agreement are microscopic, despite renewed efforts by the United States and other countries. The stability of the Middle East is also affected by the worlds efforts to find and adjust to a new geopolitical equilibrium and balance of power. The bright spot amid the gloom of conflict is the attitude and optimism among both Israelis and Palestinians, especially the young, that there are opportunities for both peace and new success in economic and industrial fields. Israels economy, the worlds 49th largest, has an underlying strength and major potential because of its innovation and development ecosystem. The discovery of large gas reserves in 2009 is creating both economic and political repercussions and challenges. Many of Israels problems are similar to those of other OECD countries (the functioning of the labour market, an ageing population, insufficient productivity). Corruption is also present. But the big economic take-off in Israel and nearby countries will not occur as long as the region remains unstable.
A travel report Israel and Palestine
Some 50 chief executives and board chairmen of companies and institutions participated in SEBs 2014 Nordic Business Delegation. During a few intensive days on location in Israel and Palestine, the group and SEBs top executives were exposed to stimulating lectures/discussions about the economic, financial and political situation in Israel and Palestine as well as the broader state of affairs in the Middle East. The presidents of Israel and Palestine were present on various occasions during the SEB conference. This report conveys some main conclusions from the conference and provides subjective reflections about the situation in and around the Middle East. The report is based on various types of information, for example from representatives of the political sphere and the private and public sectors, as well as international reports.

MONDAY MARCH 24, 2014

This issue of Economic Insights, including the travel report, is organised as follows. It begins with an attempt to summarise the political situation in the Middle East and the prospects for stability. It then describes the economic and financial situation and the outlook for Israel and to some extent Palestine as well. The final part focuses on Israels desire and ability to remain an innovation and high tech incubator.

Israeli-Palestinian peace agreement is far away The unfinished conflict between Israel and Palestine, the ongoing crises in Syria and Lebanon and the Arab Spring dominate day-to-day life in the region. Although a new round of attempted peace negotiations between Israel and Palestine began in 2013, with the US as the clear driving force, the chances of an early solution to the conflict must be regarded as still microscopic. A long-awaited peace agreement will not be a matter of achieving a perfect marriage between two possible states but of bringing about a proper divorce. It will be necessary to focus the attention of the two sides not on the price of the accord, but on the returns that such an agreement would bring to both. At least in the international community, there is a vision of a two-state solution in which Israel and an indepen-

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dent, viable, contiguous, democratic Palestine can live side by side in peace and security. But there are many differences between the two sides economic, historical, cultural and religious and Israel continues to establish new settlements that are helping undermine the prerequisites for constructive peace negotiations. Do the Israelis really want peace instead of gaining access to more land and do the Palestinians really want their own state?

stable development, but from an economic standpoint it is perhaps mainly China that may need to assume a more active political role, a task for which to put it mildly China is untested.

Israels balance sheet gets high marks Israels economy has shown impressive resilience to the 2008-09 global recession as well as the geopolitical uncertainty that continues to dominate the situation in the Middle East. The explanation can be found in strong macroeconomic fundamentals, including a surplus in Israels external transactions (current account), comparatively low government debt and a banking system with limited global linkages.

If Israel and Palestine can reach agreement, the EU which is Israels largest trade partner, buying 30 per cent of its exports and others offers the prospect of political, economic and security policy support to both sides, as well as greater access to the European market.

The security policy situation poses major challenges to the region. For Israel in particular, there are four areas that will determine stability in the near term. Aside from the conflict with Palestine, Israel can expect developments in Iran to influence its situation; the thaw between Iran and the international community will enable Iran to continue developing nuclear technology, which many view as an opportunity for Iran also to develop nuclear weapons technology. This may change the balance of power in the region in a new and destabilising way. In addition, uncertainty about the next stage of the Arab spring is also a factor than will have an impact on Israels future role in the region. The fourth area that will determine the stability of the region and affect Israel is the probable shift in US involvement in the Middle East. Increasing US energy independence (shale gas/oil) is expected to result in a reduced American presence in the Middle East and an increased focus instead on Southeast Asia, a region of growing economic importance to the US and the world. This would create a political vacuum that in light of the prevailing instability needs to be filled by someone else. It is in the interest of the world, and of course also the US, that the Middle East should undergo

Over the past decade, unemployment has fallen from 14 to 6 per cent without creating upward pressure on wages and salaries, which continue to grow by about 3 per cent annually. Israels labour market can be descrybed as flexible, with a decentralised wage formation model. Inflation is restrained and under control within the central banks target interval of 1-3 per cent. The economy is growing by about 3.5 per cent year-onyear; this is also the forecast for 2014 and 2015. Government debt is on its way down and is below 70 per cent of GDP today. The governments target is to bring debt down to 50 per cent of GDP by 2020. This will be achieved both through higher taxes (income and corporate taxes have been raised) and lower public expenditures, which are allowed to grow according to the fiscal rule: a rate of increase equivalent to yearly population growth (today 1.7 per cent) plus one percentage point. Israel has 7.7 million residents 60 per cent under the age of 25 with an estimated 20 per cent of them living in relative poverty. However, the average living standard is high and GDP per capita is in 40th place in the world.

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monitored with great interest by countries that exhibit similar challenges but so far without any noticeable impact on credit expansion and the housing market. Israel: Real exchange rate and key interest rate

Israel is an open, market-based, innovative and export-oriented OECD economy (40 per cent of which is connected to foreign trade). It is one of the countries that invest the highest percentage of GDP on research and development. Israeli industry is characterrised by high-tech competencies which, along with a strong entrepreneurial spirit, have elevated the country to a leading position in such fields as information and health care technology.

But there are many problems and challenges Under the surface, and behind its strong overall financial ratios, Israel also has many problems that need to be corrected over the next few years. For example, observers describe the economy as winnertake-all; there is corruption in a number of areas. The public sector is Greek-like and dysfunctional. Companies are not exposed to enough competition and productivity is low outside the high-tech sector. In addition, Israeli society is characterised by increased economic inequality, various weaknesses in the educational system and individuals/groups that find it difficult or are unwilling to enter the labour market.
There are additional factors that represent both threats and opportunities to the Israeli economy (aside from the obvious political ones). These include rapidly rising home prices, the appreciation of the shekel and management of expected future natural gas revenues. Home prices. Housing supply is limited and the construction permitting process is slow. Along with low interest rates, this has caused home prices to climb by 80 per cent since 2007. Meanwhile household debt remains low: 40 per cent of GDP in Israel, compared to 150 per cent in Denmark and 70-90 per cent in Sweden, Norway and Finland. The rapid rise in home prices represents an increased risk to financial stability and hampers labour mobility because of lock-in effects, lowering the long-term production capacity of the economy. Since 2009 the authorities have been using numerous macroprudential tools in an attempt to slow home price increases these efforts are being

The shekel. The Israeli currency has appreciated by a full 20 per cent (both in nominal and real terms) since 2007. Today the shekel is trading higher than its historical average and can be regarded as overvalued. Contributing factors are capital inflows from direct investments (purchases of start-ups) and speculative inflows due to expectations of further currency appreciation as an effect of natural gas production. Israels central bank has cut its key interest rate (0.75 per cent today) in order to limit currency inflows and has also launched a currency intervention programme (selling shekels for foreign currencies) based on predetermined amounts. Natural gas production. A few years ago in 2009 Israel discovered enormous natural gas reserves in the Mediterranean Sea. Since April 2013, production has been under way. According to forecasts, Israel will be self-sufficient in energy 4-5 years from now. The reserves are expected to last for 20-40 years. Exports can eventually begin. To avoid the Dutch disease1, Israel is creating a sovereign wealth fund (similar to that of Norway) that will channel export revenues into investments abroad in a controlled fashion. It is worth noting that even today, Israels assets abroad exceed its debts by the equivalent of 20 per cent of GDP. The central banks currency reserve today totals more than USD 80 billion.

The Dutch disease is the name for a set of problems that affect countries/economies that for example suddenly discover large, valuable commodity resources. The phenomenon arose in the Netherlands when that country discovered natural gas in the late 1950s. Normally the currency appreciates due to expectations of future positive capital flows, creating a risk that old export sectors will be priced out of business.

Key interest rate, per cent

Exchange rate index

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tical, commercial technology. A special Office of the Chief Scientist (OCS) in the Ministry of the Economy is entrusted with participating in discussions and providing financial support to cover up to 50 per cent of company R&D expenses.

The conclusion is that today, Israel can show impressive economic and financial strength something that is unlikely to change during the next few years. Both the government and the central bank are working systematically to build strength for the future as well and to avoid the Dutch disease.

Palestinian economy surrounded by uncertainty The picture of Palestines economy is not so easy to determine, and there are a number of obvious questions about the reliability of the available statistics. Palestine has a scattered population of about 5 million that is growing by about 3 per cent annually. Its economy is growing by about 2.5 per cent annually, and the inflation rate is 3.5 per cent. Palestines most important trading partner is not so surprisingly Israel (75 per cent of all exports). Unemployment varies between different areas and is around 25 per cent on the West Bank (youth unemployment is much higher). Palestine is heavily dependent on development assistance from other countries.
Palestines economic potential can be found in agriculture, tourism, stone mining and quarrying, the construction sector and IT. Its prospects are limited by an unclear political situation, including interruptions in international and domestic trade flows. Palestine is totally dependent on foreign financial assistance to cover its budget deficit, and its day-today transactions with other countries result in large shortages (a current account deficit of 20 per cent of GDP). The challenge is to be able to generate high enough economic growth to keep up with relatively rapid population growth. In addition, unemployment is disturbingly high.

There are several driving forces behind this ecosystem, aside from a customised industrial policy. Military investments and a large development sector in the defence industry have produced results that have broader areas of application. The immigration of engineers and technicians from Russia and elsewhere in the early 1990s also created a knowledge base for development work, while targeted partnerships with universities and the availability of a well-educated labour force further strengthened innovative power. Israel has three universities that are ranked among the worlds 100 most important educational institutions. The foundations for a good education are laid at a very early stage in the educational chain, and students are encouraged to study scientific subjects. Meanwhile sizeable resources are invested in teachers. Looking ahead, the focus will be on enabling Israel to assume a prominent role mainly in biotechnology and food production. Mentality also plays a major role. There is a strong entrepreneurial spirit and a great understanding of the need to let people make mistakes. Relations with public authorities are not surrounded with exaggerated respect, making possible a willingness to see opportunities rather than obstacles. Nor are the boundaries between industry, academia and the political sphere especially strict. Israeli forthrightness and clarity are also viewed as positive qualities that decrease the risk of misunderstandings. Some observers also cite the complexity of the Hebrew language and its different levels as a factor that allows multi-dimensional thinking. At present, Israel has more than 4,000 start-up companies in the high technology sector. Israel is regarded as one of the few countries that have succeeded in creating a market-based venture capital system that

Israels start-ups and innovative power Israel has succeeded in creating an innovation ecosystem that includes optimal infrastructure, risk allocation and social targets, with the government playing a key role in the system. The role of public authorities is not to replace the private sector or predict the next developmental step. But there is a deep-seated political understanding that economic success is based on being able to convert and apply basic research to prac-

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can offer financing even at an early stage. The sec-tor accounts for 10 per cent of the labour force but 40 per cent of total exports. More than 300 foreign companies have chosen to have a development centre in Israel, and for many of them it is their only establishment outside of their home country. Epilogue economic potential, political obstacles Shimon Peres, the president of Israel, summarised the current situation of his country with the words politics is old but technology is new. Israel and Palestine have the potential to flourish economically through stability and cooperation. Israels innovation and development ecosystem, drive and entrepreneurship are features that other countries should be trying to systematically copy. The elements are in place to create a huge economic boost for both Israel and Palestine, but the deadlocked political situation continues to prevent such a positive economic development.
Robert Bergqvist, robert.bergqvist@seb.se, mobile +46 70 445 1404 Twitter: @BergqvistRobert