No. 427 April 2000
The Goals of Reform
Following the economic stabilization plan in 1985, several financial reforms were introduced in Israel which were designed to accomplish a number of goals:
- To reduce the level of government involvement in Israeli capital markets.
- To increase capital mobility.
- To promote competition in financing activities.
- To develop the Tel Aviv Stock Exchange.
These were the major, explicit goals as stated at the time. Later in the 1980s and the beginning of the 1990s, two other targets became important. The first was to address potential conflicts of interest in Israeli financial markets, primarily between different activities of the commercial banks. The second issue, which over time came to be understood as more and more connected to the proper functioning of capital markets, was privatization and how it fit into capital markets.
Here we will address the reforms that have taken place over the past fourteen years, review the successes and the issues which have been less successful, and see what remains to be done.
Domination by Government and Banks
Before the reform, the government was the major borrower as well as creditor in the Israeli economy. It in effect set the rate of return of capital by issuing subsidized government bonds which bore interest rates well above market rates. The government issued these bonds to pension funds and provident funds, which together represent much of long-term savings in Israel, as well as to insurance companies. It also offered different subsidized bonds to banks.
In this way, the government set the rate of return on most savings. It also functioned as an intermediary when it turned around and loaned these funds either to the business sector or used the funds to finance the government’s debt and deficit, which were still very substantial in the early 1980s.
A second feature of the Israeli financial system still valid in the early 1980s was that the banking system was extremely dominant, with the Tel Aviv Stock Exchange very small, very illiquid, and of little importance. The banking system was very concentrated, with the three large banks at the time representing about 85 percent of all banking activity, and the banks were engaged in a wide range of financial activities.
At the same time, the system was facing the effects of the 1983 bank shares crisis, which resulted in the government taking over the banks and becoming the controlling shareholder of the three largest banks as well as some others.
These are the features that should be kept in mind in recalling the situation in the early 1980s. In addition, there were a number of macroeconomic features that influenced financial markets, beginning with the very large internal public debt. By 1985, the internal public debt, as a percentage of GDP, exceeded 100 percent, and this does not even include the public debt abroad, just the local debt. With the addition of the overseas debt, the annual deficits were very large, peaking at about 13 percent of GDP, and throughout the early 1980s were about 8-10 percent of GDP.
As was explained at the time, the government had very great financing needs, and the desire for the central allocation of capital was the reason why the government had to be involved in capital markets. In order to ensure the funding of the deficit, the government provided high rates of return to savers.
Since the government expropriated all capital market funds, it had to be active in the granting of credit because otherwise no one would be able to fund any activity. Indeed, the reforms came about after the government decided to stop being the almost sole financial market intermediary. At the same time, there was a major drop in the deficit beginning in 1985 and continuing afterwards.
The Government Steps Out
Since the economy was growing rapidly in the 1990s, the internal public debt as a percentage of GDP fell dramatically, and this enabled the government to step out, since the need for such large funding no longer existed. In a sense, this was a precondition for enacting the reforms. The drop in internal debt was even more dramatic than in the late 1980s and early 1990s when a good part of the repayment of debt was foreign debt rather than local debt. While Israel remains at levels of debt considerably above the Maastricht levels (60 percent of GDP), there are no longer the orders of magnitude that existed in the early 1980s.
The nature of government involvement, beginning in the 1980s, may also be seen in the composition of the government debt, by comparing the liquid non-subsidized bonds to the subsidized bonds held primarily by the pension funds. In 1985-86, the gross domestic debt was about 120-123 percent of GDP. It is now down to the high 90s. (See Table 1, column 4.)
As noted, the part of the debt which is not liquid bears interest rates which have nothing to do with the interest rates in the economy. From 1990 to 1992 there was a very big drop in this component, with a decline from 66 to 40 percent of GDP. Since 1992 this percentage has remained fairly constant. In other words, the progress in turning the still very large government debt into a liquid debt was being realized up until about eight years ago.
The liquid debt indeed grew from 1985 to 1990 and then remained more or less constant. The overall size of the internal debt showed a major decline from 1990 to 1992, falling from 115 to 95 percent of GDP, though this figure has been fairly constant since then. Therefore, as we can see, the reforms that took place in the mid-1980s manifested themselves in the early 1990s, but since then further progress has been flat.
Compared to other countries, the weight of corporate bonds as a percentage of GDP is very tiny and it was never high. There seemed to be some indication in the late 1980s and early 1990s that this might become significant, as it rose from 2 to 7 percent, but there have been virtually no corporate bonds issued since then, and as the existing stock has been redeemed over time, the percentage has gone down.
Let us finally look at the weight of the Tel Aviv Stock Exchange as a percentage of GDP. Here the calculation is somewhat different from the standard one since we remove from the stock market value that part of the stock market which is owned by the government, and that part which really constitutes a double counting, involving shares owned by other traded and listed companies, in order to avoid counting the same assets twice. This constitutes a very large component of the Israeli stock exchange, about 30-32 percent of market capitalization. It is somewhat misleading to talk about the larger amount as reflecting wealth or reflecting the position of the Israeli public in the stock market because it does not. After making the necessary adjustments, we see that about a quarter of GDP is in the stock market, a very low figure compared to other countries, but compared to the late 1980s and early 1990s it represents a big jump. One could say that there has been a large development of the Tel Aviv Stock Exchange, but we still have a way to go.
Relaxation of Restrictions
Returning to the reform and its consequences, one major precondition was a reduction in the budget deficit. Another aspect of the reform was the relaxation of investment restrictions. Up until the mid-to-late 1980s, the provident funds, which represent a large portion of long-term saving in Israel, were required to buy government bonds. When this requirement was changed, the provident funds bought more liquid assets and, at the same time, they invested more in the stock market.
There was also a relaxation of financing restrictions. In particular, until the mid-to-late 1980s, it was very difficult to issue corporate bonds or stocks because corporate financing of that sort required government approval. There were other restrictions as well that related to the banking sector. Another reform was the gradual elimination of direct credit, the process by which the government came in and acted as a direct intermediary providing credit to different parts of the Israeli economy, primarily to exporters and manufacturers. Another result of some of these reforms was a large jump in the role of equity financing of Israeli companies, with an IPO (initial public offering) wave in Israel in the early 1990s and later on in New York. (See Table 2.)
One issue on which there are different opinions is the degree to which banking competition has been enhanced. On the one hand, the possibilities of borrowing abroad have increased dramatically. Also, there is some evidence that lending rates have become more competitive. On the other hand, some continue to suggest that there is not enough competition in banking.
Another issue which is still open is the level of conflict of interest in universal banking. The Brodet committee which investigated this issue concluded that there should be some divestitures of real holdings of the banks so that banks would not hold more than a certain percentage of the assets of non-banking companies.
A Move from Government Bonds to Stocks
To see the effect of some of these reforms, let us first look at the provident funds, because they are still the largest long-term vehicle through which savings are made. In 1988, at least 78 percent of their assets had to be in government bonds. They could not hold more than 8 percent of their assets in corporate bonds and equity or in other investments. Indeed, the investments largely conformed to these limitations. Actually, the provident funds held a bit more government bonds than they needed to hold. Moreover, most of the government bonds they held were subsidized or illiquid bonds.
The government stopped issuing these bonds to the provident funds in the mid-1980s, and by 1994 we could see a number of results. First of all, the minimum amount of government bond holdings was reduced to 50 percent, and by 1994 the provident funds held 61 percent, down sharply from 86 percent. The portion of non-negotiable bonds dropped from 54 to 18 percent as the older bonds were redeemed and the portion of the liquid bonds rose from 32 to 43 percent. Looking at the data today, we see that the illiquid bonds are being phased out.
If we look at the holdings of corporate bonds, there has been no change from 1988 to 1994. However, equity holdings went from 1 to 11 percent. This is in part because the ceiling on holdings of corporate bonds and equity jumped substantially from 8 percent to 50 percent. Nonetheless, the provident funds are today nowhere near the ceilings according to which they are allowed to invest in equity and bonds. They have actually very dramatically increased their holdings of deposits (known as “GICs” in the United States). In 1994 they were close to the 25 percent ceiling that they were allowed to hold, with 22 percent. That ceiling has been relaxed and they are holding more of these assets. Therefore, there has been a movement away from government bonds to the stock market, but not as much as was hoped for, and certainly not as much as we would see in parallel institutions in other countries.
The role of the stock exchange has grown dramatically in the 1990s, raising millions of shekels, after being insignificant in the mid and late 1980s. In the early 1990s the local stock market was dominant, while beginning in 1995 the U.S. stock exchange became important.
Government’s Continuing Role
Despite the phasing out of credit and other subsidies, the Ministry of Industry and Trade still plays a very large role in the financing of industry. Looking at the components of this financing, there are capital grants, under the Law for the Encouragement of Capital Investments, and also the exercise of loan guarantees. At the beginning of the 1990s, the government offered a program by which certain companies could opt for loan guarantees instead of receiving capital grants. Now, only in the last three or four years have some of these loan guarantees been exercised; that is, the companies have defaulted and the government has been forced to step in. We can see that in recent years the capital grants and the exercise of guarantees have totaled close to two billion shekels.
R&D grants, net of royalties, have also gone up dramatically, with a big jump in 1993-94, although the figures have remained fairly constant since then. In the last few years, the government has been collecting royalties, so the gross outlays have actually grown, but there has been some revenue recovery.
All of these components together still total a substantial amount of support for industry — some three billion shekels a year. Industry gets a lot more than other sectors of the economy, but there are other sectors that get some funds as well.
Types of Credit
There are three key components to credit. The first is directed government credit, which was basically phased out in the late 1980s and early 1990s. At the same time, particularly when the directed credit was phased out, domestic bank credit jumped dramatically and in recent years has also become a major factor. Indeed, this can be viewed as one successful aspect of the reforms, where the banking system is providing the credit instead of the government directing the credit. In recent years, credit from abroad has been a negative figure in industry at least, though this is not true for building and other sectors of the economy. Even though these industrial firms are able to borrow abroad, for many years they were paying off debt. Therefore, the issue is more one of availability rather than the actual flow of credit.
Looking at the effects on the Tel Aviv Stock Exchange and of IPOs abroad, in Israel there were many IPOs in the industrial sector and in other sectors as well in 1992, 1993, and 1994, together totalling over 140 IPOs in those years. The amount in the United States was fairly constant, growing in 1996 and afterwards. The IPOs that take place in the United States involve larger sums of money. But all this is indeed a reflection of the growth of the Tel Aviv Stock Exchange and of the role that the New York Stock Exchange is playing in providing funds for Israeli industry. What we can see, however, is that the companies that go abroad are all in high-tech, software and electronics, whereas those that issue in Israel are mostly non-high-tech.
What Remains to be Done
Let us now look at what remains to be done, what we should be thinking about, and how this might lead to reforms in the financial markets.
The first issue is that, despite the economic growth in Israel in the early 1990s through 1996, there have been virtually no productivity gains throughout this decade. Cumulative economic growth in the 1990s is overwhelmingly explained by the growth of inputs of both labor and capital, while productivity has been flat. When one takes into account the cost of labor and output prices, this has resulted in a real drop in rates of return on capital in the national accounts. There is a gross and net rate of return on capital. The net rate in 1998 after depreciation was about 5 percent. This is a rate which is low by any international comparison and lower than the rate of return on government bonds in Israel today.
This raises the question first as to whether such a situation is sustainable. It may in part explain the slow-down in the Israeli economy in the last few years, because one might imagine with these rates of return that investment would be less attractive. But the question we should ask ourselves is: Can capital markets play a role in doing something about this problem?
Another issue for discussion involves the holdings of the provident funds, because the results have not been entirely as hoped for. While it is true that they no longer buy government-subsidized bonds because they are not offered, the funds have not become players on the stock market to the extent hoped for. They also apparently do not provide an impetus to the kind of corporate governance that was hoped for as well.
A related issue and perhaps a larger one over time is the role of pension funds in the capital markets. The pension funds, as opposed to the provident funds, overwhelmingly hold government-subsidized bonds, which continue to be issued to the pension funds. The role that is played by pension fund managers in other countries simply does not take place in Israel.
Despite some reforms regarding pension funds, it is very doubtful that these reforms will create a major shift in the role of pension funds in capital markets. This is a political hot potato because at the moment the pension funds not only are issued subsidized bonds, but the government has promised over time to cover any or all deficits as they arise. As a result of these two issues — the subsidized bonds and the actuarial promise — the incentives are not there for the pension funds to act differently from the way they are acting now (even if legal restrictions were lifted).
There is the budgetary cost to the government of covering these deficits, as well as issuing these bonds, as well as granting tax exemptions which are, for the most part, more extreme than in other countries. Calculating all of these effects together, depending on the assumptions, one can come up with numbers showing that the government is providing an equivalent rate of return as high as 15-20 percent.
What is happening is that the government is raising funds from the pension funds at very high rates of return and using them either for current spending or for investments in infrastructure. However, it is unlikely that in any of its activities the government is realizing rates of return as high as these. The question is how to unravel this. On the one hand, a change in the pension fund system would mean a worsening of conditions for those already in the pension funds. On the other hand, it is not entirely clear whether the current system is sustainable. If it were to be sustained somehow and the government was willing to bear the costs, it may have detrimental effects for the capital markets over time, which is an issue that has to be addressed.
Much depends on the assumptions one makes. For example, the rate of entry into the new pension funds is very critical. There actually seems to be a fairly robust rate of entry, which is worrisome. Much depends on the rate of growth of the Israeli economy. If the long-term rate of growth in Israel is 2-2.5 percent, this system is clearly not sustainable. If it were to be 5 percent, it could be borne at a higher cost, with everybody subsidizing those who are in the pension funds.
Another issue is that this system has the potential of not allowing Israel to reduce its level of debt over time to the Maastricht levels. It could be that the government’s commitment to issue these bonds is such that it will have to be in debt in an amount greater than 60 percent. Moreover, if the government has to issue these bonds to the pension funds, then virtually the entire government debt has to be illiquid.
There is clearly a need for a liquid market. That raises the possibility that the government might then come back into this as an intermediary, or will have some liquid debt.
Up until now, even though most of the government-owned companies that were privatized are listed on the Israeli stock exchange, the mode of sale was such that a kernel of control was sold by the Israeli government to “strategic investors” instead of allowing for a kernel of control to develop over time. This is an issue about which there are different views, but the policy implementation up until now has been almost uniform.
Another issue is how banking will evolve. Should there be separation of banking activities from other financial activity? Should banking be universal or not?
There is also the issue of corporate governance. Can we see over time the Israeli stock market providing the kind of monitoring for Israeli firms that we see abroad, or is the structure of ownership such that this is not likely to occur? With these layers of concentrated ownership, this is a problem.
The last issue relates to taxation. There has been a lot of talk in the past few years about the fact that capital markets are for the most part not taxed, while labor income is. Different committees have suggested taxing certain aspects of the capital markets. Yet it is important to keep in mind that for capital as a whole in Israel, there are those who do not get the assistance and the capital grants and who are subject to high taxation. It is not just the corporate tax: the capital gains tax for those who are not trading on the stock exchange is 50 percent. So the issue is not only one of labor versus capital, it involves capital markets and capital assets as a whole.
These are some of the major issues involving reform of the Israeli financial system that will have to be addressed in the next few years.