Outlook for 2011-15

• The ongoing political upheavals in the Arab world could pose new threats to Israel's security, particularly if radical Islamist movements were to gain a stronger foothold in neighbouring Egypt and Jordan.
• Although the prime minister, Binyamin Netanyahu, still retains a majority in the Knesset (parliament) after the recent departure of Labour from his coalition, we expect a fresh election to be held before the due date of 2013.
• We have raised our growth forecast for 2011 for the third consecutive month, to 4%. The pace of expansion will accelerate further in the latter part of the forecast period, to an average of 4.6%.
• Monetary policy will continue to be tightened. We now expect the Bank of Israel (the central bank) to raise its base rate to 3.5% by December 2011, and to 6.25% by the end of the forecast period in 2015.
• The budget deficit will continue to narrow. By 2015 we expect the overall fiscal position to have moved into surplus.
• The New Israeli shekel will weaken in the short term, influenced by regional uncertainties and official attempts to curb inflows of "hot money". Later in the forecast period there will be a renewed appreciation.

Monthly review

• The mass protests that have shaken the Middle East, particularly those in Egypt that brought down Hosni Mubarak, have caused considerable anxiety in Israel, as well as prompting a new source of friction with the US.
• Mr Netanyahu is facing intensified squabbling between his coalition partners over religious issues. The leader of Yisrael Beiteinu, Avigdor Lieberman, has threatened to bring down the coalition if he does not get his way.
• Following discontent over rising prices, the government has been obliged to introduce a number of concessions-including a reversal of the recent increase in excise tax on petrol and an increase in the minimum wage.
• To finance these concessions, the government has announced a spending cut of 1% encompassing all ministries-excluding defence, education and welfare. Planned reductions in direct tax rates may also need to be postponed.
• GDP expanded by an annualised 7.8% in the fourth quarter of 2010, exceeding market expectations by a large margin.
• The Bank of Israel raised its base rate by 25 basis points to 2.5% at its meeting on February 21st, following a similar increase the previous month. It was the first back-to-back rise since January 2010.

The political outlook will remain challenging, given the fractious nature of coalition politics in Israel. Thirteen parties are represented in the Knesset (parliament) and six in the government, which is led by the Likud party. Following the recent splintering of the Labour Party and its decision to go into opposition, the government controls 66 of the 120 Knesset seats, compared with 74 previously. The cohesion of the coalition will continue to be tested. Although the right-wing bias of Likud (which is led by the prime minister, Binyamin Netanyahu) and its coalition partners provides some ideological glue, there are a number of contentious issues that could easily lead to a rupture.

In the near term, the vexed question of settlement building in the West Bank and East Jerusalem is unlikely to prove such a divisive issue for the coalition as it was in the days when Labour was on board. But the rapidly-changing political circumstances in the Middle East have inserted a new factor into the equation. In particular, the ousting of the Egyptian president, Hosni Mubarak-a stout defender of the 32-year-old peace treaty between the two countries-threatens to increase Israel's international isolation. It has also added to the clamour from those (including the US) who argue that Israel needs to make much stronger efforts to secure a peace deal with the Palestinians. Although the US recently vetoed a UN Security Council resolution condemning Israeli settlements in the West Bank, there are signs that US patience may be wearing thin. There is likely to be concerted pressure from the US to resuscitate the stalled peace talks-much to the discomfort of Mr Netanyahu, who knows that this is an issue which could split his coalition. On the domestic front, draft legislation designed to ease the process of conversion to Judaism-backed by Yisrael Beiteinu, the second-largest party in the coalition, but opposed by Shas, the third-largest party in the government-has been the source of growing tensions. Mr Netanyahu has stepped into the fray by freezing the passage of the legislation. However, this has set him on a direct collision course with Avigdor Lieberman, the foreign minister and leader of Yisrael Beiteinu.

Parliamentary elections take place every four years. The next poll is not due until 2013. However, an earlier election could be triggered by a number of events, including the prime minister's resignation or the government's defeat on a no-confidence motion in the Knesset. Given the volatile nature of Israeli politics, it would be remarkable indeed if the current coalition were to complete its full term; no government has done so since 1984-88. The departure of either Yisrael Beiteinu, with its 15 seats, or Shas, with its 11 seats, would mean that Mr Netanyahu would automatically lose his majority.

The political upheavals in the Arab world-and, in particular, Egypt-have added to the sense of alarm among those Israelis who believe the country is facing a mounting existential threat. Although the 1979 peace treaty that Israel signed with Egypt has been in some respects a disappointment (see In focus), there is no doubting its importance in ensuring a lengthy period of peace between the two nations, as well as securing important co-operation on security matters-especially along Egypt's border with Gaza. If a democratically elected regime eventually assumes power in Egypt, we believe that it is unlikely to rescind the peace treaty, given the mutual benefits that it confers. But a much more worrying outcome for Israel (and the West) would be an Egyptian government dominated by the Muslim Brotherhood. Although the movement is making strong attempts to shed its pariah status, its refusal to acknowledge the legitimacy of the Israeli state-together with its support for the Hamas-led administration in Gaza-are perceived as serious threats by Israel.

Impact of events in Egypt on Israel

For Israel, the 1979 peace treaty with Egypt has been both a crucial benefit as well as a big disappointment. Both of these contrasting aspects have been thrown into sharp relief, as the turmoil in Egypt puts the treaty's future in doubt.

The agreement was Israel's first with an Arab state and, as such, was widely expected to usher in a new era of Arab acceptance of the Jewish state. In fact, the reverse happened. The Egyptian regime was discredited for many years and lost its place as the undisputed leader of the Arab world. Israel only began to win very limited acceptance in the 1990s with the Madrid and Oslo peace processes that led to agreements with the Palestinians and with Jordan.

Nor has 32 years of formal peace with Egypt gone much beyond official (government-to-government) relations. Israel remains subject to unofficial boycotts by Egyptian intellectuals and business. It is regularly vilified in the Egyptian media. Egyptian tourists do not visit Israel and, although Israelis visit Egypt's Sinai Peninsula beaches whenever their government is not warning them of imminent terrorist attacks, few travel to Cairo, Luxor or Aswan in the heart of the country. Excepting a big natural gas contract and some Israeli textile operations in Egypt, there is little bilateral trade.

However, Israel does benefit from the treaty in two critical ways. First, Egypt-the largest and most powerful of Israel's direct neighbours-is no longer a strategic threat to Israel. In fact, it often quietly fulfils the role of strategic partner. It has co-operated with Israel in containing the Hamas regime in Gaza and has been active in US-led efforts to restrain Iranian ambitions in the region. Without Egypt, Syria-the only country that constitutes a threat to Israel in conventional military terms-stands no chance in a direct confrontation.

The second important benefit is Egypt's emergence in recent years as a supplier of natural gas. Although this role is set to fade as Israel develops its own offshore gas discoveries, Egypt currently supplies 40% of Israel's rapidly growing needs. Israel's newest and biggest fields will not come on stream until 2013 at the earliest. Consequently, Egyptian gas is critical for Israel in the meantime (although it should be noted that there is a risk that the continued supply of gas could be adversely affected by probable legal action within Egypt against the Egyptian company concerned).

Both these benefits are mutual-and, arguably, no less valuable to Egypt than to Israel. Thus, whether and to what extent the treaty is at risk depends on the kind of regime that finally emerges in Egypt. Israel had previously made it quite clear that its own preference was for Hosni Mubarak to remain in office, as a long-standing ally and known quantity. Following the Egyptian president's departure, Israel may derive some short-term comfort from the fact that an army-led regime, of the sort now in power, is unlikely to seek any major change in bilateral relations-particularly as the Egyptian army is closely tied to the US, owing to the US$1.3bn in annual aid that it receives. Looking further ahead, if a democratic, secular regime were to emerge in Egypt-of the kind apparently favoured by the majority of protesters in Tahrir Square in Cairo-it would also be unlikely to rescind the treaty.

Nonetheless, some cooling in bilateral relations appears to be almost inevitable. Egypt's determination to stand up to Iran could also weaken, if only because it will become more inwardly focused. Egypt's decision to allow two Iranian naval vessels to transit the Suez Canal has already been greeted with considerable disquiet in Israel. Meanwhile, the worst-case scenario, and Israel's greatest fear, is that Islamists eventually take over in Egypt, either through elections or by exploiting the chaos. The Muslim Brotherhood, which publicly supports democracy, makes no effort to hide its antipathy to the Jewish state and some of its leaders have called for both the gas deal and the peace treaty to be revoked. An Islamist Egypt would lose US backing-both financial and military-but it would take the entire region into unexplored and dangerous territory.

Israel is also monitoring closely developments in its eastern neighbour, Jordan-the only other country in the Arab world with which it has signed a formal peace treaty. The new government appointed by King Abdullah II has announced a series of reforms. However, popular protests are continuing, with the largest opposition group- the Muslim Brotherhood-playing a prominent role.

Direct peace talks between Israel and the Palestinians ground to a halt last September after just three weeks. The Palestinians-frustrated with what they perceive to be Israeli intransigence-seem determined to press ahead with their efforts to secure a UN resolution that recognises Palestine as an independent state. The aim is to use UN backing as a means to apply increased pressure on Israel for a negotiated settlement. Mahmoud Abbas, the president of the Palestinian Authority, recently ruled out a unilateral declaration of an independent Palestinian state, saying that it would be unworkable without Israel's collaboration. The resumption of direct talks therefore remains the essential, but elusive, first step along this road.

Israel will remain focused on the strategic threat from a potentially nuclear-armed Iran but is not expected to attack Iran's nuclear installations unless it has the support of the US. This support is unlikely to be forthcoming. Meanwhile, tensions between Israel and Hizbullah, a Lebanese Shia group, will remain high. Following the collapse last January of the national unity government in Lebanon, a new prime minister-designate-Najib Mikati-has been appointed. Although Mr Mikati is a Sunni, his appointment was orchestrated by Hizbullah. There are concerns in Israel that this could pave the way to a much more confrontational stance than was the case with the previous, pro-Western, government of Saad Hariri. There has also been a renewed upsurge in tensions over Gaza. Israeli air strikes on the Hamas-controlled territory have been accompanied by rocket fire from Gaza aimed at neighbouring Israeli towns.

The counter-cyclical measures introduced during the global downturn are steadily being withdrawn, as the economic recovery that began in the second quarter of 2009 gathers momentum. With recent GDP numbers surprising on the upside-and led by resurgent domestic demand-we expect the Bank of Israel (the central bank) to step up the pace of tightening.

Mr Netanyahu has a well-known preference for tax cuts, privatisation and economic liberalisation. However, political, regulatory and fiscal constraints will limit his ability to push forward as fast as he would like. In response to a wave of recent protests, the government has been obliged to offer a raft of concessions designed to soften the impact on households of the rising cost of fuel and other sensitive items. As a result, planned cuts in corporation tax and personal taxation may need to be postponed in order to finance some of these concessions.

The privatisation of the Israel Discount Bank was recently completed. The government has also reduced its stake in Bank Leumi to 6.5%, after selling 5% of the company's shares to UBS of Switzerland in January 2011. However, the authorities have stalled on their plans to sell the postal service. The first phase of the privatisation of the ports is scheduled to begin shortly but will prove politically challenging, as will the restructuring of the politically powerful Israel Electric Corporation.

A new taxation structure for the energy sector has been approved by the cabinet and is now awaiting ratification in the Knesset. The new scheme is based on the recommendations of the Sheshinski Committee and will boost the government's share of oil and gas revenue to between 52% and 62%, from around one-third at present.

The budget deficit (excluding credit) narrowed to NIS 30.2bn (US$8.4bn) in 2010, equivalent to 3.7% of GDP. This was well below both the 2009 outturn of 5.2% of GDP and the original 2010 budget ceiling of 5.5%. Buoyant tax revenue-up by 7.5% in real terms-contributed to last year's better than expected performance, and is likely to remain strong over the forecast period, given the positive outlook for economic growth. Under the two-year budget for 2011-12, growth in real spending has been capped at 2.7% a year. However, additional spending constraints have recently been imposed on most ministries, in order to finance higher transportation subsidies (aimed at quelling popular unrest). The government is still determined to reduce the fiscal deficit to a maximum of 3% of GDP in 2011 and 2% of GDP in 2012. A key risk is that defence spending could escalate, on the back of the recent political turmoil in the region. Nonetheless, by the end of the forecast period in 2015, we expect the fiscal account to have moved into overall surplus, helped by rising revenue from oil.

Interest rates have been raised by a cumulative 200 basis points, to 2.5%, since the first move in the current tightening cycle took effect in September 2009. But real rates, based on forecast 12-month inflation, still remain negative. Rapidly rising house prices-up by over 17% in 2010-remain a key concern. The authorities have imposed stiffer criteria on mortgage lending, in an attempt to reduce speculative activity, together with other measures aimed at dampening the overheated housing market. However, the overall policy stance seems to be shifting inexorably in the direction of accelerated tightening, particularly as global pricing pressures feed through to the domestic economy and the volatile regional background makes the New Israeli shekel less attractive to foreign investors. We forecast an additional 100-basis-point increase in the policy rate over the remainder of 2011, taking it to 3.5% by December. This compares with our previous forecast of 3%. Monetary policy will continue to be tightened in 2012-15, as capacity constraints become more pronounced. We expect the policy rate to reach 6.25% in 2015.

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Israel's recovery from the global economic downturn has been rapid. According to the IMF, Israel's speedy rebound reflects a combination of decisive official action and a strengthened macro-financial policy framework. Official growth estimates for 2010 confirm the strength of the upturn. GDP increased by 4.5% last year, compared with just 0.8% in 2009. Furthermore, the pace of expansion accelerated to an impressive 7.8% in annualised terms in the final quarter. Other indicators, including the Bank of Israel's composite state of the economy index, suggest that the momentum has been carried over into this year. Although the annualised GDP numbers probably exaggerate the underlying pace of expansion, we have increased our forecast for 2011 growth to 4%. This compares with 3.4% just three months ago. One point of concern is the current growth mix: domestic demand has taken over from net exports as the main driver of the economy over the last two quarters. As a result, we expect the Bank of Israel to step up the pace of tightening, in an attempt to rebalance the economy and head off the risk of rising inflation. Despite a more restrictive monetary policy, we expect GDP to expand by an average of 4.6% in 2013-15, as export growth picks up on the back of a steadily improving global environment.

Private consumption rebounded strongly in 2010, helped by low real interest rates, declining unemployment and rising real wages. However, the scale of the increase was accentuated by the low base of the previous two years. As a result, we expect the pace of growth to moderate to 3.6% in 2011, from 5.2% last year. Despite rising interest rates and a postponement of planned income tax cuts, private consumption will remain robust over the remainder of the forecast period, supported by a further tightening in the labour market. Over the 2012-15 period, we expect consumer spending to grow by an average of 4.1%.

After slumping in 2009, fixed investment jumped by nearly 12% last year. Although prospects for fixed investment will remain sensitive to international developments, the exploitation of large natural gas deposits in the Mediterranean-which will necessitate significant investment in pipelines, terminals and associated infrastructure-will provide an important fillip over the medium term. Residential construction will also continue to recover. De-stocking was still a drag on growth in 2010. However, we believe that inventory building will re-commence in 2011, and will gather pace in 2012-13.

With exports accounting for around 40% of GDP, the level of foreign demand will remain a critical determinant of overall growth. Export performance is likely to be comparatively lacklustre in 2011. Despite a continuing recovery in the US economy, import demand from developed economies-particularly in Europe-will remain subdued. The relative buoyancy of emerging markets will provide an important offset. Exports to Asia (especially China and India) have been growing at a rapid pace-by 45% in 2010. We expect these markets to continue to outperform over the forecast period.

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Consumer price inflation ended 2010 at 2.8%, enabling the central bank to meet its 1-3% target for the first time in five years. However, a sustained increase in housing prices, which have an impact on the consumer price index (CPI) via the rental component of the index, is a continuing cause for concern. Following a recent re-weighting of the index, housing will have an even bigger influence on the CPI from henceforth (accounting for nearly one-quarter of the index). Imported inflation is also on the rise, on the back of sharply higher oil and non-oil commodity prices. Against this backdrop, we expect inflation to breach the 3% upper limit of the target range for much of 2011, averaging 3.4% for the year as whole. After a forecast dip in price growth in 2012-helped by a renewed moderation in global commodity prices-accelerating economic growth and increasing capacity constraints will push inflation back towards the top of the target range in 2013-15.

In an attempt to reduce the upward pressure on the shekel, the authorities recently unveiled a series of measures designed to curb the influx of "hot money". A 10% reserve requirement has been placed on local banks' derivative transactions with non-residents. In addition, by introducing reporting requirements for non-resident transactions above a certain size in the local-currency and fixed-income markets, the central bank has paved the way for a lifting of the tax exemption that foreigners previously enjoyed when trading short-term government debt. In the wake of these measures, the currency has indeed weakened-although arguably, it has been the political unrest in the Middle East which has played a more decisive role in reducing the inflow of capital into Israel. Given the ongoing political convulsions in the region, this uncertainty is set to persist for much of this year, and possibly beyond. A widening merchandise trade deficit will also weigh against the shekel in 2011, despite the attractions provided by rising local interest rates. Looking further ahead, we expect the current-account surplus to expand sharply in the latter part of the forecast period, leading to a renewed appreciation of the shekel.

The merchandise trade deficit will widen in 2011, as expenditure on fuel imports-which account for nearly one-fifth of total imports-increase on the back of higher world oil prices. However, helped by a continued strong performance by business service exports-predominantly software and other high-tech-related products-the surplus on the current account will still amount to a comfortable 1.5% of GDP. Later in the forecast period, the merchandise trade balance will start to benefit from reduced energy imports, as recent discoveries of offshore gas start to come on stream, boosting the current-account surplus to 4.5% of GDP in 2015. The precise impact of the gas windfall is difficult to quantify at this stage. But if predictions of a surplus for export turn out to be accurate, it will further bolster Israel's already strong balance-of-payments position, prompting calls for the establishment of a sovereign wealth fund.

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New strains developed in February for the Likud-led coalition of the prime minister, Binyamin Netanyahu. Having wriggled out of US demands for a settlement freeze and Palestinian peace talks-thereby neutralising what was widely viewed as the biggest threat to his coalition-he is now facing intensified squabbling over religious issues between his junior coalition partners, Yisrael Beiteinu and Shas, while new and unexpected tensions have emerged over the economy.

For many households, improvements in the overall macroeconomic situation have been overshadowed by sharply higher prices for food, water, energy and housing. Following these increases, a popular protest movement sprang up-to be joined by an unusual coalition of non-governmental organisations, comprising the Histadrut labour federation, the Manufacturers Association and the Union of Local Authorities, with the Histadrut threatening the government with a general strike. Coalition backbenchers also jumped on the bandwagon of popular discontent, criticising the finance minister, Yuval Steinitz, at a meeting of a faction of Mr Netanyahu's Likud party in early February and warning that Treasury policies would cost the party votes at the next election. A mass circulation newspaper, Yediot Ahronot, summed up the national mood with its February 8th headline, declaring: "The public is angry and you're ignoring it."

Mr Netanyahu responded with a series of measures, unveiled at a televised press conference on February 9th, reversing the increase in excise tax on petrol, increasing public transport subsidies and raising the minimum wage. The Histadrut, together with its partners, said that the measures did not go far enough. Nonetheless, protests that were meant to bolster the calls for a general strike flopped and the planned stoppage was called off three days later-although talks with the government over further concessions continued.

Mr Netanyahu also suffered a humiliating defeat at the hands of the Yisrael Beiteinu leader, Avigdor Lieberman, with whom he has clashed repeatedly over the last year. Mr Lieberman, as Israeli foreign minister, vetoed several proposed candidates put forward by Mr Netanyahu for the vacant post of Israeli ambassador to the UN. Instead, he has effectively forced Mr Netanyahu to appoint the ambassador to the UK, Ron Prosor, to the UN post, at the same time refusing to accept Mr Netanyahu's close adviser, Uzi Arad, as Mr Prosor's replacement in London.

More problems lie ahead. At a closed meeting of his faction in early February, Mr Lieberman declared that he would "go all the way" on key issues, including legislation-which Shas opposes-that would allow the army rabbinate to conduct religious conversions. According to Channel 10 television, Mr Lieberman told the meeting that the price for passing this law in its second and third readings "may be the dissolution of the government".

These developments within the coalition suggest that Mr Netanyahu may have erred in pushing the Labour Party out of the coalition, even though the defence minister, Ehud Barak, remains in government at the head of a rump four-member faction (Atzmaut). The leader of the Histadrut, Ofer Eini, who is closely affiliated with Labour, no longer has any interest in keeping the government afloat and is likely to cause trouble for the prime minister in the months ahead. Meanwhile, Mr Lieberman feels more powerful than ever and could, if he wishes, single-handedly bring down the coalition. Although he may not yet be ready to leave the government, he seems to be preparing the ground for his exit-perhaps when a formal indictment for alleged corruption is served against him, as is reportedly imminent.

Mr Barak's standing was further weakened when his candidate for army chief of staff (COS), Yoav Galant, was forced to stand down after the state comptroller accused him of appropriating state-owned land for private use and then lying about it. Mr Barak fought hard to keep Mr Galant's nomination on track, even proposing to appoint an interim COS to provide Mr Galant with more time to clear himself. However, Mr Galant eventually realised that he had no choice but to withdraw, and the recently retired deputy COS, Benny Gantz, was awarded the post.

The mass protests that have shaken the Middle East, particularly those in Egypt that brought down Hosni Mubarak, have caused considerable anxiety in Israel, as well as prompting a new source of friction with the US. While initially refraining from public comment on the turmoil in Egypt, Israel then lobbied the US aggressively in support of the embattled Egyptian leader-thereby angering the US administration, which had come to the conclusion that Mr Mubarak had to go.

At a January 31st press conference with the visiting German chancellor, Angela Merkel, Mr Netanyahu articulated Israel's fears regarding a possible Muslim Brotherhood takeover of Egypt and opined that conditions for democracy in Egypt were not yet in place. Following Mr Mubarak's ousting, the Egyptian military leadership announced that it would continue to honour the country's 32-year-old peace treaty with Israel, and Mr Barak quickly established direct contact with the new interim leader, Mohammed Hussein Tantawi. However, the future of Israeli-Egyptian relations remains fraught. The pipeline transporting Egyptian gas to Jordan was badly damaged by a bomb attack on February 4th, forcing a shutdown of the pipeline to Israel as well. The attack was the most evident and worrying sign that Egyptian security has lost control of the Sinai Peninsula adjacent to Israel. Much to Israel's consternation, Egyptian officials also gave their permission for two Iranian naval ships to pass through the Suez Canal on their way to Syria-the first time since the 1979 Islamic Revolution that Iran has sought to show its presence in the Eastern Mediterranean.

A grass-roots protest movement among middle-class Israelis that began on the internet-inspired by the revolutions in Tunisia and Egypt that made extensive use of social networks-has resulted in the government changing elements of its fiscal policy, with indications of a potentially much more fundamental change in the future. The protests initially focused on the price of petrol, where-in addition to monthly adjustments to reflect global developments-an increase in the excise tax (effective from January 1st) had boosted prices to a record level. However, the clamour soon spread to encompass price rises in bread, milk products and a variety of other basic consumer goods and services, including water and local government property taxes.

This inchoate protest movement was subsequently taken up by an alliance of major economic bodies. Forming a powerful ad hoc coalition under the leadership of the secretary-general of the Histadrut, Mr Eini, they demanded that the government reverse the recent rises in indirect taxes and basic goods. Despite the misgivings of the finance minister, Mr Steinitz, and some of his senior officials, Mr Netanyahu quickly caved in. On February 20th the cabinet approved a series of concessions, including a rolling-back of the excise tax rise, a 10% reduction in some public transport fares requiring an increased government subsidy of between NIS 300m (US$82m) and NIS 400m, a rise of NIS 450 (US$123) in the monthly minimum wage spread over this year and next, and a 20% increase in the household water quota charged at the cheapest rate.

In order to ensure that the budget framework remains intact, the extra spending or lost income implicit in these decisions will be covered by an across-the-board spending cut of 1% encompassing all ministries-excluding defence, education and welfare, which are the biggest spenders. Mr Steinitz is also looking into the possibility of deferring the cuts in income tax scheduled for 2012, either on corporations or individuals in the top income brackets. Given the current high level of tax revenue, this may not be necessary and Mr Steinitz reiterated his personal commitment to reducing direct taxes in a speech on February 21st. However, the mere fact that it is being considered represents a conceptual volte-face for the Netanyahu government and reflects growing opposition, even within Likud ranks, to a fiscal policy that seems to favour higher indirect taxes-hurting low-income households-while lowering direct tax rates, to the benefit of upper-income groups.

Stronger than expected GDP data for the last quarter of 2010-as well as a higher than expected inflation increase in January, together with rising global inflation-generated widespread expectations of a tightening in monetary policy at the Bank of Israel's meeting on February 21st. There was even some speculation that the central bank could be tempted to raise rates by more than 25 basis points-following seven quarter-point increases between August 2009 and January 2011. In the event, the central bank opted for another 25-basis-point increase. However, coming after a similar rise last month, this was the first time that there had been back-to-back increases since January 2010. The statement explaining the decision referred to the rise in both inflation and inflationary expectations, while singling out the ongoing rise in house prices and continued high rate of mortgage borrowing, as well as the strength of domestic demand. On the other hand, by noting that interest rates in the main developed economies remain very low, the Bank hinted at the risk involved in pushing Israeli rates too much out of line with those in Europe and North America-namely, that inflows of "hot money" could renew the upward pressure on the New Israeli shekel.

The government is continuing its efforts to cool the overheated property market via fiscal and other measures, as well as monetary policy. On February 8th Mr Steinitz and the chairman of the Knesset finance committee, Moshe Gafni, agreed a series of changes in property taxes. The price ceiling for apartments below which buyers are exempt from purchase tax-on the condition that they own no other home-will be raised from NIS 1.14m to NIS 1.35m. This measure is aimed at making apartments more affordable for young couples. However, purchase tax rates for buyers of second homes have been raised to 5% for apartments costing up to NIS 1m, 6% for those in the NIS 1-3m range and 7% for homes in excess of NIS 3m. The aim is to reduce the attractiveness of investment in second and third homes. But given the current boom conditions in the real estate market, it may simply provide a further boost to tax revenue from property transactions.

The publication by the Central Bureau of Statistics (CBS) on February 16th of its first estimate of GDP in the fourth quarter and second half of 2010 caused consternation among private-sector economists, because of its revelation of exceptionally strong growth. For the second half of 2010, GDP expanded at an annualised rate of 5.4%, with business sector GDP rising even faster, by 6.1%. Growth was domestic-led. Public-sector consumption outpaced private consumption, with annualised increases of 6.5% and 4.5% respectively. Fixed capital formation surged by 15.8%. Purchases of new vehicles provided a strong impetus to both private consumption and investment-with the heavy tax on these items generating a large share of the government's above-forecast tax revenue. The external sector, however, was a drag on growth: exports, excluding diamonds and start-up companies, rose by only 3.7% annualised in the second half, whereas civilian imports (net of ships, planes and diamonds) rose by 8.6%.

The most surprising aspect of the CBS release was the strength of fourth-quarter growth. GDP expanded by an annualised 7.8%, up from 4.4% in the third quarter and 5.2% in the second. However, the CBS reiterated its usual disclaimer, warning that the quarterly data tends to be volatile and that not too much weight should be placed on preliminary estimates.

When high GDP growth is unwelcome-or misleading

The news that Israel's GDP rose at an annualised rate of 7.8% in the fourth quarter of 2010 was quickly seized upon by the prime minister, finance minister and other government spokesmen as evidence of their successful management of the economy. But professional economists expressed both amazement and suspicion at this unexpected display of strength, which far exceeded the rate of growth in the earlier quarters of 2010.

When the initial excitement subsided, closer analysis of the data raised two sets of problems. Even if the numbers are taken at face value, the growth they reflect is concentrated in the wrong areas and appears unsustainable. Beyond that, the elevated figures for economic growth may be partly the result of statistical methodology rather than an underlying expansion of economic activity.

The data appears to tell a seemingly simple story: the domestic economy is in the throes of a consumer and investment-led boom, which is heavily focused on durable goods purchases by consumers and purchases of equipment by firms. But in both sectors, purchases of new vehicles are the dominant factor. To a significant extent, this represents a catch-up for the slump in such purchases recorded in 2009, during and after the global recession. It may also be the case that aggressive marketing of loans by the commercial banks is fuelling this consumption boom. What is almost certain, however, is that an annualised increase of 40% in consumption of durable goods, on a per capita basis, is unsustainable.

The flip side of the domestic strength is the weakness of exports. Although overall export growth ran at an annualised rate of 10% in the fourth quarter, this was much less than the parallel figure for imports-of 22.5% growth. Even worse, though, is the fact that "core exports"-excluding diamonds and start-up companies-rose at a negligible 1.1% annual pace in the fourth quarter, after falling 2.3% in the third, thus ending the year at a lower level than they had been in mid-year.

Thus, the data themselves do not represent an economic success story. But they may well be distorted anyway. In fairness, the Central Bureau of Statistics (CBS) is well aware of the potential shortcomings in its work. Every publication of quarterly national accounts data contains an italicised disclaimer on the front page noting firstly that the raw data undergo "seasonal adjustment" to take account of seasonality and the incidence of holidays. The CBS adds that "series of economic statistics in Israel are characterized by relatively high irregularity. This complicates analysis of developments on the basis of seasonally adjusted quarterly data, and it is preferable to evaluate developments over longer periods".

Several private-sector analysts have highlighted the problems stemming from the seasonal adjustment of quarterly data. Ron Eichel, chief economist at the Meitav investment house, has noted that on an unadjusted basis, the annualised rate of GDP growth in the fourth quarter was only 2.4%, and for the business sector alone, was actually negative, at -2.9%.

A different picture, at least of the industrial sector of the economy, emerged from the latest CBS data on manufacturing production, published on February 20th. For 2010 as a whole, the industrial production index rose by 7.8%. Industrial exports posted a 13.4% rise over 2009 and domestic sales climbed by 3% (both in fixed-price terms). Employment increased by 1.9%. But these trends reversed in the final quarter, with annualised trend data for industrial production declining by 6% during October-December. Sales, both to foreign and home markets also fell, by an annualised 6.2% and 1.9% respectively.

On February 6th, the prices committee of the CBS, chaired by its chief statistician, Shlomo Yitzhaki, published its bi-annual review of weightings for the consumer price index (CPI). The key change is an unusually sharp jump in the weighting for the housing component-which measures rental prices-from 20.7% hitherto to 24.4%. Consequently, housing will now comprise almost one-quarter of the CPI and developments in this sector will have an even bigger influence on overall inflation. Components with lower weightings included food (from 18.4% to 16.9%) and transport and communications (from 21% to 20.5%).

These changes were not yet in effect for the January CPI, which rose by 0.2%-above the consensus expectation-on the back of rises in the fuel, housing, fresh fruit, food and transport components. The 12-month trailing rate of inflation in January was 3.6%, above the target rate of 1-3%. Even more worrying is the fact that the annualised trend rate for the three-month period of October 2010-January 2011 was 6.1%, both for the overall CPI and for the CPI net of its housing component.

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Land area

20,325 sq km. This does not include the Gaza Strip, the West Bank, East Jerusalem and the Golan Heights, areas occupied by Israel in the 1967 and 1973 Middle East wars

Population

7,434,300 (mid-2009; Central Bureau of Statistics estimate), of whom 5,612,000 are Jewish

Main towns

Population at the end of 2007 (provisional data)

Jerusalem(a): 746,300 Ashdod: 207,300

Tel Aviv-Yafo(b): 390,400 Beersheba: 186,600

Haifa: 265,900 Petah Tiqwa: 188,900

Rishon le Zion: 224,500 Holon: 169,000

(a) Including East Jerusalem. b Municipality of the city of Tel Aviv-Yafo only, does not include population of greater Tel Aviv conurbation.

Climate

Mediterranean

Weather in Jerusalem (altitude 757 metres)

Hottest month, August, 19-29°C (average daily minimum and maximum); coldest month, January, 6-12°C; driest months, May-September, 0 mm average rainfall; wettest month, January, 133 mm average rainfall

Languages

Hebrew and then Arabic are the official languages; however, English and Russian are also widely spoken

Measures

Metric system. The metric dunum (1,000 sq metres) is also in use

Currency

The New Israeli shekel (NIS) became the official currency on January 1st 1986. 1,000 old shekels=NIS 100. There are 100 agorot in NIS 1

Time

2 hours ahead of GMT

Fiscal year

January 1st-December 31st

Public holidays

All religious holidays begin at sunset the day before. Some institutions also close the day before the major religious festivals. March 20th 2011 (Purim; banks only); April 19th-26th (Passover; first and last days are public holidays); May 10th (Independence Day); June 8th (Shavuot); August 9th (Tisha b'Av; banks only); September 29th (Jewish New Year); October 8th (Yom Kippur); October 13th (Sukkot starts); October 19th (Sukkot ends); October 20th (Simchat Torah); December 20th (Chanukah; school holiday)

Official name

State of Israel

National legislature

Unicameral Knesset of 120 members directly elected by proportional representation for a four-year term. Universal direct suffrage over the age of 18

National elections

Parliamentary election: February 1oth 2009; next election scheduled for 2013

Head of state

President (largely a figurehead), elected by Knesset majority for a five-year term. Currently Shimon Peres, who was elected in July 2007

National government

Cabinet, responsible to the legislature; the prime minister, Binyamin Netanyahu, leads a coalition government comprising his party, Likud, together with Yisrael Beiteinu, Shas, United Torah Judaism, Atzmaut and HaBeyit HaYehudi

Main political parties

Kadima (a centrist party formed when the then prime minister, Ariel Sharon, left Likud to found a new party; it includes defectors from Likud and Labour); Likud (right-wing; leads the new government); Yisrael Beiteinu (YB; a right-wing immigrant party); Labour (left-wing); Shas (a religious party); HaBeyit HaYehudi (right-wing); United Torah Judaism (an ultra-Orthodox party that includes Agudat Israel and Degal Hatora); Meretz; United Arab List; Hadash (communist, predominantly Arab); Balad (Arab)

Prime minister, economic strategy minister, pensioner affairs minister & health minister: Binyamin Netanyahu (Likud)

Vice-prime minister (& regional development minister): Silvan Shalom (Likud)

Vice-prime minister (& strategic affairs minister): Moshe Ya'alon (Likud)

Key ministers

Agriculture & rural development: Orit Noked (Atzmaut)

Communications: Moshe Kahlon (Likud)

Culture & sport: Limor Livnat (Likud)

Defence (& deputy prime minister): Ehud Barak (Atzmaut)

Education: Gideon Sa'ar (Likud)

Environment: Gilad Erdan (Likud)

Finance: Yuval Steinitz (Likud)

Foreign affairs (& deputy prime minister): Avigdor Lieberman (YB)

Home front defence: Matan Vilnai

Housing & construction: Ariel Atias (Shas)

Immigrant absorption: Sofa Landver (YB)

Intelligence & atomic energy: Dan Meridor (Likud)

Interior: Eliyahu Yishai (Shas)

Internal security: Yitzhak Aharonovitch (YB)

Justice: Yaakov Neeman (not MP)

Minorities & trade, industry & labour: Shalom Simhon (Atzmaut)

National infrastructure: Uzi Landau (YB)

Religious affairs: Yakov Margi (Shas)

Science & technology: Daniel Hershkowitz (HaBeyit HaYehudi)

Strategic affairs: Moshe Ya'alon (Likud)

Tourism: Stas Misezhnikov (YB)

Transportation & road safety: Yisrael Katz (Likud)

Welfare & social services: Moshe Kahlon (Likud)

Speaker of the Knesset

Reuven Rivlin

Central bank governor

Stanley Fischer