Outlook for 2011-15

• Following a breakdown of direct peace talks, the US faces an uphill struggle in its attempts to bring Israel and the Palestinians back to the negotiating table. Even if it succeeds, the chances of an agreement being reached remain low.
• An eventual fracturing of the current right-wing coalition still appears likely at some stage. If this happens, the prime minister, Binyamin Netanyahu, will most probably try to strike a deal with the centrist Kadima party.
• We have raised our growth forecast for 2011 slightly, to 3.6%. But this will still represent a slowdown compared with 2010. The pace of expansion will accelerate in the latter part of the forecast period, to an average of 4.5%.
• Monetary policy will be tightened gradually over the next 12 months, with the base rate reaching 3% by end-2011. Policy will become increasingly restrictive thereafter, with the policy rate peaking at 6% in 2015.
• The budget deficit will continue to narrow. By 2015 we expect the overall fiscal position to be in surplus, helped by growing revenue from offshore natural gas.
• The New Israeli shekel will remain strong. The authorities may opt for temporary controls on inflows of short-term capital, in an attempt to curb further currency appreciation.

Monthly review

• US efforts to re-launch direct peace talks between Israel and the Palestinians came to nought, as Israel refused to submit to a new West Bank settlement freeze.
• Unhappy about the stalled peace talks, several Labour ministers-although not the party's leader, Ehud Barak-are still threatening to give up their positions in the government.
• The interior minister, Eli Yishai, who is also leader of the Shas party, is under heavy pressure. He has been criticised for the handling of the recent Mount Carmel blaze, which destroyed 5,000 ha of forest and claimed 43 lives.
• Unemployment rose to 6.6% in the third quarter, from 6.4% in the second-the first increase since the recession ended in the second quarter of 2009.
• The year-to-date budget deficit to end-November totalled NIS15.9bn, sharply down on the shortfall of NIS 28.1bn recorded in the same period of 2009.
• The current-account surplus rose to US$2.3bn in the third quarter of 2010, from US$2bn and US$1.6bn in the second and first quarters respectively. However, the latest data point to a renewed weakening in the trade position.

The political outlook will remain challenging, given the fractious nature of coalition politics in Israel. Twelve parties are represented in the Knesset (parliament) and six in the government. Despite this fragmentation, both the Knesset and the government of the Likud party, led by Binyamin Netanyahu, have a right-wing bent. The current coalition arrangements provide the government with a comfortable parliamentary majority; it controls 74 of the 120 Knesset seats. Most of Likud's coalition partners, given their right-wing leanings, are likely to think twice before moving into opposition.

Nevertheless, disagreements between the coalition partners have recently spilled out into the open, fuelled by divergent views about the peace process and the vexed question of settlement building in the West Bank. Avigdor Lieberman, the foreign minister and head of Yisrael Beiteinu-the second-largest party in the coalition-strongly opposed the resumption of direct peace talks between Israel and the Palestinian Authority at the start of September. The talks lasted only three weeks. But Mr Lieberman then obstructed attempts to re-kindle the dialogue, by refusing to back a new moratorium on construction in the West Bank and East Jerusalem. Despite strong pressure from the US, Mr Netanyahu was evidently unwilling to risk the departure of Yisrael Beiteinu, and possibly other right-wing parties, from the coalition by agreeing to a fresh settlement freeze. In early December the US acknowledged that it had failed in its attempts to re-launch the talks. While pacifying Mr Netanyahu's right-wing partners, this has exacerbated tensions within the left-leaning Labour Party, the third-largest grouping within the coalition. Many of its senior members are angry that the peace process has stalled, and its leader, the current defence minister, Ehud Barak, is under mounting pressure to call a leadership contest.

Elections for the Knesset 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. Although the Labour Party is currently the weak link in the coalition, the loss of its 13 seats would still leave the government with a slim majority (of one) in the Knesset. The departure of Yisrael Beiteinu, with its 15 seats, would be more problematic for Mr Netanyahu. In such circumstances, he would probably seek to bring the centrist Kadima party, led by Tzipi Livni, on board. If successful, this would provide Mr Netanyahu with a large enough majority to remain in government. However, there is also a risk that such a realignment would antagonise the more right-wing factions within Likud, leading to its second major split since 2005 and setting off a chain of events that leads to an early election.

Despite the collapse of the direct peace talks, US officials insist that they will continue working toward a two-state solution, as part of their wider efforts to secure peace in the Middle East. The US envoy, George Mitchell, has resumed his shuttle diplomacy, and has proposed the holding of separate but parallel talks with both sides for a period of six weeks-mirroring the indirect "proximity" talks that preceded the three rounds of direct talks last September.

Meanwhile, the Palestinians-frustrated with Israeli intransigence over the settlement issue-seem determined to press ahead with their efforts to secure a UN resolution that recognises Palestine as an independent state. This idea has already received the backing of a number of Latin American countries. However, it is unlikely to make much headway, given the clear opposition of Israel and the US as well as a lukewarm response in Europe. Indeed, it is difficult to see how a lasting peace can be achieved without Israel and the Palestinians fleshing out the details at first hand around the negotiating table. The resumption of direct talks therefore remains the essential, but elusive, first step along this road.

Even if direct talks were to resume, many Israelis doubt the ability of Mahmoud Abbas, the president of the Palestinian Authority, to enforce any agreement that he might make-not least because of the fierce opposition of Hamas, the Palestinian Islamist group that controls the Gaza Strip. At the same time, many Palestinians are distrustful of Mr Netanyahu. In terms of substantive issues, the borders for a future Palestinian state, the status of Jerusalem and the right of return of Palestinian refugees remain major stumbling blocks. Mr Netanyahu is also demanding that Israel be recognised as a Jewish state, something that the Palestinians have ruled out. They believe that such an acknowledgement not only would be to the detriment of Israel's Arab citizens-who constitute around 20% of the population-but would obstruct the right of return of Palestinian refugees.

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. Instead, the US is attempting to exert increased pressure on the Islamic Republic through economic channels; its call for tougher sanctions received the backing of the UN Security Council in June. The US administration will also seek to convince Israel that a final-status agreement with the Palestinians is the best means of neutralising the potential threat from Iran, by increasing the latter's isolation in the region. Meanwhile, tensions between Israel and Hizbullah, a Lebanese Shia group, will remain high. The exchange of fire on Israel's border with Lebanon in early August represents the most serious confrontation in that area since the July 2006 war. Israel is also watching closely to see whether the Lebanese tribunal that has been investigating the assassination of former prime minister, Rafiq Hariri, directly implicates Hizbullah. If it does, there is a risk of renewed instability in Lebanon, with potentially negative overspill for Israel. There has also been a renewed upsurge in military tensions over Gaza. Israeli air strikes on the Hamas-controlled territory have been accompanied by rocket fire from the Strip aimed at neighbouring Israeli towns.

The counter-cyclical measures introduced during the global downturn are steadily being withdrawn, as the authorities gradually tighten both monetary and fiscal policy. During a previous stint as finance minister, Mr Netanyahu demonstrated a strong 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 on this particular front.

The government is proposing to reduce corporation tax by 1 percentage point to 24% in 2011 and to 20% by 2014. It was also planning to cut value-added tax (VAT) at the start of 2011 from 16% to 15.5%. But this reduction may be postponed until later in the forecast period, given the Ministry of Finance's insistence on prioritising deficit reduction.

The privatisation of the Israel Discount Bank was recently completed. However, the government will need to overcome regulatory hurdles if it is to finalise the privatisation of Bank Leumi, and it has stalled on 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 oil and gas sector is under discussion. Energy companies have complained that the interim recommendations made by the Sheshinski Committee-which include a progressive tax on profits-could jeopardise financing for the offshore Tamar gasfield. Despite the rearguard action that is being fought by the oil firms, we expect the government to accept most of the committee's proposals.

The budget deficit (excluding credit) narrowed to NIS 15.9bn (US$4.4bn) in January-November 2010, little more than half the level recorded in the corresponding period of 2009. Despite a likely boost to spending in December, as the government brings forward 2011 expenditure, the Economist Intelligence Unit estimates that the fiscal deficit narrowed to the equivalent of 3.7% of GDP in 2010 as a whole, well below the 2009 outturn of 5.1%. Under the two-year draft budget for 2011-12, growth in real spending has been capped at 2.7% a year. The government is aiming to reduce the fiscal deficit to a maximum of 3% of GDP in 2011 and 2% of GDP in 2012. These targets appear realistic, as long as there is no unexpected deterioration in the security situation (which would result in additional spending). By the end of the forecast period in 2015, we expect the fiscal account to have moved into overall surplus.

Interest rates have been raised by a cumulative 150 basis points since the first move in the current tightening cycle took effect in September 2009. However, the key rate-at 2% in December-is still 225 basis points below its October 2008 peak. Real rates, based on forecast 12-month inflation, also remain negative. Rapidly rising house prices-up by 20% over the past 12 months-remain a key concern for the Bank of Israel. The central bank has strengthened mortgage lending criteria, in an attempt to counter speculative activity in the housing market, as well as gradually raising interest rates. We forecast an additional 100-basis-point increase in the base rate over the next 12 months, taking it to 3% by the end of 2011. Monetary policy will become increasingly restrictive in 2012-15, as growth accelerates and capacity constraints become more pronounced. We expect monetary tightening over the latter part of the forecast period to be front-loaded, with a 150-basis-point jump in 2012 followed by 50-basis-point increases in each of the next three years. On this basis, the policy rate will peak at 6% in 2015.

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Israel's recovery from the global economic downturn has been comparatively rapid. In its Article IV consultation published at the end of November 2010, the IMF attributed Israel's speedy rebound to a combination of decisive official action and a strengthened macro-financial policy framework. Nonetheless, the immediate outlook remains uncertain. On the one hand, the latest GDP data (for the third quarter of 2010) appear to confirm the continued positive momentum, with output expanding by 3.8% in annualised terms. On the other hand, unemployment rose by 0.2 percentage points in the 3 months ending September (the first increase for 12 months), and exports appear to be encountering increasing headwinds. Clearly, these trends require close monitoring. But it is important to note the upturn in the jobless rate over the last quarter is largely due to a rise in the participation rate-arguably, a sign of growing confidence, as more people actively seek employment. In addition, we have revised up our 2011 forecast for US GDP growth from 1.7% to 2.2%, following an extension of the Bush tax cuts. Given the importance of the US market to Israel, this has prompted us to make a modest upward adjustment to our 2011 GDP forecast for Israel to 3.6% from 3.4% previously. From 2012 onwards, we believe that there will be stronger support for Israeli exports, as the global environment steadily improves. We expect GDP to expand by an average of 4.5% in 2013-15.

Private consumption rebounded strongly in the first half of 2010, helped by low real interest rates, declining unemployment and rising real wages. Consumer sentiment is likely to remain volatile in the short term. But improving external conditions combined with further tax cuts should lead to a steady strengthening in household spending from 2012 onwards.

After slumping in 2009, a significant recovery in investment is now under way. Fixed investment jumped by nearly 10% in annualised terms in the third quarter of 2010. Although investment prospects 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 a further fillip over the medium term.

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 our recent upgrade to US growth, import demand from developed economies-particularly in Europe-will remain subdued, although the relative buoyancy of emerging markets will provide a partial offset. The last three years of the forecast period will witness a renewed acceleration in export growth, as the global economy and world trade expand at a faster pace.

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After five months of overshooting the ceiling, inflation re-entered the 1-3% target range in April 2010, subsequently slowing to a three-year low of 1.8% in July and August before re-accelerating to 2.3% in November. The real exchange rate remains strong, helping to curb import costs. 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 cause for concern. If both housing and the volatile fruit and vegetables components are excluded, the increase in the CPI over the past 12 months amounts to just 1.1%. It remains to be seen whether recent efforts by the authorities to slow the pace of house price rises-and, indirectly, rental prices-will be effective. In turn, this uncertainty poses an upside risk to our near-term inflation forecast (an annual average increase of 2.7% in 2011). After a forecast dip in price growth in 2012, accelerating growth and growing capacity constraints will push inflation back towards the top of the target range in 2013-15.

The Bank of Israel's policy of intervening in the foreign-exchange market continues to spark controversy. The governor, Stanley Fischer, has defended the central bank's actions, arguing that it is an important means of limiting the damage to exports that would otherwise arise from a faster appreciation of the New Israeli shekel. In a recent interview, Mr Fischer even refused to rule out the possibility of international reserves reaching US$100bn (from US$68bn currently), on the back of continued intervention. However, as recently noted by the IMF, persistent one-sided intervention will add to the central bank's already considerable sterilisation losses and ultimately threaten the credibility of the floating exchange-rate regime. An alternative would be to impose temporary controls on the inflow of short-term capital. Given that the shekel will continue to receive strong support from a large current-account surplus and a steadily widening interest-rate differential with key developed economies, we believe the Bank of Israel may come round to the view that temporary restrictions on short-term capital inflows constitute the least-bad policy option.

An increase in the merchandise trade deficit in 2011, as the pace of export growth moderates, will lead to modest fall in Israel's structural current-account surplus. However, helped by a continued strong performance on the part of business services-predominantly software and other high-tech-related products-the surplus on the current account will still amount to a sizeable US$6.8bn (2.8% 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 nearly 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 introduction of a sovereign wealth fund.

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The prime minister, Binyamin Netanyahu, emerged victorious in early December as the US formally abandoned its efforts to persuade the government to renew a West Bank settlement freeze in order to meet Palestinian conditions for resuming direct peace talks. Whether the victory is real or pyrrhic, however, will only become apparent over the coming months. On the one hand, Mr Netanyahu was spared a likely coalition crisis caused by dissent on the part of his right-wing coalition partners. On the other hand, Mr Netanyahu risks accentuating Israel's diplomatic isolation. There is also the danger of a minor coalition crisis, given that the dovish Labour Party is upset about the lack of progress on the Palestinian issue.

In fact, the initiative to re-start the peace talks had effectively expired weeks before the formal US announcement on December 9th, after Mr Netanyahu had failed to gain sufficient support in the cabinet for the proposed 90-day freeze-despite the sweetener that the US had offered to Israel of fighter jets and diplomatic assurances. The bickering inside the Israeli government did not, in any case, bode well for a successful resumption of the peace talks. To complicate matters further, the Knesset approved legislation on November 23rd requiring either a super-majority or a referendum in the event of any future agreement to cede East Jerusalem or the Golan Heights. While Washington was bogged down in negotiations with Israel, the Palestinians unhelpfully stood on the side and raised new conditions. Although Palestinian negotiators were quick to voice their disappointment at the US retreat on the settlement freeze, the Palestinian president, Mahmoud Abbas, had appeared relatively unenthusiastic about prospects for the talks throughout the entire process.

Officially, the US is continuing with its efforts to get the process back on track. Israeli and Palestinian negotiators flew to Washington immediately after the freeze announcement, and the US secretary of state, Hillary Clinton, urged Israel to map out its borders with a projected Palestinian state even without direct negotiations. The US mediator, George Mitchell, also returned to the Middle East on December 12th. But it is difficult to see how the White House will succeed, after its big push over the last year has collapsed.

Mr Netanyahu's biggest domestic headache now is the Labour Party, whose relatively small size belies its importance, because it gives his otherwise right-wing, hard-line government a moderate veneer. The security expertise of its leader, the defence minister, Ehud Barak, is especially valued by the prime minister. Mr Barak himself seems determined to remain in the coalition, despite promises to quit in the absence of progress on peace talks by January 2011. But several Labour ministers are threatening to leave-a move that would trigger a leadership battle within the party.

WikiLeaks revelations prove supportive for Israel

The revelations contained in the US State Department cables published by WikiLeaks, a whistle-blowing website, have given Israel a rare diplomatic victory-although they are unlikely to change the course of Middle East diplomacy.

In terms of the commentary on intelligence matters as well as political assessments, Israel came out looking "clean". The briefings that Israeli officials gave to US diplomats in private were, on the whole, the same as those delivered to the media for public consumption. Consequently, Israel did not appear to be two-faced in dealing with key issues (although it should also be noted that only a small fraction of the cables has so far been published; according to the WikiLeaks' founder, Julian Assange, the next six months will see the publication of thousands of documents relating to Israel).

Admittedly, some comments made by the director of Mossad, the Israeli intelligence agency, Meir Dagan, were embarrassing. He called the emir of Qatar "annoying," and said that the king of Morocco is not interested in governing. But Mr Dagan was due to complete his term of office at the end of 2010, to be replaced by his former deputy, Tamir Pardo. Also, Mr Dagan's assessments were highly valued by the US above and beyond his status as Israel's spy chief.

The key positive aspect for Israel of the WikiLeaks revelations arises out of various comments regarding Iran. Israeli leaders, notably the prime minister, Binyamin Netanyahu, have long maintained that the key problem that needs to be addressed in the Middle East is not Palestinian statehood but Iran's nuclear programme and ambitions for regional hegemony. The Obama administration has appeared to argue otherwise, contending that Israel has to first move forwards on Palestinian negotiations in order to mobilise support in the region against Iran-hence the immense effort expended by the White House in trying to convince Israel to freeze West Bank settlement activity.

The WikiLeaks cables appear to support Mr Netanyahu's position. According to one release, King Abdullah of Saudi Arabia told the White House counterterrorism adviser, John Brennan, in March 2009 that the administration of Barack Obama should review its policy towards Iran, implying that he had strong reservations about the US attempting to engage the leaders of the Islamic Republic. (An earlier cable quoted the Saudi ambassador in Washington as telling his US interlocutor that the king had urged the former president, George W Bush, to "cut off the head of the snake", which has been widely interpreted as indicating that Saudi Arabia would like the US to bomb Iran's nuclear facilities). King Hamad of Bahrain, in a meeting with the then head of US Central Command, General David Petraeus, also urged that action be taken to terminate Iran's nuclear programme. Cables from the US ambassador to Egypt, Margaret Scobey, indicate that the Egyptian president, Hosni Mubarak, was not opposed to dialogue with Iran, "so long as the [US] does not believe a word [the Iranians] say". According to Ms Scobey, Mr Mubarak has a "visceral hatred" for Iran. Gulf leaders from Qatar, Abu Dhabi and Oman were also quoted as being concerned about Iran.

In the words of the Israeli prime minister, "This is the first time in modern history that there is not insignificant agreement both in Jerusalem and in countries in the region that the central threat flows from Iran, its hegemonic plans and proliferation steps." He noted that the revelations could aid peace by changing the narrative that Israel is the danger to peace and security in the region.

Mr Netanyahu is probably too optimistic. In the Gulf, Iran is certainly seen as the central threat, but closer to Israel's borders, the Palestinian issue remains paramount for Syria, Jordan and Lebanon. In any event, although the Obama administration was obviously aware of the views of various Arab leaders before WikiLeaks exposed them to the public, they did not lead to a change in US policy. Meanwhile, in the wake of the leaks, it is interesting to note that the Gulf Co-operation Council has adopted a conciliatory tone in its public comments on Iran, and Iran's new foreign minister, Ali Akbar Salehi, has called for efforts to improve his country's relations with Saudi Arabia.

A forest fire that broke out on December 8th and consumed 5,000 ha atop picturesque Mount Carmel resulted in significant domestic and foreign political fallout. Although not large by international standards, the fire was by far the biggest in Israeli history and, in a single tragic incident in which a bus was engulfed by the fast-moving flames, claimed 43 lives and shook the country.

Israeli fire-fighters were overwhelmed by the blaze and Mr Netanyahu was obliged to seek aid from overseas. Among the unexpected donors was Turkey. Israel has had frosty relations with Turkey ever since Operation Cast Lead in Gaza in late 2008 and even more so after commandos killed nine Turkish citizens aboard a ship trying to break Israel's Gaza embargo last May. Mr Netanyahu personally thanked the Turkish prime minister, Recep Tayyip Erdogan, for the aid, and the two sides met in Geneva in a bid to defuse the tensions arising from the commando raid.

Almost certainly, Turkey offered the aid as a means of breaking the diplomatic ice, and Israel was happy to respond. Nonetheless, the two sides failed to agree on a formula that would answer Turkey's demand for compensation to the victims as well as an official apology. Israel was prepared to pay compensation but would offer no more than "regret" for the deaths.

Meanwhile, the shortcomings of the fire-fighting services reverberated on the interior minister, Eli Yishai, who is also leader of the ultra-Orthodox Shas party. A damning report by the state comptroller cited neglect and red tape on the part of an array of ministries and other bodies, with Mr Yishai getting special mention. He was also pilloried in the media but refused to step down, rather accusing the media of targeting him as religious, right-wing and Sephardic. Although others clearly need to share some of the blame, both Mr Yishai and Shas are under growing internal and external pressure. In November the party expelled an outspoken Knesset member, Chaim Amsellem, trimming its representation in parliament to 10, while in mid-December it was again feuding with its coalition partner, Yisrael Beiteinu, over religious conversions, threatening another government crisis. For Mr Yishai, an early election may soon start to look like a source of possible salvation.

The Economist Intelligence Unit's democracy index ranks Israel 37th out of 167 countries, putting it among the 53 countries considered flawed democracies, along with states such as India, Hungary, Estonia and Brazil, but well ahead of other countries in the Middle East, where it is the only one considered to be democratic. Israel's position owes much to its high scores for the electoral process and political participation. The electoral system is open to new parties and the country has one of the lowest voting thresholds in the world, with just 2% of the national vote required to gain parliamentary representation. This has seen many parties come and go but has also resulted in a rather fragmented parliament and reliance on unstable coalitions in order to govern —which has at times hindered government effectiveness (holding down the score for the functioning of government) and has led to frequent elections.

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Political engagement is high

Political participation—both at a grassroots level over single issues and in terms of voter turnout at elections—is fairly high, and Israel has its second-highest score in this category. However, the divisive nature of the electoral system and the polarising nature of many of the key issues facing the country hold down the score for political culture. Israel's main weakness is in civil liberties; although there is vigorous public debate, a vocal press and free expression, Israel has at times used torture against Palestinian prisoners, and the raid on the Gaza aid flotilla caused an international outcry. Moreover, a military censor can and does occasionally block the publication of information about sensitive security events. Although the Basic Laws (that serve as a constitution) allow for freedom of faith, in reality, the orthodox bodies of each of the major faiths in Israel oversee family law, which is particularly problematic for those of a mixed-faith background or those adhering to non-orthodox streams of Judaism.

Speedy rebound from global downturn helps to preserve social calm

Israel navigated the global recession and financial crisis with relative ease. Although unemployment rose initially, it has since fallen and is now close to its historical low. Public finances are in good shape, helped by a strong recovery in tax revenue and the absence of any significant balance-sheet damage to the domestic banking system. As a result, the government will not be required to implement any major cutbacks in public spending—at least on a scale of the reductions that have helped to fuel popular discontent and mass protests in some other democracies. Nevertheless, if the government is not seen to be dealing with pressing economic issues promptly and fairly, coalition members may leave the government, weakening its majority. In addition, the stalling of the peace process poses a threat to coalition harmony. There is also a risk, given the historical precedent, that Palestinian frustration with the lack of movement in the peace negotiations could spill over into renewed violence (ie a new infitada).

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Democracy index 2010: Democracy in retreat, a free white paper containing the full index and detailed methodology, can be downloaded from www.eiu.com/DemocracyIndex2010.

Note on methodology

There is no consensus on how to measure democracy and definitions of democracy are contested. Having free and fair competitive elections, and satisfying related aspects of political freedom, is the sine qua non of all definitions. However, our index is based on the view that measures of democracy that reflect the state of political freedom and civil liberties are not "thick" enough: they do not encompass sufficiently some crucial features that determine the quality and substance of democracy. Thus, our index also includes measures of political participation, political culture and functioning of government, which are, at best, marginalised by other measures.

Our index of democracy covers 167 countries and territories. The index, on a 0 to 10 scale, is based on the ratings for 60 indicators grouped in five categories: electoral process and pluralism; civil liberties; the functioning of government; political participation; and political culture. The five categories are inter-related and form a coherent conceptual whole. Each category has a rating on a 0 to 10 scale, and the overall index of democracy is the simple average of the five category indices.

The category indices are based on the sum of the indicator scores in the category, converted to a 0 to 10 scale. Adjustments to the category scores are made if countries fall short in the following critical areas for democracy:

• whether national elections are free and fair;
• the security of voters;
• the influence of foreign powers on government; and
• the capability of the civil service to implement policies.

The index values are used to place countries within one of four types of regimes:

• full democracies—scores of 8 to 10;
• flawed democracies—score of 6 to 7.9;
• hybrid regimes—scores of 4 to 5.9;
• authoritarian regimes—scores below 4.

David Zaken, the deputy supervisor of banks and a 20-year veteran of the banking supervision department, was appointed on November 29th to replace the outgoing supervisor, Roni Hizkiyahu, with effect from January 1st. Mr Hizkiyahu notified Mr Fischer some months ago of his intention to step down, after a relatively short, but highly intensive, four-year term. Mr Hizkiyahu had been head of credit at Israel Discount Bank before being selected, in the wake of Mr Fischer's unprecedented firing of the serving supervisor, Yoav Lehman, in mid-2006. Hardly known outside of banking circles, the unassuming Mr Hizkiyahu had seemed an unlikely choice, but he proved to be the perfect foil to Mr Fischer in achieving his goal of fundamental revamping both the attitudes and modus operandi of the banking supervision department.

The relatively smooth manner in which Israeli banks navigated the global financial crisis of 2008, as well as the quiet determination the Bank of Israel (the central bank) displayed in forcing the resignation of Bank Hapoalim's then-chairman in April-May 2009, were the most obvious achievements of the Fischer-Hizkiyahu team. Behind the scenes, Mr Hizkiyahu's ability to groom potential successors allowed Mr Fischer and the search committee he established, headed by his deputy, Zvi Eckstein, to choose an "inside" candidate and thereby give preference to continuity and institutional stability.

Mr Zaken has been a key figure in preparing the banking system for the adoption of the Basel II regulatory regime. With further regulatory reforms-including Basel III-looming on both the global and domestic fronts, his knowledge and expertise, as well as the respect accorded him by both colleagues and bankers, will be essential in one of the most critical posts in the financial system.

Israel's three financial regulatory agencies, the supervisor of banks at the Bank of Israel, the Capital Markets, Insurance and Savings Division at the Treasury, and the Israel Securities Authority, jointly published on December 8th a set of uniform criteria to establish "fit and proper" standards for owners and senior executives of asset-management firms. Because the majority of such firms are now active in various fields and hence come under the supervisory purview of more than one body, the regulators are being obliged to co-operate more closely. The new criteria are one product of this effort, ensuring that owners and managers at pension and provident funds, insurance companies, mutual funds and portfolio management firms are all subject to the same rules.

The twelve criteria include being found guilty of relevant (that is, white-collar) crimes, as well as being charged with such violations-or even, in some cases, merely being under investigation. Similarly, administrative settlements or other civil punishments-such as fines imposed for violations of relevant laws or regulations-and the use of false or misleading information are all grounds for possible disqualification, or rejecting a person's candidacy for a particular post.

The regulators stress that the published list of criteria does not represent their final word on this subject, and that in every instance weight will be given to factors such as the seriousness of the crimes committed or charged, their intensity and circumstantial considerations.

The commissioner of capital markets, insurance and savings announced new regulations on November 30th, creating greater uniformity and transparency among the key products available in the pension and long-term savings market. Provident funds and the popular life-insurance programmes known as "executive insurance", both of which now serve primarily as alternative pension schemes, will move to a dual-fee structure, in which they will be allowed to charge a management fee of up to 1.2% per annum (down from 2% currently) and an initial 5% fee on new deposits. Pension funds will retain their existing structure of a 0.5% annual management fee and 6% new deposit fee.

Furthermore, the anomaly whereby pension funds and insurance schemes could offer savers insurance products, such as life and loss-of-income insurance, whereas provident funds could not, has been abolished. These moves are aimed at creating a level playing field between the different products, enabling investment advisers in the commercial banks to provide more objective advice to savers and facilitating comparisons between products on the part of consumers.

The unemployment rate rose to 6.6% in the third quarter, from 6.4% in the second-the first increase since the recession ended in the second quarter of 2009. This was the main negative finding in an otherwise strongly-positive quarterly Labour Force Survey published by the Central Bureau of Statistics (CBS) on November 30th.

On a seasonally adjusted basis, unemployment for the labour force as a whole fell from a peak of 7.8% in April-June 2009 to a low of 6.4% in the parallel quarter this year. Moreover, in the 25-64 age group, which comprises the bulk of the labour force, unemployment continued to fall in the most recent quarter, edging down from 5.7% to 5.6%. This suggests that the newly unemployed are mostly young people who have just joined the labour force. This conclusion is supported by the survey's findings regarding continued expansion of the labour force itself-a sharp rise of 0.7 percentage points from the second to the third quarters, to 57.8% of the total population over the age of 15, and a similar rise to 76% of the population aged 25-64.

Preliminary data released on December 6th by the Accountant-General Division of the Ministry of Finance showed a near-balanced budget for November. The deficit in the government's budget operations was only NIS 0.4bn (US$107m), or a surplus of NIS 0.2bn after financing activity is taken into account.

This leaves the year-to-date deficit to end-November at NIS 15.9bn, compared with the full-year deficit of NIS 42.9bn projected in the budget and compared with a deficit of NIS 28.1bn in the same period of 2009. This outcome primarily reflects strong tax revenue, which totalled NIS 180bn in the first eleven months of 2010, or 98.3% of the full-year budget projection-and compared with NIS 162.9bn in the corresponding period of 2009.

Expenditure, in contrast, totalled NIS 181.4bn in the year to end-November, only 86.6% of budgeted outlays. This represents a rise of only 2.5% over the parallel period of 2009, and half the average annual rate of increase in spending of the last five years. Typically, the Treasury runs a large budget deficit in December, sometimes pushing spending for the following year into the current one, to prevent the deficit coming in too far below target. It is likely that this tactic will be used again in December 2010.

The current-account surplus in the third quarter of 2010 widened to US$2.3bn in seasonally adjusted terms, up from US$2bn and US$1.6bn in the second and first quarters respectively. The main contributor was, as usual, the services account, which generated a surplus of US$1.75bn, but the elimination of the trade deficit-which showed a surplus of US$46m in July-September, compared with deficits of US$312m and US$458m in the two preceding quarters-was another contributory factor. On the other hand, current transfers dropped by almost US$450m, to US$1.94bn.

However, more recent data point to some renewed deterioration in the trade deficit. The November data, published by the CBS on December 12th, reveal a shortfall (seasonally adjusted) of US$700m, compared to an average monthly deficit of US$610m for the year to date.

The deterioration stems from both an increase in imports and weakness in exports. Imports, excluding diamonds, ships and planes and energy products, rose at an 8% annual rate in September-November, compared with a 5.5% increase in June-August. Merchandise exports (excluding diamonds) fell at an annualised rate of 6.5% in the latest three-month period-although this was better than the 11.7% annualised rate of decline in June-August.

The decline in exports encompassed both the high-tech sector (which accounts for just over half of total industrial exports) as well as the low-tech sector. High-tech exports fell by 6.4% in September-November, whereas low-tech exports contracted by 12.4%. However, the hardest hit sector was "mixed-high technology", where falling sales of chemicals dragged exports down by an annualised 19.6% in the latest three-month period, after a 35.3% decline in the previous three months. Only the "mixed-low technology" grouping posted a rise in September-November, of an annualised 18.5%.

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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; led by the prime minister, Binyamin Netanyahu, who formed a coalition government that took office on March 31st 2009, led by his party, Likud, with Yisrael Beiteinu, Labour, Shas, United Torah Judaism 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: Shalom Simhon (Labour)

Communications: Moshe Kahlon (Likud)

Culture & sport: Limor Livnat (Likud)

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

Education: Gideon Sa'ar (Likud)

Environment: Gilad Erdan (Likud)

Finance: Yuval Steinitz (Likud)

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

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: Avishay Braverman (Labour)

National infrastructure: Uzi Landau (YB)

Religious affairs: Yakov Magri (Shas)

Science, technology: Daniel Hershkowitz (HaBeyit HaYehudi)

Strategic affairs: Moshe Ya'alon (Likud)

Tourism: Stas Misezhnikov (YB)

Trade, industry & labour (& deputy prime minister): Binyamin Ben-Eliezer (Labour)

Transportation & road safety: Yisrael Katz (Likud)

Welfare & social services: Isaac Herzog (Labour)

Speaker of the Knesset

Reuven Rivlin

Central bank governor

Stanley Fischer