Taking the Shackles Off Israel's Economy

Finance Minister Netanyahu talks about rapid reform

It has been 32 months since the Palestinians launched their intifada against the Israelis. Violence continues to flare. A U.S.-backed peace process, called the "road map," has scarcely gotten off the ground. The Israeli economy, hit by the conflict and the tech slump, is likely to grow less than 1% this year -- after shrinking in 2000 and 2001.

Yet something is afoot in Israel's financial markets. The leading Tel Aviv stock index is up 34% so far this year. After being unable to raise money on the international capital markets for more than two years, the Israeli government recently attracted institutional investors to a commercial bond offering, raising $750 million. And investors are bidding up the shares of recently privatized El Al Israel Airlines Ltd.

What's behind the activity? Benjamin Netanyahu, Israel's Finance Minister and top economic policymaker since March, argues that one key reason smart money is heading to Israel is the government's radical program to liberalize its economy. In three months, Israel has pushed through massive reductions in state spending, including the first-ever cut in public-sector wages. Income tax rates will be cut and a pension reform is under way that will channel billions of dollars into the market in years to come.

These controversial moves sparked a general strike by public-sector workers in early May. But Netanyahu and the government -- a coalition linking Likud, pro-market Shinui, and other right-wing parties, have toughed it out. The 53-year-old Finance Minister, who holds a master's in business management from Massachusetts Institute of Technology, spoke recently with BusinessWeek editors. Here are excerpts.

Can you explain why the mood in Israel's markets is more upbeat?

Obviously there is something going on that is attracting investors. We had not been able to raise money for [almost] three years. Instead, we turned to domestic borrowing and we had to [pay] 12% on our nine-year note. [We were] quickly approaching the brink of financial collapse. [But then] the long-term note dropped. It dropped four points in two months -- before any talk of the road map. The stock market went up, before the talk of peace. Ten percent of it has to do with security and peace. And 90% of it has to do with something else. The smart money has figured out what we are doing. What we seek is to drastically reduce the public sector and drastically improve the competitiveness of the private sector.

How has this come about?

When I came into the [finance] ministry, I asked for effectively complete powers to run the economy -- control of the economic cabinet. Up to now, the head of the economic cabinet in all of Israel's governments has been the prime minister. This is the first time we've broken with that pattern. [Another reason is that] this is the most pro-market coalition [in] Israel's history. Twenty-one out of the 23 ministers are fervently pro-market. [In the Knesset] for the first time, we have an absolute majority committed to free markets. So we have both the political will and the power. And we moved with great speed.

Do you see the market rising further?

Israel has the greatest concentration of people capable of producing conceptual products -- value-added products -- in the world. I think there are only two economies that have that capacity. Ours is the most concentrated, even though it's a lot smaller than [the U.S.]. I claim that everything in Israel is undervalued. A $16,000 per capita income is ridiculous for a country like Israel. It should be around $40,000.

But you have to admit there still is a security risk.

Terror actually has been reduced from its height of two years ago. You are not supposed to be able to stop terror with military tactics, we were told. But you can. When you see a terror attack, it clouds the vision. But if you plot the number of attacks, you will see that very few of them actually get through, and the reason is that our soldiers [prevent] them. We are now building a fence around the West Bank. When it is completed, I think the incidence of suicide attacks will decrease significantly.

What about finding a political solution?

Is it possible to bring down terror through a political act? That remains to be seen. We shall see if there is a Palestinian interlocutor on the other side who actually will stop [terror] himself. The main point I am making is that either politically or with a combination of defensive measures and deterrence, terror is not going to increase -- I can guarantee you that. In all likelihood it will decrease. If you get a political solution on top of that, it's a huge bonus.

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