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Economic Insights: The Middle East – politically hobbled but with major potential

Economic Insights: The Middle East – politically hobbled but with major potential

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Published by SEB Group
Israel and Palestine have the potential to flourish economically through stability and cooperation. Israel’s innovation and evelopment “ecosystem”, drive and entrepreneurship are features that other countries should be trying to systematically copy. The elements are in place to create a huge economic boost for both Israel and Palestine, but the deadlocked political situation continues to prevent such a positive economic development.
Israel and Palestine have the potential to flourish economically through stability and cooperation. Israel’s innovation and evelopment “ecosystem”, drive and entrepreneurship are features that other countries should be trying to systematically copy. The elements are in place to create a huge economic boost for both Israel and Palestine, but the deadlocked political situation continues to prevent such a positive economic development.

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Published by: SEB Group on Mar 27, 2014
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The Middle East – politically hobbled but with major potential
MONDAY
MARCH 24, 2014
A sustainable
peace agreement
 between Israel and Palestine will be
one of several important keys
 to achieving long-term stability in the Middle East and in-creasing the chances of developing the region’s econo-mic potential. Unfortunately this novice’s conclusion is that
the near-term prospects for a peace agree-ment are microscopic, despite renewed efforts by the United States and other countries
. The stability of the Middle East is also affected by the world’s efforts to find and adjust to a new geopolitical equilibrium and balance of power.
The bright spot amid the gloom of conflict is the attitude
 and optimism among both Israelis and Palestinians, especially the young,
that there are opportunities for both peace and new success in economic and industrial fields
.
Israel’s economy
, the world’s 49
th
 largest, has an underlying strength and
major potential
 because of its innovation and development “ecosystem”. The discovery of large gas reserves in 2009 is creating both economic and political repercussions
 and challenges. Many of Israel’s problems are similar to those of other OECD countries (the functioning of the labour market, an
 
ageing
 
population,
 
insufficient productivity). Corrup-tion is also present.
But the big economic take-off in Israel and nearby countries will not occur as long as the region remains unstable
.
 
This issue of
Economic Insights
, including the travel re-port, is organised as follows. It begins with an attempt to summarise the
political situation
 in the Middle East and the prospects for stability. It then describes the
economic and financial situation
 and the outlook for Israel and to some extent Palestine as well. The final part focuses on Israel’s desire and ability to remain an
innovation and high tech incubator
.
Israeli-Palestinian peace agreement is far away
The unfinished conflict between Israel and Palestine, the ongoing crises in Syria and Lebanon and the Arab Spring dominate day-to-day life in the region. Although a new round of attempted peace negotiations between Israel and Palestine began in 2013, with the US as the clear driving force,
the chances of an early solution to the conflict must be regarded as still micro-scopic
.
 
A long-awaited peace agreement will not be a matter of achieving a “per-fect marriage” between two possible states
 
but
 
of
 
bringing about a
proper “divorce”
. It will be necessary to fo-cus the attention of the two sides not on the “price” of the accord, but on the “returns” that such an agree-ment would bring to both. At least in the international community, there is a vision of a two-state solution in which
“Israel and an indepen-
A travel report – Israel and Palestine
Some 50 chief executives and board chairmen of companies and institutions participated in SEB’s 2014
Nordic Business Delegation.
During a few intensive days on location in Israel and Palestine, the group and SEB’s top executives were ex-posed to stimulating lectures/discussions about the econo-mic, financial and political situation in Israel and Palestine as well as the broader state of affairs in the Middle East. The presidents of Israel and Palestine were present on various occasions during the SEB conference. This report conveys some main conclusions from the confe-rence and provides subjective reflections about the situation in and around the Middle East. The report is based on va-rious types of information, for example from representatives of the political sphere and the private and public sectors, as well as international reports.
 
 2
Economic Insights
dent, viable, contiguous, democratic Palestine can live side by side in peace and security” 
. But there are many differences between the two sides
 economic, histori-cal, cultural and religious
 and Israel continues to establish new settlements that are helping undermine the prerequisites for constructive peace negotiations.
Do the Israelis really want peace instead of gaining access to more land
 – 
 and do the Palestinians really want their own state?
If Israel and Palestine can reach agreement, the EU
 which is Israel’s largest trade partner, buying 30 per cent of its exports
 and others offers the prospect of political, economic and security policy support to both sides, as well as greater access to the European market. The security policy situation poses major challenges to the region.
For Israel in particular, there are four areas that will determine stability in the near term
. Aside from the
conflict with Palestine 
, Israel can expect
developments in Iran 
 to influence its situa-tion; the thaw between Iran and the international com-munity will enable Iran to continue developing nuclear technology, which many view as an opportunity for Iran also to develop nuclear weapons technology. This may change the balance of power in the region in a new and destabilising way. In addition, uncertainty about the next stage of the
“Arab spring”  
 is also a factor than will have an impact on Israel’s future role in the region. The fourth area that will determine the stability of the region – and affect Israel – is
the probable shift in US involvement in the Middle East
. Increasing US ener-gy independence (shale gas/oil) is expected to result in a reduced American presence in the Middle East and an increased focus instead on Southeast Asia, a region of growing economic importance to the US and the world. This would create a political vacuum that
 in light of the prevailing instability
 needs to be filled by some-one else. It is in the interest of the world, and of course also the US, that the Middle East should undergo stable development, but from an economic standpoint it is perhaps mainly China that may need to assume a more active political role, a task for which
 to put it mildly
 China is untested.
Israel’s balance sheet gets high marks
Israel’s economy has shown impressive resilience to the 2008-09 global recession as well as the geopolitical un-certainty that continues to dominate the situation in the
 
Middle
 
East.
 
The
 
explanation
 
can be found in
strong macroeconomic fundamentals
, including a surplus in Israel’s external transactions (current account), compa-ratively
low government debt
 and a
banking system with limited global linkages
. Over the past decade,
unemployment
 has fallen from 14 to 6 per cent without creating upward pressure on wages and salaries, which continue to grow by about 3 per cent annually. Israel’s labour market can be descry-bed as flexible, with a decentralised wage formation model. Inflation is restrained and under control within the central bank’s target interval of 1-3 per cent. The
economy is growing
 by about 3.5 per cent year-on-year; this is also the forecast for 2014 and 2015.
Go-vernment debt
 is on its way down and is below 70 per cent of GDP today. The government’s target is to bring debt down to 50 per cent of GDP by 2020. This will be achieved both through
higher taxes
 (income and cor-porate taxes have been raised) and
lower public ex-penditures
, which are allowed to grow according to the “fiscal rule”: a rate of increase equivalent to yearly population growth (today 1.7 per cent) plus one per-centage point. Israel has 7.7 million residents – 60 per cent under the age of 25 – with an estimated 20 per cent of them living in relative poverty. However, the average living standard is high and GDP per capita is in 40
th
 place in the world.
 
 3
Economic Insights
Israel is an open, market-based, innovative and export-oriented OECD economy
(40 per cent of which is connected to foreign trade). It is one of the countries that invest the highest percentage of GDP on research and development. Israeli industry is character-rised by high-tech competencies which, along with a strong entrepreneurial spirit, have elevated the country to a leading position in such fields as information and health care technology.
But there are many problems and challenges
Under the surface, and behind its strong overall fi-nancial ratios,
Israel also has many problems
 that need to be corrected over the next few years. For example, observers describe the economy as “
winner-take-all” 
;
 
there is corruption in a number of areas. The public sector is “Greek-like” and dysfunctional. Com-panies are not exposed to enough competition and productivity is low outside the high-tech sector. In addition, Israeli society is characterised by increased economic inequality, various weaknesses in the educa-tional system and individuals/groups that find it diffi-cult – or are unwilling – to enter the labour market.
There are additional factors that represent both threats and opportunities to the Israeli economy
 (aside from the obvious political ones). These include rapidly rising
 home prices
, the
appreciation of the shekel
 and management of expected future
natural gas
 revenues.
 Home prices.
 Housing supply is limited and the construction permitting process is slow. Along with low interest rates, this has caused home prices to climb by 80 per cent since 2007. Meanwhile household debt re-mains low: 40 per cent of GDP in Israel, compared to 150 per cent in Denmark and 70-90 per cent in Swe-den, Norway and Finland. The rapid rise in home prices represents an increased risk to financial stability and hampers labour mobility because of lock-in effects, lowering the long-term production capacity of the economy. Since 2009 the authorities have been using numerous macroprudential tools in an attempt to slow home price increases – these efforts are being monitored with great interest by countries that exhibit similar challenges – but so far without any noticeable impact on credit expansion and the housing market.
Israel: Real exchange rate and key interest rate
   K  e  y   i  n   t  e  r  e  s   t  r  a   t  e ,  p  e  r  c  e  n   t   E  x  c   h  a  n  g  e  r  a   t  e   i  n   d  e  x
 
 The shekel.
The Israeli currency has appreciated by a full 20 per cent (both in nominal and real terms) since 2007. Today the shekel is trading higher than its histo-rical average and can be regarded as overvalued. Con-tributing factors are capital inflows from direct invest-ments (purchases of start-ups) and speculative inflows due to expectations of further currency appreciation as an effect of natural gas production. Israel’s central bank has cut its key interest rate (0.75 per cent today) in order to limit currency inflows and has also launched a currency intervention programme (selling shekels for foreign currencies) based on predetermined amounts.
 Natural gas production.
 A few years ago – in 2009 – Israel discovered enormous natural gas reserves in the Mediterranean Sea. Since April 2013, production has been under way. According to forecasts, Israel will be self-sufficient in energy 4-5 years from now. The reserves are expected to last for 20-40 years. Exports can eventually begin. To avoid the “Dutch disease”
1
, Israel is creating a sovereign wealth fund (similar to that of Norway) that will channel export revenues into investments abroad in a controlled fashion. It is worth noting that even today, Israel’s assets abroad exceed its debts by the equivalent of 20 per cent of GDP. The central bank’s currency reserve today totals more than USD 80 billion.
1
 “The Dutch disease” is the name for a set of problems that affect countries/economies that
 for example
 suddenly discover large, valuable commodity resources. The phenomenon arose in the Netherlands when that country discovered natural gas in the late 1950s. Normally the currency appreciates due to expectations of future positive capital flows, creating a risk that “old” export sectors will be priced out of business.

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