WHAT NEEDS FIXING IN ISRAEL: EVERYTHING ELSE
Chapter 1 made one important point. The Tel Aviv Stock Exchange works because it establishes private property rights for individuals, who are free to hold or transfer title to those rights, in a virtually tax-free environment. The firms that are listed on the TASE or which trade on U.S. stock exchanges pay little in the way of direct taxes, and individuals who trade these shares pay no capital gains taxes. The lesson is that low taxation stimulates investment and new business formation.
In marked contrast, the rest of the Israeli economy revolves around the exercise of political power, often arbitrary and capricious. Here elected officials, doing what comes naturally with unchecked power, and appointed bureaucrats strive to control all aspects of the lives of ordinary Israelis. State control denies individuals any reasonable degree of economic freedom, which is the hallmark of the Western market economy. The chief tools of Government control include high taxation, state ownership of business firms and banks, licensing of monopolies and cartels, trade barriers, massive subsidies to politically favored constituencies, and, more important than all of these, the collection of massive amounts of foreign aid and charity. Foreign aid and charity, innocuously labeled unilateral transfers in the balance of payments, has averaged about 11 percent of GDP during the past three years. In stark cash terms, unilateral transfers from abroad supplied Israel with $5.93 billion in 1990, $6.72 billion in 1991 and $6.94 billion in 1992. This inflow of "free money" enables the Government to sustain socialism while putting off, year and after, genuine economic reform.
Prime Minister Yitzhak Rabin, Minister of Finance Avraham Shohat and other Israeli officials shuttle back and forth to Washington, D.C., to lock up the annual U.S. aid package of $3 billion and to solicit U.S. Jews for private contributions. For now, the annual aid package seems secure. But aid and charity are not enough. The system depends on the inflow of outside money. In 1992, Israel secured U.S. loan guarantees of $10 billion. And, as the "price of peace," the Israeli Government will doubtless ask the U.S. Government for assistance in meeting the costs of territorial concession. All of this, of course, is and will be in the name of "growth."
Each year the Scorecard seeks to identify the main themes that dominated the economic policy agenda. In 1993, the main stories, and the topics of this chapter, are the following: (a) the saga of the loan guarantees, (b) the privatization that isn't, (c) business as usual -- capitulate to Histadrut and bailout money-losing state-owned enterprises, (d) chicken economics, french fried potatoes and other stories of Israeli agriculture, (e) the lack of freedom in Israel, and (f) the year's follies.
PART A: THE LOAN GUARANTEES -- THE SAGA CONTINUES
Throughout 1992, Israeli officials pleaded their case before the U.S. Government for $10 billion in loan guarantees for the worthy purpose of assisting the resettlement of Soviet Jewish immigrants. The controversy over the loan guarantees left bitter feelings in both countries. U.S. Jews deeply resented incumbent President George Bush's refusal to grant the guarantees, even if many of them disapproved of then Prime Minster Yitzhak Shamir's refusal to suspend settlement activity in the territories. Across the ocean, the 1992 election in Israel turned in large measure on the public's perception that Rabin could get the guarantees where Shamir had failed, and the voters were right. Rabin won and got them.
To put the loan guarantee issue into historical perspective, it is necessary to retrace some elements of the controversy. On February 21, 1992, the author testified before the Subcommittee on Foreign Operations of the U.S. House of Representatives, along with economists Stanley Fischer of the Massachusetts Institute of Technology and Herbert Stein of the American Enterprise Institute on the loan guarantees. Rabushka was the only witness to question the need for them. He made the following points. First, declining immigration eliminated any budgetary requirements for loan guarantees to finance immigrant absorption. Israel would have no trouble financing resettlement costs from its internal resources. Second, there exists numerous resources on which the State of Israel could and should first draw before resorting to loan guarantees: sell state-owned firms, privatize land, eliminate wasteful subsidies to industry, to name a few. Rabushka argued that these and other pro-growth reform measures would be put on hold if Israel secured the guarantees. Third, Israel's foreign exchange reserves were sufficient to cope with any balance-of-payments problem that might arise from higher spending on imports due to immigration. Fourth, the exercise of the guarantees would add to the already massive debt of the poor, overtaxed Israeli people who, after all, would have to repay the loans with interest. This money, unlike unilateral transfers, is not "free."
All three witnesses concurred on Israel's need to undertake far-reaching economic reforms, but Stein and Fischer dissented from Rabushka's position. Stein advocated granting the full $10 billion in loan guarantees. Fischer recommended giving Israel the first year's tranche of $2 billion, but conditioning the remaining $8 billion on Israel's demonstrable progress in implementing economic reform.
Was the controversy worth the struggle on both sides and for all concerned? First, some facts. On March 17, 1993, Israel raised the first $1 billion backed by U.S. loan guarantees in the form of 30-year bonds bearing interest of 7.06 percent, with a 10-year grace period on repayment of principal. The issue included underwriting costs of $4.5 million and $45 million for the 4.5 percent risk insurance scoring fee paid to the United States Treasury. These additional expenses raised the effective interest rate to about 7.5 percent. The actual fund raising entailed 44 separate bond issues, with varying maturities and interest rates.
How did Israel put that first $1 billion to work? The agreement with the United States stipulated that a third would be used for private sector investments by putting the money at the disposal of the commercial banks, a third to boost foreign currency reserves and a third to finance infrastructure investments through the budget. Globes reported on May 19 that Shohat had asked several of Israel's largest firms to present him with investment programs to be financed by the loan guarantees. Both the Israel Electric Corporation and Israel Chemicals stated that the guarantees were "not attractive," because the interest rate was too high.
Speaking at a conference sponsored by Ma'ariv and Bank Leumi titled "What Do You Do With $10 Billion?" Prime Minister Rabin stated that the guarantees remained vital to secure foreign investment. Treasury Director-General Aharon Fogel and Bank of Israel Governor Jacob Frenkel both stated that the guarantees were necessary for long-term growth.
In a stunning turnabout, Professor Stanley Fischer said that the guarantees damaged foreign investment, rather than improved it, by projecting an image of Israel as a nation dependent on U.S. charity. Fischer acknowledged that too much political capital had been invested in getting the guarantees to give them back. In other words, it would be impolitic to admit that the proponents of the guarantees had made a mistake. So, to get out from under the economic problem, to wit, that Israel really did not need the guarantees, and to avoid political embarrassment, Fischer suggested that Israel voluntarily give up its $1.2 billion in annual economic aid, and use the guarantees to cover the loss. Fischer warned that cuts in U.S. foreign aid would eventually be inevitable and that it was in Israel's interest to lessen its image of dependence.
What a astonishing reversal of opinion. If the State of Israel accepted Fischer's reported recommendation, Israeli taxpayers would be forced to pay higher future taxes to repay the loans in place of money that currently comes in free and clear. But maybe Fischer has a point after all. Borrowed money must be repaid. Perhaps taxpayers might be more watchful about how the Government spends the proceeds of loan guarantees.
Meanwhile, Israeli taxpayers were eating millions of dollars in losses. Once Israel raised the funds backed by the guarantees, on which it is paying annual interest of about 7.5 percent, it immediately deposited the money in the United States as part of the country's foreign exchange reserves. These deposits earn much lower interest, between 3-4 percent. The potential annual losses are in the tens of millions of dollars while the money sits idle.
Compounding the political embarrassment, on July 4, 1993, the cabinet voted to transfer NIS 650 million ($230 million) from budget reserves initially allocated for immigrant absorption for other activities. (The Knesset Finance Committee ratified the decision in early August.) Recall that the Government justified its request for loan guarantees to finance immigrant absorption. Yet the Government had so little need of this money that it shifted funds allocated for immigrant absorption from purely internal sources to other activities. Indeed, Budget Director David Brodet suggested that some of the loan guarantee money be used to fund a portion of the budget deficit, which means to finance more public spending. Although the Knesset had enacted prior legislation stipulating that the 1994 budget deficit not exceed 2.2 percent of GDP, the Minister of Finance set the 1994 budget deficit at 3 percent of GDP. In other words, the loan guarantees, justified on a number of grounds and especially by Israel's promises to implement economic reform, financed deficit spending to continue the failed policies of the past.
In August, it was reported that the Ministry of Finance was mulling over plans to supply up to $600 million in loan guarantee-backed funds to the business sector. One obstacle to this idea was that interest rates on loan guarantee funds were 1.5-2 percentage points higher than local interest rates. It's hard to get firms, even state-owned firms, to take money that costs more.
Neil Cohen of The Jerusalem Post put the matter succinctly in his "Comment" column of August 6. "Earlier this week the government as good as admitted it doesn't know what to do with the money from US loan guarantees, if indeed it ever needed the money at all." (Where was Neil Cohen in February 1992?) "Was it," he asked, "worth the costs?" In the end, the proceeds of loan guarantees simply went into the state budget, making possible greater deficit spending.
In late September, Israel raised the second billion dollars in loan guarantees. The total cost, including underwriting fees was 7.02 percent for a period of 30 years. The government paid a scoring fee of $45 million to the U.S. Government.
The guarantees came with political strings. Israelis were stunned in the fall by an announcement from Washington, D.C., that the U.S. would deduct $437 million from the $2 billion in 1994 guarantees due to settlement activity in the territories. During Prime Minister Rabin's November visit to the U.S., he discussed with President Bill Clinton possible means of recovering the deductions from the loan guarantees. The press hinted that some Finance Ministry officials were relieved at the cut since they would not have to decide what to do with about a quarter of the money. But U.S. Secretary of State Warren Christopher told American Jewish leaders that he had agreed to establish a panel with Israel to try to find ways to avoid deducting as much as possible of the $437 million. Stay tuned!
Recall that the Israel Electric Corporation, a public monopoly, had previously resisted the Government's entreaty to take loan guarantee money. To sweeten the deal, the Treasury agreed to give the electricity firm $800 million, over a period of 10-30 years, at a subsidized rate of interest below 7 percent. This rate is below the level the Government paid to raise the money in the first place. (So what. It's only taxpayers' money.) About $250 million is to be allocated in 1993 with the balance in 1994. The firm will not have to repay principal during the first eight years.
Two points deserve serious consideration. First, is a subsidized loan to the Israel Electric Corporation in keeping with the spirit of the purpose of the loan guarantees -- to assist Israel with the resettlement of Jewish immigrants from the former Soviet Union? A "yes" answer would truly stretch the concept of immigrant resettlement. Second, this money, which, to repeat, overburdened taxpayers must repay, is being transferred from an arm of the Government to a public monopoly, not to genuine private sector enterprises. For the Electric Corporation to repay the loan, it merely needs to raise prices to consumers. (Meanwhile, all employees of the Israel Electric Company continue to receive, as a fringe benefit, unlimited free electricity -- even when they are on strike. So at least this money will keep IEC employees in free electricity.)
Meanwhile immigration continues at about 70,000 per year, which remains well below the projected 200,000 annual inflow that underpinned the policy decision to seek loan guarantees. There is an easy solution to the problem. Israel should ask the U.S. Government to put the remaining $8 billion in guarantees into the equivalent of an escrow account, which can be drawn down when and if immigration increases to much higher levels, say, beyond the 100,000 mark. Then the money would be available if it were truly needed. As of 1993, the money is simply fueling deficit spending. This is a strange use of U.S. guarantees.
PART B: THE PRIVATIZATION THAT ISN'T
Privatization, the selling of state-owned enterprises to private firms and individuals, has transformed the economies of Mexico, Chile and Argentina virtually overnight. These three countries have transferred ownership of public firms and banks to private hands at breakneck speed, using the proceeds of sales to pay down public debt. In the past few years, they have sold several dozen banks and more than a thousand state-owned firms. Several of the individual sales, notably the Mexican Telephone Company (Telmex) and Argentina's state-owned oil firm (YPF), exceeded $2 billion.
And Israel? After ten years, the Government remains the majority shareholder in the country's four largest banks, which control over 95 percent of the assets of the banking system. Since the preparation by First Boston Corporation in 1988 of a master plan for privatization, the Government has managed to sell a mere 7 relatively unimportant, nonbank enterprises out of a total of 160 state-owned firms to private buyers. The snail is the appropriate logo of the Israel Government Companies Authority, the state privatization agency.
Privatization means two things. First, it means transferring ownership from the state to private hands, thereby broadening the base of private property and expanding the primary institution of personal economic freedom. Second, it means transferring control and management to private hands so that purely business considerations, not political considerations, dictate the conduct of business. Although the Government collected NIS 2.5 billion from the partial sale of its shareholdings in the two largest banks, Bank Hapoalim and Bank Leumi, it remained the majority shareholder as 1993 closed. Managerial control also remained in current hands, the Histadrut and the holding company of the Jewish Agency, Israel's other two "governments." To make matters worse, the Government did not use the proceeds to pay down debt; rather, it plans to use the money to help finance the 1994 budget deficit. In short, the Government did everything wrong. It has learned absolutely nothing about privatization in the last five years.
So far as 1993 is concerned, the Government, in floating off a minority of state-held bank shares, has nationalized a portion of the country's savings, thereby diverting several billion shekels from possible financing of genuine private firms. It has not privatized either bank in the sense of transferring control to truly private firms, although it continues to talk a good line, the practice of the past five years. If, as some Israelis fear, Histadrut and the Jewish Agency regain ownership control of Banks Hapoalim and Leumi, then selling the banks will have made a travesty of privatization. Moreover, the Government has used what money it has raised in this way to support more public spending. It is a gross miscarriage of linguistic justice to call this privatization. Israel has literally stood privatization on its head.
To the details. Let's begin with the banks. Selling ownership and control of the banks is replete with political overtones. The dominant Labor Party institution is the Histadrut. Histadrut's holding company, Hevrat Ha'ovdim, currently manages Bank Hapoalim. It would like to recover ownership control after the sale of the state's interest in the bank is complete. This means that Histadrut needs to acquire about 20 percent of the shares, and the Bank of Israel must give its approval. Many Israelis believe and fear that the Labor-led Government is trying to insure its control over Israel's largest bank, and, with it, control of the country's credit system, by wiring the privatization process. Histadrut's recapture of Bank Hapoalim would entail a certain injustice since it was on Histadrut's watch that the bank shares crisis erupted. The same relationships hold for Bank Leumi and the Jewish Agency.
As the year began, the scorecard on bank sales looked like this. The Government planned to sell about 20-30 percent of both Hapoalim and Leumi. No progress had been made on selling Israel Discount Bank and an agreement to sell Bank Mizrahi to Gad Ze'evi in September 1992 collapsed after the Bank of Israel withheld consent. The intent to sell Union Bank in 1992 failed. The one success was the sale of 24 percent of Israel General Bank in August 1992, which netted NIS 40 million ($14 million).
One excuse for the snail's pace of selling the banks has been the issue of bank reform. Should the Government break up the large banks into smaller units to increase competition and decentralize the banking system before putting them up for sale? This is a plausible concern in that Israel has one of the world's most concentrated banking sectors. But this excuse disregards the fact that several Israeli Governments have postponed resolution of this issue for a decade and any further delay is just that.
To settle some of the outstanding concerns, in late April the Government announced a set of bank reforms, which were approved by the cabinet in early May. The reforms require that Banks Hapoalim and Leumi reduce their holdings of industrial shares, that the three largest banks divest themselves of some of their banking subsidiaries, that the managements of bank-directed provident and mutual funds be separated from management of the banks themselves, and their bank-controlled funds not be permitted to own stock in the banks that manage them. Perhaps admirable in their own right, these reforms barely scratch the surface of the central issues: ownership, management and competition. Nothing in the reforms prevents Histadrut and the Jewish Agency from regaining effective ownership and control over the two largest banks that account for about 70 percent of the banking assets of the country.
The Knesset Finance Committee gave its approval to the sale of 20 percent of Bank Hapoalim by the end of May. To insure a successful sale, the Government set a maximum price of the offering, giving investors an almost ironclad certainty that share prices would rise the day after the offering was completed. Institutional investors were invited to tender for three-fifths of the offered shares in advance of the general offering to members of the public. The offering was 2.2 times oversubscribed. A week later, the public at large submitted bids for the remaining shares, which were oversubscribed 140 times. Everyone wanted to get in on this sure-fire, money-making deal. Bank employees were given first rights on a tenth of the initial offering. Altogether, the sale was projected to raise NIS 835 million after the exercise of all warrants.
Every student of elementary economics knows that setting prices below market-clearing levels insures excess demand. The reason that the Bank Hapoalim shares were massively oversubscribed was that every investor believed that the Government deliberately underpriced the shares to insure a successful offering, and therefore expected the shares to rise when trading opened. Share prices rose 3 percent on the first trading day. But Histadrut still lurked in the background.
In the meantime, a group headed by Shlomo Eliyahu bought 60 percent of Union Bank, jointly owned by the Government and Bank Leumi, for $85.5 million.
In August, the Government put 20 percent of Bank Leumi up for sale, again fixing a maximum price. In light of the Bank Hapoalim experience, it comes as no surprise that the pre-sale to institutional investors was oversubscribed 10 times, while that to the public at large was oversubscribed 500 times. Anyone who received an allotment of shares was sure to make money overnight. Altogether, the Government expects to collect NIS 1.2 billion after the exercise of all warrants.
Insuring overnight profits may be a good way for the Government to build support among the public for its sales of bank shares, and perhaps ultimately transfer of ownership and control. But the process did not sit right with Bank of Israel Governor Jacob Frenkel, who strongly objected to setting a maximum price on share offerings. (He is, after all, a University of Chicago economist, which means he understands the workings of the price mechanism in allocating resources efficiently.) He described the massive oversubscription as a sign of the total bankruptcy of the maximum price system that had turned stock issues into a lottery. He noted that no other country in the world operates such a system. Frenkel also used the occasion to warn the Ministry of Finance not to use the loan guarantee money to directly allocate credit to companies at preferential (below market) terms (which it later disregarded in the case of the Israel Electric Corporation).
When Bank Leumi shares opened for trading on September 1, they rose 16 percent on high turnover of NIS 33.6 million. Traders and investors who got in on the initial offering enjoyed an immediate profit.
On October 13, the Jewish Colonial Trust, the economic arm of the Jewish Agency, which held control of Bank Leumi from its founding in 1902 through 1991, announced that it had assembled a consortium of investors to acquire a controlling stake in Leumi. The intent was to purchase 15 percent of the shares to add to its existing holding of 5 percent.
At the end of October, Frenkel announced that the minimum controlling stake of the two big banks would be set at 20 percent, a figure supported by Minister of Finance Shohat. This decision appears to clear the way for the sale of control. Meanwhile, the Government decided to proceed with the sale of an additional 10 percent of the two banks.
Frenkel was persuasive. The Knesset Finance Committee eliminated the maximum price on stock issue sales through May 1994 to curb the massive oversubscription of new offerings that was causing sharp fluctuations in short-term interest rates and other undesirable results. On November 23, the Government offered another 10 percent of Bank Hapoalim at the market price without the use of underwriters. The banks themselves simply put the shares out to tender. The Jerusalem Post reported the next day that the public only purchased 69 percent of the shares.
Explanations abounded for the failure of the offering. One critic observed that the sale took place on the same day that the Bank of Israel announced a rise in interest rates, which created a negative atmosphere on the exchange. Another observed that it was more straightforward to purchase existing shares at the known market price than bid for an unknown number of shares in the new offering. A third reason was that the absence of a maximum price eliminated the certainty that had characterized earlier bank share sales, namely, immediate profit.
Two days later, the carnage increased. The reported sale of 69 percent of the Bank Hapoalim shares amounted, in fact, to a much smaller 53 percent. Simultaneously, Minister of Finance Shohat decided to delay the sale of 10 percent of Bank Leumi, scheduled for early December, to reconsider what had gone wrong. Now that the Government was trying to unload more of its bank shares, it was unable to do so. What an interesting twist.
What would real privatization of the banks amount to? A good example is privatization of the Mexican variety, which entails selling all Government shares and transferring control to genuine private enterprises. In light of the bank shares scandal and crisis of 1983, honest-to-goodness privatization means selling control to investors other than an entity of Histadrut and the Jewish Agency. Otherwise, the wheel will have turned full circle and the country's credit system will once again rest in the hands of the two groups that were at the helm a decade ago. Stay tuned.
Now examine the minimal progress in selling nonbank state-owned enterprises. On January 4, 1993, the Government sold 4.7 percent of Israel Chemicals Ltd. in a private placement for NIS 162 million, which reduced the state's ownership in ICL to 75 percent. This is privatization? On February 8, the Ministry of Finance released its scorecard on the state of privatization: the Government had so far sold a portion of its shares in only 8 out of 170 state-owned firms, and had officially decided to sell shares in only another 12.
The year was replete with talk and promises of privatization, but the same has been true for the previous four years. It is important for observers of Israel to watch what the Government does, not what it says. Ministers, Knesset members, and appointed Government bureaucrats have learned over the years to talk a good line on privatization. U.S. politicians and American Jews, after all, must receive progress reports on economic reform in Israel. Talk is cheap and privatization is a good buzzword. Firms in the headlines during the year included the State Medallions Corporation, the Government's 35 percent share in the oil exploration firm Magen (worth about $18 million based on stock market valuation), Israel Aircraft Industries, El Al Israel Airlines, Bezek, and other small enterprises. Actual sales were another matter.
Even President Chaim Herzog got into the act. At a meeting of the Manufacturers' Association he asked: "How is it that we are incapable of doing what Hungary and Czechoslovakia have done, not to mention France, Spain and Argentina?" The cabinet privatization committee stated in late February that it would dismiss directors and general managers of state-owned firms who stand in the way of privatization. There were no published reports of minor or wholesale dismissals throughout 1993. Talk reform, practice socialism.
The second sale of the year was the Government's 51 percent stake in Industrial Buildings Ltd. for $201 million to a group of investors headed by Eliezer Fishman. The group included the Jerusalem Economic Corporation (which is controlled by Fishman and Bear Stearns) and two members of the Bank Hapoalim Group, Diur and Ophir. Several Knesset members questioned the wisdom of privatization that entails selling a government-owned firm to a bank [Hapoalim] that is itself government owned. Good question. Privatization Israeli style does not mean privatization.
The Director of the Government Companies Authority, Yossi Nitzani, reported that state-owned firms lost NIS 220.3 million in 1992. The combined NIS 1 billion loss by Israel Aircraft Industries and Israel Military Industries wiped out profits in Bezek, Israel Electric Company and Israel Chemicals.
Shekem, the state-owned department story, owns and operates 47 supermarkets, 13 storage facilities, and numerous canteens and restaurants that serve military personnel. In 1992, the firm lost NIS 11.6 million, and its valuation was placed at NIS 300 million. The Shekem public offering on September 20 was oversubscribed 600 times. The Government sold 65 percent of the shares, raising NIS 204 million. The Government stated its intention to sell the remaining 35 percent of the shares to private investors who will gain control of the company, which would bring in another NIS 130 million.
On November 29, the Government sold its shares in Naphta to the public, raising NIS 117.5 million.
The proceeds of privatization, even if the process fails to transfer ownership and control to private hands, can be used for productive purposes, such as paying off the national debt, or can be used in a negative manner, such as bailing out bankrupt socialist institutions. What will Israel do with this money? Globes reported on November 10 that Shohat planned to finance the entire budget deficit in 1994 with the proceeds of bank shares and other state-owned firms. None of this money is to be returned to taxpayers in the form of a tax cut or to reduce future tax liabilities by paying down public debt. The sclerotic spending interests, reflected in the web of ministries and politically-favored constituencies, will devour all of this money. This is exactly opposite to the successful strategies of Latin American privatization.
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