Israel's Economic Reform Paradox

One of the great paradoxes of modern times is that globalization, so beloved by free marketeers and libertarians, has begun to produce one of the most intensely regulated international economic regimes in human history. If anything, as domestic markets have been unshackled from old tariff and non-tariff barriers, the international regulatory environment in which those markets operate has become ever more restrictive.

Israel is probably the best case in point. Israelis once believed that their country was unique; and that solutions to the problems they faced had to be unique as well. International regulations and standards were therefore considered an inconvenience at best, and usually an irrelevancy. The country has few natural resources, is physically isolated at the "dead-end of the line" on most air transportation routes, has been subject to any number of international boycotts, and has been at war or in the midst of preparing for war for most of its existence. For those reasons, for almost three generations, Israeli politicians were able to convince the public that without rigid, domestic, centralized control of the economy, any slight shock would drive investors away and send domestic markets into a tailspin.

As a result, until about two decades ago, Israel had one of the free world's most restrictive, centrally-planned Bolshevikian economies, run largely as private fiefdoms by government-owned or government-approved monopolies or cartels. Protectionism and import replacement were considered to be the sine qua non of national economic security. The combination of centralization and a lack of standards, however, was an ideal recipe for corruption.

But for almost twenty years, even before the recent public campaign against corruption, Israel suspiciously, and in the face of intense opposition by domestic special interests, has been inching towards market reform. Doomsayers were everywhere along the way—and some, even today, are trying to turn back the clock. Nonetheless, today, the country has a booming, so-called free-market whose performance has surprised even the reforms' most enthusiastic boosters.

Ironically, though, this change, has come about largely because the widely-lauded market overhaul has been directed almost solely at replacing the country's old regulatory environment with one that, in many ways, is even more rigid.

All the main economic indicators and financial market regulations are in the process of being altered to bring them into line with Eurostat criteria, World Bank good governance standards, IMF protocols, and OECD regulations. Even the definition of GDP used by the Central Bureau of Statistics has been altered to conform to the one used in other western countries.

The impact of this change has been nothing less than astounding. Inflation, which once exceeded 450 percent in the 1980s, is now down to almost zero. The shekel, once an almost untradable currency, is now so solid that is has been rising against the dollar despite the fact that Bank of Israel interest rates are lower than those of the Fed. As of this writing, from the beginning of the current year, the shekel has appreciated more than 7 percent against the dollar and more than 4 percent against the trade-weighted "basket of currencies." Despite the ongoing Intifada, the continuing threat from Hizbollah and the nuclear threat posed by Iran, the risk premium for shekel transactions fell in November to an almost insignificant 0.28 percent—down from 0.3 percent in October and 0.33 percent in August. This year, the balance of payments is expected to show a comfortable surplus, despite the war in Lebanon; and despite the war, according to Bank of Israel Governor Stanley Fischer, growth will be about 4.8 percent this year—and possibly more. The stock market is at an all time high; and it now seems likely that by the end of the year, Israel will have attracted more foreign investment as a proportion of GDP than any country in the world—including China.

The biggest surprise, though, is that last month the government began issuing 20-year, unlinked "Shahar" bonds. Only five years ago, the very idea of issuing bonds that were not linked to the dollar or the Consumer Price Index at anything less than prohibitive interest rates would have been unthinkable. And yet, this long-term paper has found a market at 5.81 percent interest—only marginally more than the 5.53 percent being paid for 5 year unlinked bonds.

While much of the credit for this turnaround can be attributed to Israel's adoption of many of the standard "fixes" prescribed by free-market economic gurus—privatization, financial market reforms, low budget deficits, and fiscal and monetary discipline—there is one factor that is often ignored. None of these remedies would have had the impact they have had were it not for the exponential growth in the adoption of international standards of accounting transparency. For decades, Israel was one of the most egregious examples of opaque accounting—to the delight and satisfaction of the politicians and oligarchs who wanted to be accountable to no one. However, under pressure from the international marketplace, the Israelis were forced to adopt inflexible international reporting practices.

The battle for transparency has yet to be won. The vilification of whistleblowers such as the State Comptoller and the Finance Ministry's Accountant General by politicians and their hacks have reached fever pitch. Nonetheless, the public is beginning to take its cue from the successes achieved by foreign investors. Accountability and quality management have become national buzzwords.

Today, foreign investors can trade anywhere in the world at the speed of a glass-fiber optic cable. In order to do so efficiently and effectively, however, they have to have comparative data. These data are only useful if they arise from the same definitions of the terms used; and if they have been gathered and aggregated according to the same criteria. Moreover, as any international businessman will tell you, the informal, unwritten, and often-changeable rules, such as those that used to be pervasive in Israel, are a far more formidable barrier to trade and successful investment than are formal, clear laws and regulations that are applicable to everyone. Now Israelis want the access to the same kind of data—but on domestic matters—as foreign investors have extracted from the government and the bureaucracy on financial issues.

As the Israeli case has demonstrated vividly, investors today look not only at a country's geopolitical situation when calculating anticipated risks and returns, but even more so at companies' bottom line—and their track recording in coping with geopolitical challenges. However, in order to do so, investors need clean, unfiltered and uncontaminated data. Israelis have begun to internalize these lessons. They are now looking to their government for the same results and the same transparency foreign investors expect of Israeli companies.

Probably the best example of the market investors' drive for regulation and uniformity in financial reporting is the annual survey of international fiscal and monetary transparency that CalPERS (the largest American pension fund) carries out each year. Originally designed to be yet another proprietary analysis, its survey, based largely on IMF codes, has become an international benchmark of the comparative economic probity of emerging economies ever since the fund began posting the survey results on its website several years ago. In the past year, the State Comptroller's and Accountant General's reports, which are now also posted on their respective websites, have had the same sort of impact on the Israeli public's perception of the state of their nation.

Israel, of course has not been alone in succumbing to international pressures. As anyone who even casually follows the volatility of international currency exchange rates knows, the penalties that markets have imposed on endemic accounting opacity in south-east Asian countries, Africa and Latin America in recent years have been severe. And therein lies the key to the paradox. The new, even tighter international regulatory environment has been designed to free up international markets by providing legal clarity and equal access to honest figures, while the old, more malleable and often laissez-faire one was designed to hide corruption, cronyism and government mismanagement.

Now, Israelis want the same sort of regulation of their own elected representatives and bureaucracts.

It is a trend that, with increasing globalization, will only strengthen in the future.