Next Israeli leader certain to face growing budget problems

Whoever emerges as Israel's prime minister after Tuesday's election will need to rein in a growing budget deficit quickly before it hits economic growth.

The deficit has swelled over the past year under Prime Minister Benjamin Netanyahu and Finance Minister Moshe Kahlon, who cut taxes while spending heavily on cost-of-living subsidies and pay rises. Israel's economy has been in a holding pattern since an inconclusive election in April. Limited in power, the caretaker government was unable to rein in a gaping budget hole that grew to nearly 4% of the gross domestic product in the last 12 months, versus an initial target of 2.9%.

A national unity government could emerge following Tuesday's election, in which no single party won a majority. Such a government could be in a position to reduce pressure on state expenses, economic analysts said. "A broad government where no small party has the power to extract what they want for special interest groups makes it easier to make policy for the entire society," said Karnit Flug, who was Israel's central bank governor until late last year.

The budget would be the first challenge, she told Reuters. Other tricky economic questions will remain, whether Netanyahu continues his record-breaking tenure as prime minister, or is replaced by his rival Benny Gantz, a former military chief.

No Israeli party has ever won an election outright, so the final outcome will depend on coalition negotiations, a lengthy and expensive process. Former Defence Minister Avigdor Lieberman has emerged as potential kingmaker and favors a unity government with Gantz's and Netanyahu's parties.

Previously, Netanyahu relied on smaller religious parties which gave their support to him in return state handouts, such as costly stipends for seminary students. Those religious parties strengthened their position in Tuesday's vote but could be left out of a unity government. Israel’s economy is forecast to grow by 3.1% in 2019 and as much as 3.5% in 2020. An unchecked deficit would weigh on Israel’s debt-to-GDP ratio, which it lowered to 61% in 2018 from 74.6% in 2009.

ACTION NEEDED NOW

Bank of Israel Governor Amir Yaron warned this month that the deficit was too high to allow further growth and that cost cuts and tax increases were needed.

"Our economy is still in a good position to make changes in order to reduce the deficit, and we need to make them now," Finance Ministry chief economist Shira Greenberg said last week. She advised the government not to be too aggressive in closing the gap because the Bank of Israel, whose benchmark interest rate stands at 0.25%, has less maneuverability to help stave off a potential slowdown.

Flug, who is now a vice president at the Israel Democracy Institute, a think tank, said the economy was projected to keep growing near its potential and that the deficit should be "no more than 2.5% of GDP for 2020," reflecting adjustments of at least 20 billion shekels ($5.7 billion). That might be too optimistic for the Finance Ministry, where officials estimate a deficit target of around 2.9% next year, including more modest fiscal moves.

"At the end of the day, coalition partners will have to look at the current situation and understand ... 2020 and 2021 are not years we will have extra (funds) to give out," said Shai Babad, the ministry's director-general. Babad expects the next government to vote on the new budget for 2020 and 2021 in January, with final parliamentary approval in March.

Whoever is tasked with forming a government will have up to 42 days to entice partners. Generous offers during negotiations can end up being followed by a broad cut across all sectors, economists said. "Usually that's how they deal with it. You get, and then suddenly everyone is cut 2%," said Amir Kahanovich, chief economist for the Excellence Investment House. "It's an easy option."

($1 = 3.5403 shekels) 

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