Karnit Flug: Challenges facing manufacturing and Bank of Israel's policy
to deal with them
Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the Manufacturers' Association
Conference, Eilat, 21 November 2014.
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I was asked to open my remarks by sharing with you the answer to the question, "What
manufacturing means to me?"
I spend a lot of time visiting manufacturing plants throughout Israel. Each time I make such a
visit, I am deeply moved by the industry creativity, initiative, innovation and the ability to
continue creating even during periods of missiles and sirens. Manufacturing for me is first of
all an important source of employment and economic growth. Manufacturing operates in a
changing world, and in order to continue succeeding, it needs to adapt to changes in the
global competition environment, in the financial environment, in the regulatory environment,
and also to adjust to changes in the public discourse which, in recent years, has placed a
heavier emphasis on economics, consumerism, the cost of living, and other things. It is
important for me to emphasize that in order for manufacturing to success, it must be
profitable, since no one establishes a plant out of the goodness of their heart, and certainly
not over the long-term. In order for industry to succeed, it must be competitive, and its
employees must enjoy the proper fruits of that success. The success of Israeli manufacturing
is the success of the Israeli economy, and the success of us all.
I would like to discuss the challenges facing manufacturing in the short term in a challenging
global environment, and to outline how the Bank of Israel's policy acts to encourage growth
at this time. In the longer term as well, there are significant challenges facing us, including
the need to increase productivity, so that manufacturing can compete in the global world. I
will also discuss what policy is required in order to deal with these challenges.
The short-term challenges, and the Bank of Israel's policy to encourage growth
In recent years, growth in the Israeli economy has been slowing, in parallel with the
slowdown in growth worldwide, both in advanced economies and in emerging economies.
The decline in GDP during the third quarter is obviously also a result of Operation Protective
Edge, and we can expect that the figures for the final quarter of the year will already show a
return to the growth rates that have characterized the economy in recent years, of slightly
below 3 percent. The main factor in the moderate growth is moderate global demand, which
is reflected in a virtual standstill in global trade of goods - where Israel's goods exports have
been even lower than it in recent years - and a moderate increase in the global trade of
services, where the Israel's services exports have grown more rapidly than it.
The global slowdown, combined with global supply factors, are reflected in a decline in global
commodities prices, particularly oil, and together with the slowdown in demand, these are
reflected in a sharp decline in inflation in Israel. This was also affected, until recently, by the
prolonged appreciation of the shekel, which eroded the competitive ability of Israeli
manufacturing.
Against this background, the Bank of Israel acted both by continuously reducing the interest
rate to a low level of 0.25 percent, and by intervening in the foreign exchange market, inter
alia to offset the effect of natural gas production on the exchange rate. This policy, alongside
the strengthening of the dollar worldwide, has generated a turnaround in the exchange rate
since the last two interest rate reductions, and the shekel has since depreciated by
6.5 percent in terms of the nominal effective exchange rate, and by 12 percent against the
dollar. The current exchange rate certainly makes it easier for Israeli manufacturing to
compete in the challenging global environment.
The long-term challenges: gaps in productivity and per captia GDP vis-à-vis the other
advanced economies
Per capita GDP in Israel is about 60 percent of what it is in the US, and about 87 percent of
the OECD average. The gap has narrowed since the global financial crisis, since we bridged
it with relative success, but over time it has remained in place. An assessment of the source
of the gap shows that it is not the result of employment rates. Employment rates in Israel
have constantly increased, while in most of the advanced economies, including the US, they
declined, mainly following the crisis. As of today, the employment rate in Israel is higher than
in the US, and higher than the average among advanced economies.
In contrast, productivity in Israel, which is measured as product per hour of work, does not
close the gap with the OECD countries, and the gap has even widened relative to the US. An
assessment of the gap by industry indicates that export-oriented industries, which was
exposed to international competition, tend to have higher productivity than their peers in
other countries, while domestic-oriented industries (both in manufacturing and in other
industries) have lower levels of productivity than the same industries in other advanced
economies. Focusing on the manufacturing industries indicates that productivity in these
industries has increased relatively rapidly - reflecting, over time, the increase in the weight of
high-productivity industries that are human capital and physical capital intensive, and a
decline in the share of low-technology manufacturing. Against this background, there was no
long-term increase in employment in manufacturing.
What are the main factors in the relatively low productivity of the business sector in
Israel?
The first factor is the low capital inventory per employee, which reflects a low rate of
investment in product compared to other advanced economies. Here too, there is obviously a
gap between various industries: In those that are technology intensive, investment grew
relatively rapidly, and with it human capital and productivity, while in other industries - such
as agriculture, trade and services, and low-technology manufacturing - where most of the
output is intended for the domestic market, investment is relatively low, which is reflected in a
slight increase in labor productivity.
Productivity is obviously also affected by the amount of innovation, which relies on research
and development. The national expenditure on research and development in Israel is higher
than in other countries, reflecting the relatively high weight of technology-intensive industries,
which are obviously also research and development intensive. However, over time, the
government's share of investment in R&D has declined, and it is lower than in other
countries.
There are naturally large differences between various industries in expenditure on research
and development. However, we can see that internationally as well, the gaps in expenditure
on innovation among the manufacturing sub-industries in Israel are particularly large. While
the communications industry and the medical devices industry invest much more in R&D
than their peers in the OECD (and we have also seen that productivity in these industries is
higher when compared internationally), the plastics and food industries invest far less, in
international comparisons as well.
Alongside low investment in physical capital and in research and development, the low
investment in professional training, and to a certain extent in technological education, is also
prominent. Effective and focused professional training is tremendously important for the
ability to provide manufacturing with the human capital it requires, and a public discourse is
currently taking place regarding how to most appropriately provide this training.
Another factor that negatively impacts business sector productivity is the business
environment, as reflected in the World Bank's Doing Business Index. According to this index,
we fell two more places in the rankings in the past year, and since 2007, we have fallen from
26th place to 40th place in terms of the business environment. The decline in the ranking
does not necessarily reflect an absolute worsening, but it certainly does reflect the fact that
other countries have focused on improving their business environments, while we have
remained behind. In a competitive world, the determining factor is obviously our relative
position.
It is also clear that wages which, in a competitive environment are consistent over the long
term with labor productivity, can rise over time only if we do what is required to accelerate
increased productivity and to expand it to all industries.
The policy required to cope with the long-term challenges
In view of the weaknesses that I have mentioned, which stand behind the fact that labor
productivity in Israel is increasing slowly and that its level is still significantly far from the
forefront of the advanced economies, the directions that must be taken in order to accelerate
and expand the increase in productivity are clear:
 It is worthwhile incentivizing and supporting the adoption of advanced technologies
and technological improvements, particularly in industries that are typified by low
technological intensity, whether in the manufacturing industry or in the services
industries.
 Due to the continuing decline in the Chief Scientist's budget as a share of the state
budget and of GDP, and in view of the high return on such support to the economy,
it is worthwhile diverting budgets to such activity, while also involving medium and
low technology manufacturing.
 Professional training programs must be expanded, improved, and streamlined, with
an emphasis on post-secondary frameworks.
 It is worthwhile expanding technological-scientific studies in the secondary schools,
and supporting post-secondary technological studies, including those in
technological colleges.
 Achieving the required improvements in the business environment, while focusing
on the main points of weakness, concerning bureaucracy in the fields of construction
and real estate, in the legal environment, and so forth, should not be abandoned.
 Infrastructure reforms, including in the electricity field and in the ports, as well as
connecting manufacturing to the natural gas infrastructure, should be advanced.
The implementation of a policy to improve manufacturing productivity in Israel is the
key for manufacturing to remain strong and to provide quality employment for all parts
of the population in all parts of the country.