Government Stability
Razor-thin Majority Leaves No Room for Error

Polls conducted in the run up to an early parliamentary election held on March 17 pointed to a closely fought battle for first place between Prime Minister Binyamin Netanyahu’s center-right Likud party and the Zionist Union, an electoral bloc made up of the center-left Labor Party and the centrist Hatnuah. Against expectations, Likud won by a comfortable margin, claiming a total of 30 seats, against just 24 for the Zionist Union.

With Likud controlling less than one-half of the total of 61 seats required for a bare majority in the 120-member Knesset, the political bartering that is part and parcel of the fractured Israeli political system proved to be more difficult than usual for Netanyahu. Although the prime minister promised voters that he would deliver a right-wing coalition government, it became evident early on in the negotiations process that Netanyahu intended to exclude Neftali Bennett’s ultra-nationalist The Jewish Home from the government if he could do so. However, that strategy ceased to be feasible after Yisraeli Beiteinu pulled out of the negotiations at the 11th hour, confirming the end of a political marriage between Netanyahu and his former foreign minister, Avigdor Lieberman, that had become increasingly acrimonious over the last year.

The end result was the formation of a five-party coalition—made up of Likud, the centrist Kulanu, The Jewish Home, and two ultra-orthodox parties, Shas and United Torah Judaism—that claims a bare majority of 61 seats and is dependent for its survival on the backing of a far-right party (The Jewish Home) whose leader has made no secret of his personal dislike for the prime minister, a feeling that is evidently mutual. But potential sources of strife within the coalition are not limited to personality clashes. Although all of the parties are generally conservative in orientation, they have fundamentally different views on key issues that may be impossible to reconcile.

A case in point is a proposal floated by Justice Minister Ayelet Shaked, a member of The Jewish Home, to limit the Supreme Court’s authority to review legislation approved by the Parliament. The reform is supported by the religious parties, but is strongly opposed by Kulanu, which along with the opposition argues that the reform would weaken the underpinnings of Israeli democracy. Although Kulanu has been granted permission to vote against reform of the Supreme Court as part of its coalition deal, it is an open question whether The Jewish Home would remain in the government if the measure were defeated by one of its fellow coalition members.

Kulanu has also tangled with Shas, which threatened in late June to block all legislative business if Kulanu attempted to revise the wording of legislation requiring restaurants to publicly confirm whether the food they serve is kosher, which Kahlon contends would cause a hardship for small business owners. More generally, Shas jealously guards the special consideration its constituents have historically received in the areas of public spending and religious education, both of which are currently the responsibility of Kulanu’s founding leader, Moshe Kahlon, who demanded the Finance portfolio as the price for his party’s participation in the coalition, and whose remit was expanded to include the Haredi institutions.

The early signs suggest that the right-wing coalition will not survive for a full four-year term, and there is evidence that Netanyahu is still holding out hope that Likud might reach an agreement with the Zionist Union to form a much more stable unity government. Netanyahu has yet to appoint a minister of foreign affairs, and it is widely speculated that he is holding the job in reserve as an enticement for Labor leader Yitzhak Herzog to join the coalition.

However, Herzog threw cold water on that idea in mid-July, asserting that he will enter government as prime minister or not at all. The opposition leader appears to be assuming that Netanyahu’s coalition will splinter in due time, forcing an early election at which Labor, Hatnuah, and the centrist Yesh Atid party can make sufficient gains to form the core of a viable center-left majority government.

External Conflict
Deal a Diplomatic Defeat for Netanyahu
While there are a host of issues that divide political parties in Israel, there is unanimity on the question of whether Israel can tolerate a nuclear-capable Iran. In early July, the so-called P5+1 (the five permanent members of the UN Security Council and Germany) concluded negotiations for a deal that restricts Iran’s nuclear activities in exchange for the lifting of international sanctions. Supporters of the deal claim that it will ensure that Iran cannot develop a nuclear weapon, but Israelis across the political spectrum have assailed the agreement as a diplomatic failure on the part of the US that greatly endangers Israel’s security.

At this point, there is little more that Israel can do to influence the outcome. Obama has made clear that he will veto any changes to the deal made by his opponents in the Congress, and it is doubtful that Republican leaders can muster the votes required to override a presidential veto. During a recent visit to Israel aimed at beginning to repair frayed ties between the allies, US Secretary of Defense Ashton Carter attempted to turn the page by accentuating the virtues of the agreement, while stressing that it will come into force.

Following announcement of the deal, Herzog stated that his position on the agreement was identical to that of the prime minister, who has opposed the negotiations from the start on the grounds that Iran cannot be trusted to honor any agreements it makes. However the opposition has also criticized Netanyahu’s handling of the issue, with Yesh Atid leader Yair Lapid alleging that the prime minister’s aggressive lobbying against a nuclear agreement, which included an address to the US Congress in which he criticized the diplomacy of President Barack Obama’s administration, has hurt relations with the US and resulted in a worse deal than would have been possible if Netanyahu had instead worked cooperatively with the government in Washington. On balance, Netanyahu probably has little to gain politically from continuing to flog the issue at home.

In the absence of any clear breach of the terms of the agreement on the part of Iran, Netanyahu’s government can be expected to shift its focus more fully to relations with the Palestinians. In the closing days of the recent election campaign, Netanyahu asserted that no Palestinian state would be established while he is prime minister. The statement marked a complete reversal of Netanyahu’s repeated past assurances that he supports a two-state solution to the Israeli-Palestinian conflict, and he back-pedaled almost immediately once the voting was over.

Nevertheless, there is little prospect of a breakthrough in the immediate future. Although Netanyahu did speak with Palestinian Authority President Mahmoud Abbas on the telephone in July for the time in more than a year, reports of the conversation suggested it was mostly perfunctory. In any case, the composition of the current governing coalition will not be conducive to re-establishing fruitful communication between the two sides.

Investment Profile
Parties Prepare for Budget Fight

In terms of domestic priorities, the Knesset has until the end of August to pass a draft budget that will cover both 2015 and 2016. In July, the Knesset approved an extension for final passage of the budget until November, which means that the spending plan will actually cover just 13 months. Netanyahu lobbied for a budget that would outline spending priorities through the end of 2017, but Finance Minister Kahlon objected, noting that approval of full two-year budgets, which reduce the opportunities for fiscal debates to destabilize the government, also increase the danger of inaccurate projections that lead to imbalances.

Kahlon is a former member of Likud who parted ways with Netanyahu’s party over disagreements related to socioeconomic policy, in particular, Likud’s failure to address the problem of wealth inequality. According to media reports, Kahlon is insisting that the fiscal deficit be held to no more than 2.9% of GDP, which will require an estimated $3.3 billion in spending cuts. Toward that end, Kahlon has called upon the coalition parties to accept changes to spending levels for various budget items and delays in tax relief that to which the government committed during coalition negotiations. Both Shas and United Torah Judaism insist that all spending and tax commitments are binding.

The willingness of the parties to compromise will depend on their readiness for an early election that would likely become necessary if the government fails to secure approval of its budget. Although inflexibility on the part of the coalition partners would carry a risk of sowing instability, tolerance of a larger budget deficit would arguably be worse. Israel’s fiscal situation has become a source of concern over the last year; ratings agency Fitch revised the outlook for Israel’s single-A credit rating from positive to stable in November 2014, and the IMF has called on the government to trim the deficit to 2.5% of GDP. Against that backdrop, signals that policy-makers are willing to relax fiscal discipline in order to avoid an early election would understandably erode the confidence of investors.


Stronger Export Performance Will Lift Growth in Going Forward

In June, Israel’s Central Bureau of Statistics downgraded its estimate of first quarter GDP growth from 2.5% to 2.1%. Private consumption, which grew by 7.5%, was a key driver of expansion in the first quarter, while fixed investment and exports both contracted. Broadly speaking, the quarterly economic data has been volatile in the last year, but the general trend line points to an acceleration of annual real GDP growth, as an improved performance by the export sector in the second half of the year reinforces the positive impact of consumption, pushing the rate of expansion above 3% in 2015.

The Bank of Israel (BOI) maintained its 0.1% policy interest rate at its June meeting. With annual inflation at the lower bound of the BOI’s target band, monetary authorities are unlikely to initiate tightening before the end of the year. Strong private demand and a recovery in commodity prices will produce higher inflation next year, and the BOI will likely raise its policy rates early in 2016.

Part of the BOI’s motivation to move its base rate close to zero has been to keep the shekel from strengthening. Israel’s currency was trading at more the four to the dollar back in March, but the exchange rate had moved to ILS3.82 to the dollar by the end of July. As the BOI begins to tighten monetary policy next year, the shekel will continue to appreciate, but an improved climate for exports will limit the negative impact of a stronger currency on export competitiveness.

The current account balance recorded a comfortable surplus of $2.9 billion in the first quarter of 2015, reflecting the positive effect of low oil prices and a rebound in tourism income following the conclusion of the military operation in Gaza last year. The anticipated improved performance of the export sector in the second half of the year will help to sustain the current account surplus, which is forecast to widen to 4.8% of GDP in 2015.