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Israel: The Economic Cost of War

By Stanley Reed and Neal Sandler in Jerusalem
April 19, 2002
Business Week

Violence has ended the rapid growth of the '90s,
scaring off investors and eroding the hard-won gains of economic reform

These days, a conversation in Benny Gaon's Tel Aviv office about the situation in the Middle East calls for a bracing glass of wine, even if it's only 10 a.m. "We are back to square minus one. We are back to 1948," says the former CEO of conglomerate Koor Industries Ltd., who now runs his own $1 billion investment company, B. Gaon Holdings. A close associate of the late Prime Minister Yitzhak Rabin, Gaon was in the vanguard of Israeli executives who sought to use business to build peace between Israel and the Arabs.

Now, he's profoundly disappointed about the escalating Israeli-Palestinian violence. "Four years ago, I was strutting like a peacock at the World Economic Forum, talking with the Saudis and Jordanians about the new market of the Middle East," Gaon laments. "Now, it's all gone."

Not long ago, just about everything seemed to be going Israel's way, too. That was before the latest Palestinian intifada began in September, 2000. Signing the 1993 Oslo accords, a framework for peace with the Palestinians, helped put an end to Israel's isolated status, opening up closed markets in Asia and Europe to Israeli companies. A new model seemed to emerge as Israel began to shed its state-dominated, military-industrial economy to build a middle-class society based not only on service businesses like construction and tourism but also, increasingly, on high tech.

IN RUINS. Suddenly, venture capitalists rushed to throw money at Israeli startups. Tel Aviv became a kind of Silicon Valley on the Mediterranean, teeming with technology whizzes reaping millions and even billions of dollars by taking their companies public. The central bank made the picture more attractive by damping inflation, ending years of economic instability.

The hope was that Israel would play a pivotal role at the center of a growing, vibrant regional economy that would lift living standards in both Israel and the Arab world. Instead, war has combined with the fallout from the global technology crash to deal Israel a harsh blow. The country has been in recession for almost two years, and there is no sign of a respite. Real estate prices have plummeted 30% to 50%; hotel occupancy is running just 7% in Jerusalem during the usually busy post-Passover season; restaurants are deserted. Even harder hit is the neighboring Palestinian economy, which the international community hoped would increasingly blend with Israel's. It lies in ruins, with half the population living on less than $2 a day.

Against this depressing backdrop, Secretary of State Colin L. Powell in mid-April led the Bush Administration's most intensive diplomatic effort in the region so far. His mission: to bring an end to the spiraling violence that has killed 452 Israelis and more than 1,400 Palestinians since September, 2000. But Powell had not secured a ceasefire when he left Israel on Apr. 17. He said the U.S. would keep pushing for one, and may organize an international peace conference on the Middle East. Powell also offered $30 million in new U.S. aid -- on top of $80 million already pledged -- to repair the damage to the Palestinian economy.

BLACKENING IMAGE. Sadly, there's a strong chance the violence will continue. That adds to Israelis' worries about the direction their economy seems to be heading. Defense spending is rising sharply, after plunging from 13.5% of gross domestic product (GDP) to 8.5% in the 1990s. This year, the security burden on Israel's economy is likely to jump back up to 9.5% of GDP. The danger for Israel is that its economy could slip back to what amounts to a charity project sustained by donations of the U.S. and world Jewry. Israel got by that way in the 1980s, when the currency was a joke, inflation hit triple digits, and the bank system required a bailout.

To be sure, Israel is still a long way from such dire straits. While the shekel has declined about 12% against the dollar in the past year, there are no signs of panic. Still, day by day, it's increasingly clear that the pillars of Israel's economic strength are under threat. The conflict with the Palestinians is blackening Israel's image abroad, scaring off potential foreign investors. That in turn is darkening the prospects of the high-tech industry, which accounts for a hefty 15% of GDP. War expenditures and a decline in budget receipts threaten to undo Israel's hard-won reputation for fiscal and economic discipline. Higher taxes seem certain, and the central bank is worried that its inflation-fighting mandate will be weakened.

Israeli businesspeople are alarmed. They are beginning to make their views known privately in a country where politicians from military backgrounds traditionally call the shots. "We are eager to see the day when this is over," says a senior executive at a top Israeli company. "If it continues and people feel we are using power not just for defense but to show we are stronger, then you will hear screaming from the business community."

WARY INVESTORS. Business is already deeply anxious about the high-tech sector. After explosive growth for a decade, high-tech exports of software and other goods went into decline last year for the first time, by about 10%, to $10 billion. Israeli industry is still cleaning up the mess left after the high-tech bubble burst. The year 2000 was the peak of the boom, with startups gaining an extraordinary $3.1 billion in venture money. Companies may not get more than $1 billion this year, estimates Tobias Fischbein, high-tech analyst at Lehman Brothers Inc. in Tel Aviv. Some 500 of Israel's 3,000 fledgling companies closed last year, and industry sources think more than 100 will vanish this year.

Since the beginning of 2001, Fischbein's own index of Israeli tech stocks has fallen by 63.5%, vs. 29% for the Nasdaq in the same period. Until recently, most damage to Israel-based stocks was due to the overall Nasdaq collapse. But now, analysts say, Israeli companies are being singled out. The market capitalizations of the three major tech companies -- Check Point Software Technologies (CHKP ), Amdocs (DOX ), and Comverse Technology (CMVT ) -- are each down more than 30% this year alone. Check Point and Comverse have recently issued profit warnings.

The sudden shift in Israel's standing abroad is touching companies of all sizes. "We're not going to see any foreign money in the venture-capital industry this year," says Zeev Holtzman, chairman and CEO of Giza Venture Capital. Yanki Margalit, CEO of Aladdin Knowledge Systems Ltd. (ALDN ), a software and Internet security company with $50 million in annual sales, says his company was due to sign a deal with a major Japanese company last year when a Palestinian suicide bomber killed 21 Israelis at a Tel Aviv disco. "They called and said: 'We are not going to do it because of price issues,' but that was nonsense," says Margalit. The company clearly grew wary of dealing with an Israeli company, he adds.

SHIFTING OPERATIONS. Such attitudes mark a big change, says a senior executive at one of Israel's top tech companies. A few years ago, customers chose to ignore the situation in Israel as they focused on getting new tech products quickly. "Now, they are more concerned and looking to find reasons to be concerned," he says. "They ask: 'What happens if you can't deliver?' I believe at the end of the day this has cost us orders."

Executives say they spend a lot of time discussing "the security situation" in Israel rather than business. Some customers and board members from abroad are unwilling to visit the country for meetings. Many companies find it wise to hold board meetings in Cyprus or New York. "It's not easy to find strategic partners," says analyst Fischbein. "Would you invest in a company you hadn't visited?"

The upshot is that Israeli companies are setting up extensive operations outside the country. Such shifts are partly to protect themselves from possible disruptions. But Israel, with only 6.5 million people, is also too small a market in which to fully develop products. And earlier visions of a regional market with Arab countries have evaporated for now.

"LACK OF VISION." Some Israelis find this a big loss. "The lack of a regional market makes it very hard for companies to build globally," says Chemi Peres, managing director of Pitango Venture Capital, Israel's largest homegrown venture firm. "The risk is that [once this crisis is over] entrepreneurs will leave the country. The more we postpone building a regional market, the more we lose."

Meanwhile, Sharon's government is struggling to cope with a budget squeeze. Finance Minister Silvan Shalom told BusinessWeek the war has cost Israel about $1 billion in direct expenditures since early March, and some $5 billion in lost tourism and other business since September, 2000. "Investors are not coming," he says. "In Israel, people are afraid to go out to malls and restaurants like they used to. This brings high unemployment and makes the recession deeper. It is a cycle we are trying to escape."

Some of the official response to the slump smacks of desperation. A recent government campaign, for example, urges Israelis to buy blue and white, meaning home-produced products. "This takes us back to the 1960s, when we even tried to produce our own cars," says Eytan Sheshinski, a Hebrew University economist. "It shows a complete lack of vision."

BACK TO THE '80s? There are even worries about Israel's financial stability. The rating agency Standard & Poor's recently moved its outlook on Israel from stable to negative in response to the violence and fiscal pressures. Adding to the unease is a dispute between the government and David Klein, the central bank's governor. At issue: proposed revisions to the central bank law that Klein worries will water down Israel's commitment to fight inflation. "When you have a growing financial deficit, if at the same time you say to the markets you don't care about price stability, you have lost two major fundamentals of economic policy," Klein says.

The central bank governor also opposes the Finance Ministry's likely plan to raise taxes. "We are in a world where we compete on tax regimes against other countries," Klein says. "We can't afford to be at a tax disadvantage." Instead, Klein thinks the government should focus on pruning back the public sector, which still accounts for 54% of GDP -- one of the highest rates in the world. Despite Klein's warnings, executives such as Eitan Raff, chairman of Bank Leumi, figure inflation will rise this year--perhaps as high as 4%, compared with zero in 2000.

So is it back to the bad old days of the 1980s? Then, hard economic conditions drove many talented Israelis to seek their fortunes elsewhere. That doesn't seem to be happening this time, at least not yet. In fact, Israelis living abroad are returning home to serve in their reserve units. For now, the suicide bombers have unified the country. "This is a strong country, a moral country, building something real; it is not going to give up," says Peres, a son of Foreign Minister Shimon Peres, an architect of the Oslo process.

WILD SWINGS. But there is also fear. With investments in their own country looking like a bad bet, Israelis have been putting money into Toronto as well as Prague and Budapest, which are appealing to Israelis of Eastern European origin. Big real estate players such as Africa-Israel Investments Ltd. are investing in shopping malls and residential housing abroad, while small fry are buying apartments to rent out. An estimated $500 million has left the country or been transferred into foreign currency accounts in the first quarter of 2002, analysts say. Recently, Israelis have snapped up second homes on nearby Cyprus -- an insurance policy in case of all-out war. "They can send their families there," says Stanley Finkelstein, a Tel Aviv real estate consultant. "It is only a half-hour flight."

With suicide bombers blowing people to bits on an almost daily basis, most executives think Sharon had little choice but to go after the sources of the attacks. Yet many of them doubt Sharon has an effective strategy to create a more secure environment over the long run. And they are dismayed by the wild swings in policy in recent years. The government's approach to its Arab neighbors has whipped back and forth between such hard-liners as Benjamin Netanyahu and Sharon, and Ehud Barak, who pursued peace in almost reckless fashion.

Gaon heads a group of executives and academics who aim to propose an alternative to these policy gyrations. They want to build up the enfeebled Labor Party, an uneasy partner in Sharon's government, into a viable alternative for general elections that must take place by the fall of 2003. They also want to continue economic liberalization and put an end to the national malaise that has taken hold. "We have made huge progress in business," says Gaon. "Why aren't we doing the same in politics?"

HEALING THE WOUNDS. As Gaon and other executives look for solutions, support is growing on the left and right for separating the Israelis and Palestinians. A fence with electronic sensors already largely walls Gaza off from Israel. Recently, the Israeli security cabinet gave the go-ahead to begin work on such a barrier between parts of the West Bank and Israel, including Jerusalem.

Some Palestinians hope a physical separation from Israel could spur them to integrate their economy more closely with regional neighbors such as Jordan and Syria. There, the standard of living is similar to that of the territories. But the danger is that the Israelis could keep the Palestinians cooped up in their enclaves with little ability to trade with the outside world. Despair and radicalism would be bound to grow regardless of how high Israel builds its fences.

Clearly, the status quo makes it impossible for Palestinians to reach their potential -- economic or otherwise -- and increasingly hampers Israelis' ability to reach theirs. Prosperity on both sides could help heal the wounds of war and build a lasting peace. Instead, the wealth of Israel is trickling away, bit by bit, in a deadly war of attrition.