1

Bank of IsraelAnnual Report 2008

April 19, 2009April 19, 2009

2

2008: A Turning Point Following five years of fast growth, in the second half of 2008 the economy reached a

turning point, and the economy went into a recession as a result of the worsening global financial crisis and its increased effects on the local economy.

In the first half of the year the economy continued the same trends that had typified the fast growth period:

- High level of economic activity- Low rate of unemployment- Surplus of the current account- High savings rate- Reduction in the debt/GDP ratio- High profits in the business sector

In the last quarter of the year the economy entered a recession:- Sharp decreases in exports and tax revenues- Reduction in private consumption- Labor market: employment expansion came to a halt, wages fell and unemployment began to

rise

Inflation turnaround:- Until September – high, as a result of rising world oil and commodities prices and excess

demand- After September – dramatic decline as a result of falling world prices and a moderation of the

excess demand

3

2008 :A Turning Point (cont.)

Accelerated rates of inflation in the middle of the year as a result of the closed output gap and increased commodity prices; monetary policy at the time dealt with curbing the rise in inflation.

With the worsening of the global crisis since September and the drop in inflation, the interest rate has been reduced dramatically to an unprecedented level in Israel’s history. The Bank of Israel has purchased considerable sums of foreign currency in order to increase the country’s reserves and as a measure to deal with the accelerated currency appreciation; In February 2009 the Bank of Israel began to purchase government bonds to ease credit conditions.

The shock to Israel’s financial system was considerable, yet comparatively moderate: Stocks and private bonds fell and spreads in the credit market rose considerably.

- Banks demonstrated stability- The main impact occurred in the non-bank credit market

The budget deficit grew and the decline in the debt/GDP ratio slowed as a result of the slowdown in activity and drops in the capital market, which affected tax revenues, and due to further tax reductions.

4

GDP Growth Rates in Israel Were Higher than in the Advanced Economies

4.4

2.1 2.1 1.8

3.02.6

3.2 3.1

0.8 0.70.0

-0.8

-6.3

8.9

-0.4 -0.7

1.8

5.0 5.1 5.2 5.4

4.04.7

3.4

1.3

-0.5

-8

-7

-6

-5

-4

-3

-2

-1

0

1

2

3

4

5

6

7

8

9

10

2000 2001 2002 2003 2004 2005 2006 2007 2008 2008Q1 2008Q2 2008Q3 2008Q4

AdvancedEconomies

Israel

%

-The quarterly data is the seasonally adjusted rate of change from the previous quarter at an annualized rate.

-The growth rate for the advanced economies is a simple average of their individual growth rates (excluding

Luxembourg and Iceland).

Source: OECD Data and the Bank of Israel

5

Steep Decline in Exports and a Drop in Private Consumption

8.7

3.10.7 0.3

5.43.9 4.0 3.9

7.6

0.2 0.6

-3.1

-11.1

-2.0

8.0

17.5

4.36.1

8.5

18.5

-12.0

1.1

-44.8

6.73.0

-50.0

-40.0

-30.0

-20.0

-10.0

0.0

10.0

20.0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2008Q1 2008Q2 2008Q3 2008Q4

Private Consumption

Exports

%

- The quarterly data is the seasonally adjusted rate of change from the previous quarter at an annualized rate.- Exports of goods and services excluding support paymentsSource: CBS

6

Current Account of Balance of PaymentsCurrent Account of Balance of Paymentsas Percentage of GDP, 2000-2008

-1.8 -1.6-1.1

0.5

1.7

3.1

5.0

2.6

0.8

2.6

-0.4 -0.3

1.4

-6.5

-4.5

-2.5

-0.5

1.5

3.5

5.5

Source: Balance of payments, CBS

%

%

3.6

1.8

3.9

3.0

4.0

3.4

3.0 2.9

1.6

0.6

4.1

3.5

5.3

3.6

1.8

0.9

0.0

2.1

5.9

0

1

2

3

4

5

6

7

2000 2001 2002 2003 2004 2005* 2006 2007 2008 2009*

Deficit Target Actual Deficit

Budget Deficit** (Percentage of GDP, 2000-2009**)

*Percent of GDP; excluding credit extended. The data refers to the deficit excluding the Bank of Israel’s profits.**BOI forecast for 2009 is based on the budget that has been approved by the government.

8

Actual and Expected Rates of Inflation

0.0

1.4

6.5

-1.9

1.2

2.4

-0.1

3.43.8 3.6

5.0 5.14.6

3.4

1.9

1.2

2.7

2.01.6

2.0 1.81.4

1.92.5

2.8 2.7

-0.3

0.7

-2.5

-1.5

-0.5

0.5

1.5

2.5

3.5

4.5

5.5

6.5

7.5

2000

2001

2002

2003

2004

2005

2006

2007

2008

2008

Q1

2008

Q2

2008

Q3

2008

Q4

2009

Q1

Actual Inflation

Inflation Expectations

%

The data of “Inflation Expectations” (both annually and quarterly) is the average of the relevant time period.The quarterly data of inflation is the quarterly average of the Consumer Price Index over the last 12 months.Source: Bank of Israel

9

Rate of Unemployment: Turnaround in the Last Quarter of 2008

(2000-2008)

Source: CBS

%

6.1 6.26.0 6.0

6.3

7.3

8.4

9.0

10.4

10.7

10.3

9.38.8

5.0

6.0

7.0

8.0

9.0

10.0

11.0

12.0

2000

2001

2002

2003

2004

2005

2006

2007

2008

2008

Q1

2008

Q2

2008

Q3

2008

Q4

10

Five Years of Growth: What Have We Gained?

A rise of 10% in real per capita GDP since 2000 and 15% compared with 2001-02

Sustained surplus in the current account A decline in absolute poverty levels, in almost all population groups Increase in the participation and employment levels and a decrease

in unemployment in all population groups Improved fiscal environment: reduction in the budget deficit, public

debt and public expenditure as a percentage of GDP accompanied by tax cuts

What haven’t we gained? Cyclically adjusted, the declines in deficits have been modest Per capita GDP relative to the U.S. – return to 60% (level preceding

the recession) An increase in relative poverty (although it declined in the last two

years)

11

Per capita GDP

97.8

85.188.6

78

80

82

84

86

88

90

92

94

96

98

100

2000 2001-2002 2008

2)14.9%(

88.9

83.7

86.0

81

82

83

84

85

86

87

88

89

90

2000 2001-2002 2008

Per capita GDP in Israel Relative to the Advanced Economies1 based on Purchasing Power

Parities

Per capita GDP

)2008 prices, NIS thousands(

1.The “Per capita GDP” in the Advanced Economies of the OECD excluding Luxembourg and Iceland is the simple

average of their individual per capita GDP.

2 .Rate of change between 2001-2002 and 2008

12

6.1

9.8

8.8

0

2

4

6

8

10

12

14

2000 2001-2002 2008

Overall Unemployment Rate and the Rate for those with 0-10 Years of Education Dropped to Low Levels

Source: CBS, Labor Force Surveys

%

10.1

14.113.5

0

2

4

6

8

10

12

14

2000 2001-2002 2008

%0-10 Years of EducationOverall

13

0

10

20

30

40

50

60

70

80

1 2-4 5-6 7-8 9+

1997 2003 2007/8

0

10

20

30

40

50

60

0-8 9-10 11-12 13-15 16+

1997 2003 2007/8

0

10

20

30

40

50

60

70

80

90

0 1 2+

1997 2003 2007/8

0

10

20

30

40

50

60

70

Jewish not ultra-orthodox

Jewish ultra-orthodox

Arabs

1997 2003 2007/8

%

% %

%

Rate of Relative Poverty by Group,a 1997, 2003 and 2007/8b

By education level of head of household (years of schooling) By family size

By population group By number of earners

a Not including Arabs of Jerusalemb The data are based on a survey conducted between July 2007 and June 2008SOURCE: Based on data from Central Bureau of Statistics and Income Surveys

14

0

10

20

30

40

50

60

70

80

1 2-4 5-6 7-8 9+

1997 2003 2007/8

0

5

10

15

20

25

30

35

40

45

0-8 9-10 11-12 13-15 16+

1997 2003 2007/8

0

10

20

30

40

50

60

70

0 1 2+

1997 2003 2007/8

05

101520253035404550

Jewish not ultra-orthodox

Jewish ultra-orthodox

Arabs

1997 2003 2007/8

%

%%

%

Rate of Absolute Poverty by Group,a 1997, 2003 and 2007/8b

By education level of head of household (years of schooling) By family size

By population group By number of earners

a Not including Arabs of Jerusalemb The data are based on a survey conducted between July 2007 and June 2008SOURCE: Based on data from Central Bureau of Statistics and Income Surveys

15

47.3

50.4

43.3

38

40

42

44

46

48

50

52

2000 2001-2002 2008

%Public Expenditure as a

Percentage of GDP

• Source: Bank of Israel

78.085.1

93.7

0

10

20

30

40

50

60

70

80

90

100

2000 2001-2002 2008

%Debt/GDP Ratio (gross)

Fiscal Indicators

16

The 2001-03 Recession and the Current Recession

2001-20032001-200322ndnd Quarter of Quarter of

2008 - ?2008 - ?

Source of the Shock

Hi-tech bubble burstWorld slowdownIntifada

Global financial crisisGlobal recession

Starting Conditions(eve of the recession)

Following a short period of fast growth

Five years of sustained growth

17

Unindexed 5-Year Government Bond Yields(01/2000-02/2009)

Source: Bank of Israel and the Federal Reserve Bank of St. Louis

*Spread between the yields of the 5 year Shahar (derived from the 0-curve) and the 5 year unindexed U.S. Treasury bond.

3

5

7

9

11

13

%

Current Recession

Previous Recession 2001-2003

-1

1

3

5

7

9

01/ 00

07/ 00

01/ 01

07/ 01

01/ 02

07/ 02

01/ 03

07/ 03

01/ 04

07/ 04

01/ 05

07/ 05

01/ 06

07/ 06

01/ 07

07/ 07

01/ 08

07/ 08

01/ 09

%5 Year Israel-U.S. Government Bond Spread*

(01/2000-02/2009)

Previous Recession 2001-2003 Current

Recession

18

0

2

4

6

8

10

12

Bank of Israel Interest Rate

Fed's Interest RateECB Interest Rate

%

Interest Rates of the Bank of Israel, the Fed and the ECB (2000-2009)

Source: Bank of Israel Research Department and OECD Statistics

Previous Recession 2001-2003

Current Recession

19

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

Ratio of nonbank loans to business sector product

Ratio of bank loans to business sector product

Ratio of Credit in the Market to Business Sector ProductRatio of Credit in the Market to Business Sector Product)quarterly data, current prices(

Source: Bank of Israel

Current RecessionPrevious Recession

2001-2003

20

Banking System Indicators in Israel

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

2008Q42008Q22001-2002

2000

Rate of Loan Loss Provision

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

2000 2001-2002

2008Q2 2008Q4

Capital Adequacy Ratio

- Data refers to the end of the relevant period.

Source: Bank of Israel

3.0

3.2

3.4

3.6

3.8

4.0

4.2

4.4

4.6

4.8

5.0

NIS

Shekel / Dollar Exchange Rate

01/97-04/09((

90

95

100

105

110

115

120

125

130

135The Real Exchange Rate

by Trading Partners (100=01/1997, 01/1997-

04/2009) 119.8

Previous Recession 2001-2003

Current Recession

The Nominal and the Real Exchange RateThe Nominal and the Real Exchange Rate2009 - 19972009 - 1997

Previous Recession 2001-2003

Current Recession

•A rise in the index indicates depreciation.

•The figure for April 2009 is calculated from spot exchange rates known for the half-month, our forecast CPI from the monthly model, and an extrapolation of inflation in the countries whose currencies are in the currency basket.

•SOURCE: IFS data. For October 2008 to April 2009, Bank of Israel calculations.

21

22

Forecast

Development of Forecasts of World Economic Activity in 2009

-10

-8

-6

-4

-2

0

2

4

6

World Output USA Euro Area Emerging andDevelopingEconomies

World Trade*

07-2008

10-2008

11-2008

01-2009

03-2009

* Forecast for world trade in 2009 is a Bank of Israel estimate.

Source: IMF – World Economic Outlook

%

23

24

-2.6

6.1

3.2

0.91.1

-3.2

0.10.2

-5

-2

1

4

7

10

U.S. Euro Area Em erging andDevelopingEconom ies*

World*

2008 2009F 2010F

*Forecasts for 2009 and 2010 are given as a possible range.Source: IMF – World Economic Outlook 03/2009

3.5 to 4.5

1.5 to 2.5 -0.5 to -1.0

1.5 to 2.5

Annual GDP Growth Rates 2008-2010F%

25

Forecast for Main Macroeconomic Indicators (2008-2010)

Source: Bank of Israel Research Department

Unless otherwise indicated the figures are rates of change.

200820082009F2009F2010F2010F

GDPGDP4.01.5-1.0

Business sector productBusiness sector product4.42.7-1.5

Exports (excl. diamonds)Exports (excl. diamonds)8.07.1-3.0

Private ConsumptionPrivate Consumption3.90.9-2.2

Gross Domestic InvestmentGross Domestic Investment3.87.1-8.3-

Civilian Imports (excl. diamonds)Civilian Imports (excl. diamonds)7.06.2-0.3-

Current Account Surplus (millions $)Current Account Surplus (millions $)1.63.22.0

Rate of Unemployment (percent)Rate of Unemployment (percent)6.17.78.3

26

Thank you

27

Starting Conditions: Situation on the Eve of the Recession

*The figure refers to the condition on the eve of the recession (3 rd quarter of 2000 and the 2nd quarter of 2008)**Annual dataSource: Bank of Israel

3rd Quarter of 2000

2nd Quarter of 2008

Unemployment Rate*8.96.0

Bank of Israel Interest Rate*8.23.5

Israel-U.S. Bond Spread (percent)*2.52.0

Exports (percent of GDP)**41.444.2

Current Account (percent of GDP)**-1.80.8

Debt-to-GDP Ratio**85.178.0

Inflation Rate**0.03.8

28

Current Account of the Balance of Payments(percent of GDP)

-1.6

0.8

-1.8

-2.5

-1.5

-0.5

0.5

2000 2001-2002 2008

Source: CBS, Balance of Payments

%

Real Wages per Employee Post* for the Overall Population and for those with 0-10 Years of Education

Source: CBS

NIS

4,618

4,535 4,576

4,000

4,200

4,400

4,600

4,800

5,000

2000 2001-2002 2008

7,275 7,269 7,271

7,000

7,100

7,200

7,300

2000 2001-2002 2008

NIS

*Real wages per employee posts at 2004 prices

0-10 Year of EducationOverall

29

49.5 48.953.1

0

10

20

30

40

50

60

2000 2001-2002 2008

Overall Employment Levels and Employment Levels for those with 0-10 Years of Education

%

26.0 26.026.4

27.0

25.625.3

26.3

27.2

22

23

24

25

26

27

28

29

30% 0-10 Years of EducationOverall

Source: CBS, Labor Force Surveys

30

31

%

1.0

8.9

-0.4 -0.7

1.8

5.0 5.1 5.2 5.4

-1.5

4.0

-4

-2

0

2

4

6

8

10

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

F

2010

F

*Bank of Israel forecastsSource: CBS and the Bank of Israel

Annual GDP Growth Rates2000 – 2010*

31

37

Actual and Expected Rates of Inflation

0.0

1.5

6.8

-1.9

1.3

2.4

-0.1

3.43.8

2.5

5.8

6.6

0.4

2.01.9

1.2

2.7

2.01.6

2.0 1.81.4

1.92.5

2.8 2.7

-0.3

0.7

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

Actual Inflation

Inflation Expectations

- The quarterly data is the seasonally adjusted rate of change from the previous quarter annualized.-Inflation expectation are a 12 month average derived from the capital markets.Source: Bank of Israel

%