Israel's foreign trade policy: The benefits of its reform

We use an empirical estimation procedure to examine the effect of macroeconomic variables of Israel's trading partners on the country's exports. The main goal of our study is to use the estimation results to point to the optimal trade policy for Israel, and compare it with the current policy. Using disaggregated panel data on Israel's exports to its 22 main trading partners we were able to implement a unique estimation procedure, which enables a new and closer look at the effectiveness of the country's foreign trade policy. Our model estimates Israel's total export elasticities as well as specific elasticities of exports to each trading-partner. The model produces positive export elasticities with respect to a partner country's total imports and the real exchange rate. Free trade agreements (FTAs) were also examined, and were found to have a considerable positive effect on exports. A higher level of corruption in the destination country was found to be associated with a lower level of Israeli exports. Using our estimated results, and taking into account the array of Israel's foreign trade policy tools, we formulated recommendations for policy reform, highlighting the potential benefits of this reform on Israel's predicted exports. If no new foreign trade policy is introduced, a total growth of 74% in Israel's exports is expected over the course of 2012–2020; however, if reform recommendations are implemented, the expected growth rate nearly doubles, as Israeli exports are predicted to grow by a total of 135%.^p

The role of international trade in promoting countries’ economic growth has been the focus of extensive economic research over the years (Feder, 1982, Frankel and Romer, 1999 and Levine and Renelt, 1992). Israel's economic growth patterns show a positive and long lasting link between its international trade performance and economic growth, with exports constituting about 40% of its GDP. Fig. 1 shows the annual growth rate of both Israel's GDP and the country's exports. Being a small country with a limited supply of natural resources, Israel's policy makers’ main concern has long been to ensure its ability to compete in international markets. Since the mid-eighties, this understanding has led the country to develop policy aimed at promoting exports. This included a process of trade liberalization, especially with developed countries. Evidence concerning the effect of this policy may be seen in the composition of Israel's exports in 2010, 65% of which were designated to the USA and Europe. As part of the effort to stimulate international trade and induce openness to foreign markets, FTAs were signed with several developed countries and blocs. The first of these was signed with the U.S. as early as 1985. FTAs were then reached in the mid 1990s with the European Union, EFTA (the European Free Trade Association, which includes Iceland, Liechtenstein, Norway and Switzerland), Turkey and Canada. Several additional FTAs were signed between Israel and its trading partners1 over the last two decades and as a result, 65% of Israel's exports2 in 2010 were covered by FTAs. Despite the focus on stimulating exports to developed countries, the developing countries’ share of Israel's exports had risen over the last few years. The most remarkable increase can be seen in exports to China and India, where exports from Israel have increased annually by 22%, on average, over the last decade. This, relative to annual growth of only 7%, on average, in exports to developed countries. This development can be seen in Fig. 2. This development has led to an increase in the share of exports to developing countries out of total Israeli exports, from about 14% to 25% over the last decade. This is shown in Fig. 3. The increase in developing counties’ share of Israeli exports alongside their fast-paced economic growth in recent years, has called for special attention on the part of policy makers, concerning the potential to steer exports toward these countries. Accordingly, negotiations are being held toward the signing of trade agreements with India, China, Ukraine, Chile, Columbia and South Korea. The Foreign Trade Administration of Israel's Ministry of Industry, Trade and Labor is the country's government agency responsible for formulating and implementing the country's foreign trade policy, including operating a system consisting of 373 trade attachés charged with the development of trade, technology and economic relations. The attachés are sent to countries of vital importance to Israel's foreign trade and their deployment around the world is a key factor in the administration's ability to encourage trade activity. The exploration of new markets requires an understanding of both their specific characteristics and their potential for Israeli exports. At the same time, it also requires an analysis of the effectiveness of the various policy measures taken by the Israeli government to stimulate exports. In light of these observations, the present study examines the effect of macroeconomic variables of each destination country on Israeli exports, analyzing in particular the impact of the bilateral exchange rate, trading-partner's total real imports, trading-partner's level of corruption and the existence of a bilateral FTA. Estimation of the exchange rate effect allows for the assessment of Israeli exports’ competitiveness in destination markets, while estimation of the effect of total partner-country imports allows for the assessment of the degree to which Israeli exports are dependent on economic activity in the destination country. In addition to understanding how Israeli exports react to changes in macroeconomic variables, these assessments are helpful in determining optimal trade policy. In particular, the estimation results allow us to critically examine the current trade policy led by the Israeli Foreign Trade Administration. The study is based on extending the traditional export demand function by introducing FTA and corruption variables. The effect of FTA and the elasticities of exports with respect to economic activity, the bilateral exchange rate and corruption level are estimated for each destination country by using disaggregated data and utilizing an econometric panel technique. The use of disaggregated data on Israel's international trade with its main trading partners is unique and enables a new and closer look at the effectiveness of the country's foreign trade policy. The rest of the paper is organized as follows: Section 2 provides a review of the current literature on the effect of the explanatory variables on countries’ export performance; Sections 3 and 4 describe the model specification, estimation procedure and data used; Section 5 presents the results of the analysis while Section 6 discusses the policy implications and offers policy reform recommendations; Section 7 then concludes the paper.

This study examined how different macroeconomic variables affect Israeli exports, discussed the policy implications of the effects found and pointed to the potential benefits of foreign trade policy reform. We estimated the Israeli export demand function and its long-run elasticities, utilizing a panel database of annual bilateral trade data for Israel's 22 leading trade-partners, over the period 1995–2011. Our model estimates Israel's total export elasticities as well as specific elasticities of exports to each trading-partner country. In particular, the effects of the bilateral exchange rate, trading-partners’ total imports, the existence of bilateral FTAs and the corruption level in the trading-partner countries, were all estimated. As expected, our model reveals positive elasticities with respect to a partner country's imports, the real exchange rate and the existence of a bilateral FTA. However, the estimated elasticities vary significantly in magnitude: while the estimated elasticity of exports with respect to the real exchange rate is relatively low (0.28), the trade-partner's total import level was found to be a significant determinant of Israeli exports (with an estimated elasticity of 1.11); the estimated elasticity of exports with respect to a bilateral FTA was also found to be relatively high (0.76). Not surprisingly, corruption in the destination country was found detrimental to Israel's exports. These findings in general and our country-specific estimation results in particular may be used to assess the effectiveness of the current foreign trade policy in Israel as well as to formulate foreign trade policy guidelines and recommendations. We thus used our results to draft suggestions for policy reform, highlighting the potential benefits of this reform on Israel's exports. Our policy reform suggestions include there-deployment of Israel's commercial attachés across the world; negotiation of additional FTAs, and an increase in the coverage ceiling of export insurance. The model's simulated forecasts for the two examined scenarios (one assuming business-as-usual, and the other assuming policy reform according to our recommendations) point to a highly significant effect of the proposed reform. If no new foreign trade policy is introduced, a total growth of 74% in Israel's exports is expected over the course of 2012–2020, equivalent to a 50 billion US$ increase. In contrast, if the reform recommendations are implemented, Israeli exports are predicted to grow by a total of 135%, equivalent to a 91 billion US$ increase. Thus, in the year 2020, after the successful implementation of all reform recommendations, Israeli exports are expected to be 41 billion US$ higher than under the business-as-usual scenario. As our study provides a close look at the effectiveness of Israel's current foreign trade policy, additional research may shed light on other elements relevant to setting optimal policy. For instance, it would be interesting to investigate the effect of firm-level decisions to enter and exit foreign markets on the country's total exports. It may also be interesting to further investigate the effect of corruption in the destination country on Israeli exports, examining whether perhaps the effect is non-linear in nature. Finally, a cost–benefit analysis of our policy reform recommendations would allow us to fully understand their implications for the country's economy.