Palestine Monetary authority (PMA)

Transcription

1 Palestine Monetary authority (PMA) Inflation Report First Quarter 2016 Volume 18

2 Copyright June, 2016 All Rights Reserved. Suggested Citation: Palestine Monetary Authority (PMA), Inflation Report: First Quarter Ramallah Palestine All Correspondence should be directed to: Palestine Monetary Authority (PMA) P. O. Box 452, Ramallah, Palestine. Tel.: Fax: ii

3 Executive Summary The inflation rate in Palestine decelerated during 2016Q1 to 0.6 percent, compared to around 1.5 percent in the preceding quarter, and the same rate in the corresponding quarter of This slowdown came as a result of decelerated inflation in the West Bank, in addition to a price drop in Gaza Strip. Dislike previous quarters, the consumer price index showed minimal benefit from the reduction in global commodity prices during this quarter, which indicates the domination of domestic factors over foreign ones. However, inflation in Palestine was much lower than that registered in the MENA region in 2016Q1, but exceeded that in Jordan and Israel. In general, analysis revealed that inflation in Palestine is largely imported and shows highly sensitive to world prices, particularly for food and fuel. The approach followed in this report for inflation analysis and forecasting purposes depends on two key variables: (i) cost of imports, which reflects the inflation and exchange rates of Palestine s main trading partners, among which Israel accounts for the highest portion (80 percent of exports and 70 percent of imports on average), and (ii) world food prices, as food has the highest weight (35 percent) in the consumer price index in Palestine. Inflation forecasts show that consumer prices in Palestine are expected to increase by around 1.0 percent during 2016Q2 on an annual basis, and decrease to 0.8 percent in Forecasts depend on assumptions concerning the most likely future paths for (i) prices and exchange rates in Palestine s most important trading partners, (ii) prices in the international food markets, as predicted by international organizations such as the IMF and foreign central banks, and (iii) domestic and seasonal factors. Given that Palestine s inflation may deviate from the baseline scenario, due to deviations in foreign prices and exchange rates, the forecast is supplemented with a risk analysis. Beside the baseline, the forecast takes into account four alternative scenarios based on positive and negative one-standard deviation shock in Palestine s cost of imports and in world food prices. The expected effects on Palestine s alternative inflation outcomes show that a positive one-standard deviation shock in external conditions would increase Palestine s prices from 1 percent under the baseline scenario to nearly 1.6 percent on iii

4 average during On the other hand, a negative one-standard deviation shock may bring consumer prices in Palestine down, to -0.1 (deflation), compared to 1 percent inflation under the baseline scenario. As for financial developments in Palestine, 2015Q4 data indicate that average lending rates on the JD and the NIS have declined compared to the previous quarter, while the rate on the USD has increased. On the other hand, average deposit rates on the JD and the NIS remained relatively stable, while the rate increased on the USD. The margin between lending and deposit rates in Palestine remained noticeably higher than its counterpart in the issuing countries. Still, this margin increased on the USD to 6.1 percentage points, and reached 6.5 and 8.6 percentage points on the JD and the NIS, respectively, during 2015Q4. Dampened by a routine performance, the Palestinian stock index (Al-Quds Index) fell by 5.0 percent compared with 2015Q4, reaching points. This drop was driven by the decline in the price indices of services, banking, and investment sectors, but at varying degrees. iv

5 Contents I. RECENT ECONOMIC DEVELOPMENTS...1 REAL GDP...1 AGGREGATE DEMAND...4 INFLATION...5 GLOBAL AND LOCAL PRICES...6 LABOR FORCE AND WAGES...7 EXCHANGE RATES II. RECENT FINANCIAL DEVELOPMENTS INTEREST RATES STOCK MARKET III. MODEL BASED INFLATION FORECAST INFLATION MODEL AND ESTIMATION TECHNIQUE BASELINE INFLATION FORECAST IV. THE BALANCE OF INFLATION RISK v

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7 I. Recent Economic Developments Real GDP A more pessimistic outlook prevailed in 2016Q4 regarding global growth, amid signs of slowing activity in both advanced economies and emerging and developing ones, and specifically in the United States. Stimulus packages to spur economic growth pursued by policymakers in major economies have apparently failed to stimulate domestic demand, while concerns lingered in financial markets regarding possible future crises. Investors closely followed monetary policy developments and its repercussions on stock markets, the latter facing significant fluctuations during the quarter, in addition to growing stability risks stemming from asset markets, specifically in Asian economies. In light of the above, the International Monetary Fund (IMF) downgraded its growth expectations for the global economy 1 by 20 basis points to 3.2 percent in 2016, while expecting growth to reach 3.5 percent in A closer look at the world's major economies reveals a continued slowdown in activity within the U.S. market during the fourth quarter, disappointing investors and analysts across world markets despite positive initial estimates that ultimately contributed to raising interest rates in the U.S. A stall in consumer spending, Figure 1: Real growth rates in some main economies USA EA Japan China Source: Different Sources 2 weaker exports and slowing state and local government spending, have all weighed down on growth during 2015Q4, which reached 2.0 percent y-o-y, compared to 2.1 percent in the preceding quarter, and driving IMF growth forecasts down by 20 basis points to 2.4 percent in The fund forecasts a 2.5 percent real growth in 2017, in light of absent signs of significant improvements in the medium term. 1 International Monetary Fund, World Economic Outlook, April, Previous estimates were published in January, IFS database, BoEA, and 1

8 Similarly, performance in the Euro Area slowed during 2015Q4, as real GDP growth slightly declined to 1.9 percent, compared to 2.0 percent in 2015Q3, on the backdrop of subdued exports and sluggish domestic demand. The quarter, however, brought out different growth patterns among member countries, as signs of slowdown appeared in Germany in light of weak exports, while the French and Italian economies accelerated to mirror improvements in investments and several aspects of consumption in both countries. Contraction in Greece has also eased due to a relative increase in government spending and investment. Yet such developments could not prevent a drop in IMF forecasts for EA's 2016 growth by 20 basis points to 1.5 percent. Growth in 2017 is not expected to exceed 1.6 percent. In Japan, government efforts to spur growth failed to stop a return to slowdown, as private demand and exports remained below desired levels, with growth reaching 0.7 percent in 2015Q4, compared to 1.7 percent in the previous quarter. The Japanese economy is set to face additional internal and external challenges, if the slowdown continues in China and the euro area, or if the government remains adamant on raising consumption tax. As such, the IMF downgraded growth forecasts by 50 basis points in 2016, down to 0.5 percent, while it forecasts a 0.1 percent contraction in In the meantime, activity continued to slow in China in light of stalling industrial production, private investments, and services. Growth in real GDP slowed to 6.8 percent during 2015Q4, compared to 6.9 percent in 2015Q3, amid persistent concerns of emerging financial crises in Asian markets and receding global trade. The IMF expects current growth trends to persist in the next two years; the Chinese economy is forecasted to grow by 6.5 percent in 2016, and 6.2 percent in In a similar context, political and economic turmoil lingered within the MENA region, limiting its capacity to achieve adequate growth levels, particularly in countries like Iraq, Syria, Egypt, Libya and Yemen. As a result, the IMF lowered the region's expected growth from 3.4 percent to 2.9 percent in 2016 in light of absent political stability and the inevitably negative spillovers of sliding oil prices on exporting countries in the medium term. The region is expected to grow by 3.3 percent in

9 Regionally, growth in Israel picked up for the second quarter this year, as growth reached 2.7 percent, as opposed to 2.2 percent in the previous quarter. Government spending increased markedly following a late budget approval, in addition to a smaller drop in exports suffering from modest European demand. Private spending and investment, on the other hand, witnessed nothing but slowdown until the end of the year, driving IMF 2016 forecasts down to 2.8 percent. The Israeli economy is expected to grow by 3.0 percent in Similarly, activity in Jordan stabilized, as growth hit 2.6 percent for the second consecutive quarter. Decelerating activity in several sectors, including manufacturing, trade, services and transportation, were met with a pick-up in construction and agricultural activities. IMF forecasts for Jordanian growth stabilized at 3.2 percent in 2016 and 3.7 percent in 2017, according to latest estimates. Domestically, the real GDP growth in 2015Q4 relapsed to 6.1 percent y-o-y, as opposed to 9.6 percent in the preceding quarter, as a result of similar trends in the West Bank and Gaza Strip. However, such relatively high figures mostly reflect a marked improvement in GS economic conditions compared to the corresponding quarter (the months following the recent Israeli war in 2014). Figure 2: Real growth rates in Palestine, Jordan, and Israel Real growth in the WB stalled to 1.0 percent in 2015Q4 compared to 4.0 in 2015Q3, despite stable fiscal conditions and consistent flows of Palestinian workers into the Israeli labor market. Such developments come amid heightened political and security tension, and growing Israeli violations during the comparison period. This modest growth mainly reflected sluggish activity in most economic sectors, with a 23.9 percent contraction in agriculture and fishing y-o-y, a 5.0 percent decline in industry; a 2.8 percent fall in public administration and defense and a slight contraction of 0.1 percent in communications. A modest growth occurred in trade, construction, and services by 0.9, 1.0 and 2.5 percent, respectively. In contrast, financial services and insurance, in Palestine Jordan Israel Source: PCBS, CBS, and the Central Bank of Jordan. 3

10 addition to transportation, constituted the only exception during this quarter, growing by 10.0 and 8.7 percent, respectively, although still lower than what was achieved in the preceding quarter. Meanwhile, annual comparison points to a similar deceleration in activity in GS, as growth reached 24.7 percent, compared to 33.3 percent in the previous quarter. Nonetheless, such rates remain an indication of leaps in production levels, compared to poor economic conditions following the war in the corresponding quarter. Value added tripled in the construction sector during the fourth quarter owing to a surge in flows of construction materials to the Strip, while growth in trade and manufacturing amounted to 25.6 percent and 18.1 percent, respectively. Other activities, on the other hand witnessed more stable growth patterns during 2015Q4, as general services and financial and insurance services grew by 12.8 and 11.2 percent, respectively. Transportation and communications grew by 7.2 percent and 4.3 percent, while public administration and defense grew by a mere 0.7 percent. It is worth noting that although such developments indicate some improvement, resumed activity in the Strip, remains below levels necessary to achieve pre-war levels, not to mention those needed to create jobs and maintain economic stability in the long-run. Aggregate demand Gross Domestic Product (GDP) in Palestine has grown during 2015Q4, reaching USD 1,988.5 million in 2004 prices, scoring a growth on annual basis as most of GDP components have expanded during the quarter, particularly in the WB. Private consumption 4 has grown in the WB by 5.1 percent on y-o-y basis, Table 1: Aggregate demand at constant prices (2004=100) (USD million) Q4 Q1 Q2 Q3 Q4 Private consumption 1, , , , ,776.1 Government expenditure Investment Exports Imports 1, , , , ,236.7 GDP 3 1, , , , ,58889 Source: PCBS. while public consumption also grew, by 11.0 percent. Moreover, investment has expanded during 3 The difference between the sum of former items and the GDP is the net errors and omissions. 4 The private consumption includes; household consumption and the consumption of non-profit institutions serving households "NPISH". 4

11 the same period by 6.4 percent. On the other side, trade indicators show a negative developments as exports declined by 2.1 percent, while imports notably grew by 11.4 percent. This resulted in a wider trade deficit to USD million (in 2004 prices), which forms around 44.5 percent of GDP. However, private consumption in GS is still weak and below the pre-war level; it declined by 8.4 percent in 2015Q4, compared to corresponding levels in 2015Q4. Tarde indicators have also weakened as exports declined by 4.3 percent, while imports increased by 6.4 percent, resulting in a widening trade deficit. Conversely, extensive growth in public consumption eased the impact on GDP growth, as it increased by 12.8 percent, accompanied with another increase in investment to USD 44.3 million, due to improvement in building investment. Inflation Global commodity prices witnessed a further drop during 2016Q1, which affected the inflation rates of various countries in different ways. On one side, the decline in global prices stimulated higher consumption in some economies, which in turn led to higher inflation rates. However, that was not sufficient in some countries that suffered from the economic consequences of the financial crisis, and weakened demand in those countries led to a fall in inflation. Apart from these divergences, inflation rates in main economies persisted at low levels, and didn't exceed in most of them the (2 percent) threshold during 2016Q1. In the U.S. for example, inflation slightly increased from 0.5 percent in 2015Q4 to 1.1 percent this quarter due to an increase in prices of services like shelter and medical care. Moreover, inflation in both the Euro Area and Japan stabilized at a very low level Figure 3: Inflation rates in World regions World AC EDC MENA Sources: IFS and PCBS. (close to zero) in light of weak local demand. In general, and due to the increased inflation in the U.S in particular, inflation in Advanced Countries (AC), in 2016Q2 increased slightly by 16 basis points, reaching 7.67 percent. However, inflation in Emerging and Developing Countries (EDC) exceeded that in the AC. Although data for EDC's group are not available for 2016Q1, preliminary indicators revealed a slight increase in inflation of main economies, particularly in China where inflation increased 5

12 slightly, to 2.1 percent. It is worth mentioning that the EDC have experienced persistent price hikes during the past few years, as inflation reached its peak in 2011, before it started to decline afterwards. The MENA region experienced a notable downward trend during previous quarters, reaching its lowest levels in more than a decade, affected by both declines in commodity prices (as MENA countries depend heavily on imports), and the appreciation of the USD. As a result, inflation declined to 4.9 percent by end 2015Q4, as the most recent data indicate. In sum, due to the slight increase in both the AD and the EDC during the first quarter of 2016, global inflation grew marginally, by 4 basis points to around 3.0 percent (see figure 3). Likewise, inflation rates in Palestine and neighboring countries experienced different trends during 2016Q1. As figure (4) indicates, the movement of the inflation rate in Palestine during the quarter was conversely related to those in Israel and Jordan, while it consisted with Egypt. Inflation resumed its decline in Palestine from 1.5 percent in 2015Q4 to 0.6 percent this quarter due to a lower inflation in the WB, along with a deflation in GS. Likewise, Figure 4: Inflation rates in Palestine, Jordan, Egypt, and Israel Palestine Jordan Egypt Israel Sources: IFS and PCBS. inflation in Egypt decreased from 10.6 percent to around 9.4 percent during the comparison period. Despite price fluctuations, Egypt had the highest inflation rates among neighboring countries, which reflects its continuous political turmoil since Meanwhile, Jordan and Israel continued to experience a deflation due to a continuous drop in imported commodity prices. But deflation in both countries declined marginally during this quarter, to -1.2 and -0.5 percent compared to a deflation of -1.4 and -0.9 percent in the previous quarter, respectively. Global and local prices This section deals mainly with developments in local and global markets commodity prices, the most important determinant of inflation trends. Figure (5) shows a downward trend of global prices since the second half of 2014, particularly world oil price (WOP), which dropped by about 36.6 percent in 2016Q1 compared to the corresponding level in 2015, and by 68.4 percent compared to the corresponding level in 2014 (before the sharp declines). Moreover, the crude oil 6

13 price declined by 22.4 percent compared to the previous quarter, reaching USD 32.8 during 2016Q1. The continuous decline in the crude oil price reflected weak demand for oil worldwide due to a global economic slowdown, along with a hike in oil production to compensate for the fall of prices. Likewise, the fall in world metal prices (WMP) reflected the global slowdown, particularly the sluggish growth in China which consumes roughly half of the global metals production. As a result, global metal prices declined on both annual and quarterly bases by 20.3 percent and 1.1 percent, respectively. Also, world food prices (WFP) declined by 8.3 percent compared to the corresponding quarter of 2015 due to abundant food supplies; however, the case is the opposite when comparing with the previous quarter. Crop damage at end 2015, caused by the drought in vast agricultural areas of the world, pushed up some prices during 2016Q1, particularly those of edible oil, with expectations of further increases in coming months. As a result, WFP increased by 3.0 percent this quarter on q- o-q basis. Meanwhile, local prices witnessed several developments but conflicting trends between the WB and GS during 2016Q1. Such trends are less sensitive to domestic prices than to external factors, and the differing country-specific political and economic conditions. In the WB, commodity categories' prices either increased or remained stable. However, the general trend for main price categories was upward during 2016Q1. Thus food prices increased by 4.4 percent for the second consecutive quarter given the weak agricultural season; also the education price index increased by the same percent due to a gradual raise of tuition fees. Moreover, despite the sudden reduction of about 20 percent in local and imported medical drugs supplies in February, thus medical care price index increased by around 2.7 percent on a y-o-y basis. Additionally, the price indices of textile, restaurants and cafes, and furniture have all increased, by 2.3 percent, 1.9 percent, and 1.1 percent, respectively. Also, the transportation price index increased for the first time in three years by 1.2 percent, despite the decline in fuel prices during the same period Figure 5: Indices of primary commodity prices, 2010= Source: IFS. WFP WMP WOP 7

14 In contrast, prices of housing services continued their downward trend that began two years ago, partially affected by the decline in oil prices, in addition to the oversupply of housing units, as some observers noted. The result, the housing service price index declined by 7.3 percent on annual basis. Likewise, the communication price index declined marginally, by 1.0 percent; and the alcohol and tobacco price index declined by only 0.2 percent. In sum, the WB consumer price index increased by 1.4 percent on annual basis due to the increase in most price categories. However, consumer prices declined by 1.2 percent compared with the previous quarter due to the decline in the food price index by 2.9 percent. Meanwhile, the conflicting price trends in GS were clearer. On one side, the transportation index continued to increase, rising by 10.8 percent on annual basis. This rise reflected mainly the effect of the aggravated fuel crisis, which has relatively stabilized since the previous quarter. Furthermore, tobacco prices also notably increased in light of weak control over tobacco traders, in addition the continued adverse effect of both the blockade, and the destruction of smuggling tunnels. As a result, the tobacco and alcohol price index increased on y-o-y by 6.2 percent. Also, the price indices of cafes and restaurants services and textile have both continued to increase during this quarter, rising by 8.8 percent, and 4.1 percent, respectively. In contrast, housing services, prices continued to decline for a year, and dropping lately by 3.9 percent this quarter in light of an increasing flow of building raw materials entering the Strip. In sum, the supply of homes increased pushing house rents down. Besides, the food price index fell by 1.9 percent due to over supply during the quarter (particularly the chicken, eggs, and vegetables), coupled with a limited ability to export. Also, prices of medical care declined notably, by around 5.0 percent. There are no good reasons to explain this decline. However, tracking its movements revealed a temporarily hike during corresponding quarter, but it returned to its normal levels afterwards. Likewise, price indices of communication and furniture declined by 1.9 percent and 1.3 percent, respectively. In sum, CPI in GS during 2016Q1 declined on annual and quarterly bases, scoring a deflation by 0.2 percent and 0.8 percent, respectively. Figure 6: Web chart of the CPI components contribution to the inflation rate in Palestine Restaurants Education Recreation Others Communications 1.5 Food 1.0 Tobacco Textiles Housing Transport WB Medical GS Furnature 8

15 Overall, while food prices contributed 1.5 percentage points to inflation in the WB during 2016Q1 (see figure 6), they accounted for most of the deflation rate (-0.8 percent) in GS during the same period. Regardless of different price determinants in the WB and GS, commodity prices in Palestine hit much higher levels than in the world market, because changes to global prices are not reflected completely in local prices, which contributed in widening the price gap in recent quarters as it indicated in figure (7). Tracking price movements during 2016Q1 reveals that global gasoline price dropped by more than 33.0 percent. Meanwhile, gasoline retail price in Palestine declined by only 7.7 percent during the same period. Likewise, global gasoline prices dropped on a quarterly basis by 22.4 percent, but local prices declined by only 6.6 percent. Consequently, gasoline price in Palestine in 2016Q1 has become 4.6 times its level in the global market, compared to around 3.8 times the price in the previous quarter, particularly in light of the appreciation of the USD against the NIS during the quarter. It is noteworthy that the continuous decline in gasoline prices that started a year and half ago was accompanied by a high USD exchange rate against the NIS, and thus, the possible benefits for local consumers were limited. As a result, one liter of gasoline was about USD 1.4 (around NIS 5.6) in the local market, compared with USD 0.3 in the global market during 2016Q1. As is the case in fuel prices, other commodity prices like wheat, rice, and sugar are much higher locally than in world markets. During 2016Q2, global prices of the three abovementioned commodities decreased both globally and domestically. However, the price gap remained considerably wide. Both rice and wheat prices in the local market are 3.8 times their price in global markets, while the local prices of sugar became around 1.2 times the global prices during 2016Q2 (see figure 8). Several factors stand behind these Figure 7: Gasoline prices in USD per liter Source: PCBS and IFS. Figure 8: Local prices to global prices Source: PCBS and IFS. Palestine World local to global price ratio (right) 4.2 Wheat Rice Sugar

16 NIS / Day discrepancies, including: taxes imposed on imported products, the high cost of transportation and storage, and the oligopolistic prices. Also interesting are prices for some nonimported commodities, like fresh chicken and beef meat. Local prices of these commodities are not sensitive to global trends but are still much higher than world prices due to their high cost of production. Besides, global prices of these commodities witnessed further decline in 2016Q1, while local prices increased, which resulted in widening the price gap. For instance, fresh chicken meat prices in Palestine are now around 1.6 times the world price, and beef meat prices became more than 3.7 times the world prices during 2016Q1. Table (2) shows price developments for some selected commodities (imported and non-imported) in the local market during the current and previous quarters. Table 2: Prices of selected commodities in Palestine NIS per unit Q1 Q2 Q3 Q4 Q1 Rice Wheat Bread Beef meat Chicken meat Powder Milk (Nido) Yogurt (local) Chicken Eggs Tomatoes Sugar Gas Diesel Gasoline Source: PCBS Labor force and wages Labor force participation rate 6 in Palestine slightly increased during 2016Q1, by 0.1 percentage point reaching 45.8 percent; however, it remained relatively stable for the last two years. Meanwhile, unemployment rates continued to increase by rising 8 basis points to 26.6 percent during this quarter. This fluctuating trend is clearer in GS due to the political and economic developments in the Strip. During 2016Q1, the number of Figure 9: Labor force main indicators in Palestine LFPR UNEMPR ADW (right) Source: PCBS. 5 Unit for Wheat: 60 Kg sack; Bread: 1 Kg; Rice: 25 Kg sack; Chicken and Beef meet: 1 Kg, Powder Milk: 2.5 Kg can; Yogurt: 500 g can; 2 Kg box; Tomatoes: 1 Kg; Sugar: 50 Kg sack; Gas: 12 Kg cylinder, Diesel and Gasoline: 1 Liter. 6 The total number of persons aged 15 years and over in Palestine reached 2,894,600 in 2016Q1. 10

17 Gazan workers declined, raising the unemployment rate to 41.2 percent from the previous level (38.4 percent). Meanwhile, the number of workers in the WB relatively stabilized, and the participants in labor market declined, resulting in a slight decline in unemployment rate by 0.7 percentage point to 18.0 percent. It is noteworthy that a large number of the WB labor force work in Israel and settlement accounting for 20 percent of the total during 2016Q1. However. the Israeli labor market remains completely shut to GS workers for years 7 until the beginning of 2016, when a limited number less than 100 workers during 2016Q1 were in. Palestinian participation in the Israeli labor market is of a significant impact on both average wages and price levels in Palestine. The relatively higher daily wages of workers in Israel and settlements push local wages to rise, while the increased disposable income creates more demand for goods and services, of which the big share is imported. These pressures ultimately lead to undesirable price inflation. During 2016Q1, nominal wages in the three regions have risen compared to the previous quarter, but with varying amounts. Data revealed a huge increase in the WB nominal wages to their highest level ever, growing by 6.8 percent and reaching NIS 99.8 a day. Likewise, nominal wages of Palestinian workers in Israel and settlements increased by 5.9 percent. It is noteworthy that the increments to wages of Palestinian workers in Israel and settlements exceed that for WB, which has further widened the wage gap between the two areas. In 2016Q1, wages of Palestinian workers in Israel and settlements were about 2.1 times those of WB workers, reaching around NIS a day. However, the growth in Gaza s nominal average daily wage remained slight (below 1.0 percent) to a total of NIS 61.8 a day. The reciprocal relation between prices and wages implies that when inflation exceeds the rise in the average nominal wage, the purchasing power of real wages decline, and vice versa. During 2016Q1, the drop in prices has strengthened the purchasing power of wages. The q-o-q deflation of 1.2 percent in the WB resulted in a growth in the real wages of workers in both the WB, and in Israel and settlements by 8.0 percent and 7.1 percent, respectively. Also, in light of a deflation by 0.8 percent in GS, Gazan real wages grew by 1.6 percent. On a different note, the appreciation of the USD and the JD against the NIS during 2016Q1 raised the purchasing power of to the worker's real wages paid in these currencies by 0.8 percent. 7 The Israeli labor market closed to GS workers since the Israel's withdrawal from Gaza in

18 Exchange rates Figure (10) shows the nominal and real effective exchange rates (NEER and REER) in Palestine 8. The discrepancy between the NEER and REER indicates that changes in inflation in Palestine relative to its trading partners contributed to the appreciation of the real exchange rate during this period. The appreciation of the NEER indicates that the NIS appreciated against Palestine's trading partners currencies, while the appreciation of the REER indicates that Palestine lost competitiveness against its trading partners 9. Figure 10: Effective exchange rates and CPI in Palestine, 2010= REER NEER CPI Source: PMA and PCBS. Data show that the NEER has appreciated by 1.7 percent during 2016Q1, compared with 2015Q1, which indicates that the NIS appreciated against Palestine trading partners currencies. Likewise, the REER appreciated further by 2.1 percent during the comparison period, which indicates that Palestine lost some competitiveness against its trading partners. It is worth mentioning that the Palestinian foreign trade is substantially affected by the Israeli-imposed restrictions and other obstacles, and these effects were much stronger than the effects of changes in NEER and REER. II. Recent Financial Developments Interest Rates Lending and deposit rates in Palestine frequently move over time according to changes in the monetary policy in the issuing countries of the currencies circulated in Palestine and also to the level of cash in the banks operating in Palestine. However, tracking these movements during previous quarters reveals that lending rates on the three currencies circulating in Palestine are higher than their counterparts in the countries of origin. On the other hand, deposits are higher than their counterparts in the countries of origin for the NIS and USD, but are consistently lower for the JD in Palestine. 8 The NEER provides a weighted average of a country s nominal bilateral exchange rates, indexed on a chosen base year; The REER corrects the NEER for relative price developments. 9 NIS is the currency used in the calculation of the CPI and thus NEER and REER. 12

19 Lending Rate Deposit Rate Lending Rate Deposit Rate Average lending and deposit rates have witnessed various developments during the fourth quarter of The average lending rate on the JD and on the NIS moved in the same direction, but conflicting with USD, due to economic developments in the U.S, as will be clarified later in this section. In sum, the average lending rate on the JD and on the NIS has declined during 2015Q4, but increased on the USD. On the other hand, the average deposit rate on the JD and the NIS remained relatively stable, while it increased on the USD during the quarter, The average lending rate on the JD in Palestine notably declined after three consecutive quarters of increase, reaching 8.75 percent in 2015Q4, compared to 9.49 percent in the previous quarter. Likewise, the average lending rate on the JD in Jordan continued to decline for a year and half, and decreased by 13 basis points during this quarter, to around 8.27 percent. It is worth noting that the JD is the least circulated Figure 11: Lending and deposit rates of JD Q1 14Q2 14Q3 14Q4 15Q1 15Q2 15Q3 15Q4 LR in Palestine LR in Jordan DR in Palestine DR in Jordan Source: PMA and IFS. currency in the Palestinian market and is rarely used in daily transactions. Credit share in this currency is also the lowest, reaching 14.9 percent of total credit in 2015Q4. Similarly, the average lending rate on the NIS in Palestine has decreased below the 10 percent threshold for the first time, reaching 9.92 percent. Conversely, it marginally increased in Israel by 2 basis points to 3.43 percent, but remained at its lowest level, as the Bank of Israel maintained the unprecedented low interest rate (0.1 percent). Figure 12: Lending and deposit rates of the NIS Q1 14Q2 14Q3 14Q4 15Q1 15Q2 15Q3 15Q4 LR in Palestine LR in Israel DR in Palestine DR in Israel Source: PMA and IFS. It is worth mentioning that the high lending rate on the NIS in Palestine is mainly due to the intensive use of the NIS in daily transactions, which increases demand for the NIS. This is evident given the fact that the NIS lending rate in Palestine is consistently the highest among circulating currencies. 13

20 Lending Rate Deposit Rate Conversely, the average USD lending rate continued to increase by 48 basis points, reaching its highest in two years at 7.13 percent. At the same time, the lending rate on the USD in the U.S. increased during 2015Q4 for the first time since the beginning of In October and November the lending rate in the US stabilized at the previous level (3.25 percent), but then increased 3.37 percent In December. This change concurred with the changes of the official interest rate, which has been raised by the Fed in December for the first time in years, in light of indications of rising economic recovery. Movements in average deposit rates on currencies circulating in Palestine were limited during 2015Q4, especially for the JD and the NIS. The average deposit rate on the JD stabilized at 2.21 percent, but declined in Jordan from 3.32 percent to 3.12 percent. Additionally, the average deposit rate on the NIS remained relatively stable at 1.36 percent (declining by only 1 basis point), concurrent with the stable rate in Israel at 0.45 percent. It is worth noting that NIS deposit rates are historically lower in Palestine than in Israel, yet the repetitive lowering of key interest rates by the Bank of Israel (BoI) during the past two years has reversed this trend since then. Conversely, the average USD deposit rate in Palestine and in the U.S. increased by the same amount (13 basis points), reaching 1.02 percent and 1.14 percent, respectively 10. Generally speaking, deposit rates within the three issuing countries are low due to the vulnerable economic conditions and accommodative monetary policy, especially in the U.S. and Israel. Consequently, the margins between the average lending and deposit rates remain remarkably higher in Palestine than in the Figure 13: Lending and deposit rates of the USD LR in Palestine DR in Palestine Source: PMA and IFS. Figure 14: Margins between lending and deposit rates in Palestine compared with issuing countries Q1 14Q2 14Q3 14Q4 15Q1 15Q2 15Q3 15Q4 Source: PMA and IFS. LR in USA DR in USA Palestine USA Palestine Jordan Palestine Israel USD JD NIS 15Q1 15Q2 15Q3 15Q4 10 Interest rates on government securities and government bonds in the short-term were used as a proxy for the deposit rate in the U.S. 14

21 issuing countries, rising for the USD, and slightly falling for the JD and the NIS during 2015Q4 (see figure 14). The margin on the USD in Palestine amounted to 2.8 times that in the U.S., while the margin on JD amounted to 1.3 times that in Jordan. In comparison, the margin on the NIS remained the highest; almost three times the margin in Israel during 2015Q4. As for real interest rates 11, data indicate that real deposit rates in Palestine began to decline during 2015Q4, in light of the increase in inflation from 0.9 percent during 2015Q3 to 1.5 percent during 2015Q4. Accordingly, the average real deposit rate declined to -0.5 percent for the USD; 0.69 percent for the JD; and percent for the NIS. At the same time, the increase in inflation rates in Palestine led to a drop in the average real lending rates to 5.61 percent, 7.23 percent and 8.4 percent on the USD, JD and the NIS, respectively. Figure (15) illustrates recent developments in average real interest rates during 2015Q4, including: Figure 15: Real lending and deposit rates in Palestine by currency Q1 14Q2 14Q3 14Q4 15Q1 15Q2 15Q3 15Q4 LR on USD LR on NIS DR on JD Source: PMA and PCBS. LR on JD DR on USD DR on NIS Average real deposit rates on the three currencies circulating in Palestine have declined, and registered negative value for the USD and the NIS compared to 2015Q3. This decline implies that the real value or the purchasing power of deposits in these currencies has declined. The average real lending rates remained positive but declined for all currencies circulating in Palestine, implying that the real value of banks credit has decreased during the quarter. Stock market With the advent of 2016, and before the deadline of the annual disclosure due in February, the Palestinian stock market Palestine Exchange fell routinely. However, it showed better performance in mid-quarter due to distributing dividends in several companies, particularly the National Bank (TNB), which distributed cash dividends for its shareholders for the first time since its establishment in Nevertheless, dividends' distribution is usually followed by a 11 Fisher's equation: (1+nominal interest rate) = (1+real interest rate) * (1+ expected inflation rate). 15

22 Bahrain Abu Dhabi Egypt Kuwait Qatar KSA Dubai Muscat Amman Palestine decline in shares' prices as investors tend to change their investment positions to maximize profit. As a result, this quarter ended with a decline in Al-Quds index by 5.0 percent from its previous level, down to point (see table 3). This decline resulted from a notable drop in indices of services and banking sectors by 6.1 percent and 5.2 percent, respectively, in addition to a decline in the investment index by 0.9 percent. However, indices of the industry and insurance sectors grew by 1.1 percent and 11.6 percent, respectively. Regionally, the performance of some selected Arab countries stock markets continued to experience significant losses due to a decline in investors' confidence as oil prices continued to decline, in addition to the decelerating global economy. Those concerns led to huge losses in Arab stock markets, particularly of the Gulf States, whose public budgets were adversely affected by the dropping oil prices. Table 3: Palestine stock exchange index (Al-Quds index) Q1 Q2 Q3 Q4 Q1 Banking Industry Insurance Investment Service Al-Quds Source: Figure 16: Stock markets performance, some selected Arab markets y-o-y q-o-q Source: and The Saudi Arabia, (KSA) stock market index, for example, continued to decline for the third consecutive quarter, declining by end of 2016Q1 by 4.5 percent from the previous quarter. Moreover, indices of Bahrain and Kuwait stock markets declined by 7.0 percent and 6.9 percent, respectively, during the comparison period. Furthermore, the losses became clearer on annual comparison, particularly in the Saudi Arabian and Bahraini stock markets, in addition to the Egyptian stock market which was influenced by Egypt's weakening economic conditions. However, except for a sudden progress in the Egyptian stock market at the end of the quarter, and the stability in the Dubai stock markets indicators, the growth in the rest of selected financial markets were very limited during the quarter, as indicated by figure (16). 16

23 As to the relation between the Palestinian stock market and the stock markets in the region, data revealed that the Palestinian stock market was significantly affected mainly by the Jordanian stock market, and to a lesser extent, by the Egyptian stock market (see figure 17). However, the movements in the Palestinian stock market during 2016Q1 were more affected by internal factors, conflicting with the trends in both the Jordanian and the Egyptian stock markets. It is worth mentioning that the effects of other Arab stock markets were tested and shown to be virtually insignificant. This implies that the local stock market continues to be relatively shielded from the influence of factors affecting the region's stock markets. Figure 17: Stock markets performance in Palestine, Amman, and Egypt (q-o-q) Palestine Amman Egypt Source: III. Model Based Inflation Forecast Inflation model and estimation technique Analysis shows that the CPI in Palestine is co-integrated with (i) the CIM, which is a weighted average cost of imports, expressed in NIS, and calculated regularly by the PMA, and (ii) the world food price index. The importance of WFP reflects the large weight food occupies in the CPI basket in Palestine 12. Considering this relationship and the CPI, the question arises as to how this long-run relationship is best estimated, and how to model the short-term dynamics that explain how fast shocks to the relationship are corrected over time in order to bring the CPI back to its long-run equilibrium value. Source: PCBS, PMA, and IFS. Figure 18: CPI, CIM, and WFP In this respect, long-run and short-run relationships are estimated using three different approaches. The first is the Johansen s (2992, 299.) system-based reduced rank approach. The CPI CIM WFP 12 For more details about inflation determinants in Palestine, see Palestine Monetary Authority (PMA), Inflation Report, April

24 second is the ARDL test which is based on Pesaran, Shin (1999) and Pesaran, Shin, Smith (2001). The third is the semi-parametric Fully Modified OLS (FMOLS) approach of Phillips and Hansen (1990). Baseline inflation forecast The objective of this section is to use the basic inflation model to generate a quantitative CPI outlook for the following years on a quarterly basis, i.e. for the period 2016Q2-2017Q4. To that end, a baseline scenario for the exogenous variables, CIM and WFP, is needed. The CIM is basically the denominator of the REER index calculated by the PMA. The baseline scenario for the CIM was derived from the VECM. Thus, CIM is calculated to decline by 0.85 percent in 2016, and to increase by around 1.3 percent in The most recent IMF forecasts indicate that food prices will decline in 2016 compared with 2015 but will resume increasing in 2017, albeit at a slower pace. Accordingly, we calculate that the world food prices will decline by around 3.3 percent in 2016, and will slightly increase by around 0.4 percent in Inflation will be forecasted according to the above-mentioned three estimation techniques 13, combined with the common baseline growth rates for the CIM, and the WFP, as explained in table (4). As is well known, the use of econometrically estimated models to forecast future inflation is subject to model and coefficient uncertainty. To reduce this uncertainty, we will take the simple average of the three models. Accordingly the average inflation Table 4: Inflation outlook of the three models Assumptions CIM WFP VEC M Inflation Forecasts ARDL FMOLS Aveg. 2015* Q1* Q Q Q Q Q Q Q * Actual data. forecast for 2016Q2 will be 1.0 percent, as compared to 2015Q2. Also, we expect the average inflation rate for 2016 to drop to 0.78 percent, but to resume increasing to 1.23 percent in 2017 (see table 4). 13 VECM, ARDL, and the FMOLS. 18

25 IV. The Balance of Inflation Risk Apart from the abovementioned risks of model uncertainty, the CPI outlook also crucially depends on the assumptions regarding the course of the model's exogenous variable's forecasts; these exclusively refer to external conditions reflecting foreign inflation trends, NIS bilateral exchange rates, and world market food prices. We evaluate the risks for the CPI outlook stemming from potential shocks to these external conditions by setting up four alternative scenarios, resulting from all possible combinations of positive and negative one-standard deviation shocks in the baseline growth rates of CIM and WFP. Figure 19: Scenario assumptions for CIM and WFP These results demonstrate that taking a one- Standard Deviation (1SD) shock may not fully reflect the implied risk. Because of the existence of excess kurtosis 14, the probability distributions are leptokurtic, implying that the occurrence of extreme shocks has a probability that is higher than one would expect on the basis of a normal distribution (see figure 19) CIM Baseline CIM+1SD CIM-1SD WFP Baseline WFP+1SD WFP-1SD The results of these scenarios are displayed in table (5). They indicate that, given the assumptions, the average inflation forecasts during 2016 would range between -0.1 percent and 1.6 percent, with 0.8 percent as the central baseline outlook. In 2017, the average inflation forecasts are expected to range between -2.1 percent and 4.6 percent, with 1.8 percent as the central baseline outlook. Table 5: Baseline and risk analysis of the CPI in Palestine for 2016 and 2017 Scenario Shock Implied annual growth rate CIM Implied annual growth rate WFP (Percentage point) Implied inflation forecast Baseline * Actual data. +1SD CIM +1SD WFP +1SD CIM -1SD WFP -1SD CIM +1SD WFP -1SD CIM -1SD WFP Kurtosis measures the peakedness or flatness of the distribution of the series. 19

26 Figure (20) shows the current risk analysis of inflation in Palestine during 2016 compared with the risk analysis in 2016 predicted in the previous report (volume 17). The figure indicates that scenarios 3 and 4 give results close to the baseline forecast; but scenarios 2 and 5 involve upside and downside outliers, respectively. The figure reveals that the risk declined compared with the risk predicted in the previous issue. The upside risk to the inflation forecast is clearly related to a higher expected risk in world food prices, combined with a higher inflation in Palestine s main trading partners, compared to what is assumed in the baseline. Conversely, inflation in Palestine may turn out to be considerably lower than predicted in the baseline, in case world food prices, together with inflation in the main trading partners, turn out to be lower than expected. Apart from model uncertainty and uncertainty related to external conditions, the inflation outlook for Palestine also hinges on potential specific shocks that may perturb the economic and political conditions in Palestine itself, which are independent of shocks occurring in the rest of the world. An example of such shocks was the Israeli withholding of clearance revenues during 2015Q1, resulting in delays and/or disruptions in payment of government employees salaries, which depresses demand and causes a fall in prices. Figure (21) shows the fan chart of the balance of Palestine s inflation risk during 2016Q1 2017Q4. The chart contains the quarterly profile of the baseline inflation forecast mentioned above. The risk parameters start from a standard deviation equal to 1.5 for the 2016Q2, which is based Figure 20: Web chart of the balance of Palestine s inflation risk Figure 21: Fan chart of the balance of Palestine inflation risk during 2016Q2 2017Q4 6.0 on the inflation volatility observed during the most recent years. It then rises up to 2.5 for the 2017Q4, reflecting the fact that uncertainty rises with the forecasting horizon this issue 2016 previous issue CIM: Cost of imports WFP: World food price index : Increase by one-standard deviation : Decrease by one-standard deviation -3.0 Q Q2 Q3 Q4 Q Q2 Q3 Q4 Q Q2 Q3 Q4 20