Gross investment reached an exceptionally high level of 30 percent of GNP in the period ending in the early 1970s, but subsequently dropped to 20 percent of GNP in 1986. While this figure is substantially lower than that achieved by earlier Israeli performance, it is internationally an acceptable standard of investment and private savings.

Nonetheless, concern existed in Israel about the extent of public-sector debt. Since 1973 the government has incurred a substantial domestic and foreign debt that has resulted in a significant reduction in the proportion of private savings available for investment. From 1970 through 1983, private savings averaged slightly above 10 percent of GNP. The success of the Economic Stabilization Program adopted in July 1985 in order to cut back on government spending led to an increase in private saving, however by 1986, private savings stood at 21 percent of GNP.

Unlike the unstable trend in private savings recorded in the banking sector, investment in housing has taken a consistently high share of GNP, hitting a 40 percent peak in 1980. This high level of investment in housing, which many economists argue is not justified economically, further constrained the rise of gross business investment. For example, despite the rise of the share in GNP of gross investment in manufacturing during the 1970s, Israel's 1982- 86 average share of 4 percent clearly is below international norms.

The lack of uniformity in government investment incentives and in the rate of return on capital within the manufacturing sector may be responsible for the mix of Israeli investments. Economists generally agree that inefficiencies have arisen as a result of excessive substitution of capital for labor, underused capacity, and inappropriate project selection. Government policy has been identified as the primary factor causing capital market inefficiencies by crowding out business investment, creating excessively high average investment subsidies, and introducing capital market controls based on inefficient discretionary policy.

The 1967 Law for the Encouragement of Capital Investment provided for the following incentives to "approved-type" enterprises: cash grants, unlinked long-term loans at 6.5 percent interest, and reduced taxes. The Treasury assumed full responsibility for any discrepancy between the linked rates paid to savers and the unlinked rates charged to investors. Because inflation in the mid-1970s reached levels close to 40 percent, the real interest rate paid on long-term loans was close to -30 percent per annum, with a total subsidy on long-term loans reaching a high of 35 percent in 1977. These extremely favorable interest rates and implied subsidies led to an excessive substitution of capital for labor.

The investment system has been characterized by the following factors: private firms generally are not allowed to issue bonds, the government establishes the real interest paid to savers and the nominal interest paid by investors, and the economy is plagued by high and unpredictable rates of inflation. These conditions have maintai245 ained an excess demand for investment. The result has been a continuous need to ration loans--and an implicit role for government discretion in project approval. Thus, since the late 1960s, as a result of capital market controls, the government has been making industrial policy.

Data as of December 1988