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  As Of               Filer                 Filing     As/For/On Docs:Pgs              Issuer               Agent

 7/09/07  Israel State of                   18-K/A     12/31/06    2:163                                    RR Donnelley/FA

Document/Exhibit                   Description                      Pages   Size 

 1: 18-K/A      Amendment No. 1 to Form 18-K                        HTML     13K 
 2: EX-99.D     Current Description of the State of Israel          HTML  1,064K 

STATE OF ISRAEL

This description of the State of Israel is dated as of July 9, 2007 and appears as Exhibit D to the State of Israel’s Annual Report on Form 18-K/A to the U.S. Securities and Exchange Commission for the fiscal year ended December 31, 2006.

TABLE OF CONTENTS

LIST OF TABLES

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Tables and Supplementary Information:

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Except as otherwise specified, all amounts in this report are expressed in New Israeli Shekels (“NIS”) or in U.S. dollars (“$”, “US$”, “dollars” or “USD”). Any amounts stated in dollars in this report as of a stated date or for a stated period that were converted from NIS into dollars were converted at the representative foreign exchange rate for dollars on such date, or at the average of the representative foreign exchange rates for dollars for each day during such period, as published by the Bank of Israel. The Bank of Israel calculates the representative foreign exchange rate for dollars for any day as the average of the NIS/$ buying and selling rates prevailing in the market on such date. The representative NIS/$ exchange rates as of the following dates and for the following periods were:

Table No. 1

NIS/U.S. Dollar Exchange Rates

Source: Bank of Israel.

On June 15, 2007, the Bank of Israel representative foreign exchange rate for US$ was NIS4.175 per US$1. In October 2000, all restrictions on foreign currency derivative transactions with nonresidents were abolished. For a further discussion of the convertibility of the NIS, see “Balance of Payments and Foreign Trade—Foreign Exchange Controls and International Reserves” below.

The fiscal year of the Government of Israel (the “Government”) ends December 31. The twelve-month period ended December 31, 2006 is referred to in this Prospectus as “2006” and other years are referred to in a similar manner.

Totals in certain tables in this report may differ from the sum of the individual items in such tables due to rounding. Unless otherwise specified, amounts in NIS or USD are given in current amounts.

Figures in this report are as of June 10, 2007, except as otherwise indicated.

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SUMMARY INFORMATION

The following summary is qualified in its entirety by, and should be read in conjunction with, the more detailed information appearing elsewhere in this document.

Economic Developments in 2006: The economic recovery that began in 2003 and gained strength in 2004 and 2005, continued in 2006. The Gross Domestic Product (“GDP”) growth rate was 5.1% and the business sector GDP growth rate reached 6.4%. The economic improvement, despite the Second Lebanon War during the summer (see “State of Israel—Introduction” below), was reflected in a rapid growth of all components of GDP, including private consumption, investment in fixed assets, exports and imports. Among the factors contributed to the rapid growth in 2006 were: the continued positive global economic trend; the ongoing responsible fiscal policy that contributed to reductions of the tax burden and of the public debt; the increase in local demand, and in particular, an increase of 4.8% in private consumption; the increase in real wages; the continued tax cuts; and the increase in the value of the public’s asset portfolio. Both the number of Israeli employees and the labor participation rate rose in 2006. The unemployment rate decreased from annual averages of 10.4% in 2004 and 9.0% in 2005 to 8.4% in 2006 reaching 7.7% in the last quarter of the year. External sustainability indicators, expressed by a high surplus in current account balance of $6.8 billion in 2006, high foreign currency reserves ($29.0 billion as of December 31, 2006) and negative net external debt (negative 22.2% of GDP as of December 31, 2006), reflect a high degree of external stability both by international standards and relative to the domestic situation in the mid-1990s. In 2006, the NIS remained stable or strengthened against the main foreign currencies.

Economic Developments in the First Quarter of 2007: Preliminary figures (seasonally adjusted at annual rate) published by the Central Bureau of Statistics indicate that the GDP growth rate for the first quarter of 2007 was 6.3% and the growth rate of the business sector product reached 6.5% for the same period. Exports of goods and services increased by 11.1%, while public consumption dropped by 4.0%, reflecting cuts in government expenditures. Private consumption rose by 11.8%. Both the number of Israeli employees and the labor participation rate rose in the first quarter of 2006, and the seasonally adjusted unemployment rate decreased from 8.8% in the first quarter of 2006 to 7.7% in the first quarter of 2007.

Fiscal and Monetary Policy: The improvement in the economic outlook was supported by the ongoing firm fiscal policy, which addressed the need for increases in the budget and which reflected a relatively non-contractionary monetary policy. The budget deficit declined to 0.9% of GDP in 2006 as compared with a budget deficit of 1.9% in 2005. Israel’s net public debt as a percentage of GDP declined to 75.9% in 2006 from 81.2% in 2005 and 88.2% in 2004. The low deficit may be attributed to the fact that government revenues and GDP growth exceeded expectations, while government expenditures were in line with original plan.

Balance of Payments and Foreign Trade: Israel’s current account of the balance of payments transformed into a small surplus in 2003 and reached a surplus of $6.8 billion in 2006, as a result of a more rapid expansion of exports as compared with the expansion of imports. The expansion in exports measured 4.9% in real terms in 2006 (8.7% rise in exports not including diamonds and start-ups), continuing the 2005 rise. In 2006, total exports of goods constituted 44.5% of GDP. Israel has entered into free trade agreements with its major trading partners, and it is one of the few nations that is a party to free trade agreements with both the United States and the European Union (“EU”).

Inflation: Since 1985, inflation has been reduced and stabilized. In 2006, the average consumer price index (“CPI”) inflation rate was 2.1%.

Privatization: In recent years, the Government has made significant progress in the privatization of state-owned enterprises and the reduction of its subsidization of industry. From 1986 through April 2007, 91 Government Companies (as defined below (see “The Economy—Role of the State in the Economy”)) have been transferred to private hands, and the Government’s proceeds from privatization were approximately $14.2 billion. In 2006, proceeds from privatization totaled NIS4.7 billion.

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Capital Markets: In 2006, share prices on the Tel-Aviv Stock Exchange (“TASE”) rose. The General Index of shares and convertible securities (which is comprised of all shares and convertible securities tradable on the TASE) increased in USD terms by 15.3% in 2006, compared with an increase of 24.3% in the General Index in 2005. During 2006, the Tel Aviv 100 Index, which is comprised of the 100 largest companies by market capitalization, and the Tel Aviv 25 Index, which is comprised of the 25 largest companies by market capitalization, increased in USD terms by 22.0% and 22.6% respectively, compared with an increase of 21.1% and 24.7%, respectively, in 2005. As of December 31, 2006, the total market value of all listed equity securities was $161.4 billion, compared with $122.6 billion in 2005 and $92.1 billion in 2004. The average daily trading for equity securities increased to $326 million during 2006, compared with $223 million in 2005 and $147 million in 2004.

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Table No. 2

Selected Economic Indicators

(in billions of NIS unless noted)

Sources: Central Bureau of Statistics, Bank of Israel, Ministry of Finance.

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STATE OF ISRAEL

Introduction

The State of Israel (the “State” or “Israel”) is a highly developed, industrialized democracy. Since 1990, Israel has seen improvements in most economic indicators. GDP increased on average by 5.4% annually from 1990 through 2000. A number of negative factors converged in the last quarter of 2000 and during 2001 and 2002, including the ongoing security unrest in Israel, which negatively affected tourism, the global technology slump, which slowed investments in high-tech companies, and the global economic slowdown, which negatively affected Israeli exports. As a result, GDP decreased by 0.6% in 2001 and by 0.9% in 2002. An economic recovery began in 2003 and accelerated during 2004, 2005 and 2006. In 2006, in spite of the Second Lebanon War during July and August, GDP increased by 5.1%, following an increase of 5.2% and 4.8% in 2005 and 2004 respectively. This accelerated growth rate was the result of several factors: increased macroeconomic stability, which resulted from firm fiscal policy aimed at reducing the fiscal deficit and public debt burden; fast growth of global economic activity, particularly, global trade; increased activity in high-tech sectors; and relatively low real interest rates.

The Israeli economy is export-oriented. Following two years of recession during which a decrease in exports was measured, exports recovered in 2003 and continued to grow in 2004, 2005 and 2006. By 2006, exports constituted 44.5% of GDP. In 2006, exports rose by 4.9% in real terms (including an 8.7% rise in exports not including diamonds and start-ups). The increase in exports in both high-tech and traditional industries during 2003-2006 was a result of a variety of factors, including: the depreciation of the Israeli currency in real effective terms between 2002 and 2004; the global economic recovery; the expansion of global trade and the increase in demand for high-tech products, the decrease in real domestic wages in 2002 and 2003; and the corporate efficiency measures. Exports of services grew by 5.3%, despite a decline of 3.7% in the tourism sector caused by the Second Lebanon War. Exports of goods (in US$ terms, excluding diamonds, ships and aircrafts) to the European Union rose by 12.1%, to the United States by 27.3% and to the rest of the world by 6.2%.

In recent years, Israel has made substantial progress in opening its economy, and major trade barriers and tariffs have been removed. Israel has entered into free trade agreements with its major trading partners, and Israel is one of the few nations that is a party to free trade agreements with both the United States and the European Union. Israel has also signed free trade agreements with the European Free Trade Association (“EFTA”) countries, as well as with Canada, Turkey and Mexico.

Since 1990, Israel’s fiscal and monetary policies have been formulated and coordinated with the goals of reducing Israel’s high tax burden, narrowing the Government’s fiscal deficit, attaining levels of inflation similar to those in other industrialized countries and enhancing economic growth. As part of its economic policies, the Government has pursued a policy of privatizing state-owned enterprises, including banks. In contrast to periods of high inflation in the early 1980s, inflation has been reduced and stabilized. Between 1992 and 1999, the annual average inflation rate was 9.5%. Throughout that period, inflation gradually decreased.

Since 1999, the annual average inflation rate has been close to zero, with the exception of 2002 when the annual average inflation rate rose to 5.7% mainly attributable to a one-time increase in prices due to currency depreciation that adjusted the currency rate to domestic and external events. The annual average inflation rate was 0.7% in 2003, negative 0.4% in 2004, 1.3% in 2005 and 2.1% in 2006.

The total budget deficit (excluding net lending and the realized profits of the Bank of Israel) averaged 3.1% of GDP per year between 1995 and 2000. The total budget deficit increased to 4.2% of GDP in 2001, 3.6% of GDP in 2002 and 5.4% of GDP in 2003, mainly as a result of a decline in GDP and in tax revenue. The 2004 total budget deficit was reduced to 3.7% of GDP. The 2005 and 2006 total budget deficits were 1.9% and 0.9% of GDP, respectively, mainly reflecting higher than expected government revenues.

The implementation of a decisive fiscal policy starting in mid-2003, backed by the loan guarantees provided by the U.S. government, contributed significantly to macroeconomic stability by raising fiscal credibility and lowering economic uncertainty.

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The current account deficit of the balance of payments that existed between 1995 and 2002 transitioned into a small surplus in 2003 and has been growing ever since 2004, primarily due to the growing expansion of exports, as compared with the expansion in imports during that period. Another factor that contributed to the growing surplus is the significant expansion of financial investments of Israeli residents abroad, which produced higher interest and dividend income, partially because of higher interest rates abroad. These surpluses reflect a high degree of external stability both by international standards and relative to the situation that existed in Israel in the mid-1990s.

The unemployment rate increased from 9.4% in 2001 to 10.4% in 2004. In 2005, the average unemployment rate decreased to 9.0%, and in 2006 it dropped to 8.4% (in the last quarter of the year it reached 7.7%). Both the number of Israeli employees and the labor participation rate rose in 2005 and in 2006. The rate of participation in the civilian labor market (as a percentage of the population aged 15 and above) rose to 55.6% in 2006, compared with 55.2% in 2005 and 54.9% in 2004. In the last quarter of 2006, the number of employed Israelis increased by 62,400 from the last quarter of 2005.

Israel’s productive and highly educated population remains a principal strength of the economy. Based on 2005 statistics, approximately 41% of the Israeli population over the age of 15 has had 13 or more years of schooling. In addition, from 1990 through 2006, approximately 1.2 million immigrants arrived, increasing Israel’s population by more than 25%. The new immigrants are generally highly educated and include a high percentage of scientific, academic, managerial, technical and other professional workers. Although this wave of immigration initially placed strains on the economy by raising the budget and trade deficits and contributing to a relatively high level of unemployment, these immigrants have been successfully integrated into the economy. Today, the employment rate of immigrants who came to Israel in the first half of the 1990s is similar to that of native-born Israelis.

Over the past three decades, Israel has made progress in reducing the hostilities that have existed with Arab countries in the region since the establishment of the State in 1948. Nevertheless, the unrest in the areas administered by the Palestinian Authority, which began in September 2000 and intensified during 2001 and 2002, has been a major setback in the peace process. Since 2003 there has been an improvement in the security situation, as it relates to the Israeli-Palestinian conflict, which is reflected by the relative decline in the number of terrorist attacks and security incidents. The first peace agreement between Israel and its neighbors was the 1979 Camp David peace accord with Egypt. In September 1993, Israel and the Palestinian Liberation Organization (“PLO”) signed a Declaration of Principles, a turning point in Israeli-Arab relations. Israel signed a peace treaty with Jordan in 1994. Further agreements have also been signed between Israel and the PLO. In 2005, Israel implemented the Disengagement Plan, in which it dismantled all Israeli communities in the Gaza Strip, four Israeli towns in the northern West Bank and all of its military installations in those areas. In July and August 2006, Israel was engaged in a war against the Lebanese terror organization Hezbollah in Lebanon (the “Second Lebanon War”). See “—International Relations” below.

Geography

Israel lies on the western edge of Asia bordering the Mediterranean Sea. It is bounded on the north by Lebanon and Syria, on the east by Jordan, on the west by the Mediterranean Sea and Egypt, and on the south by Egypt and the Gulf of Eilat. Israel has a total land area (excluding the Gaza Strip and the West Bank) of approximately 21,500 square kilometers or 8,305 square miles, approximately the size of the state of New Jersey. Jerusalem is the capital of Israel.

Population

Israel’s population, including Israeli citizens residing in the West Bank, but not including foreign nationals residing in Israel for employment purposes, was estimated to be 7.11 million as of December 31, 2006, up from 6.99 million as of December 31, 2005. During the period from 1990 through 2006, Israel’s population grew by

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47.5%, largely as a result of immigration. At the end of 2005, approximately 10% of the population was 65 years of age or older, 30% was between the ages of 35 and 65, 32% was between the ages of 15 and 34, and 28% was under the age of 15. Approximately 91% of the population lives in urban areas. Twenty percent of the population lives in Israel’s three largest cities: Jerusalem (population 719,900), Tel-Aviv (population 378,900) and Haifa (population 268,300).

The Israeli population is composed of a variety of ethnic and religious groups. At the end of 2005, 76.0% of the total Israeli population was Jewish, 16.3% was Muslim, 2.1% was Christian, 1.6% was Druze and 3.9% were not classified by religion. Israel’s Declaration of Independence and various decisions by Israel’s Supreme Court guarantee freedom of worship for all Israeli citizens. Hebrew and Arabic are the official languages of Israel and English is commonly used.

Immigration

Israel has experienced a continuous flow of immigrants, in part due to Israel’s Law of Return which provides that any Jewish immigrant is entitled to become a citizen of Israel. Between 1990 and 2001, the flow of immigrants has increased dramatically. The substantial influx of immigrants during these years totaling 1.1 million increased Israel’s population by more than 23% over this period. Over the same period, total population growth was 42.5%. Approximately 91% of all immigrants to Israel since 1990 have come from the former Soviet Union. Many of these immigrants are highly educated. Of the immigrants who arrived since 1990 who were over 15 years of age, 58% had over 13 years of schooling. Of the immigrants who arrived between 1990 and 2003, approximately 62% held scientific, academic, managerial, technical or other skilled jobs. This influx of highly skilled workers has contributed to the growth of the Israeli economy since 1990.

Form of Government and Political Parties

The State of Israel was established in 1948. Israel is a parliamentary democracy, with governmental powers divided among separate legislative, executive and judicial branches. Israel has no formal written constitution. Rather, a number of basic laws govern the fundamental functions of the State, including the electoral system, the government, the legislature and the judiciary, and guarantee the protection of property, life, body and dignity, as well as the right to privacy and freedom of occupation. These laws are given special status by Israeli courts relative to other laws and, in some cases, cannot be amended except by an absolute majority vote of the Knesset, Israel’s parliament. All citizens of Israel, regardless of race, religion, gender or ethnic background, are guaranteed full democratic rights. Freedom of worship, speech, assembly, press and political affiliation are embodied in the country’s laws, judicial decisions and Declaration of Independence.

The President is the head of state and is elected by the Knesset for a single seven-year term. The President has no veto powers and the duties of the office are mainly ceremonial. The President selects one of the Knesset members to form the government, after consulting with different parties’ representatives. This Knesset member becomes Prime Minister. The current President, Shimon Peres, was elected on June 13, 2007. The Prime Minister is the head of Israel’s Government and appoints a cabinet to assist in governing the country.

The legislative power of the State resides in the Knesset, a unicameral parliament that consists of 120 members elected by universal suffrage under a system of proportional representation. The entire country constitutes a single electoral constituency. Each party receiving more than 2.0% of the total votes cast is assigned membership in the Knesset in proportion to its percentage of the total national vote. Knesset elections are held every four years, unless the Knesset votes for elections to take place earlier or if the Knesset fails to pass the annual budget by the end of March.

If a 61-vote majority of the Knesset subsequently passes a vote of no confidence in the government and proposes an alternate candidate, the government will dissolve and the President will select the alternate candidate to form a new government. If the alternate candidate fails to form a new government, new elections will be held.

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The Prime Minister, with the approval of the President, also has the authority to dissolve the Knesset. However, a majority of Knesset members may require the President to appoint another Knesset member to form a new government. If this Knesset member fails to form a new government, new elections will be held.

Currently, Israel has two major political parties, Kadima and Avoda (Labor)-Meimad. Since the establishment of the State of Israel in 1948, the Government has been a coalition government led by Avoda or Likud and supported by a majority of the members of the Knesset.

The following table presents the distribution of current Knesset seats by party as of June 2007:

Table No. 3

Distribution of Knesset Seats by Party

Following the March 2006 elections, the former President Moshe Katsav selected Ehud Olmert to form a government. Prime Minister Olmert formed a new coalition government, consisting of the Kadima party, the Avoda-Meimad party, the Shas party and Gil party. In December 2006, the Yisrael Beitenu party joined the coalition. On July 3, 2007, Ronnie Bar-On was appointed Minister of Finance.

The judicial power in Israel is exercised by the Supreme Court, District Courts and Magistrate Courts, as well as municipal courts, labor courts, administrative tribunals and religious courts. The five District Courts (located in Jerusalem, Tel-Aviv, Haifa, Beer-Sheva and Nazareth) hear all cases not within the exclusive jurisdiction of the Magistrate Courts or the specialized courts and also hear appeals from the Magistrate Courts. The Supreme Court has ultimate appellate jurisdiction over all decisions rendered by District Courts. The Supreme Court also exercises original jurisdiction by sitting as the High Court of Justice in matters outside the jurisdiction of any other court or tribunal and where it is necessary to grant relief in the interest of justice. In its capacity as the High Court of Justice, the Supreme Court hears petitions in matters of constitutional and administrative law and reviews acts of the executive branch and the Knesset. In addition, the High Court of Justice may order religious courts and labor courts to adjudicate any particular matter, or to set aside any proceeding held or decision given. Judges are appointed by the President upon election by the Judges’ Election Committee, the majority of whose members represent the legal profession. Some marital and family matters, and certain other matters related to personal status, are handled by religious courts. Most religions have their own religious courts.

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National Institutions

Israel has four so-called National Institutions: The Jewish Agency for Israel, the World Zionist Organization, Keren Hayesod and the Jewish National Fund. The National Institutions, which predate the formation of the State, perform a variety of non-governmental charitable functions. Each of the National Institutions is independent of the Government and finances its activities through private and public sources, including donations from abroad. In 2006, the National Institutions were responsible for net unilateral transfers into Israel of $300 million.

International Relations

Over the past three decades, Israel has made progress in reducing the hostilities that have existed between Israel and the region’s Arab countries since the establishment of the State of Israel in 1948. As a result of the historic visit to Israel by the President of Egypt in 1977 and the intensive negotiations held by the two countries, Egypt and Israel signed a peace treaty on March 26, 1979, which was the first between Israel and one of its neighboring countries. The Madrid Conference in 1991 marked the start of a broader peace process in the Middle East.

The mutual recognition and the signing of a Declaration of Principles between Israel and the PLO in September 1993 was a turning point in Israeli-Arab relations. A number of interim agreements were signed, and the Palestinian Authority (the “PA”) was established. As part of the 1994 Gaza Strip and Jericho Agreement signed in Cairo and the 1995 Interim Agreement on the West Bank and the Gaza Strip signed in Washington, D.C., Israel withdrew from Jericho, most of the Gaza Strip and six additional West Bank towns. The PA has gradually taken responsibility for administering those areas of the West Bank and Gaza Strip designated as self-rule areas. Several rounds of negotiations were held between Israel and the PLO in 2000, aimed at achieving a permanent agreement and an end to the conflict. Unfortunately, those negotiations did not result in an agreement. Since September 2000, relations between Israel and the PA have deteriorated due to violence and terror attacks conducted by Palestinian terror organizations against Israeli citizens and targets in violation of all bilateral agreements signed since 1993.

In April 2003, a performance-based, multi-phase plan to end the Israeli-Palestinian conflict, known as the Road Map, was released by the United States, the United Nations (the “UN”), the European Union and Russia. The first phase of the Road Map requires the immediate cessation of violence by the Palestinians, the implementation of comprehensive political reforms by Palestinians, the withdrawal from Palestinian areas controlled by the Israeli Defense Forces since September 28, 2000, and action by Israel in relation to settlements, in particular the dismantling of settlement outposts erected since March 2001. The second phase of the Road Map, which would begin upon satisfactory performance of the first phase, contemplates the creation of a temporary Palestinian state with provisional borders and an elected government. The third and final phase of the Road Map would include the negotiation of a final agreement to end the Israeli-Palestinian conflict and fulfill the vision of two states, Israel and Palestine, living side by side in peace and security. While the Road Map has been officially accepted by both the Israeli and the Palestinian sides, its implementation encountered a number of serious obstacles.

In light of the obstacles facing implementation of the Road Map, the Government of Israel initiated the Disengagement Plan, which included the evacuation of all civilians and withdrawal of all military forces from the Gaza Strip and parts of the northern West Bank.

Implementation of the disengagement from Gaza was completed in August 2005 and included the formal dismantling of Israel’s military government in the Gaza Strip and withdrawal of all Israeli troops from the ‘Philadelphi Route’ along the border between the Gaza Strip and Egypt. The withdrawal brought an end to Israeli presence and authority over the area, which began after the Six-Day War in June 1967. Disengagement from parts of the northern West Bank was completed in September 2005. On September 20, 2005, representatives of the United States, Russia, the European Union and the UN issued a joint statement, declaring that they “welcomed the successful implementation of the [Disengagement Plan] and the moment of opportunity that it brings to renew efforts on the Roadmap.”

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The Israeli government had expected that its unilateral steps will advance the peace process and the implementation of the Road Map. The election of the Hamas terrorist organization to head the PA in January 2006, and its refusal to accept the conditions for legitimacy set out by the international community, namely, the renunciation of terrorism and violence, the recognition of Israel’s right to exist and the acceptance of previous agreements and obligations, including the Road Map, have disrupted the efforts to renew the peace process. In June 2007, increasing violent clashes between the Hamas forces and the Fatah movement led by Palestinian President Abbas, have resulted in the Hamas de facto taking control of the Gaza Strip. Consequently, a new Palestinian Government was formed by Abbas. The Palestinian internal violent political conflict has increased further uncertainty regarding the potential renewal of the peace process. The renewal of the Palestinian violence also resulted in significant damage to economic relations, primarily in bilateral trade, which suffered heavily during the past seven years.

In his inaugural address to the Knesset, the elected Prime Minister Olmert outlined the policies of the new government which included a preference for negotiations with a Palestinian partner committed to “the principles of the Roadmap, which fights terror, dismantles terrorist organizations, abides by the rules of democracy and upholds, practically and thoroughly, all agreements which have thus far been signed with the State of Israel.” However, in the absence of such a partner, Prime Minister Olmert declared that the government would act “without an agreement with the Palestinians to create an understanding which will, first and foremost, be founded on a correct definition of the desired borders for the State of Israel.” The new Prime Minister also stated that Israel would work to reach understandings with the United States and Europe on its future steps.

Israel and Jordan signed a peace treaty in October 1994. By signing the peace treaty with Israel, Jordan became the second Arab country to do so, following Egypt. After resolving issues relating to borders and water, Israel and Jordan entered into negotiations to promote economic cooperation and to plan regional economic development initiatives. In addition, Israel has begun to establish economic and political relations with other countries in the region, in both North Africa and the Gulf states. In October 1999, Israel and Mauritania established full diplomatic relations. Mauritania is the third Arab country after Egypt and Jordan with whom Israel has exchanged ambassadors. Israeli authorities continue their efforts to promote peaceful relations and increase economic opportunities, with a particular focus on the goal of enhancing regional development.

Although Israel has entered into various agreements with Arab countries and the PLO, and various declarations have been signed in connection with the efforts to resolve some of the economic and political problems in the Middle East, no prediction can be made as to whether, and under what terms, a full resolution of these problems will be achieved. To date, Israel has not entered into a peace treaty with either Lebanon or Syria. On May 23, 2000, in accordance with a Government decision, Israeli military forces unilaterally withdrew from South Lebanon, in compliance with UN Resolution 425, as confirmed by the Security Council and Secretary General of the United Nations. In July 2006, an attack of the Lebanese terror organization Hezbollah on Israeli military patrol within the Israeli border led to the Second Lebanon War, which included heavy fighting during July and August 2006. The war ended with UN resolution 1701, which called the government of Lebanon to take full control of Lebanon, called for the deployment of UNIFIL soldiers throughout the South of Lebanon and prohibited the presence of paramilitary forces, including Hezbollah, south of the Litani River. Since 1948, the members of the Arab League have maintained a trade boycott of Israel. The primary tier of the boycott prohibits the importation of Israeli-origin goods and services by member states. The secondary tier of the boycott prohibits individuals in Arab League states from engaging in business with foreign firms that contribute to Israel’s military or economic development, and the tertiary tier of the boycott prohibits business dealings with firms that do business with blacklisted entities. In September 1994, the Gulf Cooperation Council (which includes Qatar, Oman, Bahrain, the United Arab Emirates, Saudi Arabia and Kuwait) suspended their secondary and tertiary trade boycotts of Israel, signifying a major shift in Israel’s relations with several Arab nations in the region. These Gulf States, as well as four other Arab League members (Algeria, Djibuti, Mauritania and Somalia) no longer enforce the secondary and tertiary boycott tiers of Israel.

Prior to the recent security unrest, Israel and its Arab neighbors had taken several initiatives to encourage the development of economic relations among the countries of the region. The formation of additional regional

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economic organizations was proposed to enhance cooperation between Israel and other countries of the region. Among these, the most important are the Middle East Development Bank (MEDB), the Middle Eastern-Mediterranean Tourist and Travel Association (MEMTTA) and the Regional Business Council (RBC).

Israel maintains a close economic, diplomatic and military relationship with the United States. Israel receives economic and military assistance from the United States in amounts that have averaged approximately $3 billion per year since 1987. In 1992, the United States approved up to $10 billion of loan guarantees during U.S. fiscal years 1993 through 1998 to help Israel absorb the recent influx of immigrants. In April 2003, the United States approved up to $9 billion in loan guarantees for the State of Israel to be issued during U.S. government fiscal years 2003 through 2005. This program was extended until 2011. The amount of guarantees that shall be issued to Israel under the loan guarantee program may be reduced by an amount equal to the amount extended or estimated to have been extended by Israel for activities that the President of the United States determines are inconsistent with the objectives and understandings reached between the United States and Israel regarding the implementation of the loan guarantee program. For United States fiscal year 2003, the amount of this reduction was $289.5 million. For United States fiscal year 2006, a reduction of $795.8 million was made. The proceeds of the guaranteed loans may be used to refinance existing debt (see “Public Debt—External Public Debt” below). In May 2003, as part of the aid package, the United States formally granted Israel $1 billion in military aid.

The Government of Israel and the United States have agreed to reduce foreign assistance to Israel. This reduction involves a phase-out of U.S. Economic Support Fund (“ESF”) assistance to Israel through incremental annual reductions in the level of such annual assistance over a ten-year period that began in fiscal year 1999. Over the same time period, the United States will increase annually the level of its Foreign Military Financing (“FMF”) assistance to Israel in amounts equal to half the amount of the annual reduction in ESF assistance. Subject to Congressional appropriations, from U.S. fiscal year 1999 through 2008, each year the level of ESF assistance will be reduced by $120 million and the level of FMF assistance will be increased by $60 million. The level of ESF assistance for U.S. fiscal year 2007 is $120 million.

Israel currently maintains diplomatic relations with more than 160 countries. Israel has established or re-established commercial, trade and diplomatic relations with several republics of the former Soviet Union, nations of Eastern Europe, and other countries that had been aligned politically with the former Soviet Union. Furthermore, the developments toward peace in the region in the last decade have facilitated the growth of commercial, trade and diplomatic relations with several Asian countries, including Japan, South Korea, China and India.

Membership in International Organizations and International Economic Agreements

Israel is a member of a number of international organizations, including the UN, the World Bank Group (including the International Finance Corporation), the International Monetary Fund (“IMF”), the European Bank for Reconstruction and Development, and the Inter-American Development Bank.

Israel has been a signatory to the General Agreement on Tariffs and Trade (“GATT”) of 1947 since 1962 and it is a founding member of the World Trade Organization (“WTO”). In addition, Israel actively participates in plurilateral initiatives conducted under the framework of the WTO, such as the Government Procurement Agreement and the Information Technology Agreement.

In March 1996, the Council of Ministers of the Organization for Economic Co-operation and Development (“OECD”) approved Israel’s request to participate in the organization’s activities, and Israel has accordingly joined certain OECD committees as an observer. Since February 2000, Israel has been in a dialogue with OECD leadership in order to promote Israel’s admission to the organization as a full member. In May 2007, OECD countries invited Israel to begin discussions on its accession to the organization. Israel has an extensive network of free trade agreements with most of its trading partners: United States, European Union, EFTA, Turkey,

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Canada, Mexico and Jordan. Approximately 75% of Israel’s foreign trade is conducted under its bilateral free trade agreements, which provide duty free access and other preferential treatment schemes. Israel is currently negotiating a free trade agreement with the MERCOSUR block (Brazil, Argentina, Paraguay and Uruguay) which is scheduled for signing by the end of 2007.

In 1975, Israel established a free trade agreement with the European Economic Community (EEC) that provided for the gradual reduction and ultimate elimination of tariffs on manufactured goods and certain agricultural products. In July 1995, Israel signed an Association Agreement with the European Union, which came into force in June 2000. The 1995 agreement, which replaced the 1975 agreement, addresses issues relating to services, competition, government procurement, and cooperation in many areas including research and development. It also expands the liberalization in agricultural products. At the end of 2004, Israel and the European Union approved an Action Plan (within the European Neighborhood Policy) to address several issues including but not limited to services, dispute settlement for trade matters and standardization. Since 1996, Israel has participated in the EU Framework Programs for Research and Development, which allow Israeli firms and academic institutions to participate in European Union research and development projects. Israel is the only country outside Europe to enjoy this special status, a status granted to Israel largely in recognition of its role as a key technological player in the global arena. Under the Fifth Research and Development Program, more than 500 Israeli projects have been implemented, with a total value of more than EUR150 million. In November 2002, Israel was admitted to the EU’s Sixth Research and Development Program and gained access to EUR17 billion in research and development tenders from European Union countries. Israel is currently negotiating its admission to the Seventh Research and Development Program. In addition, in 2004 Israel joined the EU GALILEO program for the development of a space navigation system.

In 1985, Israel and the United States entered into a free trade agreement that resulted in the elimination of all tariffs on all industrial products effective January 1, 1995. The free trade agreement with the United States also resulted in the elimination of certain non-tariff barriers to trade between the two countries.

In recent years, Israel, with the assistance of the United States, has developed new regional trade agreements that stimulate economic cooperation between Israel and its neighbors in the Middle East. Israel signed a Qualified Industrial Zones (“QIZ”) agreement with Jordan in 1997 and a separate QIZ agreement with Egypt in December 2004. The above mentioned agreements allow Egypt and Jordan to export products to the United States free of export duties if the products contain inputs from Israel (8% of input from Israel in the Israeli-Jordanian QIZ agreement, 11.7% of input from Israel in the Israeli-Egyptian QIZ agreement). The purpose of this trade initiative has been to support prosperity and stability in the Middle East by encouraging regional economic integration.

In order to promote its international economic cooperation, and, in particular, to promote Israeli investments in emerging markets, Israel has signed 32 bilateral investment treaties. The treaties provide investors from countries that are party to the treaties with basic security and protection rights when investing in another party’s country. Some of those rights include repatriation of investments and returns, a prohibition on expropriation or nationalization other than for public purposes, prompt, adequate and effective compensation, and no less favorable treatment as compared to investors from countries that are not party to the treaties.

Israel is also a party to 44 conventions for the avoidance of double taxation that cover most aspects of income tax and capital gains tax. Three more tax treaties were signed but have not yet been ratified. Most of Israel’s tax treaties are based on the OECD Model Tax Convention on Income and on Capital. Some of the treaties also include provisions from the UN Model Double Taxation Convention between Developed and Developing Countries. The conventions provide investors from countries that are parties to the conventions with greater certainty when investing in another party’s country and contribute to economic cooperation between the countries that are parties to the conventions.

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THE ECONOMY

Overview

Israel’s economy is industrialized and diversified. GDP per capita in 2006 was $19,917. From 1990 through 2006, real GDP growth averaged 4.5% per year (1.8% per capita). From 1990 through 2000, GDP increased on average by 5.6% annually, which had been, to a large extent, a product of the increased domestic demand due to the large volume of new immigrants during that period and the growth of high value-added industries, such as electronics and high-tech medical equipment. A number of negative factors converged in the last quarter of 2000 and during 2001 and 2002, including: security unrest with the Palestinian Authority, which negatively affected tourism and contributed to the fiscal deficit; the global technology slump, which slowed investments in high-tech companies; and the global economic slowdown, which negatively affected Israeli exports. As a result, GDP decreased by 0.6% in 2001 and by 0.9% in 2002. There was a recovery in economic activity in 2003, as evidenced by a 1.5% increase in GDP. The recovery gained momentum in 2004 and 2005, as expressed by a 4.8% and 5.2% increase in GDP, respectively. Despite the Second Lebanon War, this rapid GDP growth continued in 2006 with a 5.1% increase. The recovery during the years 2003 through 2006 was related to: the improvement in the global economy, as manifested by the expansion of global trade and demand for high-tech products; the adoption of a firm fiscal policy; a relatively calm security situation (apart from the Second Lebanon War); and a less restrictive monetary policy. The year 2006 was characterized by a rapid growth of all components of the GDP. In 2006, exports of goods and services increased by 4.9%, private consumption increased by 4.8% and investments in fixed assets increased by 6.4%.

The composition of Israel’s trade sector reflects the industrialized nature of its economy. In 2006, exports consisted primarily of manufactured goods, in particular high-tech goods, while raw materials and investment goods comprised 88.6% of imported goods. Especially since 1992, exports have played a significant role in Israel’s economic growth. During the period from 1992 to 2006, exports of industrialized goods (excluding diamonds) grew by an annual average of 9.7% (in volume terms). In 2000, due to rapid growth in the United States and European Union economies, Israel’s exports of industrialized goods (excluding diamonds) increased by 27.0%, while total exports of goods and services increased by 22.7%. However, total exports of goods and services decreased by 11.2% in 2001 and by 2.3% in 2002. The main factors behind the contraction in exports of goods were the global slowdown, which dampened global trade, and the decline in demand for high-tech goods. Exports of services were severely affected by the large decline in exports of tourism services caused by the security and political unrest during those years, and the decline, to nearly zero, of start-up exports (sales of start-up companies to international buyers) due to the global high-tech crisis. In 2003, exports began to recover, growing by 8.2%. The recovery in exports gained momentum in 2004, as exports rose sharply, by 18.2%. The expansion in exports continued in 2005 and 2006 as well, albeit at a lower rate than in 2004 (5.1% and 4.9% in real terms, respectively, including a 8.1% and 8.7% rise in exports excluding diamonds and start-ups). High-tech and traditional industries took part in the rise in exports of goods; the exports of services also rose, in particular the sharp increase in tourism, recovering from a slump that began in late 2000. The growth in exports during the years 2003-2006 was a result of the global economic recovery, the expansion of global trade and increased demand for high-tech products, the depreciation of the NIS in real effective terms during the period from 2002 through 2004, the decrease in real wages during 2002 and 2003, improved efficiency of business enterprises in Israel, and lower interest rates. Exports of services grew by 5.3% in 2006, despite a decline of 3.7% in the tourism sector, that was associated with the Second Lebanon War. The decline in tourism measured in the summer of 2006 followed an increase of 28.4% in 2005, and was followed by a fast recovery during the remainder of 2006. Exports of agricultural products remained stable in 2006, with an increase of 0.4%, following a sharp increase of 14.1% in 2005.

Historically, the Government has had substantial involvement in nearly all sectors of the Israeli economy. In the past 20 years, however, a central aim of the Government’s economic policy has been to reduce its role in the economy and to promote private sector growth. In order to advance these goals, the Government has pursued a policy of privatizing state-owned enterprises, including banks (see “—Role of the State in the Economy” below).

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The Government has also pursued stability-oriented monetary and fiscal policies. These policies build upon the economic stabilization program established by the Government in 1985.

The 1985 economic stabilization program was a comprehensive plan designed mainly to reduce Israel’s high inflation rates and chronic deficits in the balance of trade that resulted from high levels of defense expenditures, rising Government spending and rising oil prices.

Since 1985, Israel has made significant progress in stabilizing inflation through effective implementation of monetary policy by the Bank of Israel, fiscal restraint and trade liberalization by the Government. In 1986, the Government succeeded in reducing inflation to 19.6%. During the period of 1987 through 1991, inflation stabilized to an annual average rate of 17.8%. During the period of 1992 through 1999, the annual average inflation rate decreased to an average of 9.5%. The average rate of inflation dropped to a mere 1.1% in each of 2000 and 2001, but rose in 2002 to an average of 5.7%, mainly as the result of the currency depreciation during the first half of 2002. Since then, inflation has dropped back again, to an average annual rate of 0.7%, negative 0.4% and 1.3% in 2003, 2004 and 2005, respectively. In 2006, the average annual inflation rate was 2.1%. The Government’s inflation target for 2007 and onwards is 1% to 3%.

Gross Domestic Product

GDP is defined as gross national product (“GNP”) minus income of Israeli residents from investments abroad, earnings of Israeli residents working abroad, and other income from work and leases abroad, less corresponding payments made abroad (after deduction of payments to foreign companies with respect to production facilities located in Israel).

GDP growth averaged 5.6% annually between 1990 and 2000. From October 2000 until the beginning of 2003, the GDP growth rate declined mainly due to: the global economic slowdown, which dampened demand for high-tech products on which a significant percentage of the Israeli economy relies; the decline of the NASDAQ index, which reduced investments in Israeli start-up companies and in the high-tech industry in general; and the adverse effects of Palestinian terrorism on tourism, construction, agriculture and exports to the Palestinian Authority areas. Growth was negative 0.6% and negative 0.9% in the years 2001 and 2002, respectively. The recovery process began in 2003 and gained momentum in 2004 and 2005 with GDP growth rate increasing to 4.8% and 5.2% in 2004 and 2005, respectively. The GDP growth continued in 2006 with a 5.1% increase. Contributing factors to the rate of GDP growth include: the improvement in the global economy, as manifested by the expansion of global trade and demand for high-tech products; the adoption of a firm fiscal policy; a relatively calm security situation (apart from the Second Lebanon War); and relatively low real interest rates. In 2006, economic improvement was reflected in rapid growth of all components of GDP except for tourism, which constitutes 1.3% of GDP.

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Table No. 4

Main Economic Indicators

(in millions of NIS unless noted)

Source: Central Bureau of Statistics.

Table No. 5

Resources and Use of Resources

(in millions of NIS at constant 2005 prices)

Source: Central Bureau of Statistics.

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Savings and Investments

In 2006, gross national savings increased to 22.5% of GDP (in current prices), compared with 20.6% in 2005 and 19.1% in 2004. Gross domestic investment, the sum of investments in fixed assets and the change in inventories, totaled 17.6% of GDP in 2006 and has remained relatively stable in the past few years. In 2006, total gross domestic investment increased by 4.1% in real terms following increases of 11.5% and 1.2% in 2005 and 2004, respectively. Investment in fixed assets increased by 6.4% in 2006, following a 2.9% increase in 2005 and a 0.3% decrease in 2004.

Investment in machinery, equipment and transport vehicles increased by 10.7% in 2006. Investment in residential construction in 2006 increased by 1.7%, following a decrease of 1.3% in 2005 and a decrease of 2.6% in 2004. The residential construction sector has contracted since 1998 as a result of the decrease in demand following the slowdown in the wave of immigration and in response to the recession during the years 2001-2002.

Business Sector Product

Business sector product in Israel equals GDP less general government services, services of private non-profit institutions and housing services (representing the imputed value of the use of owner-occupied residential property). Business sector product grew at an average annual rate of 6.8% in real terms from 1990 through 2000, but decreased by 1.9% and by 2.8% in 2001 and in 2002, respectively. Since 2003, business sector product began to grow again, increasing by 2.2%, 6.8%, and 6.7% in 2003, 2004 and 2005, respectively. In 2006 it grew by 6.4%.

Table No. 6

Composition and Growth of Business Sector Product

Source: Bank of Israel.

Trade and Services. The trade and services sector consists of retail and wholesale sales, professional services, banking, hotels and other services. The trade and services sector increased by 6.3% in real terms in 2004, by 7.0% in 2005 and by 7.1% in 2006 .

Manufacturing. Manufacturing (excluding diamonds) increased by 6.8% in real terms in 2004, by 4.5% in 2005 and by 10.5% in 2006.

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Table No. 7

Manufacturing by Category

Source: Bank of Israel.

Table No. 8

Industrial Production Index

(Base: Year 2004)

Source: Central Bureau of Statistics.

Transportation. Buses are the major form of public transportation. Bus routes exist in all cities in Israel and connect Israel’s major cities smaller towns and rural areas. Israel also has a network of over 17,000 kilometers of roads, including highways that link Tel-Aviv with Haifa, Jerusalem and Dimona. Government-owned railways run from Nahariya on the northern coastline to Beer-Sheva in the south, linking some of Israel’s major cities and the southern part of the country.

Since 1993, the Government has identified infrastructure improvement as one of its top priorities. In September 2003, the Government founded the Israel National Roads Company LTD (“INRC”), a Government Company (as defined below (see “—Role of the State in the Economy”)) responsible for the inter-urban road system, traffic management and control, planning, development and maintenance of the roads and their safety.

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The budget for INRC projects in 2007 is approximately NIS2.1 billion. In recent years, the Government has approved a number of major road construction projects, including the “Cross-Israel Highway” – Israel’s North-South toll highway. The 86-kilometer central sections of this highway were opened to traffic in January 2004, and three additional sections of this highway, totaling 51 kilometers, are currently under construction. A 17-kilometer section, in the north of the State, is scheduled to open in 2009, and two sections, totaling 34 kilometers, are scheduled to open in 2008. Other projects include the Carmel Tunnel (to be completed in 2011), a fast toll lane at the east entrance to Tel-Aviv (to be completed in 2010) and Highway 431 which will serve the south-eastern suburban part of Tel-Aviv (to be completed in 2008) and, unlike existing highways, is implemented as a private-financial-initiative.

The Government considers the development of an advanced railway system a top priority. In 2000, the Government issued a tender to establish a light rail build-operate-transfer (“BOT”) project in Jerusalem. In 2003, the Government issued a tender to set up a light rail BOT project in metropolitan Tel-Aviv. The first Tel-Aviv line is expected to commence operations in 2013. The first Jerusalem line is expected to commence operation in 2009. In 2004, the Government decided to invest $4.5 billion over five years in a rail development program. As part of this development plan (i) the old line between Jerusalem and Tel-Aviv (via Beit-Shemesh) was rehabilitated and opened to the public in April 2005, (ii) a direct and upgraded line between Jerusalem and Tel-Aviv is scheduled to commence operations in 2011, (iii) the line between Tel- Aviv and Ben-Gurion International Airport was opened to the public in March 2005, and its extension through Modii’n is scheduled to commence operations in 2007, and (iv) several new and improved lines, such as Tel-Aviv-Rishon Le-Zion, Haifa-Beit She’an, Kfar Saba-Rananna-Tel-Aviv, and Ashkelon-Beer-Sheva, are scheduled to commence operations in 2010 and 2011.

Israel has three major seaports: Haifa and Ashdod, on the Mediterranean coast, and Eilat, by the Red Sea. In 2006, 20 million tons of freight were unloaded and 15.8 million tons were loaded at Israeli ports. In July 2004, the Knesset decided on a structural reform of the seaports in order to enhance competition and improve efficiency of the ports, thereby strengthening Israel’s foreign trade. As mandated by legislation, the Israel Ports Authority ceased operations on February 16, 2005 and was replaced by four Government-owned companies. Israel Ports Development and Assets Company Ltd. serves as landlord of the ports’ real estate in Haifa, Ashdod and Eilat and is responsible for developing and leasing those properties. Ashdod Port Company Ltd., Haifa Port Company Ltd. and Eilat Port Company Ltd., the three port-operating companies, received a mandate to operate port facilities that have been leased to them (in Ashdod and Haifa, for terms of 49 years; in Eilat, for a term of four years). Among the major projects are the development of the “Hayovel” terminal in Ashdod which commenced operations in May 2005, and the “Hacarmel” terminal in Haifa, which is scheduled to commence operations in 2009. The Israel Ports Development and Assets Company Ltd. is investing approximately NIS3.9 billion in these two projects.

Israel has three international airports. The Airports Authority is responsible for maintaining, developing and operating the airports and their security in accordance with the directives of the Minister of Transportation. Israel’s main airport is Ben Gurion Airport in Lod, which is located approximately 40 kilometers from Jerusalem and 20 kilometers from Tel-Aviv. Ben Gurion Airport served approximately 8.8 million passengers in 2006, compared with 8.5 million passengers in 2005 and 7.7 million in 2004, with flights to and from most major cities in Europe, Asia and North America. A new terminal opened at Ben Gurion Airport in November 2004 in order to increase the capacity for annual passenger arrivals and departures to approximately 16 million passengers. The financing for this expansion was derived exclusively from Airports Authority revenues and private project financing.

Communications. The telecommunications market presently contributes approximately 4% of the Gross National Income, and in 2006, the average ratio of household communications expenditures out of total household consumption expenditure was 7% ($130 per month). Israel’s communications market is characterized by fundamental technological and regulatory structural changes, large investments, and rapid development. The market is currently comprised of four domestic cellular operators, six international telephony service providers, one cable television provider, one satellite television provider and two fixed domestic telephony operators with universal service obligation.

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While Bezeq, the Israel Telecommunications Corp. Ltd. (“Bezeq”), remains the main fixed telephony service operator, the cable companies have acquired above 150,000 voice telephony subscribers, mainly in the households segment. In September 2004, the domestic fixed telephony market was opened to competition after the Ministry of Communications promulgated regulations allowing new entrants to provide services without the attendant obligations to provide services over large areas. Under these new regulations, three new operators were licensed to provide domestic fixed telephony services.

After being limited to three competing operators before, international telecommunications services have been opened to complete competition since the end of 2004. As of June 2007, Israel has six companies offering international telephony services. In 2005 the total number of Incoming & Outgoing minutes used in international services was 2.5 billion minutes. Israel has four cellular telephone network operators which provide digital technology countrywide coverage and modern, third generation services. As of 2006 there were approximately 8.4 million cellular subscriptions, more than one cellular phone, on average, per capita. Total cellular market revenues in 2005 were approximately $3.13 billion.

Five major Internet service providers and about seventy smaller ones serve more than three million users, including more than 60% of households (58% of households use broadband services) and more than 80% of businesses. Fixed broadband service in Israel (by either Cable Modem or ADSL) has a penetration of 99%. The cable companies and Bezeq are obligated to provide universal deployment of broadband Internet access service.

The Israeli Public Broadcasting Authority had an official monopoly on television broadcasts through 1993. As of 2001, there were three national public TV channels broadcasting in Israel and one national commercial channel. In 2002, a second commercial channel started to operate via cable and satellite and a fourth public Arabic-speaking satellite-delivered channel was launched. In addition, a Russian-speaking channel and an Israeli music channel, which are commercial special-interest TV channels, began broadcasting in 2003. A fifth public TV channel, with broadcasting related to the Knesset, started operating via cable and satellite in 2004.

The cable television market has a single cable television operator, the result of a merger of three regional operators, and a single direct broadcast satellite (“DBS”) operator that began operations in 2000. About 48% of all households subscribe to cable television, and 29% of households subscribe to the DBS service.

Construction. In 2006, investment in residential construction increased by 1.7%, following a 1.3% decrease in 2005 and a 2.6% decrease in 2004. This continuous decline in residential building began in 1998. The real CPI-adjusted prices of owner-occupied apartments decreased by 0.7% in 2006, following consecutive decreases since 1998. These decreases followed a period, from 1993 through 1996, during which the demand for housing in the central regions of Israel had increased substantially, resulting in significant increases in housing prices.

Agriculture. In 2006, agricultural exports totaled $1.031 billion, representing 2.6% of total merchandise exports (excluding diamonds). Agricultural production in 2006 included livestock (comprising 39.4% of total agricultural production), vegetables (23.0%), non-citrus fruits (17.2%), ornamental plants and seeds (8.7%), citrus fruits (4.3%), field products (7.4%) and other agricultural production. In 2006, 2.4% of all Israeli employees were working in agriculture. Investments in agriculture contributed to 2.1% of fixed investment.

The Government has implemented structural reforms in order to increase agricultural competition and productivity. In 1994, the Government launched a reform to eliminate production quotas for fowl, cattle and crops. In 1998, a reform in the dairy sector was launched, aimed at enhancing competition and efficiency and reducing pollution levels emanating from dairy farms. The effects of this reform may be noticed in the diminishing number of dairy farms and the rising number of cows per farm. The reforms in the fowl, cattle, crops and dairy sectors facilitated a sizeable shift from manufacturing, marketing and financing of agricultural products through large co-operatives, which were heavily subsidized by the Government, to a system in which decisions regarding such matters are made by individual production units, which receive fewer subsidies from the Government.

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Water and Electricity. The scarcity of fresh water is a serious problem for the entire Middle East region. Since 2000, the Government significantly increased investment in the water and electricity sectors. Israel is conducting discussions with Jordan and the PA with respect to the allocation of water resources. The primary sources of fresh water in Israel are the Sea of Galilee, the eastern mountain region aquifer (a portion of which is located under the West Bank) and the coastline region aquifer along Israel’s western border. Water from these sources is distributed throughout Israel by pipeline, including distributions to the arid areas in the south.

Approximately 70% of Israel’s fresh water is distributed through Mekorot Water Co. Ltd., a state-owned enterprise (see “—Role of the State in the Economy” below). The remaining 30% of Israel’s fresh water is supplied by private water associations established by agricultural users and certain municipalities. During 2006, Mekorot Water Co. spent NIS804 million on capital investments related to water distribution, an increase from NIS672 million spent during 2005 and NIS577 million spent during 2004.

Approximately 57% of Israel’s total water use and 40% of Israel’s fresh water use is attributable to agriculture. As almost all of Israel’s existing fresh water resources are already being consumed, Israel is investing resources to develop additional water sources, mainly from treated wastewater and desalinated seawater. Currently, desalination plants are being built by both local and foreign private sector companies through build-operate-own (“B.O.O.”) and B.O.T. projects. When all the plants are operational, the Government expects to purchase approximately 230 million cubic meters of desalinated seawater per year from the plants at an estimated cost of NIS620 million per year. During 2007, the Government plans to purchase a total of approximately 130 million cubic meters of desalinated seawater from the desalination plant in Ashkelon, which commenced operations in August 2005, and the desalination plant in Palmachim, which commenced operations in May 2007. In addition, further development of agriculture involves intensifying the yield from land that is already irrigated and the reuse of treated wastewater. As a result, in recent years there has been a reduction in the size of certain agricultural crops, such as cotton, that require large amounts of water. To address the relative shortage of water, Israeli companies have developed a number of sophisticated irrigation systems, including micro-drip systems, that permit efficient irrigation.

Israel has also increased its investment in purification and improvement of wells and sewage treatment plants. The 2006 Government budget includes provisions for both grants and loans to stimulate capital investment in these programs. The Government has also taken steps to facilitate the establishment of regional companies to assume responsibility from Israel’s municipalities for the treatment of water and sewage. The purpose of these steps is to promote professional and efficient management of water and sewerage systems and to direct the revenues from these services to investments in water and sewerage infrastructures. In July 2001, the Knesset passed a law regulating the commercial relationship between the regional companies, the municipalities and consumers. As of June 2007, nine regional companies are already in operation.

Almost all electric power in Israel is provided by the Israel Electric Corporation Ltd. (“IEC”), a Government Company (as defined below) that generates virtually all its own power (see “—Role of the State in the Economy” below). In 1996, IEC’s exclusive concession from the Government expired, and the Electricity Industry Act was enacted. The purpose of the Act is to regulate activity in the electricity industry for the benefit of the public by achieving reliability, availability, quality, efficiency and cost minimization within a competitive market. The Act provides for a ten-year transition period during which IEC has a license to transmit, distribute, supply and market electricity. Under the Act, the owner of a license for transmission or distribution functions will be required to purchase electricity from other generators of electricity, and to enable other licensed generators to use the same transmission and distribution channels to supply electricity to their own customers. IEC currently holds licenses to produce electricity at each of its 67 generation units. These licenses are valid until July 2007, and may be extended through October 2007 at the discretion of the Ministers of Finance and National Infrastructures. A public utility commission has been established to supervise electric utility services, which includes regulating the prices of electricity. In recent years, the Government has begun to open up the electricity industry to competition by setting rules for the entry of private electricity producers into co-generation of electricity and publishing a tender for generation. This plan was reflected in changes in the Electricity Industry Act in 2003 and in 2007,

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which formulated rules for the licensing of additional electrical distribution companies. The Government’s goal is to achieve a decentralized industry divided into the following segments: generation, where the Government expects to be competitive; transmission, where the Government expects a natural monopoly to take hold; and distribution, where the Government expects regional monopolies to take hold.

Energy

Israel’s main sources of energy are oil and coal. Israel is almost totally dependent on imported fuel for its energy requirements, since domestic production of crude petroleum is negligible and Israel has no domestic production of coal. Most of Israel’s foreign oil is purchased in the open market. Pursuant to the Oil Supply Arrangement, the United States has agreed to supply Israel with oil in the event of a failure of Israel’s oil supply. In 2000, a substantial amount of natural gas was discovered near Israel’s Mediterranean shore. The discovery of the natural gas could reduce Israel’s dependence on imported oil.

Israel has succeeded in significantly reducing its dependence on oil for the production of electricity by switching to coal-fired power stations located along Israel’s coastline, and by expanding a coal facility in Ashkelon. All of the coal used in Israel is imported. Israel purchases the majority of its coal from South Africa, the United States, Colombia and Australia. Smaller amounts of coal are purchased from other countries, including China. The shift to coal has not had a significant environmental impact in Israel, because most of the coal used is low-sulfur coal.

In 1997, the Government decided to establish a natural gas infrastructure in Israel. In August 2003, the Government founded Israel Natural Gas Lines Ltd. (“INGL”), a Government-owned company that was established to supervise, control and operate the natural gas transportation system. In March 2004, the first natural gas power station in Israel was inaugurated in Ashdod. Currently, this power station has the ability to produce approximately 10% of Israel’s total energy capacity.

In April 2004, INGL, IEC and the State signed an agreement for the financing, construction and operation of a natural gas transportation system that would be state-owned. Under the agreement, IEC will build the 100 kilometer underwater gas pipeline route, and INGL will construct the continental route. The underwater pipeline construction is expected to be completed in 2007. INGL has begun building the continental segment between Ashdod and Ashkelon. This segment is scheduled to be completed by July 2007. In 2005, the Government decided to build two more continental segments: one between Kiryat-Gat and Sdom, scheduled to be completed in 2008, and the other between Haifa and Alon-Tavor.

Table No. 9

Imports and Production of Crude Oil, Coal and Natural Gas

(in thousands of tons oil equivalent)

Sources: Central Bureau of Statistics, Ministry of Infrastructure.

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Tourism

Tourism plays an important role in the Israeli economy. Israel’s tourist centers include: Jerusalem, various significant religious sites, the Eilat area, the Dead Sea and its environs and the Mediterranean coast. Receipts from foreign tourism (excluding expenditures of foreign workers in Israel) in 2005 and 2006 amounted to $1.9 billion each year (1.4% of GDP), reflecting an improvement from receipts of $1.5 billion (1.2% of GDP) in 2004. However, these figures are still low compared with $3.1 billion in 2000 (2.6% of GDP), a record year.

The unrest that began in late September 2000 resulted in an immediate drop in the number of tourists entering Israel by air. Between 2000 and 2001, the total number of tourists entering by air decreased by 45.8%. In 2002, the number of tourists further decreased by 26.6%, followed by an additional reduction in tourism in the first quarter of 2003 due to the war in Iraq. Since the second half of 2003, tourism has recovered in light of the increasingly improving security situation, the favorable effects of the end of major combat activities in Iraq and the global economic recovery. In the first half of 2006 tourist arrivals continued to grow rapidly, following the fast increase of 2005 (23.5% over 2004), but the Second Lebanon War led to a sharp decline in tourism which affected the year’s total. The number of tourists arriving by air in 2006 was 1.6 million, a decrease of 5.1% relative to 2005 and 26% lower than the level during the 12-month period preceding the start of the security unrest in late September 2000. Figures for the last quarter of 2006 and the first quarter of 2007 indicate that tourist arrivals are returning to the pre-war, positive trend.

Table No. 10

Tourist Arrivals by Area of Origin and Receipts

(arrivals in thousands and receipts in millions of dollars)

Source: Central Bureau of Statistics.

Research and Development

The Government encourages investment in industrial research and development through support and incentive programs created under the Law for the Encouragement of Industrial Research and Development. The objectives of the Government’s support for industrial research and development are to: foster the development of technology-related industries; create employment opportunities for Israel’s scientific and technological labor force; and improve Israel’s balance of payments by increasing exports of high-technology products and reducing reliance on imports of such products. In 2005, approximately 4.7% of GDP was invested in civilian research and

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development. Government support of civilian research and development, including general university funds financed by the Government, totaled NIS4.2 billion in the 2005 budget, NIS4.2 billion in the 2004 budget and NIS4.8 billion in the 2003 budget.

Israel participates in 29 different international and bi-national industrial research and development joint ventures, of which three are with the United States, three with the European Union, two each with Canada and India and one each with Australia, Germany, China, France, Belgium, Italy, Ireland, Turkey, Hong Kong, United Kingdom, Greece, Taiwan, Singapore, Spain, Portugal, South Korea, Sweden, Finland and the Netherlands. The 2006 annual budget for the activity of these joint ventures is approximately NIS180 million.

Wages and Prices

In the early and mid-1980s, Israel’s economy experienced high rates of inflation, reaching a peak of 445% in 1984. In response to this crisis, in 1985 the Government implemented the Economic Stabilization Program, which succeeded in reducing the rate of inflation to 19.6% in 1986, and in maintaining the rate of inflation at an annual average of 17.8% during the period from 1987 through 1991. The price controls that were introduced as part of the Economic Stabilization Program were largely eliminated by mid-1988.

The inflation rate, measured by the CPI, averaged 9.5% during the period from 1992 to 1999, with fluctuations between 9.0% and 12.3% on an annual average basis. Inflation since 1999 has been close to zero. The inflation rate in 2002 (an annual average of 5.7%) was an exception and reflected a one-time increase in prices due to currency depreciation after several years of high interest rates that had delayed the exchange-rate adjustment. The average annual inflation rate was 0.7% in 2003, -0.4% in 2004, 1.3% in 2005 and 2.1% in 2006.

Both the Ministry of Finance and the Bank of Israel have stated that reaching and maintaining price stability is one of their main priorities. Since the end of 1991, the Government has announced annual inflation targets as part of its effort to further reduce inflation (see “Public Finance—The Budget Process and Deficit Reduction” below). The Bank of Israel has adopted a restrictive monetary policy in recent years. As a result, since 1999, inflation has been below government targets most years.

Since November 1993, the Bank of Israel has adjusted its key interest rate on lending to banks on a monthly basis. Beginning in June 2003, the Bank of Israel lowered the key interest rate at an accelerated rate, reaching 5.2% by the end of 2003. In 2004, the key interest rate was lowered to 3.9% and by September 2005, the interest rate reached 3.5%. Subsequently, the Bank of Israel increased the interest rate gradually up to 4.5% in December 2005, and to 5.0% in April 2006. A cautionary reaction to the deterioration in security led the Bank of Israel to increase the rate to 5.5% in August 2006. Since November 2006 the interest rate has been gradually decreased and was set at 3.5% in June 2007.

Real interest rates, derived from the Bank of Israel’s key interest rate, have fallen from more than 6% in mid-2003 to about 2.9% in March 2007. The public’s inflation expectations are calculated as the difference between nominal yields (on unindexed Government bonds) and real yields to maturity (on CPI-indexed Government bonds). During 2006, the public’s inflation expectations for one year and two years ahead, as derived from the capital market, were near the lower end of the inflation target range of 1-3%.

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Table No. 11

Selected Price Indices

(percentage change, annual average)

Source: Central Bureau of Statistics.

The wage system in Israel is subject to comprehensive indexation under nationwide cost-of-living agreements. These agreements are negotiated by Israel’s nationwide labor union and representatives of the major employers’ organizations in the private sector. After the agreements are negotiated, the Minister of Labor validates the agreements for all workers in the public and private sectors. The current 2002 agreement provides employees a cost-of-living increase at an agreed-upon percentage tied to changes in the CPI. Furthermore, wages in certain industries are subject to labor agreements that guarantee additional periodic wage increases, as well as equality of treatment with respect to wage increases with workers in other specified industries. In the past decade, wage linkage between sectors weakened as a result of a decrease in the scope of unionization and an increase in the use of individual employment contracts. In 2003, the Ministry of Finance reached an agreement with the labor unions on cutbacks in public sector employment and a temporary wage reduction prior to the Knesset’s adoption of the comprehensive economic plan in May 2003. The temporary wage reduction under this agreement expired in July 2005. The Ministry of Finance is expected to conduct negotiations with labor unions regarding future wage conditions over the course of 2007 and 2008.

Real wage per employee post (nominal wage deflated by the CPI) in the business sector significantly decreased in 2002 by 6.6%. In the public services sector, real wages decreased by 4.9%, as a result of a decrease in demand for labor and a rise in prices. In 2003, the real wage per employee post declined by 3.0% (2.5% in the business sector and 4.2% in the public services sector). In the public services sector, the nominal wage per person employed declined in 2003 by 3.5%, mainly due to public sector wage reductions that were part of the comprehensive economic plan adopted in May 2003.

In 2004, the real (CPI-adjusted) wage per employee rose by 2.5%. The increase was 1.5% in the business sector and 4.6% in the public service sector. This increase was the result of a general economic recovery and a one-time change in timing of wage supplements in the public services sector. In 2005, real wages rose by 1.0% (1.5% in the business sector and 0.0% in the public services sector). In 2006, real wages rose by 1.6% (1.7% in the business sector and 1.2% in the public services sector).

Employment and Labor

One of Israel’s most important resources is its experienced and highly educated work force. In 2005, approximately 41.3% of the Israeli population over age 15 had 13 or more years of schooling. With this highly-educated population, Israel has developed an export-oriented, technology-based industrialized economy. In 2005, 29% of the Israeli work force consisted of scientific, academic, professional, technical and related workers, while 24% consisted of administrative or managerial workers. These percentages compare favorably with the percentages of such workers found internationally. The employment qualifications of recent immigrants have been consistent with the high quality of the Israeli work force, with two-thirds of immigrants from the former Soviet Union having been employed there as professionals, scientists, engineers or technical staff.

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The wave of immigrants since 1990 led to significant growth in the Israeli labor force. In 2006, Israel’s civilian labor force averaged a total of 2.8 million people compared to 1.9 million in 1992.

The recession that began in late 2000 caused the unemployment rate to increase from 8.8% in 2000 to 10.3% in 2002. Despite the economic recovery that began in 2003, the unemployment rate continued to climb in 2003 to a rate of 10.7%. The unemployment rate decreased to 10.4% in 2004, 9.0% in 2005 and 8.4% in 2006 (7.7% in the last quarter of 2006). The number of Israeli employees, and, the rate of civilian labor force as a percentage of the population over the age of 15 (the “labor participation rate”) rose in 2006. In Israel, the labor participation rate is negatively affected by the relatively large number of soldiers. The average labor participation rate increased from 54.1% in 2002 to 55.6% in 2006. Compared with the last quarter of 2004, the number of employed Israelis increased by 74,400 in the last quarter of 2006. The increase in the participation rate and the number of Israelis employed is attributed, among other factors, to the successful implementation of government policy of cutting transfer payments and reducing the number of foreign workers. In 2006, business sector employment increased by 65,000 (compared with an increase of 63,000 in 2005) and employment in public services increased by 15,000, compared with a decrease of 30,000 in 2005 and a decrease of 3,000 in 2004 (year-on-year averages).

Table No. 12

Structure of Employment in Israel

Sources: Central Bureau of Statistics, Bank of Israel and Ministry of Finance calculations.

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The unemployment rate among immigrants in 2005 was 8.5%, even less than that of the native-born population (9.0%). Surveys undertaken by the Israeli Central Bureau of Statistics indicate that immigrant unemployment declines with length of stay in the country. Immigrant participation rate in the labor force stood at 58.2% in 2005 compared to 55.2% for the working age population as a whole.

Despite the initial difficulties experienced by many of the professional and other highly skilled immigrants in finding suitable employment, statistical data regarding employment in Israel suggest that immigrants have moved from their original jobs into jobs better suited to their education and other employment qualifications. One important factor in this transition has been the professional requirements of Israel’s high-tech companies, which have matched well with the educational and professional background of many of the immigrants.

Table No. 13

Principal Labor Market Indicators

(annual average)

Source: Central Bureau of Statistics.

The General Federation of Labor in Israel (the “Histadrut”) has historically played a significant role in the Israeli economy and social system. As part of a structural and organizational reform, the Histadrut concentrates today on its function as a trade union and a social organization. The Histadrut also has a major influence on labor and social legislation in the Knesset.

Over 30 trade unions are members of the Histadrut. Although the percentage of union workers has been declining (mainly due to the termination of the link between membership in the Histadrut and the General Health Insurance Organization, which is the largest provider of health services), a considerable part of the Israeli labor market is unionized. The Histadrut signs collective bargaining agreements, which affect workers in both the public and private sectors. In addition to nationwide agreements (such as the cost-of-living agreement), the collective bargaining network includes collective agreements between occupation or industry unions and employers’ associations. Such agreements predominantly affect the public sector. Collective agreements cover issues related to wages, conditions of employment and social benefits.

Role of the State in the Economy

Historically, the Government has been involved in nearly all sectors of the Israeli economy, particularly in defense-related and monopolistic businesses. Before the privatization process, ownership of industry in Israel was divided between the Government, the Histadrut and the private sector, with the Government and the Histadrut owning prominent interests in several key industries. In recent years, the Government has made significant progress towards the privatization of state-owned enterprises. As part of this process, the Government has implemented structural reforms aimed to enhance competition in some essential monopolistic sectors such as the communication sector, oil refineries and the seaports. In addition, the Government has begun the process of introducing competition to additional sectors and industries, such as the electricity sector and capital markets.

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As of June 2007, there are 99 state-owned enterprises, 40 of which are business-oriented enterprises. The remaining state-owned enterprises include funds established as vehicles for employee savings or educational institutes.

State-owned enterprises are divided, by law, into two main categories: Government Companies (including their subsidiaries) and Mixed Companies. In addition to state-owned enterprises, the Government is also involved in some sectors through statutory authorities.

Government Companies (a category that excludes state-owned banks acquired pursuant to the Bank Shares Arrangement, see “—Privatization” below) are those where the Government owns more than 50% of the voting shares and which are subject to the provisions of the Israeli Government Companies Law and the regulations promulgated thereunder (collectively, the “GCL”), as well as the directives of the Government Companies Authority (see “—Privatization” below). The GCL regulates the management and operation of Government Companies and the circumstances under and procedures by which the Government may sell shares in Government Companies or reorganize Government Companies.

Mixed Companies are companies in which the State owns 50% or less of the voting shares. Under the GCL, Mixed Companies are not subject to the same degree of regulation as Government Companies. However, Mixed Companies are subject to certain limited provisions of the GCL, including the Government’s appointment and qualification of certain directors.

Government Companies play a significant role in the Israeli economy. Although they employed only 1.8% of the Israeli work force, in 2005 Government Companies accounted for 8% of total exports and 8% of investment in fixed assets. These companies include several public service monopolies and a number of companies that either engage in activities considered crucial to Israeli national security or provide important services to the Government.

To increase competition in the markets in which these companies participate and thus prepare them for privatization, the Government has initiated a number of regulatory arrangements with the major Government Companies. Nevertheless, the pace of privatization may be affected by the need for further regulatory and structural reforms and formulation of policies that will define the post-privatization environment in which these companies will operate. The development and implementation of some of these policies and reforms may take a considerable period of time.

Privatization. An essential element of the broader structural reforms initiated by the Government over the past several years to promote the growth of the private sector and to enhance competition is the Government’s move towards privatizing its business holdings. Privatization efforts have included the full or partial sale of state-owned companies and banks and the transfer of activities that were previously performed by the Government or statutory authorities to private entities. From 1986 through June 2007, 91 companies changed their status as Government Companies and the Government’s proceeds from privatization from 1986 through April 2007 were approximately $14.2 billion. In 2006, proceeds from privatization totaled NIS4.7 billion.

Privatization of all state-owned enterprises, other than banks, is conducted by the Government Companies Authority. The responsibility for privatization of banks is vested with the Ministry of Finance, through M.I. Holdings Ltd., a wholly-owned Government Company. M.I. Holdings Ltd. advises the Minister of Finance regarding bank privatizations and manages the process in accordance with the Minister’s instructions. The Ministerial Privatization Committee (the “Privatization Committee”), consisting of the Minister of Finance, as chairman, the Minister of Justice and three other ministers, has the power to initiate the privatization of any Government Company or Mixed Company without the consent of the minister directly responsible for such Government Company or Mixed Company, and to authorize preparatory measures necessary to effect such privatization. The Government Companies Authority also has general authority relating to the supervision of Government Companies, including the right to convene board meetings, to set reporting and supervision instructions and to issue directives to Government Companies in connection with decisions of the Privatization Committee.

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In 1983, as a result of the collapse in the share prices of several large banking institutions on the TASE, the Government entered into an arrangement (the “Bank Shares Arrangement”) with the shareholders of several banking institutions, whereby the State purchased shares from the banks’ shareholders at the time of the crisis. As a result, the State gained a controlling stake in five of the six largest Israeli banks (although the State did not exercise any management control over these banks). The Government’s current privatization program is intended to result in the sale of the Government’s controlling interest in these banks. Implementation of this program is ongoing as the Government continues to reduce its bank holdings through a variety of public and private transactions.

Between 1993 and 2001, the Government sold 27.7% of the total outstanding shares of Israel Discount Bank Ltd. In February 2005, the Government sold control of the bank, 26% of the bank’s issued share capital for a total of NIS1.3 billion. This sale was completed in January 2006, following the approval of the Bank of Israel. With the controlling share of the bank, the buyer bought the option to purchase an additional stock package totaling 25% of the issued share capital of the bank. In May 2006, the Government sold an additional 6.09% of the bank’s shares. As of June 2007, the State still holds 25.0% of the shares in Israel Discount Bank Ltd. If the option is exercised, the holdings of the State in the bank will decrease to zero.

Between 1997 and 2000, the State sold 72.4% of the total outstanding shares of Bank Hapoalim Ltd. in private sales for a total of $2.3 billion. In July 2005, the State sold its remaining holdings of Bank Hapoalim Ltd. which comprised 0.01% of the bank’s outstanding shares.

Between 1993 and 1999, the State sold 97.2% of the total outstanding shares of United Mizrahi Bank Ltd. in both public and private sales, for a total of $525.5 million. In July 2005, the State sold its remaining holdings of United Mizrahi Bank Ltd. which comprised 0.5% of the bank’s outstanding shares.

Between January 2000 and July 2005 the State sold 24.85% of the total outstanding shares of Bank Leumi Ltd. In November 2005, the State sold a share package of 9.99% coupled with an option to purchase an additional 10.01% of the issued and outstanding shares of the Bank. This option was not exercised due to the buyer’s failure to obtain Bank of Israel’s authorization for the transfer of the controlling means in the bank. In May 2006, the State sold 2.85% of the bank’s shares to the employees of the bank. As of June 2007, the State owns 11.9% of Bank Leumi Ltd.

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Table No. 14

Selected State-Owned Companies

(at, or for the period ended, December 31, 2006)⁽¹⁾

(in millions of dollars, except percentages)

Sources: Ministry of Finance, Government Companies Authority.

Below are summary descriptions of the state-owned companies included in the above table. Also described below are specific steps planned or taken by the Government to prepare companies for privatization or reform their structure and operations.

Bezeq is a state-owned (Mixed Company) that specializes in telecommunications. Its operations are subject to regulatory arrangements by the Government, such as tariff and structural supervision. Arrangements implemented since 1994 are designed to increase competition in the communications sector. International telephony services are provided by six companies (of which one is a wholly-owned subsidiary of Bezeq). Cellular services are provided by four companies (of which one is wholly-owned by Bezeq). In June 1999, Bezeq’s exclusive right to supply fixed telecom services was terminated. Since the end of 2000, initial steps have been taken to introduce competition into the supply of fixed telecom and other internal communication services, including competition from other communication companies involved in the cellular and cable services. Between July 1997 and February 1998, the State sold a 21.4% interest in Bezeq in a sale to Merrill Lynch & Co. and in a public offering in Israel, which together raised a total of $508.7 million and reduced the State’s ownership level to 54.6% (fully diluted). In 2003 the State reduced its holdings in Bezeq in two dispositions, representing 3.6% and 5.8%, and resulting in income to the Government of more than NIS1 billion. As of November 2003, the State held 49.1% of Bezeq’s shares. As a result of these sales, Bezeq (with its subsidiaries) became a Mixed Company. In June 2004, the State sold 2.7% of Bezeq’s issued share capital on the TASE, which raised a total of $76.2 million, and after which the State’s holdings in Bezeq declined to 46.4%.

In October 2005, the State sold the controlling shares in Bezeq, through the sale of 30% of the total outstanding shares of the company coupled with a four-year option to buy another package of 10.66%, for a total of $972 million. Additionally, in November 2005, Bezeq’s employees were granted an option to purchase 4.71% of Bezeq’s shares. If all outstanding options are exercised by the new owners of Bezeq’s shares and by the employees, the State’s ownership in Bezeq will be reduced to 1.01% on a fully-diluted basis.

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Israel Electric Corporation Ltd. (IEC) is a legal monopoly responsible for the entire Israeli electricity industry. Since 1992, IEC has been subject to tariff supervision that includes efficiency incentives. In March 1996, IEC’s exclusive concession from the Government expired, the Electricity Industry Act was enacted, and an authority for the supervision of public electric utility services was established. The purpose of the Act is to regulate activity in the electricity industry for the benefit of the public, by achieving reliability, availability, quality, efficiency and cost minimization within a competitive market. The Act, as amended, provides for an eleven-year transition period, during which IEC has a license to transmit, distribute, supply and market electricity. Under the Act, the owner of a license for transmission or distribution functions will be required to purchase electricity from other generators of electricity, and to enable other licensed generators to use the same transmission and distribution channels to supply electricity to their customers. On January 1, 1998, IEC received licenses, valid until March 3, 2006, to produce electricity at each of its 67 generation units. These licenses were extended until July 2007.

In August 1999, the Government decided to implement structural changes in the electricity sector in order to open the electricity sector to competition as is common in other developed countries. For this purpose, the Minister of Finance and the Minster of National Infrastructures appointed an inter-ministerial committee headed by the Director General of the Ministry of Finance and the Director General of the Ministry of National Infrastructures. The committee was empowered to prepare a detailed proposal to accomplish the structural change.

In recent years, the Government has began to open up the electricity industry to competition by setting rules for the entry of private electricity producers into co-generation of electricity and publishing a tender for electricity generation. The Government’s goal is to achieve a decentralized competitive industry, divided into the following segments: generation, which the Government expects to be competitive; transmission, where the Government expects a natural monopoly to take hold; and distribution, where the Government expects regional monopolies to take hold.

In March 2003, the Government decided to reform the electricity sector in accordance with the recommendations of the Committee and amended the Electricity Industry Act accordingly. On May 29, 2003 the Knesset approved changes in the Electricity Industry Act that are designed to achieve a decentralized competitive structure of the electricity sector. The purpose of extending the IEC licenses was, among other things, to enable the Government and the employees to complete negotiations regarding the structural reforms and the resulting employee rights.

In February 2007, an amendment to the Electrical Industry Act was passed, providing for a change in the structure of the IEC. Pursuant to the amended law, starting in 2008, IEC’s operations will gradually split into several generation, distribution and transmission subsidiaries and into a number of retail and other services companies. In addition, a Government Company will be formed and be in charge of the system’s management and will coordinate between the various companies, e.g., such Government Company shall balance supply and demand, supervise competition and plan future development. Regulatory requirements applicable to the power generation and to the retail segments will be lifted gradually with a view to achieving competitive market conditions. By 2013, the Government intends to privatize 49% of the generation and retail subsidiaries.

The Ports Authority, which had centralized operations, assets and control of all of Israel’s ports, was traditionally one of the strongest and most significant monopolies in Israel. On July 22, 2004, the Knesset passed a law to abolish the Ports Authority and to divide the Ports Authority’s activities and framework among three newly-formed Government Companies each of which would operate either the Haifa, Ashdod or Eilat port. An additional Government Company would hold and manage the ports’ assets and lease them to the three port operating companies. In February 2005, the Port Authority was abolished and the four successor companies commenced operations. As part of the privatization process, the three ports companies are expected to be competitive, and portions of these companies are to be sold to the public.

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Israel Railways was separated from the Ports and Railways Authority pursuant to a December 2002 amendment to the Ports and Railways Authority Law. On July 1, 2003, Israel Railways began operating as a Government Company. In 2003 the company commenced a five year, $4.5 billion investment plan that is expected to have a positive impact on the Israeli transportation system and the Israeli economy generally.

Bazan Oil Refineries Ltd. (“Bazan”) is the only oil refinery company in Israel. Bazan operates in the framework of Government reforms that have linked fuel prices in Israel to fuel prices in the international market. Bazan is permitted to sell its products only to wholesalers and certain key customers. In May 1971, the Government, who had held 100% of the company, sold 26% of its interest to The Israel Corporation Ltd., a public company, through a private placement. In December 2004, the Government decided to separate and privatize the refinery facilities.

The Government, as a preliminary step prior to the planned privatization of Bazan, purchased back the minority shares of 26% from The Israel Corporation Ltd. in the first quarter of 2006 for $137 million. In September 2006, the State of Israel, along with Bazan, sold their holdings in Oil Refinery Ashdod Ltd. in a private placement for $756.6 million. In February 2007, 44% of the shares of Bazan were sold in a private placement, followed by a sale of the remaining 56% through an IPO. The proceeds from these two sales totaled $1.538 billion.

El Al Israel Airlines Ltd. used to be the Israeli national air carrier. El Al operates in a competitive market with foreign airlines under the Government’s “open sky” policy. In 1995, El Al emerged from a reorganization program that it had operated under since 1982 due to labor difficulties at that time. In July 2002, after canceling a prior privatization plan, the Privatization Committee decided to privatize the State’s holdings in El Al in stages. In June 2003, the Government began the El Al privatization process by offering 15% of El Al’s shares on the TASE. The shares were bundled with two sets of options for the remaining 85% of the shares. The first set of options was exercisable within the year. The second set of options were exercisable between 18 months and four years from the offering date. In addition, El Al employees were offered the opportunity to purchase shares and options for approximately 9% of El Al. The total amount raised through the initial offering (which did not include the exercising of options) was NIS64 million, of which El Al received NIS22.1 million and the Government received the remainder. As of June 2007, all of the options had been exercised. As a result, El Al is now a private company.

Zim Israel Navigation Company Ltd. is the largest shipping company in Israel and most of its operations are in international shipping markets. In 1970, the Government sold control of Zim to The Israel Corporation Ltd., a public company. Prior to February 2003 Zim was a Mixed Company, with the State and The Israel Corporation Ltd. holding 48.6% and 48.9% of the company’s share capital, respectively. In February 2003 the State sold the balance of its holdings to The Israel Corporation Ltd. for $113 million.

Israel Aircraft Industries Ltd., Israel Military Industries Ltd. and Rafael-Armament Development Authority Ltd. (“Rafael”) are three defense-related Government Companies. Currently, the State holds 100% of each of these companies’ share capital. Over the past several years, these three companies have been restructuring and streamlining their operations, primarily in preparation for privatization. Rafael was formerly an authority under the Ministry of Defense; in January 2002, it was converted into a Government Company. Israel Aircraft Industries Ltd. has reduced the number of its employees and is consolidating some of its operations. Israel Military Industries Ltd., which is experiencing financial difficulties, was partially privatized through the sale of several factories. One subsidiary of Israel Military Industries Ltd., Ashot Ashkelon Ltd., has begun the privatizing process and Israel Military Industries Ltd. has been preparing for privatization, starting with implementing a reorganization program that calls for internal separation of the various units within the company.

Mekorot Water Company Ltd. (“Mekorot”) is the state-owned water company. It supplies approximately 65% of the water Israel consumes. Approximately 27% of Mekorot’s income from supplying water is subsidized by the Government through payments intended to compensate Mekorot for the below-market fees charged mainly from agricultural and other consumers. In 1993, Mekorot and the Government agreed on an arrangement

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establishing efficiency incentives for the years 1993 through 1998 and securing Mekorot a normative return on equity, thereby enabling it to raise capital in private capital markets rather than receiving subsidized loans from the Government, and reorganizing Mekorot and the Government water factories. In 2002, the Government and Mekorot agreed to continue to operate under a similar arrangement, which has been extended since.

As part of the structural reorganization plan, in July 2003, two new Government Companies were established: Mekorot National Carrier Ltd. and Mekorot Initiatives and Development Ltd. These companies, as well as Mekorot Water Company Ltd. are now subsidiaries of the new parent company, Mekorot Holdings Ltd.

Mekorot Water Ltd. serves as the National Water Authority under the Water Law (and would be responsible for operation of the water system, including production and establishment and renewal of water enterprises). Mekorot National Carrier has the leasehold on the properties of the National Carrier (and would be responsible for the maintenance and development of real property and other assets). Mekorot Initiatives and Development Ltd. manages and operates various water-related projects (including cooperation with private entrepreneurs on new water and sewage infrastructures, wastewater purification and other activities in the competitive segment).

Petroleum and Energy Infrastructures Ltd. (“PENIN”) provides infrastructure services for the petroleum industry, and acts as the sole provider of storage and transportation services for refined oil. PENIN’s subsidiaries plan, build, operate and maintain systems and facilities for the transportation and distribution of petroleum products. The State controls the rates of PENIN’s products and services. Through January 2001, PENIN operated under a concession from the Government. In January 2001, an agreement in principle was signed between the State and PENIN to govern PENIN’s activities after the end of the concession. Implementation of this agreement is currently under negotiation.

INRC was established in September 2003 as a state-owned company, replacing the Support Unit of the Ministry of Transport (MAA’TZ), which ceased operations. The company assumed responsibility for the inter-urban road system, traffic management and control, planning, development and maintenance of the roads and their safety. INRC operates as the Government inter-urban sole planner and developer managing a perennial development plan with an estimated budget of NIS19 billion.

The state-owned Israel Postal Company Ltd. and its subsidiary, the Postal Bank Ltd., were established in March 2006 so as to replace the Israel Postal Authority. These steps were made in order to enhance efficiency in the postal services in Israel and provide a base for enhancing competition in the postal and banking service sectors.

In July 1996 the Knesset decided to transfer the supervisory authority over the Israel Railway from the Ports and Railway Authority to a designated Government Company established specifically for this purpose. Israel Railways Ltd. was formed in January 1998 as a Government company and commenced activities in July 2003. As part of its plan to develop the railway system, the company invested NIS1.8 billion during 2006.

Government Subsidies. Prior to 1985, the Government heavily subsidized certain segments of the Israeli economy, including basic foodstuffs and agricultural products. Since 1985, the level of direct Government subsidies has been significantly reduced. The remaining direct Government subsidies consist primarily of subsidies for water, public transportation and agricultural investments and production. Government subsidies for public transportation totaled NIS2.3 billion during 2006. Government subsidies for water totaled approximately NIS271 million and government subsidies for agricultural investments and production totaled NIS577 million during 2006.

Economic Incentives. The Government provides significant assistance to the manufacturing sector under laws designed to encourage investment in “approved enterprises,” mainly in peripheral regions of the country. A project that qualifies as an “approved enterprise” is eligible for assistance in the form of cash grants or tax benefits.

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Beginning in January 1997, the Government significantly reduced the rate of grants. For the purpose of determining eligibility for grants, three industrial regions were identified: Region A, generally the most remote regions of the country; Region B, generally the peripheral regions of the country (closer to the central regions than A); and Region C, all other regions. The grant rate for Region A is 24% for investments up to NIS140 million and 20% for investments above this limit, compared to 10% for Region B for all levels of investments, and 0% for Region C for all levels of investments. The Negev area has a unique grants program, where the rate of grants can reach up to 32% for investments up to NIS140 million and up to 30% for investments above this limit. In 2005, the Government started implementing a three-year experimental program targeted to encourage employment in regions A and B. Under this program, industrial factories that increase the number of employees will be eligible for grants up to 15% of salary costs.

In the 2007 budget, the Government commitment for grants to the manufacturing sector totaled NIS198 million, compared to NIS164 million in 2006.

Kibbutzim and Moshavim

Kibbutzim are collective settlements that traditionally were primarily agricultural. However, most kibbutzim now derive a majority of their revenues from manufacturing, tourism and other services. There are approximately 267 kibbutzim in Israel with approximately 117,700 inhabitants. Moshavim are cooperative settlements, most of which consist of individual owners of small farms. Moshavim derive a large percentage of their revenues from agriculture. There are approximately 442 moshavim with approximately 233,300 inhabitants. Kibbutzim and moshavim both experienced financial crises in the 1980s.

In 1988, the Government and the bank creditors of the moshavim agreed on a rescue and recovery program for the moshavim. In 1992, the Knesset approved legislation requiring partial debt forgiveness by the moshavim’s bank creditors, partial repayment of moshavim debt using the proceeds of certain required asset sales by the moshavim, and restructuring of the remaining moshavim debt at below-market interest rates. The total outstanding amount of the moshavim debt, subject to the 1992 legislation as of December 31, 2006, is NIS14.35 billion. Implementation of the 1992 legislation remains ongoing, and as of December 31, 2006, the 1992 legislation had been implemented with respect to approximately 94% of the individual moshavim members and 95% of the moshavim union obligors on the moshavim debt.

Pursuant to agreements signed between the kibbutzim, their bank creditors and the Government between 1989 and 1999, in order to establish a rescue and recovery program for the kibbutzim, an aggregate of NIS14.8 billion (as calculated for December 31, 2006) was written off by the banks, of which NIS6.2 billion was paid to the banks by the Government. An additional NIS13.3 billion of the kibbutzim’s outstanding loans from the banks were restructured and funded entirely by below-market loans from the Government to the kibbutzim’s creditors.

The Environment

Since the establishment of the Ministry of the Environmental Protection (“MOEP”) in 1989, many laws and regulations relating to the protection of the environment have been promulgated. The MOEP seeks: to incorporate environmental considerations into decision-making and planning processes; to promote sustainable development; to implement programs for pollution control, monitoring and research; to develop and update legislation and standards, to ensure effective enforcement and supervision; to improve environmental education and awareness; and to advance regional and global cooperation on the environment. The country’s environmental legislation encompasses laws for the protection of natural resources, for the abatement and prevention of environmental nuisances and for the safe treatment of certain contaminants and pollutants. Israel’s legislation also includes comprehensive laws, such as the Planning and Building Law and the Licensing of Businesses Law, that provide a framework for controlling the use of resources and promoting sustainable development.

Israel has ratified nearly all of the major international conventions on environmental matters and has ensured that its national legislation conforms with these conventions. Israel is a party to international conventions on such

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subjects as climate change, transboundary movements of hazardous waste, protection of the ozone layer, biological diversity, wetlands protection, international trade in endangered species, and protection of the Mediterranean Sea from pollution. Israel ratified the Kyoto Protocol to the UN Framework Convention on Climate Change in February 2004 and soon thereafter created a Designated National Authority (“DNA”) for the Clean Development Mechanism (“CDM”). The CDM in Israel provides investors from industrialized countries with opportunities to implement projects in a wide variety of fields, most notably in the waste and energy sectors. By June 2007, 17 projects have been approved by the DNA, and the carbon credit market from the CDM project in Israel is currently estimated at €25 million per year, which will be used to advance environmental projects in Israel.

Several other environmental laws and regulations were promulgated in Israel in recent years, ranging from regulations on the collection of beverage containers for recycling (2001) to several sets of regulations on the prevention of water pollution, including requirements for wastewater treatment plants to stabilize and treat the sludge they generate for agricultural use or soil conditioning (2004). Revised regulations on environmental impact assessment, which introduce environmental considerations in earlier stages of planning and decision making processes and incorporate sustainable development principles, came into force in September 2003. In January 2004, regulations were promulgated to implement the Montreal Protocol, by restricting production, consumption, importation and exportation of substances that deplete or are likely to deplete the ozone layer. In August 2004, the Knesset enacted the Law for the Protection of the Coastal Environment, which recognizes the coastal environment as a national resource that must be protected for the benefit and enjoyment of the general public and establishes principles for the sustainable management, development and use of the coastal environment. To encourage the reduction of air pollution from vehicular sources, purchase taxes on hybrid cars were reduced from 90% in 2004 to 30% in 2005, the sulfur content of fuels was significantly reduced, new diesel vehicles are required to comply with stringent Euro4 standards and cars are now required to go through stricter annual air pollution checks.

The Non-Ionizing Radiation Law, which aims to protect the public and the environment from the harmful impact of exposure to non-ionizing radiation, including radiation from cellular base stations and electricity network installations was enacted in January 2006. A landfill levy, which seeks to internalize the external costs of landfilling, was approved by the Knesset in February 2007 and a Tire Disposal and Recycling Law was enacted in January 2007. Limits on pollution from industrial sources are imposed by a variety of methods, including by ambient and emissions standards.

Along with governmental and financial measures, the State has been convincing industries that pollution prevention and waste reduction are cost-effective. Hundreds of Israeli companies are voluntarily adopting environmental management systems, such as ISO 14000, as they recognize their importance in creating international business opportunities. The Government has also taken several steps to promote environmental quality and sustainable development. In May 2003, the Government decided to prepare a sustainable development strategy for the country. Economic ministries, especially the Ministry of Finance and the Ministry of Industry, Trade and Labor, have taken the lead and initiatives such as green taxes and environmental fair disclosure have been promoted in recent years.

The Government has taken several steps to decrease pollution produced by public utility providers. A November 2002 Government decision called for the introduction of renewable energy into the electricity sector. Within the framework of this decision, the public utility commission (see “The Economy—Water and Electricity” above) has established tariffs for the production of energy from renewable sources, based on the estimated costs of pollution prevention per ton of emissions. The introduction of natural gas to the electricity sector (see “The Economy—Energy” above) is expected to have major consequences on pollution abatement from the electricity sector.

In November 2004, the Government approved an action plan to reduce pollution from the industrial zone of Ramat Hovav, which includes some of Israel’s major chemical industries. The plan includes actions to advance wastewater treatment, remediate the evaporation ponds and the national hazardous waste treatment site and prevent pollutant emissions into the atmosphere. Industrial plants in the Ramat Hovav industrial park have already begun establishing in-house effluent pretreatment facilities in accordance with the Government decision. In 2006, the Government approved the allocation of NIS230 million for the remediation of hazardous waste treatment at the site.

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BALANCE OF PAYMENTS AND FOREIGN TRADE

General

As a small country with a relatively limited domestic market, Israel is highly dependent on foreign trade. International trade (exports plus imports) of goods and services amounted to 88.3% of GDP (at current prices) in 2006.

Following a goods and services trade deficit of $3.5 billion in 2002 and $1.0 billion in 2003, the goods and services trade balance in 2004 was a surplus of $0.7 billion, which balanced ($0.0 billion) in 2005 and increased to a surplus of $0.9 billion in 2006. This improvement in the trade balance was the result of a significant increase in exports of goods and services, and a moderate increase in imports of goods and services.

Economic and military assistance furnished by the United States, German reparations and personal and institutional remittances increased by 23.8% in 2006 to $7.4 billion, following decreases of 4.9% in 2005 and 2.1% in 2004.

Official reserve assets increased during 2006 by 3.8% to $29.4 billion, compared to $28.3 billion in 2005 and compared to $6.9 billion at the end of 1994.

As of December 31, 2006, Israel’s net external debt was negative $31.7 billion (negative 23.4% of GDP), as compared to positive $11.1 billion (8.6% of GDP) at the end of 1995.

Balance of Payments

Israel’s balance of payments consists of two parts: (i) the current account, which measures the trade balance (receipts and payments derived from the sale of goods and rendering of services), the balance of income payments and transfer payments; and (ii) the capital and financial account, which reflects borrowing by the Government and the private sector, foreign direct investment in Israel and investment by Israeli residents abroad and assets and liabilities of commercial banks.

In the second half of the 1990s, the current account deficit steadily decreased, due mainly to an improvement in Israel’s terms of trade and a greater increase in exports than the increase in imports. In 2002, the current account deficit was 0.6% of GDP. Israel’s current account deficit of the balance of payments transitioned into a small surplus in 2003, which grew in 2004, 2005 and 2006. In 2003 and 2004, the current account surplus was $1.4 billion and $2.9 billion, respectively. In 2005, the current account surplus was $4.3 billion and in 2006 it grew to $6.8 billion. The surplus in the last four years attests to the high external stability both by international standards and relative to the deficits of the mid-1990s.

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Table No. 15

Balance of Payments

(In millions of dollars)⁽¹⁾