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Israel's Technology Industry as an Economic Growth Engine


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Microsoft Corp.'s Israel Research and Development Center

Microsoft Corp.'s Israel Research and Development Center was inaugurated in 2006.

Photograph by Arden Pennell

Over the past 40 years, Israel's economy has transformed from being closed and poor into one that is open, developed, and driven forward by a high-tech sector that is well regarded around the world. Much of the credit for this can be attributed to successive Israeli governments for realizing that a civilian research and development industry could become an engine of economic growth, and then implementing policies to create it and ensure its expansion. However, the government's actions vis-à-vis the high-tech sectorand by extension the wider Israeli economystand at a critical juncture. As strong as the industry is, concerns exist about its sustainability in the face of the global economic slowdown and a weakening of the structural components underpinning its success. The government, as the achievements of its policies over the last 40 years demonstrate, and particularly the previous 20, has the ability to help surmount these challenges and preserve Israel's technological edge in order to ensure renewed progress in the decades to come.

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Policy Success

Israel has implemented numerous initiatives and policies to leverage the technology sector as a vehicle for economic growth, beginning in 1969 with the establishment of the Office of the Chief Scientist (OCS), which has become the main instrument for fostering innovation and manages several programs that offer grants and other assistance to high-tech companies. The state also provides tax breaks and additional benefits to attract overseas investment in technology firms and encourage foreign companies to establish operations in Israel.

The success of government R&D policy can be seen in a number of ways. On a quantitative basis, Saul Lach of the Hebrew University in Jerusalem has demonstrated that the return to the economy of state investment in high-tech ranges from 473% to more than 1,000%.a More broadly, the government achieved its goal of building a robust high-tech sector. From a small base even as late as 1993, there are now approximately 4,000 high-tech companies, one of the highest concentrations of such firms outside of Silicon Valley. These companies employ almost 250,000 staff, while the segment's share of business sector employment in 2007 was around 9%. An indicator of the strength of the industry is the presence of multinational corporations such as Intel, IBM, Motorola, and Microsoft, which provide experience to their staff in managing on a wide scale, completing big projects, marketing, and dealing with large customer accounts.

The growth in the high-tech sector accelerated after 1993 following the implementation of Yozma, a program designed to create a venture capital industry and make large-scale start-up financing readily available for the first time. Since then, VC firms have raised $13 billion, mostly from overseas, and backed companies that have accounted for $35 billion in exits. Most exits have been in the form of initial public offerings on exchanges abroad or sales to foreign acquirers, with the latter accelerating the increase in the presence of overseas companies in Israel. These successes have provided VCs with the returns that have enabled them to raise further funds and invest in more high-tech businesses, thus ensuring the continued development of the sector.

In addition, the high-tech industry, as per the government's aim, has become an engine of economic growth. Between 1995 and 2007, while Israel's gross domestic product increased two-and-a-half times to $164 billion, high-tech GDP more than tripled to approximately $18 billion, or more than 10% of the total figure. From 19952008, high-tech exports jumped more than fourfold from $5 billion to $23 billion, with their contribution to total exports growing from 20% to 32% respectively. Furthermore, the expansion of the technology sector has helped create of tens of thousands of jobs in ancillary fields such as law firms and accountancy practices.

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The Work Force

There are many reasons why Israel's innovation industries have become an integral part of the economy. One factor is the work force: per capita, Israel is among the leading countries in the world for the number of engineers, Ph.D.s, patents, and citizens with a tertiary education, as well as for the standard of its research institutions as ranked by the World Economic Forum. In addition, Israelis enter the work force at a higher average age than in other countries after having completed compulsory national service, where they develop problem-solving, leadership and teamwork skills, and take on significant responsibilities. These elements have fostered a culture of innovation that has led to the pioneering of widely used technology such as Voice over Internet Protocol (VoIP), Internet firewalls, voicemail, Intel's Centrino Wi-Fi chips, and the disk-on-key flash memory device. The caliber of the work force has also played an important role in drawing multinational corporations and international investment to Israel.


A major reason why there are so few big high-tech companies in Israel is that many are sold, often to foreign acquirers, before they become large.


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Challenges

However, the high-tech sector is vulnerable despite its apparent strength. Among the greatest concerns is the global economic crisis, which has led to a reduction in the sources of credit and equity capital. The IPO market has stagnated, with not a single Israeli company listing on a foreign exchange since 2007, a notable fact given that Israel has more firms traded on Nasdaq than any other country outside North America. With revenues falling, businesses of all sizes and types are feeling the effects of the slowdown, leading to layoffs and company closures, and stymieing R&D projects and the establishment of new firms.

Israel is particularly exposed to the slump because of its reliance on exports and foreign capital, especially with the dollar weakening against the shekel. In 2008, sales abroad accounted for 40% of GDP, while from 19992008, the direct share of overseas financing in total VC investments was approximately 60%, although the overall foreign participation was much greater because Israeli VCs raise the vast majority of their funds from abroad. Much of this capital goes toward early-stage companies in the software, communications, networking, and semiconductors sectors and not enough to firms at a later stage of development or in other industries. These trends have contributed to a failure to create large companies, ensure diversity and spread the benefits of Israel's high-tech success to the wider economy and society. Moreover, Israel's tertiary education system is declining, threatening the basis of the country's technological edge and economic growthits work force.

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Addressing the Challenges

As great as the challenges facing Israel are, there is much it can do to negate the effects of these difficulties. A policy paper for the Israel Democracy Institute (IDI) formulated by a team chaired by Arnon Bentur of the Technion-Israel Institute of Technology, and comprising government economic advisors, high-tech business leaders, leading academics, Chief Scientist Eli Opper and one of the writers of this column, Orna Berry, has called on the country's ruling coalition to reinvigorate the government's involvement in the high-tech sector with the aim of helping it overcome the economic crisis. Such involvement has become static in recent years, as pointed out in the report The Future of Growth Promotion in Israel: A Return to Boosting Avant-Garde Industries and Scientific-Technological Innovation,b the OCS's 2009 budget is only two-thirds of what it was in 2000. While the authors of the paper understand the spending constraints on the government, Israel should do its utmost to reverse this trend as a strategic priority, especially given that state investment in the high-tech sector has been shown to create wealth and generate returns for the economy.

To help stave off job losses, for example, and ensure a continuation of the innovation that is so vital to Israel's prosperity, the report recommends that the government increase its assistance to companies in reducing the costs of R&D projects. To lower the dependence on foreign capital, the authorities should encourage local institutional investment in the high-tech sector, which is minimal, through the loosening of prohibitive regulation and via the provision of tax incentives.

Another goal that the policy paper identifies is the need to encourage the development of large companies, defined as employing over 450 workers and generating annual sales of more than $100 million. Just 1% of high-tech businesses in Israel belong to this category, and since 1995, only four companies have been created that have remained independent and now satisfy the second criterion. This is significant, because the advantages of large companies to the economy are manifold. One of the most important advantages is that because they often locate some of their manufacturing in different regions in Israel and employ workers withall types of backgrounds, they spread the benefits of the high-tech sector socially and geographically. In addition, job creation at big corporations is higher than at small firms, with OCS figures demonstrating that a company experiences a substantial growth in the number of its employeesfrom dozens to hundredsafter it crosses the threshold of $100 million in sales a year. Large firms are also more likely to be profitable, contribute to the tax base, less likely to close, and have greater resources for development.

A major reason why there are so few big high-tech companies in Israel is that many are sold, often to foreign acquirers, before they become large. This is partly a consequence of VC financing being such a prominent source of capital in Israel, and is the disadvantage of a model that has otherwise brought the country huge benefits. Furthermore, the size of most Israeli VC funds means that late-stage financing is mostly beyond their scope, because much larger sums of money are needed than at earlier junctures. There is also an almost total lack of post-VC funding, and in particular, private-equity mezzanine capital. The result is that growth companies find it difficult to raise the cash required to build the operational infrastructuresuch as in finance, management, manufacturing, sales, and marketingthat enable them to expand. The government should fill in this gap by providing the necessary resources and reducing the risks involved, especially in regard to the building of large plants and other advanced projects, while simplifying the prohibitive bureaucracy associated with these processes.

This fostering of links between the private and tertiary sectors should also be widened as part of an overall strategy aimed at reversing a decline in the education system that threatens the quality of Israel's future work force and hence the long-term status of its high-tech industry. Major problems include a relative decline in the number of R&D university personnel at a time that this is rising in Europe and Asia, an aging faculty that is not being adequately replaced, high staff-student ratios, a "brain drain" to the U.S., and a fall in the proportion of undergraduates in science and engineeringsubjects that are vital for entry into high-tech positions.

Immediate action that Israel should take to offset these trends, in addition to that noted above, includes expanding the higher-education budget in order to recruit new faculty members and attract researchers back to Israel from abroad; increasing grants for doctorates and post-doctorate studies; promoting a return to academic study among high-tech workers who have recently lost their jobs; and widening the scope of scientific research funds. As with other areas of government policy, a strengthening of the education system would help spread the benefits of the high-tech sector by facilitating the drawing in of more of those from Israel's lower socioeconomic echelons.

As has been demonstrated, Israel's high-tech sector constitutes a major part of its economy, so despite a surfeit of problems the government faces, it should give high priority to helping solve the difficulties the industry is experiencing. The government should not wait for this growth engine of the economy to splutter to a halt, especially with international competition for investment increasing as countries such as China, India, Finland, and South Korea execute strategies to promote their own high-tech sectors.

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Authors

Orna Berry (orna@gemini.co.il) is a venture partner at Gemini Israel Funds, the former chair of the Israel Venture Association, and the former chief scientist of the Israeli government.

Yigal Grayeff (yigal@gemini.co.il) is a communications manager for Gemini Israel Funds and was formerly a journalist, working for the Jerusalem Post in Israel and Dow Jones Newswires in the U.K.

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Footnotes

a. The research was conducted by the research firm Applied Economics (http://www.applied.co.il) with Saul Lach's academic supervision.

b. See http://www.idi.org.il/sites/english/events/TheAnnualEconomicForum/Documents/

DOI: http://doi.acm.org/10.1145/1610252.1610264

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Figures

UF1Figure. Microsoft Corporation's Israel Research and Development Center was inaugurated in 2006.

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The Digital Library is published by the Association for Computing Machinery. Copyright © 2009 ACM, Inc.


 

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