Israel's vicious circle of economic deterioration could break down, UBS Warburg wrote in its weekly report, infusing a note of hope.

There are two key factors that could improve Israel's sorry economic situation: aggressive stabilization policy by the Bank of Israel, and the treasury's willingness to genuinely cut the 2003 budget.

The prime minister's intervention in economic matters led the Finance Ministry and Bank of Israel to reestablish cooperative relations after months of feuding, the bank notes. Moreover, there are signs that the treasury's policy is coming closer to that of the central bank.

The vicious circle had been that the weak shekel, "itself the result of fiscal slippage and a deteriorating economic and security environment," prompted the Bank of Israel to step up its monetary response. But that undermined growth, and therefore dragged down tax revenues, which in turn prompted the currency weakness, UBS wrote.

A break in the cycle was unpredictable "because the failure has been one of confidence," the analysts continued. But finally, the Bank of Israel and Finance Ministry are dancing in tandem, which could provide the key impetus to break the cycle, restore confidence and halt the slippage.

The Bank of Israel's aggressive moves, raising lending rates by 4.5% in the space of month to 9.1%, sent the markets a strong signal about its determination to keep inflation expectations in check. Meanwhile, the Finance Ministry has agreed to consider trimming the 2002 and 2003 budgets even further.

Assuming that the Finance Ministry really does make fresh budget cuts, UBS believes the Bank of Israel's rates have peaked.

On the flip side, for all the cooing between the Bank of Israel and treasury, UBS does not see the government deficit coming in below 5% in 2002, because of the "acutely weak economic activity". UBS sees negative economic growth of 1% in 2002, but sees a turnaround in 2003 bringing positive growth of 1.8%.

The investment bank sees unemployment creeping down by 0.2% in 2002 and 2003, to 10.4%.