By Steven Scheer

JERUSALEM (Reuters) - There will be no direct impact on Israel's economy from Britain's decision to leave the European Union, Prime Minister Benjamin Netanyahu said on Sunday.

Britain is Israel's second-largest trading partner by country after the United States, and Europe is Israel's largest trading partner.

Key share indexes declined 3.1 percent in Tel Aviv on Sunday, Israel's first day trading since Britain voted to leave the EU, but this was minor compared to the sharp falls seen on Friday in global stock markets, which lost about $2 trillion in value.

Israel's government bond prices surged up to 2.5 percent, with yields down as much as 11 basis points, on improved inflation expectations.

"There is no direct impact on Israel, except for the fact that we are part of the global economy," Netanyahu said at Sunday's cabinet meeting, noting he met with his finance minister and the central bank chief.

"Israel's economy is strong, it has very considerable foreign exchange reserves, therefore, to the extent there is some effect, it is not expected to be strong, other than the unrest in the global economy."

On Friday, sterling suffered a record one-day plunge to a 31-year low against the dollar. The shekel jumped 6.2 percent versus the pound, 0.8 percent against the euro <EURILS=> but slid 1.6 percent versus the dollar <ILS=>.

Finance Minister Moshe Kahlon said Israel's economy was strong, pointing to a 4.8 percent jobless rate and what he said was one of the lowest budget deficits among developed countries.

But he said the ministry and Bank of Israel had set up a "situation room" to monitor developments around Brexit 24 hours a day.

Analysts believe Israel's exports will continue to suffer in the wake of the weakening of the pound and euro against the shekel.

The finance ministry's chief economist, Yoel Naveh, noted that Israeli exports to Britain are around $5 billion a year and that even a permanent depreciation of the pound would have less than a 0.1 percent negative impact on overall exports.

He said it was possible that Britain's exit from the EU would improve Israel's ability to compete in the European market, particularly in high productivity items where Israel has a relative export advantage like pharmaceuticals, machinery and equipment and electronics. These make up a significant portion of British exports to Europe, Naveh said.

Ofer Klein, head of economics and strategy at Harel Insurance, said the decline in oil prices will offset some of the effect of a drop in exports to Britain and Europe post-Brexit, while inflation expectations will come down as a result of a slowdown in economic growth in Israel due to weaker exports.

Israel's economy grew an annualized 1.3 percent in the first quarter and is forecast to grow about 2.8 percent in 2016.

One positive for the economy will be cheaper imports from Europe as well as consumers benefiting from lower fuel costs and prices of vacations in London.

"Interest rates will remain unchanged until at least the middle of 2017 and the Bank of Israel will buy foreign currency in the event of a rapid strengthening of the shekel," Klein said.

(Editing by Tova Cohen and Digby Lidstone)