Yves here. Helmer continues his discussion of the high and rising cost of the war in Gaza on Israel’s economy. Helmer was early to point out that Israel’s economy can’t endure a long war, even with US economic support. Too many important sectors are taking hits with no prospect of recovery under conflict conditions, and uncertainty when and if they could get back to their old level in the unlikely event that Israel backed down.
Note that the ratings agencies are more timid about downgrades than Helmer indicates. For corporate issuers, the norm is to downgrade only when the bonds are already trading at a lower ratings level, as in to validate Mr. Market. Similarly, in the subprime mortgage securitization era, the agencies were extremely slow to downgrade, there out of reluctance to admit how poor their ratings practices had been. Mind you, that does not diminish the fact that presumed-late downgrades of Israel were pushed back a tad more by Israel and US temper tantrums.
By John Helmer, the longest continuously serving foreign correspondent in Russia, and the only western journalist to direct his own bureau independent of single national or commercial ties. Helmer has also been a professor of political science, and an advisor to government heads in Greece, the United States, and Asia. He is the first and only member of a US presidential administration (Jimmy Carter) to establish himself in Russia. Originally published at Dances with Bears
Twice already the warning of the obvious has been posted in the money markets — Israel cannot survive a long war with the Arabs and Iran.
In this long war, the gods do not favour the Chosen People, it was reported on October 27, three weeks after the Hamas offensive began. The decline in Israel’s export earnings from tourism and diamonds; the loss of imported supplies for manufacturing and consumption from the Houthi blockade of the Red Sea; and increasing risk to both imports and exports at the Mediterranean ports within range of Hamas and Hezbollah strikes were identified at that time.
The international ratings agencies, Moody’s, Fitch and Standard and Poors, postponed announcing the obvious for as long as they could.
In attrition war, on the economic front just like the Gaza and other fire fronts, the Axis of Resistance wins by maintaining its offensive capacities and operations for longer than the US and US-backed Israeli forces can defend. Like troops, tanks, and artillery pieces, the operational goal is to grind the enemy slowly but surely into retreat, then capitulation. Last week, Moody’s had already decided in-house to downgrade Israel; for several days senior management fended off a ferocious attack from Israeli officials and their supporters in the US trying to compel postponement of the downgrade and the analytical report substantiating it.
On February 6, in a review of the shekel, bond, credit default swaps (CDS), budget deficit, and other indicators, the conclusion was there could be no stopping the money markets from moving against Israel. Negative ratings from the agencies raise the cost of servicing Israel’s state and corporate bonds, and put pressure on the state budget. A ratings downgrade is a signal to the markets to go negative against the issuer – this usually comes after the smart money has changed its mind and direction. In Israel’s case, however, there has been an exceptional delay between negative outlook and downgrade. The last Fitch report on Israel was dated October 17; Moody’s followed on October 19; Standard & Poors (S&P) on October 24.
That Israeli and US tactics had forced postponement of new reports from the troika was obvious. A fresh warning was published on this website: as real estate and other tax collections collapse, Israel will have to make a large cash call on the US. This is going to come in the near future, just as the government in Kiev has been forced into calling on Congress as the Ukraine war is being lost. The longer both wars are protracted, the more obviously the loss of confidence expresses itself in Washington.
In a report dated last Friday but not issued until Saturday, the Jewish sabbath, the agency officially reduced Israel’s rating from A1 to A2, and added pointers of further downgrading to come. The Anglo-American press immediately reacted against Moody’s. “Israel hits back”, the Financial Times headlined. The newspaper added: “[Prime Minister Benjamin] Netanyahu, in a rare statement over the Jewish Sabbath, said: ‘The rating downgrade is not connected to the economy, it is entirely due to the fact that we are in a war. The rating will go back up the moment we win the war — and we will win the war.’” In the Associated Press report, “Israel’s finance minister blasts Moody’s downgrade”. Rupert Murdoch’s platform Fox claimed: “Israel has a strong, open economy despite Moody’s downgrade”. “Israel’s creditworthiness remains high,” according to the New York Times, “but the rating agency noted that the outlook for the country was negative… A rating of A2 is still a high rating.”
The press release version of Moody’s report is republished verbatim so that its meaning can be understood without the propaganda.
Three points have been missed in the Anglo-American counterattack and Israeli government’s bluster. The first is the warning that Israel will soon have to request enormous cash backing from the US, and if there is any sign of weakening on that in Washington, the collapse of the Israeli economy and its capacity to continue its war is inevitable. The Moody’s report camouflaged the point this way: “The related issuances benefit from an irrevocable, on-demand guarantee provided by the Government of the United States of America (Aaa negative) with the government acting through USAID. The notes benefit explicitly from ‘the full faith and credit of the US’ and as per prospectus, USAID is obligated to pay within three business days if the guarantee is called upon.”
The second point strikes at announcements from Israel Defence Forces (IDF) generals and Netanyahu of their plan to expand their operations on the northern front – the Litani River ultimatum they called it in December. According to Moody’s report, “downside risks remain at the A2 rating level. In particular, the risk of an escalation involving Hezbollah in the North of Israel remains, which would have a potentially much more negative impact on the economy than currently assumed under Moody’s baseline scenario. Government finances would also be under more intense pressure in such a scenario.”
The third point is the most explosive. After cutting Israel’s rating to A2, Moody’s warned that further and deeper downgrades may follow, but that there is presently no way the ratings agency can predict what will happen next. “The ongoing military conflict with Hamas, its aftermath and wider consequences materially raise political risk for Israel as well as weaken its executive and legislative institutions and its fiscal strength, for the foreseeable future.”
In flagging those last four words – “for the foreseeable future” — Moody’s has told the markets that the strategic initiative in this war has now passed to the Axis of Resistance. Of course, the Arabs and Iranians already know.
The text which follows is the unedited version of Moody’s release. Two illustrations have been added with captions which do not appear in the original.
London, February 09, 2024 — Moody’s Investors Service (Moody’s) has today downgraded Government of Israel’s foreign-currency and local-currency issuer ratings to A2 from A1. Moody’s has also downgraded Israel’s foreign-currency and local-currency senior unsecured ratings to A2 from A1 and the foreign-currency senior unsecured shelf and senior unsecured MTN programme ratings to (P)A2 from (P)A1. The outlook is negative. Previously, the ratings were on review for downgrade. This concludes the review for downgrade initiated by Moody’s on 19 October 2023.
Israel’s backed senior unsecured rating has been affirmed at Aaa. The related issuances benefit from an irrevocable, on-demand guarantee provided by the Government of the United States of America (Aaa negative) with the government acting through USAID. The notes benefit explicitly from ‘the full faith and credit of the US’ and as per prospectus, USAID is obligated to pay within three business days if the guarantee is called upon.
For the history of the US Government’s loan guarantees to Israel, click. The US Congress and President may revoke loans and loan guarantees if there are US weapons violations, breaches of international law, civil activities outside the 1967 borders of the state, etc. The first ruling by the International Court of Justice on Israel’s genocide in Gaza is the most powerful judicial challenge to date for the US Congress.
The main driver for the downgrade of Israel’s rating to A2 is Moody’s assessment that the ongoing military conflict with Hamas, its aftermath and wider consequences materially raise political risk for Israel as well as weaken its executive and legislative institutions and its fiscal strength, for the foreseeable future.
While fighting in Gaza may diminish in intensity or pause, there is currently no agreement to end the hostilities durably and no agreement on a longer-term plan that would fully restore and eventually strengthen security for Israel. The weakened security environment implies higher social risk and indicates weaker executive and legislative institutions than Moody’s previously assessed. At the same time, Israel’s public finances are deteriorating and the previously projected downward trend in the public debt ratio has now reversed. Moody’s expects that Israel’s debt burden will be materially higher than projected before the conflict.
The A2 rating also takes into account the sovereign’s long-standing strengths including very high economic strength, derived from a diversified, high-income and resilient economy; very high monetary policy effectiveness, recently illustrated by the central bank’s ability to swiftly stabilise financial markets; a solid banking sector and the government’s very strong liquidity position and market access. These strengths are moderated by fiscal and debt metrics which, already prior to the conflict were weaker than many similarly-rated sovereigns.
The negative outlook reflects Moody’s view that downside risks remain at the A2 rating level. In particular, the risk of an escalation involving Hezbollah in the North of Israel remains, which would have a potentially much more negative impact on the economy than currently assumed under Moody’s baseline scenario. Government finances would also be under more intense pressure in such a scenario. More generally, the consequences of the conflict in Gaza for Israel’s credit profile will unfold over a long period of time. The negative impact on the country’s institutions and/or public finances outlined above may prove more severe than Moody’s currently assesses.
Moody’s maintained Israel’s local-currency country ceiling at Aaa. The five-notch gap between the local-currency ceiling and the sovereign rating balances the limited government footprint in the diversified Israeli economy and external stability against elevated geopolitical risks. The foreign-currency country ceiling has also been maintained at Aaa, in line with the local-currency ceiling, and reflects very low transfer and convertibility risks, given the very open capital account, the central bank’s very large foreign currency buffers of 39% of GDP as well as solid policy effectiveness.
RATIONALE FOR DOWNGRADE TO A2
ELEVATED POLITICAL RISKS ARE LIKELY TO PERSIST, WEAKENING EXECUTIVE AND LEGISLATIVE INSTITUTIONS
One key driver for the downgrade of the ratings to A2 is that Israel’s elevated exposure to political risks will likely persist for the foreseeable future, even through a reduction in the intensity of or pause in fighting in Gaza.
While there are currently negotiations underway to secure the release of the hostages against a temporary ceasefire and more humanitarian aid into Gaza, there is no clarity on the likelihood, time frame and durability of such an agreement. Also, the governments of the United States and neighbouring countries have presented the broad outlines of a longer-term plan that would include a new governance and political leadership framework in Gaza, which in turn could contribute to improved security for Israel. However, the Israeli government has so far rejected such plans. Moreover, even if a plan is eventually agreed, its durable success will be, for a long time, highly uncertain. As such, Moody’s assesses that geopolitical risk and, in particular security risk, will remain materially higher for Israel into the medium to long term. Equally, Israel may face a period of elevated domestic political upheaval and renewed polarisation when the war cabinet dissolves.
Heightened security risks relate to higher social risk for Israel. In turn, this environment weakens the country’s institutions, in particular the executive and legislative which, for the foreseeable future, will dedicate significant institutional capacity to restoring security. Moody’s assessment also takes into account the strong track record and recent indications of the strength of civil society and the judiciary, which have shown to provide strong checks and balances. The Supreme Court cancelled the government’s attempt to restrict judicial overview, underlining the strength and independence of the judiciary. Moreover, the strength of civil society has been on display since the start of the military conflict.
ISRAEL’S PUBLIC FINANCES ARE WEAKER THAN ASSUMED BEFORE THE CONFLICT
Over the coming years, Israel’s budget deficit will be significantly larger than expected before the conflict. The Bank of Israel estimates the cost of the conflict for the years 2023-2025 to stand at around NIS 255 billion or around 13% of (2024 forecast) GDP, which includes both higher defense and civilian spending as well as lower tax revenues. The interest bill will also be permanently higher. According to the Ministry of Finance, spending will be permanently higher by at least 1.4% of GDP and potentially closer to 2% of GDP if the conflict lasts longer or escalates further than currently expected.
In its baseline scenario, Moody’s expects Israel’s defense spending to be nearly double the level of 2022 by the end of this year and to continue to rise by at least 0.5% of GDP in each of the coming years, with risks tilted towards yet higher defense spending. The 2023 budget deficit was raised from less than 2% of GDP to 4.2% of GDP in the supplementary budget approved in mid-December. The revised 2024 budget sets a deficit of 6.6% of GDP (versus a pre-conflict forecast of around 2.5%).
These estimates take into account a number of mitigating measures. The 2024 budget incorporates a series of deficit-reducing measures, for 2024 and the following years. The single-most important measure is a VAT rate increase by one percentage point next year, which is estimated to bring additional revenues of 0.35% of GDP per year. In total, the government aims to legislate deficit-reducing measures of around 1.1% of GDP both on the revenue and spending side for 2025, with measures of a similar magnitude targeted to remain in place over the following years. If approved in full, these measures could broadly compensate the higher defense and interest spending, although budget deficits will remain much wider than expected before the conflict. The government’s willingness to raise taxes is a positive sign about the strength of the country’s institutions, given the reluctance of successive governments in the past to consider higher taxes.
Still, as a result of much higher budget deficits, Israel’s government debt ratio will rise to a peak of 67% of GDP by 2025, from 60% in 2022. Before the conflict started, Moody’s expected that Israel’s debt burden would decline towards 55% of GDP.
RATIONALE FOR NEGATIVE OUTLOOK
At the A2 rating level, downside risks remain.
In particular, Moody’s considers that the risk of an escalation of the conflict remains significant, especially one involving Hezbollah to the North of Israel, notwithstanding awareness of the very negative consequences of a full-scale conflict on both sides. Conflict with Hezbollah would pose a much bigger risk to Israel’s territory, including material damage to infrastructure, renewed calls on reservists and further delays to the return of the evacuees to the region. The Ministry of Finance estimates that real GDP could contract by up to 1.5% overall this year if this downside scenario materialized compared with positive growth of 1.6% under a status quo scenario.
So far the economy has managed the fall-out from the conflict reasonably well, with high-frequency indicators pointing to a swift rebound over the past three months. The labour force is approaching pre-conflict levels, as schools reopened and reservists have started to be released from duty. That said, some sectors of the economy, in particular construction which relies to an important extent on workers from the West Bank, are operating at much lower levels than normal. Under a scenario of outright conflict in the North, the negative economic impact would spread to more sectors and be longer-lasting. Government finances would also be under more intense pressure in such a scenario, as defense spending would likely be even higher than currently assumed.
More generally, the consequences of the conflict in Gaza for Israel’s credit profile will unfold over a long period of time, potentially well beyond the period of active fighting. The negative impact on the country’s institutions and public finances outlined above may prove more severe than Moody’s currently assesses.
ENVIRONMENTAL, SOCIAL AND GOVERNANCE CONSIDERATIONS
Israel’s ESG Credit Impact Score at CIS-3 reflects elevated social risks linked to the current conflict and Israel’s weakened security environment and to a lesser extent environmental risks which are mitigated to some extent by governance considerations.
Israel has moderate exposure to environmental risks, reflecting primarily physical climate risks and more specifically water stress risk. Israel’s water scarcity reflects its geographical location in a semiarid climate zone. The authorities’ sound water management provides an important mitigant, including through drip irrigation systems, seawater desalination and wastewater recycling. Its overall E issuer profile score is therefore moderately negative (E-3).
Moody’s recently lowered its assessment of Israel’s exposure to social risks (S-4), to reflect the negative impact of the conflict on its assessment of the country’s health and safety situation, as well as risks related to longer-term demographic changes and their impact on the labour market. A lasting solution to the conflict with Hamas is not assured and the security of Israel’s population is less established than assumed before the Hamas attacks. Civil society has proven to be resilient to previous episodes of conflict and indications so far suggest that this remains the case. However, combined with the long-standing challenges with regards to demographics – in particular large differences among the country’s different population groups with respect to labour market participation rates, income, skill and productivity levels – social risks are material, reflected in a highly negative social IPS score.
The so-called “demographic time bomb” has been reversed in Israel. Instead of higher fertility among the Arab population gradually outstripping the Jewish population, the Arab rate has been declining while the fertility rate among the Jewish ultra-Orthodox and settler populations, the haredim, has accelerated. Annexation of the Arab territories and genocide aimed especially at Arab women and children are the fundamental policies of the haredim, and accordingly of the Israeli government and IDF. This cannot be reversed by the replacement of Prime Minister Netanyahu. For analysis of the underlying demographic changes in Israeli society, click to read.
Governance considerations mitigate the above social and environmental risks to some extent, reflected in a positive governance and institutions score (G-1). Civil society and the independent judiciary have proven to provide strong checks and balances in Israel’s institutional structure. The country’s macroeconomic and monetary policy framework is sound and has supported timely policy interventions. In the past, Israel conducted independent inquiries into major security failings and also established a commission to assess the country’s longer-term defense needs, which were important signals for high levels of transparency and disclosure.
By virtue of the ratings having been on review for downgrade, the conclusion of the review deviates from the previously scheduled dates announced in the EU Sovereign Release Calendar, published on https://ratings.moodys.com.
- GDP per capita (PPP basis, US$): 51,990 (2022) (also known as Per Capita Income)
- Real GDP growth (% change): 6.5% (2022) (also known as GDP Growth)
- Inflation Rate (CPI, % change Dec/Dec): 5.3% (2022)
- Gen. Gov. Financial Balance/GDP: 0.4% (2022) (also known as Fiscal Balance)
- Current Account Balance/GDP: 3.9% (2022) (also known as External Balance)
- External debt/GDP: 29.7% (2022)
- Economic resiliency: a1
- Default history: No default events (on bonds or loans) have been recorded since 1983.
On 06 February 2024, a rating committee was called to discuss the rating of the Israel, Government of. The main points raised during the discussion were: The issuer’s institutions and governance strength, have not materially changed. The issuer’s fiscal or financial strength, including its debt profile, has materially decreased. The systemic risk in which the issuer operates has materially increased.
FACTORS THAT COULD LEAD TO AN UPGRADE OR DOWNGRADE OF THE RATINGS
Given the negative outlook, an upgrade to the rating is unlikely. Moody’s would stabilize the outlook if there was evidence that Israel’s institutions are able to formulate policies that support the economic and public finance recovery and restore security while dealing with a wide range of policy priorities.
The ratings would likely be downgraded if the situation in the North escalated to a full-scale conflict with Hezbollah with a significantly more negative impact on Israel’s infrastructure and ability of the economy to recover. Indications that Israel’s institutional capacity is more diminished than Moody’s currently assesses by the need to focus on the country’s security would also be negative. Moreover, an increasing likelihood of a materially larger negative impact on the sovereign’s economic and fiscal strength over the medium term than Moody’s currently projects would also put downward pressure on the rating.
NOTE: the cartoon in the lead was composed by Steve McGinn of Newton, Massachusetts.