Israel’s Economy Receives a Red Card

Moody's downgrading of Israel's credit rating was hardly unexpected but given at this irregular time, with a continued negative outlook, it represents an extremely unusual step, reflecting Moody's assessment that geopolitical risks have increased sharply for the short and long terms.

Minister of Finance, Bezalel Smotrich, speaking at a press conference. Photo by: Chaim Goldberg/Flash90

Moody’s downgrading of Israel’s credit rating was hardly unexpected after the negative outlook that the agency issued in February, but the fact that this downgrade was given at an irregular time and involved a reduction of two levels, and that the negative outlook remains in force even after this change, represents an extremely unusual step, which reflects Moody’s assessment that the geopolitical risks and the serious implications for Israel’s creditworthiness have increased sharply for the short and long terms.

The direct outcome of this decision, the severity of which was not foreseen by the markets, is that the cost of government borrowing—that is, the interest on government bonds issued to cover the deficit—will rise. Consequently, we can expect a rise in interest rates in Israel, as the rate for government bonds is used as a benchmark for all interest rates in the country. This rise, alongside the growth in the budget deficit due to the war and the consequent rise in national debt, will result in much larger resources being allocated to interest payments over the coming years. If we also consider the expected rise in defense spending for the foreseeable future, then we can expect cuts to spending on public services—health, education, welfare, and investment in infrastructure—which was already relatively modest even before the war. These developments will undoubtedly require a significant increase in taxation—the Israeli public will feel these developments in their wallets.

The reasoning given by Moody’s for its decision focuses on the implications of the ongoing war, its increased intensity in the north, the security and geopolitical risks to Israel, the weakening of Israel’s economy over time and the expectation of a decline in potential growth, the country’s fiscal situation over time, the government’s conduct, the great uncertainty regarding the “day after” the war, and the absence of government plans for dealing with the consequences.

Regarding the fiscal context, Moody’s noted that with lower growth over time and higher defense spending for an extended period, the budget deficit is expected to be higher and last longer than previously estimated. As a result, the agency expects the public debt ratio to rise to 70% before stabilizing at that level.

Regarding budgetary policy, it is worth noting that Moody’s does not accept the finance minister’s assessment that the deficit will stand at 6.6% of GDP, as stated in the updated 2024 budget. Neither does it believe that the steps announced as part of the (delayed) planning of the 2025 budget will be carried out to an extent sufficient to achieve a deficit of 4% of GDP, as stated by the finance minister; rather, Moody’s forecasts a deficit of 6% of GDP in 2025, which, along with the low growth rate it forecasts (of just 1.5% in 2025), will result in a further sizable increase in the public debt ratio.

It is also worth noting that in its announcement in February, Moody’s warned the government about its budgetary conduct. However, this warning did not prevent the government from deciding to increase the 2024 budget in order to continue funding the evacuees in the north and in the south, using a “special budgetary box” to circumvent a spending ceiling, instead of funding this expense by cutting other expenditures and changing spending priorities. Neither did the February warning cause the government to cut coalition funds, which serve narrow political interests, or close down superfluous government ministries; nor did it lead it to begin discussions about the 2025 budget on time; nor to formulate agreements on steps to ensure that the budgetary framework would be kept to, so as to avoid a further increase in public debt.

In addition to all the above, Moody’s also lowered its governance score for Israel, to reflect “deteriorating institutional strength and governance.” In this context, the agency noted the fact that the minister of justice has delayed making important judicial appointments, including the appointment of a new president of the Supreme Court, despite a ruling on this issue by the Supreme Court itself.

Moody’s has shown the government of Israel two red cards, as well as an additional yellow card. Now, the other credit rating agencies and the markets are watching extremely closely to see how the government responds.

One of the main elements that will affect the defense outlook, the budgetary picture, and future growth is the government’s defense spending plan, which is currently being examined by the Nagel Commission. It is important that the final plan is based not only on an updated defense strategy and threat assessment, but also on an assessment of the needs of Israel’s society and economy, and the need to ensure the continued flourishing of the Israeli economy.

Only a flourishing economy can shoulder an increased burden of defense expenditure. When setting the defense budget, the fundamental approach that should be adopted is one of managing risks on all fronts (including the economic and financial fronts).

The increased intensity of the conflict in the north requires higher expenditures, for which the Finance Ministry will have to find solutions in the coming weeks. Funding these expenses via another “special budgetary box” (i.e. circumventing, once again, the expenditure ceiling) runs the risk of further damaging the trust of the markets and the credit rating agencies. Formulating the budget for 2025 as soon as possible to meet the budgetary framework announced by the minister of finance, including a modification of spending priorities in order to support economic recovery and make it possible to meet the various social and defense challenges facing the country, would help the State of Israel to successfully overcome the difficult crisis we are all currently experiencing, make the most of the strengths of Israel’s economy and society, and flourish once more.