Chartbook 266 Israel's downgrade

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. … The outlook is negative. … 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.

External judgements do not often make much impression on Israel’s government. This one did.

Prime Minister Netanyahu and extremist Finance Minister Bezalel Smotrich responded with scorn. Israel officials scrambled to London to argue their case with. the ratings agencies. Meanwhile, Israel’s business lobby demanded that Netanyahu’s right-wing government should reassess its priorities.

No one should be under any illusion that a financial crisis is about to halt Israel’s onslaught on Gaza. Israel’s public finances have been built to avoid precisely that contingency. But the domain of finance is one in which a wider array of forces are brought to bear on Netanyahu’s violent program to rearrange the territorial and demographic order in Palestine. It is a domain in which the array of forces engaged both inside and outside Israel are nakedly exposed and weighed as to their significance.

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Israel’s debt has a complex political history. In its early decades. Israel did not worry much about credit rating. Its debts were political, pure and simple. It was thirty years ago that it revised that strategy. Israel set out to compete on the terms of the global market and succeeded.

Israel gained one ratings upgrade after another, and neither the second Intifada nor a war with Hezbollah in Lebanon could shake that. Moody’s downgrade in February 2024 is thus significant in a double sense. Not only it is the first downgrade that Israel has ever received. But, more specifically, it is the first slight delivered by the ringmasters of global finance, to the strategy of financial strength that has shaped the last decades of Israeli history.

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The war is very expensive. On 27 November in its first comprehensive assessment, the Bank of Israel itemized the cost as follows.

As the Bank explained:

The forecast in Table 1 is based on the assumption that the war’s direct impact on the economy will reach its peak in the fourth quarter of 2023, and will continue into 2024 with declining intensity. Accordingly, our assessment is that the war will result, on average, in the loss of about 3 percent of GDP by the end of 2024.[3]  The impact to GDP is expected to be from both the supply side and the demand side.  On the supply side, the broad mobilization of IDF reserve troops and the partial closure of educational institutions, mainly in the first two months of the war, are expected to be reflected in a decline in the supply of labor in all industries.  In the construction industry, a particularly significant impact is expected to the supply of labor due to restrictions on the entry of laborers from Judea and Samaria, and the complete stoppage of employment of laborers from Gaza.  These are expected to continue having an effect in 2024 as well.  In the agriculture industry, a serious impact is expected due to the departure of foreign workers. In addition to the decline in the supply of labor, production capacity in the combat areas and in threatened regions has been harmed due to the impact to physical capital and the ability to work. On the demand side, negative consumer sentiment is expected to have an impact on consumer demand.  Demand for the export of tourism services is also expected to decline, as experience from previous security incidents shows that this impact is expected to be prolonged.  In contrast, in the construction industry, an increase in demand is expected within the forecast period due to the need to rehabilitate structures.  In view of these developments, our assessment is that the broad unemployment rate[4] among the prime working ages, which has increased in the fourth quarter of 2023, will remain high in 2024.

Since November the Bank of Israel’s estimate of the final cost of the war has been revised upwards, step by step to stand, as of February 2024 at 255 bn NIS, or $69 billion. According to Moody’s this amounts to c. 13 percent of forecasted GDP for 2024.

This is far short of total war. Spread over several years it is roughly on a par with the effort that Russia is making in Ukraine. The impact on the Israeli economy in 2023-2024 has been likened to that of the COVID shock.

If Israel were carrying a debt burden like that in the early 1990s - similar to that of Italy today- such a shock might spell severe trouble. This would be especially true, if Israel were heavily reliant, as it once was, on foreign sources of funding. But the aim of conservative grand strategy since the 1990s, as has been spelled out by Arie Krampf, has been precisely to avoid such a scenario.

Israel’s debt-to-gdp today, is on a par with that of Germany, not Italy. Before the conflict Moody’s expected the ratio to decline towards 55 percent. The war will push it from 60 to 67, which would make it the envy of fiscal hawks around the world.

Of Israel’s borrowing, 80 percent or more is placed in Israeli currency on domestic bond markets. And those markets will absorb more debt, even if Israel needs to issue bonds to the tune of 10 percent of GDP.

Israeli pension funds and other large institutional investors manage a total stock of 3 trillion shekels of savings. Early in Israel’s Gaza campaign, Israel’s local bond issuance was more than six times oversubscribed.

Were markets stressed, bond yields would surge. So far, Israel’s interest rates on local currency debt have remained on a par with those paid by the US Treasury on similar maturities.

As Yali Rothenberg, the Finance Ministry’s accountant general, said in an interview with Bloomberg: “We are well capable of financing the State of Israel even in more extreme scenarios than the current fighting.”

When it does choose to borrow abroad, Israel’s excellent connections in global finance mean that it can sidestep public bond offerings in favor of private placements via Wall Street banks such as Goldman Sachs Group Inc. or via Deutsche Bank. As Rothenberg told Bloomberg: “Israel’s recent international bond placements were to large institutional investors “who really believe in Israel even in a state of war … This is a strong message they are sending.””

In January alone Israel was able to carry through four private debt deals raising a total of $1.7 billion. For the year as a whole, analysts project that Israel might tap $10 billion in private funding. The rates on these loans are higher than on local currency debt. $500 million of debt due in 2027 issued in Brazil in January, carry a dollar-equivalent yield of about 5.3%.

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The slap on the wrist from Moody’s, serves mainly to heat up the debate within Israeli politics about the priorities of the Netanyahu administration.

When the Bank of Israel issued its first comprehensive report on the likely costs of the war on 27 November it was nor merely an analytical exercise. As Galit Alstein of Bloomberg reported:

Governor Amir Yaron warned “the fiscal ramifications” of the war will endure over the medium term and urged caution from the government as it hammers out a new budget. “Alongside the need to provide a budgetary response to needs created by the war, in emergency times as well there is considerable importance to maintaining a responsible fiscal framework,” he said. “It is important that the government cut new expenditures of a prolonged nature.” …. A debate is unfolding in Israel over changes to its current budget, with central bank officials recently criticizing the ruling government’s reluctance to scrap outlays on religious programs and West Bank settlements at a time when it’s under pressure to raise funding to finance the war effort. … Tensions over the special allocations have meanwhile ratcheted up between Prime Minister Benjamin Netanyahu and his political rival, ex-Defense Minister Benny Gantz, who recently formed a national unity government for the duration of the war. Gantz has said that his party would have to “consider its future steps” if the discretionary financing remains in the new budget.

Yaron formerly taught finance at the University of Pennsylvania’s Wharton business school. He has repeatedly intervened on questions both of Israel’s fiscal policy in Netanyahu’s coalition and on the independence of the judiciary.

Avi Simhon, Chair of Netanyahu’s National Economic Council was prompted to fired back:

Both the Bank of Israel and the Budgets Division are exactly the types who put on a belt and braces and hold their trousers up with their hands. Over-conservatism has a price. … "The Budgets Division told me that Israel’s risk indicator, the CDS, reflected high risk. That the State of Israel was in terrible danger. I said, ‘Baloney.’

On 1 January the central bank judged inflation to be sufficiently under control and financial markets to be sufficiently stable to cut interest rates to 4.5. But the fiscal burden of the war remained a major concern and on January 10 Yaron returned to the fray:

In a letter sent on Wednesday morning to Netanyahu and his finance minster, Bezalel Smotrich, Yaron urged immediate budget adjustments to reduce expenses and increase revenues over the next two years. Some of the steps he laid out are highly unpopular and for now appear unlikely to be taken by the government. “The order of the day is to undertake a vigorous and decisive activity — despite all the difficulties and challenges involved, which will strengthen the economic and financial strength of the Israeli economy and avoid lost years,” Yaron said. … Yaron’s focus in the letter is on two specific measures that Netanyahu’s government has been reluctant to adopt — increasing a 17% value-added tax rate and canceling long-promised tax benefits for parents with young children.

In the days that followed, business leaders rallied around Yaron’s calls for cuts especially to the discretionary funds set aside by the coalition to pay for the projects of Netanyahu’s religious allies. Since the fall, coalitions of economists and business experts have been lobbying in the name of wartime economies, for cuts to coalition funding of the religious right-wing. In January 2024 they returned to the battle:

As the cabinet vote approached, a letter signed by 200 of Israel’s top business leaders and chief executive officers called on the government to avoid “damage to Israel’s national and economic strength,” asking it to consider the risk of a possible credit rating downgrade. It’s a view echoed by Dov Kotler, head of one of the country’s two biggest banks. “National priorities must change,” Kotler, Bank Hapoalim’s CEO, said in a rare interview. “Anything that supports defense and growth stays, anything else gets thrown out.”

When the budget was finally agreed in the government on January 16, Gantz and his allies in the National Unity Party voted against it.

The fiscal program backed by the cabinet offers a mix of measures such as tax hikes and spending reductions — including a 5% cut to ministry budgets — to help cope with a steep increase in expenditure to 582 billion shekels this year.

The VAT rate went up. The levy on bank profits was raised. There is to be a 15 percent cut to many programs directed at the Arab community in Israel.

But it spared many of the controversial outlays on religious institutions and other political causes advocated by Netanyahu’s ultra-Orthodox and far-right allies, whose support he needs to remain in power.

The “coalition funds” - an 8 billion-shekel discretionary allocation set aside for the five parties comprising the ruling government - were cut by far less than the critics from the business establishment demanded.

As Andrew Abir, the central bank’s deputy governor commented caustically: “The business of government is about prioritizing, Any government has to make some form of prioritization around the sums of spending or, on the other hand, the taxation it raises.” Meanwhile, from Davos, Governor Yaron, gave his blessing to the cabinet compromise, declaring his support for the government’s efforts to stablize debt to gdp at 67 percent. “Steps taken to stabilize Israel’s future debt are a very important statement to the markets,” Yaron said in an interview with Bloomberg TV.

The markets for their part had seen the writing on the wall. When Moody’s announced its downgrade decision on February 9, which placed Israel on a par with Emerging Markets like Poland and Chile, the markets had already priced in the news. The main reaction came in the market for credit default swaps, where prices indicated that Israel’s risk of default was now on a par with that of Mexico and Indonesia.

Finance Minister Smotrich did not take the news of Moody’s downgrade well. He dismissed Moody’s assessment as “a political manifesto based on a pessimistic and unfounded geopolitical worldview.” PM Netanyahu issued a statement declaring that: “It is entirely due to the fact that we are at war,” he said in a statement. “The rating will go back up as soon as we win the war.” The question on the mind of the market was whether the war might be about to spread.

As Bloomberg reported, Yali Rothenberg the Accountant General took issue with Moody’s analysis

“We have a lot of appreciation for Moody’s, but their decision is not consistent with macroeconomic and fiscal data”. Rothenberg said the Finance Ministry’s bond auctions on Monday drew record demand from local investors and the rate of interest returned to pre-war levels, which he described as a sign of market confidence after the downgrade. “Even if Moody’s decision is professional, it incorporates geopolitical elements that, in our opinion, had been given way too much weight,” he said on a call with reporters.

The business lobby reacted less calmly:

The downgrade and the negative credit outlook are “dangerous developments the like of which we have not seen in 36 years, even during previous wars and challenges that we have coped with,” warned the Israel Business Forum, representing a group of the 200 largest companies in Israel, including the largest employers in the private sector. The business forum said that Moody’s action was “further proof that the budget proposal for 2024 is not balanced and is not focused enough on measures that support growth and the rehabilitation and recovery of the economy the day after. We believe that it is not too late to submit a responsible budget with a lower deficit than the one set and with an order of priorities that is biased towards supporting growth, while encouraging innovation, creativity and productivity,” the business forum said in a statement. “It is likely that such a proposal could have led to a different result, and even prevented the negative outlook set for the economy.”

According to Haaretz, Israel’s Finance Ministry under its fanatical Minister is deeply divided.

The ministry's various divisions are in the midst of a bitter turf war over policy issues such as the 2024 budget. But at the bottom of it is a power struggle and disputes over who is to blame for leaks to the media. Many officials on Sunday said they were indignant that the accountant general division and its head, Yali Rothenberg, had not kept the other ministry divisions abreast of Moody's intention to lower the rating from A1 to A2. They only learned about the decision from media reports after the report was released, even though the accountant general had been informed by the agency of its decision at the end of last week. Rothenberg did notify Smotrich and the ministry's director general, Shlomi Heizler, but he refused to tell anyone else in the treasury, in particular the budget division. Rothenberg was supposedly worried that the downgrade would be leaked to the press in violation of Moody's policy.

On February 12 Rothenberg flew to London to hold talks with Moody’s and Fitch in the hope of limiting the damage. Fitch will publish its latest opinion on Israel in March and Standard & Poor’s by May. S&P has Israel at the highest rating of the three firms.

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But what is really at stake in these struggles over the budget and Israel’s fiscal future are not just the economic numbers. Moody’s reassessment of Israel’s situation did not begin on October 7. Moody’s began reviewing Israel’s rating during the constitutional crisis provoked by Netanyahu’s attack on the judiciary in the spring of 2023. Now what is at stake also goes beyond the immediate fiscal situation. What is at stake is the entire strategy of an “economic peace” in the Middle East and the rationale of Israel’s relentless assault on Gaza.

As Antonio Pita comments perceptively in El Pais

It is not the details of fiscal policy that concern the ratings agency most. Moody’s acknowledges the soundness of the national economy in its report, and has also done so de facto by waiting four months to lower the bond rating. In other conflicts, the decision has been immediate. It is rather the sensation that no one knows what exactly the “total victory” Netanyahu aspires to implies, or when it will come.

This is the backdrop against which we must evaluate the financial aid promised by Washington to Israel. The aid that the Biden administration and Congress are pushing, amounts to a gratuitous subsidy to the tune of $14.5 billion. If we take the Bank of Israel’s estimate of 255bn NIS as our guide, then Washington is promising to cover 20 per of Israel’s total war costs. If the cost in gross defense spending comes to 107 NIS, as the Bank estimated back in November, America’s politicians are planning to reimburse Israel for almost exactly half the cost of its campaign of destruction. And the US rushes to provide this aid, even though, as Israel’s financial technocrats insist, Israel is more than capable of paying for its own war. And were it to do so, Israel’s debt to gdp ratio would be far lower than that born by US tax payers.

The purpose of American aid is first and foremost to satisfy domestic political imperatives. For their own reasons, America’s politicians want to be seen to be spending American tax-payers dollars on Israel. As far as Israel is concerned the effect of the aid is not primarily financial or economic. Its main effect is political. Unlike Moody’s, whose downgrade puts in question the course of both Israel’s domestic and foreign policy, America’s massive support relieves the pressure on Israel’s government to revise its domestic priorities and provides lavish endorsement for Israel’s effort to erase the Palestinian question by brute force.

If as Smotrich’s says the Moody’s downgrade is based on a geopolitical worldview, one wonders whether the rating agency is not underestimating the forces that stand in support of Israel’s violent and costly campaign.

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