For the first time in the state's history, Israel's credit rating was downgraded to A2.
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The international credit rating agency Moody's announced Friday the downgrade of the State of Israel's credit rating to A2 level (or A under the terminology used by other agencies), from A1, with a negative outlook (down from moderate). This means that the credit rating may continue to decline.
This was the worst-case scenario that could have happened from the Israeli government's perspective, which invested efforts to prevent the credit rating downgrade. Importantly, since 1995 when Israel was added to the rankings, Israel's credit rating has never declined.
In an exceptionally harsh and critical text, the international rating agency Moody's states that the geopolitical risks, especially the security risk, will remain substantially high in the medium and long term.
Also, the State of Israel may face a period of heightened domestic political turmoil when there is no longer a national unity government.
In the company's view, the rise in security risks is also linked to a rise in socioeconomic risks in Israel, which in turn will weaken the country's institutions, especially the executive and legislative branches, which in the foreseeable future will devote their time to restoring security. Moreover, Moody's believes that "the risk of escalating the conflict remains significant, especially one involving Hezbollah in northern Israel."
The downgrade of Israel's credit rating means that the broad implications of the current conflict with Hamas, both during and after it ends, substantially increase Israel's geopolitical risks. They weaken the legislative and executive branches and damage the state's fiscal resilience in the foreseeable future.
Moody's estimates that while fighting in Gaza may decrease in intensity and even stop, there is currently no agreement to end the confrontation or a long-term plan to rehabilitate and strengthen Israel's security. The poor security environment indicates an increase in social risks and also signals the weakness of the legislative and executive branches, contrary to the company's previous assessments.
At the same time, the state's fiscal situation is deteriorating and the downward trend in the debt-to-GDP ratio has reversed. The company expects the debt burden to be substantially higher than forecasts made before the confrontation.
In its baseline scenario, Moody's expects that Israel's defense spending will be almost double what was recorded in 2022 by the end of that year, and will continue to grow at a rate of at least 0.5% of GDP annually in the coming years, with risks tilting spending even higher. The budget deficit for 2023 rose from less than 2% of GDP to 4.2% in the amended budget approved in mid-December. The amended budget for 2024 sets a deficit target of 6.6% of GDP.
These estimates take into account several offsetting impacts or adjustment measures taken by the government. The 2024 state budget incorporates a series of steps to reduce the deficit for 2024 and subsequent years. Moody's notes that the most significant offsetting impact is the 1% VAT increase next year. In total, the government intends to legislate measures to reduce the deficit in 2025 by around 1.1% of GDP, both on the expenditure and revenue sides, with similar magnitude steps to remain in place in subsequent years. If fully approved, these measures could roughly offset the higher security and interest spending. However, as a result of the high projected deficit rates in the coming years, the debt-to-GDP ratio will rise to a peak of 67% by 2025, from 60% in 2022. Before the war began, the company's forecast was that Israel's debt-to-GDP would fall to around 55% of GDP.
The rationale for the negative rating outlook is the risk of escalating fighting in the north. Moody's believes that "the risk of escalating fighting remains significant, especially one involving Hezbollah in northern Israel, despite the high awareness on both sides of the negative implications of such large-scale fighting. Fighting against Hezbollah would pose a much greater risk to Israeli territory, and is expected to include significant damage to infrastructure, remobilization of reserve soldiers and further delays in allowing evacuated residents to return to the area. According to Moody's, the Ministry of Finance estimates that real GDP may contract by up to 1.5% this year in a negative scenario, compared to positive growth of 1.6% given preservation of the status quo."
On the positive side, Moody's stresses that so far the economy has coped relatively well with the implications of the confrontation, with immediate indicators pointing to a rapid recovery in the last three months. The labor force is approaching pre-October 7 levels, schools have reopened and reserve soldiers have begun to be released from active reserve duty. However, some sectors of the economy, especially construction, which relies heavily on workers from the West Bank, operate at much lower levels than usual. Moody's estimates that in a scenario of direct confrontation in the north, the negative economic impact would affect more sectors, over a longer period of time, even beyond current assessments.
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