By Libby George, Karin Strohecker and Steven Scheer
LONDON/JERUSALEM (Reuters) – Israel’s economy has been navigating the chaos of an ongoing war for almost a year, risking escalation into a regional conflict. However, increasing borrowing costs are starting to strain its financial system.
According to the finance ministry, the direct cost of funding the war in Gaza through August was 100 billion shekels ($26.3 billion). The Bank of Israel estimates this could rise to 250 billion shekels by the end of 2025, with Israel’s incursion into Lebanon against Hezbollah adding to the expenses.
As a result of credit ratings downgrades, the economic repercussions are expected to linger for years. The cost of insuring Israel’s debt against default is at a 12-year high, alongside a ballooning budget deficit.
“As long as the war continues, the sovereign debt metrics will continue to worsen,” said Sergey Dergachev, portfolio manager at Union Investment.
While Israel’s debt-to-GDP ratio was at 62% last year, the borrowing requirements have surged, indicating potential fiscal strain in the future.
“Even if Israel has a relatively strong foundation, it will still face challenges on the fiscal side,” Dergachev noted, adding that this could eventually impact the country’s credit rating.
Israel’s finance minister has expressed confidence in the economy’s resilience, stating that credit ratings should recover once the war concludes.
The high cost of the war can be attributed to expenses such as the Iron Dome air defenses, significant troop mobilizations, and intense bombing campaigns. This year, debt-to-GDP reached 67% and the government deficit climbed to 8.3% of GDP, surpassing the previous forecast of 6.6%.
While core buyers of Israel’s international bonds, such as pension funds and major asset managers, are unlikely to divest their assets immediately, the investor pool has shrunk.
Some investors are considering selling or avoiding Israel’s bonds due to concerns over the Environmental, Social, and Governance (ESG) implications of the war’s conduct. Norges Bank reduced its holdings in Israeli government bonds in 2023 due to increased market uncertainty.
“Valuations are reflecting these concerns, evident in the wider spreads at which Israeli bonds are trading compared to similarly rated countries,” said Trang Nguyen, Global Head of Emerging Markets Credit Strategy at BNP Paribas.
Israel’s finance ministry stated that government finances have been effectively managed since the conflict began, highlighting strong demand in the domestic market and ongoing familiarity with Israel’s credit among international investors.
While Israel’s domestic bond market remains robust, foreign investors have scaled back. Central bank data indicates a decline in the share held by non-residents, while the amount of outstanding bonds has increased.
Equity investors are also reducing their exposure to Israel, as evidenced by international investors’ cuts to Israel funds and the declining ownership of Israeli stocks by global funds.
Foreign direct investment into Israel dropped in 2023, and ratings agencies have warned about the war’s unpredictable impact on such investments.
This trend underscores the importance of local investment and government support. In April, the government allocated $160 million to boost venture capital funding for the tech sector, a key contributor to Israel’s economy.
Other costs, including housing displaced individuals and addressing worker shortages due to mobilization, are straining sectors like agriculture and construction.
The economic growth has been hindered, with GDP dropping over 20% in the fourth quarter of the previous year. Data from the first three months of this year show that GDP remains below pre-attack levels.
Israel has managed to raise funds successfully, with significant debt sales in international markets. Israel Bonds, the diaspora bond vehicle, aims to secure another record haul above $2.7 billion this year.
However, the combination of rising borrowing costs, increased spending, and economic pressures poses challenges for the future.
“Israel can continue to navigate through these challenges due to a sizable domestic investor base that can fund further deficits,” said Roger Mark, analyst at Ninety One. “However, local investors are looking for signs of consolidation efforts from the government.”
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As Israel’s economy grapples with the financial implications of a prolonged war, the road ahead remains uncertain. While the government asserts the nation’s economic resilience, challenges such as rising borrowing costs, credit downgrades, and dwindling investor confidence loom large.
Amidst these obstacles, the importance of local investment and government support cannot be understated. Efforts to boost key sectors like technology and address the fallout of the conflict on various industries will be crucial for Israel’s economic recovery.
Despite the hurdles, Israel’s ability to navigate through these turbulent times reflects a level of strength and adaptability. With domestic investors stepping up to support the economy and ongoing fundraising initiatives, Israel is showing resilience in the face of adversity.
Looking ahead, the government’s response to the economic challenges post-war will be closely watched by investors and analysts alike. As uncertainties persist, the path to economic stability and growth for Israel will require strategic decision-making and a concerted effort to rebuild and revitalize the financial landscape.
($1 = 3.8055 shekels)
