Israel must tackle economic issues raised by Moody's downgrade, central bank chief says

Amir Yaron believes country’s economy has the ability to recover from war

Protesters take part in a demonstration against Israel's government in Habima square in Tel Aviv. EPA

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Israel's government must take action to tackle the economic challenges raised by rating agency Moody's, which downgraded the country's credit rating last week amid the war in Gaza, its central bank chief has said.

“In order to strengthen the trust of the markets and of the ratings agencies in the Israeli economy, it is important that the government and the Knesset act to deal with the economic issues raised in the report,” Bank of Israel governor Amir Yaron said on Sunday.

Moody’s Investors Service on Friday downgraded Israel’s credit rating from A1 to A2 with a negative outlook, attributing the move to its assessment “that the continuing 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”.

Israel’s public finances are also deteriorating and the country’s debt burden is expected to be materially higher than projected before the conflict, Moody's said.

The agency expects the public debt to gross domestic product ratio to peak at 67 per cent, from 60 per cent in 2022.

Before the conflict started, Moody's expected that Israel's debt burden would decline towards 55 per cent of GDP.

However, Mr Yaron stressed that the country could handle the stress due to the economy’s high potential growth and the structural surplus in the current account.

“Israel has experienced geopolitical crises in the past, when the debt to GDP ratios were much higher, and there was never any delay in repayment of government debt,” he said.

Israel's Ministry of Finance expects spending to be permanently higher by at least 1.4 per cent of GDP and potentially closer to 2 per cent of GDP if the conflict lasts longer or escalates further than currently expected.

In its baseline scenario, Moody's expects Israel's defence 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 per cent of GDP in each of the coming years, with risks tilted towards yet higher defence spending.

The Bank of Israel estimates the cost of the conflict for the years 2023-2025 to stand at about 255 billion shekels ($64.4 billion) or 13 per cent of the GDP forecast for this year, which includes both higher defence and civilian spending as well as lower tax revenue.

Last year's budget deficit was raised from less than 2 per cent to 4.2 per cent of GDP in the supplementary budget approved in mid-December. The revised budget for this year sets a deficit of 6.6 per cent of GDP, compared with a pre-conflict forecast of about 2.5 per cent.

Israel has said it has no immediate plans to end the war raging in Gaza that began in October, which has killed more than 28,100 Palestinians.

While Israel's economy has so far managed the fallout from the war “reasonably well” with the labour force approaching pre-conflict levels, some sectors of the economy, in particular construction, are operating at much lower levels than normal, Moody's said.

There are also heightened risks of an escalation involving Hezbollah in the north of Israel, “which would have a potentially much more negative impact on the economy than currently assumed”, the agency said.

But Mr Yaron said the Israeli economy is “rooted on strong and healthy economic fundamentals”.

“We have known how to recover from difficult periods in the past and rapidly return to prosperity, and the Israeli economy has the strength to ensure that this will happen this time as well,” he said.