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The rise in Israeli spending to continue feeding its war machine in its six-month assault on Gaza is a threat to the country’s economy, which is already facing structural challenges, analysts have said.
The country is facing weak governance and policy implementation risks and with an uphill political battle at hand on the domestic front, a further rise in the national defence budget will disrupt government finances.
In March, members of the Israeli parliament, the Knesset, passed a revised budget package of 584 billion shekels ($160 billion), or 724 billion including debt repayments that the country must make.
Spending was boosted by 70 billion shekels from the original budget passed last year, with 55 billion going to the military and only 15 billion to finance civilian needs.
Israel will need to carefully calibrate its borrowings to sustain its military campaign as that could lead to devaluation of the Israeli currency and a rise in inflation, Bank of Israel governor, Amir Yaron, warned last week.
Israel’s war plans are especially taxing for a burdened economy. The list is long, including a rising population and low labour productivity, particularly among Ultra-Orthodox Jews.
With little chance of a de-escalation in Israel’s war efforts in the medium term, uncertainty is mounting, affecting everything from domestic consumption to industrial output and flows of investment into Israel.
"The war with Gaza has clearly worsened the domestic Israeli growth and fiscal trajectory,” said Hasnain Malik, head of emerging markets strategy at Tellimer, an investment research firm in Dubai.
“How lasting the impact is on the country's attractiveness as a destination for foreign direct investment remains to be seen.”
There is no sign the Israeli government is ready to bow to increasing international pressure to stop attacks in the Gaza Strip.
Last week, the UN Security Council voted on a resolution that demanded an immediate ceasefire between Israel and Hamas until the end of Ramadan. But Israel has continued to hit civilian targets and fire rockets into Rafah.
Israeli Prime Minister Benjamin Netanyahu has vowed to continue the war until the complete dismantling of Hamas, despite the worsening human catastrophe in Gaza.
The war broke out when Hamas fighters attacked southern Israel, killing about 1,200 people and taking more than 200 hostages.
Israel retaliated with air strikes and a siege of the enclave, with the death toll standing at more than 33,000 and 75,750 injured.
Much of Gaza is completely destroyed. It suffered about $18.5 billion in damage to critical infrastructure in the first four months of the Israeli bombardment alone, equivalent to 97 per cent of the combined GDP of the occupied West Bank and Gaza in 2022, according to a joint report by the World Bank and the UN released on Wednesday.
Rising debt-to-GDP ratio
It's been six months since the hostilities in Gaza began and the longer Israel continues its military campaign, the bigger the pressure will be on the country’s financial health.
“The notion that the Israeli economy is unaffected or that it has been marginally affected by the war in Gaza is misleading,” said Nassib Ghobril, a Lebanon-based economist.
“Unanimous opinions and actions by international rating agencies point to the growing impact of the war on most aspects of economic activity and public finances, as well as its continuing impact in the foreseeable future.”
Borrowing is the primary source of funding for the war, which is driving up the country’s debt-to-GDP ratio higher.
It rose 1.4 percentage points to 61.9 per cent at the end of last year, “hurting one of the country’s top strategic assets”, Mr Yaron said in a letter to the government when presenting the Bank of Israel's annual report.
“An assessment by markets that Israel is moving towards an increasing debt route in the medium and long term could lead to an additional increase in yields, devaluation and inflationary pressures."
Defence spending shooting up
The conflict has led to the doubling of Israel’s defence budget this year and as part of the plan for 2024, the government has authorised an increase of 10 billion shekels a year in military expenditure for eight years.
There are some in Israel who argue this temporary increase should be at least double the agreed amount to build Israel’s defences, which will further deteriorate the country’s debt-to-GDP ratio.
“It is important to regularly examine the volume of the increase in the defence budget against its civilian and economic significance, both temporary and permanent,” the central bank’s annual report said.
“Additional defence expenditure will require an increase in the government’s revenue sources or a blow to civilian expenditures in Israel, which in any case are very low by international comparison.”
Without careful calibration, these two factors may weigh down the economy’s potential growth, the banking regulator added.
"The war in Gaza is harming economic performance and the public finances, leading to an increase in public debt," said Pat Thaker, editorial director for the Middle East and Africa at the Economist Intelligence Unit.
However, Israel's core macroeconomic indicators, particularly its external position, remain strong overall.
"It has the capacity to withstand the shock, but risks are firmly on the downside," Ms Thaker added.
Wider economic impact
Elliot Garside, an economist at Oxford Economics, said the war would “keep disrupting the economy” throughout the first half of this year through three main channels: tourism, private consumption and investment.
Fitch Ratings, which maintains a negative outlook on Israel’s sovereign ratings, said with the announced intention to enter the city of Rafah in the south of Gaza, Israel’s war is expected to continue into the second quarter of this year, “with a risk of intense operations continuing beyond” that period.
“This implies continued high spending on immediate military needs and disruption to production in the border areas and in tourism and construction,” Fitch analysts wrote in their latest Israel economy report released on Tuesday.
The war and associated economic disruption contributed to a 6.6 per cent drop in government revenue last year, while a 12.5 per cent rise in spending was driven by mitigation measures for those affected and military spending.
Israel’s budget deficit reached 4.1 per cent of GDP versus the initial government budget estimate of 0.9 per cent. The revised budget includes about 3.6 per cent of GDP in new spending – largely related to the war, Fitch data indicated.
“We forecast a budget deficit of 6.8 per cent, slightly above the budget's forecast,” Fitch analysts said.
Israel's economy grew 2 per cent in 2023 even though it shrank by an annualised 19.4 per cent in the fourth quarter of last year, according to official data.
It is expected to expand by about 2 per cent this year, depending on how long the war extends.
Structural economic weaknesses
Outside of the war, Israel's economy is also facing deep structural weakness.
The country's central bank has warned that these endemic problems need to be addressed through effective policy direction to ensure sustained growth.
The low level of basic skills among workers, low employment rates particularly among Arab women, a need to upgrade and expand physical infrastructure, rising poverty rate and rapid population growth are some of the issues it highlighted.
“The Bank of Israel has in recent years submitted to the government several reports that include detailed recommendations for dealing with these challenges,” Mr Yaron said in the letter to the government.
Labour productivity, which currently is at less than the average of developed economies, is another major structural problem faced by Israel.
The fast-growing Ultra-Orthodox sector accounts for 7 per cent of the economy, expected to rise to about 25 per cent in the next four decades. However, only 55 per cent of Ultra-Orthodox men work and if this trend continues, it will put increased pressure on the taxation system.
Political chaos and rising international pressure
Mr Netanyahu is becoming increasingly isolated in his pursuit of achieving Israel's stated objectives of the war: the complete dismantling of Hamas.
The human tragedy that has unfolded and the relentless siege of the civilian population has turned international opinion against Israel.
US President Joe Biden on Thursday told Mr Netanyahu that US policy will change towards the war unless Israel immediately takes concrete steps to address Gaza's humanitarian crisis.
The comments, which followed an Israeli strike that killed seven aid workers in Gaza, mark the first meaningful shift in rhetoric from the Biden administration since the war began.
During a phone call between Mr Biden and Mr Netanyahu, the US President “emphasised that the strikes on humanitarian workers and the overall humanitarian situation are unacceptable”, the White House said in a statement.
“He made clear the need for Israel to announce and implement a series of specific, concrete and measurable steps to address civilian harm, humanitarian suffering and the safety of aid workers,” it added.
“He made clear that US policy with respect to Gaza will be determined by our assessment of Israel’s immediate action on these steps.”
Israel must change how it is carrying out the Gaza war or face consequences, White House says
At home, Mr Netanyahu is also facing a rising wave of demonstrations in which protesters are demanding his government resign.
Last week, tens of thousands of people rallied against the Israeli Prime Minister in what has been described as the largest mass protest since the Gaza war began.
Anti-government protesters and relatives of Israeli hostages held in Gaza gathered outside the Knesset building calling for Mr Netanyahu to step down and vowed to intensify action against the policies of his wartime cabinet.
Demonstrators also marched to Mr Netanyahu's Jerusalem residence and blocked entrances to the city, where protest groups have set up a tented city.
Policy implementation risks
Protesters also took aim at the divisive military exemption granted to Israel's Ultra-Orthodox Jews, who received spending allocations in the revised budget despite opposition protest, with Mr Netanyahu bowing to the pressure of religious parties within his fragile coalition government.
Mr Netanyahu filed a last-minute deferment on the extension of a March 31 deadline to devise a new military conscription plan, as the issue of Ultra-Orthodox Jews joining the military service continues to divide his cabinet.
Protesters and opposition parties are already calling for an early election, which could add to the country's economic burden.
"The political climate will remain fractious even once the conflict ends, with a likely government collapse prompting elections by late 2024 and impairing fiscal adjustment," Ms Thaker at EIU said.
Israel's credit profile is also reflective of the higher political risks, weaker executive and legislative institutions and fiscal strength due to the continuing military conflict in Gaza, its aftermath and wider consequences, Moody’s Investors Service said.
“We score fiscal policy effectiveness somewhat lower at ‘BAA’ to reflect relatively large budget deficits on a structural basis and the polarised political environment, which has resulted in Israel operating without an approved budget over a number of years," Moody’s said in its latest credit note on Israel.
The rating agency said geopolitical and, in particular, security risk will remain “materially higher” for Israel in the medium to long term.
“Equally, Israel may face a period of elevated domestic political upheaval and renewed polarisation when the war cabinet dissolves,” it added.
