Downgrade and debt: Israel's economy isn't as resilient in war as it once was

As Israel basks in the afterglow of its recent military success—the elimination of Hezbollah leader Hassan Nasrallah—looming economic challenges cast a long shadow over the nation’s future. The Israel Defence Forces delivered a crucial blow to one of its most formidable enemies and the nation erupted in jubilation. However, as many Israelis celebrate, a more sobering reality is unfolding in the financial arena. Moody’s recent decision to downgrade Israel’s credit rating from A2 to Baa1 raises critical questions about the country’s long-term financial health prompting analysts to consider the broader consequences of ongoing military engagements on the nation’s economy.

A downgrade with deep implications

Moody’s downgrade of Israel’s credit rating marks one of the sharpest financial setbacks in nearly three decades. Unlike past military conflicts, where the country’s economic resilience was evident, this time the signals are more concerning. According to The Jerusalem Post emphasised that this two-notch downgrade is not a routine financial fluctuation but a severe indication of deeper systemic issues. The agency’s analysis makes it clear that there is growing concern over Israel’s ability to recover swiftly, especially given the prolonged nature of the current military conflict and the lack of a clear exit strategy.

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While Israel’s credit rating remained stable even during the Second Intifada, the current downgrade reflects a more significant problem: a perception of ineffective governance. Moody’s analysis points out that beyond the immediate costs of the war, Israel is suffering from institutional weakness, with an inability to address political instability and the growing tensions related to military service exemptions for the ultra-Orthodox population. This failure to implement meaningful reforms has diminished international confidence in the government’s capacity to manage not only military challenges but also its fiscal responsibilities.

Rising cost of borrowing

The immediate consequence of Moody’s downgrade is a rise in borrowing costs, which threatens to strain an already overburdened national budget. Professor Dan Ben-David from Tel Aviv University told The Jerusalem Post that Israel’s deficit, already ballooning due to war-related expenditures, will now face even higher interest costs, which will inevitably cut into funding for critical domestic services like healthcare, education and defence. As borrowing becomes more expensive, the government will be forced to make difficult choices potentially sacrificing long-term investments in social infrastructure to cover war expenses.

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Moody’s decision to downgrade Israel’s credit rating goes beyond the immediate conflict. The agency expressed concern over Israel’s governance issues and the absence of a comprehensive post-war recovery plan.

Private sector under stress

The ripple effect of the downgrade extends far beyond government borrowing. The Times of Israel reported that businesses, especially those relying on loans, will now face higher interest rates, which will in turn push up costs for consumers. As borrowing becomes more expensive for companies, it could result in higher prices across various sectors, adding to the country’s inflationary pressures. In August 2024, Israel’s inflation rate stood at 3.6 per cent, already above the government’s target range of 1 to 3 per cent. With rising borrowing costs, this inflation is likely to persist, further burdening the average Israeli household.

The impact on businesses does not end with increased borrowing costs. As international companies reevaluate the risks of doing business in Israel, there are fears of layoffs and delayed investment projects. The Israeli private sector, particularly small and medium-sized enterprises, will likely bear the brunt of this downturn, with many companies facing the threat of closure due to mounting costs and decreased consumer spending power.

Long-term financial risks

The Times of Israel said that this downgrade could lead to a snowball effect negatively impacting savings portfolios, pension funds and other investment vehicles. Government bonds will now carry greater risks potentially lowering their value and reducing the returns for ordinary Israelis.

As Israel’s public debt rises, the country’s financial future becomes more uncertain. According to Al Jazeera, the Bank of Israel estimated that war-related costs for 2023-25 could amount to $55.6 billion and a combination of higher borrowing and budget cuts will be necessary to meet these obligations. With the country’s debt-to-GDP ratio already projected to remain above 70 per cent and the public deficit expected to reach 7.8 per cent in 2024, there is little room for error in Israel’s fiscal management.

Smotrich expressed strong confidence that the deficit would shrink to 6.6 percent by year’s end despite disagreeing with the current projections. However, this optimistic forecast may not align with the reality on the ground. As military spending continues to rise, particularly on wages for reservists and artillery for the Iron Dome defence system, the pressure on public finances will only increase. Fitch Ratings echoed these concerns, forecasting that military expenditures would permanently increase by 1.5 per cent of GDP, making it difficult for the government to rein in its debt in the near future.