Analysis

A year of war saps Israel’s borrowing strength, while costs balloon

Foreign investors reduce holdings of local bonds, some raise concerns over Israeli assets, as the country grapples with rising cost of borrowing to finance high war spending

Illustrative: View of the Tel Aviv Stock Exchange. (Courtesy)
Illustrative: View of the Tel Aviv Stock Exchange. (Courtesy)

For a year, the Israeli economy has ridden out the chaos of a war that risks spiraling into a regional conflict, but rising costs of borrowing are starting to strain its financial architecture.

The direct cost of funding the war with the Hamas terror group in Gaza through August was NIS 100 billion ($26.4 billion), according to the Finance Ministry. The Bank of Israel reckons the total could rise to NIS 250 billion by the end of 2025 — but that estimate was made before the ground offensive began in Lebanon against Iran-backed Hezbollah, which will add to the tally.

That has led to credit ratings downgrades, which are amplifying economic effects that could reverberate for years, while the cost of insuring Israel’s debt against default is near a 12-year high and its budget deficit is ballooning.

“As long as the war continues, the sovereign debt metrics will continue to worsen,” said Sergey Dergachev, portfolio manager at Union Investment.

Although Israel’s debt-to-GDP, a core metric for economic health, stood at 62% last year, borrowing needs have blown out.

“Even if Israel has a relatively good base, still it will be painful on the fiscal side,” Dergachev said, adding: “And over time, it will put pressure on the rating.”

Smoke rises from Kiryat Shmona after a rocket fired by Hezbollah from Lebanon hit the town, September 24, 2024 (Channel 12 screen grab used in accordance with Clause 27a of the Copyright Law)

Finance Minister Bezalel Smotrich has said the economy is strong, and the country’s credit ratings should rebound once the war has ended.

Monday marks one year since the October 7, 2023, terror onslaught in southern Israel, in which Hamas-led terrorists murdered some 1,200 people and took 251 hostages to Gaza. On October 8, Lebanon-based terror group Hezbollah began firing missiles and drones into northern Israel, saying it was acting in support of Gaza as Israel fought Hamas there. That fighting in the north steadily escalated over the months, boiling over last month when Israel began a major offensive against the terror group by killing nearly its entire top leadership and launching a ground operation in southern Lebanon.

The cost of the war is steep due to Iron Dome air defenses, large-scale troop mobilization and intensive bombing campaigns. This year, debt-to-GDP hit 67%, while the deficit is 8.3% of GDP, well above the 6.6% previously expected.

While the core buyers of Israel’s international bonds — pension funds or major asset managers lured by its relatively high sovereign debt rating — are unlikely to shed the assets at short notice, the investor base has narrowed.

Privately, investors say there is increasing interest in offloading Israel’s bonds, or not purchasing them, due to concerns over the ESG — environment, social and governance — implications of how the war is conducted. ESG behavior is a rubric that investors use to screen for socially responsible companies when deciding where to park their money.

Norges Bank sold a small holding in Israeli government bonds in 2023 “given increased uncertainty in the market,” a spokesperson for Norway’s sovereign wealth fund said.

Firefighters work to extinguish a fire after a rocket fired by Hezbollah from Lebanon hit a local municipality storage building in Kiryat Shmona, northern Israel, Sept. 24, 2024. (AP Photo/Leo Correa)

“What you do see reflecting these concerns is obviously the valuations,” said Trang Nguyen, global head of Emerging Markets Credit Strategy at BNP Paribas, adding Israeli bonds were trading at far wider spreads than similarly rated countries.

Asked about rising borrowing costs and investors’ ESG concerns, the Finance Ministry said government finances had been “effectively managed” since the start of the war.

“Israel’s robust domestic market demonstrates strong demand, and international investors remain familiar with our credit,” the ministry added.

While the domestic bond market is deep, liquid and expanding rapidly, foreign investors have pulled back.

Central bank data shows the share held by nonresidents declined to 8.4%, or NIS 55.5 billion, in July from 14.4%, or nearly NIS 80 billion, in September last year. Over the same period, the amount of outstanding bonds grew by more than a fifth.

“Israeli institutions actually are buying more during the last few months and I guess some global investors sold bonds because of geopolitics and uncertainty,” a Finance Ministry official said, declining to be named.

A cowshed on Moshav Beit Shearim in northern Israel after a Hezbollah rocket hit in the early hours of the morning, killing fifteen dairy cows and seriously injuring a further three, September 23, 2024. (Israel Police)

Equity investors are also cutting back. Data from Copley Fund Research showed that international investors’ cuts to Israel funds, which began in May 2023 amid a contentious planned overhaul of the judiciary, accelerated after the October 7 Hamas onslaught.

Global funds’ ownership of Israeli stocks is now at its lowest in a decade.

Foreign direct investment into Israel dropped by 29% year-on-year in 2023, according to UNCTAD — the lowest since 2016. While 2024 figures are not available, ratings agencies have flagged the war’s unpredictable impact on such investment as a concern.

All this has amplified the need for local investment and government support.

The government in April pledged $160 million to boost venture capital funding for the crucial tech sector, which accounts for some 20% of the economy.

This adds to other costs, including housing thousands of people displaced by the fighting, many in hotels vacant due to the steep drop in tourists.

Prime Minister Benjamin Netanyahu and Finance Minister Bezalel Smotrich during a cabinet meeting convened to approve the 2024 amended state budget, January 15, 2024. (Haim Zach, GPO)

The displacements, worker shortages due to the mobilization of reserve soldiers, and the barring of Palestinian workers, are hindering the agriculture and construction sectors.

The latter has been a key factor curtailing economic growth, which plunged more than 20% in the fourth quarter of last year and has yet to recover. Data from the three months to the end of June show seasonally adjusted GDP remained 1.5% below pre-attack levels, Goldman Sachs calculations show.

Israel has thus far had little trouble raising money. It sold some $8 billion of debt on international capital markets this year. Its diaspora bond vehicle, Israel Bonds, is targeting a second annual record haul above $2.7 billion.

But rising borrowing costs, coupled with rising spending and economic pressure, loom.

“There is room for Israel to continue muddling through, given a large domestic investor base that can continue to fund another sizable deficit,” said Roger Mark, analyst in the Fixed Income team at Ninety One.

“However, local investors are looking for at least some signs of consolidation efforts from the government.”

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