Fitch sees ‘watered down’ judicial overhaul not having doomsday effect on economy

As the Israeli shekel hit its weakest rate since 2017, in light of heightened domestic social and political tensions, Fitch Ratings expressed confidence Monday that the proposed changes to the country’s judicial system have been sufficiently “watered down” to not cause long-term damage to Israel’s resilient economy.

In an interview with Bloomberg, Cedric Berry, Fitch’s lead analyst on Israel, explained that the rating agency’s call last week to affirm Israel’s A+ credit rating, with a stable outlook, is also based on the belief that Israel will not elect another hard-rightwing government.

“Even if Israel’s government lasts four years, it’s unlikely that a similar coalition would be formed afterward, so it would take a very strong reform drive to inflict a significant amount of damage,” Berry said. “And we don’t think that’s where the government is headed.”

The growing fear among the business and tech community is that the contested judicial overhaul will erode Israel’s stable democracy and weaken checks and balances, which will make venture capitalists and other moneymakers leery of investing their money in the country, triggering an outflow of funds and luring talent to move abroad.

“Even if there is a bit of movement outwards of talent and capital, there is still quite a lot of activity that will remain in Israel and be sufficient to drive the economy,” Berry said. “It’s always a question of scale.”

Echoing comments made by Prime Minister Benjamin Netanyahu in international interviews, Fitch said in its report issued on August 14 that “the government’s initial judicial overhaul package has been watered down, but remains highly controversial and faces strong civil society and political opposition.”

In the report, Fitch noted that Israel’s favorable credit rating “balances a diversified, resilient and high value-added economy and strong external finances against a relatively high government debt/GDP ratio, ongoing security risks and a record of unstable governments that has hindered policymaking.”

“In our view, we are likely to see new investments in Israel when the global trends turn,” Berry said. “The key message here is that it’s not doomsday.”

For Israel’s credit profile to suffer, it would have to experience “a significant exodus of both talent and capital, and that’s not something that we anticipate at this point,” he said.

Other global credit-rating agencies have until now held off downgrades, as the Israeli government led by Netanyahu has expressed that it would make every effort to reach a broad agreement or some form of consensus with the opposition and will not advance unilateral legislation on the judicial overhaul.

At the end of July, Moody’s Investors Service warned about “negative consequences” and “significant risk” for Israel’s economy, following the passage of the first bill of the government’s contested judicial overhaul without broad consensus. Moody’s cautioned that Israel’s “executive and legislative institutions have become less predictable and more willing to create significant risks to economic and social stability.”

The rating agency pointed out that some of its earlier concerns regarding the proposed reforms’ impact on Israel’s economy are also starting to materialize, citing the slump in venture capital investments during the first half of the year since the judicial plan was presented and referring to data that showed that 80% of new Israeli startups chose to register overseas during the same period.

Total investments in the Israeli tech industry in 2023 are forecast to reach $7.5 billion, a 55% drop from 2022, according to estimates by Start-Up Nation Policy Institute (SNPI), which tracks the industry. Israeli tech firms raised close to $15 billion in capital last year and, during a bonanza funding year in 2021, nabbed $25.6 billion in private investments in total.

Back in April, Moody’s cut Israel’s credit outlook from “positive” to “stable,” citing a “deterioration of Israel’s governance” and upheaval over the government’s bid to dramatically overhaul the judiciary, while warning that the country’s credit rating could come “under downward pressure if the current tensions were to turn into a prolonged political and social crisis.”

“One of the big questions for the future of Israel is whether uncertainty is temporary or a sign of a structural change in investor perception,” Barry said. “It would likely require a stronger and a more detrimental reform agenda from the government to structurally change that perception.”

Political uncertainty around the government’s proposed judicial overhaul has seen the shekel weakening by about 12% against the US dollar since it was first announced in January, sending thousands of people protesting in the streets every week.

On Monday, the shekel hit 3.80 against the dollar in intraday trading, the weakest level since 2017. Since last week, the local currency dropped by about 2% against the greenback, while the Tel Aviv stock indices fell by 3% to 4% versus an average decline of 1.3% in the S&P 500 index and the Dow Jones index.

Commenting on the local market jitters, Fitch’s Berry said that shares and currencies “tend to react more strongly than economic fundamentals,” which is what the company uses to examine a country’s sustainability, he added.

Local strategists at Bank Hapoalim attributed the recent heightened devaluation of the shekel to a number of factors, including the downturn in global stock prices around the world, which they said technically lead to purchases of foreign currency by institutional investors; the weakness of the local high-tech sector that reduces foreign currency collections and salary payment conversions; and the political uncertainty that triggers an outflow of funds.

“The depreciation comes at a bad time for the economy as it affects the prices of imports, from cars, raw materials to the prices of travel abroad, and therefore slows down a decline in inflation,” Bank Hapoalim strategists wrote in a report on Sunday. “The Bank of Israel has several tools in its arsenal to deal with the devaluation, or at least to slow down the rate.”

The market is already pricing in the probability that the Bank of Israel will hike interest rates to 5% in coming months, according to Bank Hapoalim. Since April 2022, the central bank has steadily raised borrowing costs from a record low of 0.1% to 4.75% at the end of May. The rate hike cycle was paused in July for the first time in more than a year, in light of first signs that inflation is moderating.

“We are far from the point where the Bank of Israel can feel comfortable with the inflation rate, and we estimate that if the devaluation continues there is a chance that we will see the implementation of a type of measure [by the central bank],” Bank Hapoalim added in the report.