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Israel at 74: Economy shows resilience, though clouds loom large on the horizon

While Israel has weathered the past two years well, economically speaking, experts note areas of caution like flow of funds, inflation, housing prices, cost of living

Shoshanna Solomon is The Times of Israel's Startups and Business reporter

Soldiers at the 74th Independence Day ceremony, held at Mount Herzl, Jerusalem on May 04, 2022 (Yonatan Sindel/Flash90)
Soldiers at the 74th Independence Day ceremony, held at Mount Herzl, Jerusalem on May 04, 2022 (Yonatan Sindel/Flash90)

One word probably best defines Israel’s economy as the nation celebrates its 74th birthday: resilience.

Similar to the way Israelis have learned to painfully but quickly bounce back from the horrors of wars and terror attacks, the economy too has managed to rebound following economic crises. Cafés, bars and squares will be thronged with revelers celebrating Independence Day this year as usual, even as the nation has been shaken by a new spate of terror attacks.

Israel’s economy fared better than most other countries during the 2008 financial crisis, due to the responsible fiscal and monetary policies of its government and the central bank, the surplus in its current account, the nation’s high foreign exchange reserves and its strong banking system.

Similarly, the economy has quickly recovered from the worst recession ever wrought by the deadly COVID-19 pandemic, with the booming tech industry leading the charge.

Even so, experts said in interviews with The Times of Israel, while there are no major internal threats to the economy, there are dark clouds on the horizon coming from outside sources, including the deadly war in Ukraine, rising inflation, and spiraling stock markets. Israel is capable of standing up to these challenges with the appropriate policies, the experts said, but leaders must be on the alert to effectively and quickly address them.

A legacy of caution

“Once again, Israel has proved to be a very resilient economy,” said Victor Bahar, chief economist at Bank Hapoalim, in a phone interview, summing up the state of the nation’s economy on this Independence Day. “As time passes, we are realizing that it is something structural within the economy, which means that each time there is a crisis, Israel manages to survive better than other advanced economies.”

“Maybe the legacy of (the) economic crisis and hyperinflation in the 80s still plays a role in the minds of policymakers as well as citizens,” he said. That legacy “can be seen in the high private saving rate of Israeli consumers and prudent fiscal policy of Israel’s governments over the years.”

Victor Bahar, the chief economist at Bank Hapoalim (Inbal Marmary)

All of this, along with the strong tech sector, which chugs along even amid falling rockets or a raging pandemic, has helped the nation get quickly back on track.

The Israeli economy is recording strong growth this year. The Bank of Israel forecasts the economy will grow 5.5% in 2022. The forecast is higher than the GDP growth estimate of 3.5% for the world in 2022, of 3.0% for the eurozone and of 3.5% for the US, by ratings agency Fitch.

Unemployment in Israel, which shot up to its highest level in at least 50 years to an average of 15.7% in 2020, is now back down almost to pre-pandemic levels of around 3%.

“At the outbreak of the pandemic most people thought that the shock in the labor market would be a prolonged one,” said Bahar. “But we have actually returned to a full employment situation much earlier than the most optimistic views. For that, I give a lot of credit to the government, which in July canceled all the unemployment benefits for furloughed workers. This caused people to just go back to work.”

Prime Minister Naftali Bennett’s government took the reins in June 2021 with a wobbly coalition of left, center, and right-wing parties, and one Arab faction. The new government’s policy has been to keep the economy open despite the pandemic. It also managed to pass a budget in November, the first one since 2018.

Prime Minister Naftali Bennett places a wreath during the official Memorial Day ceremony at Mount Herzl military cemetery in Jerusalem on May 4, 2022. (Amos Ben Gershom/GPO)

The government’s economic performance has been “more than good,” said Hapoalim’s Bahar.

The new government has also initiated reforms, passed with the budget’s accompanying Arrangements Law, the most important of which is the gradual increase in the retirement age of women from 62 to 65 according to Bahar.

“No previous government dared to touch this, and the move is seen as a huge success by all economists,” Bahar said.

The new government has also allocated funds for investment in infrastructure and transportation and is opening up the economy by reducing import customs on certain products. “These are a lot of reforms,” said Bahar. “Considering this is a fragile government with a narrow coalition, they have managed pretty well.”

Israel’s gross domestic product surged 8.1% in 2021, the biggest increase in 21 years and more than the 5.3% average growth for OECD countries, according to data compiled by the Central Bureau of Statistics. Israel’s GDP per capita also marked impressive growth in 2021, rising by 6.3%, compared to an average rise of 5% for OECD nations. GDP per capita has surged 37% in the past decade, to $43,500 in 2022 from $31,850 in 2012, according to data compiled by consultants BDO, published in The Marker. In 2020, amid the pandemic, Israel entered the club of top 20 nations with the highest GDP per capita.

Israelis stand still next to their cars on a freeway as a two-minute siren sounds in memory of victims of the Holocaust in Tel Aviv, Israel, April 28, 2022 (AP Photo/Ariel Schalit)

At 74, “Israel has reached a peak, and is among the 10 to 20 richest and most advanced countries in the world,” said Sergey Vastchenok, a senior analyst at Oppenheimer.

The nation has managed a “very impressive transition” in its economy, said Vastchenok, “mostly due to the Israeli high-tech sector.”

Indeed, Israel’s vibrant tech sector has been the growth engine of the nation’s economy for some three decades, pulling in international investments, attracting multinationals and becoming a fertile ground for M&A activity, as foreign firms snap up Israeli technologies.

During the pandemic, the tech sector in Israel and globally became turbocharged, with demand for technologies surging as office workers, fitness classes and schools transitioned to remote mode. Israel, with one of the world’s most thriving tech ecosystems and more than 7,000 startups, was well positioned to seize this opportunity. Its tech firms helped buffer the economy against the worst of coronavirus’s ravages.

Israeli tech firms raised close to $5.6 billion in the first quarter of 2022, on par with the same quarter a year earlier but below the $8.1 billion raised by Israeli tech firms in the fourth quarter of 2021. In 2021 Israeli firms raised an extraordinary record sum of over $25 billion, surpassing the $10 billion raised in 2020.

The first quarter of 2022 saw 39 Israeli tech exits — M&A deals, initial public offering of shares and buyout — totaling almost $9 billion, after the sector saw a record $23.4 billion of such activity in 2021.

SentinelOne holds its initial public offering of shares on The New York Stock Exchange, June 30, 2021 (NYSE)

The shekel in 2021 became one of the strongest currencies in the world, and the budget deficit, which ballooned to 11.6% of GDP in 2020 with the handing out of grants and benefits to aid those affected by pandemic lockdowns, is now back down to just 1.2% of GDP, much lower than pre-pandemic levels. In 2019 the budget deficit was 3.7% of GDP. The nation’s debt-to-GDP ratio, which surged to 72.6% in 2020, is forecast to be around 66% at the end of 2022.

“I don’t know of any other country that has reduced its budget deficit level in such a manner as quickly,” said Bahar.

There were, as of April 12, 92 Israeli-founded unicorns, or privately held tech firms that are valued at more than $1 billion, with 15 new unicorns born this year, compared to a total of 42 in 2021 and 19 in 2020, according to Tech Aviv, which tracks the industry. These firms are mainly based in Israel, New York and Silicon Valley, and employ a vast array of workers, including lawyers, salespeople, designers and marketing professionals, as well as programmers and engineers.

“Kids in Israel today understand that they don’t have to be software programmers to be able to take part in the tech economy,” said Eden Shochat, a partner at Aleph VC, which has some $850 million in assets under management.

There are “initial signs” that these tech firms are having a trickle-down effect on the rest of the economy, he said. “We are seeing people that historically have not been part of this sector, now participating in the industry in a variety of roles,” he said, adding that he hoped the coming year will give this trend an added push.

Eden Shochat, co-founder and equal partner at Israeli VC firm Aleph. (Courtesy of Aleph VC)

But not all is rosy in the so-called Startup Nation, where the tech industry still touches just some 10 percent of the working population, and many, including women, Arab Israelis and the ultra-Orthodox, are left on the sidelines. This is deepening the already large income gaps: Israel has one of the highest levels of income inequality among OECD nations, and while some people struggle to pay for essentials, tech workers are snapping up expensive homes and whizzing around Tel Aviv in sporty electric cars.

This income inequality “might have a long-term effect on the social aspects of Israel,” warned Hapoalim’s Bahar. “It could damage the unity of our society, and that may be the main problem right now.”

Housing prices and the high cost of living are also two large issues that the government needs to urgently address.

Meanwhile, the tech sector suffers from a huge shortage of qualified workers. This could curb the sector’s growth, impacting the economy.

In addition, the lingering effects of the pandemic, the war in Ukraine, and rising inflation are battering stock markets worldwide, leading to plunging valuations at publicly traded tech firms that could trickle down.

A pedestrian walks past the New York Stock Exchange, Monday, Jan. 24, 2022, in New York. (AP/John Minchillo)

The plunge in the stock markets “is affecting everything and everyone,” said Aleph’s Shochat, noting that these trends could affect both valuations and multiples of tech firms in the coming two to three years.

But macro conditions “come and go,” he said. “They are transitory. Innovation, however, is a constant.”

Darker clouds ahead

Israeli policy makers cannot rest on their laurels over the evident economic resilience, warned former Bank of Israel deputy governor Nadine Baudot-Trajtenberg in an interview with The Times of Israel.

Israel’s economy is “doing well,” she said, and has “taken advantage of all of the opportunities it was given. But, she warned, “the clouds coming from the outside are much bigger than what we have seen in the past year.”

These include the war in Ukraine, which is causing global destabilization, and higher inflation levels and interest rates, all of which are affecting capital markets globally.

Former Bank of Israel deputy governor Nadine Baudot-Trajtenberg. (Bank of Israel)

These factors are bound to impact the flows of funds into Israel, Baudot-Trajtenberg said, curbing the level of investment in Israeli tech and startups, weakening the shekel and further fueling local inflation.

“For us, the shock is going to come from the financial flows,” she said.

One of the reasons Israel has enjoyed “really low inflation” was the strengthening of the shekel over the past 10 years, due in part to the fact that interest rates in Israel were higher than elsewhere, she explained. In addition, institutional investors hedged their positions in foreign assets by buying shekels, pushing the Israeli currency higher. Now as the foreign markets turn, “we are going to see a de-hedging of positions by the institutions, which is sort of like saying there is more money going abroad, or less money coming in. ”

This weakening of the shekel, which has been happening in the past few weeks, will further feed into local inflation, she said, leading to higher mortgage and loan repayments.

“Looking ahead, we have bigger challenges but we are also in a good situation to take on these challenges if the [government’s] policies are appropriate,” said Baudot-Trajtenberg.

Future threats, however, will not be as clear-cut and dramatic as that posed by the pandemic, which garnered an immediate emergency response by the government.

“When there is a dramatic crisis, you respond immediately,” she said. “The problem now is that the water is not boiling hot; it is slowly rising in heat.”

“Will we, therefore, take the appropriate steps? Because even if the challenges are bigger, they are not boiling over. They will be felt gradually. And that is always a dangerous thing for politicians, who tend to postpone making decisions.”

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