Israel’s credit downgrade amid risk of regional escalation is a call to take action

S&P cut Israel’s credit score warning about further downgrades in light of higher defense spending and a ballooning deficit; higher taxes are inevitable, says expert

Sharon Wrobel

Sharon Wrobel is a tech reporter for The Times of Israel.

The headquarters of US financial company Standard and Poor's (S&P) in lower Manhattan, New York, May 2014.   (mixmotive via iStock by Getty Images)
The headquarters of US financial company Standard and Poor's (S&P) in lower Manhattan, New York, May 2014. (mixmotive via iStock by Getty Images)

Ratings agency S&P Global over the weekend joined Moody’s Investors Service in cutting Israel’s sovereign credit rating by one notch, as regional tensions with Iran heated up and the war with the Hamas terror group is expected to last longer than previously estimated.

The action in itself to lower Israel’s fairly high credit score to A+ from AA- as risks of a geopolitical escalation heightened was very much a fait accompli. The move will increase the country’s borrowing costs, but it does not reflect concern that Israel would not be able to repay its debt.

However, the agency’s decision to keep its negative outlook on the Israeli economy opens the door for more downgrades down the line as the country faces higher military and civilian war spending, and global investor sentiment turns sour. While the government has not yet come up with a plan for how to finance growing war expenditure, raising taxes is now becoming inevitable, say experts.

S&P’s downgrade came less than a week after Iran used over 300 ballistic missiles, drones, and cruise missiles to attack Israel, and as the country is in its seventh month into a war with Hamas, that is costing the economy billions of shekels, with no end in sight.

“We expect a wider regional conflict will be avoided, but the Israel-Hamas war and the confrontation with Hezbollah appear set to continue throughout 2024 versus our previous assumption of military activity not lasting more than six months,” S&P analysts said.

Moody’s in February cut Israel’s credit rating, by one notch, from A1 to A2, and changed its outlook to negative, citing the war’s impact on government spending, as well as fiscal and political risks. Both ratings agencies view higher permanent military spending, and uncertain macroeconomic prospects, as risks that could impair Israel’s ability to bring down its growing debt pile in the future in an environment of fractious domestic politics.

Damage to apartments from rockets fired by Hezbollah in Kiryat Shmona, northern Israel, on the border with Lebanon, February 29, 2024. (AP Photo/Ariel Schalit)

Since October 8, Hezbollah has attacked Israeli communities and military posts along the border almost daily with rockets, drones, anti-tank missiles, and other means, to support Gaza during the war with Hamas. Israel has threatened to go to war to force Hezbollah away from the border if it does not retreat and continues to threaten northern communities, from where some 70,000 people were evacuated to avoid the fighting.

“Due to recent events, there is a 50 percent probability that we are going to a worse scenario in the next half a year,” Prof. Zvi Eckstein, head of the Aaron Institute for Economic Policy at Reichman University and a former Bank of Israel deputy governor told The Times of Israel. “Facing a medium-sized intensive fight with the Hezbollah will have an additional negative impact on the economy because of the need for a large callup of reserve soldiers, similar to what we saw in the first few months of the war, an increase in defense spending, and a dramatic increase in the number of employees not being able to go to work in the north.”

S&P, which will be reviewing Israel’s credit rating again on May 10, warned that it could lower the country’s score in the next 12 to 24 months “if the impact of the conflicts on Israel’s economic growth, fiscal position, and balance of payments proves more significant than we currently project.”

S&P expects the economy to grow at a mere 0.5% in 2024, following 2% growth last year. That is more pessimistic than the Bank of Israel forecast of 2% for this year. Assuming that military operations gradually subside by the end of this year growth will rebound in 2025 with 5%, according to S&P and in line with the central bank’s projection.

The ratings agency expects Israel’s government deficit will widen to 8% of national output in 2024, due to increased defense spending, which is higher than the target of 6.6% of GDP set by the government for this year. S&P cautioned that it forecasts higher deficits over the medium term with government debt to peak at 66% of GDP in 2026.

“The forecast by the Finance Ministry is biased to a much more optimistic scenario and they are likely to revise the target soon and will be considering raising taxes to deal with the rising deficit,” Eckstein said.

Prof. Zvi Eckstein, head of the Aaron Institute for Economic Policy at Reichman University and former deputy governor of Bank of Israel. (Courtesy)

The government could be bringing forward a hike of 1% in value-added tax (VAT) – from the current 17% to 18% — which is planned for 2025. VAT levied on goods and services is a regressive tax, meaning that a higher rate harms the lower-income population more than higher earners, and contributes to increasing the already high cost of living.

Raising VAT by 1% adds NIS 7 billion ($1.9 billion) to NIS 8 billion to the state’s coffers, Eckstein estimated. In addition, the government could also increase taxes on coal, carbon, or plastic in support of the environment, adjust income tax brackets to the standard of living, and use expenditures from unnecessary ministries that are not related to the war effort.

In response to S&P’s downgrade, Finance Ministry accountant general, Yali Rothenberg was quick to reassure investors that Israeli government bonds are a “safe and liquid asset” and that the Israeli economy is diverse, innovative, and fundamentally strong.

Rothenberg also called on the government to act and take the necessary steps to show fiscal responsibility and to ensure long-term growth of the economy and a decrease in the debt-to-GDP ratio.

“These steps would signal to the market that this is a responsible government,” said Eckstein. “The strength of Israel’s economy is unparalleled and as long as the government would respond with higher taxes, it is likely to continue to function reasonably well, even if there will be more downgrades as the war intensifies and the deficit goes up.”

Times of Israel staff contributed to this report.

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