Market braces for downgrade of Moody’s Israel credit outlook amid judicial jitters

The shekel continued its weakening streak on Thursday ahead of Friday’s inflation data and as investors awaited an update on Israel’s credit rating from Moody’s Investor Service.

The local currency depreciated as much as 1% to around 3.66 against the US dollar in intraday trading amid reports that Moody’s rating agency is set to publish an update on the country’s sovereign rating as early as Friday, although an imminent release has not been confirmed. The report comes amid ongoing protests against the government’s efforts to radically overhaul the judiciary, and as Israel reels from a string of terror attacks and rocket barrages from beyond its borders.

“The market expects, which seems reasonable, that Moody’s is likely to reduce Israel’s outlook from positive to stable and affirm the country’s A1 credit rating as the agency has already been very critical of the judicial reform,” Jonathan Katz, chief economist at Leader Capital Markets, told The Times of Israel.

In April last year, Moody’s upgraded Israel’s economic outlook from stable to positive, affirming the country’s credit rating as A1. Before that, the country had earned a positive outlook from Moody’s in July 2018, which was lowered to stable in April 2020 when the COVID-19 pandemic started gaining pace.

Weekly mass protests around the country against the government’s highly divisive efforts to weaken the judicial system have continued even after the coalition paused the legislation late last month to allow dialogue on reaching a compromise between the sides.

Prime Minister Benjamin Netanyahu and President Isaac Herzog have in recent days held talks with senior Moody’s officials in an attempt to avert a downgrade in the country’s credit rating and to reassure the agency that legislation has been put on hold in an effort to reach broad agreements, Channel 12 reported.

This Aug. 13, 2010 photo shows a sign for Moody’s Corp. in New York. (AP Photo/Mark Lennihan)

In early March before the pause, Moody’s already warned that if the judicial changes are legislated as planned, they “could risk weakening Israel’s institutions and governance (…) and as such be credit negative.”

The rating agency also cautioned about “longer-term risks for Israel’s economic prospects, particularly capital inflows into the important high-tech sector.” The high-tech sector has long been touted as the main engine of Israel’s economic growth, accounting for 49% of total exports and generating around 15% of GDP in 2022.

“We continue to believe that there is broad political consensus on the direction of economic and fiscal policies despite the fragmented political landscape. However, stronger fiscal and debt metrics may not be sufficient to offset weakening institutions if the content of the judicial reforms and the way they are passed point to such weakening,” Moody’s wrote in the March issuer comment.

Although the plans for the judicial overhaul are on hold until after the Knesset Passover recess, they have not been canceled, while Israel’s strong economic fundamentals of fast growth and robust government finances that have driven its rapid recovery from the COVID-19 crisis are moderating, Katz noted.

Earlier this month, the OECD cautioned that the country’s pace of economic growth is expected to moderate, warning that “risks are skewed to the downside, related to high global and domestic uncertainty.” The organization sees GDP slowing from the 6.4% growth rate last year to 3% in 2023 and 3.4% in 2024.

Taking all these factors into account and the “big unknown” of where the judicial initiative is heading, Israel’s “positive outlook is not warranted,” Katz said, adding that Moody’s update is likely to also include some form of warning that if Israel takes the path of implementing the planned judicial changes in full it could risk a downgrade of its country credit rating.

Meitav Dash chief economist Alex Zabezhinsky (Rami Zarnegar/Courtesy)

Alex Zabezhinsky, chief economist at Meitav investment house agrees, with Katz that Moody’s is unlikely to downgrade Israel’s credit rating, but unlike Katz he believes it may even affirm its outlook for now.

“Since Moody’s comment in March, the situation has somewhat improved in that the advancement of the reform has paused and the sides have entered into dialogue and there are ongoing talks to reach a compromise so from that perspective Moody’s is not likely to cut Israel’s credit rating or even change its outlook, but rather wait for the outcome of the recent efforts,” said Zabezhinsky.

Earlier this month, Bank of Israel economists presented an analysis of the potential economic ramifications depending on the intensity of the shocks over the next three years if the proposed legislative and institutional changes lead to an increase in Israel’s risk premium. In a case where the shock of the legislative changes subsides relatively quickly, the potential impact could be a 0.8% annual hit to GDP and cost the economy NIS 14 billion. In case shocks from the changes persist, the adverse impact is estimated at about 2.8% to GDP, or NIS 50 billion per year.

Investors on Thursday also looked ahead to Friday’s release of the March consumer price index (CPI), a measure of inflation that tracks the average cost of household goods. CPI has been hovering above 5% in annual terms for the past six months, falling short of the government’s target range of 1% to 3%.

Economists forecast that inflation rose 0.4% to 0.5% over the past month and 5% to 5.1% over the past 12 months. Inflation quickened faster than expected in February, taking annual inflation over the past 12 months to 5.2%. Analysts had expected an annual rate of 5%.

The rise in inflation came despite steps taken by the Bank of Israel to rein it in. The central bank has over the past year steadily hiked its benchmark interest rate from a record low of 0.1% last April to 4.5% earlier this month in a bid to bring down price growth.

Jonathan Katz, chief economist at Leader Capital Markets (Courtesy)

Inflation has been slower to ease in part due to a weaker shekel, which is making imported goods more expensive. Since the beginning of this year, the local currency has depreciated about 4% against the US dollar. The US dollar index, which measures the greenback against six major world currencies, has declined about 2% since the start of 2023.

Both Katz, who forecast a month-on-month increase of 0.5%, and Zabezhinsky, who expects a 0.4% rise, cited seasonal price rises of clothing, rental costs, and the impact of a weaker shekel on travel costs as the main components driving the March CPI.

Earlier this month, central bank chief Amir Yaron said that the “high volatility” in the shekel in recent weeks was partly impacted by the recent events in the country.

“From the beginning of the year, there has been a marked depreciation of the shekel vis-à-vis the dollar and in terms of the nominal effective exchange rate, and even some separation from the strong connection that there was between the S&P 500 and the exchange rate,” Yaron said.

Looking ahead, Katz expects inflation print to be higher in the coming months citing the lag effect of a weaker shekel making imported goods such as home appliances and new vehicles more expensive, and higher global energy prices.

In the next 12 months, Katz expects inflation to ease to between 3.1% to 3.2%, still above the central bank’s target range of 1%-3%, while Zabezhinsky sees price growth cooling down to 2.7% over the same period.

In the optimal outcome of a reasonable compromise or if the judicial overhaul is shelved, both Katz and Zabezhinsky see one more interest rates hike of 25 basis points to 5% at the next central bank meeting in May.