Overview

• Our baseline scenario assumes that the Israel-Hamas war will remain centered in Gaza, but there are risks that it could spread more widely with a more pronounced impact on the economy and security situation in Israel.
• We now forecast the Israeli economy will contract by 5% in the fourth quarter of 2023 compared with the third, before rebounding in early 2024. The contraction will stem from security-related disruptions and reduced business activity; the drafting of a large number of reservists; the foreign tourism sector shutdown; and a broader confidence shock.
• Meanwhile, we expect that additional budgetary measures to support households and businesses, as well as an increase in defense spending, will increase the average general government deficit to 5.3% of GDP in 2023-2024, compared with 2.3% of GDP in our previous forecast.
• We therefore revised the outlook on Israel to negative from stable and affirmed the 'AA-/A-1+' ratings.

Rating Action

On Oct. 24, 2023, S&P Global Ratings revised the outlook on its 'AA-' long-term foreign and local currency ratings on Israel to negative from stable. At the same time, we affirmed the 'AA-/A-1+' long- and short-term foreign and local currency sovereign credit ratings.

As sovereign ratings (as defined in EU CRA Regulation 1060/2009 "EU CRA Regulation"), the ratings on Israel are subject to certain publication restrictions set out in article 8a of the EU CRA Regulation, including publication in accordance with a pre-established calendar (see "Calendar Of 2023 EMEA Sovereign, Regional, And Local Government Rating Publication Dates: Midyear Update," published July 6, 2023, on RatingsDirect). Under the EU CRA Regulation, deviations from the announced calendar are allowed only in limited circumstances and must be accompanied by a detailed explanation of the reasons for the deviation. In this case, the reason for the deviation is the significant increase of geopolitical and security risks around Israel, which materially affects our projections for Israel's economic and fiscal performance. The next scheduled ratings review for Israel is on Nov. 10, 2023.

Outlook

The negative outlook reflects the risk that the Israel-Hamas war could spread more widely or affect Israel's credit metrics more negatively than we expect. We currently assume the conflict will remain centered in Gaza and last no more than three to six months.

Downside scenario

We could lower the ratings on Israel if the conflict widens materially, increasing the security and geopolitical risks that Israel faces. We could also lower the ratings in the next 12-24 months if the impact of the conflict on Israel's economic growth, fiscal position, and balance of payments proves more significant than we currently project.

Upside scenario

We could revise the outlook to stable if the conflict is resolved, resulting in a reduction in regional and domestic security risks without a material longer-term toll on Israel's economy and public finances.

Rationale

The outlook revision primarily reflects the material escalation in geopolitical and security risks that Israel faces following the attack by Hamas on Oct. 7, 2023, when militants crossed the border from the Gaza Strip, taking hostages and killing both military and civilian citizens. Since then, rockets have continued to be fired from Gaza into Israel. Israel has responded with aerial and artillery strikes on Gaza, where casualties have also been reported, and appears to be preparing a ground offensive in Gaza.

Although it is difficult to predict the direction of events, our base case assumes the conflict will remain centered in Gaza. We do not expect the conflict to spread more widely. Several countries in the region are trying to mediate, while U.S. Secretary of State Antony Blinken and President Joe Biden have also held a series of meetings with Israeli and key regional Arab country officials in recent days. The U.S. has also deployed some of its military forces closer to Israel with the likely goal of deterring other regional governments from entering the conflict.

Over previous decades Israel has experienced several military escalations around Gaza, but we consider the current developments to be of a greater magnitude, and the risks of the conflict widening in the region remain. Iran and Hezbollah (a Lebanese Islamist group with close ties to Iran) have openly stated that, depending on developments in Gaza, they might intervene more extensively in the conflict. In recent days, there has also been an exchange of fire in the north of the country between the Israeli Defense Forces (IDF) and Hezbollah as well as Syria.

In our view, an additional risk could come from the potential for rising tensions between the Jewish majority and Arab-Israeli minority within Israel, as happened during a previous war with Hamas in May 2021, but this risk appears to be contained at the moment.

Even though we assume the conflict will not spread beyond Gaza, we expect it will still hurt Israel's economic performance. The main avenues of transmission are the following:

• Negative direct economic effect from continuing rocket attacks and resulting logistical disruptions and reduction of business activity;
• Reduced labor force and additional costs for the government after over 300,000 IDF reserves (representing 3% of Israel's population) called to active service;
• Extended suspension of gas production at the Tamar gas field due to its proximity to Gaza;
• Adverse impact on the Israeli tourism sector from the security situation and flight suspensions; and
• Indirect effects via expected reduced domestic investment and inward foreign direct investment flows.

While it is difficult to gauge the scale of the downturn, we forecast Israel's quarterly GDP will drop by 5% in fourth-quarter 2023 compared with third-quarter 2023, with all expenditure components shrinking, including domestic demand, exports, and imports. This fourth-quarter GDP fall would be slightly over half of the drop experienced in the second quarter of 2020, at the onset of the COVID-19 pandemic. In both cases, mobility became restricted, businesses shut down, and the tourism sector was disrupted. This expected drop would also be higher than the output reductions following previous military escalations (including the 2014 Gaza war, the 2012 operation in Gaza, the 2008-2009 Gaza war, and the 2006 Lebanon war).

In our view, the structure of the Israeli economy, which is mostly focused on high tech services exports, with a high percentage of employees able to work from home, should somewhat cushion the impact. Additionally, we expect that international support could mitigate some of the negative macroeconomic effects on Israel.

We anticipate the economy will return to growth in the first quarter of 2024 and recover its pre-war output levels by the end of next year. Our current headline growth forecasts are 1.5% in 2023 and 0.5% in 2024, followed by an acceleration to 5% in 2025 as confidence returns and reconstruction and the investment cycle kick in more fully.

We expect Israel's budget deficits will widen in 2023-2024 on account of likely additional government support provisions to households and businesses, as well as extra spending on defense. We forecast an average deficit of 5.3% of GDP in 2023-2024, compared with 2.3% of GDP in our previous forecast.

Israel has several buffers, in our view, which should help mitigate the economic and fiscal impact. In particular, the level of government debt is moderate, at an estimated 60% of GDP. The debt is mostly denominated in local currency and largely held domestically, meaning it is less prone to more volatile nonresident portfolio rebalancing.

The Bank of Israel's international reserves also remain strong at US$199 billion (38% of 2022 GDP) as of end-September 2023, and they cover the gross external debt of the whole economy by 1.4x. We expect Israel will continue to run recurrent current account surpluses averaging 4% of GDP in 2023-2026. The central bank has announced a US$30 billion intervention strategy to smooth excessive exchange rate volatility, as well as additional credit loosening measures for certain commercial bank customers affected by the war.

Key Statistics

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Ratings Score Snapshot

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Related Criteria

• General Criteria: Environmental, Social, And Governance Principles In Credit Ratings, Oct. 10, 2021
• Criteria | Governments | Sovereigns: Sovereign Rating Methodology, Dec. 18, 2017
• General Criteria: Methodology For Linking Long-Term And Short-Term Ratings, April 7, 2017
• General Criteria: Principles Of Credit Ratings, Feb. 16, 2011
• General Criteria: Methodology: Criteria For Determining Transfer And Convertibility Assessments, May 18, 2009

Related Research

• Credit Conditions: War In The Middle East Compounds Global Geopolitical Risks, Oct. 18, 2023
• Israel Ratings Affirmed At 'AA-/A-1+'; Outlook Stable, May 12, 2023

In accordance with our relevant policies and procedures, the Rating Committee was composed of analysts that are qualified to vote in the committee, with sufficient experience to convey the appropriate level of knowledge and understanding of the methodology applicable (see 'Related Criteria And Research'). At the onset of the committee, the chair confirmed that the information provided to the Rating Committee by the primary analyst had been distributed in a timely manner and was sufficient for Committee members to make an informed decision.

After the primary analyst gave opening remarks and explained the recommendation, the Committee discussed key rating factors and critical issues in accordance with the relevant criteria. Qualitative and quantitative risk factors were considered and discussed, looking at track-record and forecasts.

The committee's assessment of the key rating factors is reflected in the Ratings Score Snapshot above.

The chair ensured every voting member was given the opportunity to articulate his/her opinion. The chair or designee reviewed the draft report to ensure consistency with the Committee decision. The views and the decision of the rating committee are summarized in the above rationale and outlook. The weighting of all rating factors is described in the methodology used in this rating action (see 'Related Criteria And Research').

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