War doesn’t come cheap – Israel’s credit downgrade

Israeli soldiers stand next to their military vehicles just outside the Gaza Strip, on 10 March 2024

David Rosenberg writes in Haaretz on 14 August 2024:

Not much of what Finance Minister Bezalel Smotrich and Prime Minister Benjamin Netanyahu had to say in response to Fitch’s decision to lower Israel’s credit rating on Monday stands up to fact-checking scrutiny. But the fact is they did say one truthful thing, and it is one that many of their critics seem determined to ignore.

But first, a little background: When it announced on Monday that it was cutting Israel’s rating to A from A-plus, Fitch was the last of the big three credit ratings agencies to do so. S&P Global cut Israel to A-plus from AA-minus in April and Moody’s did the same in February, to A2 from A1. Both warned that further downgrades might come. Fitch was the outlier – it actually removed Israel from Rating Watch Negative list in April, meaning that while Israel’s outlook remained Negative the risk of a downgrade wasn’t imminent.

Fitch has finally come to the conclusion that the war in Gaza will not be over soon (now saying it could run “well into 2025)” and that the fighting risks escalating into a much bigger conflict. “In addition to human losses, [that] could result in significant additional military spending, destruction of infrastructure and more sustained damage to economic activity and investment,” Fitch said.

That is the reality Israel faces. Wars are expensive to fight in terms of money and men (and women) and, if they extend to the home front, as is all but inevitable in the case of missile wars, they cause extensive human and material costs.  This week Fitch estimated that the fighting would increase the budget deficit this year to 7.8 percent of gross domestic product. That is up from the 6.8 percent it predicted in April and higher than it has been in practice the past 20 years (not counting the pandemic year of 2020).

Smotrich was therefore correct when he said that a “downgrade in the wake of the war and the geopolitical risks it creates is to be expected.” Give him credit for that much. The real question Israel faces is how long the war will go on, and that’s where Netanyahu and Smotrich start to lose their grip on reality.  As they have said umpteenth times, “total victory” over Hamas will bring a decisive end to the fighting, after which the economy and government finances will presumably get back on track.

Never mind that Yoav Gallant, his own defense minister, was simultaneously pooh-poohing the idea on Monday, Netanyahu stayed on message: “The lowering of the rating is a consequence of Israel’s dealing with a multi-arena war that was imposed on it. The rating will go up again when we win – and we will indeed win,” he assured us in a tweet, without predicting when exactly we will indeed win.

Unfortunately, their critics are no better at coping with the reality of the long war ahead of us. Instead of victory, they put their faith in a cease-fire/hostage agreement. But an agreement cannot address the long-term threats posed by Hezbollah and Iran any more than “total victory” can, and without Netanyahu’s “total victory,” the Hamas threat will continue to fester as well.

Fitch doesn’t believe there is any way Israel can go back to the era prior to October 7. “Israel is likely to maintain a stronger presence along its borders than in the past, plans to widen mandatory draft and to increase domestic military production, which would also add to spending,” it said.

When we win

In money terms, which is after all Fitch’s interest in this business, it predicted a permanent increase in military spending of close to 1.5 percentage points of gross domestic product, about a third higher than the pre-war level.

Even now, war and war-related spending has caused the budget deficit to balloon to 8.1 percent of GDP in the 12 months through July. The Finance Ministry says the deficit will start to shrink later in the year because the rise now reflects the sudden surge in military costs after October 7. But given the growing risks of wider war and slowing economic growth, Smotrich ought to be thinking about adjusting spending. He doesn’t seem to be.

Then there is the issue of the 2025 budget, or more precisely, the lack thereof. Smotrich vowed on Monday that “we will pass a responsible budget that continues to support all the needs of the war on the front line and in the rear until victory, while maintaining fiscal frameworks and promoting growth engines.” Despite all three ratings agencies (S&P, Moody’s and Fitch) assigning Israel a Negative outlook, he predicted that “very soon the credit rating will be raised.”

Here is the reality: Smotrich held a two-day marathon round of talks in June on the 2025 spending package. It was followed by a meeting in July with Netanyahu, Bank of Israel Governor Amir Yaron and two aides, accompanied by a press-handout photo that looked as if it had been lifted out of SimCity – five men with blank expressions sitting with hands folded on a big conference room table bereft of a single document.

Since then, the budget-making process hasn’t moved forward. Finance Ministry officials are anxious enough about the delays that they have begun work on a “shadow budget” for 2025 without the cabinet ever having approved a budget framework.  There is speculation that Smotrich and Netanyahu plan to delay the budget process as long as possible (and perhaps find a way to use the war-time emergency to avoid passing a budget at all) because they don’t want to pay the political price of having to close a 30-billion-shekel ($8.1 billion) gap between projected expenses and income with spending cuts and tax hikes.

Plans for long-term defense spending also appear to have succumbed to politics. It took until May, seven months into the Gaza war, for Smotrich to agree with Gallant on forming a government committee to examine the army’s future needs and costs, and the panel only convened for the first time this month.

In the face of rising strategic threats, Israel has no choice but to boost defense spending. But in doing so it risks overspending and/or misspending, as it did after the Yom Kippur War. Having a panel of experts weigh needs and resources is the logical way to establish priorities. But Gallant fears that Smotrich is less interested in ensuring proper policies than in turning the committee into an attack dog to be sicced onto the army for its October 7 failures and help the politicians strengthen their hold on the defense establishment.

Adjusting for the many months of war that appear to be lying ahead of us and for the new era of higher defense spending requires careful, considered work. But Smotrich – aided and abetted by Netanyahu – is determined to do nothing but offer empty assurances.

Without a budget and a plan for how to pay the higher defense costs, Israeli government finances risk spinning out of control, taking the economy with it.

How the war will play out is as much in Iran’s and Hezbollah’s hands as it is in Israel’s. Israel has control over how to cover its costs and mitigate its economic impact, but it seems its political leaders are unwilling to do so.

This article is reproduced in its entirety