In a surprising move, Moody’s credit rating agency delivered a blow to the Israeli economy, downgrading its credit rating from A2 to Baa1, with a continued negative outlook. This is the lowest rating Israel has received since Moody’s began assessing the country in 1995. The downgrade reflects deep concerns about Israel’s geopolitical situation, macroeconomic indicators, and the government’s policy responses in the face of ongoing military conflict.

However, many experts argue that this decision is not fully supported by Israel’s current economic reality.

Moody’s forecasts a prolonged weakening of Israel’s economy due to the ongoing military conflict, warning that the economic recovery seen after past conflicts may not materialize this time. The agency points to a range of risks, including heightened geopolitical instability, weakened governance, and uncertainty in fiscal management. The downgrade was driven by expectations of slower economic growth and a rising fiscal deficit, estimated to reach 6% of GDP in 2025 due to increased defence spending.

Economic Indicators Say Otherwise

Critics of Moody’s downgrade, including Israel’s Accountant General Yehli Rotenberg, argue that the decision is excessive and not justified by the country’s macroeconomic data. Israel’s economic fundamentals remain strong compared to other countries in its new rating group, such as Peru and Kazakhstan. Israel’s debt-to-GDP ratio, projected to reach 70%, is still significantly lower than that of major economies like the UK, France, and the US.

Moreover, Israel enjoys a near-zero unemployment rate of 2.8%, a positive balance of payments, and substantial foreign exchange reserves exceeding $200 billion. The high-tech sector remains robust, contributing to strong private consumption and tax revenues. Despite inflation and a growing fiscal deficit due to the war, these indicators suggest that Israel’s economy is far from the weakened state described by Moody’s.

Despite these positive economic indicators, Israel’s bonds have been trading negatively in global markets for months, signalling investor unease. The spread on Israel’s dollar bonds has widened, placing the country in line with lower-rated nations like Peru. This suggests that Moody’s decision may simply be reflecting market sentiment rather than economic fundamentals.

Nevertheless, the majority of Israel’s debt is raised domestically, where interest rates remain more favorable. This raises questions about whether Moody’s assessment accurately represents Israel’s actual economic position or is overly influenced by market volatility and geopolitical fears.

Part of Moody’s concern stems from scepticism over the Israeli government’s fiscal strategy. While the Israeli Ministry of Finance has proposed budget cuts and tax increases to mitigate the deficit, Moody’s analysts remain doubtful about the feasibility of these measures, especially as the government continues to grapple with military conflicts and internal political challenges. The agency’s downgrade also reflects a loss of confidence in Israel’s governance, citing delayed judicial appointments and unresolved domestic issues, such as the bill to recruit ultra-Orthodox men for military service.

In addition, Moody’s decision heavily factors in geopolitical risks, particularly the escalating conflict with Hezbollah and Iran. The rating agency warned that the lack of an exit strategy from these conflicts, along with the disruptions to trade and transportation, could further strain Israel’s economy. While Israel has weathered past conflicts without suffering such severe economic consequences, Moody’s does not foresee a quick resolution or recovery in this case, citing the prolonged and unpredictable nature of the current conflict.

Justified or Not?

Moody’s downgrade has sparked debate about whether the agency’s pessimistic outlook is fully justified by Israel’s economic reality. On one hand, the downgrade aligns with market sentiment and reflects legitimate concerns over the government’s ability to manage escalating defense costs and fiscal uncertainty. On the other hand, Israel’s economic fundamentals, particularly its low debt ratio, strong labor market, and high-tech sector, suggest that the economy is more resilient than Moody’s rating implies.

Ultimately, the downgrade appears to be driven more by concerns about geopolitical risk and governance than by the country’s actual economic performance. Whether other rating agencies, like S&P, will follow suit remains to be seen.

Main article photo: Signage is seen outside the Moody’s Corporation headquarters in Manhattan, New York, US.
(photo credit: Reuters/Andrew Kelly)