Moody's downgrades Israel's credit rating on heightened geopolitical risk

The rating agency says it does not expect a swift and strong economic recovery as in earlier conflicts

The northern Israeli city of Haifa, where manufacturing is a major employer. Moody's has downgraded Israel's credit rating as it tackles two military fronts. AFP

Credit rating agency Moody's Ratings on Saturday downgraded Israel’s long-term local and foreign-currency issuer ratings to Baa1 from A2 and maintained its negative outlook on intensified geopolitical risk in the region.

The country, which had a credit rating of A1, had been downgraded to A2 in February amid the war in Gaza.

“The key driver for the downgrade is our view that geopolitical risk has intensified significantly further, to very high levels, with material negative consequences for Israel's creditworthiness in both the near and longer term,” Moody’s said.

“Longer term, we consider that Israel's economy will be more durably weakened by the military conflict than expected earlier.”

With heightened security risks, Moody’s said it no longer expects a swift and strong economic recovery as in previous conflicts.

In turn, a delayed and slower economic recovery in combination with a more prolonged and broader military campaign will more persistently affect public finances, further pushing out the prospect of a stabilisation of the public debt ratio, the agency added.

The Israeli army has launched an intensive air assault on Lebanon, killing more than 500 people, including dozens of women and children.

Israeli officials said the assault aims to eliminate Hezbollah's military capabilities to allow northern Israeli residents to return home after months of displacement, following cross-border fighting that began on October 8, a day after Hamas's attack on southern Israel and the start of Israel's war in Gaza.

The operation also aims to put pressure on Hezbollah to halt its attacks on Israel, which the group says will continue until Israel agrees to a ceasefire in Gaza. Negotiations for a truce have so far failed.

The cross-border fighting has long threatened to escalate into all-out war.

“The significant escalation in geopolitical risk also points to diminished quality of Israel's institutions and governance, which have not fully mitigated actions detrimental to the sovereign's credit metrics,” Moody’s said.

The negative outlook suggests that downside risks persist at the Baa1 rating level.

A severe escalation of the conflict with Hezbollah could be consistent with a markedly lower rating, in particular if Israel's economic and fiscal strength were to weaken further. The risk of a broader escalation involving Iran remains, even though it continues to be low, the agency said.

“There is no visibility on an exit strategy from the military conflict that would restore a level of certainty and security, on which the economy and business investment ultimately rely. In addition, the conflict and absence of a clear route to its resolution contribute to high social tensions and rising risks to Israel's trade given transport and shipping restrictions, concerns around Israeli suppliers being able to meet schedules, risks of formal or informal trade restrictions and, more generally, rising risks of undermining Israel's relations with key allies,” according to Moody’s.

The agency said it expects Israel’s economic growth to remain weak in the remainder of this year and in 2025.

In the second quarter, real gross domestic product growth was just 0.2 per cent compared to the first quarter and 1.5 per cent below the level of a year ago, with growth nearly exclusively driven by government consumption, while investment and exports contracted, a composition that is unlikely to materially change in the near term, the agency explained.

“We expect real GDP growth of only 0.5 per cent this year, and have materially lowered our expectation for growth next year to just 1.5 per cent, from 4 per cent previously.

“We pencil in longer-term real GDP growth closer to 3 per cent, rather than the pre-war 4 per cent, which is still comparatively robust growth compared to many other advanced economies,” Moody’s added.

The ratings agency said that a clearer picture of the longer-term damage of the conflict to the Israeli economy is starting to emerge.

First, supply constraints on the labour market will remain stronger than expected for longer. Second, investment is likely to remain more subdued for longer because the risk premium for doing business in Israel will remain elevated as long as security is undermined. Third, GDP growth will be lower due to a higher tax burden, with taxes being raised to finance higher defence spending, it estimated.

Israel's economy grew less than expected in the second quarter of this year amid the volatility caused by the war in Gaza.

The country’s GDP expanded by 1.2 per cent in the April-June period, the Central Bureau of Statistics said in an initial estimate in August. It was below the consensus forecast of 4.4 per cent and the 3 per cent growth estimate from the online platform Trading Economics.