Rating history

Outlook revised to stable from negative....January 2005

Local currency ratings lowered to ‘A+/A-1’....October 2002

Outlook revised to negative from stable....April 2002

Local currency ratings raised to ‘AA-/A-1+’....August 1996

Foreign currency ratings raised to ‘A-/A-1’....December 1995

Long-term foreign currency ratings raised to ‘BBB+’....September 1993

Foreign currency ratings raised to ‘BBB/A-2’....January 1993

Foreign currency ratings of ‘BBB-/A-3’ assigned....October 1988

Default history since 1975

None

Analysts

David Cooling, London
(44) 20-7176-7109
david_cooling@standardpoors.com

David T. Beers, London
(44) 20-7176-7101
david_beers@standardpoors.com

Analysis

Published on January 11, 2005

Major rating factors

Rationale

On Jan. 11, 2005, Standard & Poor's Ratings Services revised its outlook on the State of Israel to stable from negative, on improving economic and fiscal prospects. At the same time, the 'A-/A-1' foreign currency and 'A+/A-1' local currency ratings on Israel were affirmed.

The solid investment grade ratings on Israel reflect its advanced, prosperous, export-oriented economy with few balance-of-payments pressures, underpinned by structural reforms. These strengths are offset, however, by Israel's vulnerability to its complex geopolitical environment, and the comparatively weak financial position of its government.

Growth prospects continue to improve in response to the strengthening of external demand and a sharp recovery in private consumption and investment. In 2005, per capita incomes are forecast to expand by almost 2% in real terms, lifting nominal per capita incomes to $17,440, which is 27% higher than the estimated 'A' median. Exports expanded by 12% in real terms to account for 42% of GDP, reflecting improvements in the global technology sector. Consequently, the current account remains almost balanced at a deficit of 0.1% of GDP, or 0.2% of current account receipts (CARs). Export growth and a stabilization of domestic security risks have also bolstered foreign direct investment inflows, which reached an estimated 1.8% of GDP at year-end 2004.

Balance-of-payments pressures remain negligible. Net public external debt is modest, at 10% of CARs, and benefits from low interest costs relative to Israel's peers, a favorable term structure, and a dedicated overseas investor base. Israel's gross external financing requirement (current account deficit plus short-term debt, including long-term debt due within a year) is expected to remain comfortable at 132% of reserves in 2005, down from 142% as recently as 2002.

In 2004, fiscal outcomes were modestly better than those budgeted. Expenditure restraint and a stronger-than-anticipated recovery in economic growth enabled the government to meet its deficit target of 4% of GDP. Although the general government debt burden is forecast to stabilize at 108% of GDP, it will remain among

the highest of all rated sovereigns for the foreseeable future. Few material changes are expected to economic policy, despite the inclusion of the Labor (Avoda) Party in the governing coalition. Economic policy is underpinned by conditionality in the recently revised US loan guarantee program, which runs until 2008. The program sets out a clear path of fiscal consolidation and structural reforms.

Israel's small, open economy remains vulnerable to external shocks. Its complex geopolitical environment has a pervasive influence on consumer confidence and domestic demand. Furthermore, exports are concentrated in high technology sectors. Despite the flexibility of these sectors relative to other industries, this concentration leaves Israel's exports vulnerable to shifts in global demand.

Outlook

The stable outlook balances the nascent improvement in the government's finances which should be sufficient to stabilize the central government debt-to-GDP ratio in 2005 with the implementation risks stemming from fresh domestic political instability and the heightened prospect of early elections. Renewed economic growth, coupled with sustained expenditure discipline, is forecast to curb fiscal imbalances and lower the debt-to-GDP ratio in the medium term. Nevertheless, the challenges associated with the implementation of the government's fiscal consolidation and reform agenda remain considerable. Slippage in the implementation of the government's economic program could quickly result in a further period of unsustainable fiscal deficits and a rapid increase in the public debt burden, placing renewed downward pressure on the credit ratings on Israel.

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