Current events in Israel create a dissonance for the international rating agencies. On the one hand, Israel’s macro numbers for 2022 look terrific. On the other hand, the world is following the moves to reform Israel’s judicial system with concern, and the talk is of a possible downgrade of Israel’s sovereign credit rating.
The sovereign credit rating is an assessment of the risk that a country might not repay its debts. How do the rating agencies arrive at that assessment? Can matters relating to the country’s legal system be given a high weighting?
The simple answer is that the rating looks to the future. Outwardly, the Israeli government’s reforms look as though they could deter investors and might adversely affect the country’s rating. The full answer, however, is complicated. How complicated? Former senior officials in the Accountant General Department in the Ministry of Finance say there will be no effect, but a review by Moody’s seems to indicate otherwise.
The people who understand the sovereign rating in all its complexity are those who serve in the Accountant General Department. Being responsible for managing the country’s debt, they are the people to whom the credit rating agencies address their enquires and comments before making a rating announcement. We talked to several former senior officials in the Accountant General Department and asked them whether Israel’s rating was in any real danger. Most of them sought to be reassuring, and gave as their assessment that the rating would remain stable in the short term, but they expressed various fears about the shock waves from the legal upheaval.
The only one who agreed to be interviewed for attribution was former Accountant General Yaron Zelekha. Zelekha, currently director of accountancy studies at Ono Academic College, expressed guarded support for the changes to the judicial system, and said, "Professionally speaking, there are no grounds for downgrading the rating."
Zelekha explained how the rating agencies examine us. "There are two ratings for government debt, one for debt in local currency, and the other for debt in foreign currency. Israel’s local debt burden is very low, and the state budget for last year was balanced. I hear that the government plans a responsible budget for 2023-2024, and does not plan to allocate funding for all the coalition agreements that were signed. So as far as local currency debt is concerned, the risk is very low.
"The foreign currency debt rests on three points, in rising order of importance. The first is the scheduling of the debt, and for Israel the schedule is very comfortable. The second is the foreign exchange reserves held by the Bank of Israel, which are high, even too high. And the most decisive point, which is the balance of payments. In the past few years, the surplus of exports over imports has been so large, that the risk of default on foreign currency debt is slight."
Zelekha cites examples from around the world to illustrate why the fear is unjustified. "If there was a connection between legal reforms and a country’s credit rating, then the ratings of Kuwait and Qatar would be low, and we would have seen a decline in Hong Kong after China trampled democracy there."
Poland’s economy also grew until the changes in the regime that led to a downgrade of its credit rating.
"We are not where Poland was, and there too the credit rating has been stable in the past few years. I also hear comparisons with Hungary, but there the hit to the credit rating was because of bad economic policy. The bottom line is that there are no fears for Israel’s credit rating."
Then why has S&P chosen to comment on the matter publicly?
"The agencies see themselves as having a say, and they express their opinions on whether the moves are good for the economy. They monitor the economy continually, and seek further details from the professionals. At the moment there’s a storm raging, and they will certainly approach the Accountant General and schedule a meeting with him. They may also ask for a meeting with the governor of the Bank of Israel, the minister of finance, and perhaps even with the prime minister. And they will probably receive responses to the effect that the reform has nothing to do with property rights, the law of contract, or damage to democracy."
"The talk creates a new situation in the markets"
Other former senior Accountant General Department officials with whom we spoke were not as optimistic as Zelekha, but agreed that Israel’s sovereign rating could be expected to remain stable in the foreseeable future. "The rating agencies work slowly," one of them explained, but added, "The capital market works much faster, and that’s where our problem lies."
One source, who was involved in talks with the rating agencies in the past, believes that they do not go into minute detail in examining changes in the legal system. S&P’s rating outlook for Israel has been "Stable" for years, and the process of changing the outlook takes months. On the other hand, "The talk itself creates a new situation on the markets, which respond quickly," the source said.
The market that reacts fastest to deterioration in the financial stability of the country or in the independence of its institutions is the foreign exchange market. In general, it is difficult to determine the cause of volatility on that market, but the source believes that the weakness in the shekel in the past few days against the dollar and the euro stems directly from investors’ fears.
"The changes in the exchange rate stem from the discourse about the changes in the legal system. At the beginning of the month, the shekel-dollar exchange rate reached NIS 3.5, and the shekel strengthened until the end of last week. Since then, there has been a sharp weakening, and there is no other reason.
"Israel’s risk spreads have already widened on the markets," the source added. "World markets have seen positive performance since the beginning of the year, and in Israel the indices are negative. Had the government said, ‘We’re ready to open it up to discussion’, that might have calmed investors and the rating agencies."
The agencies think otherwise
Immediately after the results of Israel’s election in November became known, international rating agency Moody’s warned of the consequences of comprehensive legal reform for Israel’s credit rating.
In response to an enquiry, Moody’s referred "Globes" to an analysis for investors in Israeli government debt that it published on November 3, even before the coalition was formed, in which it stated that election promises by the Religious Zionism party concerning the legal system were liable to have a negative impact on Israel’s credit rating. Moody’s specifically mentioned the promise to weaken the ability of the Supreme Court to strike down laws, and stated that implementation of these changes would be a clear negative factor in assessing the strength of institutions and governance in Israel, which up to now has been a positive factor in the country’s credit rating.
The warning about the negative impact of radical change in the legal system was part of a comprehensive review in which Moody’s analysts wrote that because of the make-up of the large coalition majority for Prime Minister Benjamin Netanyahu, the incoming coalition could be expected to be more united and more stable than the outgoing one. They added that Israel’s economy had demonstrated immunity to political developments in the past.
In a further review, published on November 24, Moody’s affirmed Israel’s A1 rating. In presenting its methodology for determining a sovereign rating it lists "Institutions and Governance Strength", in which the sub-criterion "Strength of Civil Society and the Judiciary" has a 20% weighting. "Institutions and Governance Strength" is one of four factors, the others being "Economic Strength", "Fiscal Strength", and Susceptibility to Event Risk".
There are only three global credit rating agencies: Moody’s, S&P, and Fitch. In an interview with Reuters two weeks ago, S&P analyst Maxim Rybnikov said, ""If the announced judicial system changes set a trend for a weakening of Israel's institutional arrangements and existing checks and balances this could in the future present downside risks to the ratings. But we are not there yet."
Published by Globes, Israel business news - en.globes.co.il - on January 31, 2023.
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