In two weeks’ time, international credit rating agency Moody’s is due to announce whether it has decided to downgrade its rating for the State of Israel or leave it at its current level of A1.
In normal times, the rating agencies publish their decisions twice a year on preset dates. Moody’s was due to publish a rating decision for Israel three months ago. At that time, the Ministry of Finance was only concerned about a possible downgrade of the rating outlook, because of the government’s judicial overhaul program, but then, just days before Moody’s was meant to release its decision, war broke out.
Moody’s decided to postpone its decision and wait until the picture became clearer. At the same time, the agency put Israel on "negative watch", a process at the end of which it will be decided whether to cut its rating to A2. Rival rating agencies Fitch and S&P also announced that they were examining a rating downgrade for Israel. The Moody’s review is close to being completed, after a series of meetings held by the firm’s analysts with senior officials at the Ministry of Finance and the Bank of Israel last week.
In Moody’s methodology, a sovereign rating has four components. The first is economic strength, in which Israel stands out, according to the special report that Moody’s published at the beginning of the war. By this measure alone, Israel’s rating should have jumped at one go to AA3, promoting it to the same league as Hong Kong, Britain, and Qatar.
Israel’s rating has, however, come under downward pressure from the second component in the formula: institutions and governance strength, which is two ratings lower than the economic strength rating. The third component is fiscal strength, while the fourth and last is the great unknown: susceptibility to event risk, which will be directly affected by the war.
What is Moody’s concerned about?
Moody’s is well aware of Israel’s proven ability to recover economically from shocks fairly quickly. The firm stated at the beginning of the war that the greatest risk to Israel’s rating was significant escalation of the military conflict or its expansion beyond Israel’s borders. Three and a half months into the war, the nightmare scenario of a general conflagration in the Middle East has not materialized.
Another risk that Moody’s stressed at the beginning of the war as a potential reason for downgrading was that it might come to the conclusion that the military confrontation was liable to weaken Israel’s institutions materially, particularly the effectiveness of its policy making. In other words, Moody’s was concerned about fiscal indiscipline following the war, such as characterized Israel after the Yom Kippur War.
Here, Israel has a certain difficulty. Beyond the NIS 220 billion "hump", as Governor of the Bank of Israel Amir Yaron calls the one-time cost of the war, there is uncertainty over a permanent increase of NIS 15-20 billion in annual defense spending in the coming years. Prime Minister Benjamin Netanyahu talks of linking defense spending to GDP, and Moody’s is concerned about the burden this will place on the country’s financial flexibility.
The Israeli officials with whom Moody’s spoke recently tried to show that the exceptional expenditure on defense had fiscal backing. The hope is that the measures approved by the government last week in the revised 2024 state budget, such as adjustments amounting to NIS 16 billion in 2024, a 1% rise in the rate of VAT from 2025, and a mileage tax on electric vehicles from 2026, will satisfy the rating agency.
If Moody’s is convinced that what was approved by the government is what will actually happen, there is a good chance that the threat to Israel’s rating will be removed. But here we return to the problem of institutions and governance strength. Of all the rating agencies, Moody’s was the most stridently critical of the government in its stance on the judicial overhaul. The agency is familiar with Israeli politics, and understands that not every economic measure agreed in the government translates into action on the ground, particularly those planned for future years.
How will a rating cut affect Israel’s ability to raise debt?
Leader Capital Markets chief economist Yonatan Katz seeks to be reassuring. "It’s important to say that we know that, in practice, the rating has already fallen, if we look at Israel’s pricing in the market," he explains. "We see this in the yields on Israeli bonds internationally, and even in the local market. We see Israel’s spread at 30 basis points greater than on US government bonds. This is something we haven’t seen for a very long time. That is to say, the market is actually already pricing in a rating downgrade, so the rating announcement is not really a drama."
Katz believes that a downgrade will have only a short-term effect on market indices. "We’ll probably see a moderate change, but not, I think, anything significant or prolonged."
If the market is already pricing in a rating downgrade, what difference does it make if the rating falls or remains where it is?
"That really is a good question. The credit rating does, however, attract media attention and make headlines. It’s an official analysis showing that our situation is not as good as it was. But on the whole, in my view, its significance is very minor," Katz says.
Ironically enough, it could be that Israel only has something to gain from the event. If the rating falls, the effect will be small. If it doesn’t fall, the positive effect will be felt. Katz: "Because the market is already pricing in a rating downgrade, that would be a surprise, and we might see the shekel strengthening a little."
How will the public be affected?
Issuing government bonds is the main way in which the state finances its debts. The level of interest rates that the Ministry of Finance pays is especially significant at a time like this, when the government has large unplanned expenditure. And when Israel’s debt becomes more expensive to service, everyone feels it in their pocket.
"We all have pension funds, advanced training funds, and sometimes mutual funds as well," explains David Reznik. senior fixed income analyst at Bank Leumi. "When the price of Israel’s debt rises, it means that the price of the bonds falls, because there’s an inverse relationship between yield and price. So if, for example, we look at the performance of our advanced training fund in October, we will probably see a decline. Whether it’s a moderate decline or a steep one, in almost every investment track there’s investment in government debt, and there’s a direct effect on these holdings, which decline."
Published by Globes, Israel business news - en.globes.co.il - on January 22, 2024.
© Copyright of Globes Publisher Itonut (1983) Ltd., 2024.