The IDF has switched from defense to attack. This will be a war that entails military and civilian expenditure the likes of which we have not seen since the Yom Kippur War. The goal of destroying the military and governing capacity of Hamas requires a massive military effort. The need to fight in the extensive and convoluted system of tunnels that Hamas has built over a decade means a long war, and the longer it goes on, the greater will be the economic damage.
Our recent wars have involved the home front as well. The residents of the Western Negev were hard hit by the murderous assault of October 7, and, together with the rocket fire at other places, the damage was estimated at NIS 5-6 billion in the first week alone: houses destroyed, vehicles burnt, factories and installations out of action, and unharvested crops.
The war has caused the most extensive ever evacuation of settlements in Israel, in the south and in the north. Some 125,000 people have been displaced. Rehabilitation of the settlements in the Negev will require rebuilding of houses, production facilities, and infrastructure, to the tune of NIS 3-4 billion, in order for existing residents to return and new ones to be absorbed.
The economy, however, is a secondary problem. It will take time, but if we deal with the security problem, the economy will sort itself out - Israel has been through such crises before. That is on the assumption that the approach is responsible and not spendthrift. This is where I feel concern.
I don’t know, for example, what the economic implications are of extending the area entitled to compensation to up to 40 kilometers from the Gaza Strip. If it amounts to NIS 1 billion and calms the population there, then it may be that the cost is worthwhile.
The problem is that I don’t trust Minister of Finance Bezalel Smotrich. Disputes between the minister and the Budgets Division are practically normal. It has always been that way. The assumption has been that the minister has political considerations, but is still on the same page as the ministry professionals.
It seems that Smotrich has his own dreams and his own agenda. This means that the following forecast depends on a return to talking about the economy, and talking much less about politics and ideology.
The minister of finance must listen much more to his professional staff, and to the Bank of Israel. This applies not just vis-à-vis the Budgets Division, which is supposedly the most miserly. The minister has an economic adviser called the Bank of Israel, and its view is very clear. The business sector too, while it has its interests, still talks sensibly. He should listen to it.
At the moment, the Bank of Israel is fulfilling its function as the central bank, dealing with exchange rates, the capital market, and monetary policy, and I haven’t heard it speak in a strong voice as an economic adviser. It would be good if it were to become more involved in that respect.
Good opening position
Israel’s opening economic position in this war was good, even though economic trends before the war deteriorated because of the judicial overhaul proposals. Foreign currency reserves were high, the balance of payments was good, and the fiscal deficit for 2023 was expected to be under 2% of GDP.
The Ministry of Finance should not be complacent about this opening position, given the challenges facing the economy, but it should be generous in the right places.
Three weeks of the defensive posture cost NIS 8 billion in pay for some 360,000 military reservists, keeping them fed and watered, and equipment and weapons procurement (excluding munitions for the Air Force, paid for out of US military aid). The government’s extra civilian expenditure was about NIS 4 billion, including housing for 125,000 evacuees, compensation payments and arrangements for those harmed financially, and special expenditure on health, welfare, and education.
In November and December 2023, the fighting and the mobilization of the reserves will continue, and I estimate that the military cost will be another NIS 20 billion, and that the civilian cost, which has run into management and operational difficulties, will be another NIS 13 billion.
This means that government spending between October 7 and December 31 will grow by some NIS 45 billion.
Assuming that the government diverts about NIS 12 billion to financing this expenditure form existing budgets (including coalition party allocations), and that the damage to state revenues will be about NIS 10 billion, then the fiscal deficit will grow by about NIS 42 billion, 2% of GDP, bringing it to 3.5% of GDP, without any military operations in the north.
Government debt will be reasonable, and will amount to about 63% of GDP by the end of 2023. Financing the deficit will increase the debt servicing burden further, because of the high interest rates in Israel and abroad.
The budget for 2024 will have to go back to the drawing board, since it is irrelevant to the new reality. Military and civilian spending will grow further, and will challenge the budget and the economy.
Financing of the deficit must first of all come from diverting budgets from less vital items to the needs of the war and its civilian consequences. Distortions caused by coalition pressures, the contribution of which to the economy and society is minimal, and even negative, will have to be fixed. A temporary rise in the fiscal deficit and in government debt is unavoidable.
The main way of financing the war is through issues of government bonds, since the availability of finance on overseas debt markets has been impaired.
In my view, because of both short-term and medium-term considerations, the fiscal deficit for 2024 should be set at no more than 5% of GDP, or 7% if the northern front becomes active. Government debt will then be 66-68% of GDP, and the deficit will be between NIS 100 billion and NIS 140 billion. This takes into account a reduction in tax receipts, and assumes that Air Force munitions will continue to be supplied from US aid and will be external to the budget.
The labor market and GDP
Mobilization of the reserves, amounting to about 8% of the workforce, mainly men aged 21-45, harms GDP. The construction industry is the main victim, since Palestinian workers are not being allowed in, foreign workers have left, and Israeli Arabs fear to go out to work. For similar reasons, there is a shortage of manpower in agriculture.
Supply chains and logistics have been disrupted by the mobilization of drivers and warehousemen, and in service sectors the number of layoffs will grow. The decision that entitlement to unemployment benefit for unpaid leave will not be as it was during the Covid pandemic, but will be partial, is important.
In the fourth quarter, GDP will shrink by 5%, as a result of the decline in activity in some industries, and the switch of civilian product to military product. Instead of forecast annual GDP growth of 3%, GDP will rise by about 2%.
Mobilization of the reserves for an extended period in 2024 will cause a loss of industrial manpower, and a full outbreak of war in the north will entail further, prolonged mobilization, and additional costs, and will lead to greater harm to the economy.
A continuation of the fighting, at low intensity, and continued mobilization of the reserves, will affect growth in 2024, forecast at 1.5%, while the unemployment rate will reach 5%. Military expenditure will have an impact in 2025-2027 as well.
To the extent that fiscal and monetary policy work correctly in a coordinated way, they will have a beneficial effect on growth and inflation.
Given the Bank of Israel’s $200 billion in foreign currency reserves, and the governor of the bank’s declaration that $30 billion will be used to stabilize the currency, the shekel-dollar exchange rate will not go significantly higher than NIS 4/$.
Inflation in 2024 will be in the range of 4-5%.
David Brodet was budgets commissioner in the Ministry of Finance from 1991 to 1994, and director general of the ministry from 1995 to 1997. He has served as chairperson at several Israel companies, among them Bank Leumi (2010-2019) and El Al (2020-2021).
Published by Globes, Israel business news - en.globes.co.il - on November 8, 2023.
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