Israel’s economy is paying a high price for the expanding war

In late September, as Israel’s nearly year-long war deepened and its credit rating was downgraded again, the country’s Finance Minister Bezalel Smotrich said that while Israel’s economy was under pressure, it was resilient.

“Israel’s economy is bearing the brunt of the longest and costliest war in the country’s history,” Smotrich said on Sept. 28, a day after Israeli airstrikes killed Hezbollah leader Hassan Nasrallah in the Lebanese capital, Beirut, heightening fears that tensions with the militant group would ease. into a full-blown conflict. “The Israeli economy is a strong economy that attracts investment even today.”

Nearly a year after Hamas’ deadly Oct. 7 attack, Israel is advancing on multiple fronts: launching a ground invasion of Hezbollah in Lebanon, launching airstrikes in Gaza and Beirut, and threatening retaliation for an Iranian ballistic missile attack earlier this week. As the conflict spreads across the wider region, economic costs will also spiral upwards, both for Israel and other Middle Eastern countries.

“If the recent escalation escalates into a longer and more intense war, it will have a greater toll on economic activity and growth (in Israel),” Karnit Flug, former governor of Israel’s central bank, told CNN on October 1.

The war has significantly worsened the situation in Gaza, long ago plunging it into an economic and humanitarian crisis, and the West Bank is “undergoing rapid and alarming economic decline,” the United Nations said in a report last month.

Meanwhile, according to BMI, a market research firm owned by Fitch Solutions, the Lebanese economy could shrink by up to 5% this year due to cross-border attacks between Hezbollah and Israel.

According to the worst estimates of the Institute for National Security Studies at Tel Aviv University, Israel’s economy may shrink even further.

Even under a more benign scenario, researchers also predict that Israel’s gross domestic product per capita – which has surpassed Britain’s in recent years – will decline this year as Israel’s population grows faster than the economy and living standards decline.

Before the October 7 attack and the subsequent war between Israel and Hamas, the International Monetary Fund projected that Israel’s economy would grow by an enviable 3.4% this year. Currently, economists’ forecasts range from 1% to 1.9%. Growth next year is also expected to be weaker than earlier forecasts.

But Israel’s central bank has been unable to cut interest rates to breathe life into the economy as inflation accelerates, fueled by rising wages and rising government spending to finance the war.

“Long-term” economic damage

The Bank of Israel estimated in May that war costs would total 250 billion shekels ($66 billion) by the end of next year, including military spending and civilian spending such as housing for thousands of Israelis forced to flee their homes north and south. This equates to approximately 12% of Israel’s GDP.

These costs look set to rise even further as fierce fighting with Iran and its proxies, including Hezbollah in Lebanon, adds to the government’s defense bill and delays the return of Israelis to their homes in the north of the country. On September 30, Israel launched a ground invasion of southern Lebanon, targeting Hezbollah.

Finance Minister Smotrich is confident that the Israeli economy will recover once the war ends, but economists fear the damage will outlast the conflict.

Flug, a former governor of the Bank of Israel and now vice president of research at the Israel Democracy Institute, says there is a risk that the Israeli government will cut investment to free up resources for defense. “This will limit the potential growth (of the economy) in the future,” she said.

Researchers at the Institute for National Security Studies are similarly pessimistic.

Even a withdrawal from Gaza and calm on the border with Lebanon would leave the Israeli economy in a weaker position than before the war, they said in an August report. “Israel is expected to suffer long-term economic damage regardless of the outcome,” they wrote.

“The projected decline in growth rates in all scenarios compared with pre-war economic forecasts and the increase in defense spending could increase the risk of a recession reminiscent of the lost decade after the Yom Kippur War.”

The 1973 war, also known as the Arab-Israeli War, launched by Egypt and Syria against Israeli forces in the Sinai Peninsula and Golan Heights, ushered in a long period of economic stagnation in Israel, in part due to the country’s massive increase in defense spending.

Similarly, potential tax increases and cuts in non-defense spending – some already discussed by Smotrich – to finance what many believe will become a permanently enlarged military could hurt economic growth. Such measures, combined with a weakened sense of security, could also trigger an exodus of highly educated Israelis, especially tech entrepreneurs, Flug warned.

“These don’t have to be very large numbers, because the technology sector is highly dependent on several thousand of the most innovative, creative and enterprising people,” she said of the sector that accounts for a whopping 20% ​​of Israel’s economic growth output.

The large-scale departure of high-earning taxpayers has further damaged Israel’s finances, which have suffered from the effects of the war. The government is delaying the publication of next year’s budget as it grapples with competing demands that make it difficult to balance its books.

The conflict caused Israel’s budget deficit – the difference between government spending and revenues, mostly from taxes – to double to 8% of GDP, from 4% before the war.

Government debt has skyrocketed and become more expensive as investors demand higher returns on purchasing Israeli bonds and other assets. Multiple downgrades of Israel’s credit ratings by Fitch, Moody’s and S&P will likely further raise the country’s borrowing costs.

In late August – a month before Israel carried out attacks on the Lebanese capital and a ground attack on Hezbollah in the south of the country – the Institute for National Security Studies estimated that just one month of “high-intensity war” in Lebanon against the militant group, with “intense attacks ” in the opposite direction, which destroys Israeli infrastructure, could cause Israel’s budget deficit to skyrocket to 15% and reduce its GDP by as much as 10% this year.

Uncertainty ‘biggest factor’

To reduce the fiscal hole, the government cannot rely on a healthy flow of tax revenue from businesses, many of which are failing and others reluctant to invest, although it is unclear how long the war will last.

Coface BDi, a major Israeli business intelligence firm, estimates that 60,000 Israeli companies will close this year, compared with an annual average of about 40,000. Most of them are small companies with up to five employees.

“Uncertainty is just bad for the economy and bad for investment,” said Avi Hasson, CEO of Startup Nation Central, a nonprofit that promotes the Israeli tech industry around the world.

In a recent report, Hasson warned that the extraordinary resilience of Israel’s tech sector so far “will not be sustainable” in the face of uncertainty caused by the prolonged conflict and the government’s “disruptive” economic policies.

Even before the October 7 attack, government plans to weaken the judiciary prompted some Israeli technology companies to incorporate in the United States. War-induced insecurity has exacerbated this trend: Most new technology companies are formally incorporated abroad despite tax incentives to start companies locally, and a large number are considering moving some of their operations outside Israel, Hasson told CNN last month.

He remains bullish on Israeli technology, pointing to solid fundraising, but warns that the industry’s future development “depends on regional stability and responsible government policies.”

Other sectors of the Israeli economy, although less important than technology, have been hit much harder. The agriculture and construction sectors are struggling to fill the gaps left by Palestinians whose work permits have been suspended since October last year, causing prices of fresh vegetables to rise and housing construction to plummet.

Tourism has also suffered, with arrivals plummeting this year. Israel’s tourism ministry has estimated that the decline in foreign tourists has translated into a loss of 18.7 billion shekels ($4.9 billion) in revenue since the start of the war.

Norman, a boutique hotel in Tel Aviv, has had to lay off some staff and cut prices by up to 25%, in part because some properties – including its rooftop Japanese restaurant – remain closed to save costs.

According to the hotel’s general manager, Yaron Liberman, occupancy has dropped from more than 80% before the war to less than 50% today.

“We know that the day the war ends, it’s going to be crazy for business to come back here,” he told CNN in mid-September, citing correspondence from potential visitors who would like to visit Israel but can’t book a flight or provide security. travel insurance.

But for now, “the biggest factor is uncertainty,” Liberman said. “When will the war end?”

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