Iran-Israel conflict: Will S&P credit rating drop harm Israel's economy?

In an unscheduled revision, ratings company on Thursday, cutting the long-term score from AA- to A+ after Israel’s confrontation with Iran escalated last week. A rating was expected from S&P next month, and this deviation from schedule was allowed due to the significant increase in geopolitical and security risk in Israel and its impact on Israel’s risk profile, the company said.

This rating cut follows Fitch Ratings’ April decision to leave Israel’s A+ rating and remove a negative watch while adding a negative outlook and Moody’s February downgrade of Israel’s score.

The updated credit score, along with the other recent ratings, has the potential to impact Israel’s economy in a number of ways. A country’s credit rating, or sovereign credit rating, is a score given to a country based on how the rating company perceives its ability to pay back its debt.

How can the update impact Israel's economy?

This rating can give investors an idea of the risk involved in investing in a particular country (such as buying a country’s bonds). In determining the rating, companies will assess a number of factors impacting a country’s economy as well as anticipated future events.

The rating drop signals to investors that investing in Israeli bonds is more risky. This means that Israel may need to offer a higher interest rate on them to compensate investors for taking the risk. This could make Israel’s debt more expensive for the country, as it would need to pay more for the money it borrows.

The effects of the war on Israel's economy

The Israel-Hamas war has led to a doubling of the country’s borrowing, the Finance Ministry said last week. Israel raised 160 billion shekels ($43 billion) in debt in 2023 – half of it, 81 billion shekels, since the outbreak of the war in October, according to the ministry.The total debt amounted to 62.1% of the gross domestic product in 2023, up from 60.5% in 2022 due to the spike in war spending, and it is expected to reach 67% in 2024.

GOING FORWARD, the debt raised may be more expensive given the rating drop and in the context of the other recent ratings.

An additional and possibly significant impact of the rating drop is the signal it sends that things could get worse before they get better. Not only did Israel’s current rating go down, but in its assessment, the company made clear that Israel’s rating could drop further if the conflict in which Israel is currently involved escalates, expands to regional instability, or has a significant impact on the country’s economic parameters.

The rating was based on the assumption that there would not be a wider regional conflict and that if such a conflict were to occur, Israel’s rating could be downgraded again.

This sends a message to those considering investing in Israel that things could get worse, leaving investors reluctant to put their money in the country, either because the risk seems too great or because they prefer to wait and see how risk parameters develop before buying Israeli bonds.

This negative statement about the present and future could possibly also serve as a signal to those investing in Israel’s private sector that Israel is not a stable place to do business – not only with its government but more generally.

The rating could also potentially influence the Bank of Israel’s decision on whether to change its interest rate. One of the roles of Israel’s central bank is to maintain stability in Israel’s financial markets. This goal could take on more weight in the bank’s monetary decision-making as the rating drop signals instability, leading the BOI to signal stability by leaving the interest rate unchanged, IBI Investment head economist Rafael Gozlan explained to TheMarker.

The BOI interest rate is the center of the range between the rate at which the bank lends and the rate at which the bank borrows money from Israel’s commercial banks, and this rate impacts those that the banks then offer to customers. When the BOI interest rate increases, the prime rate also increases. Many other interest rates are determined by the rate or are directly tied to it.

Israel’s access to capital markets and its ability to raise capital, while always important, may become much more significant as the costs of the Israel-Hamas war force the country to increase its defense budget, care for those impacted, and rebuild critical infrastructure.

This rating, alongside the negative signals of the other rating companies, may begin to impact this access beyond simply driving up the cost of Israel’s debt if investors decide that the risk is too great. While Israel’s ratings are still far above the lower bar for what is considered “investment grade,” meaning investments in Israel are still considered to have a relatively low risk of default, this rating is a step in the wrong direction.

S&P said that Israel’s outlook will be upgraded back to “stable” if the company sees a decrease in the risk of military escalation and moderation in the broad security risk it currently identifies.

Reuters contributed to this report.