The Moody’s credit downgrade: Economic policy change cannot wait - opinion

Over the weekend, Moody’s Investors Service announced that it had downgraded Israel’s credit rating from A1 to A2 and assigned it a “negative” credit outlook. The latter means there is a risk of additional reductions in the credit rating if the country’s security, geopolitical, and economic situation worsens, and especially if the situation on the northern border deteriorates into war. 

The decision’s direct effect is that the country’s cost of credit – the interest it has to pay on government bonds issued to finance the deficit – will increase and will also apply to the recycling of debt issued in the past. This can be expected to lead to interest-rate hikes for all credit, because the rate on government bonds serves as a marker for the entire economy. 

The higher credit cost, alongside the huge increase in the budget deficit as a result of the war, means that the funds allocated to cover interest payments on the debt will increase. If we add to this equation the expected long-term rise in defense spending, outlays on public services – healthcare, education, welfare, and investment in infrastructure – which were relatively modest even before the war, will be squeezed. The inevitable result is also a major tax increase.

The reasons for Moody’s decision focus on the war’s ramifications for the country’s security and geopolitical risks, the long-term impact on the economy and public finance, the government’s performance, the major uncertainty about the day after the war, and the lack of a government plan to deal with all the above. 

Moody’s notes that “the weakened security environment implies higher social risk and indicates weaker executive and legislative institutions than Moody’s previously assessed.” It warns further that “Israel’s public finances are deteriorating and the previously projected downward trend in the public debt ratio has now reversed.” 

Moody’s foresees that the debt burden will be substantially higher than forecast before the start of the hostilities, both due to the costs of the war (military and civilian) and because of the anticipated long-term increases in defense spending and debt repayment. 

A balance of opinions

IN ADDITION to its warning about the government’s performance and its focus on the risks, Moody’s takes favorable notice of the factors that mitigate the risks, especially the strength of Israel’s civil society and judiciary, which provide strong checks and balances, and a sound macroeconomic and monetary policy that reacts swiftly to developments. The report adds that after wars in the past, Israel conducted independent inquiries into its security failings and set up commissions to study its longer-term defense needs – important signs of transparency and disclosure. It remarks further that the economy has rebounded swiftly over the past three months, although some sectors, notably construction, which depends on foreign workers, are still sluggish.

Looking ahead, Moody’s writes that, in general, “the consequences of the conflict in Gaza for Israel’s credit profile will unfold over a long period of time.” It would change its outlook to “stable” only “if there was evidence that Israel’s institutions are able to formulate policies that support economic and public finance recovery and restore security while dealing with a wide range of policy priorities.”

In other words, only a government that acts on behalf of all the people and adjusts its priorities to support economic recovery, while dealing with the security and social challenges, will make it possible for Israel to make it to the other side of the severe crisis we are all experiencing now. Only by fully taking advantage of the strengths of society and the economy can the country prosper once again.

Our policymakers would be well advised to study the risk analysis and assessment in Moody’s report closely and to take all possible steps to mitigate the risks. A key first step in this direction would be to establish a commission tasked with developing recommendations for a long-term defense budget, based on a post-October 7 security conception and a broad socioeconomic perspective. 

The state of Israel cannot afford to wait to make concrete economic policy changes. This obligation applies to the current government and to its successors. 

The writer is vice president for research at the Israel Democracy Institute and a former governor of the Bank of Israel.