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IF Insights: Israel feels ‘Gaza Pinch’ as its economy struggles

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Israel nearly collapsed in 1973 due to the cost of armaments and drafting 200,000 army reservists for Yom Kippur

Only a month after the Hamas attack, Israel’s economy has already begun to feel the economic costs of war. Their central bank sold USD 30 billion of foreign exchange reserves to support the shekel after it fell to its lowest level versus the dollar in almost a decade.

Credit rating agency Standard & Poor’s (S&P) now sees Israel’s economy contracting some further, as the Gaza conflict shows no signs of settling down.

S&P, which affirmed Israel’s rating at AA-, the fourth-highest score, cites lower business activity, depressed demand from consumers, and a very uncertain investment environment, as well as the massive call-up of reservists, as reasons for the downturn.

S&P analysts Maxim Rybnikov and Karen Vartapetov also see Israel’s average budget deficit rising to 5.3% of GDP in 2023 and 2024, due to a wartime increase in fiscal expenditure to support households and businesses and an increase in defense spending. That is more than twice the S&P’s previous forecast of 2.3% of GDP.

The ratings agency also predicted that Israel’s economy will expand by only 1.5% in 2023 and 0.5% in 2024, followed by faster growth of 5% in 2025 as consumer confidence returns and reconstruction and the investment cycle kick in more fully.

The Bank of Israel’s research department also assessed a grim picture by the end of October 2023, as it foresaw the costs of the war leading to an increase in Benjamin Netanyahu’s government deficit to about 2.3% of GDP in 2023, from 1% forecasted previously, and to about 3.5% in 2024. The central bank now expects the economy to grow by 2.3% in 2023 and by 2.8% in 2024, as private consumption falls and the ability to work is constrained.

S&P reiterated that the negative outlook reflects the risk that the “Israel-Hamas war could spread more widely or affect Israel’s credit metrics more negatively than we expect.”

To ensure the Israeli economy’s return to a stable rating outlook, S&P has laid out the pre-requisite of “reduction in regional and domestic security risks without a material longer-term toll on Israel’s economy and public finances.”

The cost of default insurance has skyrocketed, and construction and restaurant firms have closed. On October 19, the finance ministry announced intentions to increase defence spending and help unemployed citizens. Four days later, the central bank lowered its annual growth prediction from 3% to 2.3%.

Since military and economic forces fight the war against Hamas in Gaza, an essential concern arises. Can Israel handle the economic pain of a protracted armed conflict? The country’s conflicts since leaving Gaza in 2005 have been expensive, to say the least.

Military and infrastructure repairs cost billions of shekels—a considerable chunk of their GDP. The country has one of the highest per-person incomes in the Middle East, therefore, the conflicts did not seem like a threat initially.

Thus, Hamas’s October 7 attacks and inevitable battle are sending economists to the history books. Israel nearly collapsed in 1973 due to the cost of armaments and drafting 200,000 army reservists for Yom Kippur. The central bank estimates that a year of intifada (Palestinian uprisings from the late 1980s to the 2000s) cost 3.8% of GDP in 2002.

As per Israeli officials, three major challenges await the Israeli economy. The first is employment. Workers are scarce due to the economy and conflict. Since October 7, the military has mobilized about 360,000 reservists, or 8% of the workforce, higher than in 1973. Most jobs have been abandoned, leaving a huge economic gap as the reservist forces are Israel’s most productive workers.

Start-Up Nation, an Israeli NGO, estimates that 10% of tech workers have been called up. Industry workers are 25% more productive than the OECD average of predominantly developed countries. The rest of the economy workers are two-fifths less productive. Few reservists are from ultra-Orthodox communities that refuse work.

There is another reason for labour shortages. About 200,000 West Bank Palestinians work in Israel or its settlements in low-skilled occupations. Unrest in the West Bank prevents many workers from crossing the border, and even if they do, they might unionize and strike. The IMF said absent Palestinian labour slowed the Israeli economy during the second Palestinian intifada, which lasted from 2000 to 2005.

Due to Israel’s restricted labour market, reservists and Palestinians have few replacements. Unemployment is 3.2%, according to the central bank, which has raised interest rates to calm the economy for months.

Firms may only hire temporary military replacements due to strict labour restrictions, which is unattractive. Investors fear cash will leave “Silicon Wadi” for California. According to Start-Up Nation, 70% of tech companies were already failing. After the conflict, there may be fewer jobs.

Moreover, policymakers face the collapse of private consumption. Staying home has impacted consumption habits due to uncertainty and fear of a protracted war or a second front opening with Lebanon or Iran. For nearly three weeks restaurants and malls have been without customers. Those with workers to open found few customers.

Tourism, Israel’s primary industry after IT, has halted. The border towns with Gaza and Lebanon have been cleared, halting commercial activity. All war-affected firms except the largest will receive covid-style grants for fixed costs. VAT payments were delayed. Workers who work in dangerous environments have been promised benefits. These are all expenses draining the zionist exchequer.

The final difficulty for Israeli officials is controlling the conflict’s monetary costs. Restoring companies, paying reservists, and sheltering towns in hotels will be costly. A substantial boost in defence funding is needed to fund a ground invasion this year and arm Israel for next year.

Israel’s debt is 60% of GDP, a very low percentage for an affluent nation. It is expected to grow to 62% even if the war continues until the end of the year. The central bank has USD 170 billion in forex reserves.

Additionally, if Congress approves President Joe Biden’s USD 14 billion military aid request, America will assist. However, uncertainty increases over time as the conflict could expand to a regional war if unchecked. The primary deficit in Israel is expected to rise from 3% to 8% in 2024.

The economy was struggling before Hamas’s attack, as after a rough first eight months, government revenue fell 8% in September. The revenue base is shrinking and borrowing costs are rising. More destruction and expensive reconstruction will result from a longer war.

Now Or Never

A chorus of local politicians says that a ground invasion of Gaza should be brief and effective since the government cannot pay its way forever. There is also the question of waning international support for the Israeli cause after gruesome reports and images of civilian casualties flood the internet.

In the next few months, individuals and enterprises will receive considerable financial aid, but fighting is eroding Israel’s labour, capital, knowledge, and support from the international community faster than it can be replaced.

Other economies may have endured much worse damage in pursuit of military victories, but Israel cannot afford to be too weak among too many hostile neighbours and no reliable regional partners.

Though war is profitable for the military-industrial complex, it remains more expensive than ever for the global economy.

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