Israel Ratings Affirmed At 'AA-/A-1+'; Outlook Stable

  • We expect Israel's economic growth will remain resilient in the face of softer global growth.
  • Despite a widening budgetary deficit in 2019, we believe that the new government will ensure net public debt remains below 60% of GDP.
  • Heightened external security risks emanating from Syria and Iran will weigh on the country's creditworthiness.
  • We are affirming our 'AA-/A-1+'ratings on Israel.
  • The outlook is stable.
RATING ACTION
On Feb. 1, 2019, S&P Global Ratings affirmed its 'AA-/A-1+' long- and 
short-term foreign and local currency sovereign credit ratings on Israel. The 
outlook is stable.

OUTLOOK
The stable outlook on Israel balances external and security risks against 
Israel's solid economic growth prospects. The outlook also factors in our view 
that Israel's net creditor position will remain about 35% of GDP over our 
forecast horizon, providing the economy with substantial buffers in the event 
of an external shock.

We could take a negative rating action if Israel's economic, 
balance-of-payments, or fiscal performance weakened markedly beyond our 
forecast, or if security risks increased substantially.

A positive rating action could stem from strong fiscal consolidation efforts 
that result in a material reduction in net general government debt or interest 
payments, or a major and unexpected improvement in the Middle East's security 
environment.

RATIONALE
The ratings are supported by Israel's prosperous and diverse economy, strong 
external balance sheet, and flexible monetary policy framework. The ratings 
are constrained by Israel's moderately high public debt burden and, in our 
view, significant security and geopolitical risks.

Institutional and Economic Profile: A wealthy economy and effective 
institutions support prudent macroeconomic policies
  • We project Israel's diversified, competitive, and resilient economy will experience average growth of about 3% over the medium term.
  • We do not expect major policy shifts after the new government is formed following the early election in April 2019.
  • High exposure to external and domestic security risks weigh on the country's creditworthiness.
Israel's economy continues to thrive and benefit from diversification, with 
high-value-added manufacturing and services sectors, especially in the 
information technology industry. The information and communication sector 
contributes over 8% of the gross value added, and scientific and technical 
activities about 3%. This is underpinned by sizable expenditures on research 
and development, exceeding 4.5% of GDP on average--the highest among member 
countries of the Organization for Economic Co-operation and Development 
(OECD).

We expect Israel's economy will expand by slightly over 3% on average through 
2022. Growth will stem from private consumption on the back of a strong labor 
market, continued corporate investment activity (not least in the hi-tech 
sector), and the robust performance of services exports. We expect growth will 
benefit from an additional boost in 2020 as a result of the large Leviathan 
gas field and Intel projects coming online, and then will moderate to 3% over 
the long term, broadly in line with labor and productivity trends. Even though 
we revised our growth forecast for 2019 to 3.2% from 3.5% owing to expected 
moderation of Israel's key trading partners' economic growth, we note that 
levels still remain elevated by OECD standards and that the projected growth 
comes on top of Israel's already vigorous economic performance. The economy 
has not faced recession in the last 15 years, and GDP in U.S. dollar terms has 
increased by over 55% since 2010, with the unemployment rate remaining at 
historical lows.

Israel's domestic political situation remains highly fragmented, resulting in 
the break-up of the existing coalition in late 2018 and a subsequent snap 
election due in April 2019. Although it is difficult to forecast the next 
government's composition, public opinion polls suggest only a modest change is 
expected, if any. Even if election outcomes trigger elevated tensions 
regarding the government's formation, and result in challenging budget 
discussions in late 2019, we note that political fragmentation in the past has 
not undermined Israel's commitment to prudent macroeconomic policies, which 
remains included in our base-case assumptions. By international comparisons 
and based on policy outcomes, we view institutional and governance structures 
in Israel as generally effective.

That said, political polarization could constrain the government's capacity to 
address longer-term structural issues in the economy and society. These 
include excessive red tape, infrastructure gaps, weak labor market 
participation and poor skills of some social groups (mainly Haredi men and 
Arab-Israeli women), and housing-related matters. We believe that domestic 
political volatility--exemplified by recent amendments to basic laws and 
proposals to reshape the Supreme Court's powers--will likely stay elevated 
over the rating horizon.

In addition, Israel is exposed to persistent geopolitical risks. The announced 
withdrawal of the U.S. forces from Syria, Israel's neighbor on the northern 
border, and the Syrian regime's consolidation of its position, could lead to 
elevated risk of open military tensions with Iran and Iranian-supported 
Hezbollah and other militant groups actively involved in Syria. Russian 
support for the Syrian regime complicates the issue further, despite Russia 
and Israel maintaining broadly cordial relations. 

Even though we expect the U.S. administration will stay committed to 
supporting Israel if regional security risks heighten, any significant armed 
conflict could adversely affect the ratings on Israel, since it would likely 
undermine business confidence and weaken economic growth potential, or could 
result in immediate budgetary pressures. 

We also note continued divergence between the U.S. and other stakeholders 
(notably the EU) with regards to the peace process with Palestinian 
authorities, especially after the U.S. moved its embassy to Jerusalem. This 
might lead to repeated outbreaks of violence in Gaza and surrounding areas, 
and could trigger a backlash from the international community.

Flexibility and Performance Profile: Fiscal performance in 2019 will weaken, 
but risk to fiscal stability is contained 
  • Past pro-cyclical fiscal decisions will likely widen fiscal deficits in 2019 to above 3% of GDP, but net public debt is likely to stay below 60% of GDP.
  • Israel's substantial net external asset position remains a key credit strength.
  • Monetary policy effectiveness is high, with real estate price dynamics posing a key challenge.
Exceptionally favorable macroeconomic conditions, one-off fiscal revenues, and 
exchange-rate appreciation have supported Israel's public finances in recent 
years. In 2015-2017, the government exceeded its deficit targets, setting 
public debt on a downward trend. Despite a strong headline performance, 
however, the underlying fiscal stance has been pro-cyclical, with a number of 
tax and expenditure measures contributing to widening structural deficits. 
With the business cycle now maturing, we expect general government deficits 
will increase somewhat in 2019 to 3.3% of GDP, resulting in a modest pick-up 
of gross public debt as a share of GDP. 

In our view, Israel's weaker headline performance does not pose risks to 
macroeconomic stability. This is because government debt is now much lower 
than in the past, having declined by over 10 percentage points in the last 10 
years to an estimated 61.1% of GDP in 2018. At the same time, given elevated 
security risks, the Israeli government might require larger fiscal buffers 
relative to similarly rated peers. In this respect, one of the challenges 
facing the new government will be to re-establish the declining trajectory of 
public debt, while at the same time keeping cost containment measures 
growth-friendly.

Although downside risks remain, especially if nominal GDP growth is weaker 
then we anticipate, our base-line scenario assumes that headline fiscal 
deficits will decline to less than 3% of GDP from 2020. We base this view on: 

  • Political consensus on containing public debt, resulting in, we assume, a reasonable degree of fiscal discipline, anchored by compliance with existing fiscal rules (i.e. the "numerator" rule) and a multiyear spending agreement with the defense ministry (the source of fiscal slippages in the past); and
  • Expected proactive fiscal consolidation measures by the new government that would accommodate new spending proposals, including those related to the recently announced goal of enhancing public infrastructure (i.e. long-term national infrastructure strategy), without compromising fiscal stability.
Accordingly, we expect net general government debt (that is, gross debt net of 
liquid government assets, mainly in the form of deposits at the Bank of Israel 
[BOI; the central bank]) will stay below 60% of GDP through our forecast 
horizon.

Strong export performance and the ongoing development of Israel's offshore 
natural gas fields, with significant export capacity, support the country's 
strong external profile. Although we expect Israel's current account 
performance will weaken somewhat due to the strength of domestic demand and 
real effective exchange rate appreciation, which will weigh on the trade 
balance, we assume that resilient high-value-added services exports will keep 
the current account in surplus. This will enhance Israel's position as a net 
creditor versus the rest of the world, with liquid external assets exceeding 
gross external debt by over 50% of current account payments. Israel's net 
external asset position is in the 15 strongest from 133 sovereigns we rate 
globally. These dynamics also contain the country's gross external financing 
needs (payments to nonresidents), indicating low dependence on external 
financing.

We consider Israel's monetary policy flexibility a credit strength. With the 
output gap closing and unemployment rate at historical lows, headline 
inflation since mid-2018 has been at the lower end of the BOI's 1%-3% target. 
This prompted the central bank to hike its policy rate last November for the 
first time since 2011. At the same time, the BOI's policy stance remains 
accommodative, not least due to the need to counter the strength of the shekel 
to maintain the competitiveness of Israel's exports. In recent years, BOI has 
also intervened in foreign exchange markets, over and above its commitment to 
purchase foreign currency to offset the impact of domestic natural gas 
production on the balance of payments. Therefore, we view the exchange rate 
regime as a managed float, which somewhat hampers monetary policy flexibility, 
in our view.

Despite some weakening of the shekel against the U.S. dollar in 2018 (driven 
in particular by higher rates in the U.S.), we expect Israel's strong 
fundamentals, namely its current account surpluses, strong net foreign direct 
investment inflows, and high GDP growth rates will likely lead to renewed 
shekel appreciation over the long term. The exchange rate will continue to 
pose pricing risk, adding to the need for continued innovation and reduction 
of regulatory pressures for local businesses to remain competitive in external 
markets.

One of the key challenges to monetary policy continues to be rising house 
prices. Real house prices have increased by over 100% since the end of 2007. 
The BOI's past attempts to dampen the housing market by raising interest rates 
delivered limited results. Thereafter, the BOI shifted focus to a series of 
macroprudential measures targeted at the mortgage market. More recently, the 
government has implemented comprehensive measures to cut speculative demand 
and increase the housing supply, including freeing up more land for 
development, changing the tendering criteria, allowing foreign presence in the 
construction market, and accelerating processes for construction permissions. 
Given capacity constraints, relatively low productivity in the construction 
industry, and continued growth in demand, addressing the supply shortage might 
take time, however.

Israeli banks' exposure to the local real estate sector, mainly to residential 
mortgage loans, has increased in recent years. We estimate the banking 
system's current exposure to loans for construction, commercial real estate, 
and mortgages at over 45% of total bank loans compared with 32% 10 years ago. 
The housing market seems to have cooled off, with real housing price growth 
slowing in 2017-2018 to below an estimated 2%, from elevated levels of 6% in 
2012-2016. At the same time, the combination of supply constraints and 
economic and population growth will continue to drive moderate house price 
appreciation, in our view. Even though the tightening of macroprudential 
measures has reduced systemic risks to Israel's banking industry, any abrupt 
correction in house prices could still weigh on the economy (for more detail 
on financial stability risks and the Israeli banking system see "Banking 
Industry Country Risk Assessment: Israel," published Nov. 26, 2018, on 
RatingsDirect).