Israeli economy still strong (for now) despite huge Gaza war costs

A ballooning budget, a widening deficit, rising inflation, a falling currency, and a ratings agency downgrade have given some cause for concern, yet the fundamentals remain sturdy.

Economists says the impact of war is expected to grow in the second half of 2024.
Economists says the impact of war is expected to grow in the second half of 2024.

Israeli economy still strong (for now) despite huge Gaza war costs

While Gaza has been taking a deadly pounding for almost eight months, Israel’s economic and financial health has not, despite the war costing billions and the military’s budget doubling. Although Israel’s standing has been hit politically and diplomatically, its reserves are still high, and trade is still booming—especially in the profitable tech sector. The costly boycott and divestment that Israel’s actions might have triggered has not materialised.

On the other side of the Gaza fence, life is very different. Israel has killed tens of thousands, destroyed and damaged homes and infrastructure, and more than a million people are homeless and desperate. Unfazed, Israel is bedding in for a longer campaign, with national security adviser Tzachi Hanegbi estimating that the war would last until at least the end of the year.

Israel’s finance ministry recently said the budget deficit for the past 12 months had widened to 7.2% of gross domestic product (GDP), up from 6.9% a month earlier. For 2024, the total deficit is expected to be $33bn, peaking in September. Some now ask whether the Middle East’s most advanced economy can escape full exposure. Israel’s tech sector, for instance, relies on dealing with an international community increasingly opposed to what is happening in Gaza.

Read more: Is the war in Gaza turning Israel into a pariah state?

Economic endurance

According to Ryan Bohl, senior Middle East and North Africa analyst at business risk consultant RANE, Israel “continues to have ample reserves and a strong debt position that allows it to weather several more months of war.” Israel’s foreign currency reserves topped $200bn for the first time in 2021 and have remained high throughout the conflict, in part because the White House gave $14.5bn and because Israeli welfare payments are being cut to pay for the war.

In February, Economy Minister Nir Barkat said he expected Israel’s debt burden to grow to around 70% of gross domestic product (GDP). On the eve of the Hamas attacks on 7 October 2023, the debt-to-GDP ratio was 60%. For now, robust economic fundamentals are mitigating the risks posed by rising debt. Israel has posted a current account surplus for the past two decades, having learned to shield itself from external shocks.

Economist Amir Kahanovich says that since Israel’s establishment, it has “faced periods of delegitimisation, negative sentiment, boycotts by Arab countries, security embargoes, and, more recently, the effects of the BDS (Boycott, Divestment, and Sanctions) movement, that has greatly intensified since the Gaza war”. He added that these challenges toughened the Israeli economy, including “a reliance on self-production of security equipment and food, the establishment of reserves, and the accumulation of significant foreign exchange reserves”.

The BDS campaign has spread around the world

Factors for concern

Yet the longer the war lasts, the more costs will rise, and the more difficult it will be to contain its economic impact. The bill is already estimated to have reached $16bn, enough to widen Israel’s budget deficit to 7% of GDP as of April.

“The primary challenge for Israel’s economy lies in the rising defence spending and government aid programmes, which push the country towards expensive debt and higher taxes,” says Kahanovich.

During the last three months of 2023, Israel’s armed forces spent an additional $8bn, equivalent to 2% of GDP, on top of what is normally spent. In December, increased borrowing provided a cash injection, but the defence budget might make up 9% of GDP by the end of this year, the highest level in decades. Estimates from Israel’s central bank suggest that the cost of war could quadruple to $67bn if it dragged on throughout 2025.

Bohl thinks Israel might have to “cut expenditure for non-defence related items”, with a bill of that size requiring “macroeconomic reforms, like pushing the ultra-Orthodox population into the economy”. So far, Israeli Prime Minister Benjamin Netanyahu has not done so because the ultra-Orthodox parties are coalition partners. His emergency war budget even contains funding for new religious schools, where young ultra-Orthodox men choose to study the Torah while their secular peers serve.

Inflation was up in March and April, approaching the upper limit of Israel’s 3% target, while the value of the shekel value has fallen by about 5% since the war erupted. Rising war costs will make it difficult for Israel to maintain the fiscal discipline needed to rein in inflation, which will be fuelled by higher military spending.

Israel’s central bank has rolled back a monetary easing plan for this year, which should help control consumer prices, yet the outlook for rising inflation means a much-needed economic boost through cuts to interest rates now looks unlikely.

Israel's tech sector relies on dealing with an international community increasingly opposed to what is happening in Gaza.

Business slowdown

Given Israel's policy of compulsory conscription and the call-up of reservists, war has reduced staffing levels across all industries, while business and investment deals have been put on hold as boardrooms seek to navigate the uncertainty and insecurity. The tech sector—which accounts for half of Israel's exports and a lot of its income tax receipt—is among the most exposed. According to a report by Startup Nation Central, private funding for Israeli tech is down around $10bn in 2023 from $19bn in 2022.

Analysts say the huge pre-war protests against Netanyahu's controversial judicial reform may have contributed to this, but other sectors have also been hit by war, including agriculture, tourism, and construction, the latter in part because Israel has blocked Palestinian construction workers from the occupied West Bank. Around 200 Israeli companies operating outside Israel have provided what Kahanovich calls "a revenue stream that is less impacted by domestic conditions".

Despite this, ratings agencies S&P and Moody's downgraded Israel's credit rating in February and April respectively, with growth forecasts now cut to between 0.5-0.6% this year, from nearly 2% in 2023 and 6.5% in 2022. Israel's GDP fell 21.7% in the first three months of the war, then rebounded 14.1% in the following quarter. Economists wonder whether that recovery will last, as the impact of war is expected to grow in the second half of 2024.

Isolation concerns

Some countries have reduced their diplomatic and trade ties with Israel amid growing anger over its conduct in Gaza. Among them is Turkey—one of Israel's biggest trading partners before the decision. Others are recognising Palestinian statehood, much to the chagrin of Netanyahu and his cabinet.

Thomas COEX / AFP
Spain's Prime Minister Pedro Sanchez is applauded by MPs after delivering a speech to announce that Spain will recognise Palestine as a state on May 28 at the Congress of Deputies in Madrid on May 22, 2024.

Read more: Unilateral recognition inches Palestinian statehood forward

A recent editorial in the Financial Times called this "a wake-up call, a moment for moderate Israelis to realise that, despite worldwide sympathy over Hamas's horrific 7 October assault, their far-right government's actions are driving Israel into greater isolation".

Another area impacted by war is foreign investment. The pre-war fashion was of normalising ties with the Arab world in US-brokered deals. Now, Israel's actions in Gaza appear to have poured cold water on bigger hopes, such as a deal with Saudi Arabia. However, Bohl thinks Israel's economy will adapt to wartime conditions, "especially if Gaza becomes, as is most likely, an insurgency," requiring frequent Israeli raids. "In that case, Israel will de-mobilise the bulk of its forces... which in turn will weaken international pressure on Israel, as the global community adjusts to this new reality."

No halt in aid to Israel

Despite criticism of Israel's human rights abuses in Gaza, governments in the West have continued providing aid to Tel Aviv. This supports both the Israeli army and Western arms manufacturers. The US, while lamenting Israel's conduct, shows no signs of ending its support, whether military or otherwise.

Ori Goldberg, an Israeli political commentator, says, "suspending aid is the only real stick Israel's allies have over it" but doubts whether US President Joe Biden would do so, even though his support for Israel will likely have cost him Democratic votes in an election year. For his part, Khalil Sayegh, a Gaza-born political analyst based in Washington, felt that pressure on Israel would more likely come from Europe than the US.

"Even if, hypothetically speaking, Biden has changed his position, there will be consequences at the US Congress, and we all know how the US Congress works," said Sayegh. "It has been pro-Zionism for years, passing laws punishing whoever seeks to make aid for Israel conditional. For Europe, it's different. We've seen strong reactions."

Despite a ban on arms sales to Israel from several European countries, including the Netherlands and Spain, Kahanovich says "increased international pressure on Israel is unlikely to be highly effective and will likely remain symbolic".

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