Year of war creates cracks in Israel’s borrowing power By Reuters

By Libby George, Karin Strohecker and Steven Scheer

LONDON/JERUSALEM (Reuters) – Israel’s economy has overcome the chaos of a war that threatens to spill over into a regional conflict for nearly a year, but rising borrowing costs are beginning to strain its financial architecture.

The direct cost of financing the war in Gaza through August was 100 billion ($26.3 billion), according to the finance ministry. The Bank of Israel believes the total could reach 250 billion shekels by the end of 2025, but that estimate was made before Israel’s incursion into Lebanon to fight Hezbollah, which will add to the number.

That has led to downgrades in credit ratings, amplifying economic effects that could reverberate for years, while the cost of insuring Israel’s debt against default is near its highest level in 12 years and its deficit budget is growing.

“As long as the war continues, sovereign debt values ​​will continue to worsen,” said Sergey Dergachev, portfolio manager at Union Investment.

Although Israel’s debt-to-GDP ratio, a basic measure of economic health, was 62 percent last year, borrowing needs have disappeared.

“Even if Israel has a relatively good base, it will still be fiscally painful,” Dergachev said, adding, “And over time, it will put pressure on the rating.”

Israel’s finance minister said the economy is strong and the country’s credit ratings should rebound once the war is over.

The cost of the war is high due to Israel’s Iron Dome air defenses, large-scale troop mobilization, and intensive bombing campaigns. This year, debt-to-GDP has reached 67%, while the government deficit is 8.3% of GDP, well above the previously anticipated 6.6%.

While the main buyers of Israel’s international bonds – pension funds or major asset managers attracted by the sovereign’s relatively high debt rating – are unlikely to shed assets anytime soon, the investor base has narrowed.

Privately, investors say there is growing interest in offloading or not buying Israel’s bonds because of concerns about the ESG implications of how the war is playing out.

Norges Bank sold a small stake in Israeli government bonds in 2023 “given the increased uncertainty in the market”, a spokesman for Norway’s sovereign wealth fund said.

“What you see reflecting these concerns is obviously the valuations,” said Trang Nguyen, global head of emerging market credit strategy at BNP Paribas (OTC: ), adding that Israeli bonds trade at much wider spreads than countries with similar quotas.

Asked about rising borrowing costs and investor ESG concerns for this story, Israel’s Finance Ministry said government finances had been “effectively managed” since the start of the war.

“Israel’s robust domestic market demonstrates strong demand and international investors remain familiar with our credit,” the ministry added.

While Israel’s domestic bond market is deep, liquid and expanding rapidly, foreign investors have pulled back.

Central bank data showed the share held by non-residents fell to 8.4 percent, or 55.5 billion shekels, in July from 14.4 percent, or nearly 80 billion shekels, in September last year. During the same period, the value of outstanding bonds increased by more than a fifth.

“Israeli institutions have actually been buying more in recent months and I think some global investors have sold bonds because of geopolitics and uncertainty,” said a finance ministry official, declining to be named.

Equity investors are also cutting back. Data from Copley Fund Research showed that international investors’ drawdown of Israeli funds, which began in May 2023 amid disputed judicial reforms, accelerated after the October 7 Hamas attacks.

Global funds’ ownership of Israeli stocks is now at a ten-year low.

Foreign direct investment in Israel fell 29% year-on-year in 2023, according to UNCTAD – the lowest since 2016. Although figures for 2024 are not available, rating agencies have flagged the war’s unpredictable impact on such investments as being a concern.

All this has amplified the need for local investment and government support.

In April, the government pledged $160 million in public money to boost venture capital funding for the crucial technology sector, which accounts for about 20 percent of Israel’s economy.

This is on top of other costs, including housing thousands displaced by the fighting, many in vacant hotels due to a sharp drop in tourist numbers.

Displacement, labor shortages due to mobilization, and Israel’s refusal to allow Palestinian workers to enter hamper its agricultural and construction sectors.

The latter was a key factor dampening economic growth – which fell more than 20% in the fourth quarter of last year and has yet to recover. Data for the three months to the end of June showed seasonally adjusted GDP remained 1.5 percent below pre-attack levels, Goldman Sachs calculations show.

Israel has so far had little trouble raising money. It sold about $8 billion of debt on international capital markets this year. Its diaspora bond vehicle, Israel Bonds, is targeting a second annual record of more than $2.7 billion.

But rising borrowing costs, along with rising spending and economic pressure, loom.

“There is room for Israel to continue to flounder, given a large domestic investor base that can continue to fund another sizable deficit,” said Roger Mark, an analyst in the fixed income team at Ninety One.

“However, local investors are looking for at least some signs of consolidation efforts from the government.”

($1 = 3.8055 shekels)