On a recent Saturday afternoon walk in Jerusalem’s Old City, usually bustling in summer high season, most shops were shuttered. Only a few intrepid Korean pilgrims were visible, along with small groups of Jews holding prayerbooks headed to the Western Wall. The war has largely scared off tourists, with knock-on effects for subsidiary businesses like restaurants and retail shops.
In looking back at forecasts from the end of 2023, two things are clear. First, they were too optimistic in forecasting an early end to the war, with a corresponding limited impact on the economy. Second, the Israeli economy has thus far been quite resilient, though the challenges are significant. Going forward, this resilience will be put to the test.
Around the turn of the new year, forecasts from the Bank of Israel saw the war winding down sometime in 2024, tourism beginning its recovery late in the year and economic growth in 2024 at two percent. The 2024 budget deficit was expected to reach 5 percent of gross domestic product (up from around 1 percent prior to the war) and then fall in subsequent years.
The first quarter of 2024 saw the economy bounce back to a large extent after the shock of October 7, 202. But recent indicators now suggest a slowdown in economic growth during the second quarter of 2024 and beyond. Current forecasts from the Bank shave economic growth to 1.5 percent in 2024 and the direct impacts of the war are expected to flow into 2025. Uncertainty remains notably high, particularly with regards to the northern front and potential war with Hezbollah.
Wars are expensive. Given the government’s rising revenue demands, it has turned to its two main revenue-raising tools: selling bonds (debt) and taxation. The ongoing geopolitical uncertainty contributes to Israel’s current high risk premium, meaning that investors require a higher rate of return for investing in Israeli bonds, which raises borrowing costs and potentially further impacting economic growth and stability moving forward. On the taxation side, the value added tax is scheduled to increase from 17 to 18 percent in January 2025. The government has also raised taxes on cigarettes and will likely seek out other ways to increase or impose indirect consumption taxes, although the Prime Minister has ruled out direct income tax increases as a political non-starter at this point.
Tax increases alone cannot bring the country out of the deficit hole, and military spending is untouchable during a war. Thus the need for non-military spending cuts. To date the government has not been able to agree on what parts of the discretionary budget to cut. The Bank estimates that even with a 8.2 billion dollar spending cut, the debt to GDP ratio is set to hit 68.5 percent in 2025 (though it would begin to fall as war expenses decline) —a far cry from about 60 percent on the eve of the war. Without spending cuts, these estimates would be even higher, leaving the country far less able to deal with other shocks to the economy.
Inflation has stubbornly stabilized near the upper limit of the Bank of Israel’s target range of 3 percent and remains a concern. Forecasters predict that inflation will reach around 3.5 percent at the start of 2025, in part due to the aforementioned value added tax increase, and then ease back towards 3 percent. But there are many factors that can disrupt this trajectory, such as a further deterioration of geopolitical events, depreciation of the shekel, ongoing supply constraints in the housing sector due to a limited workforce, fiscal instability, and global oil prices, to name a few.
The hi-tech industry, Israel’s main engine of economic growth, expanded significantly during the pandemic but saw a slowdown in 2023, owing mainly to global factors rather than the war. Total investment in the high-tech sector has experienced a bit of a rebound as of late. According to the research firm RISE Israel, total investment in the second quarter of 2024 is expected to be around $2.5 – $3.0 billion, higher than the $1.7 quarterly average of 2023. This sizable increase is due in large part to a single firm—Wiz—that announced the largest ever financing round for an Israeli company at $1 billion.
What does all this mean for Israel’s financial stability? Any assumptions and trajectories depend on major combat operations in Gaza ending and the situation with Lebanon calming down, allowing the government to reach a fiscally responsible path and tourism, investment and business to recover. But assigning target dates to these geo-political events is a fools errand.
Israel has been in similar situations in the past and has taken the necessary economic steps to right the fiscal path. By leveraging its experience and resilience, there is hope that the country can navigate these challenges and emerge stronger, with renewed opportunities for growth and economic prosperity.
