Fitch: War slows public debt reduction

Higher defense and 'compassionate' social spending could raise credit risk.

The Fitch credit rating agency is confident of Israel's ability to continue to reduce it's public debt, albeit at a slower pace because of the cost of the war in the Lebanon. "Fitch expects Israel's public debt burden to rise slightly in the second half of 2006 but to end the year substantially below the end-2005 level. And it should decline again next year, providing the budget parameters agreed this week are adhered to," said Richard Fox, head of Middle East and Africa sovereign ratings for the agency. "But this third fiscal shock in six years emphasizes once again the vulnerability of Israel's public finances to unexpected and costly developments in the security situation." Fitch praised the country's pace of reducing the ratio of national debt to gross domestic product. "Israel's overall public debt fell sharply in the first half of 2006, reaching 91 percent of GDP in June," the agency said. "This marked an acceleration of the declining trend that took hold in 2005, due to the combination of a conservative fiscal stance and rapid economic growth." Because of the war, Fitch expects this ratio to increase slightly to 93% or 94% of GDP by end-2006 as the budget deficit increases and the economy slows. "But the trend of year-on-year reduction in public debt, which is a key ingredient to the progress of Israel's sovereign rating, would continue." On the assumption that the budget framework approved by the cabinet on Tuesday will be preserved, Fitch forecasted the country's public debt would come down to 90% of GDP in 2007. On a less optimistic note, Serhan Cevik, an analyst at investment house Morgan Stanley, warned there was a real threat to creditworthiness arising from the combination of higher defense spending and a "compassionate" increase in social expenditures. In addition, Cevik said that the rationalization of the welfare system, which increased the poverty risk in the short run, had already started to deliver promising results, noting that the unemployment rate had come down from 10.9% in 2003 to 8.7% this year - the lowest in six years. "Increasing welfare payments has long failed to eradicate poverty in Israel," said Cevik. Instead Morgan Stanley suggested that in the medium-term, the government should cut military expenditures and "irrational" welfare payments to free up funds for education, the single most important factor determining the risk of poverty.