Israel’s government is praising itself for a few strong trees in an economic wildfire - analysis

Instead of addressing the concerns of investors, agencies, and economists around the world, Netanyahu and Smotrich dismissed warnings in favor of baseless guarantees that the economy is doing fine.

MARKET DATA at the Tel Aviv Stock Exchange.  (photo credit: AMIR COHEN/REUTERS)
MARKET DATA at the Tel Aviv Stock Exchange.
(photo credit: AMIR COHEN/REUTERS)

The Tel Aviv Stock Exchange opened with gains on Wednesday after two days of sharp declines due to political turmoil. As of 10:45 a.m., the Tel Aviv 35 Index rose 1.5%, the Tel Aviv 125 Index added 1.1% and the Bank Index jumped 2.5%. In spite of this resurgence, however, a vast and looming cause for concern shadows over Israel’s economy.

On Tuesday, one day after the Knesset passed the first law in its controversial judicial reform, Israel’s sovereign credit rating was lowered by credit rating agency Morgan Stanley, fellow leading agency Moody’s Investor Services warned that the country’s economy poses a “significant risk” to investors, and financial service organization Citi warned that investments in the country are “much more tricky and dangerous.”

“We see increased uncertainty about the economic outlook in the coming months and risks becoming skewed to our adverse scenario,” wrote Morgan Stanley in its downgrade announcement.

These concerns are only the latest in a months-long parade of warnings from hundreds of economists, experts, and executives from Israel and around the world that the current government’s plan for judicial reform will lead to a sharp economic decline. They argue that the resulting instability in Israel’s judicial system is likely to scare of investors, thereby neutering one of the country’s primary economic drivers; in response, start-ups, and entrepreneurs are likely to base themselves in other countries in order to secure investments, and Israel’s fruitful hi-tech ecosystem will subsequently shrivel on the vine.

These most recent blows to Israel’s sovereign credit spell trouble for its economy. Dr. Itzchak Raz, an economist at the Hebrew University of Jerusalem, elaborated, noting that this trouble begins simply: “The cost of raising capital will go up,” he said.

Coronavirus & Israeli Tech (credit: JERUSALEM POST)
Coronavirus & Israeli Tech (credit: JERUSALEM POST)

From there, the issues begin snowballing and increasing in complexity. “To someone who’s not an economist that might sound like something small, but it means that Israeli citizens will pay higher interest rates for government debt, and the Israeli government will find it harder to raise funds needed to invest in infrastructure, or provide other public goods,” Raz said.

“Those reports are not just saying something about the credit rating of Israel, they’re saying something about the entire economic environment. It’s a very strong signal to investors around the world that are considering buying Israeli bonds or Israeli stocks, or to directly invest in a start-up company. And what they’re signaling is that the Israeli economic environment has become unpredictable and riskier and that growth potential is lower. And that would have a very broad effect with all of the Israeli economy,” he continued. “And after reading the comments issued by Moody’s yesterday, I think that effect is a pretty severe one.”

Smoke in a fancy envelope

A joint response from Prime Minister Benjamin Netanyahu and Finance Minister Bezalel Smotrich aimed to dismiss Moody’s special announcement as “a momentary reaction,” pointing out several positive factors in Israel’s economy – though a closer look reveals that a striking majority of their reasoning is flawed at best.

On the reasonable end of their argument, the ministers defended the strength of the economy by pointing to Israel’s well-performing defense and gas industries, its tight labor market, and that a recent removal of regulations is increasing Israel’s free market.
From there, however, they began grasping at straws, highlighting Israel’s slowing inflation as a reason to feel confident. However, only 10 days ago when Bank of Israel governor Amir Yaron announced that the bank’s counter-inflation measures were finally – and tentatively – showing positive results, he also explicitly warned against the precise economic scenario that is actively unfolding.
As he detailed the bank’s forecast for inflation decreasing, Yaron warned that “The main risk to the forecast is the realization of a scenario in which legal and institutional changes will be accompanied by an increase in the state’s risk premium, continued devaluation of the shekel, damage to exports, and a decrease in local investments and demand for private consumption.”
By disregarding Yaron’s warning in their statement, said Raz, “The ministers are revealing either that they just don’t care or that they’re completely ignorant regarding the way economies work.”

He explained that, based on extensive economic research literature that has been developed over several decades, that economic growth is dependent on several fundamental factors, chief among them being: good institutions in which there are effective checks and balances; limited and shared government power; the respect of minority rights; efficient, professional, and non-political bureaucracy; and an independent central bank.

“They’re attacking all of those things,” Raz said. “And they’re never bothering to stop and listen to experts around the world issuing very dire warnings. And they continue to respond in the same way: ‘this is all nonsense, the Israeli economy is doing great.’

“In fact, the data comes in and shows us that we’re not doing that well,” Raz continued. “And a lot of evidence suggests that we’ll do worse and worse as we move forward, and in the long run, the Israeli economy would simply perform much worse than it could have performed in the absence of these legislative decisions.”
In their joint response to Moody’s, Netanyahu and Smotrich pointed to a few well-performing aspects of Israel’s tech ecosystem: “Intel is planning its largest investment outside the US and will invest $25 billion in Israel, Nvidia is building a supercomputer in Israel, and we are promoting artificial intelligence, cyber, and chip manufacturing in Israel,” they stated.

Skirting the larger issue like it’s going out of style

The issue, though, is that while Intel’s (currently unfinalized) investment and Israel’s recent technology advancements are wonderful in the short term, the ministers’ claims fundamentally overlook the damage that is being done to the hi-tech sector supporting those current successes.

To put it another way: they are pointing proudly at a couple of strong evergreen trees growing in the forest, without mentioning that they’ve begun throwing gasoline into the forest fire they started a few meters away.
“What they’re doing is they’re making investors around the world even more nervous, and instead of really trying to understand what leading economists around the world are saying, and what credit agencies are saying, and what the World Bank is saying, they’re just ignoring all of that and issuing a statement that is just empty words, calling it a ‘momentary reaction,’” said Raz. “And they’re just revealing to the world how ignorant they are regarding the factors that generate economic growth.”
The ministers’ response concluded with the vaguely reassuring promise that “Israel’s economy is based on solid foundations and will continue to grow under experienced leadership that leads a responsible economic policy.”
In a sense, they are correct: Israel’s current economy is based upon an extremely solid foundation: its hi-tech ecosystem, which represents more than half of its exports, and is a huge engine driving its economic growth.
However, as the increasingly long list of forecasts, credit ratings, and reports pile up against the judicial reform and its undoubtedly negative effect on the Israeli economy, foreign investors have already begun looking elsewhere for stable investment opportunities, Israeli entrepreneurs have begun moving their money and businesses out of the Start-Up Nation. Suddenly, one Israel’s largest “solid foundations” has begun to crumble underfoot.