By Steven Scheer
JERUSALEM (Reuters) - A two-notch downgrade of Moody's (NYSE:MCO) Israel credit rating may not be the last, analysts say, as war on two fronts spurs state spending and raises fears that the economy may not recover as quickly as in past conflicts.
The surprise move by Moody's on Friday to lower Israel's credit rating to "Baa1" from "A2" was criticised by government officials but reflected uncertainty over Israel's economic prospects as conflicts rage.
"The ratings would likely be downgraded further, potentially by multiple notches, if the current heightened tensions with Hezbollah turned into a full-scale conflict," Moody's said.
Bank Hapoalim economist Victor Bahar noted that "a Baa1 debt rating usually characterises countries that are much less wealthy and developed than Israel".
The downgrade kept Israel's rating three notches into investment grade, down from six earlier this year.
"There are a lot of issues that we have to do in order to keep this current rating," said Yair Avidan, a former Israeli banking regulator.
Israel's year-old war against the Palestinian Islamist group Hamas in Gaza has cost an estimated 250 billion shekels ($67 billion). At the same time, it has been responding to rocket fire from Hezbollah in Lebanon.
MOODY'S QUESTIONS CHANCES OF RAPID RECOVERY
Moody's said the unusual length of the conflict and the lack of a clear prospect of resolution raised doubts about how fast the economy would recover.
"It's definitely quite a strong indication that they believe the risks are moving up further than they thought before, and the deterioration is fast," said Karnit Flug, a former central bank chief now at the Israel Democracy Institute.
Israeli politicians, including Finance Minister Bezalel Smotrich, said the Moody's downgrade, which followed cuts by Fitch and S&P Global, underestimated the strength of the Israeli economy.
Fitch expects Israel to increase defence spending long-term from pre-war levels by close to 1.5% of GDP, and S&P Global also bemoaned ever-rising geopolitical risks and a widening budget deficit.
Israeli Accountant General Yali Rothenberg said it was clear that war on several fronts would exact an economic price, but said there was "no justification" for the latest Moody's downgrade.
But growth has taken a clear hit over the past year, slowing to an annualised 0.7% in the second quarter - or a contraction of 0.9% on a per capita basis as Israel's population expands - increasing the pressure on government finances.
WAR WITH HEZBOLLAH COULD SHRINK ECONOMY, EXPAND DEFICIT
According to the Aharon Institute for Economic Policy at Reichman University, an all-out war with Hezbollah including a land campaign would lead to an economic contraction of 3.1% this year and a budget deficit of 9.2% of GDP.
With the defence budget ballooning and Prime Minister Benjamin Netanyahu's coalition partners insisting on keeping favoured spending programmes in the delayed 2025 budget, Moody's has been critical of fiscal policy.
Finance Minister Bezalel Smotrich's draft targets a deficit of 4% of GDP and 35 billion shekels in spending cuts.
A senior government official said Moody's should have waited until the 2025 budget was approved, but that process has already been delayed by two months amid coalition wrangling.
"What is clear is that they do not have confidence in the government regarding the fiscal outlook," Flug of the Israel Democracy Institute said.
For many in Israel's business sector, the underlying strength of the economy and its dynamic high tech sector outweigh questions over government spending targets.
Yossi Abu, chief executive at NewMed Energy, called Moody's decision "a colossal mistake" that "reflects a lack of understanding of Israeli resilience and the Israeli spirit".
For its part, the Bank of Israel has been urging spending cuts and tax hikes to rein in a deficit that the government had projected at 6.6% of gross domestic product for 2024 but is currently running at 8.3%. Moody's sees a 7.5% deficit this year.
($1 = 3.7074 shekels)