The U.S. ratings agency Moody's cut Israel's sovereign credit rating Friday due to the impact of its ongoing conflict with Palestinian resistance group Hamas in Gaza, citing material political and fiscal risks.
The impact of the conflict raises political risk and weakens Israel's executive and legislative institutions, and its fiscal strength for the foreseeable future, said the agency, which had begun the review for a downgrade on Oct. 19.
The country's rating was cut to "A2," which is five notches above investment grade, while its credit outlook was kept at negative by Moody's, meaning a further downgrade is possible.
It was the first time Israel has been downgraded, Bloomberg reported.
Moody's said it expects Israel's debt burden to be "materially higher" than projected before the conflict and defense spending to be nearly double the level of 2022 by the end of this year in its baseline scenario.
The agency also lowered its outlook for Israel's debt to "negative" due to "the risk of an escalation" with the far more powerful Lebanese group Hezbollah that operates along its northern border.
Israel launched indiscriminate airstrikes and a ground offensive that have killed nearly 28,000 people in Gaza, mostly women and children, according to local health officials. The strikes came after Palestinian resistance group Hamas's Oct. 7 attack, which resulted in the deaths of about 1,160 people in Israel, according to Israeli figures.
Bank of Israel Governor Amir Yaron said on Sunday the country's economy was strong and would recover from the impact of the conflict, but called on the government to address issues raised by Moody's.
To boost the confidence of markets and ratings companies in Israel, it was key for "the government and the Knesset act to address the economic issues raised in the report," Yaron said.
"We knew how to recover from difficult times in the past and quickly return to prosperity, and the Israeli economy has the strength to ensure that this will be the case this time as well," he said.
Since the start of the conflict, Yaron has urged the government to maintain fiscal discipline and trim spending on items not related to Israel's military offensive in Gaza.
Israeli Finance Minister Bezalel Smotrich on Saturday brushed off the downgrading, suggesting the decision was not based on sound economic reasoning and was tantamount to a pessimistic "manifesto."
"The Israeli economy is strong by all measures. It is capable of sustaining all war efforts, on the front line and homefront, until, with God's help, victory is achieved," he said in a response to the decision.
Following the attack, S&P Global Ratings lowered Israel's credit outlook from stable to negative on risks that the Israel-Hamas conflict could broaden.
Fitch – which is the last of the big three U.S. ratings agencies – placed Israel on negative watch over risks from the conflict.
"The weakened security environment implies higher social risk and indicates weaker executive and legislative institutions than Moody's previously assessed," the ratings agency said in the statement explaining its decision.
"At the same time, Israel's public finances are deteriorating and the previously projected downward trend in the public debt ratio has now reversed," it continued.
"Moody's expects that Israel's debt burden will be materially higher than projected before the conflict," it added.
The downgrade, if prolonged or if it leads to further such moves, would raise borrowing costs for Israel and could lead to budget cuts and tax hikes to keep the budget deficit from spiraling out of control.
Israel's debt-to-gross domestic product ratio, Moody's noted, looked likely to peak at 67% by 2025, versus 62.1% in 2023.
Still, that ratio has been much higher in the past during periods of economic crises for Israel, but "there was never any delay in the government's debt repayments," Yaron said.
Lawmakers last week gave initial approval to a revised 2024 state budget that added tens of billions of shekels to finance the conflict and compensate those affected, as well as a rise in the budget deficit this year to 6.6% of GDP from 2.25%.
Prime Minister Benjamin Netanyahu on Friday reacted to Moody's move on Friday, saying "the rating will go back up as soon as we win the war – and we will win."
"While fighting in Gaza may diminish in intensity or pause, there is currently no agreement to end the hostilities durably and no agreement on a longer-term plan that would fully restore and eventually strengthen security for Israel," Moody's said in a statement.
There has been one truce to date, lasting a week at the end of November.
"While there are currently negotiations underway to secure the release of the hostages against a temporary cease-fire and more humanitarian aid into Gaza, there is no clarity on the likelihood, time frame and durability of such an agreement," Moody's said.
Israeli forces are gearing up for a ground assault on the southern Gaza city of Rafah after Netanyahu earlier rejected Hamas' latest offer for a cease-fire and return of hostages held in the Gaza Strip.
More than a million people driven southward by the Israeli bombing of Gaza are packed into Rafah and surrounding areas.
U.S. President Joe Biden has called Israel's response to the Hamas attacks "over the top," and the United Nations has said Palestinian civilians in Rafah needed to be protected.
