Israel’s economy is paying a high price for its widening war

London (CNN) — In late September, as Israel’s nearly year-long war widened and its credit rating was downgraded yet again, the country’s finance minister, Bezalel Smotrich, said that, while Israel’s economy was under strain, it was resilient.

“Israel’s economy bears the burden of the longest and most expensive war in the country’s history,” Smotrich said on September 28, a day after Israeli airstrikes killed Hezbollah’s leader Hassan Nasrallah in Lebanon’s capital Beirut, ratcheting fears that tensions with the militant group would turn into a full-blown conflict. “The Israeli economy is a strong economy that even today attracts investments.”

Almost a year after Hamas’ deadly attack on October 7, Israel is pushing forward on multiple fronts: launching a ground incursion against Hezbollah in Lebanon, carrying out airstrikes in Gaza and Beirut, and threatening retaliation for Iran’s ballistic missile attack earlier this week. As the conflict spills over into the wider region, the economic costs will spiral too, both for Israel and other countries in the Middle East.

“If recent escalations turn into a longer and more intense war, this will take a heavier toll on economic activity and growth (in Israel),” Karnit Flug, a former governor of Israel’s central bank, told CNN on October 1.

The war has significantly worsened the situation in Gaza, pushing it into an economic and humanitarian crisis long ago, and the West Bank is “undergoing a rapid and alarming economic decline,” the United Nations said in a report last month.

The Lebanese economy, meanwhile, could contract by up to 5% this year due to cross-border attacks between Hezbollah and Israel, according to BMI, a market research firm owned by Fitch Solutions.

Israel’s economy could shrink even more than that, based on a worst-case estimate by the Institute for National Security Studies at Tel Aviv University.

Even in a more benign scenario, its researchers also see Israel’s gross domestic product per head — which in recent years overtook the United Kingdom’s — falling this year, as Israel’s population grows faster than the economy and living standards decline.

Before the October 7 attack and ensuing Israel-Hamas war, the International Monetary Fund forecast that Israel’s economy would grow by an enviable 3.4% this year. Now, economists’ projections range from 1% to 1.9%. Growth next year is also expected to be weaker than earlier forecasts.

Yet Israel’s central bank is not in a position to cut interest rates to breathe life into the economy because inflation is accelerating, propelled by rising wages and soaring government spending to fund the war.

‘Long-term’ economic damage

The Bank of Israel estimated in May that costs arising from the war would total 250 billion shekels ($66 billion) through the end of next year, including military outlays and civilian expenses, such as on housing for thousands of Israelis forced to flee their homes in the north and south. That is equivalent to roughly 12% of Israel’s GDP.

Those costs look set to rise further as fiercer fighting with Iran and its proxies, including Hezbollah in Lebanon, adds to the government’s defense bill and delays the return of Israelis to their homes in the country’s north. Israel launched a ground incursion into southern Lebanon targeting Hezbollah on September 30.

Smotrich, the finance minister, is confident that Israel’s economy will bounce back once the war ends, but economists are concerned the damage will far outlast the conflict.

Flug, the former Bank of Israel governor and now vice-president of research at the Israel Democracy Institute, says there is a risk the Israeli government cuts investment to free up resources for defense. “That will reduce the potential growth (of the economy) going forward,” she said.

Researchers at the Institute for National Security Studies are similarly downbeat.

Even a withdrawal from Gaza and calm on the border with Lebanon would leave Israel’s economy in a weaker position than before the war, they said in a report in August. “Israel is expected to suffer long-term economic damage regardless of the outcome,” they wrote.

“The anticipated decline in growth rates in all scenarios compared to pre-war economic forecasts and the increase in defense expenditures could exacerbate the risk of a recession reminiscent of the lost decade following the Yom Kippur War.”

The 1973 war, also known as the Arab-Israeli war, launched by Egypt and Syria against Israel’s forces in the Sinai Peninsula and Golan Heights, ushered in a long period of economic stagnation in Israel, partly as the country massively ramped up defense spending.

Likewise, potential tax hikes and cuts to non-defense spending — some already mooted by Smotrich — to fund what many expect to become a permanently enlarged military, could hurt economic growth. Such measures, coupled with a weakened sense of security, could also spur an exodus of highly educated Israelis, notably tech entrepreneurs, Flug warned.

“It doesn’t have to be in very large numbers, because the tech sector is very dependent on a few thousand of the most innovative, creative and entrepreneurial individuals,” she said of a sector that accounts for a hefty 20% of Israel’s economic output.

A large-scale departure of high-earning taxpayers would further dent Israel’s finances, which have taken a knock from the war. The government has delayed publishing a budget for next year as it grapples with competing demands that make it hard to balance its books.

The conflict has caused Israel’s budget deficit — the difference between government spending and revenue, mostly from taxes — to double to 8% of GDP, from 4% before the war.

Government borrowing has soared and become more expensive, as investors demand higher returns to buy Israeli bonds and other assets. Multiple downgrades to Israel’s credit ratings made by Fitch, Moody’s and S&P are likely to raise the country’s cost of borrowing even further.

In late August — a month before Israel carried out strikes on Lebanon’s capital and the ground incursion against Hezbollah in the country’s south — the Institute for National Security Studies estimated that just one month of “high-intensity warfare” in Lebanon against the militant group, with “intensive attacks” in the opposite direction that damage Israeli infrastructure, could cause Israel’s budget deficit to soar to 15% and its GDP to contract by up to 10% this year.

Uncertainty ‘the biggest factor’

To shrink the fiscal hole, the government can’t rely on a healthy flow of tax revenue from businesses, many of which are collapsing, while others are reluctant to invest while it’s unclear how long the war will last.

Coface BDi, a major business analytics company in Israel, estimates that 60,000 Israeli firms will shut this year, up from an annual average of around 40,000. Most of these are small, with up to five employees.

“Uncertainty is just bad for the economy, bad for investment,” said Avi Hasson, the CEO of Startup Nation Central, a non-profit that promotes Israel’s tech industry globally.

In a recent report, Hasson warned that the remarkable resilience of Israel’s tech sector so far “will not be sustainable” in the face of the uncertainty created by the prolonged conflict and the government’s “destructive” economic policy.

Even before the October 7 attack, government plans to weaken the judiciary were prompting some Israeli tech companies to incorporate in the United States. The insecurity created by the war has exacerbated that trend, with most new tech companies formally registered overseas, despite tax incentives to incorporate locally, and a large number considering moving some of their operations outside Israel, Hasson told CNN last month.

He remains bullish on Israeli tech, pointing to robust fundraising, but cautions that the industry’s future growth “depends on regional stability and responsible government policies.”

Other sectors of Israel’s economy, while less important than tech, have been hit much harder. The agriculture and construction sectors have struggled to fill gaps left by Palestinians whose work permits have been suspended since October last year, pushing up prices for fresh vegetables and leading to a steep decline in housebuilding.

Tourism has also taken a knock, with arrivals down sharply this year. Israel’s tourism ministry has estimated that the drop in foreign tourists has translated into 18.7 billion shekels ($4.9 billion) in lost revenue since the start of the war.

The Norman, a boutique hotel in Tel Aviv, has had to lay off some staff and cut its prices by up to 25%, partly because some of its facilities — including its Japanese rooftop restaurant — remain closed to save on costs.

Occupancy levels have fallen from above 80% before war to below 50% currently, according to the hotel’s general manager Yaron Liberman.

“We know the day when the war will finish it’s going to be crazy here as far as business coming back,” he told CNN in mid-September, citing correspondence from would-be guests keen to visit Israel but unable to book flights or secure travel insurance.

But for now, “the biggest factor is the uncertainty,” Liberman said. “When is the war going to end?”

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