International rating agency Fitch has downgraded Israel's long-term local currency rating to A from A+ but affirmed the long-term foreign currency rating of A- and the short-term foreign currency rating of F1. The outlook on all the ratings remains negative.
The downgrade of the long-term local currency rating reflects the sharp rise in the budget deficit and public debt ratio over the last two years as the economy has moved into recession under the combined impact of the global slowdown, the high tech slump and the violence associated with the intifada.
Fitch first signaled deteriorating Israeli creditworthiness in May last year, and the ratings have been on negative outlook since October 2001. Israel's combination of high public debt and high budget deficit are now second only to Japan's amongst investment grade countries and severely constrain its macroeconomic policy options.
Fiscal policy has been pro-cyclical, as the authorities battle to stem further deterioration in public finances, while concern over rising public debt has played a part in this year's drop in the shekel. The rapid feed through of shekel weakness to inflation has prompted a sharp increase in both nominal and real interest rates, which are at two-year highs. High public debt is dictating both tighter fiscal and monetary policy than would otherwise be appropriate in a deep recession.
The affirmation of the long-term foreign currency rating acknowledges that the rising public debt burden has not so far materially impacted Israel's external balance sheet. Although the current account deficit has widened, reserves are still up year to date. Israel's overall net external debt continues to decline and is lower than many higher rated sovereigns.
Public net external debt is also modest and has declined and benefits from a unique structure. Almost half of the public external debt is guaranteed by the US and a further third is held by the Jewish diaspora as State of Israel bonds. Demand for the latter has increased this year while the US has recently affirmed its strong support for Israel, which has political and military as well as financial dimensions. Israel's external market obligations are modest, with no international bond maturing until 2005. External liquidity is strong.
The continuing negative outlook reflects the downside risks surrounding Israel's short to medium term prospects. Israel's gross domestic product (GDP) will fall by at least 1.5 percent this year and any recovery next year is unlikely to prevent a third year of declining per capita GDP. The global economic outlook has become more gloomy; the hi-tech slump contains structural as well as cyclical elements that will take time to work out; and the security situation continues to depress business and consumer confidence. Conflict involving Iraq could exacerbate the short-term outlook.
The deterioration in Israel's public finances has been less severe than in other investment-grade countries that have faced prolonged periods of declining per capita GDP, thanks to the government's strong efforts to contain spending and bolster revenues. Fitch expects any overshoot in this year's state deficit target to be small and is encouraged by the decline in the deficit in the 2003 budget. If fully implemented, Fitch believes this would come close to stabilizing debt to GDP, although a further increase cannot be ruled out.
By contrast, a significant overshoot of the deficit target either this year or next would likely result in a downgrade of both the foreign and local currency ratings. Failure to pass the budget by the end of December would be a concern as it would reduce the fiscal adjustment planned next year. Introduction of corrective measures to offset fiscal slippage would be necessary to avoid negative rating action.
The relative impact of cyclical and structural elements in Israel's recession and their implications for future growth prospects remain unclear. Against this background, a more vigorous structural reform effort would help offset the constraints the high debt burden places on Israel's macroeconomic policy options. — (menareport.com)
© 2002 Mena Report (www.menareport.com)
