Israel

Slow growth ahead as war-related risks will persist

The Israeli economy softened in 2024 due to the widening war and tight monetary policy amid inflation risks. Barring a further widening of the war, economic growth could accelerate gradually in 2025 owing to a recovery in private consumption (50% of GDP) and investment (25% of GDP) and compared to the low base from the previous year. The recovery in private consumption would be supported by the historically low unemployment rate (2.8% in July 2024) and by wages rising faster than inflation. The latter is due to a shortage of workers caused by the war. Inflationary pressures are expected to persist but at a lower level as monetary policy is expected to stay tight at least at the beginning of 2025. Stabilisation of the shekel (ILS strengthened nearly 8% vs. USD in October 2024 compared with a 10-year low of 4.08% at the start of the war on 7 October 2023) should also help reduce inflation and improve the business environment. However, expected increases in indirect taxes on consumer goods as part of the fiscal adjustment will keep inflationary pressures on the upside.

In addition, any further intensification and expansion of the war would cause an increase in production costs for manufacturers and constructors. Although the demand for construction will remain high, continued restrictions on the movement of Palestinian workers making up a large part of the construction labour force and on the supply of raw materials will limit the supply of new housing. This will slow the recovery in GDP growth, and push up housing prices. The hydrocarbon and defence sectors will benefit from high external demand amid the diversification of European energy sources and from the war in Ukraine and on home ground. The ICT sector, which accounts for approximately 20% of Israel's national output, will continue to face challenges due to the low level of funds raised by tech companies and to labour shortages, particularly for small start-ups. Tight financial conditions and the war are expected to keep pressure on corporate profits, particularly in the ICT and construction sectors, thereby increasing non-payment risks. Reduced non-military government spending will reduce the contribution of public consumption to growth, as opposed to exports of services, which will continue to make a positive contribution.

Services to drive external surplus, budget deficit to narrow slightly

Although Israel is partially insulated from high commodity prices due to its domestic gas production (estimated at close to 27 bcm in 2025), an escalation of the conflict involving other actors in the region creates the risk of energy disruptions. The Israeli government could order the closure of gas fields under the threat of rocket fire. As the global economy recovers, demand for Israeli goods is expected to increase, albeit at a gradual pace due to subdued growth in Europe which accounts for 30% of exports. Consequently, the merchandise trade balance will remain in deficit (4% of GDP in 2023). Nevertheless, Israel’s external position will stay healthy. The services account will remain in surplus on the back of computing services and research and development.. Conditions in the tourism sector are expected to remain under pressure due to the sharp decline in demand and the decision by many international airlines to periodically suspend flights to Israel due to the ongoing conflict. In the wake of a notable increase to over three million tourists in 2023, total arrivals declined by 80% during the first eight months of 2024. It is anticipated that the recovery will be gradual, with a significant reliance on domestic tourists. Services, as well as electronic components, communications equipment, precision and medical equipment, diamonds, and agrochemicals will continue to be the key pillars of the resilient external surplus. The primary income balance will remain in deficit mainly due to income repatriated by foreign companies and interest payments while the secondary income balance will keep its surplus thanks to the transfers from the diaspora and foreign governments. War conditions will continue to weigh on foreign investments in Israel (USD 14.4 billion in 2023 vs. USD 25 billion in 2022) while domestic investments are also expected to slow (USD 30 billion in 2023 vs USD 42.5 billion in 2022). However, the country will remain a net creditor to the rest of the world and its international reserves, which totaled USD 213 billion (around 53% of GDP) in August 2024, will continue to ensure Israel’s robust external position.

After letting the public deficit-to-GDP ratio widen in 2024, the government aims to reduce it in 2025 by freezing public sector salaries, pensions, and allowances, while increasing income tax on the lowest bracket and the value-added tax (VAT) from 17% to 18%. Higher interest rate payments related to credit rating downgrades in 2024 and higher borrowing needed to finance military spending will keep the deficit level elevated. But the risks related to the fiscal position will remain low as Israel will keep relying on easy access to domestic and international capital markets to finance the fiscal gap.

Persistent risks related to escalation and expansion of the war

Failure to broker a ceasefire increases the risk that the war could spill over into other areas in the region. The probability of a full-scale Israeli confrontation with Hezbollah and Iran persists. In addition to ongoing fighting between Israel, Hamas, and Hezbollah, its extension in Lebanon and Syria, and more attacks in Iraq and Jordan, as well as the US-led international coalition's bombing of the Houthis in Yemen in response to their attacks on ships using the Red Sea also increase the risk of escalation and expansion of the war across a wider region. The rapprochement between Saudi Arabia and Israel will likely be postponed as Riyadh’s stance on normalisation is conditional on the creation of a Palestinian state. This will also test the freshly normalised relations with the UAE, Morocco, and Bahrain which could continue to provide new investment opportunities and financing for Israel. Ties with Türkiye are likely to remain tense as the latter took a harsh position against Israel’s attacks in Gaza. Consequently, diplomacy-based cooperation on eastern Mediterranean gas operations and exports between Israel and Türkiye, which also involve Egypt, Greece, Cyprus and even Lebanon, will remain impacted by the war. Additionally, Israel will continue to take a dim view of renewing the international nuclear deals with Iran.

Furthermore, Israeli domestics politics, which were already in turmoil before the war, are expected to remain fractious. Domestic social and security risks (increased tensions between Palestinians and Israeli settlers in the West Bank, harsher restrictions on the Palestinian population in Israel, rising internal protests to push the government to secure a cease fire and free the hostages, etc.), the Netanyahu government's failure to eliminate Hamas (the government’s official objective in waging the war) and disagreements between the far-right and centrist parties over the conduct of the war continue to exacerbate domestic tensions. This will pressure the current government to call snap elections (the next elections are scheduled for October 2026). However, as long as the war continues, the proposed highly contentious judicial reform which, in its preliminary stages, would have thwarted the Supreme Court's ability to veto government actions and appointments, is not expected to return to the agenda.

Last updated: October 2024