Moody’s says war is weakening Israel’s economy

Moody’s Ratings has cut its forecast for Israel’s economic growth in 2026, warning that fragile ceasefires and continued geopolitical uncertainty are weighing on the country’s recovery and public finances. In its latest assessment, the agency said Israel’s economy is now expected to grow by 3.7 per cent this year, down sharply from the 5 per cent forecast issued in January. However, this would still represent an improvement from growth of 2.9 per cent in 2025. Moody’s maintained Israel’s sovereign credit rating at Baa1 with a stable outlook, while revising its expectations for public debt. The debt-to-GDP ratio is now forecast to stabilise at around 70 per cent, compared with an earlier estimate of 68 per cent. The revision marks a more cautious turn from January, when Moody’s changed Israel’s outlook from negative to stable after concluding that the Gaza ceasefire had materially reduced the country’s exposure to geopolitical risks. Since then, however, Israel has fought a six-week war with Iran, which began on February 28, while conflict with Hezbollah in Lebanon has also intensified again. Although Moody’s acknowledged that the Israeli economy had repeatedly shown resilience during periods of conflict, it said the security environment continued to pose risks to both economic activity and government finances. The agency said the “fragile and tenuous” ceasefire agreements with Iran, Hezbollah and Hamas should allow activity to recover following a weak start to the year, provided that the agreements remain in place. The war with Iran contributed to a 3.8 per cent contraction in the first quarter, according to the Bank of Israel, as military mobilisation, supply disruptions and weaker activity affected the economy. However, conditions have since begun to recover as reservists returned to work, energy prices declined and the shekel strengthened. The central bank forecast is slightly more optimistic than Moody’s, projecting growth of 4 per cent in 2026 and 5.5 per cent in 2027. It also expects inflation to stand at 1.8 per cent this year, while the budget deficit is forecast at 4.9 per cent of GDP and public debt at around 69 per cent. However, those projections assume that there will be no renewed fighting with Iran, that the intensity of the conflict in Lebanon will decline and that the defence budget will not rise significantly beyond the amounts already allocated. The central bank warned that a larger increase in military spending would push the deficit, debt and inflation higher. Meanwhile, the International Monetary Fund, IMF review, published earlier this month offered an even weaker outlook, forecasting growth of 3.5 per cent in 2026, down from 4.8 per cent before the latest regional war. The IMF said high defence expenditure, military mobilisation and shortages of foreign workers would continue to weigh on the economy, while urging the government to rebuild fiscal buffers and stabilise public debt. Despite the weaker growth forecast, Moody’s said that “the economy continues to demonstrate resilience to military conflict and the impact on government finances remains controlled”. It added that Israel’s rating could eventually be upgraded if the ceasefires remain in force and public finances improve more quickly than expected. Conversely, a new escalation that causes lasting damage to economic growth or government finances could lead to a downgrade. Moody’s also identified any weakening of judicial independence as a potential risk to the rating. Those concerns have gained importance after Israeli cabinet members voted to defy a Supreme Court ruling involving the country’s broadcast regulator, prompting warnings that the dispute could develop into a constitutional crisis. Bank of Israel Governor Amir Yaron has separately warned that disregarding court decisions could undermine democratic institutions and increase economic uncertainty. At the same time, Yaron said Israel’s next government, following the October 27 election, would need to contain the rising debt burden and reconsider the scale of military expenditure. Defence spending has doubled since the October 7, 2023 Hamas attacks to around 8 per cent of GDP, while the debt ratio has increased from about 60 per cent in 2023 to around 70 per cent. In his fiscal warning, Yaron also called for greater investment in education, infrastructure and other drivers of long-term growth, while suggesting that higher taxes may be needed in 2027 to prevent debt from continuing to rise. Israel’s position forms part of a wider picture in which Moody’s sees geopolitical tensions, rising defence costs and elevated debt placing increasing pressure on national economies, although countries are entering this period with markedly different levels of fiscal protection. For Cyprus, which is geographically close to the conflict and heavily dependent on imported energy and tourism, Moody’s has also lowered its expectations for economic growth. In its Cyprus review, the agency said the island’s A3 rating with a stable outlook continued to reflect its high wealth levels, strong economic performance and improving public finances. However, it warned that the Middle East conflict was already weighing on tourism demand and feeding through to inflation. Moody’s expects Cyprus’ economic growth to slow from 3.8 per cent in 2025 to 2.3 per cent in 2026, before recovering to 2.8 per cent in 2027. The agency said the conflict would adversely affect energy prices and tourism, although the diversification of the island’s visitor markets offered some protection, with EU countries accounting for 42 per cent of arrivals. Nevertheless, Cyprus enters the period with considerably more fiscal space than Israel. The government recorded a budget surplus of 3.4 per cent of GDP in 2025, while public debt declined to 55.3 per cent of GDP. Moody’s expects surpluses of 2.3 per cent in both 2026 and 2027, with debt falling further to 37.7 per cent by 2030. The agency said Cyprus’ highly productive information and communications technology sector, which accounted for 14.4 per cent of real gross value added in 2025, and the continued diversification of the economy had strengthened its resilience. However, Moody’s also identified rising expenditure on infrastructure, healthcare, public-sector salaries, defence and climate adaptation as risks that could place greater pressure on public finances in the coming years. It said the main concern was that several of these pressures could emerge simultaneously, although Cyprus’ rapid fiscal improvement had provided substantial room to absorb them. Elsewhere in southern Europe, Greece has moved in the opposite direction from Israel following years of fiscal repair. Moody’s returned the country to investment-grade status in March 2025, raising its rating from Ba1 to Baa3 with a stable outlook, after citing faster-than-expected improvements in public finances, institutional reforms and greater resilience to future economic shocks. In its Greek assessment, Moody’s said the country should continue to record substantial primary budget surpluses, allowing it to steadily reduce its still-high debt burden. Greece’s debt had already fallen by more than 40 percentage points from its 2020 level, reaching 154 per cent of GDP in 2024. The improvement reflects a broader recovery from Greece’s sovereign debt crisis, including stronger institutions, a healthier banking sector and greater political stability. While the country’s debt remains the highest in the euro area, Moody’s said the government’s policy stance had increased its capacity to withstand future shocks. Italy has also received a more favourable assessment. Moody’s granted the country its first upgrade in 23 years in November 2025, lifting its sovereign rating from Baa3 to Baa2 with a stable outlook. The agency cited Italy’s record of political and policy stability, fiscal discipline and progress in implementing its National Recovery and Resilience Plan. It said Italy was leading EU countries in the number of payment requests and disbursements linked to the programme. However, Italy’s public debt remains among the highest in Europe, while population ageing and limited long-term growth continue to weigh on its credit profile. Moody’s expects the government debt burden to begin declining gradually from 2027, provided the country maintains fiscal discipline and political stability. France presents a less favourable European picture. Moody’s maintained the country’s Aa3 rating in October 2025 but changed its outlook from stable to negative, warning that political fragmentation could make it harder for the government to control its budget deficit and stabilise public debt. In its French outlook, the agency said the postponement of pension reform could aggravate fiscal pressures and weaken potential economic growth by reducing labour supply. It also warned that the strength of France’s institutional framework was being tested by an increasingly difficult domestic political environment. More broadly, Moody’s has warned that Europe’s changing security environment will add another layer of pressure to government finances. Following the shift of greater responsibility for European defence from the US to NATO’s European members, the agency described the development as credit negative for European sovereigns. During a NATO summit in Turkey earlier this month, the alliance’s 32 members agreed to transfer more responsibility for Europe’s security to European governments and away from the US. Moody’s said the eventual effect on each country’s credit rating would depend on how the transition and the resulting increase in defence costs were managed.