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Bank of Israel sees increased risk to economy due to judicial overhaul uncertainty

The Bank of Israel warned on Wednesday that growing and prolonged uncertainty around the implications of the government’s efforts to advance its controversial judicial overhaul poses a threat to the country’s financial system and economy.

In its Financial Stability Report for the first half of 2023 report, the Bank of Israel presented the challenges to the country’s financial system and raised its assessment of the level of risk to Israel’s macroeconomic environment to “medium-high,” from “medium-low,” citing concerns of legal and institutional changes leading to a slowdown in the tech sector and a weakening of the shekel exchange rate.

The central bank explained that the increased risk level also stems from other factors, including continued interest rate hikes due to rising inflation and expectations of a slowdown in local and global economic growth.

While the Bank of Israel said the local financial system “remains stable,” thanks to the resilience of the banking system and insurance companies, it cautioned that if the uncertainty around the economic consequences of the legislative changes increases, this may “challenge the financial system in the medium-term.”

The Bank of Israel bi-annual Financial Stability report assesses changes and risks in the financial system according to three main parameters: the macroeconomic environment; asset markets, including stocks and bonds; and credit to households and the business sector.

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As such, it provides an indicator of the economy’s various exposures to shocks originating in Israel and the rest of the world. The report seeks to raise awareness among policy makers about the risks that may affect the financial system in the short and medium terms, the central bank said.

Bank of Israel governor Amir Yaron speaks at the Aaron Institute for Economic Policy conference at Reichman University, June 13, 2023. (Oren Shalev)

For now, the Bank of Israel sees the economy growing at a rate of 3% in each of the years 2023 and 2024. As the main risk to the forecast, the central bank cited a scenario in which the advancement of the legal and institutional changes leads to an increase in Israel’s risk premium, continued devaluation of the shekel, damage to exports, and a decline in local investments and demand for private consumption. Should this risk materialize, the central bank estimates that the damage to Israel’s GDP in each of the coming three years will be between 0.8% and 2.8%.

In its review of the stability of the financial system for the first half of the year, the Bank of Israel said that the advancement of the proposed legislation was already having an impact on the economy.

“Uncertainty surrounding legislative changes raised the economy’s risk premium, and was accompanied by a depreciation of the shekel that contributed to the increase in inflation, a decline in equity prices, and increased volatility in the foreign exchange market and in the financial markets,” according to the central bank report.

The steps taken in recent months by the government have created a “negative sentiment” in financial markets which only intensified with the advancement of the proposed legislation, it was added. The Bank of Israel pointed out that in particular during the month of February and March, as progress was made in advancing the legal changes, the risk premium of the economy surged while the shekel weakened significantly, and the local stock market underperformed compared to its global counterparts.

Overall, in the first six months of the year, the Tel Aviv Stock Exchange’s benchmark TA-125 index fell by 2.1%, while major global stock indexes were up during the same period. Meanwhile, the shekel depreciated 2.7% against the US dollar as the greenback weakened against other currencies, according to the central bank.

Bank of Israel governor Amir Yaron cautioned last month that weakness in the local currency due to uncertainty around the judicial overhaul has led to “excess” inflation of at least 1% to 1.5%, while indicating that if the trend continued the central bank would need to raise borrowing costs to rein in price growth.

Tech workers protest Israel’s right-wing government in Tel Aviv, on Januay 24, 2023. The Hebrew on the blue sign reads: ‘No democracy, no high tech; and the yellow sign reads: “No to the coup d’etat.’ (AP/ Maya Alleruzzo)

The Bank of Israel has steadily raised interest rates 10 consecutive times from a record low of 0.1% in April 2022 to 4.75% at the end of May. The aggressive interest rate increases have been rapidly fueling the costs of mortgage and loan holders, who are struggling to meet monthly payments.

The Bank of Israel highlighted that households and corporations still have “security buffers” built up partly due to fiscal incentives and monetary easing during the COVID-19 period.

“The repayment capacity of both households and the business sector remains strong,” according to the report. “However, with regard to credit to the business sector, companies in the real estate and construction industry – a major industry in terms of the financial system’s exposures – posed increased risk.”

Business executives, startup founders and employees have been at the forefront of mass protests against the changes to Israel’s judicial system advanced by the coalition government, led by Prime Minister Benjamin Netanyahu, since the start of the year. The concern is that the judicial overhaul plan undermines Israel’s system of checks and balances and its democratic character, which in turn, it is feared, threatens the ecosystem’s position as a stable hub for investments.

Israel’s tech ecosystem is a key engine of growth for the local economy, as it generates about 16% of GDP and over 50% of exports, and contributes more than 25% of the total income tax collected by the government.

Commenting on the medium and long-term consequences of the proposed structural legal changes perceived as weakening the independence of the country’s judicial institutions, the Bank of Israel cited the risk of the ability by local companies to attract foreign investment, in particular from venture capital funds, the credibility of policymakers and overregulation.

Recent data by venture capital firm Viola showed that fundraising by Israeli tech firms in the first half of the year plunged 73% to $3.2 billion versus $12 billion during the first half of 2022, and marked the lowest figure since at least 2018. Tech investments have continued to slump globally, albeit at a slower pace. In the first six months of the year, global funding activity dropped 50% to $168 billion from the $333 billion raised during the same period in 2022.

Following last month’s passage of the first bill in a series of legal changes advanced by the government, global credit rating agencies Moody’s Investors Service, and Standard & Poor’s issued warnings that the continued political turmoil around the widely contested judicial overhaul is posing risks to economic growth and social stability in Israel.

Moody’s raised concerns about the slump in venture capital investments into local tech firms during the first half of the year since the judicial plan was presented and cited data showing that 80% of new Israeli startups chose to register overseas during the same period. In addition, a survey by Start-Up Nation Central, which tracks the local tech ecosystem, found that almost 70% of Israeli startups are taking active steps to pull money and shift parts of their businesses outside the country due to the uncertainty created around the proposed judicial overhaul.

In response to the the Bank of Israel report, the high-tech protest group said the findings and risks presented “show once again” how the Netanyahu government is “destroying” the economy while ignoring experts’ warnings.

The government was pursuing its judicial overhaul “instead of facing the reality of high cost of living, the flight of entrepreneurs and investors, and the collapse of the education, health and welfare systems,” the group said. “Netanyahu and [Finance Minister Bezalel] Smotrich can continue with lies about a solid economy that will be revealed when the dust settles, but the truth is that it is not dust, but an economic desert that they are leading us into.”