War Budget Leaves Netanyahu Caught Between Markets and Politics

(Bloomberg) -- With Israel’s war against Hamas costing the economy around $260 million every day, payouts to ultra-orthodox schools and other causes championed by right-wingers in the ruling coalition have set off a reckoning for Prime Minister Benjamin Netanyahu.

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The conflict is taking a harrowing toll on lives. It’s also become more expensive for Israel than first predicted and is putting a strain on public finances. But it’s the controversial handouts that have set a national debate alight and kept markets on edge as Finance Minister Bezalel Smotrich prepares within days to unveil a new budget for what remains of 2023 and then present plans for next year.

Built into Israel’s expenditure program are so-called “coalition funds,” or discretionary spending earmarked to the five parties comprising Netanyahu’s government, the most religious in Israel’s history. A record 14 billion shekels ($3.6 billion) in transfers approved last May will partly go toward religious schools — some exempt from teaching subjects like English and math. Other favored projects include the development of Jewish settlements in the occupied West Bank.

While the special allotments are a fraction of the total budget for 2023-2024, they have become a marker of competing priorities at a time when Israel confronts its worst armed conflict in half a century.

The war began on Oct. 7 when Hamas, designated a terrorist organization by the US, swarmed from Gaza into southern Israeli communities and killed around 1,200 people. More than 11,000 have died in Gaza, according to the Hamas-run health ministry, since Israel began retaliatory airstrikes and launched a ground offensive.

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What happens to the coalition funds may determine just how forgiving markets will be to a government that’s already seen the war inflict an economic toll of almost $8 billion, according to estimates from the Finance Ministry.

“As long as the government clings to its coalition funds, it will pay more for its debt,” says Rafi Gozlan, chief economist at IBI Investment House.

The verdict of global traders will matter as the government increasingly turns to bonds to pay for the war. Its budget deficit ballooned more than sevenfold in October from a year earlier. The Finance Ministry has, moreover, announced plans to borrow 75% more in November than last month.

Israeli assets from the shekel to bonds have recouped most if not all their losses from the aftermath of Hamas’s attack. But an aura of risk still hangs over the government’s debt.

The cost to insure Israeli sovereign bonds against a default is more than double what it was before the war began. And the risk premium, or spread, investors demand to hold Israeli dollar notes over US Treasuries remains about 25 basis points higher.

The unprecedented funding for religious programs and West Bank settlements was called into question long before the war upended the $520 billion economy, with critics warning it would suppress growth.

But it stands out even more now that Netanyahu committed to paying “whatever economic price this war exacts on us.”

The 2023 budget plans outlined by Smotrich envisage a spending increase of 35 billion shekels, much of it on the military and with the bulk financed by debt.

Coalition funds that haven’t yet been used amount to almost 8 billion shekels. Yet the ruling parties have so far resisted fully diverting those funds or cutting the programs linked to them. Their cost exceeds the total 2023 budget for public hospitals or state-funded higher education.

Smotrich, a lifelong settler, has suggested scrapping less than what the Finance Ministry’s budget department proposed, despite his pledge to strip out spending not “essential to support the fighting.”

The government’s stance has drawn the ire of investors and many top analysts. In a letter sent last week to Netanyahu and Smotrich, 300 prominent economists from Israel and abroad urged them to “immediately come to your senses.”

“A basic and necessary step would be to halt financing of anything unessential to war, first and foremost the coalition funds,” the group said in the letter signed by the likes of Nobel economics laureate Josh Angrist.

The outlook is worsening after a brief turnaround last year that saw Israel run its first budget surplus since at least 2000, with military spending declining for the first time in over a decade.

Smotrich has said the budget deficit could reach 4% of economic output this year and 5% in 2024. That’s more than double the government’s previous forecasts but still less than the figure of 7.1% forecast by Moody’s Investors Service.

What Bloomberg Economics Says...

“Israel is likely to spend more, not less, on defense going forward. That would reverse a multiyear trend that brought Israel’s military spending from around 9% of GDP in the 1990s to 4.5% last year.”

—Ziad Daoud, chief emerging markets economist, and Gerard DiPippo. For more click here.

For Netanyahu and his allies, the funding may be key to their political survival. Back in May, some parties threatened to bring down the coalition unless the spending was agreed to.

Discord over the issue is palpable within the Finance Ministry, creating a rift between Smotrich and a division run by technocrats seen as less beholden to political interests.

The budget department has called for tougher measures to cover higher spending and a drop in revenue — including diverting coalition funds and shuttering some government ministries. In a letter to Smotrich, the department’s head warned the fiscal decisions will be closely scrutinized by rating companies.

The task of drawing up a new budget has fallen to Smotrich. He has said the goal is “structural, growth-enhancing reforms.”

But the 43-year-old, who heads an ultra-nationalist party, also wants to maintain 1.2 billion shekels earmarked for a teacher pay bump at orthodox schools while moving ahead with more spending on settlements — financing he said is “necessary for protection” at a time when tensions in the West Bank are increasing.

The symbolism of sparing a favored constituency — where many men don’t work and are exempt from military conscription — has only riled critics.

“If no significant change is made to the budget, Israel risks signaling a weak governance capacity,” two former central bank governors, Karnit Flug and Jacob Frenkel, wrote in a newspaper column, suggesting the result could be a rating downgrade.

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