S&P lowers Israel credit rating after Treasury leaks deficit breach

International credit ratings agency Standard & Poor’s on Thursday lowered Israel’s local currency credit rating, just one day after leaks from the Finance Ministry indicated that the finance minister was planning to raise the 2013 deficit ceiling to 4.9 percent, or 50 billion shekels ($14 billion), the largest deficit in the country’s history.

This is the first time in more than two decades that Israel has seen its local currency credit rating lowered. A statement from S&P said the decision stemmed from, among other factors, „recent fiscal slippage, highlighting the gap between fiscal performance and other key metrics such as economic performance, external balances, and monetary policy flexibility.”

While it lowered the credit rating of Israel’s domestic currency, the agency reaffirmed a high foreign currency rating of A+. Israel’s local currency rating also rests at A+, and economists at the agency predicted stability in Israel’s credit rating.

„Our affirmation of the foreign currency ratings reflects our view of Israel’s prosperous and diverse economy as well as the medium-term impact of natural gas production on the external account,” the agency said. „Our stable outlook signals that we believe that risks to fiscal consolidation and threats to Israel’s economic growth will be sufficiently managed to support an ‘A+’ sovereign credit rating.”

The failure to pass a budget, under-performing fiscal policy and the apparent decision to raise the deficit spurred S&P’s decision to downgrade the local credit rating, the agency said. Still, it noted that economists believe in Jerusalem’s ability to mitigate the deficit and prevent future downgrades.

Finance Minister Yair Lapid’s headache does not end there. Fitch Ratings, which last week affirmed Israel’s long-term foreign currency issuer Default Ratings at A, announced on Thursday that the Finance Ministry’s apparent decision to raise the deficit ceiling would affect Israel’s ranking in oversees markets. Fitch said that Israel’s decision to raise the deficit ceiling to 4.9% was beyond what the agency expected.

Jerusalem was reeling after S&P’s decision on Thursday, and officials tried to project calm. Economic analysts said that S&P’s decision to reaffirm Israel’s foreign credit rating was the most important piece of news. Officials said that the local currency credit rating was less important in determining the country’s overall credit outlook compared to the foreign rate.

Responding to the news, Lapid said that the rating downgrade at this time was unsurprising: „This is a delayed reaction to the very situation we’re working to fix at the moment. We have to look in the mirror and say, 2013 and 2014 are the two years we have to cover the overdraft, we’ll really take off when we take care of that.”

„Right now we’re being responsible, and as long as I am finance minister, we’ll safeguard responsible policy,” he said. „In the meeting I called with the Bank of Israel Governor [Stanley Fischer], he said he supported fiscal policy aimed at a 3% deficit in 2014.”

Members of the coalition turned up the heat on Lapid on Thursday. Sources close to Prime Minister Benjamin Netanyahu said the prime minister had not been brought up to date on the Finance Ministry’s apparent decision to raise the deficit ceiling to 4.9%,. They said Netanyahu would not have supported the move because he believed it could damage the stability of Israeli markets.

Still, sources close to the prime minister said Netanyahu acknowledged that the government might have no choice but to breach the deficit ceiling. Budgets Department head Gal Hershkowitz and Prime Minister’s Office Director-General Harel Locker met on Thursday to discuss the deficit. Fischer, who told Lapid two weeks ago that he opposed raising the deficit ceiling, was surprised by news on Thursday that Lapid was still considering the idea.

Netanyahu and Lapid attempted on Thursday evening to reach Fischer, who is in the U.S. The three will likely meet before next Sunday’s cabinet meeting to reach a compromise on Israel’s deficit target, perhaps settling closer to 4.5%.

The deficit that Lapid set will probably be higher after real spending this year. As it stands, the 2013 deficit target is 2.5% higher than the original 2-3% target. Given the Israel Electric Corporation’s standing debt, the deficit could soar to the unprecedented amount of NIS 60 billion ($17 billion) or 6.45% of gross domestic product.

Lapid reached out on his Facebook page on Thursday.

„The new budget will start August 1,” he said. „We’ve lost a chunk of the year. In 2014, we’re headed for a deficit ceiling of 3%, which is responsible and moderate, while producing tough measures.”

If the 2013-2014 budget is approved and a 4.9% deficit is set for 2013, the expected cuts in government spending for 2013 will be halved to NIS 6.5 billion ($1.7 billion), instead of NIS 13 billion ($3.4 billion).

Despite breaching the deficit ceiling, the government will impose NIS 13 billion in taxes this year, though the government will only be able to collect approximately NIS 5 billion because the 1% VAT increase (to 18%) will only go into effect in August. The Finance Ministry is seeking to freeze 1% in pay raises to public sector employees in July.

Opposition Chairwoman Shelly Yachimovich welcomed Lapid’s decision to raise the deficit ceiling.

„The decision to breach the spending limit is a welcome decision, which will loosen, slightly, the chokehold on Israel,” she said.

Opposition to the move was louder within the coalition, where MK Meir Sheetrit (Hatnuah) said, „I object to the move. We need to cut the deficit vertically, not horizontally.”

In the meantime, it turns out that 90% of the government’s debts come from public pension funds and other savings funds, according to an annual report by Finance Ministry Accountant-General Michal Abadi-Boiangiu. According to the data, the government covers the debt by dipping into pension funds and employee savings funds.

Politicians and economists digest downgrade

Politicians and economists across the board responded to S&P’s downgrade by criticizing the government’s economic policy, saying it precipitated the agency’s decision.

„Lapid’s lack of experience is beginning to come out, and we’re all going to pay the price,” a senior unnamed Likud official said.

„When [Lapid] decides on cuts and then decides to increase spending, he is zigzagging. His announcements may cost us billions. It’s not like writing any old Facebook post,” the official said.

„Breaching the deficit ceiling is irresponsible and myopic,” said MK Nachman Shai (Labor). „Future generations will have to pay off their parents’ accumulated debt.”

Economists told Israel Hayom that they believed S&P’s downgrade was a warning directed at Jerusalem.

„When they come and drop the local currency credit rating it looks pretty ridiculous,” Rafi Gozlan, a chief economist at IBI Investment House, said.

„At face value it seems more like a declarative move. [S&P] is sending a message to the government: Look, things aren’t being properly managed here.

„If the deficit is 3% in 2014, especially if the public has confidence in that, everything will calm down. But, if not, the story will get more complicated.”

„What happened yesterday was not pretty,” a senior government official in Jerusalem said on Thursday. „Still, it’s important to note that the agency made its decision the day before yesterday, before it was aware of the new 4.9% deficit ceiling for 2013.”

The leak that the Finance Ministry was planning to breach the deficit ceiling for 2013 to carry the biennial budget did not surprise everyone on Thursday. Before S&P’s downgrade was announced, Ofer Klein, the economics and research department head at Harel Investments and Financial Services Ltd., said the finance minister’s considerations were unsurprising. Klein said he expected that „within the first seven months of 2013, until the budget is approved, the real deficit will hover around 4.5% of GDP, so it was unreasonable to think that the 2013 deficit would be 3% of GDP, even if deep cuts and tax hikes were introduced.”

„This financial transgression reflects the irresponsible fiscal policy of the last one and a half years. The decision isn’t so dramatic, but it is a red light,” said Yaniv Pagot, chief strategist at the Ayalon Investment House.