Fitch Affirms Israel at 'A+'; Outlook Stable

Fitch Ratings has affirmed Israel's Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) at 'A+' with a Stable Outlook. The issue ratings on Israel's senior unsecured Foreign- and Local-Currency bonds have also been affirmed at 'A+'. The Country Ceiling has been affirmed at 'AA' and the Short-Term Foreign- and Local-Currency IDRs at 'F1+'.

KEY RATING DRIVERS

Israel's IDRs balance strong external finances, robust institutional strength and solid macroeconomic performance against a government debt/GDP ratio that is high relative to peers and ongoing political and security risks.

Israel's external balance sheet remained strong in 2016. The country has returned annual current account surpluses each year since 2003 and posted an estimated surplus of 3.9% of GDP in 2016. This was lower than the record 2015 surplus of 4.6% of GDP, given deterioration in the trade balance on the back of robust import demand and sluggish growth in goods exports (services exports grew strongly). Fitch expects current account surpluses to persist in 2017 and 2018, albeit at lower levels, averaging 3.2% of GDP.

There has been further accumulation of foreign-exchange reserves, which reached USD98.5 billion at end-2016 (11.5 months of current external payments) from USD90.6 billion at end-2015. Reserves rose further to USD103.3 billion by end-March 2017. Fitch expects Israel's net external creditor position to be 43% of GDP in 2017, an improvement from 35.1% in 2014 and 23% in 2008. This is more than three times the 'A' median, and only just short of the 'AA' median. Fitch's international liquidity ratio for Israel has also continued to improve strongly.

Further gas sector development will lend additional support to the external balance sheet. Production at the Tamar gas field off the coast of Israel, which commenced in 2013, has reduced the need for gas imports. The government approved an amended natural gas framework in July 2016, thus providing the regulatory green light for the development of the larger nearby Leviathan gas field. The controlling consortium, which has agreed a number of supply contracts, is aiming for production to start in 2020.

Israel's public finances remain a weakness relative to 'A' category sovereigns. Government debt/GDP continued to reduce in 2016, falling to 62.2% (end-2007: 74.6%, end-2003: 95.2%), but was still some way above the peer median of 52%. Budget deficits were relatively small in 2015-16, with the central budget deficit narrowing to 2.1% of GDP in 2016, as the strength of private consumption and the housing market contributed to revenue outperformance even as some tax rates were cut. However, we expect the budget deficit to widen in 2017-2018 and forecast government debt/GDP to remain fairly stable in 2017-2018 rather than continuing a downward path.

Other features of public debt are fairly favourable. The share of external debt is low, declining to less than 8% of GDP in 2016 from 20% of GDP in 2006, and the government is gradually lengthening the maturity of its debt: average time to maturity reached 7.5 years in 2016. Israel benefits from high financing flexibility. It has deep and liquid local markets, good access to international capital markets, an active diaspora bond programme, and US government guarantees in the event of market disruption.

Israel's ratings will continue to be constrained by political and security risks, but its credit profile has shown resilience to periodic conflict and political shocks over an extended timeframe. Conflicts with military groups in surrounding countries and territories flare up intermittently and can be damaging to economic activity or lead to increased spending commitments (although Israel's defence capabilities have continued to improve). The ongoing war in Syria poses risks to Israel and neighbouring countries, which could have an impact on Israel. Relations with some countries in the region can be tense. There has been no progress towards peace between Israel and the Palestinians. Fitch believes prospects for a realistic peace process remain bleak.

Domestic politics can be turbulent, with coalition governments often not lasting their full term. In 2017 the risk of fresh elections has sharpened owing to rifts within the patchwork coalition. In tandem, the prime minister, Benjamin Netanyahu, has come under increasing pressure over a number of ongoing police investigations. None of the coalition parties has a clear incentive for elections, but relations are fractious and could suddenly precipitate a new vote.

Five-year average real GDP growth is on a par with rating category peers. Growth accelerated in 2016 to 4% on the back of a strong labour market and rising incomes together with some recovery in investment. Expansionary fiscal policy and accommodative monetary policy, with the Central Bank policy rate staying at a record low of 0.1%, were also supportive. Effects related to vehicle imports provided a one-off 0.5pp boost to the GDP calculation, according to the Bank of Israel. This will not be repeated in 2017 and we expect growth to moderate to 3.1%.

GDP growth has been slowing in recent years, despite the 2016 performance. Annual growth averaged 3.3% in 2012-2016, compared with 4.5% in 2004-2011, due in part to slower working-age population growth, less productive additions to the labour force, sluggish world-trade and competitiveness challenges. In response, the government is seeking to enact structural reforms to improve efficiencies in some markets and the business environment overall, as well as boosting labour market participation.

Inflation was negative in 2015 and 2016 due to lower commodity prices, currency strength (especially against the euro), administrative price reductions and measures to stimulate competition. On balance, Fitch expects robust domestic demand, higher rents and elimination of one-off factors to push inflation back into the lower-end of the Bank of Israel's 1%-3% target range in late 2017 or early 2018 despite further appreciation of the shekel. Further one-off administrative measures by the government to reduce the cost of living could slow this process.

Israel's well-developed institutions and education system have led to a diverse and advanced economy. Human development and GDP per capita are above the peer medians, and the business environment promotes innovation, particularly among the high-tech sector. However, Doing Business indicators, as measured by the World Bank, have slipped below peers. The government also faces socio-economic challenges in terms of income inequality and social integration.

SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO)

Fitch's proprietary SRM assigns Israel a score equivalent to a rating of 'A+' on the Long-Term FC IDR scale.

Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:Structural features: -1 notch to reflect political and security risks, which could have significant negative effects on the economy and public finances.

• Structural features: -1 notch to reflect political and security risks, which could have significant negative effects on the economy and public finances.
   
• External finances: +1 notch to reflect the fact that Israel's strong net external creditor position relative to peers is not captured in the SRM. Further gas-sector development should support Israel's external balance sheet over the medium term.

Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.

RATING SENSITIVITIES

The main factors that could, individually or collectively, lead to positive rating action are:

• Significant further progress in reducing the government debt/GDP ratio.
   
• Sustained easing in political and security risks.

The main factors that could, individually or collectively, lead to negative rating action are:

• Sustained deterioration of the government debt/GDP ratio, either through widening fiscal deficits or a structural decline in GDP growth.
   
• Serious worsening of political and security risks.
   
• Worsening of Israel's external finances, for example, due to a loss of export competitiveness.

KEY ASSUMPTIONS

Fitch assumes regional conflicts and tensions will continue. The tolerance of the rating depends on the economic and fiscal implications of any conflict. Fitch does not assume any breakthrough in the peace process with the Palestinians or a prolonged serious deterioration in domestic security conditions.