Fitch: Israeli Election Can Boost Structural Reform Capacity

The outcome of the Israeli general election in March should enhance the country's capacity for structural fiscal reform, Fitch Ratings says. If successfully implemented, such reforms could make it easier to achieve sustainable deficit reduction that would bring the debt-to-GDP ratio closer to the 'A'-category median. 

This month's legislative elections saw Benjamin Netanyahu's Likud party secure 30 of the 120 Knesset seats. On Wednesday, Netanyahu was mandated to form a government, starting formal negotiations with other party leaders that could last between four and six weeks (informal talks were already underway). 
The election delivered a more decisive outcome than opinion polls had predicted. This suggests that Netanyahu will not have to rely on support from an ideologically diverse range of parties and can build a more cohesive and longer-lasting coalition than had been expected. 

Israel's domestic politics can be turbulent, with a fragmented legislature and fluid parties leading to sometimes unstable coalition governments; the previous government served only half of its term. Avoiding such an outcome would mean the new government is better placed to enact substantive fiscal reforms, such as removing tax exemptions, reducing spending rigidities, for example on military expenditure, and potentially reforming fiscal rules and introducing a medium-term fiscal framework.

Israel's fiscal position improved last year, despite the setback to consolidation in 3Q14 because of military operations against Hamas in Gaza. Preliminary official estimates put the central government's 2014 deficit at 2.8% of GDP, the lowest since 2008 and in line with the original budget projections. The costs of the Gaza operations were partly offset by subsequent cuts and by capital expenditure under-execution and revenues were boosted by the bounce-back in economic activity and by one-off items. 

Monthly government spending in 2015 is limited to one-twelfth of the level budgeted for the previous year until a new budget is agreed. We think growth will strengthen to 3.2% this year, helped by the Bank of Israel supporting the competitiveness of the shekel. A combination of a contained deficit and stronger growth should allow a modest decline in debt/GDP this year. 

Nevertheless, debt/GDP, at around 67%, is a key rating weakness and well above the 'A' category median of 48.8%. Fitch believes it will take some time for this gap to narrow. 

Continued progress in reducing the debt/GDP ratio toward the peer median, accompanied by a sustainable reduction of the fiscal deficit, would be positive for the ratings.