Fitch Upgrades Israel to 'A+'; Outlook Stable

Fitch Ratings has upgraded Israel's Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) to 'A+' from 'A'. The Outlooks on the long-term IDRs are Stable. The issue ratings on Israel's senior unsecured Foreign- and Local-Currency bonds are upgraded to 'A+' from 'A'. Fitch has also upgraded the Short-Term Foreign- and Local-Currency IDRs to 'F1+' from 'F1' and the Country Ceiling to 'AA' from 'AA-'.

KEY RATING DRIVERS

The upgrade of Israel's IDRs reflects the following key rating drivers:

Israel's external balance sheet has continued to strengthen. The country has returned annual current account surpluses each year since 2003, and in 2015 posted a record surplus of 4.6% of GDP. The current account surplus narrowed by around 20% yoy in 1H16, to USD6.3bn, because of a worsening trade balance. Nevertheless, there has been further accumulation of foreign-exchange reserves, which had reached USD98bn by end-October 2016 (almost 12 months of current external payments), from USD90.6bn at end-2015. Fitch expects current account surpluses to persist in 2017 and 2018.

Fitch expects Israel's net external creditor position to be 43% of GDP in 2016, an improvement from 35.1% in 2014 and 23% in 2008 when we last upgraded Israel's IDRs. This is four times the 'A' median, and in line with 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 near-by Leviathan gas field. The final investment decision has not yet been made, although a number of supply contracts have been agreed. The controlling consortium is aiming for production to start in 2020.

There has been a sustained reduction in Israel's government debt/GDP ratio to 63.9% at end-2015 (end-2007: 74.6%, end-2003: 95.2%). The debt structure is also favourable; for example, foreign-currency debt fell to 8.7% of GDP in 2015, from 14% in 2008.

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 IDRs also reflect the following key rating drivers:

Despite the fall in its public debt/GDP ratio, Israel's public finances remain a weakness relative to 'A' category sovereigns. The 2017-2018 two-year budget is expansionary, and we expect government debt/GDP to remain fairly level in 2016-2018 rather than continuing a downward path.

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. Frequent yet uncoordinated attacks by young Palestinians and Arab Israelis have continued with varying intensity since September 2015. These incidents reflect the lack of progress towards peace between Israel and the Palestinians. Fitch believes prospects for a realistic peace process remain bleak.

Although Israel's borders are currently relatively quiet, conflicts with military groups in surrounding countries and territories flare up intermittently and can be damaging to economic activity. The ongoing war in Syria poses risks to Israel and neighbouring countries, which could have an impact on Israel, although direct spillover has so far been negligible. Relations with some countries in the region can be tense.

Domestic politics can be turbulent, with coalition governments often not lasting their full term. The current coalition was expanded in May to a five-seat from a one-seat majority, and the government agreed on a two-year budget for 2017-2018. Nevertheless, the majority is still narrow, and domestic political relations can be fractious and prompt a sudden election.

GDP growth is on a par with peers, but has slowed in recent years. Annual growth averaged 3.1% in 2012-2015, 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 has remained negative in 2016 due to lower commodity prices, currency strength (especially against the euro), administrative price reductions and measures to stimulate competition. Fitch expects robust domestic demand and elimination of one-off factors to push inflation into the lower-end of the Bank of Israel's 1%-3% target range in 2017.

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 AND QUALITATIVE OVERLAY

Fitch's proprietary Sovereign Rating Model (SRM) assigns Israel a score equivalent to an 'A+' rating on the Long-Term Foreign-Currency IDR scale.

Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final Long-Term Foreign-Currency IDR by applying its Qualitative Overlay (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.
• 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 Long-Term Foreign-Currency 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 a 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 a negative rating action are:

• Sustained deterioration of the government debt/GDP ratio.
• 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, but their impact on Israel will not worsen significantly. Renewed conflict with Hamas in Gaza is possible, despite a serious degradation of Hamas's military capacity. 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.