JP Morgan warns: "Investors should pay more attention to Israel's budgetary risks."
JP Morgan warns: "Investors should pay more attention to Israel's budgetary risks."
The investment giant warns of the enormous budgetary and financial challenges of the economy following the war: "The cumulative deficit of the government may reach 9% by the end of 2024."
The world's largest investment bank J.P. Morgan warns of the enormous challenges facing the Ministry of Finance and the Accountant General.
In an in-depth financial review spread over 11 pages, J.P. Morgan economists predict a jump in the Israeli government's budget deficit to around 4.5% of GDP in both 2023 and 2024. The significant update is regarding the 2024 budget, which they predicted in the previous review regarding a deficit of only 2.9% of GDP. Further to this, JP Morgan emphasizes that "the risks concern a wider deficit.”
This means an accumulated deficit of at least 9% of GDP over the years 2023-2024 with very great pressure in the coming months: "State revenues may decrease by 1% in terms of GDP (actual revenues may decrease by approximately 2.5%) to the level of 23.4% of GDP." JP Morgan emphasizes that “the increase in spending will depend mainly on the duration of the war and on the approval of the US military aid package."
The review focuses almost entirely on the recruitment challenges that are placed before the Accountant General of the Ministry of Finance - who is responsible for financing that deficit. That is, as soon as such a huge deficit is created in such a short period of time, it means that there is not enough tax revenue to cover the expenditure and therefore the Accountant General must raise the money in several ways, the most common of which is raising debt in the capital markets (through government bonds).
"We anticipate a high domestic bond issuance in the coming months, when the (gross) issuance program for November has become one of the largest since 2006."
Although the American bank is warning against a "worsening of the fiscal outlook", at this stage, J.P. Morgan gives credit to the Accountant General: "We expect fiscal pressures to weigh on the bond market, but we doubt whether demand is at risk of 'evaporation' (disappearance of financial players who would like to purchase Israeli bonds)”. That is, the investment bank believes that the local market is able to "absorb" the demand.
Also, the bank believes that "the threshold for the purchase of bonds by the Bank of Israel is high, in our opinion", that is, given the yields and demand, it is doubtful whether the Bank of Israel will be forced to come to the aid of the treasury and purchase government bonds as it did, for example, during the coronavirus pandemic. First of all, because the risk premium is still under control, the market is working properly and functioning, the demands are still high, and also because this step is against the policy of the Bank of Israel to maintain a strong shekel and stable inflation.
Recall that the purchase of bonds by an actor like the Bank of Israel creates demand and causes price increases, which means a decrease in yields (prices and yields in bonds work in opposite directions, as the price increases, the yield decreases, and vice versa).
Within the report, there are less flattering parts that must be taken into account both by the Minister of Finance, by the Accountant General, and by the Chairman of the Securities Authority.
“Investors should pay more attention to budgetary risks"
The report's editors note that "during most of the 2000s, fiscal developments did not particularly worry Israeli investors in the bond market. The government's average deficits were about 2.8% of GDP in 2001-2019 and about 2.9% of GDP in 2010-2019, and did not bother the investors against the background of the rally in the global capital markets, the low inflation, and the strength of the shekel.
"Even during the recent periods of sharp fiscal deterioration, such as during the pandemic period when the budget deficit reached 11.3% of GDP," the report's editors continue. "Government bonds were ‘well insulated’ against the background of the Bank of Israel's bond purchase program."
"Now," the bank's economists add, "with great uncertainty regarding the results of the war, the budgetary costs, and the lower probability of quantitative expansion (purchase of bonds) by the Bank of Israel, we think that investors should pay more attention to the budgetary risks. As of today, these risks are insufficiently priced by the market, against the background of only moderate corrections in the consensus budget forecast."
"October figures indicate a significant deterioration in the government's financial situation"
J.P. Morgan emphasizes that the spread between 10-year Israeli government bonds and the equivalents in the U.S. has increased by 46 basis points since the war, "as the increase in the spread is accelerating these days." These are important warnings.
"The effect of the war on Israel's fiscal (budgetary) situation seems significant," they write. According to them, the Ministry of Finance should reveal details of the revised 2023-2024 budget in the coming days, "but it is already clear that the impact of the war on the economy and the government's financial situation was significant."
They also add: "The governor of the Bank of Israel stated that the debt-to-GDP ratio is expected to rise to a certain extent above 65% of GDP by the end of 2024, compared to 60% now," while in another part of the review they emphasize that without the war, the debt-to-GDP ratio would have been expected to decrease to about 57% GDP.
JP Morgan warns: "In a more negative scenario (a conflict that lasts until mid-2024 and without American aid), we fear that the deficit may reach higher levels. Looking beyond the crisis period, military expenditures may remain high in the coming years as well. But this will be less ‘pressing’ from the point of view of financing the (immediate) deficit."
In the review, they note all the latest fiscal indicators for the month of October and conclude: "The October data indicate a significant deterioration in the government's financial situation." In this context, the review indicates that the "sensitivity" of tax revenues and shocks in activity (changes in GDP growth) is higher than 1 (meaning very high sensitivity) and can reach up to -2.5%. That is, a decrease of 1% of GDP may cause a 2.5% decrease in the state's tax revenues.
