Analysis

Israel at Risk of Credit Rating Drop if It Reins in the Courts

S&P warned last year it would look askance at such a move. Investors may act more quickly than the rating agencies

Prime Minister Benjamin Netanyahu in the Knesset, May 21, 2019.
Olivier Fitoussi

The reported plan by Prime Minister Benjamin Netanyahu to advance legislation limiting the High Court’s powers to override legislation passed by the Knesset and government administrative decisions could jeopardize Israel’s credit rating.

Even before that happens, it could also deter foreign investors worried about legal protections.

Sovereign credit ratings are determined mainly by macroeconomic factors, such as the level of public debt, the budget deficit and monetary policy. But they are also influenced by other factors, such as the quality of governance and the rule of law.

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The ratings not only enable the state to borrow money abroad, but they also serve as a barometer for private overseas investors as to how attractive a country is to invest in. A higher credit rating helps bring in more foreign capital and not just to the stock and bond market.

Last August, when the international ratings agency Standard & Poor’s announced it was raising Israel by one notch from A-plus to AA-minus — seven years after its previous ratings upgrade — the analysts pointed out that there would be a price to pay if Israel’s politicians interfered with the country’s judicial system.

“We believe that domestic political volatility — exemplified by recent amendments to the Basic Laws or proposals to reshape the Supreme Court’s powers — will likely stay elevated over the rating horizon,” the report said, “rating horizon” meaning over the next seven years.

A source in the Israeli financial markets said that he understood this comment to mean that S&P had taken into consideration domestic politics, in particular proposals to impinge on the court’s powers, in making its rating decision.

“Apparently they felt that something is heading in the wrong direction — a methodological emphasis that reflects the fact that a quarter of the rating decision is based on political or geopolitical assessments,” said the source, who asked not to be identified.

At this stage it’s only a warning based on concerns that the political establishment may try to undermine the rule of law and justice system. In any case, the ratings process works slowly — if it happens it won’t happen immediately, but a year or more after the problematic legislation is passed.

The rating for Israel is traditionally released in August. If the legislation on court powers is completed before then, the strongest reaction we are likely to see from S&P in its August 2019 report is a more sharply worded comment than last year’s.

But the flow of foreign investment may begin to slow before that as investors understand that the warning that S&P made has materialized. The market operates quickly to price in new risks. The financial market source said he works with executives from leading world financial organizations and knows how they think and act.

“When they look at the S&P report from August with its warnings and developments in the field going into the direction the rating company warned about, they won’t wait to see if a rating change comes or doesn’t come. Based on internal decision making, they will take steps, such as reducing credit lines, pricing credit higher or even decide not to expose themselves to the Israeli market in various ways, like financial investment,” the source said.

Asked this week by TheMarker how it would respond to legislation curtailing the court’s authority, S&P responded cautiously.

It noted that its methodology for sovereign ratings gives a 25% weighting to institutional factors. In particular it looks at how government institutions and decision makers influence the quality of credit from the perspective of sustainable public finance, advancing balanced economic growth and the ability to withstand economic and political shocks.

“We believe that policy formulation in Israel is efficient and predictable, supported by mature and responsible institutions, and by well-established checks and balances (including an independent judiciary, free mass media and an active civil society),” S&P said.

As to moves to rein in the courts, S&P said they didn’t constitute “an immediate risk” because they were at this stage only proposals that could be amended. It said it would examine the issue if and when they changes are legislated.

Political developments could prevent other ratings companies — Moody’s and Fitch — from upgrading Israel’s rating. Right now, only S&P is the only agency that has awarded Israel an AA-plus, so that financial institutions are likely to pay more attention to the lower ratings by the other big agencies.

“Practically speaking when you relate to a particular country and its risks, and whether you should invest in it and lend to it, it’s not enough that only one rating company responds. In other words, if Moody’s and Fitch don’t raise the rating, S&P’s raise will not have much of an effect,” the source said.

The other two ratings agencies don’t have to change their rating at all if they are unhappy with developments in Israel to in effect issue a warning. Moody’s rates Israel an A with a Positive outlook; Fitch an A-plus.

Poland provides a good example of what could happen to Israel. In January 2016 S&P lowered the country from A-minus to BBB-plus after the nationalist government elected the previous October began a “reform” of the Constitutional Tribunal to make it subject to the government’s will and moved to assume control of public broadcasting.

S&P explained that Poland’s system of checks and balances had been significantly undermined.

The other agencies didn’t adjust their ratings and slowly S&P reversed course. In December 2016 Poland’s outlook was raised to Stable from Negative and in April 2018 to Positive. Last October, the rating itself was restored to A-minus.