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Bank of Israel: Underinvestment in Infrastructure More Damaging to Israeli Economy Than Ongoing War

The Bank of Israel report for 2023 states that high poverty and low investment in infrastructure and in education are a greater threat to the Israeli economy than the war | Cuts that were made in order to balance the budget amid increased war spending will have painful effects long term, report finds

צעירים חרדים בשכונת סנהדריה בירושלים (צילום: יונתן זינדל/פלאש90)
Ultra-Orthodox men in Jerusalem. The Bank of Israel report found that education for ultra-Orthodox boys fails to prepare them for the labor market, resulting in problematic effects on the Israeli economy. (Photo: Yonatan Zindel/Flash90)
By Erez Raviv

The Israel-Gaza war is having deleterious effects on the Israeli economy, the Bank of Israel reported in late March. According to the report, Israel’s GDP grew by 2% in 2023 and per capita GDP did not grow at all, as the central bank has been slowing the increase of the interest rate.

In the last quarter of 2023, Israeli GDP decreased by 5.6%, which the Bank of Israel attributed to the effects of the war. But the report also emphasized that fundamental problems in the Israeli economy—such as high poverty, low investment in infrastructure, and underemployment in the ultra-Orthodox sector—are more threatening to the economy than the current war.

Prime Minister Benjamin Netanyahu, who received the report on Thursday, said, “I think there is proof here that the economy is strong, that we are currently in a recovery similar to the one we experienced after other security crises and other wars. This is a good and encouraging sign.”

Netanyahu expressed his support for the increased defense budget, saying that new defense needs had become clear over the course of the war. He also said that Israel ought to increase its ability to independently produce weapons.

According to the Bank of Israel report, the economic trend in the country was positive until the war broke out, with the country enjoying full employment, an accelerated rate of nominal wage growth, a low level of unemployment, and a high rate of job vacancies. That trend was reversed after the war began.

The report stated that Israel was able to more easily weather the economic effects of the war due to the country’s low ratio of debt to GDP. At the war’s onset, Israel’s debt to GDP ratio was 60.5%. That ratio has risen to 61.9% amid the ongoing war.

As a result of restrictive monetary policy, Israel’s inflation rate decreased from 5.4% at the beginning of 2023 to 3%, the upper limit of the inflation target, at the year’s end. According to the bank, the high interest rate, which rose to 4.75% in 2023, led Israelis to spend less and save more. The rate of increase for business credit overall evened out, and credit for small businesses and consumers decreased.

A sharp change also occurred in the housing sector. Rents increased until the middle of the year and then began to even out. At the outbreak of the war, many construction companies suffered from a labor shortage, due to the ban on employing Palestinian workers from Gaza or the West Bank, and the construction industry operated at partial loss.

The bank anticipates that the economic impacts of the war will continue for years to come, as Israel invests more in defense and as affected areas in the north of Israel and around Gaza rebuild. The report notes that the security establishment has been given permission to increase spending by 10 billion shekels ($2.71 billion) annually for the next eight years. Meanwhile, a professional committee will calculate the ideal budget for the defense establishment in the medium term.

A Weak Shekel

The shekel weakened in 2023, after years of gaining in value. This trend worsened the cost of living crisis in Israel and contributed to inflation, due to the increased cost of imported products.

With the outbreak of the war, the shekel weakened compared to most global currencies and then stabilized between 3.6 and 3.7 shekels to the US dollar. The report attributes this to a change in export and import patterns and to the Bank of Israel’s plan to allocate $30 billion to the sale of foreign exchange reserves and $15 billion to exchange transactions.

Imports to Israel decreased sharply after the war began due to decreased demand. The decrease in exports was more moderate, and was mostly due to a drop in tourism. In the fourth quarter of 2024, Israel’s current account surplus grew significantly, with the country exporting significantly more value than it imported.

The shekel remains weak, with the Bank of Israel describing a process of excess depreciation—in other words, the already weak shekel continuing to lose value. The bank has reported that it sold off only $8 billion at the beginning of the war. The country’s foreign exchange reserves actually increased by $10.5 billion despite the sale, mainly due to capital gains from holding shares and from interest income from holding bonds.

Short-Term Thinking

Certain trends related to the war and government policy are putting a heavy burden on economic growth, the report said. In order to create a more balanced budget amid increased war spending, the government agreed to stop civil infrastructure projects, significantly cut the budget for a five-year plan to develop Israel’s Arab sector. The report warned that these decisions would result in long-term damage to productivity.

The five-year plan for the Arab sector is meant to increase the sector’s integration into the Israeli economy by improving education and infrastructure in Arab towns and villages. Cuts to the plan would harm national income in the long term, the report said.

The Israeli government also recently decided to increase the length of service for soldiers and reservists. The report warned that such a decision would harm the labor market.

The report also pointed to more fundamental problems in the Israeli economy, which are expected to have worse long-term effects on the economy than the war or the response to it. “The fundamental challenges of the economy are found in low labor productivity and low basic skills of some sectors in the population compared to what is common in developed countries, as well as in a much higher poverty rate than that prevailing in them,” the report reads. One key example of this phenomenon is the ultra-Orthodox school system, where boys are not given the knowledge or skills necessary to integrate into the labor market.

“A real upgrade is required in the scope and quality of the infrastructure in the economy, especially transportation infrastructure,” the report continued. “The rapid growth of the country’s population intensifies the challenges related to the scope of the infrastructure as well as the provision of public services, chief among them high-quality education. The Bank of Israel has submitted several reports to the government in recent years with detailed recommendations for dealing with these challenges.”

The report noted that the approved budgets for 2023-2024 did not include any macroeconomic reforms, which would be necessary in order to deal with these challenges.

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