The war drags down the economy: Israel sharply lowers its growth forecast, doubles defense spending, and raises fiscal deficit target to 4.9%

# Zhang Yaqi

Source: Wall Street News

Israel’s parliament approved a 2026 budget totaling 699 billion shekels on Monday, with defense spending surging more than 120% from pre-war levels. Affected by fighting on multiple fronts, the government raised its deficit target to 4.9% of GDP, fueling rising debt pressure, a negative sovereign rating outlook, and a sharp stock market sell-off. The central bank is expected to keep interest rates unchanged at 4%, balancing the dilemma of rising inflation and downwardly revised growth.

The cost of war is permeating Israel’s public finances. Israel’s parliament passed the 2026 state budget in the early hours of Monday, amounting to 699 billion shekels (approximately $222 billion). The fiscal deficit target was set at 4.9% of GDP, with defense spending jumping more than 120% compared with levels before the 2023 Gaza conflict. The budget shortfall will be covered mainly through borrowing and cuts to civilian expenditure.

The Bank of Israel is expected to leave its benchmark interest rate unchanged at 4% for the second consecutive meeting on Monday and will publish its first updated macroeconomic forecasts since the outbreak of the Israel-Iran conflict. Bank of Israel Governor Amir Yaron has already warned that a higher deficit target combined with lower growth projections will push up Israel’s debt-to-GDP ratio. While Fitch Ratings maintained Israel’s sovereign rating at A, it revised the outlook to negative and forecast the actual deficit will widen further to 5.7% of GDP this year, exceeding the government’s target.

Israeli assets have already come under pressure. According to Bloomberg, the TA-35 Index plunged 3.8% last Friday, marking its biggest one-day drop in nearly a year, erasing all gains since the conflict erupted in late February. Israel is currently fighting on multiple fronts, engaging in direct conflict with Iran and military operations against Hezbollah in Lebanon.

Over the weekend, Yemen’s Houthi movement announced it was joining Iran’s side, firing missiles at Israel and opening a new front. This further boosted risk premiums in the crude oil market, reignited domestic inflation expectations in Israel, and put the country’s central bank in a monetary policy dilemma.

## Surge in Defense Spending, Deficit Expansion Funded by Borrowing

Israel’s Knesset approved the 2026 state budget in the early hours of Monday by a vote of 62 to 55. Defense spending was the largest single item in the budget, reaching 143 billion shekels — an increase of roughly 120% from before the 2023 Gaza war. The government also set aside a 6 billion shekel special reserve for Iran war-related costs or other military needs, bringing supplementary defense funding to at least 38 billion shekels (about $12.4 billion), roughly 2% of GDP. These funds will mainly be used to replenish Israel’s military stockpiles and pay reservists.

The deficit target had previously been expected at 5.1% of GDP but was narrowed to 4.9% after Israeli banks agreed to make a one-time tax payment of around 3 billion shekels to the treasury. Other funding sources include 10 billion shekels in above-target government revenue and a unified 3% cut to all civilian government ministries. Since Israel launched military reprisals against Hamas in October 2023, government borrowing has expanded sharply, peaking at nearly 280 billion shekels in 2024.

Israeli Prime Minister Benjamin Netanyahu said in a video statement last week: “This war costs a great deal, so we need a special budget that includes tens of billions of shekels to strengthen defense spending.”

## Political Compromises Pave Way for Budget Passage

The smooth passage of the budget was partly due to a series of political concessions by Netanyahu to build consensus within his coalition government. He shelved several bills that had caused friction inside the ruling bloc, including a highly controversial proposal to exempt ultra-Orthodox men from military service. Finance Minister Bezalel Smotrich abandoned his push for a state-regulated dairy reform — a measure intended to ease public cost-of-living pressures. Standing alongside Netanyahu last week, Smotrich said: “Wartime requires unity and national responsibility.”

The budget’s approval carries special political significance for Netanyahu’s cabinet: under Israeli law, failure to pass a budget by March 31 would trigger automatic government dissolution.

The budget legislative package also includes several tax incentives: tax exemptions for overseas Israelis and Jewish immigrants returning to Israel to counter war-driven brain drain; tax breaks for middle-class employees; and corporate tax reductions for research and development activities at technology companies.

## Growth Forecasts Slashed Across the Board, Debt Pressure Mounts

In a Bloomberg survey of economists, all respondents predicted the Bank of Israel would hold its benchmark interest rate steady at 4%. The central bank will simultaneously release its first updated macroeconomic forecasts since the conflict began on February 28, followed by a press conference led by Governor Amir Yaron.

Economic growth projections have been sharply revised downward across institutions from pre-war levels. Yaron told reporters last week that before the current conflict, the central bank had expected 5.2% growth this year with a fiscal deficit target of 3.9% of GDP — “a level that would have stabilized our debt-to-GDP ratio.” Now, a higher deficit paired with weaker growth will push the ratio higher. Rafael Gozlan, chief economist at IBI Investment House, currently forecasts 2026 growth at around 4% with downside risks. Bank Hapoalim, Israel’s second-largest lender, projects economic expansion of just 3% if the war ends by the end of the month.

While Fitch maintained Israel’s A-rating, it revised the outlook to negative and forecast the fiscal deficit will widen to 5.7% of GDP this year from 4.7% in 2025, exceeding the government’s 4.9% target, mainly because actual military spending is expected to surpass official projections.

## Rising Inflation Creates Monetary Policy Dilemma

The expanding conflict has also put the Bank of Israel in a monetary policy bind. Israel relies on domestic natural gas production, which has partly offset the shock of surging global oil prices, but local analysts have begun raising price forecasts. Bank Hapoalim lifted its 12-month inflation projection to 2.2%, above the midpoint of the central bank’s 1%–3% target range, citing persistent pressure on airfares and potential new taxes that could lift inflation. “A prolonged war could push inflation even higher,” the bank’s economists wrote in a note to investors. “At the same time, most major central banks have shifted to rate-hiking mode, making it unlikely the Bank of Israel will move against the tide.”

On the rate path, some analysts expect one 25-basis-point rate cut over the coming year, but Bank Hapoalim believes the benchmark rate could eventually fall to 3.5%. The bank noted: “Once the war ends, contracting output and an expected decline in oil prices will bring rate cuts back onto the agenda earlier than markets currently price in.”

---

## Risk Warning and Disclaimer

The market is subject to risks; investment requires caution. This article does not constitute personal investment advice and does not take into account the specific investment objectives, financial situations or needs of individual users. Users should consider whether any opinions, views or conclusions in this article are suitable for their specific circumstances. Investment based on this article is at your own risk.