Among the many differences between Israel’s current war against Hamas in Gaza and the other wars it has fought in the past few decades, one aspect has gone underexamined: its economic impact. Israel’s previous wars have had limited economic fallout, in part due to their brevity. By contrast, the current conflict against Hamas promises to be a more protracted campaign that will affect a more significant swathe of the Israeli population and disrupt supply chains to a much greater degree.
Fortunately, the Israeli economy entered the war in relatively good shape in terms of its resilience and strength. The economy has recorded high, albeit declining, annual rates of growth, averaging 3.9 percent since 2000. The International Monetary Fund forecast growth for 2023 at 3.1 percent, increasing to 3.6 percent by 2026. This sustained expansion gave Israel one of the highest per capita incomes in the Middle East, placing it roughly on a par with Spain and Italy.
In addition, Israel’s financial metrics were strong prior to the war, with a budget and current account surplus, and a falling debt-to-GDP ratio in 2022. Before the start of the war, the Bank of Israel had $200 billion of foreign exchange reserves, or the equivalent of a year’s worth of imports. In a June 2023 report, the IMF characterized Israel’s banking sector as “broadly robust” with little concern of any systemic risks emanating from the industry.
The success of the Israeli economy stems from several critical factors. Israel’s governance and business environment stand out in the region, helping it develop a diversified economy with many start-ups. Israel has invested heavily in education and spends more of its GDP on civilian research and development than any other country. Its highly skilled workforce enables the country to attract large volumes of foreign direct investment into growth sectors, such as information technology and pharmaceuticals, making Israel the Middle East’s technology hub.
However, even prior to the Israel-Hamas war, the judicial overhaul proposed by Prime Minister Benjamin Netanyahu’s government had already incurred some economic costs. The leading credit agencies expressed concern that the judicial reforms would further undermine Israel’s relatively weak institutional rating and create deep and lasting political divisions, due to the massive and prolonged protest movement they catalyzed. Foreign investors were also growing anxious about the nation’s prospects and delaying their investments. However, in the end, only Moody’s acted, lowering Israel’s outlook from “positive” to “stable” in April 2023.
By contrast, the impact of the war is set to be far more significant and long-lasting. In the immediate aftermath of Hamas’ unprecedented attack on Israel on Oct. 7, substantial areas in southern Israel bordering Gaza and in northern Israel bordering Lebanon were evacuated due to ongoing missile fire from Hamas and Hezbollah respectively. The attack also led to the closure of schools and nonessential retail shops across the country, with the latter restrictions eased only gradually.
Another immediate impact was on the availability of labor. The fighting in Gaza and tensions with Hezbollah on the border with Lebanon have forced Israel to mobilize around 360,000 reservists, which represents about 8 percent of the country’s labor force, for an undetermined period. Israeli authorities also barred about 110,000 West Bank Palestinians and 18,500 Gazans with work permits from crossing the border for security reasons. And after Hamas killed many Thai workers in the initial attack on Oct. 7 and took dozens of others hostage, nearly all the rest left the country. Many foreign workers from other countries have similarly headed home, and it is unclear how many will return without a lasting end to the fighting.
The labor shortages due to the war have affected nearly all the significant sectors of the Israeli economy. Agriculture, particularly in the south, suffered severe crop losses due to the loss of up to 40,000 Palestinian and foreign workers.
The war mobilization has also affected Israel’s dynamic high-tech industries, which have spearheaded the economy’s growth for several decades and now account for 14 percent of jobs and almost a fifth of gross domestic product. The sector also attracts significant foreign investment and is a major source of exports. However, high-tech industries have suffered more than most, with a disproportionate share of their mostly young and male workforce called for reserve duty. One company, Magic Software, has reported that 14 percent of its employees are currently serving in the army.
Israel’s economy has recovered quickly from the country’s previous brief wars, but this conflict already exceeds them in terms of duration, personnel shortages and supply chain disruptions.
Even before the war, there were indications that many high-tech companies and their educated employees were relocating away from Israel. This trend may increase because of the war-related drop in domestic sales and increased uncertainty over future prospects. If that does turn out to be the case, the result will be a severe erosion of Israeli expertise, making the country’s tech industries less appealing to investors. As the high-tech sector is by far Israel’s most productive industry, its slowdown would significantly affect overall economic growth.
Israel’s historical preoccupation with energy security, arising from a lack of domestic resources and cross-border interconnections, had eased since the discovery of offshore natural gas reserves in 2009-2010. However, the war forced a five-week precautionary shutdown at the Tamar gas field—the principal source of domestic power-generation feedstock as well as for exports to Egypt—which lies close to the Gaza coastline. Gas exports returned to normal levels after Tamar reopened in mid-November. Still, foreign investors needed for further gas development may only commit significant funds once a peace process appears in the offering.
Israel’s tourism sector, which accounts for around 2.8 percent of GDP and about 3.5 percent of total employment, had not fully recovered from the pandemic-era drop in business. The war in Gaza will not improve matters. Nearly all international airlines suspended flights to Israel after Oct. 7, though some are gradually returning to normal operations. In a bitter irony, the hospitality industry has been less affected, as the Israeli government housed many evacuees from the border with Gaza in hotels. While the war started at the end of the tourist high season, it will probably discourage those who had planned visits over the Christmas-to-New Year’s holiday. The summer season is also in jeopardy as tourist security concerns typically linger for some time after the end of a conflict.
Before the war, the Israeli housing market faced higher interest rates, declining prices and falling sales. The war has exacerbated those trends. The Bank of Israel left the prime interest rate unchanged at 4.75 percent after Oct. 7, in part to stabilize the exchange rate. But high interest rates and the uncertainty generated by the war have resulted in a sharp drop in new mortgages and home sales. Also, Palestinians from the West Bank and Gaza and foreign guest workers made up about one-third of the home construction industry’s labor force. However, as mentioned, most of the former cannot enter Israel and most of the latter have left.
In the short run, Israel’s strong macroeconomic fundamentals and manageable fiscal situation have allowed the government to increase expenditure to stabilize the economy. However, a sharp contraction of around 11 percent is expected to occur in the last quarter of 2023, with the top three ratings agencies having lowered Israel’s outlook to negative during October.
Israel’s economy has recovered quickly from the country’s previous brief wars, but this conflict already exceeds them in terms of duration, personnel shortages and supply chain disruptions. Moreover, the direct cost of the war is around $246 million per day. Assuming that the fighting is limited to Gaza and lasts up to one year, and that 150,000 of the reservists are demobilized relatively soon, the war will cost up to $51 billion. Defense spending is also likely to remain high in the medium to long term, with implications for the economy and the government’s ability to allocate resources to social spending.
While Israel’s stated goals for the war are the military defeat of Hamas and the return of all hostages, there are serious doubts over whether the former is attainable, even after a prolonged period of conflict. And even if Israel does succeed in its goals, it may end up responsible for providing services and security in Gaza, which would be a further drag on its economy.
The critical factor in determining the long-term economic impact of the war, therefore, will be whether it results in a peace accord. If not, the Israeli economy will continue to suffer from reduced investment and slowed economic and productivity growth due to brain-drain and the loss of high-tech firms to other countries, as well as severe labor shortages in sectors such as construction and agriculture.
The implications are clear. For the first time, Israel needs the considerable economic benefits a two-state solution offers in the form of greater access to the labor that will be critical for its own economic recovery. The alternative is a forever war that Israel cannot afford to fight.
Robert Looney is a distinguished professor at the Naval Postgraduate School in Monterey, California. He specializes in issues relating to energy security and economic development in the Middle East, Africa, South Asia and Latin America.