Israel's central bank chief presented on Sunday the yearly report of the Bank of Israel for 2023, in which he also detailed the impacts of the Israel-Hamas war on the last quarter of the year.
"The war's adverse impact on the economy was seen on many levels," said Bank of Israel Governor Professor Amir Yaron in a letter to the Government and Knesset Finance committees attached to the report.
"GDP contracted, private consumption, and particularly investment, declined sharply, and exports declined by a more moderate pace," said Yaron, touching on the adverse impact on employment of Israeli workers, which he also said began to recover by the end of 2023.
There was a particularly acute impact in the construction and agriculture industries where there was a severe shortage of foreign workers, impacted by a prohibition to employ Palestinian laborers, said the report.
Lawmakers approved an amended 2024 state budget in March that added tens of billions of shekels to fund Israel's war against Hamas in Gaza as the conflict nears six months.
Yaron called for a committee to be formed to establish the size of the defense budget "in an informed manner."
"It should delineate Israel’s defense needs in the coming years and formulate an appropriate multi-year budget program that will take into account all the ramifications on the economy."
Yaron also said that if there are additional increases in the defense budget, they must be accompanied by fiscal adjustments to "at least prevent an enduring increase in the public debt to GDP ratio."
Israel intends to add some 20 billion shekels ($5.4 billion) of defense spending a year.
The amended budget sets a deficit of 6.6% of gross domestic product (GDP) in 2024, revised from a pre-war level of 2.25%. In February, the deficit rose to 5.6% over the previous 12 months from 4.8% in January.
The ratio of public debt to GDP grew from 60.5% to 61.9% this year.
The bank's monetary committee focused on stabilizing the markets with the outbreak of war, implementing a number of tools, including selling $30 billion in foreign exchanges.
Israel's economy impacted by existential events
The report also touched on the impact of the judicial overhaul on Israel's economy, saying that along with the war, it was one of the two "significant domestic events" that impacted Israel's economy in 2023.
The overhaul led to a number of "flashpoints" that were accompanied by reactions in the fiscal markets, said the report.
Medium- and long-term risks can result from structural changes that are perceived as harming the quality or independence of institutions or their reliance on the rule of law, said the report, explaining that such changes may deter investors (both domestic and foreign investors and make debt more expensive. Expectations of these long-term risks can raise the risk in the short term, impacting short-term indicators.
"The program of legislative changes and the resulting atmosphere in Israel were reflected during the period in the financial markets. Throughout the year, in view of the milestones in the process, the shekel depreciated markedly, and the Israeli capital market, as well as Israeli companies trading abroad, underperformed other countries," said the report.
The report said, "In addition, venture fund investment data showed underperformance in capital raised for startup companies." It added that when the overhaul was not advanced, financial shocks were less intense.
GDP growth was slower than in previous years for the first three quarters of 2023, and for the year overall, GDP grew by only 2%, meaning GDP per capita did not grow at all in 2023.
Inflation peaked in the beginning of 2023 at 5.4%, and gradually declined over the course of the year. Its annual level is 3%, which is the upper bound of the target rate.
"Tight monetary policy, the decline in inflation worldwide, and the acyclical fiscal policy adopted by Israel during the period contributed to the decrease in inflation until the war. In contrast, the depreciation of the shekel delayed the convergence of inflation to its target," said the report.
Yaron said Israel's economy faces significant challenges, particularly low labor productivity and a lack of standard-skills education that prevent ultra-Orthodox Jewish men and Arab women from integrating into the labor market.
"Looking ahead, the economy is facing significant challenges deriving from the war, in addition to structural challenges related to its fundamental problems that have existed for some time already," he said.
"The Israeli economy has known how to recover from more than a few difficult periods in the past and to return rapidly to prosperity," concluded Yaron. "It is based on robust and solid economic foundations that have been built over years, which provide strength and stability," and responsible economic policy will help achieve sustainable growth, he finished.
Reuters contributed to this report.