Israel 2026: The Fiscal-Political Reset After Gaza, Lebanon, and the Iran Strikes

The war ledger and the cumulative cost estimate #

The Bank of Israel, in its 2024 annual report and financial stability surveys, estimated cumulative direct war costs through end 2024 at approximately 250 billion shekels, roughly 67 billion dollars at the average shekel rate for the period. The figure includes military procurement and operations, evacuee compensation for residents of the north and the Gaza envelope, infrastructure repair, and direct payments to households and businesses under the Property Tax Compensation Fund. Lebanon-specific incremental cost, isolated by the Bank of Israel, sits at 60 to 75 billion shekels of the headline figure, reflecting the November 2024 ceasefire that ended a fourteen-month exchange with Hezbollah.

The two Iranian direct strikes on Israel in April 2024 and October 2024, and Israeli strikes on Iranian missile production and air defense in October 2024, consumed Arrow 3, David's Sling, and Iron Dome interceptors at unusually high rates. The Knesset Foreign Affairs and Defense Committee disclosed in early 2025 that interceptor restocking and accelerated procurement of Arrow 4 and Iron Beam contributed roughly 24 billion shekels to the 2024 to 2025 supplemental defense envelope. The Houthi campaign in the southern Red Sea cut Eilat port traffic by more than 85 percent through 2024, drove Eilat Port Company into a state-supported workout in mid-2024, and added an estimated 0.3 percent of GDP in higher logistics costs for Israeli importers routing through Haifa and Ashdod.

GDP path: from the Q4 2023 collapse to flat 2024 to recovery #

Real GDP contracted 19.4 percent annualized in the fourth quarter of 2023, the steepest single-quarter print outside the early COVID period, driven by the immediate reservist call-up of roughly 360,000 personnel that withdrew about 8 percent of the labor force for several weeks. The Central Bureau of Statistics revised 2023 full-year growth to 2.0 percent, with the first three quarters contributing virtually all the gain. Calendar 2024 closed at approximately zero growth, with services and construction depressed throughout, while high-tech exports held up better than feared because most reservist call-ups concentrated in combat and combat support roles rather than R and D centers.

The Bank of Israel and IMF Article IV staff converge on 2.0 to 2.5 percent growth for both 2025 and 2026, with the upper end conditional on the ceasefire holding, normalization of construction labor inflows from the West Bank and from Asian source countries under bilateral agreements signed in 2024, and a resumption of inbound tourism that ran at less than 25 percent of 2019 levels through 2024. The output gap, which the Bank of Israel estimates at minus 2.5 to minus 3.0 percent of potential at the start of 2025, is expected to close gradually through 2027.

The fiscal pivot and the Section 33 budget #

The central government deficit reached 6.9 percent of GDP in calendar 2024, against a pre-war path that had targeted 1.0 to 1.5 percent. The 2025 budget, passed by the Knesset on 25 March 2025 under Section 33 of the Basic Law on the State Budget, set a 4.7 percent deficit ceiling, raised VAT from 17 to 18 percent effective 1 January 2025, froze most discretionary civilian items in nominal terms, and added 79 billion shekels of incremental defense outlay relative to the original 2024 baseline. The Ministry of Finance also cancelled scheduled income tax bracket adjustments and froze public sector wage drift through end 2026.

Two compositional features of the 2025 budget are politically loaded. Settlement-related allocations through the Settlement Division and the Ministry of Settlements and National Missions were preserved and modestly expanded even as civilian ministries absorbed real cuts, a pattern flagged by the State Comptroller in his March 2025 special report. Ultra-Orthodox education and welfare funds, the subject of multiple Supreme Court challenges through 2024, were retained inside the coalition agreements that secured the budget vote. The 2026 budget, which the Ministry of Finance must table by 31 October 2025, will need to find further fiscal compression in a coalition whose most cohesive members defend the most politically contested categories.

Public debt to GDP rose to roughly 69 percent at end 2024 from 61 percent at end 2022. The Ministry of Finance debt management division extended average maturity to 8.4 years through longer dated domestic shekel issuance and Israeli sovereign dollar bonds, including the March 2024 8 billion dollar deal that priced wide of pre-war benchmarks. The 2026 to 2028 redemption profile is manageable under the IMF Article IV baseline, but is sensitive to a renewed conflict episode or to a downgrade that pushed Israeli paper out of additional reserve manager mandates.

Sovereign credit: three downgrades, three stabilizations #

S and P Global Ratings cut Israel from AA minus to A plus in October 2023, then to A in May 2024, with a negative outlook revised to stable in February 2025 after the Gaza ceasefire and the Section 33 budget. Fitch downgraded from A plus to A in August 2024 and moved to stable in March 2026. Moody's took the most aggressive action, cutting from A1 to A2 in February 2024 and to Baa1 in September 2024, the lowest rating Israel has held in two decades, before stabilizing the outlook in April 2025. All three agencies cited the same variables: the open-ended nature of the conflict at the time of action, deteriorating fiscal metrics, and institutional uncertainty from the judicial reform episode that preceded the war.

The market reaction was orderly. Israeli ten-year shekel yields peaked near 5.4 percent in late 2023, drifted back to 4.6 to 4.8 percent through 2025, and ended the first quarter of 2026 near 4.5 percent. Dollar denominated Israeli sovereign spreads widened to 175 basis points over US Treasuries at the worst point and have since compressed to 110 basis points, consistent with mid A. The technical risk for 2026 is index inclusion: a fourth downgrade by any agency would push Israeli paper out of certain Aa-rated reserve manager mandates and could force a discontinuous repricing rather than the orderly drift that has characterized the post-ceasefire window.

Bank of Israel, the shekel, and the rate path #

The Bank of Israel cut the policy rate from 4.75 percent to 4.50 percent in January 2024, then held at 4.50 percent through the first quarter of 2026, against a Federal Reserve path that delivered 75 basis points of cuts in 2024 and a further 50 basis points through April 2026. The implied shekel-dollar carry has narrowed but remains positive, and the central bank has been explicit that the rate path is constrained by inflation expectations, supply-side war effects, and the wage settlements signed by the public sector and large private employers in 2024 and 2025. Headline CPI ran at 3.2 percent year on year in March 2026, above the 1 to 3 percent target band but below the post-war peak of 3.8 percent.

The shekel reached 4.08 per dollar in March 2024 at the trough of confidence, recovered to 3.55 by late 2024 on the back of the Lebanon ceasefire and Iranian de-escalation, and has since settled in a 3.95 to 4.05 range through the first four months of 2026. The Bank of Israel announced a 30 billion dollar foreign exchange intervention envelope in October 2023, of which roughly 8.5 billion was deployed in the November 2023 to February 2024 window, and the remainder serves as a credible reserve. Reserves stood at 218 billion dollars at end March 2026, comfortably above the IMF reserve adequacy metric. Dollar denominated unit of account effects matter for foreign investors and for the high-tech sector, which earns roughly 75 percent of revenue in dollars and pays 55 to 60 percent of cost in shekels.

Reservist call-ups, the labor market, and Mizrahi Tefahot lending #

Reserve duty under Section 17 of the Defense Service Law reached a peak active mobilization of approximately 360,000 personnel in the late October 2023 wave, with sustained mobilization above 200,000 through the first half of 2024 and a tapering to 80,000 to 100,000 average through end 2024. The Manpower Directorate disclosed cumulative reserve duty days of roughly 80 million through end 2024, against a pre-war annual baseline near 6 million days. The labor market response has been complex: headline unemployment stayed below 4 percent throughout because reservists are not counted as unemployed, but full-time equivalent labor input fell by 4 to 6 percent across most of 2024 by Bank of Israel estimates.

Bank lending tells the story of who absorbed the shock. Mizrahi Tefahot Bank, the largest mortgage lender, expanded total credit by 9.4 percent in 2024 against a banking system average near 5.5 percent, with growth concentrated in housing finance and in business lending to mid-market industrial and construction borrowers. Hapoalim and Leumi grew more slowly and provisioned more aggressively against the construction and small business books. The composition is informative: settler municipalities and adjacent kibbutz zones in the north and Gaza envelope received targeted lending under government guarantee programs, while non-settler peripheral towns saw tighter credit. The divergence is small in aggregate but politically visible, and the State Comptroller flagged it for review in the 2025 special report.

Gaza reconstruction, ICJ measures, and the regional reset #

The World Bank, UN, and EU rapid damage and needs assessment of February 2025 priced Gaza reconstruction at 53 to 83 billion dollars over a ten to fifteen year horizon, against a 2022 nominal Gaza GDP near 2.5 billion dollars. Funding pledges through April 2026 amount to roughly 6 billion dollars in firm commitments, the bulk from Gulf donors and the European Union, against a working assumption that Israel will neither fund nor obstruct reconstruction. The Egyptian-led plan endorsed at the Cairo summit in March 2025 sets a five-year phasing that requires an interim Palestinian governance arrangement the Israeli coalition has not endorsed, the principal source of slippage on disbursement.

The legal architecture is binding and unresolved. The International Court of Justice provisional measures order of 26 January 2024, in the case brought by South Africa under the Genocide Convention, requires Israel to prevent genocidal acts, ensure humanitarian access, and report at six-month intervals. The merits phase will run for several years. The ICC arrest warrants issued in November 2024 against Prime Minister Netanyahu and former Defense Minister Gallant constrain travel to ICC member state jurisdictions. The effect on sovereign credit and on banking relationships is graduated: foreign currency clearing has not been disrupted, but selected European pension funds and Norwegian sovereign wealth divestments through 2025 illustrate the channel through which legal exposure becomes a financial cost.

Regionally, the Hezbollah leadership decapitation in September 2024 and the November 2024 ceasefire reset the northern security picture for the first time in two decades. Iran's regional axis has been weakened, with the December 2024 fall of the Assad government in Syria removing a key transit corridor. Saudi-Israel normalization, advanced in September 2023, is frozen, and the Gulf states have conditioned re-engagement on a credible path to Palestinian statehood. The high-tech sector, at roughly 14 percent of GDP and 53 percent of services exports, maintained recurring revenue because reservist call-ups distributed unevenly, but new venture capital formation in 2024 ran at 60 percent of the 2021 peak and inflows depend on a sustained ceasefire through 2027.

Sources #

• Bank of Israel, annual report and financial stability survey
• Israel Ministry of Finance, budget and debt management
• Israel Central Bureau of Statistics, national accounts and labor
• IMF Article IV Israel
• World Bank, UN, EU Gaza interim damage and needs assessment
• Brookings Doha Center, Middle East analysis
• S and P Global Ratings, Israel sovereign actions
• Fitch Ratings, Israel sovereign actions
• Moody's Investors Service, Israel sovereign actions
• The Times of Israel, budget and policy reporting