Month of war leaves Israel with tricky economic outlook

Wed Aug 13, 2014 6:20am EDT

* Conflict with Hamas ruins Gaza economy, costs Israel too

* Fitch warns on Israeli budget deficit, but positive overall

* Growing calls for boycott of Israeli products hurts sentiment

By Luke Baker

JERUSALEM, Aug 13 (Reuters) - Israel's month-long war with Hamas in Gaza has added fuel to a Palestinian boycott movement and may damage investor sentiment towards Israel at the margins, even if the $250 billion hi-tech economy looks set to emerge largely unscathed.

Analysts expect the war to have dented growth and cost several billion dollars - foreign tourism alone fell by 25 percent in July. But Israel has weathered such storms in the past and tends to rebound within a few months, with output expanding at around 3-4 percent a year in recent years.

The additional concern this time is that unrest in the West Bank has become more frequent and intense, the threat of a resumption of war in Gaza - the fourth in eight years - is very real, and international criticism of Israel has been loud, particularly in Europe, fuelling those who support a boycott.

While none of those factors alone will hole Israel's economy below the water line, they have the potential to sour confidence, knocking the country off its steady path, which has helped it attract vast flows of foreign direct investment.

"There was a slowdown in the economy even before the Gaza conflict because of falling internal demand, and exports were down," said Luis Costa, Citibank's head of foreign exchange and interest rate policy for central Europe, Middle East and Africa.

"The corporate sector is screaming for stimulus... There's more cautious international investor sentiment towards Israel."

At the same time the Palestinian-led BDS movement - for Boycott, Divestment and Sanctions - has ramped up its activities, calling for foreigners not to buy products made in West Bank settlements and pressuring artists to avoid Israel.

Several EU countries have warned companies about doing business with Israeli firms based in or having links to settlements, and the European Union has put restrictions on the scientific research projects it will fund with Israel.

Alex Joffe, a Middle East historian who tracks international action against Israel, predicts the Gaza conflict will fuel the nascent consumer and business backlash, citing recent steps taken by companies in Belgium and Britain, among others.

"These moves, plus growing anti-semitic protests and attacks throughout Europe, Canada and the United States, suggest that when the fighting in Gaza stops, Israel will be targeted for economic boycotts, in international forums, and in other contexts like colleges and universities," he wrote in a commentary last month.

DEFENCE SPENDING

From the point of view of the largest foreign investors, the BDS movement, founded in 2005, is not significant, at least not yet. It draws headlines and can damage sentiment at the margins, but Israel's broader economy, built on hi-tech innovation, pharmaceuticals and engineering, is largely unaffected.

"The economy is not isolated from these things, but certain elements are, such as the hi-tech sector, and that's where the foreign direct investment is going," said Paul Gamble, the director of sovereign ratings at Fitch, a credit ratings agency.

"I'm comfortable that will continue."

Instead Fitch's concern is that the Gaza war reinforces the risk of Israel being drawn into repeated costly conflicts, driving up defence spending, blowing out the budget and raising red flags over the sustainability of government finances.

"One of the things we are thinking about is the longer-term impact on defence spending," said Gamble, who cautioned in a report last week the budget deficit was likely to be missed, largely because spending on defence will not now be trimmed.

"We don't know if there's going to be a new status quo that's sustainable. From the point of view of international investors, you have to ask if ... you are going to see a conflict of this kind of magnitude every few years?"

That uncertainty, when combined with falling domestic demand - the central bank unexpectedly cut interest rates last month to try to stimulate activity - and the marginal risks that the BDS movement carries, has the potential to darken the outlook.

"We're not at the stage of BDS impairing investment in Israel - there's a pretty captive audience of investors willing to invest in Israeli pharma or hi-tech," said Citibank's Costa.

"But we are starting to see a bit of a division here on views on how Israel should be conducting itself."

The flipside is that if serious progress can be made in ongoing negotiations with Egypt and Hamas over Gaza, lowering the risk of another conflict, and more fruitful discussions with the Palestinian Authority over the West Bank take place as a result, many of the economic clouds could be dispersed. (Editing by Jeremy Gaunt)