* War with Hamas weighing on consumers, industry, tourism
* Bank of Israel has cut interest rates twice; at record low
* Budget deficit target set to be missed
* Economists see growth potential dropping to around 3 pct
By Steven Scheer
JERUSALEM, Aug 26 For more than a decade,
Israel's high-tech-fuelled economy has weathered the global
financial crisis and several military conflicts with little
impact on growth or the free flow of foreign investment.
But its strong run, which led former finance minister Yuval
Steinitz to coin its justifiably upbeat tag as the 'Best in the
West', may be coming to an abrupt end, with the era of
sustainable high growth rates consigned to history.
The war against Hamas in Gaza, which ran into a 50th day on
Tuesday, has taken a heavy toll, hitting tourism, slowing
consumer spending as people stay indoors and denting
manufacturing, especially in plants close to Gaza.
Even before the conflict began on July 8, growth was
weakening. A preliminary estimate showed the economy grew an
annualised 1.7 percent in the second quarter, down from 2.8
percent in the first, while unemployment inched above 6 percent
from 5.7 percent in late 2013.
With a concerned central bank expecting the war to knock
around half a percentage point off output, forecasts for growth
of around 3 percent this year now look wildly optimistic, and
the budget deficit is likely to exceed its 3 percent target.
After a decade of growth of 3-5 percent a year - during
which Israel's economy has nearly tripled in nominal terms to
$300 billion - some are even predicting a complete reversal.
"We might have a recession," said veteran Israeli economist
Ayelet Nir, although she adds it wouldn't be a deep one.
Prospects of a sharp downturn, coupled with near zero
inflation, prompted a second surprise interest rate cut in the
past month on Monday, when the Bank of Israel trimmed its
benchmark rate to an all-time low of 0.25 percent.
"We are definitely in a slowdown in activity," said central
bank governor Karnit Flug.
Economists point out that the economy - 40 percent dependent
on exports, mostly high-tech goods and software - is still
looking solid compared with much of Europe and the West.
But like most developed economies, Israel is becoming more
services-oriented, which means growth depends on its major
trading partners buying its high-value services.
With the largest, Europe and the United States, both
struggling and the shekel currency strong, Israel has to
work even harder to be competitive and grow its exports.
Add to that war-weary consumers who are growing fed up with
the high cost of living -- even if inflation is stable -- and
the days of Israel posting up to 5 percent growth may be over.
"Our growth potential is not as high as before," said Nir,
who projects long-run output of around 3 percent.
"The population growth is not as high as in the past,
investment is not as high as in the past, productivity is very
low ... and Israel is transitioning from manufacturing to
services," she said. "It is happening very fast."
SQUEEZED ON ALL SIDES
Mai Doan, an emerging markets economist at Bank of America
Merrill Lynch, said many of Israel's problems stem from the fact
that the world has changed: Global trade has slowed, while
fiscal restraint has weighed on growth, especially in Europe.
"Israel is a developed country so we are not talking high
single digits (anymore). So 2-1/2 or 3 percent is a decent rate
of growth," she said.
Once the Gaza conflict ends, the next problem Israel faces
is the 2015 budget and the risk of missing fiscal targets.
Finance Minister Yair Lapid has said the 3 percent deficit goal
for 2014 will likely be breached.
A 2015 target of 2.5 percent of GDP is also in jeopardy due
to a likely jump in the defence budget. At the same time, Lapid
had promised not to raise taxes or limit social spending.
"There is some room for manoeuvre but not much," Nir said.
"It can be 3 to 3.5 percent but not 5-6 percent again."
One perennial bright spot for Israel has been more than $10
billion a year in foreign direct investment as global companies
such as Apple and Google snap up Israeli tech firms. In 2013,
Israel was ranked fourth among the OECD -- a club for rich
countries -- for foreign direct investment.
The country has also seen heavy investments in developing
its natural gas sector, although investment in residential
building and industries has declined over the past year.
Nir fears that the current round of fighting could dent
inflows as companies take a wait-and-see approach.
Such flows have also been an Achilles heel for Israel's
economy, prompting the shekel to appreciate sharply and making
exports relatively more expensive. As a result, the Bank of
Israel has bought more than $55 billion of foreign currency
since 2008 in a bid to weaken the shekel.
It now stands at a nearly one-year low of 3.58 versus the
dollar, after a 4.5 percent depreciation in the past month.
But in historical terms it remains strong. Only a month ago,
it stood at a three-year high of 3.40, having appreciated 20
percent since 2009.
"What's hurting Israel now is the tradeable sector due to
the strong shekel," Doan said.
Analysts doubt the Bank of Israel will push its key rate to
zero but if it does, the next step would be to buy bonds,
following the pattern of 'quantitative easing' adopted in the
"There is a good chance that Israeli rates will stay low
even when the United States starts to raise them," Nir said.
(Reporting by Steven Scheer; editing by Luke Baker and John