One Year Ahead Five Years Ahead
Risk Category Year Ago Current 06/10 Worst Case Best Case Worst Case Best Case
Political Risk 63.5 64.5 60.0 66.5 59.5 73.0
Financial Risk 39.0 42.5 36.0 43.0 33.5 43.5
Economic Risk 34.0 41.0 36.0 41.5 31.5 43.0
Composite Risk 68.3 74.0 66.0 75.5 62.3 79.8
Risk Band Mod. Low Mod. Low Mod. Low


Government Stability/External Conflict
Diplomatic Misstep

In May, Israeli and Palestinian negotiators began holding so-called “proximity talks,” with US Mideast Envoy George Mitchell meeting separately with representatives from each side.  Although the arrangement breathed some life into a peace process that had completely stalled for more than a year, given the limited objectives of the proximity talks – namely, the establishment of a basis for a return to direct negotiations – it is difficult to interpret this latest development as anything other than a major step backward.

The near-universal pessimism that greeted the initiation of indirect talks appeared to be validated on May 31, when commandos conducting a raid on an international aid flotilla threatening to run the Israeli blockade of Palestinian-controlled Gaza killed nine people, reportedly after meeting resistance from knife- and club-wielding pro-Palestinian activists on board one of the ships.  The Israeli government has defended the operation as a justifiable defense of its national security, but the incident has provoked widespread condemnation and left Israel vulnerable to international isolation.

It is too early to tell whether the botched raid will have a negative impact on the stability of Prime Minister Binyamin Netanyahu’s coalition government, which includes both the center-left Labor Party and smaller right-wing parties.  The affair has focused international attention on the blockade, which was initiated in mid-2007, after Gaza fell under the control of Hamas, a radical Islamist movement that refuses to acknowledge Israel’s right to exist.  The early indications are that much of the international outrage would subside were Israel to lift the embargo, but such a move would risk triggering a revolt by Netanyahu’s nationalist partners.

The prime minister and his conservative Likud party have based their entire political strategy on selling the notion that the rest of the world (with the possible exception of the US) either desires Israel’s destruction or does not care enough to prevent its destruction, a belief that they have used to justify their uncompromising approach to peace negotiations.  Obviously, Netanyahu’s credibility stands to be enhanced if reality provides confirmation of that worldview, and observers both within and outside Israel have suggested that the circumstances surrounding the raid and the government’s immediate response appear to be guided by a desire to manufacture such confirmation.

In any case, the regime does not appear to be in any immediate danger of collapsing.  However, the extent of the diplomatic fallout remains to be seen.  The key risk in this regard is the possibility that international responses might include economic penalties, a development that could make it more difficult to craft a 2011 budget that satisfies all of the government partners.

Netanyahu Doubling Down

In the wake of the botched raid, governments across Europe and the Middle East have stepped up their denunciations of Israel’s policy of “collective punishment” of the 1.5 million inhabitants of Gaza and demanded the lifting of the blockade.  Israel insists that the blockade is necessary, owing to the unwillingness of Hamas to bring an end to Gaza-based missile attacks on Israeli territory, and the danger that the free movement of goods into the region would facilitate the smuggling of arms and munitions.

Netanyahu has stated in no uncertain terms that his government will continue to closely control who and what enters and exits the region.  The Israeli government has also categorically rejected calls for an international investigation into the raid.

Although Netanyahu’s strategy of digging in is understandable from the standpoint of domestic politics – polls consistently show overwhelming public support for the blockade – it increases the risk of Israel’s international isolation.  In Europe, moves to organize non-official boycotts of Israeli goods are already under way, and the Palestinian Authority (PA) and its UN allies are demanding that sanctions be imposed.

Unfortunately for Netanyahu, he cannot count on the outrage dissipating with the passage to time.  Pro-Palestinian activists have asserted that they will continue to challenge what they deem to be an illegal embargo, and another ship carrying aid was stopped on June 5.  Israel’s use of an alternative means of preventing the breach of the blockade – military personnel boarded the ship from speed boats after stopping the vessel – has merely reinforced the belief among critics that the violence on May 31 could have been avoided.

Moreover, the blockade will be less effective going forward.  To the extent that the policy has “worked,” that was largely due to the cooperation of Egypt, which imposed tight restrictions on its own border with Gaza.  However, in the wake of the Israeli raid, Egypt loosened control of the border, making it much easier for people and goods to move in and out of the territory.

Special Relationship with US May Be Tested

Meanwhile, the status of the proximity talks has been thrown into doubt.  Mahmoud Abbas, the president of the Palestinian Authority (PA), has declared that he will implore US President Barack Obama to make “bold decisions” regarding the peace process during a planned meeting between the two leaders in early June.  Presumably, among the bold decisions Abbas seeks from Obama is the application of pressure on Israel to end the siege of Gaza.  The chances of Netanyahu doing so are slim to none.

Nevertheless, the US remains hopeful of salvaging the peace process, and has displayed extreme caution in its response to the raid on the flotilla.  In her first official statement on the incident, US Secretary of State Hillary Clinton underlined the Obama administration’s recognition of Israel’s right to self-defense, while bluntly stating the siege of Gaza was both “unsustainable and intolerable.”  However, the revelation that an American-born student was among those killed could make it more difficult for Washington to sustain a stance of neutrality.

For their part, both Israeli Prime Minister Binyamin Netanyahu and PA President Abbas have confirmed their commitment to moving forward with the proximity talks.  However, it is difficult to see how the process can move beyond that point, even if indirect negotiations continue.  Neither side has given any indication that it is prepared to compromise on the sticking points that contributed to the prolonged stalling of talks, and the deadly raid on the flotilla – which the PA leader has condemned as an act of terrorism against the Palestinian people – has, if anything, diminished the scope for flexibility on either side.

The botched raid has also seriously complicated Israel’s broader foreign policy, as most of its traditional allies (other than the US) have joined the chorus of condemnation.  The incident has inflicted especially serious damage on Israel’s relationship with Turkey, historically its closest ally in the Muslim world.  The ship boarded by Israeli commandos was sailing under a Turkish flag, and at least four of those killed were Turkish citizens.  Prime Minister Recep Tayyip Erdogan has denounced the assault as a massacre, and Turkey has recalled its ambassador to Israel.  In addition, Turkish lawmakers have demanded a serious reconsideration of Turkey’s political, military, and economic ties with Israel.

Israel’s alienation of Turkey has potentially serious negative implications for the broader Middle East peace process.  The government in Ankara has been working for months to establish a basis for talks between Israel and Syria, an effort that has produced some results.  However, Turkey is unlikely to continue playing such a role in the wake of the assault on the flotilla, and even if it were, it is an open question whether Turkey can claim to be an honest broker given its tacit support for the activists’ attempt to run the Gaza blockade.

Perhaps the larger danger is that Israel will lose its credibility on the issue of threats to its security, in particular, that posed by Iran and its nuclear ambitions.  The US has been pushing hard to win international backing for tighter sanctions on Iran, but Washington’s efforts to forge a united global front against the regime in Tehran could well unravel in the aftermath of the flotilla raid.

Netanyahu has consistently refused to discount the possibility of unilateral action by Israel to eliminate Iran’s nuclear capability.  That factor may well have influenced the Obama administration’s own decision to discard an agreement for a nuclear-fuel swap brokered by Brazil and Turkey, in favor of pursuing stronger sanctions, a move that has left both Brazil and Turkey feeling betrayed by the US.

Should Israel’s actions prove the undoing of the sanctions effort, thereby negating any diplomatic benefit for the US that might have balanced the costs of alienating Turkey and Brazil, not to mention undoing the hard work that Washington has put into persuading Russia and China to back the plan, the Obama administration would be justifiably irate.

That the US and Israel have a special relationship is undeniable.  But if US support for Israel begins to seriously undermine other alliances that are crucial to immediate US security interests – and the US relationship with Turkey certainly falls into that category – Israel risks seeing its relationship with the US become less special.  In that event, the perceived threat posed by Iran would increase accordingly, as would the danger that Israel might feel compelled to act on its own, with potentially disastrous consequences for regional stability.

No Immediate Threat to Government Stability

Armchair international law experts are debating the legality of Israel’s actions, although historical precedent would seem to suggest that Israel operated within the common understanding of the law.  But there is already an emerging consensus that the decision to drop armed commandos onto a sea-borne vessel was ill-conceived and played into the hands of the activists, who made clear that they were hoping to provoke an aggressive response.  Defense Minister Ehud Barak, the leader of the Labor Party, has been the main focus of criticism in the immediate aftermath of the raid; Yedioth Ahronoth, the country’s most widely read newspaper, demanded Barak’s resignation on the front page of its June 1 edition.

The decision to go ahead with the raid apparently was made by Netanyahu and Barak, who did not present the plan to the sub-Cabinet grouping of seven senior ministers, as is the standard operating procedure in such cases.  Pointed criticism in the press attributed to anonymous senior government officials indicates that the exclusion of key members of the government from the decision-making process has created a rift in the Cabinet.

While it is early yet, there is no real indication that Netanyahu’s government is in serious trouble.  An opinion poll conducted by TNS/Telesker found that two-thirds of respondents believed there was a better way to deal with the flotilla, and more than 40% blamed Defense Minister Barak for the deadly outcome.  However, less than 10% expressed the opinion that either Netanyahu or Barak should resign over the affair.

Similarly, while key Cabinet officials might be perturbed at being left out of the discussions regarding the raid, there is little reason to believe that the most influential among them, Foreign Minister Avigdor Lieberman, the leader of the far-right Israel Is Our Home (Yisrael Beitenu) party, would have objected to an aggressive approach.  In any case, Netanyahu’s stance on the blockade will go a long way toward repairing any damage to ties between his Likud party and its right-wing allies.

Assuming Netanyahu does not bend to international pressure on the embargo or other pet right-wing issues, such as Jewish settlements in the West Bank and the status of Jerusalem, the only real threat to the survival of his government in the coming months is the possibility that Labor might desert the coalition.  But that is also unlikely, as an early election is the last thing Labor wants at the moment.

Labor’s decision to join a right-wing coalition was very controversial, and divided the party’s base.  Barak defended the move on the grounds that it would enable Labor to influence the direction of peace negotiations, and unless he is able to point to practical results that prove the wisdom of his decision – which will not be possible if a snap election is held in the near term – he will have a hard time reuniting the party’s base.  Moreover, given Barak’s central role in the botched raid, Labor would likely incur the most damage from any electoral backlash generated by the incident.

OECD Accepts Israel

The diplomatic furor over the flotilla raid was unleashed a mere four days after Israel was formally admitted to membership in the Organization for Economic Cooperation and Development (OECD), in the process confirming the country’s status as a developed democracy.  As a result of its acceptance in the club of global economic powerhouses, Israel is certified to have achieved (and is obligated to continue adhering to) OECD standards in the areas of state regulation, investment and intellectual property rights, environmental protection, anti-corruption measures, and macroeconomic management and transparency, all of which stand to improve the country’s ability to attract foreign investment and buyers for its sovereign bonds.

But OECD membership also represents a stamp of democratic legitimacy, a factor that ensured Israel’s application would be controversial.  Palestinian Prime Minister Salam Fayad and numerous other Arab and Muslim leaders lobbied OECD members to block Israel’s accession bid on the grounds that its treatment of the Gaza population, and the more general restrictions on the movement of goods and people across its borders, were not in keeping with the political principles of the organization.  In the weeks leading up to the May vote, Turkey, whose relationship with Israel had already soured over the military campaign conducted in Gaza in December 2008, was threatening to use its veto to thwart Israel’s bid, but ultimately relented.

Against that backdrop, it would not be surprising if the events surrounding the flotilla raid have left some OECD members feeling that they gave Israel the benefit of the doubt and have been played for suckers.  Nor is it a stretch to conclude that membership in the organization might itself have contributed to a sense among Israeli leaders that they need not concern themselves with the opinion of the international community.

Such considerations could lay the ground for an effort among other OECD members to ensure that the Israelis “don’t get away with it.”  Indeed, it is not surprising that Norway, Ireland, and Turkey, the three members who expressed the strongest reservations about admitting Israel, have also been among the loudest critics of the flotilla killings.

But even traditionally reliable European supporters of Israel, such as the UK, have denounced the raid, and established organized campaigns in the US, Europe, and elsewhere to boycott Israeli businesses, goods, and participation in sports and cultural performances over Israel’s treatment of Palestinians in Gaza are attracting growing support.  Meanwhile, a major investment firm in Israel has announced that it is divesting all of its Turkish holdings in response to Ankara’s threats to cut ties with Israel.

Whether these events portend real trouble for Israel is difficult to predict.  But it is safe to say that an export-dependent economy whose ability to attract investment is already hampered by security concerns can ill afford to respond to the spread of such sentiment with muteness or, even worse, defensive hostility.  Unfortunately, that appears to be how Netanyahu and other officials in his government intend to handle the problem.

Moderate Recovery

The OECD has noted some areas where improvement is needed.  Currently, one-fifth of Israel’s population lives below the poverty line, well above the OECD average of 11%.  Moreover, nearly one-half of all Israeli Arabs and 60% of the orthodox Jewish population are poor, and due to the low employment levels of women in the latter group, total labor participation in Israel stands at 59%, compared to the OECD average of 67%.

That said, the OECD has highlighted Israel’s numerous successes on the economic front.  Significantly, the public debt-to-GDP ratio is on track to fall below 70% in the medium term, far below the levels in the US, Germany, France, the UK, and several other richer countries.  Similarly, the 10-year average inflation rate in Israel is about one-half of the average for the other OECD members.

Diplomatic battles aside, the debt-related turmoil in Europe will likely have a negative impact on Israel’s economic fortunes in the near term.  Israel’s economy emerged from recession faster than most in the developed world, but growth has been driven by exports, which are sensitive to developments that contribute to weaker demand in major markets or strengthen the currency.  The debt troubles in Greece hold the potential to produce a double whammy, as the specter of a wider contagion has fueled concerns of another European (or possibly even global) recession and pushed the value of the shekel higher against the euro.

The full extent of Greece’s predicament only became apparent in late April, when the country’s debt rating was downgraded to “junk” status and warnings were sounded of a possible default on debt payments falling due in mid-May.  Those developments occurred less than a week after the Bank of Israel revised its 2010 forecast for real GDP growth upward to 3.7% (from 3.5% previously), based on an improved outlook for corporate earnings and expectations of a strong rebound in exports.

That is in line with the Finance Ministry’s forecast of 3.5%–3.9%, a somewhat slower anticipated pace of growth than the unofficial projection of 3.8%–4.3% announced by Finance Minister Yuval Shteinitz on April 27, the same day that Greece’s debt rating was cut.  In late May, the OECD forecast that the economy will grow by 3.8% this year, despite the gloomy outlook for Europe, as benign inflation and falling unemployment fuel stronger household demand and private investment.

However, the economy grew by just 1.2% (year-on-year) in the first quarter of 2010, compared to 2.3% in the final quarter of 2009, as gross capital investment contracted by 12%, and growth rates for exports, private consumption, and government expenditure held fairly steady.  Measured quarter-on-quarter, the seasonally adjusted pace of growth slowed to 0.8%, from 1.2% in the October–December 2009 period, as exports contracted by slightly more than 1% compared to the fourth quarter of last year.  On that basis, the official forecasts already appear to be too optimistic, and with the cloud over Europe growing darker with each day, and the impact of any post-raid economic fallout still to be determined, real GDP growth is likely to be held closer to 3% in 2010.

The government has set a goal of reducing the budget deficit from 5.2% of GDP in 2009 to 3% next year and 2% in 2012, and is counting on a planned cut in the corporate tax rate from 25% to 24% and the continued reversal of a hike in the value-added tax (VAT) that was implemented in 2009 to fuel the strong growth that will be required to close the budget gap while easing the tax burden.  But weaker than forecast growth in 2010 may put the near-term deficit target out of reach, forcing a delay in planned tax cuts that will hold real GDP growth to 3%–3.5% in 2011.

Rising commodity prices and somewhat stronger domestic demand will generate upward pressure on consumer prices in 2010, but the tightening of monetary policy since August 2009, the further appreciation of the shekel, and dissipation of the effects of last year’s increase in the VAT will hold inflation near the middle of the central bank’s target range of 1%–3% in 2010.

Both exports and imports will rebound in 2010, but higher commodity prices, stronger demand for consumer durables, and more robust investment in machinery and equipment will contribute to stronger growth of imports that will widen the trade deficit.  Diplomatic difficulties are expected to have a negative impact on the performance of the tourism sector, which will limit the near-term increase in the services surplus, but the income deficit is forecast to narrow this year, contributing to a current account surplus of $5.6 billion, or about 2.2% of GDP.