New Fighting Spooks Investors in Israel

The opening of a second front in Lebanon has shaken the Tel Aviv bourse. The key question: Will Israel's robust growth survive the fighting?

Israel's economy has been on a roll recently, with record foreign investment and growth in gross domestic product (GDP) of 6% in the first quarter. But the picture could now change. On July 12, just minutes after word came of fighting along Israel's northern border with Lebanon, the Tel Aviv Stock Exchange fell by more than 4% on heavy trading. Israel's currency, the shekel, which had gained nearly 7% in value in recent weeks on the strength of the country's strong economic performance, dropped by more than 1% against the dollar.

The July 12 conflict comes on top of ongoing fighting in the Gaza Strip, but its implications are far more serious. Israeli troops crossed the Lebanese border for the first time since Israel withdrew from the country six years ago. The escalation came after the kidnapping of two Israeli soldiers and the killing of eight others in an attack by the Lebanon's Hezbollah Shiite militia.

Israeli Prime Minister Ehud Olmert threatened that Lebanon would pay a heavy price and convened an emergency session of his cabinet to determine Israel's response. "The opening of a second front in the north has investors very concerned and has raised the level of uncertainty," says Richard Gussow, senior analyst at Excellence Nessuah, a Tel Aviv-based investment bank.


  Brokers reported that most of the selling was by Israelis. Still, the response of other investors will be significant. In the past two years, foreigners have become major players in the local market and typically account for 30% to 40% of the trading in blue chip stocks on any given day. "Foreign investors take a long-term perspective and are likely to take a wait-and-see attitude before deciding to pull out their funds," predicted Sagie Poznerson, head of trading at the Tel Aviv-based Leader & Co. investment firm.

Foreign investors have primarily been buying companies like Bezeq Telecom (BZQIF.PK), which fell 5.5% on July 12, and Bank Hapoalim, (BKHYY.PK), the country's largest, which shed 4.7%. Many of the largest Israeli companies by market capitalization also trade on U. S. exchanges, including Teva Pharmaceuticals (TEVA), Partner Communications (PTNR), Nice Systems (NICE), Koor Industries (KOR), and Blue Square Israel (BSI).

The Tel Aviv market has retreated sharply on several occasions in recent months. In January, it dropped after then-Prime Minister Ariel Sharon fell ill and was incapacitated. Investors worried again later in the month, when the Islamist Hamas movement won the elections in the Palestinian Authority. In both instances the market recovered. This time, the effects could be longer-lived. "The market's direction will depend entirely on how long the events along the northern border last," says Poznerson of Leader & Co.


  The question is whether the Lebanese incursion will end up having an impact on the booming Israeli economy. Economists have been predicting 5.2% GDP growth this year. And the Bank of Israel reported earlier this month that foreign investment hit $11 billion in the first half of this year—equal to all the money that came in during 2005, which was itself a record year. Mergers-and-acquisitions activity is also up sharply, with foreign companies ponying up over $2 billion so far this year on Israeli firms.

The government has even been running a budget surplus due to a sharp rise in tax receipts. This led the government to lower the value-added tax (VAT) by one percentage point, to 15%, on July 1. Economists have issued upbeat predictions for 2007, as well, with GDP growth expected to hit 5% again. The improved economic picture in recent years has led to a dramatic decline in Israel's country risk. The spread between Israeli and U.S. government bonds has narrowed to as little as 1.2%.

Part of the credit goes to the country's high-tech industry, which has led an export and investment boom. High-tech exports rose by nearly 29% in the second quarter of the year, accounting for nearly half the country's $19.4 billion in foreign sales. "The Israeli high-tech industry has in the past been largely immune to the geopolitical developments in the region," says Yoram Oron, managing partner of Vertex Venture Partners, a leading venture firm.


  His only concern is that if the fighting to the north continues for any length of time, foreign investors may refrain from visiting Israel, as they did in the years of the Intifada. That forced many in the local high-tech industry to schedule meetings abroad at neutral locations.

While high tech may be relatively safe, other sectors are far more susceptible to the perils of war. "The tourism and service sectors are the most vulnerable," says Leonardo Leiderman, chief economist at Bank Hapolaim.

Tourism was up by more than 25% in the first five months of this year. But airlines and hotels are already bracing for a wave of cancellations if the fighting continues. While noting that it is still too early to offer a complete economic assessment, Leiderman believes that greater uncertainty could have a direct impact on investments and consumer sentiment.

If that happens, Israel's three-year-old economic boom could come to an abrupt and unfortunate end. The next few days are likely to determine whether the fighting along Israel's northern border is an isolated event or if it will have broader implications for the region—and for Israel's humming economy.

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