Israel’s economy entered 2026 in a condition that defies easy categorization. It has absorbed two-plus years of active military conflict, a significant contraction in foreign direct investment, and credit rating pressure from the major agencies, while simultaneously maintaining a technology export sector that continues to attract global capital, a central bank managing one of the more complex monetary environments in the developed world, and a labor market that, outside the sectors most directly exposed to conflict, has proven surprisingly resilient.

The picture isn’t simply bad or good. It’s layered, and understanding it requires separating the near-term fiscal damage of wartime spending from the structural characteristics of an economy that has, over decades, built genuine competitive advantages in high-value industries.

The GDP Impact of Sustained Conflict

Israel’s GDP growth slowed sharply after the October 2023 escalation. The International Monetary Fund’s World Economic Outlook data showed Israeli GDP growth falling well below pre-conflict forecasts, with particular pressure on construction, tourism, agriculture in border regions, and domestic consumption.

The direct costs of military operations have been substantial. Israel’s defense budget as a percentage of GDP has climbed to levels not seen in decades. For context, Israel already had one of the higher defense-to-GDP ratios among OECD-adjacent economies before the escalation, in the range of 5% of GDP. Wartime expenditures pushed that considerably higher, straining an already challenging fiscal position and adding to the national debt load.

The Bank of Israel has published assessments of the cumulative fiscal cost of the conflict, factoring in direct military expenditure, infrastructure damage, displacement of workers in conflict zones, and lost tourism revenue. The aggregate figures run into the hundreds of billions of shekels when full economic impact is incorporated.

Construction, which had been a driver of Israeli GDP growth, effectively halted in many areas due to labor shortages (a significant share of Israel’s construction workforce had been Palestinian workers from Gaza who could no longer access worksites) and supply chain disruptions. The sector’s pain has been particularly acute and its recovery timeline remains uncertain.

Defense Spending and the Budget Strain

Running a wartime economy while trying to maintain normal public services creates fiscal stress that eventually shows up in bond markets and credit ratings. Israel’s case is no exception.

S&P Global Ratings downgraded Israel’s credit rating in 2024, citing the war’s economic costs and uncertainty around the conflict’s duration and geopolitical fallout. Moody’s followed with similar action. These weren’t catastrophic cuts (Israel remained investment grade), but they raised the country’s borrowing costs at precisely the moment when the government needed to borrow more.

The defense budget trajectory is the central fiscal challenge. Maintaining a high-tempo military operation while simultaneously rebuilding damaged infrastructure, supporting displaced populations, and managing public debt is arithmetically difficult. The Israeli government has had to weigh whether to raise taxes, cut civilian spending, or continue borrowing at elevated rates, none of which are politically costless.

For sovereign debt investors, the key metrics to watch are the debt-to-GDP trajectory and whether Israel can reduce defense spending meaningfully once active operations wind down. Historical precedent from past Israeli conflicts suggests that the economy has the capacity to recover relatively quickly once security conditions stabilize, but the current conflict’s scale and duration have created more lasting fiscal damage than predecessors.

The Shekel and Bank of Israel Policy

The shekel weakened materially in the early months of the conflict as risk premiums spiked, then partially recovered as the Bank of Israel intervened in currency markets to defend stability. The Bank of Israel committed to selling up to $30 billion in foreign exchange reserves and engaging in swap operations to provide dollar liquidity to markets, a signal that it would not allow a disorderly currency depreciation.

Monetary policy has been caught between competing pressures. Inflation remained a concern given wartime supply disruptions and fiscal stimulus, arguing for tighter monetary policy. But the economic slowdown and credit market stress argued for accommodation. The Bank of Israel navigated this by keeping rates elevated enough to maintain credibility while signaling readiness to ease as conditions warranted.

The shekel’s performance against the dollar and euro remains a meaningful barometer for international investors assessing country risk. A stable-to-strengthening shekel signals that capital flows haven’t deteriorated beyond manageable levels. Continued weakness would suggest deeper confidence problems in the investment community.

The Technology Sector: The Economy’s Load-Bearing Wall

Israel’s technology sector is the part of the economy that most challenges the simple “war economy” narrative. The sector, built over decades from a pipeline rooted in military intelligence and elite combat units, most prominently Unit 8200 (Israel’s signals intelligence unit), has shown a degree of resilience that is both remarkable and structurally explained.

Cybersecurity is the flagship. Israeli cybersecurity exports reached billions of dollars annually in the years leading up to the conflict and haven’t collapsed during it. Companies spun out from military intelligence units bring operational experience and problem sets that no university program replicates. The global demand for cybersecurity solutions has if anything increased as geopolitical instability has raised state-sponsored threat activity worldwide.

The startup ecosystem in Tel Aviv and other innovation hubs continued operating, though at reduced velocity. Venture capital data from the Israeli Venture Capital Association showed investment declining from peak 2021 levels, which was consistent with global VC compression, but Israel hasn’t experienced an exodus of its core technology workforce. The human capital that makes the sector productive has largely stayed.

Healthcare technology, agricultural technology, and fintech remain meaningful export segments. Israel’s water technology sector, driven by necessity given the country’s geography, has global customers and continued operating largely independent of the security situation.

For equity investors with exposure to Israeli tech stocks, whether through direct holdings, Israeli ETFs, or global technology funds that hold Israeli companies, the key question is whether the talent pipeline sustains. As long as elite military units continue producing entrepreneurially-inclined technologists, the structural supply of high-quality startups continues.

FDI into Israel fell sharply after October 2023, which was predictable and rational. Multinational corporations pulled back on expansion plans, real estate investment stalled, and tourism investment went to near zero. The question for 2026 is whether that pullback represents a permanent reappraisal of Israel as an investment destination or a temporary pause.

World Bank data on foreign direct investment flows provides the baseline. Israel had been a consistent attractor of FDI relative to its GDP size, particularly in technology and life sciences. The disruption to that trend has been real but hasn’t yet triggered the kind of permanent disinvestment (major companies pulling operations entirely) that would signal structural damage.

Several large technology companies with Israeli R&D operations have maintained or only modestly reduced their footprint, in part because the engineers and researchers there are difficult to replicate elsewhere. Google, Intel, Apple, and Microsoft all have meaningful Israeli R&D centers that represent embedded capital that doesn’t redeploy easily.

The key watch factor for FDI recovery is the security trajectory. International capital follows risk assessment. A demonstrable reduction in active conflict and a clearer path to regional stability would likely trigger a meaningful rebound in FDI, particularly from U.S. technology investors who have long viewed Israel as a favorable R&D jurisdiction.

Credit Rating Outlook and Sovereign Risk

The credit downgrades from S&P and Moody’s were significant but not disqualifying for institutional investors. Israel remains investment grade, which means it can still access global debt markets, pension funds can still hold its bonds, and index inclusion remains intact.

The path back to a stable or positive ratings outlook runs through fiscal consolidation. That means demonstrating a credible plan to reduce the defense-spending-driven deficit once active military operations allow it, showing that the economy can return to positive GDP growth on a sustained basis, and maintaining the institutional quality that gives Israel’s government bonds credibility: an independent central bank, transparent public finance reporting, and rule of law.

The IMF’s Article IV consultations with Israel have consistently noted the country’s structural economic strengths while flagging the fiscal risks from conflict. Those consultations are worth reading for investors seeking the IMF’s formal assessment.

Labor Market Disruptions and Reconstruction

The labor market effects of the conflict are uneven. Sectors far from conflict zones and not dependent on international tourism or trade have experienced something closer to normalcy. The technology sector’s labor market remained competitive, with salary levels that reflect ongoing global demand for Israeli engineers.

The most severe disruptions have been in the northern and southern border regions, where ongoing security concerns have displaced workers and shut down agriculture. Reconstruction of damaged infrastructure will eventually represent a demand stimulus, but the timing and scale of reconstruction depend on conflict resolution trajectories that remain uncertain.

The government has maintained significant fiscal transfers to support displaced households and businesses, which has cushioned the human cost but added further to the deficit.

What Investors Should Monitor

Several specific data points provide early signals on Israel’s economic trajectory:

Bank of Israel policy rate decisions: movement toward rate cuts signals the Bank’s assessment that inflation is under control and the economy needs stimulus, a net positive signal.

Shekel/dollar exchange rate: a strengthening shekel reflects improved capital flow confidence.

Technology sector deal flow: VC investment rounds closed by Israeli startups, tracked by data providers and the IVC, indicate whether the innovation pipeline is intact.

FDI monthly data: the Central Bureau of Statistics publishes monthly economic data including investment flows.

Credit rating reviews: S&P and Moody’s typically schedule formal reviews annually, with potential off-cycle actions if conditions change materially.

Reconstruction contract awards: when large infrastructure contracts begin flowing, it signals that the government believes the security situation is stable enough to commit capital.

Israel’s economy has survived and ultimately recovered from multiple severe shocks across its history. The institutions, the human capital, and the structural competitiveness of its technology exports aren’t going away. The near-term picture involves real pain, elevated risk, and fiscal pressure. The medium-term picture, contingent on security conditions, looks considerably more favorable than the current discount in asset prices might suggest.