If turmoil arising from the government's contentious judicial reforms continues, Israel's economy may face ratings downgrades, falling foreign investment and a weaker tech sector, investors and analysts warn.

The government rammed through the first of a series of laws on Monday aimed at neutering the powers of Israel's Supreme Court in favor of Prime Minister Benjamin Netanyahu's executive branch.

The move sparked widespread protests, with workers from doctors to tech firms downing tools and taking to the streets. The shekel currency has fallen over 2% versus the dollar in the days since, declining since the plans first emerged in January to over 9%.

"The main issue for external investors looking at Israel at the moment is just the uncertainty," said Hamish Kinnear, senior Middle East and North Africa analyst at Verisk Maplecroft. "There is no clear endpoint. While that remains the case, this will be a question mark hanging over Israel's economy."

Growth torpedo?

Israel's stock market has also badly underperformed amid the uncertainty, with MSCI's Israel index lagging the main global stock indices, such as the MSCI All Country World, by around 14% as domestic investors shunned the market.

Until the end of June, however, foreign investment into Israeli equities had remained strong because of its compelling economic picture, according to data from Copley Fund Research.

The percentage of global funds with exposure to the country stood at 35.5%, the highest since 2017, while Israel saw the largest increase in new ownership of any country this year, with a 3.44% gain in the number of funds with money in the country.

Maplecroft's Kinnear said comparatively low inflation versus similar countries had buoyed investment, but more civil unrest could derail incoming cash.

Gross domestic product is expected to expand around 2.5% this year and 3% next year but could be just 1.0% and 1.6%, respectively, if domestic tensions are unresolved, Morgan Stanley has warned.

"Israel is still a fundamentally beautiful investment story. The problem is this government – the longer they pursue this judicial reform, it's going to undermine that story," said Roger Mark, a fixed-income analyst at fund manager Ninety-One.

Mark said that many investors, as well as the key rating agencies, had expected the government to water down the reform to a greater extent. Now that looks unlikely; investors could avoid the country.

"From a bond perspective, I think most bond and FX investors will be waiting on the sidelines, potentially looking to fade any extremes that we might see in the next few weeks."

Netanyahu's allies claim the Supreme Court has been too interventionist for years and its powers need to be curbed.

The Supreme Court will hear an appeal against the judicial reform law in September, which could bring the court into direct conflict with the government. "In the short term, there's this risk of an immediate constitutional crisis," Kinnear said.

Tech problems

The big worry is that upheaval could knock investment in Israel's technology sector – the poster child of the economy that accounts for almost a fifth of GDP, more than half of exports and a quarter of income tax revenues.

High-tech has been the fastest-growing sector in Israel for more than a decade, with innovations in cybersecurity, artificial intelligence and other fields adopted around the world.

According to a recent survey from the Israeli Innovation Authority, the uncertain business environment prompted up to 80% of new Israeli startups to register overseas through March this year, up from 20% in 2022, and tech firm fundraising had already slumped 65% in the second quarter.

The reform backlash "threatens to push the economy onto a permanently lower growth path," Nicholas Farr, emerging Europe economist with Capital Economics, wrote in a note.

Ratings in question

The country's credit rating is also under scrutiny, as all three of the leading agencies, S&P Global, Moody's and Fitch, have already flagged concerns about the government's policy direction.

Moody's cut Israel's sovereign credit to a "dislike" stance, while S&P said on Thursday the unprecedented protests would lower economic growth this year. S&P warned in May that it could lower its AA- Israel rating "if regional or domestic political risks escalated sharply, depressing Israel's economic, fiscal, and balance-of-payments metrics."

Fitch, meanwhile, which already rates the country a notch lower at A+, said previously that the judiciary changes could have a "negative impact on the credit profile" by weakening governance indicators and policymaking and hurting investor sentiment.

"I would not be surprised if the ratings or at least outlook on the ratings get cut," said Natalia Gurushina, the chief emerging market economist at fund manager VanEck.

"The new laws could lead to a significant institutional deterioration and potentially affect capital inflows into areas like the tech sector."