Moody's Investor Service, the global credit rating agency maintained Israel's A1 credit rating underpinned by the country's high levels of economic, institutional and financial strength adding though that it was constrained by its security situation and high military spending.

"The modest contraction in the economy and signs of an incipient recovery are evidence of the economy's underlying flexibility and exceptional resilience in the face of various shocks, which reflects in part the lack of toxic assets in the country's banking sector and the absence of a housing bubble," said Anthony Thomas, a Vice President-Senior Analyst in Moody's Sovereign Risk Group. "Indeed, against a backdrop of numerous challenges over the past decade such as the collapse of the hi-tech bubble, disengagement from Gaza in 2005, Operation Cast Lead, the global financial crisis could almost be categorized as ‘more of the same.'"

Moody's expects the local economy to contract by 1 percent this year and return to positive growth of 1.8% in 2010.

"This is another vote of confidence by an important credit rating agency into the Israeli economy and the budgetary and economic policies of the government," said Finance Minister Yuval Steinitz. "It is evidence that the Israeli economy has succeeded to weather the global economic crisis in a respectable manner when many countries around the world are suffering from significant credit downgrades."

Thomas added although the recession now appeared to be over for Israel, still a more robust recovery will have to come from global rather than domestic developments, given that Israel is a small, open economy. Overall domestic growth for the economy will depend on hi-tech exports to its main markets which are the US and the EU although Israel has made meaningful progress in new market areas, notably China, stated the report. In the longer term, Thomas said the country's growth model appears to be intact.

"That the economic model is intact is fortunate," says Thomas. "The economy's lack of natural resources and small size leave it few alternatives to being an innovative exporter."

While Moody's considers economic and financial risk to be low in Israel, however, political risk - namely the security situation - is more serious. Thomas pointed out that the country has the highest military expenditure in the world, which has contributed to its government debt over time and represented the main constraint on its ratings.

"Renewed efforts to improve Israeli-Palestinian relations would be important validation of the country's A1 government ratings," said Thomas.

Israel's total defence budget in 2008 amounted to over 8% of GDP, compared with nearly 4% in the US, 2½% in NATO as a whole and an average below 2% for the European members.

"The US' new administration has shown heightened interest in the peace process with Palestine, but Israeli-Palestinian tensions are unlikely to ease enough to reduce defense spending meaningfully," said Thomas. "If defense spending could be reduced, all else equal, the government's debt metrics would improve. This is particularly important in Israel given the role its relatively high debt/GDP and debt/revenue ratios have played in limiting the upside to its ratings outlook."

Thomas added that ongoing frictions with Iran and, to a lesser extent, Syria would probably limit any defense budget cuts.