Major fears are sweeping into Israel's economy

Hundreds of anti-Netanyahu protesters gathered on Wednesday outside a hair salon after the prime minister’s wife, Sara, was spotted at a hair salon nearby.

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New concerns about Israel’s economy are leading global investors to question the money they have in the country.

Massive protests have intensified in recent weeks as Israel’s parliament, the Knesset, moves closer to creating a law that would profoundly change the way the country’s judicial system operates. Critics — who polls indicate represent a majority of Israel’s population — say the changes will endanger the country’s democracy.

The law would alter Israel’s judicial system by giving sitting governments full control of judicial appointments. It would also weaken the country’s Supreme Court to the point of effectively ending its role as a check on executive and legislative power.

In a sign of the seriousness of opposition to the proposed law, graduates of elite military programs and reservists in crucial parts of the Israeli army have threatened not to show up for duty and have begun petitions in protest of the changes.

In a recent report, the Finance Ministry’s chief economist Shira Greenberg wrote that “credit rating agencies are likely to react to these developments.”

So far all three ratings agencies — S&P Global, Moody’s and Fitch — have held steady, keeping Israel in a high credit tier, giving global investors a certain amount of reassurance.

You can’t separate Israel’s unicorns and startups and scale-ups from the equity market. As funding slows, we’ll see the impact on the stock market, and that’s happening now.

Steven Schoenfeld

CEO, MarketVector

Fitch reaffirmed its rating on Wednesday, but it published a special section on the economic risks of judicial reform in its note. The firm warned proposed judicial reform “could have a negative impact on Israel’s credit profile by weakening governance indicators or if the weakening of institutional checks leads to worse policy outcomes or sustained negative investor sentiment.”

Fitch pointed to the passing of similar rules in other countries, which it said had led to “significant weakening of World Bank governance indicators” in those places. Those indicators play an important role in shaping the ratings assigned to countries.

Fitch pointed out that the judicial proposal in Israel has been met with “strong civil society and political opposition,” in turn splitting Israeli society. Israel is the second biggest economy by GDP in the Middle East after Saudi Arabia.

Moody’s: Changes ‘would clearly be negative’

In an earlier report, Moody’s ratings service raised similar concerns regarding the legal system, writing that “implementation of such changes would clearly be negative for our assessment of the strength of institutions and governance, which we have so far considered to be a positive feature of Israel’s sovereign credit profile.”

A drop in Israel’s credit rating would increase the cost of borrowing and hurt fundraising. Both are crucial due to Israel’s need for outside investment from institutions based in the United States, Europe and elsewhere.

A major part of the Israeli economy is tied to the value of the Israel shekel against the U.S. dollar. In February the shekel plunged, ending the month down almost 10% from its level of Feb. 3. That in turn hurt critical parts of Israel’s economy including real estate, as companies and individual citizens moved their money into U.S. dollars or other currencies.

The shekel’s fall also led to a drop in investor confidence. The Tel Aviv Stock Exchange tumbled about 8% in February.

Steven Schoenfeld, the CEO of MarketVector, said he believes investors are right to worry about the situation in Israel. MarketVector maintains stock indexes, including the Blue Star Fund, which Schoenfeld created to track Israeli stocks.

“Most of the concern is in Israel’s crucial venture capital and private equity areas,” Schoenfeld said.

“You can’t separate Israel’s unicorns and startups and scale-ups from the equity market,” he added. “As funding slows, we’ll see the impact on the stock market, and that’s happening now.”

Yaron tries to calm execs

Bank of Israel Governor Amir Yaron has tried to calm markets and business leaders.

A source with direct knowledge of the matter told CNBC that Yaron warned at a meeting hosted by Prime Minister Benjamin Netanyahu last week that the political crisis could become an economic one, and that “the issue must be dealt with.”

Members of Netanyahu’s cabinet maintain that a compromise is still possible — though critics dispute that claim. Insiders told CNBC that representatives of the government are in contact with important Israeli business executives in an effort to ease the impact on the economy.

Through the the central bank, Yaron declined to be interviewed for this report. However, he said in a statement last week that “the shekel has depreciated,” which would force the government to act with “tremendous responsibility” in terms of the budget.

The budget is another consideration that ratings agencies have cited as being potentially problematic for Israel’s economy.

The government may come under pressure to make expenditures designed to benefit select pockets of the population that are parts of the current coalition’s base.

Otherwise, Israel may face a sixth election in less than four years.