2 Economic Developments in 1994–98
Author:
International Monetary Fund
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Language:
English
Print Publication Date:
09 Nov 1999
Keywords:
BOOK; economy; Pennsylvania; wage; infrastructure needs; Palestinian economy; Gaza economy; per capita income; Gaza seaport; standard of living; Unemployment; Income
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Abstract

In the five-year period 1994–98, the Palestinian economy experienced challenges that would have been daunting even for more developed and robust economies.1 Population growth was among the highest in the world, creating substantial demand for basic social services. The policy and regulatory framework in which the private sector operated was significantly revamped. Some restrictions on the Palestinian economy became tighter, and closures, imposed by Israel for security concerns, led to a significant slowdown in economic activity.2 The cumulative effect of permits, closures, and changes to the policy and regulatory framework, together with uncertainty regarding final status, created an environment of extraordinary uncertainty for the private sector. Given the circumstances, however, the economy has shown a remarkable degree of resilience, helped by substantial improvements in infrastructure and donor aid on a very large scale. After a deep recession in 1995-96 associated with periods of severe closures, economic activity picked up, especially in 1998, and the rate of unemployment declined markedly from its peak two years earlier. For the period under review as a whole, however, economic growth did not keep pace with population growth, and per capita income declined substantially.

Introduction

In the five-year period 1994–98, the Palestinian economy experienced challenges that would have been daunting even for more developed and robust economies.1 Population growth was among the highest in the world, creating substantial demand for basic social services. The policy and regulatory framework in which the private sector operated was significantly revamped. Some restrictions on the Palestinian economy became tighter, and closures, imposed by Israel for security concerns, led to a significant slowdown in economic activity.2 The cumulative effect of permits, closures, and changes to the policy and regulatory framework, together with uncertainty regarding final status, created an environment of extraordinary uncertainty for the private sector. Given the circumstances, however, the economy has shown a remarkable degree of resilience, helped by substantial improvements in infrastructure and donor aid on a very large scale. After a deep recession in 1995-96 associated with periods of severe closures, economic activity picked up, especially in 1998, and the rate of unemployment declined markedly from its peak two years earlier. For the period under review as a whole, however, economic growth did not keep pace with population growth, and per capita income declined substantially.

This chapter gives an overview of macroeconomic developments in the West Bank and Gaza for the period 1994-98 and discusses factors that contributed to the overall weak growth performance. It also examines developments in institution building and economic policies, drawing on the more detailed analysis in the subsequent chapters.

Overall Macroeconomic Developments

The Palestinian economy, after a spurt of growth in 1994, went into a deep recession in 1995 and 1996, but began to recover in 1997 and, especially, in 1998. The paucity of national accounts data for this period calls for considerable caution in interpreting economic developments, and it is difficult to judge with precision how deep the recession was in 1995-96 and how strong the recovery has been in 1997 and 1998 (Figure 2.1 and Box 2.1). Over the period 1994-98, real GDP growth in the West Bank and Gaza is estimated to have averaged about 2 percent per year, well below the population growth rate. Both real GDP and GNI per capita are estimated to have declined by 10-15 percent over the five-year period (Figure 2.2).3 Unemployment, despite a marked decline in 1997 and 1998, was still twice as high at the end of 1998 as in 1993.

Figure 2.1
Figure 2.1

Real GDP and Real GNI

Source: IMF staff estimates based on data provided by the Palestinian authorities.
Figure 2.2
Figure 2.2

Growth Performance

Sources: IMF staff estimates based on data provided by the Palestinian authorities; and IMF World Economic Outlook (WEO) data base.

Real GDP and GNI growth in the West Bank and Gaza during this period has run countercyclically to developments in the Israeli economy, which expanded rapidly in 1994-96 and weakened in 1997-98. Given the close integration of the West Bank and Gaza with Israel—in 1993 one-quarter of the Palestinian labor force worked in Israel and the settlements, and Israel has remained the dominant trading partner throughout—the two economies might have been expected to follow a similar course. Also, all else being equal, the boom in the Israeli economy in 1994-95 should have led to higher demand for Palestinian workers and Palestinian goods and services.4 For reasons that are related more to political than economic developments, however, employment of Palestinians in Israel declined in these two years, contributing to a recession in the West Bank and Gaza. Similarly, despite a weakening of the Israeli economy in 1997-98, employment of Palestinians in Israel and the settlements has recovered markedly. These fluctuations in labor income from Israel, where the average wage for Palestinian workers is almost twice as high as that in the West Bank and Gaza, contributed significantly to the 1995-96 recession and to the recovery in 1997 and 1998.

For the five-year period as a whole, the trend was one of expansion in public sector employment and expenditure, muted private sector activity, substantial inflows of donor aid, and high and fluctuating unemployment.

Creation and Expansion of the Public Sector

The Palestinian Authority (PA) was created in 1994, and its initial challenge was to provide basic public services and to create an environment conducive to economic growth. The PA gave priority to establishing the fiscal and economic institutions that have taken over the key functions of the Israeli Civil Administration (ICA), as well as expanding into new areas. Under the ICA, current expenditure hovered around 12-14 percent of GDP, while under the PA current expenditure rose to about 25 percent of GDP in 1998. This was mainly due to a rapid expansion of the wage bill as a result of new recruitment in the civil service and the police. Initially, the increase in public sector employment was reasonable, as the PA expanded the range and quality of the services it provided. Since 1997, however, the expansion has become excessive and a cause of serious concern. At the same time, the past five years have witnessed strong growth in tax revenue to almost 25 percent of GDP in 1998, which compares well with countries in the region. This has allowed the PA to bring the recurrent budget into a broadly balanced position in 1998, from a deficit equal to about 3 percent of GDP in 1996, despite the substantial increase in current expenditure (Table 2.1). The liquidity situation of the Ministry of Finance has nonetheless remained precarious, especially in 1998, because some revenue continued to be channeled to accounts outside of its control, obliging the Ministry of Finance to borrow further from the domestic banking system and to resort to arrears accumulation.

Table 2.1

Selected Economic Indicators

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Sources; Palestinian Central Bureau of Statistics, Ministry of Finance, Ministry of Planning and International Cooperation, Israeli Central Bureau of Statistics; and IMF staff estimates.

IMF staff estimates based on data from Palestinian Central Bureau of Statistics. See Box 2.1 for data sources.

Includes workers without permits and workers in Israeli industrial zones.

Includes net errors and omissions from the national accounts.

Includes investment through UNRWA and NGOs, where financing is recorded by the Ministry of Planning and International Cooperation.

On an accruals basis.

IMF staff estimates based on data from the Palestinian Central Bureau of Statistics, the Israeli Central Bureau of Statistics, and the Ministry of Planning and International Cooperation.

Total donor financing includes disbursements through the development plan plus donor support for UNRWA’s operational budget, and donor support to NGOs outside of the development plan. The development plan refers to all aid recorded by the Ministry of Planning and International Cooperation.

Economic Data

The General Statistics Law, approved in 1994, created the Palestinian Central Bureau of Statistics (PCBS). The PCBS has made considerable progress in the short time since its inception, given the difficult environment for data collection. The PCBS operates with high professional standards, and now regularly collects and publishes data on employment (quarterly) and consumer prices (monthly), as well as data in a range of areas, including industrial activity, demographics, education, health, household expenditure, and housing. It has also made progress in establishing a set of national accounts, although at this stage data exist only for 1995 and 1996 and only in terms of U.S. dollars. Most of the data can be accessed through the PCBS’s website (www.pcbs.org).

This paper relies on PCBS data to the extent possible. The national accounts data are mainly IMF staff estimates based on PCBS’s national accounts for 1995 and 1996 and on information on public finance from the Ministry of Finance, donor assistance from the Ministry of Planning and International Cooperation (MOPIC), and employment and other economic data from the PCBS. Data on imports and exports from the Israeli Central Bureau of Statistics (ICBS) are also used. The shortage of data creates large uncertainty about the development of the economy during the period studied, especially for private sector activity. The estimates for annual real GDP growth rates follow closely the developments in employment in the local Palestinian economy, a reasonably good indicator of real economic activity.

For demographic and labor market data, the paper has used the ratios for employment, unemployment, and other labor market indicators from the PCBS for 1995-98. These ratios have been applied to a series of population levels for 1994-98 that was computed by IMF staff, based on the 1997 PCBS population census.

The paper has used monthly monetary and banking data from the PMA for 1996-98.

For data on donor assistance to the PA, UNRWA, and NGOs, the paper relies on the MOPIC data base, using a slightly different definition of public investment than MOPIC. In addition to projects categorized as public investment in the MOPIC data base, it also includes projects under the headings “equipment,” “in kind,” and “employment generation” when those projects contain a substantial infrastructure component (e.g., infrastructure rehabilitation).

The most solid information on economic activity comes from data on labor market developments from the PCBS and the monetary and banking data from the PMA. The MOPIC data on external financing also provide a reasonably good basis to estimate public investment. The major weakness in data on economic activity relates to the balance of payments, which hampers a comprehensive analysis of economic developments. The PMA is formally responsible for producing balance of payments data and, in cooperation with the PCBS, is working to improve the situation as a matter of priority.

Public investment, all of which was financed by donors, averaged about 6 percent of GDP annually in 1994-98, contributing to a substantial improvement in basic infrastructure (Figure 2.3).5 Initially, public investment was hampered by, among other things, the difficulties in quickly setting up efficient project implementation mechanisms and also because a substantial portion of donor aid had to be devoted to technical assistance and transitional and budgetary support. With the gradual decline in the need for budgetary support to the PA, by 1998 donor funds were no longer required for this purpose, and the share of aid that went to finance investment rose.

Figure 2.3
Figure 2.3

Developments in Investment, Aid, and Employment

Source: IMF staff estimates based on data provided by the Palestinian authorities.1 See footnote 7 in Table 2.1 for definitions.2 includes workers without permits.

Weak Private Sector Economic Activity

The path of the Palestinian economy over the last five years mirrored the developments in private sector economic activity, especially in construction activity and private consumption. The construction sector experienced a boom in 1994-95, fueled by a surge in immigration and prevailing optimism about political and economic development. A worsening of the political situation and a decline in labor income from Israel contributed to a sharp decline in construction activity in 1995-96, but there were indications of a recovery in this sector in 1997-98. At the same time, there is no evidence of increased private investment in productive capital over the last five years, in contrast to the substantial amount of public investment that took place. Furthermore, real private consumption per capita is estimated to have declined by about 10 percent in the same period—somewhat less than the estimated decline in real per capita income—reflecting the mitigating effects of donor aid and transfers from Palestinians living abroad. In terms of economic activity by sector, based on employment data, growth was strongest in the service sector (including the public sector, commerce, and banking) and in manufacturing, whereas agriculture and construction experienced sluggish growth for the five-year period as a whole, although the latter recovered somewhat in 1997-98.

External Trade Deficits and Donor Financing

Developments in the balance of payments were characterized by a sharp decline in net exports of goods and services in 1995-96, financed by inflows from donors and Palestinians living abroad, and from continued, although erratic, labor income from Israel. While the data on trade are particularly weak, total imports of goods and services in the West Bank and Gaza appear to have increased to over 70 percent of GDP in 1998 (Table 2.2). The bulk of imports still came from Israel, although the share of imports coming from other countries rose somewhat because of the increase in imports related to aid-financed investments and, to some extent, because of the PA’s initiatives to increase direct imports. Although exports of goods and services experienced positive growth during the period, the deficit on the balance of goods and services widened in 1996 to about 50 percent of GDP and appears to have remained at that level in 1997 and 1998 (see Box 2.2 for a description of the composition of trade). Net factor income fluctuated widely, reflecting developments in labor income from Israel, which averaged about 16 percent of GDP over the five-year period. In all, the current account deficit in 1998 (excluding current transfers) exceeded 30 percent of GDP, compared with about 20 percent in 1994, and was financed by current and capital grants from donors and capital inflows from Palestinian nonresidents.

Table 2.2

National Accounts

(In percent of GDP)

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Sources: See Box 2.1 for data sources.

Includes nonprofit organizations serving households.

Includes net errors and omissions from the national accounts.

Following the signing of the Declaration of Principles in late 1993, donors ultimately pledged over $3.7 billion in support of the West Bank and Gaza for the period 1994-98.6 From that time on through September 1998, more than $2.5 billion in donor assistance was disbursed—an average of $500 million a year—with about three-quarters of all disbursements going through the PA and the rest through UNRWA and NGOs. Donor assistance was very generous both in scope and terms—with about 95 percent of disbursements in the form of grants—and donor aid per capita for the West Bank and Gaza is now among the highest in the world, averaging over $200 annually. While donor aid did not jump-start the Palestinian economy, as had been envisaged in 1993, it played a key role in improving the physical infrastructure and strengthening institutions.

The large deficit on the balance of goods and services raises concerns about competitiveness. Prices and costs in both the West Bank and Gaza are much higher than in Jordan, for example, and for many goods the difference seems to exceed what can reasonably be explained on the basis of higher productivity in the West Bank and Gaza. Several factors may have contributed to undermine the competitiveness of the Palestinian economy. For example, the costs of conducting business in general, and trade in particular, are excessive because of restrictions on trade and transportation caused by the system of permits and security check points (Box 2.3).

Price Developments

Consumer price inflation in the West Bank and Gaza broadly followed Israel’s inflation, although the monthly variance was about twice as high; it declined to 5.6 percent on average in 1998 from about 14 percent in 1994 (Figure 2.4). The 12-month rate of inflation of 9.7 percent in 1998 was higher owing to the pass-through of rising import prices from the depreciation of the new Israeli sheqel (NIS) in the second half of the year. The close correlation of inflation in the West Bank and Gaza with that of Israel is not surprising given the close integration of the two economies: most imports into the former continued to come from the latter, and almost all nondurable consumer goods, as well as a large part of durable consumer goods, were priced in sheqalim. There was also little difference in inflation patterns between the Gaza Strip and the West Bank: the correlation for the monthly change in consumer prices in the last three years was 0.8 between the two regions. Furthermore, there is no clear evidence that closures affected aggregate consumer prices in one direction or another during this period (Box 2.4 and Figure 2.5).

Figure 2.4
Figure 2.4

Inflation

Sources: Data provided by the Palestinian authorities; and IMF staff estimates.
Figure 2.5

Inflation and Labor Flows

Sources: IMF staff estimates based on data provided by the Palestinian authorities; and UNSCO.

High and Fluctuating Unemployment

As a consequence of weak growth, the economy was unable to absorb the large inflow to the labor market in the last five years, and the unemployment rate rose to very high levels even though it has declined markedly since its peak in 1996. Overall, in 1994-98, the labor force is estimated to have increased by about 147,000 people, while employment increased by 92,000, which includes an increase in public sector employment to over 90,000 in 1998 from about 23,000 in 1993.7 Job growth in the private sector in the West Bank and Gaza is estimated at less than 2 percent a year, with most growth taking place in 1997 and 1998 (Table 2.1 and Figure 2.3).

Structure of the Economy

The most important sectors in the Palestinian economy, in terms of gross value added, are services (including government), agriculture and fishing, manufacturing, and wholesale and retail trade. The structure mirrors broadly the data on employment by sector, although construction is relatively more important for employment than for gross value added. Furthermore, manufacturing accounts for over 40 percent of exports of goods from the West Bank and Gaza and more than a quarter of total imports.

There are important differences in the structures of the economies of the West Bank and the Gaza Strip: the economy of the West Bank is based to a larger extent on agriculture and manufacturing, while the Gaza economy depends relatively more on services, including government services.

Sectoral Composition of GDP at Factor Cost, 1996

(In percent of GDP)

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Source: Palestinian Central Bureau of Statistics.

Includes the PA and municipalities. The data are on a national accounts basis and therefore not directly comparable to the fiscal data.

Composition of Imports and Exports

(In percent)

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Source: Palestinian Central Bureau of Statistics.

In percent of GDP. The total trade deficit does not exactly match the data in other tables.

Competitiveness

The issue of competitiveness has not attracted much interest in discussions of the Palestinian economy, at least not beyond references to monopolistic markets and trade restrictions. For any economy experiencing a prolonged period of slow growth and a current account deficit of about 20 percent of GDP, external competitiveness would be high on the list of policy issues. Why this has not been the case in discussions of the Palestinian economy might be in part because the West Bank and Gaza does not have its own currency, although the absence of a currency, of course, does not mean that competitiveness is not an issue.

The lack of time series data prevents a formal test of competitiveness in the West Bank and Gaza, but an impression can be formed by comparing the actual price levels for goods and services with comparable countries. IMF staff compared the price levels of 48 consumer goods and services in the Gaza Strip, Jerusalem, Jordan, and the West Bank.1 The products were chosen based on availability and reasonable comparability, but ideally the comparison should also include items such as wages, rents, and other services. The comparison revealed large differences in price levels across these four places, with Jerusalem being most expensive followed by, in turn, the West Bank, the Gaza Strip, and Jordan. Compared with Jordan, the unweighted average price for this basket of goods is almost 60 percent higher in Jerusalem, 32 percent higher in the West Bank, and 16 percent higher in the Gaza Strip.

The price level differences among the Gaza Strip, Jerusalem, and the West Bank are in line with what could be expected on the basis of relative income levels (higher income because of higher productivity brings about higher prices of nontradeable items); however, the difference between the West Bank and, especially, the Gaza Strip on the one hand and Jordan on the other seems excessive and beyond what might be expected on the basis of productivity differences. There is little reason to believe that productivity in the Gaza Strip is higher than, or even as high as, in Jordan.

Higher prices without correspondingly higher productivity would suggest a cost competitiveness problem. A study by MAS found that unit costs (including wage costs) in the garment industry were twice as high in the West Bank and Gaza as in Jordan, mainly due to significantly higher import costs.2 In other sectors, however, higher costs and wages do not reflect a competitiveness problem because they are accompanied by higher productivity and quality than for similar products in Jordan, as in the footwear industry.3 In the Gaza Strip, in particular, but also in the West Bank, there are many factors that contribute to the inflation of costs. Transportation costs are very high because of check points, the convoy system, and lack of immediate access to a seaport. Production costs are further inflated by high import costs because of the lack of free access to alternative import markets and because of the lack of competition among importers (certain key commodities must be imported through monopolies). Another source of concern for competitiveness, especially for the future, relates to wage developments. Wage growth that is not matched by productivity growth leads to a loss in competitiveness, and the risk of this is strongest when public sector wage increases lead, rather than follow, those of the private sector.

Furthermore, the West Bank and Gaza receives large amounts of foreign aid, which allows a higher level of domestic expenditure than the economy would otherwise provide for. It is crucial for the PA to be vigilant and ensure that aid be used judiciously; otherwise it can produce effects similar to those of “Dutch disease,” with a more appreciated real exchange rate (defined as the price of nontradeable goods and services compared to that of tradeable goods and services) adversely affecting the development of the export sector. This is particularly important because the current level of aid is higher—and the terms of aid more favorable—than what is considered likely in the future.

1 Data for Jerusalem (which refers to East Jerusalem), the Gaza Strip and the West Bank are from the PCBS (first quarter of 1998), and data for Jordan come from the Department of Statistics in Jordan (December 1997). The list of goods and services consists mostly of agricultural products, but also includes coffee, tea, textile products, school and nursery fees, and haircuts. The price comparison is between the unweighted average of all 48 goods and services, without adjustments for product and quality differences or effects from subsidies and taxes. 2 MAS (1996b). 3 UNCTAD (1998a).

Wide fluctuations occurred in the unemployment rate as well, reflecting the economic cycle and changes in access to the Israeli job market for Palestinian workers. Fischer and others (1994) warned that unemployment could rise to dangerous levels if labor flows to Israel were not maintained, and, indeed, unemployment rose rapidly to about 24 percent in 1996 from less than 7 percent in 1993 as the number of Palestinians working in Israel and the settlements, including those without permits, declined to about 55,000 on average in 1996 from over 100,000 in 1993. Unemployment peaked in the second quarter of 1996 at about 28 percent, but declined rapidly since then to around 13 percent at the end of 1998. This mainly reflected a recovery in the employment of Palestinians in Israel and the settlements to about 107,000 in 1998, which was a period of solid job creation in the Palestinian private sector for the first time in the past five years. Nevertheless, unemployment at the end of 1998 was still about twice as high as the level recorded in 1993.

Living Standards and Poverty

As a result of the unfavorable macroeconomic developments and the high level of unemployment, real per capita income and consumption declined over the period. Lack of data precludes a detailed assessment of the implications for poverty and standard of living, but there is reason to believe that the level of poverty increased further, mirroring the developments in income and unemployment.8 In the absence of a developed system of social assistance, poverty is closely linked to unemployment. On average, a family with a head of household employed at the going wage rate should be above the poverty level. At the same time, the large inflow of donor aid (e.g., for employment generation projects and investment in basic infrastructure) mitigated considerably the negative effects of rising unemployment and declining per capita income. The standard of living of Palestinians benefited considerably from such employment generation projects and investments, which included improvements in roads, water, and sanitation. These effects were not fully captured in measurements of GDP and income per capita. At the outset, most government expenditure and donor aid went to the Gaza Strip, where the initial need was largest, but at the end of 1998 the distribution of resources was roughly equal between the two regions.

The Effects from Closures

Palestinians must have permits to enter into Israel, including to go between the Gaza Strip and the West Bank. Furthermore, a large number of Palestinians commute to Israel and the settlements as day workers for which they need work permits. The permit system adds significant transaction costs to conducting business in the West Bank and Gaza.

Israel imposes closures when the security situation deteriorates or there is a risk that it could deteriorate (for example, around important Jewish holidays). There are essentially two types of closures. Under an external closure, all movement of goods and people is blocked between Israel and the West Bank and Gaza (and therefore also between the Gaza Strip and the West Bank). An internal closure also blocks the movement of goods and people between areas in the West Bank.

The number of work days lost because of closures rose each year from 1993 to 1996, when it peaked. According to UNSCO (1997, 1998a, and 1998b) closures were in effect 17 days in 1993, 64 days in 1994, 80 days in 1995, 90 days in 1996, 57 days in 1997, and 14 days in 1998.

Closures affect the economy through many different channels, including the loss of labor income, trade, and production. The incidence of closures also increases the general uncertainty associated with conducting business and trade in the West Bank and Gaza, which in turn depresses private investment. Given the many different channels through which closures affect the economy and given the lack of detailed information on the Palestinian economy, the cost of closures is impossible to estimate accurately, but the following is an illustration.

According to the PCBS’s labor force survey, roughly 100,000 Palestinians worked in Israel and the settlements in 1998 and earned a daily net wage of about NIS 100 (about $25). Thus, annual labor income from Israel is about $600 million (assuming 20 working days per month), or about 17 percent of GDP. The first order effect from a ten-day external closure would thus be about $25 million in lost labor income, or about 0.7 percent of GDP. This is only the first order impact from the closure, and does not take into account the multiplier effects on GDP. It also does not take into account the effects from disruptions to trade and domestic production, which can be substantial. Also, the cost of closures is not linear over time. Rather, longer closures have higher daily costs because trade involving perishable products may be permanently lost. A study by MAS and the World Bank (1999) estimated the annual costs of closure and permit policies at about 11-18 percent of GNI in the West Bank and 31-40 percent in the Gaza Strip for the period 1994-96.

A priori, it is not obvious how inflation in the West Bank and Gaza is affected by closures. Closures can lead to shortages of imported goods, which, in turn, can lead to a supply-driven increase in prices. At the same time, closures lead to a significant reduction in labor income, which, in turn, tends to depress demand and prices. A simple inspection of Figure 2.5 does not seem to show any clear relationship between changes in aggregate CPI and closures—as measured by the monthly flows into Israel and Israeli-controlled areas of Palestinian workers with permits.

Factors Explaining the Poor Economic Performance

Although the Palestinian economy began to recover in 1997, and more strongly in 1998, for the last five years as a whole economic growth was disappointing, with a substantial decline in per capita income. Performance was also disappointing compared to what could reasonably have been expected based on the amount of donor assistance provided and the comparative growth in neighboring countries, particularly Israel. A 1993 World Bank study of the West Bank and Gaza could serve as a counterfactual point of reference for the expectations that prevailed in 1993. It included a discussion of six medium-term scenarios in which the projections for real GNI per capita growth ranged from 4 percent a year to minus 3 percent, depending on the assumptions for labor opportunities in Israel; progress in policies (in a broad sense, including PA policies as well as those in other areas, such as expanded opportunities for trade); and the amount of capital inflows (Box 2.5). Given the uncertainties surrounding most economic variables in the Palestinian economy, any medium-term projection should be considered as purely illustrative, but it is interesting that the actual outcome of real GNI per capita growth was close to the worst case scenario (Figure 2.6). This projection had assumed an abrupt and persistent decline in labor opportunities in Israel and faltering inflows of foreign capital. The West Bank and Gaza, however, received substantial inflows of foreign aid and, while the decline in labor opportunities for Palestinians in Israel and the settlements in 1994-96 was abrupt, it was not persistent, and it recovered in 1997 and 1998. What actually materialized with respect to foreign aid and employment in Israel was, thus, closer to the middle scenario assumption, and, on that basis, the West Bank and Gaza could have been expected to register an annual real GNI per capita growth of about 1-2 percent, rather than the minus 3 percent that actually occurred.

Figure 2.6
Figure 2.6

Real Per Capita GNI

(Actual versus World Bank projections)

Sources: IMF staff estimates based on data provided by the Palestinian authorities; and World Bank (1993).

This section examines the factors that are likely to have had an important impact on the growth performance, focusing on (1) demographic factors; (2) the effects of restrictions on trade and the movement of goods and people, including closures; and (3) delays in strengthening governance and in creating an environment supportive of private investment.

Impact of Demographic Factors

The demographic trends in the West Bank and Gaza put substantial strains on the economy. The West Bank and Gaza seems to be in a demographic transition phase, where child mortality, in particular, has gradually declined over a long period of time without as yet a corresponding decline in fertility. As a result, the underlying population growth of about 4 percent (abstracting from migration) is very high, and a large part of the population, about 47 percent, is below 15 years of age.9 The high population growth—one of the highest in the world—implies that the economy would also have had to grow at a rapid rate (faster than any economy in the region) just to prevent per capita income from declining. This in turn would have required a substantial accumulation of productive capital which, as mentioned, did not materialize.

With such a large proportion of the population below working age, a labor force participation rate of 40 percent, and an unemployment rate of about 15 percent in 1998, the result is that one Palestinian worker supports 5-6 people. A high dependency rate may have important negative effects on macroeconomic variables, such as saving and investment. With most income used for consumption, it tends to depress private saving, and, to the extent that the private sector lacks access to foreign capital, a low saving level might in turn negatively affect capital accumulation. Moreover, a high demand for housing stemming from the population growth absorbs a large share of private saving that might otherwise have been used for more productive capital formation. Finally, high population growth also exerts a strain on the budget because the tax base is small while budgetary demands for social services, in particular education, grow fast, reflecting the age structure of the population, limiting the scope for the government to devote resources to infrastructure investment.

Intensified Restrictions and Closures

Probably the most adverse effect on the Palestinian economy during the last five years resulted from the intensification of controls (including periods of closures) and the permit system. The latter reduced the scope for trade diversification and hindered the movement of goods and people between the West Bank and the Gaza Strip, and occasionally among regions in the West Bank. The negative effects from closures, which peaked in 1996, are substantial and were a main factor behind the recession in 1995–96. Conversely, the much lower incidence of closures in 1998 contributed to the recovery in economic activity in that year (Box 2.4).

The World Bank Medium-Term Projections in 1993

In 1993, the World Bank developed six medium-term scenarios for the Palestinian economy, with projections for growth over the period of five years into the future.1 The three key assumptions underlying the scenarios relate to: (1) policies, (2) capital inflows, and (3) labor flows to Israel The most optimistic scenario, with an annual growth rate in per capita GNI of 4 percent, assumed the implementation of good policies, which included expanded opportunities for trade, medium capital inflow, and gradual decline in Palestinian employment in Israel. The worst outcome, resulting in declining per capita GNI of 3 percent per year, assumed the implementation of weak policies, faltering capital inflow, and an abrupt and persistent cutoff of employment in Israel. The remaining four scenarios combine variations on these assumptions. All six scenarios assumed a replacement of employment in Israel by domestic employment, but envisaged that replacement would be faster in the abrupt labor cutoff scenario that would result in initially higher unemployment and falling real wages.

1 World Bank (1993).

Aggregate trade data suggest that, with imports exceeding 70 percent of GDP and exports of almost 20 percent, the West Bank and Gaza meets the conventional definition of an open economy, although the trade imbalance would appear unsustainable.10 At the same time, it has been extremely difficult to conduct trade with countries other than Israel.11 There is a wealth of anecdotal information on cases where trade was frustrated by the restrictions, including those in the form of security check points and permit requirements, that caused disruptions and created excessive transaction costs. Furthermore, the Interim Agreement mentioned the opening of an airport and a seaport, both of which would have reduced the costs of conducting foreign trade. Both projects, however, have been subject to extensive delays; the Gaza International Airport was opened only in late 1998 but does not yet operate as a regular airport. The Gaza seaport, arguably more important for trade than the airport, has not yet been built.

The trade situation was also complicated by the fact that the extensive documentation requirements for exporters and importers can vary, depending on the check point, and that all trade between the West Bank and the Gaza Strip has to be conducted through the convoy system. Access between the Gaza Strip and the West Bank was basically free until the Gulf War, but during 1993-98 the two regions were almost completely separated. The Interim Agreement envisaged a safe passage between the West Bank and the Gaza Strip, but by the end of 1998 it still had not been established. These restrictions ossified the Palestinian economy, thereby making it exceedingly vulnerable to shocks. The restrictions on the movement of goods and productive capital amplified the effects of negative shocks, like closures, and, at the same time, they prevented the economy from fully reaping the benefits of positive shocks, such as the decline in oil prices in 1996-97, to the terms of trade. In addition to the direct effects on the economy, the permit system and its implementation, including the imposition of closures, created an environment of acute uncertainty and excessive transactions costs, both of which were key factors behind the sluggish growth in private nonconstruction investment.12

Institution Building and Governance

When the PA was created in 1994, it faced the daunting challenge of creating policy institutions and a legal and regulatory environment conducive to private sector economic activity. In many areas institutions had to be created from scratch, while in others the existing institutional structures inherited from the ICA could be used but had to be adapted. The PA made good progress in certain areas of institution building, such as setting up policy institutions and creating an efficient tax administration. Also progress was achieved in banking supervision and in the area of legal institution building, with the ratification of many laws, including in the economic area the Monetary Authority Law, the Investment Promotion Law, and the Organic Budget Law.

The success in establishing an efficient tax administration contributed to an increase in government revenue to about 25 percent of GDP in 1998 from about 8 percent in 1994. Similarly, the establishment of the PMA in 1994 was associated with a strong expansion in the banking sector. Private sector deposits with the banking system increased to about $2.2 billion (more than 60 percent of GDP) at the end of 1998 from about $0.5 billion at the end of 1994, with a corresponding increase in bank credit to about 21 percent of GDP in 1998 from about 3 percent in 1994.

At the same time, progress in institution building was slow in other important areas, such as fiscal expenditure management, and in enhancing transparency and in public sector governance operations. Also, despite some progress in reforming the legal and regulatory framework, much remains to be done to make it more conducive to long-term economic development. Furthermore, difficulties remain in defining the exact role of the public and private sectors, decentralization, and the coordination of different public sector entities. The actions of the PA have sent ambiguous signals regarding its commitment to establishing a market economy: a number of monopolies were established; the PA is directly involved in important commercial activities and its involvement seems to be growing in a manner that is not transparent; regulations are cumbersome; and, in general, the economic environment cannot be described as conducive to private sector activity. Perceptions of inefficiency, weak financial management, and inadequate transparency have also deterred private investors.

Conclusion

Overall economic performance in the West Bank and Gaza over the period 1994–98 was disappointing, although a recovery, especially in 1998, constituted a positive development. Also, on the positive side, the large inflow of donor aid supported an ambitious public investment program, and progress in institution building took place. However, there was no evidence of increased private investment in productive capital, a main factor behind the upward trend in unemployment. Economic growth and, in particular, private investment were hampered by the extensive restrictions imposed on the Palestinian economy; severe disruptions to labor income, trade, and production from closures; and an institutional environment not yet conducive to private sector economic activity and investment. All these factors contributed to an environment of extreme uncertainty and high transaction costs with further negative effects on private investment. In addition, demographic dynamics most likely depressed saving and investment in the private sector. Demographic trends will continue to present a formidable challenge to the Palestinian economy over the medium term.

1

This section draws partly on a paper by Stanley Fischer and others (forthcoming).

2

Closures and their economic impact are discussed in Box 2.4.

3

GDP plus net factor income from abroad equals gross national income (GNI). GNI plus net current transfers from abroad equals gross disposable income (GDI).

4

Employment of Palestinians in Israel and the settlements includes those working in Israeli industrial zones.

5

Public investment includes investment implemented by the PA, the United Nations Relief and Works Agency (UNRWA) and nongovernmental organizations (NGOs).

6

About $2.2 billion was pledged at the donors meeting in 1993 and subsequent pledges amounted to about $1.5 billion. These disbursement data refer to aid channeled through the development plan as recorded by the Ministry of Planning and International Cooperation (MOPIC) and do not include disbursements to UNRWA’s operational budget (but they do include aid for investment projects implemented by UNRWA) and disbursements to some NGOs outside of the development plan.

7

Data on public sector employment do not include employees in municipalities or in public enterprises.

8

A study by the Palestine Economic Policy Research Institute (MAS) showed that about one-fifth of the population could be classified as poor at the end of 1995, with poverty defined as an annual per capita income of $650 or less (MAS, 1996a). The MAS study has been criticized for, among other things, using a sample too limited in size rather than one based on full-year observations.

9

See Box 7.1 for a description of the population.

10

See Barnett and others (1998) for a detailed discussion of the trade system in the West Bank and Gaza. The paper argues that the trade regime could be improved if the PA and Israeli authorities worked toward eliminating trade barriers that are not essential for security, focused more on the maintenance of trade, and eliminated weaknesses in the Interim Agreement in the trade area. It suggests that the PA utilize the trade options in the Interim Agreement, and that it be wary of introducing or maintaining measures, such as sole agency requirements and import monopolies.

11

The Economic Protocol of 1994 left many issues in the trade area open to interpretation and negotiation. The Joint Economic Committee (JEC) was set up with the purpose of monitoring implementation and resolving disputes relating to economic matters. Many of the issues were handled also by the Joint Civil Affairs Coordination and Cooperation Committee (CAC) and the lack of coordination between the two committees created confusion and delays. In addition, the PA would have been able to better prioritize and defend its interests in these fora with more effective internal organization and coordination.

12

See Barnett and others (1998) for an analysis of uncertainty and investment in the West Bank and Gaza.

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Cover West Bank and Gaza Strip
West Bank and Gaza Strip
Economic Developments in the Five Years Since Oslo
ISBN:
9781557758279
Publication Date:
09 Nov 1999
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781557758279.071
Pages:
100
Figure 2.1

Real GDP and Real GNI
Figure 2.2

Growth Performance
Figure 2.3

Developments in Investment, Aid, and Employment
Figure 2.4

Inflation
Figure 2.5

Inflation and Labor Flows
Figure 2.6

Real Per Capita GNI

(Actual versus World Bank projections)