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The Economy of the West Bank and Gaza: From Dependent to Autonomous Growth

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1994
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THE HANDOVER of power in the West Bank and Gaza was a source of euphoria for many Palestinians. But they are entering a new era in an economically more fragile state than for decades. Economic success will depend crucially upon reorienting policies so as to shift the economy onto a path of autonomous development.

The economy of the West Bank and Gaza strip (commonly referred to as the Occupied Territories) is entering a new era of self rule in a state of crisis. Economic difficulties started in the early 1980s, with stagnation setting in after 1987. While expectations of peace fueled a recovery in 1992, this was followed by a severe recession in 1993. Since the late 1980s, open unemployment has increased sharply, underemployment is rampant, jobs for school and university leavers are so scarce that wage differentials have almost disappeared, and poverty has risen dramatically. Many public services are in disarray: municipalities are starved of cash; power outages are frequent; public water supply is below quality standards; and sanitation is very poor.

While conditions worsened during the Intifada (uprising), starting in late 1987, the fundamental reasons for the present crisis lie in the loss of the past sources of growth of the West Bank and Gaza—employment in Israel and in the Gulf. But the Palestinian Authority also faces potentially major new opportunities. Compared to Eastern Europe and the former Soviet Union, where reform started with an implosion of traditional markets and (for most) only tiny amounts of foreign assistance relative to the size of their economies, the West Bank and Gaza could enjoy a large expansion in trading opportunities, while benefiting from sizable economic assistance. In October 1993, donors pledged $2.4 billion for the reconstruction of the infrastructure in the West Bank and Gaza during the next five years.

But these opportunities could easily be squandered. Ensuring medium- and long-run success will depend on structural policy choices and the building of new institutions to provide employment and raise living standards. This article outlines the issues and choices facing the new Palestinian Authority, in the context of the structures that evolved during the Israeli occupation. Throughout, the focus is on economics rather than on politics. Political events are, of course, crucial for the future, but, political progress can be undermined by economic failure.

Patterns of the past

The origins of the present economic crisis lie mainly in the structural imbalances in the past patterns of development. Past economic performance and current economic structures have been profoundly influenced by the 25 years of development under the Israeli occupation. Incomes and wages boomed in the 1970s, stalled in the early 1980s, and declined later in the decade (see chart). The factors underlying the sharp fall in performance are apparent when past growth is decomposed into the components of production (changes in labor force, capital, and productivity of labor and capital). The results reveal that there was rapid growth of the capital stock during both the 1970s and 1980s (indeed, investment rates of 30–40 percent rivalled East Asia) but actual declines in employment. Overall productivity growth, while significant in the 1970s, was negligible in the 1980s for the West Bank and turned negative for Gaza (see table). Throughout, the bulk of capital investment went into housing, and very little into industry.

Incomes stagnated in the 1980s

(per capita national disposable income)

Sources: Israel Central Bureau of Statistics and the IMF.

The West Bank and Gaza—a brief profile

The West Bank and Gaza, together with what are now Israel and Jordan, were among the areas ruled by the Ottoman Empire prior to 1917. Toward the end of World War I, Britain gained control of Palestine, and in 1922, the areas were entrusted to Britain by a mandate of the League of Nations.

Escalating strife and unsuccessful British attempts to mediate between Jewish and Palestinian nationalisms caused Britain to return its mandate to the United Nations in 1947. The UN suggested Palestinian and Jewish independence on a partition basis. The Palestinians and Arabs rejected the suggestion, and the State of Israel was proclaimed in 1948. In the aftermath of the ensuing military conflict, the Gaza Strip came under Egyptian control and the West Bank, under Jordanian control. During the 1967 Arab-Israeli war, the West Bank and Gaza were occupied by Israel, which administered the areas as the occupying power, except that East Jerusalem has been formally annexed by Israel and is considered part of Israel by the Israeli authorities. Israel’s annexation of East Jerusalem has not been recognized by the United Nations.

The West Bank and Gaza have a combined area of about 6,000 square kilometers; a 1993 population of 1.8 million; a GNP of about $3.1 billion; and a GNP per capita of $1,725. The population of East Jerusalem is about 300,000, including about 150,000 Jews, mostly settled there since 1967. In addition, there are about 135,000 Israeli settlers residing in some 150 settlements that have been built in the West Bank and Gaza over the past 25 years.

It is estimated that currently about 35 million Palestinians live outside of the West Bank and Gaza. Some have maintained residency rights and are, in principle, free to return, while the return of others will be subject to negotiation between Israel and the Palestinians. How many Palestinians might actually return would also depend upon their perceptions of future economic opportunities in the West Bank and Gaza.

Until the recent assumption of authority by the Palestinians, all powers of government concerning the West Bank and Gaza had been vested in the Coordinator of Government Activities appointed by the Israeli authorities. The Civil Administration (CA), working on behalf of the Coordinator, was responsible for administering all economic matters including, inter alia, granting licenses and permits, regulating trade, collecting taxes, organizing public infrastructure and services, and supervising the operations of local governments. The CA had about 22,000 employees, of which approximately 95 percent were Palestinians. Most policy-making and senior administrative positions in the CA were, however, staffed by Israelis. Powers in Gaza and Jericho have been handed over by the CA to the Palestinian authority. According to the Declaration of Principles, signed by Israel and the PLO, the CA would be dissolved following inauguration of the Palestinian Governing Council.

Local-level governments in the West Bank and Gaza consist of 29 municipalities and 96 village councils. In addition, there are 27 refugee camps run by the United Nations Relief and Works Agency (UNRWA). Generally, local governments are responsible for operating power, water, solid waste, and local road services within their jurisdiction; the CA, on the other hand, has direct responsibility for delivering education, health and inter-city road services. The provision of services in the refugee camps is mostly the responsibility of UNRWA.

Much of this pattern was the result of the international and domestic policies that stemmed from the occupation. Policies of both Israel and Arab states created asymmetries in economic relations with neighboring economies. After 1967, there was a surge in opportunities for manual labor in Israel and greater openness to imports from Israel. Exports of competitive products to Israel, however, notably in agriculture, were restricted. Arab states were open to labor and capital flows, but trade in goods was (with limited exceptions) not allowed because of the Arab boycott of Israel. Trade with the rest of the world was, in practice, limited by the weakness of trading networks.

Clearly, these patterns led to a heavy dependence on outside sources of employment, a trade pattern heavily dominated by trade with Israel, and a large trade deficit of some 26 percent of GDP in the late 1980s—financed almost entirely by the substantial flow of labor income from abroad. The number of Palestinians working in Israel rose from zero to about 75,000 in 1979 and to 110,000 by 1987, accounting for 35 percent of the employed population in the West Bank, 45 percent in Gaza, (and all of the growth in Palestinian employment) and 7 percent of total employment in Israel. Further, the oil price hikes of the 1970s fueled a surge in demand for skilled labor in the Gulf, helping pull up domestic wages.

But from the 1980s onward, the picture drastically changed. Growth in Israeli demand for Palestinian labor declined with slower overall growth and the saturation of the market for construction labor; and demand for skilled labor in the Gulf was hit by the fall in the oil price and increasing use of Asian labor, even before the Gulf crisis. By 1992, 21 percent of West Bank income and 29 percent of Gaza’s income still came from work in Israel, a significant but unknown amount from the Gulf; only 5–7 percent came from domestic manufacturing.

At the same time, there were heavy constraints on domestic production. Opportunities to invest in domestic production of goods were restricted by an extensive framework of regulations that limited investment in activities competing with Israeli producers. Other restrictions included severe constraints on expansion of industrial land (causing sky-high urban land rents by the 1990s), an underdeveloped formal financial system, and a high degree of uncertainty faced by private producers with respect to their legal position and tax obligations.

Why the sharp fall in performance?(percent per annum)
West BankGaza
1970–791980–871970–791980–87
Annual growth:
GDP8.543.566.271.57
Capital18.877.956.076.09
Labor-0.63-0.95-0.74-0.45
Contribution to GDP growth of:
Capital3.553.182.432.44
Labor-0.38-0.57-0.440.27
TFP25.370.954.29-0.60
TFP as a percent of growth in GDP63.0027.0069.00-38.00
Sources: Israel Central Bureau of Statistics, and authors’ computations.

Domestic development was further constrained by the under-provision of public goods (water, sanitation, roads, and electric power) that were held by fiscal and institutional constraints to levels far below that in economies of a comparable income level. For example, drinking water per capita is under half that of Tunisia and Jordan, and a quarter of Egypt’s; electricity supply per capita is 80 percent of Egypt’s and two thirds that of Jordan’s. In addition, land and water resource bases have stagnated or declined—in part due to land confiscation by Israel—in the face of a large population increase over the past 25 years.

This mixture of asymmetric integration in the region and regulatory repression at home explains the pattern of growth illustrated in the table. Booming growth in labor incomes abroad pulled the economies along in the 1970s. Domestic production responded, with big shifts of labor from low-return agriculture into services in particular—generating high overall productivity increases. Labor income from abroad financed large private investment (in addition to large imports of consumption goods)—but most of this was in housing, and so had little impact on productive capacity. And when employment abroad stalled, so did domestic production. To make matters worse, the economy was then hit by a series of shocks.

Recent shocks

The Intifada contributed to the post-1987 decline, through strikes, reduction in Israeli demand in nonconstruction sectors, and some tightening of economic controls. But this only sharpened the problem of faltering growth. The unbalanced nature of past economic development left the Palestinian economy highly vulnerable to external economic shocks. Israeli hyperinflation was completely imported in the mid-1980s. West Bank residents could, and did, shift into the Jordanian dinar in 1988–89, but were then hit by the unexpected Jordanian devaluation. The Gulf crisis (1990–91) exacerbated the situation, temporarily leading to a border closure with Israel, and permanently leading to a loss of Palestinian employment in the Gulf, especially in Kuwait, in part because of the Palestine Liberation Organization’s (PLO) support for Iraq. It also hastened the financial squeeze on the PLO, which in turn led to reduced grant flows into the West Bank and Gaza.

Following several years of intermittent disruptions caused by curfews and border closures, the number of permits issued for work in Israel was sharply reduced in March 1993. There were security and political reasons for this, but it also marked a turning point in the demand for Palestinian labor in Israel, as the Israeli construction boom faded and new immigrants (mostly from Russia) replaced Palestinian workers in industry and services. The number of workers with jobs in Israel collapsed again in early 1994 due to security concerns, but has gradually increased to about 55,000 at the present time. As a result, the domestic labor market has been hit dramatically in recent years, with falling wages in both the West Bank and Gaza since 1991, and rising unemployment, especially in Gaza.

Post-peace economic strategy

The recent economic shocks—from the Gulf to Israel—add up to a large and permanent adverse change in the external sources of income growth. Future income growth will have to depend on an expansion of domestic production. There is an urgent short-run need to offset the fall in labor demand, to prevent the economy from entering a vicious cycle of falling income and rising social unrest. The creation of jobs at home is also a central medium-term goal to help attract back Palestinian labor from Israel and make room for Palestinians now abroad.

Palestinian economic policymakers face significant policy choices. Should markets in Israel be preserved or trade be reoriented to the Arab world? Should the government play a leading role in jumpstarting the economy, promoting industry, and macroeconomic independence? How will the population cope with the first years of depressed labor demand? And what is the best use of the foreign capital windfall? Resolving these questions becomes more difficult when the interests of Israel and Jordan are brought into play.

International economic relations. Past development has been characterized by asymmetric integration within the region. If Palestinian wages and employment are to grow, trade in goods will now have to substitute for exports of labor. Does increased autonomy mean disengagement from Israel? This would almost certainly be a mistake from an economic perspective: in the short run, loss in income, especially from those still working in Israel, could send the economy into a vicious downward spiral. In the long run, it would mean forsaking a strategic opportunity—the exploitation of the intermediary position of the Palestinian economy between Israel and the Arab economic world. Turning inward behind trade barriers is also not viable for a small, open economy. An ideal approach would be one that both maintains strong economic ties with Israel—but on more symmetric terms—and diversifies to markets in the region and elsewhere. However, as long as Israel does not have direct economic relations with the other countries of the region, the extent to which they can trade in the West Bank and Gaza will remain limited. Some of these concerns are already evident in the initial economic agreements with Jordan and Israel (see article in this issue by Karim Nashashibi and Oussama Kanaan).

Government spending and taxing. In the past, the economy of the West Bank and Gaza had both too much and too little government. There has clearly been too little in the provision of economic and social services. Expanding infrastructural services will play a vital role in removing constraints or costs to business expansion (e.g., in developing industrial land and in expanding the provision of electric power, roads, and water). This will require policy changes in some areas, such as land allocation decisions, a crash rehabilitation and investment program, and the establishment of the sectoral institutions (most sectors now have some combination of weak public institutions and a multiplicity of nongovernment bodies).

In the medium to long run, both economic infrastructure and social development are central to maintaining the historical comparative advantages of Palestinians (in skills and entrepreneurship) and in supporting the steady reorientation of comparative advantage in favor of greater interdependence. As with trade, an interdependent strategy on infrastructure, for example by strengthening links throughout the region on power grids, transport and telecommunications networks, is going to provide more real autonomy than costly attempts at self-sufficiency. For social services, Palestinians are probably still ahead in skills within the Arab world, though this advantage has been eroded by the large brain-drain. (Since the Gulf war, more skilled workers have returned, contributing to the compression in domestic wage differentials.) A sensible education strategy is likely to require improving quality and a swift modernization of curricula at all levels. The tertiary education system has been heavily oriented toward the academic subjects and the professions. A substantial reorientation is likely to be needed to support growth in skilled employment.

“As with trade, an interdependent strategy on infrastructure… is going to provide more real autonomy than costly attempts at self-sufficiency.”

But greater provision of these services will require more spending. So, too, will the development of Palestinian police and security (that could require at least 5 percent of GDP). Security and the rule of law is, of course, a necessary condition for any economic activity and is likely to be the main initial concern of the leadership. More public spending implies more finance. Does it mean more taxes? Some of the taxes paid by the residents of the West Bank and Gaza currently accrue to the Israeli treasury (estimated at about 8 percent of GDP). Under the recent economic agreement, these will largely be assigned to the Palestinian Authority. But even then, this will not solve the public finance problem immediately. A major need for the Palestinian Authority will be to widen the tax base and strengthen administration—hardly the most popular enterprise for the new regime.

Regulating for private sector growth. Private entrepreneurship has a crucial role to play in moving the economy onto a more autonomous growth path. A combination of too much and too little public action is also true here: the government has been active in controlling and restricting private production, and has been weak in providing the legal, financial, and institutional infrastructure for private activities. International experience suggests that government direction of economic activity would be costly and counterproductive. But there is an important role for a stronger, not weaker, government in support of private investment.

There are two kinds of policies that affect the business environment: lifting regulatory burdens and building institutions. Lifting regulatory burdens can often be undertaken swiftly and the new Palestinian authority would need to take further steps in this area. Building institutions, by contrast, takes time. In particular, the legal and regulatory systems that are so important to protecting private activity and enforcing contracts need to be carefully fostered. Absence of financial services will also be a short-run constraint on activity. Some checking services are already being provided with apparent efficiency by money lenders, and, as almost everywhere in the world, equity is the primary source of finance for expansion. However, a sound banking system is of great importance to future development, to support the mobilization of household deposits and provide working capital and other financial services to an expanding business community. This will require decisions over entry, banking regulations, and supervision. Some of the groundwork for these have now been laid with the economic agreement with Israel that establishes a Palestinian monetary authority. A forthcoming agreement with Jordan is likely to strengthen banking relations between the two economies.

Macroeconomic policy. Should the new Palestinian Authority have an independent fiscal and monetary policy? The recent agreement leaves this open. Greater independence would be desirable to insulate the economy from shocks from its neighbors (Jordan, in particular, faces significant macroeconomic risks—though some of these are linked to the potential movement of capital into the West Bank and Gaza). In the future, it may be important to manage inflows of capital from Palestinian investors. However, the scope for independence will be limited by the high degree of capital mobility in the region—something already recognized in the common banking requirement for arrangements with Jordan. And the real gains to independence come when macroeconomic credibility is established, something that is hard to earn and that requires a track record of prudence. Indeed, in view of the substantial fiscal pressures that the Palestinian Authority will face in the coming years, stability might in fact be strengthened by the absence of an independent monetary policy.

If a system with an independent currency were chosen, it would be desirable to start with a relatively restricted version, as in a currency board (in which the domestic currency is backed one-for-one by foreign currency). This could gradually evolve to a fully fledged currency that brought greater policy discretion, once discipline and the associated demand for the currency were well established.

Labor demand and poverty in the transition. Employment and real wages will be the primary determinants of the extent and depth of poverty. There are well-developed mechanisms for protecting vulnerable groups via extended family and community networks and the activities of the United Nations Relief and Works Agency. However, these mechanisms are best at dealing with declines affecting selected groups and are least well-equipped to deal with widespread declines in labor demand, since most households and communities suffer adverse effects at the same time.

A pro-labor strategy will be helped by two of the core features of the future strategy. First, the rehabilitation and expansion of social and economic infrastructure will lead to more jobs in the construction phase. Second, permanent jobs should increasingly flow from the reorientation of production as trade in goods substitutes for export of labor.

These measures are likely, however, to leave a significant gap of high unemployment and underemployment. This matters most for unskilled labor, since unskilled workers are disproportionately in poor households with the weakest alternative coping mechanisms. The best way of reaching this group is via low-wage public works, preferably, but not necessarily, in productive activities. Low wages are important both to allow greater employment for a given budget and as a self-selection device for targeting poorer households, as well as to avoid pushing up wages for permanent productive activities. The Civil Administration started a public works scheme after the border closure of 1993, employing up to 20,000 workers at times, depending on the tempo of closures. The stigma of association with the Civil Administration should not deter a program that is an effective way of getting cash to the poor.

But such a transitory policy is to be sharply distinguished from permanent public employment. There is an urgent need to build up the Palestinian administration—indeed, while many Palestinians worked in the Civil Administration, very few were in policymaking positions and thus have little experience in running an administration. In addition, there will also be the task of integrating Palestinian returnees from Tunis. But the size of the civil service needs to be carefully controlled to avoid future fiscal and public pay problems—this could be a difficult area to manage in view of both the slack market for skilled Palestinians and the pool of PLO quasi-public officials now living abroad.

Using external money effectively. Available financing ($2.4 billion) now represents both a one-time opportunity and a potential danger if the economy does not adjust far and fast enough to an autonomous path. The danger is of a failure, on the part of the new Palestinian Authority, the international community, or Israel, to establish the policy and structural conditions that would sustain rapid growth and attract private capital over the medium term. There are many ways in which this could occur. There could be inadequate resolution of the supply-side constraints on growth, whether in the form of the legal framework for private sector activity or tackling infrastructural bottlenecks. Trading opportunities might remain restricted, whether due to failures to improve access in the Arab world, the OECD or Israel, or to an attempt to spur industrialization through trade protection and subsidies. Public savings could stall, owing to failures in revenue mobilization or excessive current spending, and there could be public investment in inefficient and unproductive activities.

Foreign assistance-led growth also creates its own source of vulnerability. Other countries in the world, and many in the Middle East, have experienced booms that ended in busts. When booms are generated by foreign inflows, a reduction of such flows can wreak havoc with the domestic financial system, as well as with social and economic well-being when the system in place is not flexible enough to adjust to a fall in foreign resources. A key principle is that foreign official inflows should complement, not substitute for, the domestic tax effort. Unless there is progress on the domestic front to mobilize resources for development, the provision of external finance in the interim could set the economy of the West Bank and Gaza on a path of external dependency, making it vulnerable to debt crises.

Conclusion

Past economic growth in the West Bank and Gaza was driven by demand for Palestinian labor in outside centers of activity, in Israel and the Gulf. As these sources of growth are disappearing, most Palestinian households are entering the interim period in a more economically insecure state than for very many years. Peace can open opportunities: for trade, more independent public action, and foreign resources. These opportunities could be used to reorient the economy toward new, domestic sources of growth or could be squandered. The economic strategy that is chosen is likely to make the difference. Five areas are especially important: maximizing trade linkages; providing the environment for private investment; building institutions—from the health ministry to a private banking system; providing a safety net during what could be a tough transition, especially via temporary publicly financed employment; and managing aid to foster autonomy rather than create dependency, not least by expanding the domestic tax base. Some of these policies will require facing internal conflicts, while others involve negotiations with Israel and Jordan. It is likely that action in all of these areas will be necessary to shift the economy onto a path of autonomous development.

At the request of the Multilateral Working Group on Economic Development and Regional Cooperation, the Bank expanded its contribution to the key challenges facing the Middle East region to include an assessment of the development needs and prospects of the economies of the West Bank and Gaza. The result has been a six-volume study, Developing the Occupied Territories: An Investment in Peace. The overview volume is complemented by five other volumes that focus on key areas—macroeconomics, private sector, agriculture, infrastructure, and human resource development. This article draws upon the findings of Volume 2: Macroeconomics. Prem Garg coordinated the Bank’s task force on the Occupied Territories and guided the preparation of the six-volume report.

For further reading, please see: Program for Development of Palestinian National Economy for the Years (1994–2000), Executive Summary, PLO, Department of Economic Affairs and Planning, July 1993; Declaration of Principle on Interim Self-Government Arrangements, September 13, 1993, Appendix 1 to the Near East Economic Progress Report, No. 1, The Institute for Social and Economic Policy in the Middle East, Harvard University, March 1994; Protocol on Economic Relations between the Government of the State of Israel and the PLO, representing the Palestinian People, April 29, 1994, Near East Economic Progress Report, No. 2, The Institute for Social and Economic Policy in the Middle East, Harvard University (forthcoming); The Economics of Middle East Peace, edited by Stanley Fischer, Dani Rodrik, and Elias Tuma, The MIT Press, 1993; and Securing Peace in the Middle East: Project on Economic Transition, edited by Stanley Fischer, Leonard J. Hausman, Anna I). Karasik, and Thomas C. Schelling. The MIT Press, 1993.

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