Chapter

II. Economic Developments and Policies in 1996 and Prospects for 1997

Author(s):
Milan Zavadjil
Published Date:
February 1997
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Economic developments in the WBGS in 1996 were dominated by political and security factors. The frequent border closures and increased political uncertainties resulted in a reduction in the number of Palestinians working in Israel, disruptions to trade and to the public investment program, and a general weakening of confidence. As a result, over the year as a whole, per capita income fell, unemployment rose to 34 percent, and only modest headway was made in developing the physical and institutional infrastructure (see Table 1). After the construction boom of 1994 and 1995, private investment also fell in 1996. By the second half of 1996, per capita income was about 20 percent lower and the unemployment rate 16 percentage points higher than in 1993, before the signing of the Oslo accords (Charts 1 and 2).1 However, some progress was made in establishing and strengthening economic institutions and processes.

Table 1.West Bank and Gaza Strip: Key Economic Indicators, 1993–97(In millions of U.S. dollars, unless otherwise indicated)
19931994Est.

1995
Est.

1996
Proj.

1997
Real GDP (percent change)–1.310.83.3–1.65.4
Real GNP (percent change)–10.13.9–2.4–2.98.1
Real GDP per capita (NIS, 1986 constant prices)1,4701,5671,4241,3461,364
Real GNP per capita (NIS, 1986 constant prices)1,7661,7641,5381,4351,492
Workers in Israel (in thousands) 1/83.053.032.125.135.0
Workers in WBGS (in thousands) 1/316.2328.9342.0335.8355.9
Unemployment rate (in percent)18.024.729.034.231.5
Inflation rate (based on CPI)11.014.010.87.98.1
Revenue296269425670814
Current expenditure273298492782866
Current deficit23–30–67–112–52
Public investment9886189160255
Foreign–financed employment programs------53--
Overall deficit–75–115–257–325–307
Exports of GNFS245312473413470
Imports of GNFS1,3331,2421,9081,7451,949
Remittances (receipts)586400262218329
(End of period)
Net foreign assets4351,0101,3201,882
Domestic loans97270398
Total deposits5231,1421,695
Demand deposits306465584
Time and savings deposits2176781,111
Sources: Palestinian and Israeli authorities; and IMF staff estimates.

Annual averages.

Sources: Palestinian and Israeli authorities; and IMF staff estimates.

Annual averages.

Chart 1West Bank and Gaza Strip: Selected Economic Indicators, 1992-96

Sources: Palestinian and Israeli authorities; and IMF staff estimates and projections.

1/ Excludes underemployment.

Chart 2West Bank and Gaza Strip: Labor Market Indicators, 1992-96

(In thousands)

Sources: Palestinian and Israeli authorities; and IMF staff estimates and projections.

A. Situation at the Beginning of 1996

Economic developments in 1996 were disappointing, particularly in view of the more promising situation that prevailed at the end of 1995, following the signing of the Interim Agreement in September 1995 and the associated easing of political tensions and uncertainties. At the Ministerial Conference on Economic Assistance to the Palestinian People held in Paris on January 9, 1996, the PA expressed its resolve to pursue institution-building efforts and to continue the implementation of tight fiscal policies, with a view to achieving a balanced recurrent budget by 1997. Donors, in turn, were to shift away from emergency and recurrent budget financing and concentrate increasingly on providing financing and assistance aimed at an accelerated implementation of core public sector investment projects which were endorsed at the October 1995 Consultative Group (CG) meeting for the WBGS. This was seen as the best means to increase domestic employment, while laying the basis for reinvigorated private investment and trade.

B. The Border Closure and the Palestinian Authority’s Response

As a consequence of three suicide attacks in Israel, a strict border closure was imposed on the WBGS on February 25, which virtually prohibited the movement of goods and labor to and from the WBGS. This led to the immediate unemployment of about 50,000 workers previously working in Israel (out of an estimated workforce of 530,000). The blockade of merchandise trade exacerbated the fall in domestic incomes, in particular of those engaged in the production of exportables, notably in agriculture. Shortages in raw materials and other imported capital inputs disrupted the public investment program and investment activities in the private sector, especially in the construction sector, leading to a further sharp fall in domestic employment. Real GDP is estimated to have fallen by about 10 percent in the first quarter, and the unemployment rate to have risen to about 38 percent at the end of the first quarter from 29 percent in January.2

Box 2.The West Bank and Gaza Strip at a Glance

Area and population

The WBGS has a population of 2.55 million (Appendix Table 11). With about 38 percent of the population living in the Gaza Strip, its distribution is highly uneven; the West Bank has a population of 1.58 million and an area of 5,800 squared kilometers, whereas the Gaza Strip has a population of about 1 million and an area of 400 squared kilometers. It is a very young population, with about 50 percent below the age of 15. The population is predominantly Palestinian although Palestinians in the WBGS represent less than one-half of the world’s Palestinian population (it is estimated that about 3.5 million Palestinians live in the diaspora).

Economic characteristics

The WBGS has a GDP of about US$3.2 billion (in 1996), and a somewhat higher GNP (because of the importance of remittances from workers in Israel) of US$3.4 billion; thus a GDP per capita income of US$1,255 and GNP per capita income of US$1,333. The WBGS’ economy is largely service-oriented, with services and commerce representing about 58 percent of GDP, construction representing 21 percent, agriculture 14 percent, and industry 7 percent (in 1993). Since Israel’s military occupation in 1967, the WBGS’ economy has been highly dependent on Israel’s. In 1993, there were 83,000 workers from the WBGS in Israel (about 21 percent of total WBGS employment), with remittances from those workers representing about 20 percent of GNP. Trade with Israel represented about 75 percent of exports of goods from and 87 percent of imports into WBGS. Given this dependence, the recurrence of border closures since 1995 has stifled the economy.

Social indicators

On the whole, social indicators in the WBGS are close to the average for countries in the Middle East and North Africa region (MENA). Life expectancy at birth is 68 years, compared with MENA’s average of 66 years. Illiteracy rate is 40 percent, compared with 39 percent for MENA. Infant mortality is 37 per 1,000, compared with MENA’ average of 49 per 1,000. Gross primary enrollment (percent of school age population) is about 100 percent compared with the MENA average of 97 percent.

Confronting a severe worsening in economic and financial conditions, the PA, with the help of donors, implemented a series of short-run measures designed to alleviate the adverse effects of the border restrictions on the more vulnerable segments of the population. These included:

  • providing temporary employment through public works, the funding for which was covered domestically through a 5 percent solidarity charge on the wages of the employees of the PA, and from external funds channeled through the Hoist Fund, the United Nations Development Program (UNDP), the United Nations Relief and Works Agency (UNRWA), and the Palestinian Economic Council for Development and Reconstruction (PECDAR).3 The total number of workers employed in these programs has risen from about 10,000 workers in April to about 40,000 workers in subsequent months;
  • providing social assistance to families deprived of their breadwinners’ income as a consequence of the closure; and
  • importing essential foodstuffs with the objective of preventing sharp increases in their prices and ensuring their availability to the population (largely at cost).

The Israeli authorities started to relax, in a gradual fashion, border restrictions starting in mid-April. The number of permits granted to Palestinian workers increased from about 15,000 in April to 36,000 in August and about 40,000 toward the end of the year. Restrictions on merchandise trade were also relaxed (more on imports than on exports), but the recovery of trade was inhibited by the rise in transportation costs as a result of more stringent security controls at the borders. Moreover, there were intermittent border closures in the second part of 1996 (notably, in late September and early October, and again in early November) so that the average number of workers employed in Israel is estimated at 25,100 in 1996, compared with 116,000 in 1992. With the gradual increase in Palestinian employment in Israel, and the implementation of the employment generation programs, real GDP recovered in the second half of the year. Nevertheless, it is estimated to decline by about 2 percent for the year as a whole, reflecting substantial declines in private and public investment (particularly construction) as a result of increased uncertainty, and in private consumption, which was only partially offset by the expansion of PA recurrent spending (Table 2, Appendix Tables 12 and 13, and Chart 3).4 The induced slowdown in economic activity led to a contraction in imports of goods and nonfactor services in 1996 by 9 percent. Nevertheless, a large trade deficit remained and together with the estimated rise in net foreign assets of US$310 million was financed, as in previous years, by unrequited transfers and capital inflows.

Table 2.West Bank and Gaza Strip: National Income Accounts, 1993–96(In millions of NIS, 1986 constant prices)
19931994Est.

1995
Est.

1996
GDP 1/3,3403,7013,4953,438
Resource gap–1,324–1,124–1,632–1,497
Imports of goods and nonfactor services1,6201,4972,1651,958
Exports of goods and nonfactor services296373533461
Gross domestic expenditure4,6644,8255,1274,935
Consumption386540544,4104,228
Private3,5163,6983,8043,438
Government349356606790
Gross fixed investment799771717706
Private638663452393
Government161108265313
Net factor income671465281229
Remittances671465281229
Receipts712482297244
Payments41171616
Net investment income----–1--
Receipts--------
Payments----1--
GNP4,0114,1663,7763,666
Sources: Palestinian and Israeli authorities; and IMF staff estimates.

Figures for exports and imports, and thus for GDP, in 1995 and 1996 are not comparable to those for earlier periods, because of a break in the series for exports and imports starting in 1995 (see Section V).

Sources: Palestinian and Israeli authorities; and IMF staff estimates.

Figures for exports and imports, and thus for GDP, in 1995 and 1996 are not comparable to those for earlier periods, because of a break in the series for exports and imports starting in 1995 (see Section V).

Chart 3West Bank and Gaza Strip: Gross Fixed Investment, 1992-96

(As a percent of GDP)

Sources: Palestinian and Israeli authorities; and IMF staff estimates and projections.

Despite the pressures on expenditures and revenues emanating from the border closures, the PA managed to limit the increase in the recurrent deficit (see Section III below). Reflecting perseverance in improving revenue administration, PA revenues, at US$670 million, exceeded the draft budget target by 21 percent (Table 3). Nonwage expenditures exceeded the target by over one-half because of spending related to (i) the border closure; (ii) unbudgeted expenditures due to institution building; and (iii) at least an additional unbudgeted US$32 million spent from accounts not under the control of the Ministry of Finance. In addition, overall wage and salary payments exceeded 1996 draft budget target modestly, reflecting in large part higher than anticipated police recruitment. In all, the recurrent budgetary deficit is estimated at US$112 million, about US$37 million higher than targeted under the draft budget. Public investment did not provide the envisaged boost to the economy in 1996; PA capital outlays are estimated at US$160 million, well below the level in 1995 and the amount envisaged at the time of the Paris Conference.

Table 3.West Bank and Gaza Strip: Summary Table of the Fiscal Operations of the Palestinian Authority, 1995–97(In millions of U.S. dollars)
1995

Draft

Budget
1995

Est.
1996

Draft

Budget

1996

Proj.
1997

Draft

Budget
Revenue 1/216.0424.9554.3670.1814.2
Domestic revenue114.5158.5207.4247.2301.1
Tax revenue84.7108.2136.6169.4205.1
Nontax revenue29.950.370.977.896.0
Revenue clearances101.4266.4346.8422.9513.1
Current expenditure443.7492.0629.3782.2866.0
Wage bill civil service187.9193.8249.7247.6296.0
Wage bill police force96.6110.5147.3153.7199.0
Nonwage budgetary expenditure 2/159.1187.7232.3348.9371.0
Other expenditure 3/------32.0--
Current balance excluding foreign––227.7–67.1–75.0–112.1–51.8
financed employment programs
Foreign–financed employment programs------53.1--
Current balance including foreign––227.7–67.1–75.0–165.2–51.8
financed employment programs
Capital expenditure143.4190.0272.8160.0
Of which: PMA capital10.0--------
Overall balance–371.1–257.1–347.8–325.2
Financing225.4272.8
Domestic financing----
Foreign financing225.4325.0272.8266.8
Recurrent budget financing92.0135.0--53.7
Employment generation programs------53.1
Capital expenditure133.4190.0272.8160.0
Financing gap145.7--75.051.8 4/
Memorandum items:
Revenue 5/6.713.217.220.723.0
Current balance 5/6/–7.1–2.1–2.3–3.5–1.5
Overall balance 5/–11.5–8.0–10.8–10.1
Sources: Palestinian and Israeli authorities; and IMF staff estimates and projections.

Estimates of revenue include collections transferred to bank accounts outside the control of the Ministry of Finance (see footnotes 1 and 3, Table 5).

Including expenditures on emergency programs associated with the border closures and additional unbudgeted expenditures that were not included in the 1996 draft budget (see footnotes 1, 2, and 3, Table 6).

From accounts not directly under the control of the Ministry of Finance (see footnote 4, Table 6).

Projected recurrent budget financing gap for 1997.

In percent of GDP.

Excluding foreign–financed employment programs.

Sources: Palestinian and Israeli authorities; and IMF staff estimates and projections.

Estimates of revenue include collections transferred to bank accounts outside the control of the Ministry of Finance (see footnotes 1 and 3, Table 5).

Including expenditures on emergency programs associated with the border closures and additional unbudgeted expenditures that were not included in the 1996 draft budget (see footnotes 1, 2, and 3, Table 6).

From accounts not directly under the control of the Ministry of Finance (see footnote 4, Table 6).

Projected recurrent budget financing gap for 1997.

In percent of GDP.

Excluding foreign–financed employment programs.

Despite the unsettled political and security conditions, banking system deposits and net foreign assets increased sharply in 1996. This reflected the increasing role of the banking system as the keeper of the WBGS’s residents’ financial savings, which was not accompanied by a proportional expansion of domestic bank lending. Rapid deposit growth was maintained throughout 1996, due to the growing number of banks and bank branches throughout the WBGS and the continuing shift in portfolio preferences from cash to deposits, evident since the PA assumed responsibility for the banking system. In all, deposits are estimated to have increased by US$550 million during 1996. However, domestic credit is estimated to have increased by less than one-fourth of that amount, largely as a result of the high risks of bank lending in the WBGS and the depressed demand for capital by local investors in the prevailing uncertain political and economic environment.

While changes in the CPI in the WBGS are usually governed by the rate of inflation prevailing in Israel, two additional effects, acting in opposite directions, came into play in 1996 as a result of the intensified border closure. Tight restrictions on imports put upward pressure on prices in the period immediately following the closures (particularly in Gaza), but the decline of remittances and other sources of income (including those derived from export activities) exerted a strong downward pressure on prices, leading to a steady fall in the monthly rate of increase in the CPI. Monthly increases in the CPI, which averaged over 1.5 percent per month in the first quarter, fell to negative levels toward the end of the year, well below the levels recorded by the CPI in Israel (Table 4). The inflation rate for the year as a whole is estimated at about 8 percent, compared with 11.5 percent in Israel.

Table 4.West Bank and Gaza Strip: Inflation Rates (Based on Cost of Living Index), 1993–96 1/
19931994Est.

1995
Est.

1996 QI
Est.

1996 QII
Est.

1996 QIII
Est.

1996 QIV
Est.

1996
West Bank and Gaza11.014.010.85.11.02.4–0.67.9
Israel11.112.38.12.84.11.111.5
Jordan4.83.64.53.3–4.13.96.5
Sources: Palestinian Central Bureau of Statistics; and IMF staff estimates.

All figures are on an annual basis, except for figures shown for quarters, which show the rates of increase over the previous quarter.

Sources: Palestinian Central Bureau of Statistics; and IMF staff estimates.

All figures are on an annual basis, except for figures shown for quarters, which show the rates of increase over the previous quarter.

Box 3.Impact of Employment of Palestinian Workers in Israel on Budgetary Revenues

The employment of Palestinian workers in Israel has an important direct and indirect impact on budgetary revenue for the PA. This mobile work force affects the PA budgetary revenue in two ways.

First, a rise in Palestinian workers employed in Israel would lead to an increase in revenue clearances from customs duties and VAT and domestic revenue. As Palestinian workers in Israel remit or bring back their earnings, consumption in the WBGS is boosted once the higher disposable income is spent. Income which is spent on third-party imports would generate custom duties and other indirect taxes, including VAT through the clearance system (see Box 4). Goods purchased directly from Israel will generate only VAT revenue (again through the clearance system). Alternatively, if the income is spent on goods and services produced domestically in the WBGS, the tax base will also be enhanced. In the first instance, indirect taxes will be generated. This is followed by a second order impact as domestic sellers pay income taxes, as well as increase their own spending on other goods and services which, in turn, would create a further multiplier effect.

Second, more Palestinian workers employed in Israel would lead to an increase in revenue clearances in income tax and health fees for the PA, as Israel transfers virtually all income tax and health fees which are withheld on Palestinian workers. In 1995, this amounted to approximately US$16 million.

With an average daily wage of US$30, and workers assumed to work 26 days per month, 10,000 additional workers employed in Israel would generate US$94 million per year. Assuming an average propensity to import and consume of 0.6 and 0.9 respectively, it is estimated that a further US$19 million in taxes could be raised for every additional 10,000 Palestinian workers in Israel.

C. The Palestinian Authority’s Policy Stance in 1997 and its Medium-Term Strategy

The medium-term economic strategy of the PA is geared toward addressing the unemployment problem. About one-third of the labor force is currently unemployed and this could increase unless strong economic growth is achieved—as the labor force and population are projected to continue growing by 4 percent a year. A substantial increase in investment to GDP ratios from the current 18–19 percent, as well as efficient use of resources, will be therefore required to reduce unemployment. While in the short run, better implementation of the public investment program could provide a boost to investment, in the medium term, the PA will need to rely on increased private investment.

Box 4.Revenue Clearance System

Under the Protocol on Economic Relations signed by the PA and Government of Israel on April 29, 1994, the two sides have established a revenue clearance system to apportion an agreed pool of selected tax revenues which have arisen as a result of the de facto customs union. On indirect taxes such as customs duties and VAT on Israeli-Palestinian transactions, tax revenues accrue either to the Palestinian or the Israeli side according to the “destination principle” and the transfer of revenues is made periodically after a reconciliation of accounts. In the case of petroleum excises collected by the Israeli authorities, all revenues are transferred automatically to the PA. On direct taxes, such as income taxes and health fees paid by Palestinian workers in Israel and in the Israeli settlements, 75–100 percent of revenues collected at source are transferred. As the collecting agent, Israel levies a 3 percent service fee on all gross clearance revenue.

Transfers from the clearance system have formed a significant and stable source of revenue for the PA. In both 1995 and 1996, 63 percent of PA revenues originated from the clearance system. VAT clearance revenue, which routinely amounted to nearly one-third of total revenue, was by far the most importance source of clearance revenue.

On indirect taxes, the revenue clearance is based on actual payments or bookkeeping transactions. For customs duty, VAT, and purchase taxes on third-party goods that are imported by Palestinian entities and destined directly for WBGS, a coding system used in import declarations has ensured that the correct fiscal revenues are properly transferred to the PA. As the initial problems associated with taxpayer education have largely been resolved, the system is now working relatively smoothly.

For VAT on Palestinian-Israeli transactions, the invoicing mechanism that supports the functioning of the VAT was a natural candidate for revenue clearance. Because the VAT is a multi-stage tax, to avoid tax cascading, each side has agreed to recognize all invoice-supported VAT payments that have been made to the other side. This arrangement permits each tax authority to recover from its counterpart the amount that is allowed to be deductible from the VAT liabilities by firms in its own jurisdiction. This feature provides an incentive for both sides to widen the coverage of their respective VAT because doing so will automatically increase the amount each can recuperate from the other side. This system, which requires considerable coordination, has functioned well following the introduction of a unified invoice system in January 1995.

On direct taxes, the Protocol specifies that 75 percent of income taxes paid by Palestinian workers who are employed in Israel be transferred to the PA. This revenue-sharing formulae recognizes the principle that income tax should in part be used to finance the infrastructure which makes production possible and in part be used to finance the social services consumed by the workers. As most Palestinian workers employed in Israel commute to work daily and are therefore more likely to consume their social services in WBGS, the income tax deducted at source from wages of Palestinian workers in Israel is thus shared between the two authorities. In addition, the Protocol further specifies that 100 percent of all health fees paid by Palestinian workers in Israel and in the Israeli settlements be transferred to the PA in recognition of the service criterion.

To increase investment and savings, the PA is implementing structural measures in the fiscal, financial, external, and regulatory areas, although success will depend also on the political and security situations. In the macroeconomic area, the goal is to maintain domestic financial stability and promote private sector activity and confidence by the pursuit of a tight fiscal policy and the continuation of institution-building efforts, including by increasing the transparency and accountability of fiscal operations. The PA intends to reduce substantially the recurrent deficit in 1997 and achieve small but rising surpluses thereafter, so as to allow for a domestic budgetary contribution to public investment and for an increasing focus of donor assistance on building infrastructure and on other investment projects.

Assuming modest improvements in security and political conditions, the outlook for 1997 is for a moderate recovery in exports and private investment, and an increase in the number of Palestinian workers in Israel to 35,000 (see Table 1). Under such conditions, real GDP is projected to rise by 5–6 percent, and the unemployment rate is projected to fall slightly to 31.5 percent. The PA draft budget aims at reducing the recurrent deficit from an estimated US$112 million in 1996 (3.5 percent of GDP) to US$52 million in 1997 (1.5 percent of GDP), while taking steps to ensure a substantial rise in foreign-financed capital expenditures. The main factor contributing to the reduced recurrent deficit in 1997 is the projected 21 percent increase in revenues, which reflects the expansion of the revenue base in late 1996, the rebound in economic activity and, to a lesser extent, a modest further improvement in tax administration. In addition, recurrent expenditures will be restrained through avoiding a general wage increase, and strict limits on nonwage expenditures. However, new PA employment is expected to rise by 9 percent due to the recruitment of 3,000 new policemen, as well as 3,700 teachers and health personnel.

To achieve the above budget target, improvements are being undertaken in expenditure management and revenue collection. In particular, all revenues, expenditures, and external financing are to be centralized under the control of the Ministry of Finance by March 1, 1997, with the aim of increasing efficiency in the use of budgetary resources. This will also enhance prospects for donor support to cover the recurrent budget deficit. Efforts continue to be made to strengthen the Budget, Treasury, and Audit Departments at the Ministry of Finance. In the area of revenue administration, with the basic revenue structure in place, the focus is on improvements in enforcement, particularly in the income tax area, and the recruitment of qualified staff. The establishment and operationalization of large taxpayer units should also help tax collection, including the VAT.

From 1967 until a few years ago, the expansion of income in the WBGS was driven by employment in Israel and the Gulf states. Since 1992, however, such employment has been in decline, with little prospect for an immediate recovery. Employment for the rapidly growing labor force will therefore need to be generated through the growth of exports of goods and services, which will require an environment conducive to private sector investment and growth. The general policy of the PA in this area is to continue to avoid interventions in the product market and the distortion of price incentives. In the same spirit, the PA is making efforts to remove some of the domestic impediments to private investment, in particular, by improving the regulatory environment. This would involve, with assistance of the World Bank, the review, consolidation, and improvement of a wide set of laws that currently regulate private sector activity (including the Investment Law).

The PA has undertaken to dismantle import monopolies (notably on petroleum products, cement, tobacco, and some electronic products) by end-1998, which currently represent the major structural distortion in the economy, as well as steps to improve their operations until that time. The PA is also aiming at further encouraging private sector investment through the strengthening of financial intermediation. Toward this end, efforts to strengthen the capabilities of the Palestinian Monetary Authority are currently underway, especially in the area of bank supervision and regulation, with a view to ensuring a sound financial system with well-regulated banking operations.

The PA is continuing its efforts to mobilize external resources from donors, in particular in the context of the Ad Hoc Liaison Committee (AHLC) and the Consultative Group (CG), with a view to ensuring the availability of funds to cover the recurrent budget gap in 1997, and to eliciting support for and the prompt disbursement of funds for key public investment projects. At the CG meeting convened by the World Bank on November 19–20, 1996, donors pledged some US$880 million to support the public investment program. However, considerable follow-up work is required to ensure that these pledges are translated into commitments and disbursements for specific investment projects in the public investment program. Donors have also endorsed the 1997 draft budget target, and it is expected that commitments to cover the 1997 recurrent budget financing gap will be made at the next AHLC meeting.

1As discussed in Appendix I, all macroeconomic data are subject to a high degree of uncertainty.
2Excludes underemployment.
3The Johan Jorgen Holst Peace Fund is a World Bank administered fund used by donors to support the PA’s recurrent budget and start-up and employment generation activities. PECDAR was established in 1994 to act as an implementing agency for investment projects.
4Real GNP is projected to decline by 3 percent, reflecting additionally the decline in workers’ remittances.

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