1. Introduction
Author: Milan Zavadjil1
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

Abstract

The economy of the West Bank and Gaza Strip faced a difficult external environment in 1997. Two intensified (and at times total) border closures that were triggered by security incidents in Israel jolted the economy, which was already weakened by high unemployment and permanent border controls that raised transportation and other costs, distorted investment incentives, and undermined competitiveness. The closures, coupled with the lack of progress in the peace process, gave rise to a profound pessimism concerning the economic prospects of the West Bank and Gaza Strip. The loss in confidence constrained both private investment and consumption, while public investment continued to be constrained by a broad array of factors, most of which reflected the unfavorable political and security situation. As a result, GNP increased by only 2 percent in real terms, implying a significant drop in per capita income.

The economy of the West Bank and Gaza Strip faced a difficult external environment in 1997. Two intensified (and at times total) border closures that were triggered by security incidents in Israel jolted the economy, which was already weakened by high unemployment and permanent border controls that raised transportation and other costs, distorted investment incentives, and undermined competitiveness. The closures, coupled with the lack of progress in the peace process, gave rise to a profound pessimism concerning the economic prospects of the West Bank and Gaza Strip. The loss in confidence constrained both private investment and consumption, while public investment continued to be constrained by a broad array of factors, most of which reflected the unfavorable political and security situation. As a result, GNP increased by only 2 percent in real terms, implying a significant drop in per capita income.

On the basis of fiscal data available as of November 1997, preliminary estimates for 1997 indicate that the Palestinian Authority maintained recurrent expenditures on an accrual basis within the budgeted amount, and that the recurrent fiscal deficit has been kept under the $52 million envisaged under the budget. Nevertheless, the Ministry of Finance continued to encounter severe liquidity difficulties as revenues continued to be diverted to accounts outside the Ministry of Finance, and, in the third quarter, Israel temporarily suspended the transfer of clearance revenues, resulting in rising payments arrears and overdraft.

Despite all the difficulties, significant progress was made in institution building in 1997. Working closely with the World Bank and the IMF, the ministries of Finance and Planning and International Cooperation improved their operations, as reflected in the preparation of the 1998 budget and investment plan. The audit function of the Palestinian Authority became fully operational, and further steps are expected in the near future to further improve fiscal transparency and accountability.

Prospects for 1998 remain highly uncertain. On the one hand, the border closure has been relaxed and the Israeli authorities have indicated that in the future the impact of security procedures on the movement of goods and labor will be minimized. On the other hand, there is deep pessimism over political and economic prospects, so that any recovery of private consumption or investment is likely to be limited. Thus, GNP growth of only 2 percent is forecast for 1998.

Against this background, the Palestinian Authority has formulated a bold budget for 1998 that envisages a small recurrent surplus and, for the first time, a contribution to the public investment program from domestic sources. Most important, the budget envisages a leveling off of the rapid public employment growth evident in the last three years, with virtually all additional employment limited to the education and health sectors in order to cater to the rapid growth of the population. In addition, at the December 1997 Consultative Group meeting held in Paris, donors reiterated their support for Palestinian development and indicated their intention to commit another $750 million. It is hoped that a substantial amount will be channeled to development projects and that, with more active monitoring of implementation, the public investment program will finally provide a significant boost to the economy.

The revival of private investment hoped for at the time of the Oslo accords has not materialized. Estimates show the share of private investment in GDP fell from 19 percent in 1993 to about 10 percent in 1997. Moreover, private investment has been focused on the residential construction sector rather than on the traded-goods sectors.

Chapter 2 presents an assessment of the recent experience of the Palestinian economy and examines its prospects for 1998 and beyond. Chapter 3 concludes that the current uncertain border status and closures are the key reasons why expectations for a revival of private investment following the signing of the Oslo peace accord have not been met. Other constraints to increased private investment include the absence of an adequate public infrastructure and a legal and regulatory framework, inadequate access to finance in some cases, as well as uncertain prospects for peace. It is also found that the regime of closures, through a reduction in the profitability of the export sector, results in a distorted pattern of investment. Nevertheless, some measures in the trade, fiscal, financial, and regulatory areas could be implemented even in the current circumstances to enhance prospects for an increase in private investment. These measures are the subject of the latter part of this chapter and the following three chapters.

The Palestinian Monetary Authority has been attempting to support private investment by encouraging banks to expand domestic lending, through both moral suasion and its available policy instruments. Chapter 4 finds, however, that attempts to employ monetary policy measures—which in the context of the West Bank and Gaza Strip essentially mean changes in reserve requirements or the use of direct measures—can lead to only minimal increases in output and employment, while entailing risks in terms of the soundness of the banking system. The Palestinian Monetary Authority should therefore focus on policies that create a stable financial environment, notably a stable and thriving banking sector, especially through improving bank supervision and regulation.

Chapter 5 examines how fiscal policy could be employed to improve the prospects for long-term growth in the West Bank and Gaza Strip. In the absence of a national currency, fiscal policy has a crucial role to play in macroeconomic management, as the composition of government expenditures and the efficiency of the tax system will affect total factor productivity growth profoundly, and private sector investment and growth in particular. This chapter reviews the state of the income tax system and how it can be modified to be more efficient, equitable, and simpler. The need to maintain the currently very favorable health and education indicators in the context of a rapidly growing population will represent a major challenge for the Palestinian Authority. In addition, the physical infrastructure is in need of major development, especially in the transportation, water, and social sectors. The need to increase recurrent health and education expenditures in real terms, as well as to make a contribution to the financing of the public investment program, will require that increases in employment and nonwage spending outside these core areas are kept to a minimum, while the efficiency in the delivery of services and the contribution of the population to their financing will have to be increased.

Finally, Chapter 6 examines the trade system of the West Bank and Gaza Strip and finds that it has not only been shaped by the Economic Protocol with Israel, but is also the outgrowth of security measures taken by Israel, trade policy measures implemented by the Palestinian Authority, and to a lesser extent, bilateral trade arrangements concluded by both Israel and the West Bank and Gaza Strip. In addition to reviewing the much-discussed long-term options for the development of the trade system in the West Bank and Gaza Strip—customs union or free trade area—this chapter examines measures that could be taken immediately by the Palestinian Authority and Israel to improve the trade links of the West Bank and Gaza Strip with the rest of the world. The establishment of a seaport and airport in the Gaza Strip, safe passage between the Gaza Strip and the West Bank, further improvements in Israeli security procedures, the elimination of Palestinian import monopolies, and the utilization by the Palestinian Authority of options available under the Economic Protocol to promote trade independence are considered to be the most promising steps in this respect.