Abstract

Economic conditions in the West Bank and Gaza Strip have deteriorated substantially since 1993 due to adverse political developments.1 The imposition of generalized border closures triggered by security incidents in Israel, which are characterized by strict security controls on the movement of goods and labor into and out of the West Bank and Gaza Strip, as well as intermittent total closures that virtually prohibited such movement, have led to an increase in the rate of unemployment to about 30 percent, a contraction in external trade, disruptions to the implementation of the public investment program, and a steady erosion in private sector confidence. By the end of 1996, the unemployment rate was 15 percentage points higher and income per capita about 20 percent lower than in 1993, and only modest improvements had been made in developing the domestic productive base and infrastructure (Table 1). On the positive side, despite the unfavorable overall economic and political environment, the Palestinian Authority persevered in the pursuit of a prudent fiscal policy and in strengthening economic institutions and processes.

Economic conditions in the West Bank and Gaza Strip have deteriorated substantially since 1993 due to adverse political developments.1 The imposition of generalized border closures triggered by security incidents in Israel, which are characterized by strict security controls on the movement of goods and labor into and out of the West Bank and Gaza Strip, as well as intermittent total closures that virtually prohibited such movement, have led to an increase in the rate of unemployment to about 30 percent, a contraction in external trade, disruptions to the implementation of the public investment program, and a steady erosion in private sector confidence. By the end of 1996, the unemployment rate was 15 percentage points higher and income per capita about 20 percent lower than in 1993, and only modest improvements had been made in developing the domestic productive base and infrastructure (Table 1). On the positive side, despite the unfavorable overall economic and political environment, the Palestinian Authority persevered in the pursuit of a prudent fiscal policy and in strengthening economic institutions and processes.

Table 1.

Key Economic Indicators, 1993-98

(In millions of U.S. dollars, unless otherwise indicated)

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

Annual averages.

At the start of 1997, there were hopes that a sustained improvement on the political front would allow a modest economic recovery during the year. The economic outlook at the time, as reflected in IMF staff projections, was for an increase in real income per capita of about 4—5 percent in 1997, reflecting an easing of border closures and an accelerated implementation of public investment projects. This rather optimistic outlook seemed vindicated by developments in early 1997, as restrictions on the flows of goods and labor were gradually relaxed and the rate of unemployment abated to close to 25 percent by the end of February.

Economic Developments and Progress in Institution Building in 1997

Hopes for a significant improvement in political and security conditions in the West Bank and Gaza Strip and for an associated improvement in economic performance were short-lived. The “on-off” economic cycles inherent in the regime of border closures continued in 1997 with the imposition of two strict blockades on the flows of goods and labor in March-April and August—September triggered by attacks in Israel. Although the intensity of the border restrictions on these flows varied widely during the year, as did the extent of induced disruptions to investment activities, by year-end it was clear that the envisaged recovery had failed to materialize. For the year as a whole, real income per capita is estimated to have declined by 3.5 percent, while the rate of unemployment fell only slightly to an average of 31 percent (Figure 1).

Figure 1
Figure 1

West Bank and Gaza Strip: Selected Economic Indicators, 1992–97

Sources: Palestinian and Israeli authorities; and IMF staff estimates and projections.1 Excludes underemployment.

The outward-oriented sectors were again hit severely by the blockades on the movement of goods, as seen in an estimated contraction in real terms of 9 percent in exports of goods and nonfactor services and of 6 percent in imports in 1997 (Tables 2, 3, and 4). While the number of Palestinian workers in Israel increased from an average of about 22,000 in 1996 to about 35,000 in 1997, the monthly rate of unemployment remained at more than 28 percent throughout the year, reflecting the subdued pace of expansion in domestic employment (Figure 2).2 There was no significant pickup in private investment activities, and the pace of implementation of the public investment projects continued to be slow, with expenditures on the ground limited to about the same level as in 1996. The picture with regard to private consumption was also bleak, as reflected in recent micro-level surveys showing about a 9 percent fall in average real monthly household expenditures in January-September 1997 compared to the same period in 1996.3 Finally, because of liquidity difficulties, public consumption expenditures were compressed to below normal levels until later in the year and did not provide the economy with the envisaged boost.

Table 2.

West Bank and Gaza Strip: National Income Accounts, 1993–97

(In miiiions of Israeli new sheqalim, 1986 constant pnces)

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Sources: Palestinian and Israeli authorities; and IMF staff estimates.
Table 3.

West Bank and Gaza Strip: National Income Accounts, 1993–97

(In mlilions of U.S. dollars)

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Sources: Palestinian and Israeli authorities; and IMF staff estimates.
Table 4.

West Bank and Gaza Strip: Balance of Payments, 1993–971

(In millions of U.S. dollars)

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Sources: Israeli Central Bureau of Statistics; Ministry of Planning and International Cooperation; Palestinian Monetary Authority; Ministry of Economy and Trade; and IMF staff estimates.

There is a break in trade data starting with 1995.

Figure 2
Figure 2

West Bank and Gaza Strip: Labor Market Indicators, 1992–97

(In thousands)

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

The Palestinian Authority succeeded in containing the recurrent deficit at an estimated $50 million, slightly less than the level targeted in the 1997 budget, despite the pressures induced by the two border closures (Table 5 and Figure 3).4 A tight stance with regard to both nonwage and wage expenditures allowed the containment of recurrent spending within the budgeted $866 million. The Palestinian Authority maintained a restrictive employment policy throughout the year, while wage increases were limited to a 10 percent raise for teachers. Moreover, in contrast to the situation in 1996 when the Palestinian Authority had to implement a series of unforeseen measures to alleviate the effects of closures, in 1997 there were virtually no “emergency” or other unbudgeted expenditures. Palestinian Authority revenues, at an estimated $816 million, were slightly above the amount envisaged in the budget, despite the weaker-than-anticipated economic activity. The effects of the slower economic growth, especially on revenue clearances from the value added tax, were offset by a sustained strengthening in revenue administration, especially in domestic tax collection and enforcement, and unexpected increases in clearances from customs duties, reflecting a shift from indirect imports via Israel to direct imports.

Table 5.

Fiscal Operations of the Palestinian Authority, 1996–97

(In millions of U.S, dollars, unless otherwise indicated)

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

On cash basis, estimates of revenue include collections transferred to bank accounts outside the control of the Ministry of Finance.

From accounts not directly under the control of the Ministry of Finance.

In percent of GDP.

Excluding foreign-financed employment programs.

Payment arrears incurred in the second quarter of 1997 for civilian wages of $10 million, pension contribution for police of $6 million, and nonwage expenditure arrears of $5 million; and in the third quarter for wages $3.9 million, for police pension fund $13.2 million, and for nonwage expenditures $51.4 million.

While donors provide data on their total disbursements in the West Bank and Gaza Strip, only limited information is available on amounts spent by government agencies and ministries.

Figure 3
Figure 3

West Bank and Gaza Strip: Fiscal Indicators, 1994–98

(In millions of U.S. dollars)

Sources: Palestinian and Israeli authorities; and IMF staff estimates and projections.1 According to 1998 budget.

Despite the tight expenditure policy and the relatively favorable revenue developments described above, the Palestinian Authority continued to encounter significant liquidity difficulties throughout the year. These resulted in forced compressions of cash expenditures, an associated accumulation of arrears, as well as recourse to borrowing from the domestic banking system. Whereas in the past liquidity difficulties were induced by the diversion of petroleum and other excise revenue to accounts outside the control of the Ministry of Finance, in 1997 these problems were further compounded by the temporary withholding of clearance revenue transfers by Israel in August and September. This led to an increase in expenditure arrears to about $69 million and in the net overdraft of the Ministry of Finance at domestic banks to about $100 million by the end of September.5

The Palestinian Authority has continued to make steady progress in strengthening its capacity in revenue administration and expenditure management. With the basic structure of a modern tax system and administration in place, efforts in 1997 focused on improving revenue collection, especially from banks and large enterprises, on enforcement, and on the design of a tax audit strategy to address the underreporting of taxable income. The recruitment of qualified staff and the training of tax officers, in particular in the VAT and customs area, has also proceeded apace, and the efficiency of the revenue processing and information systems has been enhanced. In the area of expenditure management, oversight of ministries and public agencies by the Ministry of Finance has been improved through the implementation of a comprehensive set of financial regulations, and there has been a marked improvement in the budget preparation process, in particular through better coordination between the Ministry of Finance and other ministries. In contrast, efforts to improve the transparency of fiscal operations have been slow, with the full centralization of all revenues and expenditures under the control of the Ministry of Finance yet to be undertaken.

The expansion in banking system deposits and net foreign assets experienced a slowdown in 1997, reflecting a tapering off in the rate of increase in the number of banks and bank branches throughout the West Bank and Gaza Strip (Table 6 and Figure 4). While the rate of growth of time and savings deposits remained largely steady at an average of about 1 percent per month, demand deposits stagnated, with periods of closures generally inducing temporary reductions in their level. The slower growth and sensitivity to closures of demand deposits reflect both the transient falls in private incomes and expenditures, which depress the transactions demand for money, as well as increases in the precautionary demand for cash during closures. The evolution of the private sector loans to deposits ratio shows an overall rising trend, from 21 percent in January 1996 to about 30 percent toward the end of 1997. While this trend has been interrupted and tempered by the recurrence of closures, it is clear that there exists a strong potential for the ratio to rise steadily during protracted closure-free periods, as witnessed in the period November 1996 to March 1997, and starting in September following the second episode of closures.

Table 6.

West Bank and Gaza Strip: Consolidated Accounts of the Deposii Money Banks, 1994–971

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Sources: For 1996 and 1997, figures are from the Palestinian Monetary Authority (PMA). For 1994 and 1995, figures were compiled by the Palestinian Economic Policy Research Instituto.

Figures reprasent end-of-month balances.

Data from the Bank of Palestine may be Incomplete.

Figure 4
Figure 4

West Bank and Gaza Strip: Selected Monetary Indicators

Source: Compiled from data provided by the Palestinian Monetary Authority.

The Palestinian Monetary Authority has persevered in its efforts to strengthen its capacity in the area of bank supervision and regulation. The supervision department at the Palestinian Monetary Authority now requires all banks to submit on a regular basis information that would allow a comprehensive assessment of bank soundness, including an appraisal of the quality of banks’ loan portfolios, liquidity, and earnings. Although the recurrence of border closures does not appear to have adversely affected public confidence in the banking system, some difficulties in the payment system during closures have been reported. In particular, some banks have temporarily been unable to clear checks due to the restrictions on the movement of bank employees and other bank physical resources, including currency. Although these disruptions have so far not had any serious consequences, in view of their temporary nature and the public’s expectations of their removal in accordance with the cycle of closures, the Palestinian Monetary Authority is currently seeking to devise ways to minimize the induced costs.

An important objective of the Palestinian Monetary Authority continues to be the promotion of domestic lending and the stemming of what is viewed as the “export of funds” outside the West Bank and Gaza Strip. To help achieve this objective, the Palestinian Monetary Authority has issued guidelines requiring banks to satisfy the following two ratios by the end of 1997: a minimum loan-to-deposit ratio of 30 percent and a maximum ratio of foreign assets held abroad to total deposits of 90 percent. However, as such requirements may encourage unsound lending practices, a repeal of these guidelines and an increasing focus on indirect means to promote bank lending should be considered by the Palestinian Monetary Authority.

The recurrence of border closures has continued to weaken the linkages between changes in the consumer price index (CPI) in the West Bank and Gaza Strip and economic developments in Israel (Table 7). While the rate of inflation in the West Bank and Gaza Strip for the year as a whole averaged 6 percent, only slightly lower than that recorded in Israel (7 percent), the recurrence of closures resulted in important differences between the inflation rates in the two economies in the course of the year, in particular in the second and third quarters. The strong downward pressures on prices during closures, induced through the decline in remittances and other sources of income, were particularly strong following the imposition of the second blockade, as reflected in the steady fall in the monthly rate of increase in the CPI in the West Bank and Gaza Strip from 1.1 percent in July to an average of about 0.3 percent during August–October.

Table 7.

West Bank and Gaza Strip: Inflation Rates (Based on Cost of Living Index), 1993–971

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

Inflation rates show percentage changes in (end-of-period) CPI. Figures shown for quarters show rates of increase over previous quarter.

The Palestinian Authority’s Policy Stance in 1998 and Beyond

The Palestinian Authority’s medium-term economic approach is focused on developing the economy’s domestic productive base and infrastructure, especially in the outward-oriented sectors, with the primary aim of reversing the declining trend in living standards and reducing the high unemployment rate. A key to achieving this objective would be the recovery of private investment from the currently depressed level of 10-11 percent of GDP toward the range of 15-20 percent of GDP that is characteristic of countries at similar levels of development. It is also important to step up the pace of implementation of the public investment program to take advantage of the sizable resources that have been committed by donors. It will not be easy to achieve these objectives, given the unfavorable “exogenous” factors faced by the Palestinian Authority, notably a particularly adverse trade environment due to the recurrence of border closures, a small domestic market, and a high population growth rate (including immigration) of about 5–6 percent per year (Table 8). Despite these challenges, the Palestinian Authority is persevering in the implementation of a broad range of policies and institution-building measures in the fiscal, regulatory, and external areas, geared primarily toward ensuring a stable macroeconomic environment and encouraging a more prominent role for the private sector.

Table 8.

West Bank and Gaza Strip: Popuiation and Labor, 1993–97

(In thousands, unless otherwise indicated)

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

In the fiscal area, the Palestinian Authority is pursuing a prudent public expenditure policy with the objective of achieving increasing recurrent budget surpluses starting in 1998 while reorienting the pattern of public expenditures toward the health and education sectors and physical infrastructural investments. The draft income tax law currently being discussed aims at ensuring a favorable business environment, in particular by avoiding excessive income tax rates. This approach is being supported by institution-building measures to further enhance the capacity of revenue administration, especially through improved tax collection and enforcement, and to increase the effectiveness of expenditure management, focusing in particular on enhancing fiscal transparency and accountability.

An increasingly active role is being taken by the Palestinian Authority in the planning and the implementation of the public investment program. Palestinian Authority capital expenditures under the program will henceforth be incorporated into the Palestinian Authority budget, starting with the 1998 budget, and the Palestinian Authority will be assuming increasing responsibility for financing such expenditures. The Ministry of Planning and International Cooperation, with some assistance from the World Bank, has prepared a detailed Palestinian Development Plan that presents a coherent strategy for public investment for the years 1998–2000. The plan envisages investment expenditures of $3.5 billion over the three-year period, of which about $0.8 billion are linked to ongoing or partially funded projects. In the Consultative Group meeting convened by the World Bank in Paris in December 1997, donors indicated their intention to commit $750 million in support of the proposed development plan, with $500–600 million expected to be disbursed in 1998, considerably more than in earlier years.

The macroeconomic framework underlying the 1998 budgetary projections assumes only timid improvements in security and political conditions and in the external trade situation, the same average number of Palestinian workers in Israel as in 1997 (35,000), and continued weak private investment, but some recovery in public investment, which reflects an envisaged higher pace of implementation. Under such conditions, real GDP is projected to rise by 2 percent and average unemployment to remain virtually unchanged at about 31 percent. The 1998 Palestinian Authority draft budget is based on a tight recurrent expenditure policy, aimed at the achievement of a small recurrent surplus, compared with an estimated deficit of $50 million in 1997 (1.5 percent of GDP).6

The key factor underlying the expected improvement in the fiscal position in 1998 is the containment of recurrent expenditures at $872 million, close to the 1997 level, in particular through the absence of a general increase in Palestinian Authority wage rates, and the limiting of increases in Palestinian Authority employment to about 3 percent—consisting of a modest increase in the number of workers in the education and health sectors, with minimal increases in other sectors. Palestinian Authority revenues are prudently projected in the draft budget to increase roughly in line with GDP, on the basis of a continuation of the rising trend in customs revenues from clearances associated with the shift from indirect to direct imports and improved customs administration; and modest increases in the other revenue components, in line with the projected slow recovery in economic activity and assuming only gradual improvements in tax administration.

To ensure the attainment of the above budgetary targets, it is important that the Palestinian Authority perseveres in its efforts to further strengthen expenditure management and revenue administration. A key measure would be the full consolidation of all revenues and expenditures under the control of the Ministry of Finance, which will enhance fiscal transparency, increase the resources available to the budget, and help prevent the reemergence of liquidity problems. The successful implementation of the public investment program in 1998 hinges on reduced disruptions due to border closures, a continuation of efforts to improve coordination between the Palestinian Authority and donors, and a close follow-up by the Ministry of Planning and International Cooperation of implementation on a project-by-project basis. With regard to revenue administration, the focus should be on further strengthening VAT and income tax collection, especially from large enterprises, on enhancing enforcement through the effective implementation of the audit strategy, and on raising the effective yield of trade taxes, notably through the creation of an import monitoring unit.

The Palestinian Authority is working closely with World Bank and IMF staff to strengthen the legal and regulatory framework with the aim of improving incentives faced by private investors and limiting the scope for discretionary interventions by the Palestinian Authority in private activities. Toward this end, several key laws are currently being revised, including the Investment Law, the Income Tax Law, and the Company Law. In the same spirit, as part of its general policy to minimize the distortion of incentives and avoid arbitrary interventions in private activities, the Palestinian Authority intends to consolidate all Palestinian Authority commercial operations, including import monopolies, under a fully transparent framework, before their complete elimination by the end of 1998.

It is important that the steady expansion of the bank deposit base in the West Bank and Gaza Strip continues to be complemented by measures to strengthen bank regulation and supervision, with the aim of ensuring a stable financial system and the expansion of sound bank lending. This will be facilitated by the the Banking Law (expected to be enacted in early 1998) and the Palestinian Monetary Authority Law (enacted in late 1997), which establish a coherent legal framework for banking sector operations and provide a clear legal basis for the Palestinian Monetary Authority to enforce prudential regulations on banks and impose penalties in case of noncompliance. The Palestinian Monetary Authority intends to encourage domestic bank lending through measures to facilitate the use of collateral and improve the quality of information available on borrowers, as envisaged in the World Bank Financial Sector Development Program, including through the enactment of the Property Law, the Secured Lending Law and the Condominium Law, and the development of information systems for the registration of assets. The Securities Law is expected to be implemented by mid-1998, which will provide a framework for the regulation of the capital market’s operations in line with international standards.

A key component of the Palestinian Authority’s medium-term approach is the expansion of trade with the outside world, especially in view of the West Bank and Gaza Strip’s small domestic market, the continual disruptions to trade flows with Israel, and the weakness of trade links with non-Israeli markets. The Palestinian Authority is working closely with the World Bank and the IFC in developing industrial zones in the West Bank and Gaza Strip that could be at least partially insulated from the effects of border closures through special security arrangements with Israel. The Gaza Industrial Estate is now nearly complete and is expected to be fully operational by end-1998. In the same spirit, the Palestinian Authority is according a high priority to improving the access of the West Bank and Gaza Strip to markets outside Israel through the development of seaports and airports, to strengthening transport links with Jordan and Egypt, and to tightening the economic integration of Palestinian territories through the establishment of a safe passage between the West Bank and the Gaza Strip.

1

For a detailed review of developments in the West Bank and Gaza Strip prior to 1997 and a discussion of statistical issues, see International Monetary Fund, Recent Economic Developments, Prospects, and Progress in Institution Building in the West Bank and Gaza Strip, Middle Eastern Department, February 1997.

2

The rise in the number of Palestinian workers in Israel was especially pronounced in the fourth quarter of 1997, rising from about 33,000 in September to 47,000 workers in December.

3

See United Nations, Economic and Social Conditions in the West Bank and Gaza Strip, Quarterly Report, October 1997, and subsequent updates, for an overview of the results of the household expenditure surveys undertaken by the Palestinian Central Bureau of Statistics in 1996-97.

4

The estimates of the fiscal outcome are preliminary, based on data available as of November 1997.

5

The net overdraft of the Ministry of Finance at domestic banks was estimated at $70 million at the end of 1996.

6

Details of the 1998 budget will become available once the budget is approved by the Legislative Council.

Recent Experience, Prospects, and Challenges to Private Sector Development
  • View in gallery

    West Bank and Gaza Strip: Selected Economic Indicators, 1992–97

  • View in gallery

    West Bank and Gaza Strip: Labor Market Indicators, 1992–97

    (In thousands)

  • View in gallery

    West Bank and Gaza Strip: Fiscal Indicators, 1994–98

    (In millions of U.S. dollars)

  • View in gallery

    West Bank and Gaza Strip: Selected Monetary Indicators