4 The Reemerging Banking Sector

International Monetary Fund

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Author: International Monetary Fund

Language:: English

Keywords:: BOOK; economy; Pennsylvania; wage; infrastructure needs; PMA law; bank representative; incorporated bank; bank Licensing; PMA operation; Currencies; Commercial banks; Credit; Bank credit; Foreign banks

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Abstract

The reemergence of the banking sector in the West Bank and Gaza in the last five years has been a positive development. The banking sector has grown rapidly and plays an important role in the economy. Furthermore, the Palestinian Monetary Authority (PMA) was set up in late 1994 with the responsibility, among others, to license, regulate, and supervise banks. It has achieved important progress in institution building, especially in the areas of accounting, statistics, bank licensing, regulation and supervision, and in the payments and clearing system. Still, much remains to be done, especially in banking supervision and effective enforcement of bank regulations. This chapter discusses developments in the banking sector and the progress achieved in institution building, as well as challenges for the future. It also discusses developments in bank lending for investment and the banking sector’s role in supporting economic development.

Introduction

Growth of the Banking System

The banking sector in the West Bank and Gaza has expanded strongly since 1994, as evidenced by the increase in the number of banks and branches, and the growth in deposits and lending. After 1967, the banking system played a rather limited role in the economy, and by the end of 1993 there were only four banks operating in the West Bank and Gaza, with a total of 16 branches (including headquarters). Following the signing of the Economic Protocol in 1994 and the establishment of the PMA, the banking sector expanded rapidly and, by the end of 1998, the number of banks operating in the West Bank and Gaza had increased to 22, with a total of 102 branches. A salient characteristic of the Palestinian banking system is the large presence of foreign bank branches. Out of the 22 banks, 13 are branches of foreign banks.

Deposits

Private sector deposits with the banking system increased from insignificant levels in 1993, when most savings were held with banks abroad or in cash, to $2.2 billion (about 60 percent of GDP) at the end of 1998 (Table 4.1). This level compares well with countries in the region (Figure 4.1). The fast growth in deposits reflected the reintermediation process as people shifted their savings into the domestic banking system and reduced their holdings of deposits abroad and cash. This process was faster than many had expected. In late 1996, it had been argued that it would be impossible for deposits to reach this level before a successful conclusion of final status negotiations.¹

Table 4.1

Consolidated Banking System

Sources: Palestinian Monetary Authority; and IMF staff estimates.

^¹Includes investment in nonfinancial companies.

Table 4.1

Consolidated Banking System

				1994	1995	1996	1996	1997	1998	1998	1998	1998
				Dec.	Jun.	Jan.	Dec.	Dec.	Mar.	Jun.	Sep.	Dec.
					(In millions of U.S. dollars)
Deposits of the private sector				523	804	1,211	1,501	1,815	1,903	2,037	2,172	2,216
	Demand deposits			306	376	493	485	543	556	594	656	605
	Time and savings deposits			217	428	718	1,017	1,273	1,347	1,443	1,516	1,611
Net foreign assets				…	…	1,012	1,375	1,485	1,541	1,554	1,685	1,669
	Central bank			…	…	0	87	109	141	156	174	182
	Commercial banks			…	…	1,012	1,289	1,376	1,401	1,397	1,511	1,487
Net domestic assets				…	…	199	126	331	362	483	487	547
	Net claims on the nonfinancial
		public sector		…	…	23	−184	−188	−134	−98	−91	−89
		Net claims on the PA		…	…	0	−44	−118	−76	−71	−61	−55
			Deposits	…	…	0	62	176	142	136	125	136
			Loans	…	…	0	19	58	3	1	1	20
			Overdraft	…	…	0	0	0	63	63	62	61
		Net claims on local government		…	…	3	−21	−24	−20	−17	−15	−17
			Deposits	…	…	0	21	24	20	17	15	17
			Loans	…	…	3	0	0	0	0	0	0
			Overdraft	…	…	0	0	0	0	0	0	0
		Net claims on nonfinancial
			public enterprises	…	…	20	−119	−46	−38	−9	−14	−17
			Deposits	…	…	0	123	51	45	22	18	21
			Loans	…	…	20	2	3	3	12	3	2
			Overdraft¹	…	…	0	2	2	5	2	1	2
	Credit to the private sector			97	179	251	409	563	606	653	665	733
		Loans		97	179	…	128	191	203	223	261	299
		Overdraft		…	…	…	252	324	351	374	349	381
		Other¹		…	…	…	29	48	52	56	55	54
	Other items (net)			…	…	−75	−99	−44	−110	−72	−88	−98
					(In percent of GDP)
	Memorandum items
	Total assets of banks			…	…	…	66	85	…	…	…	95
		Of which: branches of foreign banks		…	…	…	58	73	…	…	…	71
	Total loans of banks			…	…	…	13	18	…	…	…	24
		Of which: branches of foreign banks		…	…	…	11	15	…	…	…	19

Sources: Palestinian Monetary Authority; and IMF staff estimates.

^¹Includes investment in nonfinancial companies.

Table 4.1

Consolidated Banking System

				1994	1995	1996	1996	1997	1998	1998	1998	1998
				Dec.	Jun.	Jan.	Dec.	Dec.	Mar.	Jun.	Sep.	Dec.
					(In millions of U.S. dollars)
Deposits of the private sector				523	804	1,211	1,501	1,815	1,903	2,037	2,172	2,216
	Demand deposits			306	376	493	485	543	556	594	656	605
	Time and savings deposits			217	428	718	1,017	1,273	1,347	1,443	1,516	1,611
Net foreign assets				…	…	1,012	1,375	1,485	1,541	1,554	1,685	1,669
	Central bank			…	…	0	87	109	141	156	174	182
	Commercial banks			…	…	1,012	1,289	1,376	1,401	1,397	1,511	1,487
Net domestic assets				…	…	199	126	331	362	483	487	547
	Net claims on the nonfinancial
		public sector		…	…	23	−184	−188	−134	−98	−91	−89
		Net claims on the PA		…	…	0	−44	−118	−76	−71	−61	−55
			Deposits	…	…	0	62	176	142	136	125	136
			Loans	…	…	0	19	58	3	1	1	20
			Overdraft	…	…	0	0	0	63	63	62	61
		Net claims on local government		…	…	3	−21	−24	−20	−17	−15	−17
			Deposits	…	…	0	21	24	20	17	15	17
			Loans	…	…	3	0	0	0	0	0	0
			Overdraft	…	…	0	0	0	0	0	0	0
		Net claims on nonfinancial
			public enterprises	…	…	20	−119	−46	−38	−9	−14	−17
			Deposits	…	…	0	123	51	45	22	18	21
			Loans	…	…	20	2	3	3	12	3	2
			Overdraft¹	…	…	0	2	2	5	2	1	2
	Credit to the private sector			97	179	251	409	563	606	653	665	733
		Loans		97	179	…	128	191	203	223	261	299
		Overdraft		…	…	…	252	324	351	374	349	381
		Other¹		…	…	…	29	48	52	56	55	54
	Other items (net)			…	…	−75	−99	−44	−110	−72	−88	−98
					(In percent of GDP)
	Memorandum items
	Total assets of banks			…	…	…	66	85	…	…	…	95
		Of which: branches of foreign banks		…	…	…	58	73	…	…	…	71
	Total loans of banks			…	…	…	13	18	…	…	…	24
		Of which: branches of foreign banks		…	…	…	11	15	…	…	…	19

Sources: Palestinian Monetary Authority; and IMF staff estimates.

^¹Includes investment in nonfinancial companies.

A large degree of concentration in the banking system remains, and the three largest Jordanian banks operating in the West Bank and Gaza—the Arab Bank, the Cairo-Amman Bank, and the Bank of Jordan—accounted for more than 80 percent of bank deposits at the end of 1998. This concentration of deposits in foreign banks is due to a combination of factors, including the fact that depositors are familiar with these banks and that these banks may be perceived as more secure because they are considerably larger, well established, and more experienced than the newer local banks, and are also subject to supervision by their home countries.

Bank Lending

The fast growth in deposits allowed banks to increase their lending to the local economy. Since 1994, credit to the private sector grew as a share of total deposits from 18 percent (3 percent of GDP) to about 32 percent (21 percent of GDP) in 1998, of which approximately 80 percent was extended by branches of foreign banks. While the level of credit to the private sector is still low when compared with that of other countries in the region, the implied annual (compounded) credit growth in 1994-98 was about 45 percent in real sheqel terms (Figure 4.1). This growth rate is rapid by any standards, and it is highly doubtful that bank credit could have grown significantly faster without creating undue risk to the quality of the loan portfolio. A large portion of the claims on the private sector was in the form of overdrafts or very short-term credits (up to six months), including trade credits, while there was only limited growth in long-term credit. At the end of 1998, more than half of all credit to the private sector was in the form of overdrafts. It is possible, however, that overdrafts were used, and continuously rolled over, to finance investment as well, as is often the case in neighboring countries.

Currency Composition of Deposits and Lending

Three currencies circulate in the West Bank and Gaza—the Jordan dinar (JD), the new Israeli sheqel (NIS), and the U.S. dollar.² The free circulation of these three convertible currencies has contributed to ensure reasonably stable prices and relatively low interest rates. Use of these three currencies has also helped reduce somewhat the transactions costs of foreign trade, although other constraints have had the opposite effect. The Jordan dinar has remained important for historical reasons, and, although its use in the West Bank and Gaza has declined in the last five years, a large share of deposits and bank credit are still in dinars, certain pensions continue to be paid in dinars, and the shares of 15 out of 20 companies on the Palestinian Securities Exchange are traded in dinars.³ The sheqel is used extensively, especially in cash and check transactions, because of the close interaction between the Palestinian and Israeli economies: most imports come from Israel, and one-fifth of the labor force works in Israel (in 1998) and receives salaries in sheqalim. Also, revenue clearances from Israel (about 60 percent of budget revenue) are in sheqalim, and the PA’s budget is executed largely in sheqalim. Moreover, most consumer products are priced in sheqalim. The dollar has always played an important role as a store of value, but in 1994-98 it also became increasingly important in bank credit and in transactions for durable consumer goods, rents, and investments. Also, a large part of aid inflows is denominated in dollars.

The last five years witnessed a shift in the currency composition of deposits in favor of the dollar and away from the dinar, with the dollar becoming the main currency for store-of-value purposes. In March 1995—the earliest date for which information on currency composition is available—more than half of deposits were held in dinars, followed by the dollar and the sheqel. At the end of 1998, however, more than 60 percent of total deposits were held in dollars, and the share of deposits held in dinars had fallen to 24 percent, and that in sheqalim to 14 percent (Figure 4.2). Small amounts of other currencies were also held.

A similar shift occurred in the currency composition of bank credit, including overdrafts. At the end of March 1995, almost all bank credit was denominated in either Jordan dinars (52 percent) or sheqalim (46 percent), but at the end of 1998, the dollar had become the most important currency for bank credit, accounting for 48 percent, whereas the sheqel accounted for 25 percent and the dinar for 26 percent. There was, however, a marked difference in currency composition within bank credit, between the categories of loans and overdrafts. About 60 percent of loans and 40 percent of overdrafts were denominated in dollars. The sheqel accounted for only about 4 percent of loans but 40 percent of overdrafts, reflecting the large amount of commerce between Israel and the West Bank and Gaza. The remainder—about 35 percent for loans and 19 percent for overdrafts—was denominated in dinars.

The Role of the PMA and the Banking System in Economic Development

The banking sector in the West Bank and Gaza can be expected to play an important role for economic growth and development in the future. The experience of other countries shows that, although growth in the banking, system is in part endogenous to economic development, in a market economy, the banking sector serves many functions that support economic growth, including mobilizing and efficiently allocating savings, facilitating trade and risk management, and exerting discipline on corporations (see, for example, Levine, 1996). However, only a sound banking system, with well-capitalized and well-managed banks, can perform these functions effectively. An unsound system, in contrast, imposes a considerable burden on the economy and thereby undermines growth prospects. The most important role of the PMA in promoting economic growth and development in the West Bank and Gaza is to safeguard the soundness and efficiency of the banking system to allow it to perform the above-mentioned functions.

Banking problems typically arise when one or several of the following conditions exist: large macroeconomic instabilities, active government intervention in the banking system to direct or subsidize credits to certain sectors of the economy, a large degree of connected lending and state ownership of banks, a lack of competition in the banking system, banking operations with implicit or unlimited explicit public sector guarantees of liabilities, ineffective banking supervision, or a lack of adequate information on the financial conditions of banks.

Most of these conditions do not apply to the West Bank and Gaza. For example, the PA does not own banks, and there is competition in the banking sector, including from foreign banks. Also, there is no system of directed or subsidized credits to specific sectors of the economy, and, despite sluggish economic growth in the last five years, macroeconomic conditions, with low inflation and low interest rates, cannot be said to have created problems for the banking sector. More fundamentally, the PMA has achieved important progress in institution building in the last few years with the support of substantial technical assistance, including that provided by the IMF, the World Bank, and bilateral donor countries. The PMA has made particularly good progress in the areas of accounting and computerization, and in the payments and clearing system.

Further progress is warranted, however, in bank supervision, the main responsibility of the PMA today. Although current bank regulations cover all major areas and are in principle appropriate, a major concern is that regulations and instructions are not strictly enforced and not always observed by banks. The PMA can effectively discharge its supervisory responsibility only if it fully exercises its authority to enforce regulations and instructions.

Box 4.1.

Bank Licensing and Prudential Regulations

The PMA is the agency charged with, among other things, licensing, regulating, and supervising banks operating in the West Bank and Gaza. There are two types of licenses for locally incorporated banks: a Class A license, which applies to basic commercial banks, and a Class B license for banks that want to invest a larger share of their capital in equity investments (which covers investment banks and Islamic banks). The minimum capital is $10 million for Class A licensed banks and $20 million for banks with a Class B license. A foreign bank may open a branch in the West Bank and Gaza provided it has a letter of comfort from its home supervisor and that the branch has a capital endowment (dotation de capital) of $5 million. Only banks are allowed to accept deposits in the West Bank and Gaza.

Locally incorporated banks must observe a risk-weighted capital adequacy ratio of 10 percent (cash and loans with cash collateral have zero weight, while all other assets have a risk weight of 100 percent). Branches of foreign banks must have a capital endowment of $5 million. Furthermore, all banks are subject to a 4 percent minimum cash ratio and a 25 percent liquid assets ratio. Regarding risk concentration, locally incorporated banks’ exposure to individual debtors cannot exceed the equivalent of 10 percent of their capital base. Finally, open currency positions are limited to 5 percent of capital base for each of the three circulating currencies, and to 20 percent of capital for all other currencies in aggregate.

The current regulations cover all major areas and are, in principle, appropriate, but there is a weakness in enforcement, and banks frequently ignore some of the regulations.

Institution Building⁴

Since its establishment, the PMA has been responsible for the licensing, regulation, and supervision of banks operating in the West Bank and Gaza. It has established prudential requirements for capital adequacy, liquidity, risk concentration, loan classification/ provisioning, and foreign exchange exposure that are consistent with generally accepted standards (Box 4.1). The rapid expansion of the banking system in recent years, both in the number of banks and branches operating in the West Bank and Gaza and in the growth of deposits and lending, has posed a formidable challenge to the PMA. Initially, the PMA monitored banks’ compliance with these regulations entirely through off-site inspection, using the monthly statistical reports from banks. More recently, the PMA has hired additional bank examiners, and in 1998 on-site inspections began. The PMA has established good communications with banks and, as it has become more experienced, has acquired a growing stature in the banking system.

Box 4.2.

The Payment System

The PMA established a semiautomated clearing and settlement system in January 1996, with two operational centers—one in Gaza and one in Ramallah. Initially the system was used only for the clearing and settlement of checks denominated in Jordan dinars, but it was extended in May 1996 to cover the clearing and settlement of checks denominated in dollars. At that time, a semiautomated clearing and settlement system for dinars and dollar credit transfers was also set up. The clearing and settlement facilities were further extended in June 1998 to cover checks and transfers denominated in sheqalim. Prior to 1996, the West Bank and Gaza was tied to the Tel Aviv clearinghouse through correspondent accounts with Israeli clearing banks. Checks denominated in dinars were cleared and settled manually and on a bilateral basis. There was no central clearing institution in the West Bank and Gaza, and courier services were used to send documents and checks between banks. It was not uncommon that the clearing of a check drawn, for example, on a Nablus bank and deposited in Ramallah could take seven days. The inefficiency of this system became increasingly apparent as the banking sector expanded.

The PMA administers the clearinghouse, supervises the organization of exchange of payment transactions among banks, determines the balance arising from such operations, and settles the result. The Clearing House Rules that govern the clearing process require all authorized banks to join the clearinghouse, either in Gaza or Ramallah or both, and to participate in the clearing transactions. The Clearing Council consists of one representative from each bank and is headed by the Governor of the PMA. Its decisions are mandatory for all banks. Bank representatives meet every day at clearing rooms in Gaza and Ramallah to clear checks and transfers. Following this, a bank has three days to verify a check or transfer within a region (i.e., the Gaza Strip or the West Bank) and four days for checks between Gaza and Ramallah.

Upon conclusion of the clearing sessions in Gaza and Ramallah, the settlement figures are sent to the PMA in Gaza for consolidation and calculation of the net settlement position for each bank. Banks must cover their shortages (in all three currencies) by 2 p.m. the same day.

An efficient payment system is an essential part of a functioning market-oriented economy. Cash appears to remain the dominant form of payment in the West Bank and Gaza with the sheqel the most commonly used currency, although precise data are not available. Checks are the most important noncash form of payment, with the vast majority of transactions denominated in sheqalim followed by dinars and dollars. In the past, checks were cleared outside the West Bank and Gaza, but the PMA has come a long way in establishing a local infrastructure for clearing and settlement systems, with operational centers in Ramallah and Gaza. Clearing facilities for checks and transfers denominated in dinars and dollars were introduced in 1996 and for sheqalim in June 1998 (Box 4.2). With the extension to sheqel denominated checks and transfers, the volume and value of payments cleared in the system increased sharply, to about 2.3 million checks in 1998 from about 110,000 in 1997. The ratio of sheqel checks to dinar and dollar checks is roughly 15 to 1.

There has been considerable progress in many areas of banking sector reform, but more needs to be done in several areas.

The PMA Law was approved in 1998 (see Box 4.3), but many of its provisions have not been implemented, therefore undermining the PMA’s position as bank supervisor. Furthermore, a banking law is currently under consideration by the Legislative Council. The first draft of this law, which would provide the PMA with the necessary legal framework to ensure the soundness of the banking system, was prepared in 1995 with the assistance of the IMF, and it is important that it be enacted without further delay. It is also important to keep regulations under review to ensure they reflect the rapidly changing circumstances.

Box 4.3.

The PMA Law

The PMA Law became effective on March 2, 1998. The law states that the overall objectives for the PMA should be securing banking soundness, maintaining monetary stability, and encouraging economic growth. It stipulates the duties and responsibilities of the PMA, including the issuance of a currency (in due course); licensing, regulation, and supervision of banks; management of the gold and foreign exchange reserves of the PA; and serving as financial agent to the PA and other public institutions. The law also specifies that only banks can take deposits in the West Bank and Gaza and that all banks have to be licensed by the PMA. While the PMA Law is generally sound, it contains elements that can be a source of ambiguity. For example, the law stipulates that the PMA shall organize credit quantity and quality in order to respond to the requirements of economic growth.

The law stipulates that the management of the PMA shall be undertaken by a board consisting of nine directors, including the governor (chair), the deputy governor, a representative from the Ministry of Finance, and six independent persons with experience in banking, finance, and economic and legal affairs (although they should not work in the banking sector). The board is responsible before the chairman of the PA. The law requires the board to meet at least once a month. As of yet, no directors or deputy governor have been appointed.

The governor and the deputy governor are appointed by the chairman of the PA, at the proposal of the cabinet, and the term is four years but can be renewed without limits. The law also stipulates the circumstances when the governor, the deputy governor or other directors may be removed. The six independent members of the board are all appointed by the chairman of PA, but three of them have to be proposed by the cabinet and one by the governor. The PMA Law stipulates that the PMA must provide the Ministry of Finance with interest-free loans to cover any “seasonal deficit” in the budget, up to a maximum equal to 10 percent of local revenues, as estimated in the budget law. Such loans would be for three months but can be rolled over up to twelve months.

In the area of banking supervision, it is crucial that the PMA strictly enforce regulations and instructions, and for it to have complete authority to operate as an independent bank supervisor and regulator with the full support of the Palestinian Authority and without interference in its operations. Furthermore, both PMA’s off-site and on-site inspection capabilities need to be strengthened, which will require further training and improvement of the quality of data provided by banks. The PMA has been slow in staffing managerial positions, including the Board of Directors, deputy governor, and general and executive managers, as stipulated by the PMA Law, which has hampered the efficiency of PMA operations. Finally, given the large presence of foreign bank branches in the West Bank and Gaza, it is important that the PMA develop close contacts with supervisory authorities in the home countries of these banks (mainly Jordan and Egypt). The home country authorities must be able to effectively supervise the activities of these branches, including through regular on-site inspections.
Regarding the payment system, the PMA has assumed responsibility for the coverage of settlement and is thus exposed to considerable settlement risk, although this is reduced somewhat by the required reserves that banks hold with the PMA. The PMA could be further insulated from settlement risk by encouraging banks to use the interbank market to cover deficiencies, and by requiring banks to use collateral for their overdrafts with the PMA.

Growth in Credit for Investment

Despite the strong growth in credit to the private sector, as noted above, the level of outstanding credit to the private sector is still relatively low.⁵ There continues to be a perception in the West Bank and Gaza that this is due to the poor performance of banks, although the exact nature of this underperformance has not been articulated. These concerns have led to pressure on the PMA to urge banks to increase domestic lending. The PMA has responded by introducing a floor on the ratio of lending to deposits (40 percent) and a ceiling on the ratio of foreign assets to deposits (65 percent).⁶ It recognizes the risk associated with pressuring banks to undertake lending that they would not otherwise have done and therefore treats these ratios as indicative, rather than binding, targets. Nonetheless, the mere existence of such targets, even if only indicative, signals a willingness to interfere directly in the market, which in turn could undermine further growth—even precipitate a decline—in deposits should depositors become uncomfortable with the increased risk in banks’ lending activities.

Causes of Slow Growth of Credit

Several economic explanations on both the demand and supply side can be advanced for the slow expansion in credit for long-term investment. First, demand for investment and long-term credit has been subdued because of the depressed economic activity and the high level of uncertainty stemming from, among other things, the risk of closures and the elusiveness of final status.⁷ Furthermore, the private sector’s willingness to undertake long-term investments is negatively affected by the lack of a strong and transparent legal and regulatory system.⁸ In the absence of a well-functioning legal institutional framework and the means by which to gauge creditworthiness, banks too are reluctant to make long-term commitments, which has consequences on the supply of credit. A long-term investment is much more exposed to the risks of a changing environment, including modifications to institutions, laws, and regulations. It is less risky to engage in short-term commercial transactions because they are largely reversible, while long-term investment projects are not—at least to the extent that the project cannot be repossessed.⁹ This is why the bulk of bank credit in the West Bank and Gaza is in the form of overdrafts and short-term credits and why banks rely heavily on collateral. At the same time, the absence of clear land titles and the difficulty in collateralizing movable and fixed assets are obstacles to the expansion of collateral-based lending.

The Role of the PMA and the PA

In order to support increased bank lending and private investment, the PMA and the PA should move ahead resolutely to create an overall market-oriented legal and regulatory environment that will allow and facilitate the use of collateral. With better definition and protection of property rights, the PMA could also help create a secondary market where banks would be able to trade long-term assets, such as housing loans. The further development of the Palestinian Securities Exchange (PSE) would also improve the availability of financing for the private sector (see Box 4.4).

The PMA can support the growth and development of a sound banking system through strict enforcement of regulations and instructions, and through initiatives such as enhanced training for banks on the monthly and quarterly data requirements. The PMA could also consider allowing banks to expand their range of products, provided they have the expertise and resources to do so. The credit bureau set up by the PMA in September 1996 is a good example of how the PMA can help improve the banking system. Banks may access this information when they need to appraise the creditworthiness of potential clients, which should help them make better-informed credit decisions.

At the same time, the PMA and the PA should avoid direct interference in the bank lending process, either to channel credit to particular sectors or influence the overall level of credit. Credit decisions are best left to a well-regulated and supervised banking system, while government intervention is only likely to weaken banks’ portfolios and lead to an inefficient use of resources, as shown by the experience elsewhere.¹⁰

Box 4.4.

The Palestinian Securities Exchange

The Palestinian Securities Exchange (PSE), located in Nablus in the West Bank, was set up in 1996 and conducted the first trading session in February 1997. PSE is a private stock company and is directed by a board under an agreement with, but with no representative from, the Palestinian Authority. The board oversees and decides on the operations and administration, and approves any amendments to the rules and regulations of the PSE.

There are currently 20 companies listed on the stock exchange out of which 15 have the Jordan dinar as their trading currency and five the U.S. dollar. Most of the listed companies are in the services sector, including banking, insurance, and investment. Four companies are engaged in manufacturing. For a company to be listed on the PSE, the subscribed capital must exceed $750,000, the number of outstanding shares must exceed 100,000, the company must have at least 250 shareholders with $100 shares at par value, and at least 25 percent of the common stock must be held by the public.

The PSE is currently conducting two trading sessions a week (Sundays and Wednesdays), but plans to begin daily trading sessions in the future. The PSE began broadcasting market information on the Reuters Network in November 1997.

Six brokerage firms are currently members of the PSE. For a brokerage firm to become a member of the PSE, it must be established and registered in the West Bank and Gaza, and at least half of the company’s board of directors must be residents of the West Bank and Gaza. The company must also have paid-in capital of at least $1 million.

Trading on the PSE is conducted over a computerized exchange management system. The trading system is order driven and orders may be entered via remote terminals located at members’ offices throughout the West Bank and Gaza.

At the end of 1998, the market capitalization of the PSE was about $588 million (14 percent of GNI), up from $529 million at the end of 1997. The level of market capitalization (in percent of GNI) compares well with developing countries of the same income per capita level. The average monthly value of transactions was $5.7 million, 150 percent higher than in 1997.

Monetary Policy and Currency

The present monetary arrangement in the West Bank and Gaza, with three convertible currencies circulating freely, is working well, and there is no evidence that it has constrained growth. This arrangement has provided an open exchange regime, crucial for a small economy that relies on trade and transfers of money from abroad. It has also helped ensure relatively low inflation (in sheqel terms), and has not prevented the rapid expansion of bank deposits and credit.

At the same time, under the present arrangement there is virtually no scope for the PMA to influence monetary and credit developments. Policies to influence bank lending include, in principle, altering of reserve requirements, reserve deposit remuneration, and the redepositing of required reserves with local banks. The scope for these instruments to affect credit growth, however, is extremely limited, and their use entails considerable risks to the banking system.¹¹ The PMA has not tried to influence credit growth by altering reserve requirements, but it does place a large share of its reserves with local banks, a practice that it would be prudent to discontinue.

The West Bank and Gaza is by no means unique in not having an independent monetary policy; many countries share this feature. Many countries have, in fact, explicitly chosen arrangements—such as fixed exchange rates, sometimes under a currency board system, or adoption of another country’s currency—that severely limit the scope for independent monetary actions.¹² Such arrangements have the advantage of enhancing confidence in monetary discipline and can result in lower interest rates than under more discretionary arrangements by reducing or eliminating the devaluation risk premium. Also, even in countries that are able to conduct a reasonably independent monetary policy, at best such a policy can only affect short-term economic growth, while the long-run output path of the economy is determined by other factors, such as openness to trade, the legal and regulatory environment, the quality of government institutions, and the level of saving and investment.

Nevertheless, a question frequently arises regarding the West Bank and Gaza having its own currency.¹³ From an economic point of view, as with any reform, introducing a Palestinian currency would seem desirable only insofar as it represents an improvement over the current situation. The West Bank and Gaza differs in two important aspects from most other cases where currencies have been introduced. First, the current arrangement works well, whereas in other places new currencies were often introduced to replace a soft, nonconvertible currency or after a period of hyperinflation. Second, in the West Bank and Gaza, people would have to be induced to switch from three well-known convertible currencies to the Palestinian currency, whereas in the countries of the former Soviet Union, for example, the currency that was replaced was not convertible and pretty much disappeared from the system.

In any event, certain preconditions have to be met before a currency can successfully be introduced, including a prudent and disciplined fiscal policy, a generally sound banking system, and an efficient and credible institutional framework. The latter would include a well-functioning banking supervision department and effective enforcement of prudential regulations. It would also be necessary to issue new laws, such as a foreign exchange law; decide on (and prepare for) the choice of an exchange rate regime; set up a foreign exchange market; undertake organizational changes in the PMA; negotiate with Israel and Jordan on the mechanics of redemption; and address a host of technical issues, like the printing of a new currency.

In the West Bank and Gaza, the successful introduction of a new currency—in the sense that people would be willing to replace a significant part of their holdings in dollars, Jordan dinars, and sheqalim in favor of the new untested currency—would only be possible if policies and institutions are sufficiently credible to inspire public confidence in the convertibility and stability of the value of the new currency. It would be vital to maintain an open exchange system and to allow the sheqel, the dinar, and the dollar to continue to circulate freely. In view of these circumstances, and given the lack of experience of the PMA in conducting monetary policy, a fixed exchange rate under a strict currency board might be the best arrangement. Currencies have been successfully introduced in some countries, such as Estonia, under currency board arrangements. The main economic advantage of a Palestinian currency under a strict currency board, compared with the current situation, would be the extra revenue from seigniorage, although this revenue would not be substantial over the medium term (Box 4.5). Aside from seigniorage, a system that has no domestic currency is essentially equivalent to a currency board with no exit option.

Box 4.5.

Seigniorage

The Interim Agreement leaves the issue of a Palestinian currency for the future. Aside from the macroeconomic policy and political implications of a Palestinian currency, the introduction of a currency would create public revenue from the monetization process, i.e., seigniorage. The PMA already receives seigniorage on the required reserves that are not remunerated.¹ In developed countries, seigniorage is typically not a very important source of revenue, and in the medium to long run, it would not he large in the West Bank and Gaza either.

If a Palestinian currency were introduced, it would replace some of the foreign currency now circulating in the West Bank and Gaza. It is extremely unlikely that it would replace all of it, and the public would most likely prefer to hold a large part of their store-of-value money in dollars and also hold sheqel balances, given the amount of transactions conducted with Israel. The extent to which seigniorage from currency in circulation could be an important source of revenue depends on the willingness of the public to hold a new currency rather than continue holding dollars, sheqalim, and dinars. The demand for a new currency would increase as it gains credibility as a stable and convertible currency. In the long run, when currency demand grows in line with GDP, yearly seigniorage, in addition to what the PMA already receives, could amount to around 1/2-1 percent of GDP, assuming a currency-to-GDP ratio of 10 percent, nominal real GDP growth of 4-5 percent, and inflation of 3-4 percent. During the period when the new currency would replace some of the foreign currencies, seigniorage might be larger.

¹ Some studio use the term seigniorage for the part of monetization revenue that relates to real money demand, to distinguish it from the revenue from the inflation tax, which stems from the currency holders’ attempts to maintain their real money balances. Here the term seigniorage covers all revenue from monetization, including from the inflation tax.

The introduction of a Palestinian currency under a currency board arrangement would require a reorganization of the PMA, as well as revisions to the PMA Law, to establish the fixed exchange rate by law and to eliminate the provisions that allow, and even require, the PMA to lend to the Ministry of Finance. Under a currency board, base money is backed entirely by foreign exchange reserves, and the PMA would not be able to undertake any domestic lending, including loans to the government. In addition, the scope for the PMA to act as a lender of last resort to the banking system would be quite narrow, limited to its holdings of foreign reserves in excess of the reserve cover. It is precisely from these restrictions that the currency board derives its credibility.

Furthermore, under a currency board the monetary base can only expand on the basis of purchases of foreign exchange, so the exchange regime needs to be very open. The West Bank and Gaza meets this requirement because it has very few exchange restrictions currently in place on current and capital account transactions. Any attempt to introduce exchange restrictions could seriously diminish the attractiveness of a new Palestinian currency, and could cause it to be used and held less than it would under a continued open exchange regime.

During the past five years, important preconditions for a successful currency introduction, such as firm fiscal expenditure control, sound fiscal management, effective banking supervision, and enforcement of regulations, were not in place, and some of them still are not. From this perspective, a currency introduction during that time would most likely have led to very limited acceptance of the new currency, and there is no reason to believe that credit growth would have been stronger. It is also likely that interest rates on loans denominated in the new currency would have been considerably higher than on loans in other currencies. Because the authorities will have basically only one shot at introducing a currency, it is critical that the preconditions be met and, in this regard, the authorities have been prudent in placing priority on improving banking supervision and fiscal management.

See comments in MAS (1996c).

Article IV of the Economic Protocol of 1994 stipulates that the sheqel will be one of the circulating currencies and that it will legally serve as means of payment for all purposes, including official transactions, and further, that any circulating currency, including the sheqel, will be accepted by the Palestinian Authority and by its institutions, local authorities, and banks when offered as a means of payment for any transaction.

The West Bank was under Jordanian administration until 1967. During the period 1967-91, many Palestinians kept bank accounts in Jordan or held Jordan dinars as store of value.

This section draws on information prepared by the staff of IMF’s Monetary and Exchange Affairs Department.

About two-thirds of deposits are held as foreign assets.

The reduction in the ceiling on banks’ investments abroad to 65 percent of deposits from 90 percent became effective on December 31, 1998.

See Barnett and others (1998) for a fuller discussion of the effect of uncertainty on private investment in the West Bank and Gaza.

In addition to updating laws and regulations, the authorities are in the process of modernizing the entire system for dispute settlement. They are also taking measures to improve court facilities and to increase the number of judges.

See Bates (1996) for a more general discussion of this issue.

In some countries, the authorities have intervened in the credit market to either direct credit to certain sectors that were perceived as having difficulties in accessing the credit market, at least at prevailing interest rates, or to attempt to raise the overall level of credit. Such government intervention has typically taken the form of lending floors imposed on banks, as in the West Bank and Gaza loans at subsidized rates; credit guarantees; or directed credits, usually targeted at certain industries, stateowned enterprises, or agriculture. Although individual sectors may have benefited, there is no evidence that directed credits have had a positive impact on overall economic growth, whereas they have generally led to suboptimal allocation of resources.

Barnett and others (1998) discusses the credit channel and concludes that it has only very limited scope to affect credit growth in the West Bank and Gaza. The credit channel operates by altering the banking sector’s willingness to supply credit, e.g., by changing reserve requirements, as compared with the more common monetary transmission mechanisms, such as the interest rate, exchange rate, and asset prices.

At the end of 1998, out of the IMF’s 182 members, 26 did not issue their own legal tender (currency), 7 had adopted a fixed exchange rate in the context of a currency board, and 37 had more conventionally fixed exchange rates. Since then, the 11 countries participating in the Economic and Monetary Union (EMU) of the European Union have adopted the euro as their common currency.

The Economic Protocol (Article IV, Section 10b) mentions that both sides will continue to discuss the possibility of introducing a mutually agreed Palestinian currency.

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Introduction

Growth of the Banking System

Deposits

Bank Lending

Currency Composition of Deposits and Lending

The Role of the PMA and the Banking System in Economic Development

Institution Building4

Growth in Credit for Investment

Causes of Slow Growth of Credit

The Role of the PMA and the PA

Monetary Policy and Currency

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