Setting the Stage for a National Currency in the West Bank and Gaza: The Choice of Exchange Rate Regime

Contributor Notes

Author(s) E-Mail Address: sbeidas@imf.org and mkandil@imf.org

This paper sheds light on the quantitative behavioral responses of key economic variables in the Palestinian economy in the face of major economic shocks and draws implications for the choice of an exchange rate regime should a decision be taken to introduce a national currency. Time-series regression analysis shows that (i) wages and prices are flexible in the face of various shocks; (ii) the real wage appears rigid in the face of various shocks and increases despite higher unemployment; (iii) an appreciation of the new Israeli Sheqalim real effective exchange rate decreases exports and imports; and (iv) money demand appears stable in the face of exchange rate shocks. Although a fixed exchange rate system may initially be desirable to establish credibility of the new currency, some flexibility of the exchange rate is desirable over time.

Abstract

This paper sheds light on the quantitative behavioral responses of key economic variables in the Palestinian economy in the face of major economic shocks and draws implications for the choice of an exchange rate regime should a decision be taken to introduce a national currency. Time-series regression analysis shows that (i) wages and prices are flexible in the face of various shocks; (ii) the real wage appears rigid in the face of various shocks and increases despite higher unemployment; (iii) an appreciation of the new Israeli Sheqalim real effective exchange rate decreases exports and imports; and (iv) money demand appears stable in the face of exchange rate shocks. Although a fixed exchange rate system may initially be desirable to establish credibility of the new currency, some flexibility of the exchange rate is desirable over time.

I. Introduction

The analysis of this paper sheds light on the quantitative behavioral responses of key economic variables in the Palestinian economy in the face of major economic shocks and draws implications for the choice of an exchange rate regime should a decision be taken to introduce a national currency. The paper does not debate whether introducing a currency is the right course of action. Rather it is assumed that this would be a political decision. The paper’s objective is to show econometrically the responsiveness of the economy to shocks and to infer the optimal choice of the exchange rate regime for the newly introduced currency.

The nexus of the credibility of the currency and the regime choice, given the changing environment (following separation from Israel) and since all currencies currently circulating are convertible and stable, has been examined in previous papers. To summarize,2 the successful introduction of the new currency in the West Bank and Gaza (WBG) will hinge on four factors: (i) organization of the foreign exchange market, including the choice of exchange rate regime, (ii) development of institutions to handle distribution of the new currency and ensure smooth transition given existing contracts, (iii) assigning the central bank the responsibility to vary the quantity supplied in line with the objectives of monetary policy, and (iv) coordination with the Israeli and Jordanian authorities to ensure smooth redemption of sheqalim and dinar in circulation.

Previous studies suggest that a currency board anchored on one of the world’s main currencies (rather than a basket) would ensure the highest credibility and lowest cost of the process and, hence, provide the most suitable monetary and exchange framework.3 They argue that the introduction of a local currency is a complex process, involving institutional changes and a range of economic choices. They suggest that the guiding principle in the process should be to ensure that the benefits associated with the current situation will be maintained, while the costs of setting up the new regime will be minimized. This would appear to require actions in at least three areas: (i) a macroeconomic policy framework consistent with monetary stability; that is, a prudent budgetary policy and an efficient, market-oriented monetary policy framework; (2) the choice of an exchange rate regime that maximizes credibility, while minimizing costs and potential disruptions associated with the new currency; and (3) supporting structural policies in the areas of banking, financial markets, and labor markets.

These recommendations were not based on quantitative analysis of the economic implications of alternative regimes. Rather they hinge upon what is deemed to receive the highest public confidence and credibility—perhaps the most important issue. However, this paper considers that any exchange rate regime will require considerable institutional change and credibility buildup. Therefore, it focuses on estimating the responses of key variables to shocks.

The merits of the choice of the exchange rate regime depend on the nature of the shocks that buffet the economy. When shocks emanate from the domestic money market (e.g., an increase in money demand), the central bank intervenes to accommodate these shocks in order to maintain the stability of the exchange rate under a fixed regime. Money supply will increase as the monetary authority buys foreign reserves to prevent the appreciation of the local currency. In the absence of the central bank’s intervention (e.g., under a flexible exchange rate regime), an increase in money demand increases the interest rate, adversely affecting the real economy. This is an argument in favor of fixed rate regimes in order to isolate the real economy from fluctuations in money demand.

When shocks are mostly real, floats are, in theory, the more effective choice. When domestic prices are sticky, and thus change at best slowly in response to shocks, a depreciation of the exchange rate is necessary in the face of a negative real shock. A depreciation of the exchange rate reduces the price of tradable goods at precisely the moment that demand for them has fallen and, therefore, partially offsets the effect of the negative shock. Thus, the exchange rate acts as an automatic stabilizer in flexible rate regimes.

The paper is organized as follows: Section II discusses the choice of the exchange rate regime in light of the key characteristics of the Palestinian economy, while Section III elaborates the technical approach and estimation results, with a focus on susceptibility to shocks. Section IV draws conclusions.

II. Choice of Exchange Rate Regime and Characteristics of Palestinian Economy

In choosing an exchange rate regime, countries have to trade off the advantages of stability against flexibility. Having said that, economists differ in their assessment of how regimes perform under various exchange rate arrangements. Important characteristics of the economy would favor more stability or flexibility of the exchange rate.4

The classical view is that there are three main advantages to fixing the exchange rate. First, is to reduce transaction costs and exchange rate risk.5 The more dependent the money demand function on exchange rate fluctuations, the higher the risk of exchange rate flexibility. Fixing the exchange rate increases confidence in domestic currency and stabilizes money demand. Second, in economies that are highly dependent on imports, exchange rate flexibility increases the risk of inflation. Fixing the exchange rate increases price stability and anchors inflationary expectations. Third, fixing the exchange rate provides a credible nominal anchor for monetary policy.

Notwithstanding the advantages of stability in the face of nominal shocks, fixing the exchange rate may be costly on export competitiveness and real growth. In the absence of exchange rate flexibility, adjustments in relative prices and real wages are necessary to mitigate the effects of external shocks and domestic real shocks on economic growth. Absent these adjustments, fixing the exchange rate may result in loss of competitiveness and exacerbate the effects of real shocks on output growth. A floating regime enhances a country’s (automatic) ability to absorb (external and real) shocks (i.e., depreciating the currency vis-à-vis trading partners). Moreover, there are several increasingly important advantages to floating the exchange rate. First, is the ability to pursue an independent monetary policy.6 Second, due to the more limited rationale for holding reserves, the country is able to utilize these reserves domestically.7

The Palestinian economy has a number of characteristics that are relevant for the introduction of a national currency and the determination of the appropriate exchange rate regime. The importance of each of these characteristics and the nature of the real or external shocks may change over time. Some obvious shocks include the regional effect of oil price changes, regional political developments, regional trade agreements and shifting trade patterns, and movements in labor remittances and grants from official donors. Some favor a fixed regime, while others favor flexibility.

A. Characteristics Impacting the Real Economy

Flexibility of factor markets

Descriptive statistics suggest that average wages have remained remarkably stable in spite of persistent unemployment rates.8 In Gaza, where the unemployment rate rose above 30 percent in recent years, nominal wages have been virtually constant. Since inflation has been very low in Gaza, real wages have changed very little.9 This is not the case in the West Bank, where average wages are higher than in Gaza. In the West Bank, while nominal wages have also remained fairly stable, real wages declined as a result of higher inflation rates in the West Bank (relative to Gaza) during the last few years (see Table 1).10 Overall, fluctuations in the real wage over time indicate some downward rigidity during the recessionary conditions surrounding the Intifada period (Figure 1). Notwithstanding the rigidity of the real wage, the large increase in unemployment suggests that labor markets were adversely affected by the slowdown in the economy attributed to political instability. Despite lower average real wage in Gaza relative to the West Bank, unemployment remains very high (Table 5). While additional flexibility of the real wage may be necessary in the face of excess supply of labor and high unemployment, such flexibility may not be sufficient absent policy measures to revive aggregate economic conditions. The degree of the flexibility of wages is estimated in the Section III.

Figure 1.
Figure 1.

Developments in Average Wages, 1998/Q1–2004/Q2

Citation: IMF Working Papers 2005, 070; 10.5089/9781451860894.001.A001

Sources: Palestinian Central Bureau of Statistics, and IMF Staff estimates
Table 1.

Developments in Real Average Daily Wages, 2000–Q2/2004

article image

Although labor is relatively mobile, it is highly dependent on the Israeli labor market, where wages are relatively high compared to neighboring countries.11 The Israeli labor market has been a very important source of employment and income for many Palestinians (Table 5) and net factor income from abroad rose fairly steadily during 1996–99 reaching 21 percent of GDP. These “internal” remittances from Palestinians working in Israel are a significant component of aggregate income and fuel domestic demand since a large share of that income is spent on goods and services produced in the WBG. Annual labor income from Israel amounted to more than 16 percent of Gross National Income (GNI) in 1999.

Measured in terms of the new Israeli sheqalim (NIS), the common currency for most cash and retail transactions and wage payments, Palestinian and Israeli inflation rates are very closely related overall.12 Depreciation of the NIS triggers higher inflation in Palestine and Israel. The behavior of both inflation rates closely follows the fortunes of the NIS against the U.S. dollar—at least up to the second quarter of 2003, when the WBG inflation differed from Israel’s (Figure 2). This may be attributed to a more recent emphasis of monetary policy in Israel on inflation targeting. Since over two thirds of all goods imported by WBG are imported from Israel, Israeli imports, therefore, have a very high share in the Palestinian consumption basket. Any change in Israeli prices is directly transmitted to the WBG through this channel. In addition, transportation costs in WBG have risen sharply since the beginning of the Intifada (Figure 2). In the West Bank this has more than offset the depressing effect of lower economic activity on price inflation.13 The degree of the flexibility of prices is estimated in the Section III.

Figure 2.
Figure 2.

Price and Exchange Rate, 1998/Q1–2004/Q2

Citation: IMF Working Papers 2005, 070; 10.5089/9781451860894.001.A001

Sources: Palestinian Central Bureau of Statistics, and IMF Staff estimates

The choice of the exchange rate system is likely to be shaped around relative flexibility of wages and prices and subsequent effects on real wages. The more flexible real wages are the less the impact of exchange rate rigidity on the real economy. While labor mobility is an important factor, the downward rigidity of the real wage signals concerns about potential recovery under a fixed exchange rate system.

Trade pattern and denomination

The economy is small and open and the direction of trade is uncertain.14 The economy is small and open in the sense that it does not influence world prices of its exports and imports and has a small population (of over 3.6 million) and economy (of about US$3.5 billion—which has contracted—as a consequence of the Intifada from US$4.5 billion in 1999). The sum of both exports and imports was over 100 percent of GDP in 1999, a high level by international standards. Clearly, the Intifada impacted negatively on openness (Table 2). Imports dominate while exports are well below their potential (see below). Other balance of payments flows, composed of net factor income from workers in Israel, official transfers and remittances from expatriate Palestinians, were 30 percent of GDP in 1999 rising to 50 percent in 2003. In terms of trade restrictiveness, there are no restrictions on current or capital transactions and given the customs union with Israel, with a common low tariff rate set by Israel, the economy is unrestrictive. However, the trade regime is complex and suffers from non-tariff barriers imposed by Israel (due to cumbersome trade and transport restrictions for security concerns).15 More recently internal closures, prevention of usage of the Gaza airport and no safe passage between Gaza and the West Bank also hamper trade.

Table 2.

Fiscal and Balance of Payments Developments, 1998–2004

article image
Sources: Palestinian Central Bureau of Statistics and IMF Staff estimates.

The current trade pattern is dominated by trade with Israel, accounting for more than 95 percent of Palestinian exports. It appears that a large part of these are re-exported to other countries but presently there are no data to indicate the final destination or the currency denomination.16

The choice of the exchange rate system is likely to be shaped around the vulnerability of trade (exports and imports) to changes in various exchange rates. High dependency on imports may provide support to a fixed exchange rate system to minimize the effects of exchange rate shocks on inflation (historically, inflation has not been a major concern). Nonetheless, exchange rate flexibility may be a necessary ingredient to boost export competitiveness.

B. Characteristics Impacting the Nominal Economy

Degree of currency substitution

There has been no Palestinian currency for over fifty years and three foreign currencies circulate freely: the Israeli sheqalim,17 the Jordanian dinar,18 and the U.S. dollar. By far the largest share of currency denomination, in both deposits and lending, is in terms of U.S. dollars (see Figure 3 and Table 3).19 This is a little surprising given that all fiscal operations are in sheqalim and most donor aid is in euros. Nonetheless, this phenomenon has been fairly stable for deposits over the years, while the share of U.S. dollars in bank loans, by contrast, has continued to increase.

Figure 3.
Figure 3.

Currency Composition of Total Deposits, 1999–2004

(in millions of US dollars)

Citation: IMF Working Papers 2005, 070; 10.5089/9781451860894.001.A001

Table 3.

Currency Composition of Private Deposits, 1998–2004

article image
Source: Palestinian Monetary Authority

Residents only.

Predominately Euros

The choice of the exchange rate system is likely to be shaped around changes in money demand in response to changes in various interest and exchange rates, and thus is estimated in Section III. However, even if money demand is found to be stable in the face of shocks, a key challenge for a newly introduced currency would be to gain market share at the expense of the three other circulating currencies voluntarily and over time. This is likely to hinge upon confidence in the currency and its stability—which will be monitored by economic agents and thus transparency in exchange rate management will be critical.

C. Other Characteristics

Capital account and transfers

The degree of WBG’s involvement in international capital markets is very small and international reserves are believed to be low.20 The economy is dependent on “external” remittances, through large net current transfers and net factor income (Table 2).21 The two items together generated a fairly constant income flow equal to around 30 percent of GDP during 1994–2000. Net current transfers and net factor income are large, offsetting the large deficit in the Palestinian trade balance. The inflow of foreign reserves is likely to serve as a security buffer to sustain the stability of the exchange rate after the introduction of national currency. Nonetheless, a strong international reserves position should be in place under a fixed exchange rate system. Foreign reserve losses could be large should the need to defend the currency against speculative attacks arise. However, capital outflows are expected to be small since most flows are expected to be long term direct investment—assuming stability and peace prevail for reconstruction. In addition, the inflow of remittances and foreign aid may strengthen the ability of the monetary authority to defend the peg, but cyclical disturbances in these flows and the risk of outflows should increase vulnerability under a fixed exchange rate system.

Institutional considerations

The Palestinian Monetary Authority (PMA) is a nascent institution with no experience in exchange rate management. It supervises and regulates the banking system; this role in effect is limited to the Palestinian banks without being able to offer these banks a lender-of-last-resort (LOLR) facility. Prudential ratios are generally consistent with the Basle I. Nonetheless, there is a need for a LOLR facility, which neither the Jordanians nor the Israelis have been willing to offer. The authorities have had no recent experience with any form of exchange rate management. On the positive side, there has been no recent history of high inflation to counter against.22

In terms of fiscal discipline, the authorities’ commitment has not been put to the test yet, with revenues predominately emanating from the customs union with Israel and expenditure and arrears pressures building up (Table 2).23 24 The lack of seigniorage adds to the fiscal tightness. Fiscal discipline is necessary for financial and nominal stability, regardless of the exchange rate regime. The success of a fixed exchange rate regime would highly depend on fiscal discipline in the face of potentially huge shocks and lack of institutional capacity to design and implement necessary reforms.

III. Empirical Results

A. Data and Measurement Issues

The econometric work in this paper is based on quarterly data from the Fund’s Economic Data Sharing System (EDSS), the Palestinian Central Bureau of Statistics (PCBS) and the WBG’s Desk’s estimation from 1998 to 2004.25 Given non-stationarity, the logarithm of each variable and the first difference were taken. The method of estimation was ordinary least squares (OLS), unless endogeneity was found then the model was reconfigured using instrumental variables, with the lags of the same explanatory variables from the OLS model as instruments. If serial correlation was found, it was corrected using heteroscedasticity consistent standard errors (t-HACSE).26

In addition to aggregate data (Appendix I), available data differentiate wages by region: wages in Gaza, wages in West Bank, and wages for Palestinians working in Israel and settlements. Table 4 contains a summary of average daily wages.

Table 4.

Statistics of Average Daily Wages, by Region, 1998–2004

article image
Source: Palestinian Central Bureau of Statistics, and IMF Staff estimates.
Table 5.

Palestinian Labor Market Developments, 2000–2004

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

Includes employment in Israel and the settlements as well as those considered underemployed.

Central government only.

Includes employment in local authorities and public enterprises.

B. Estimation Results

As aforementioned, the choice of the exchange rate system is likely to be shaped around three factors: relative flexibility of wages and prices and subsequent effects on real wages, the vulnerability of trade to changes in various exchange rates, and changes in money demand in response to changes in various interest and exchange rates. The more flexible real wages are the less the impact of exchange rate rigidity on the real economy; an argument in favor of a fixed exchange rate system. High dependency on imports may provide further support to a fixed exchange rate system to minimize the effects of exchange rate shocks on inflation. On the other hand, exchange rate flexibility may be necessary to boost export competitiveness. Instability of money demand in response to exchange rate fluctuations would signal the need for a fixed exchange rate to anchor expectations.

The Palestinian economy has been subject to a composite of real and nominal shocks that are likely to continue to pose a threat on stability and economic performance in the period ahead. The choice of the exchange rate should aim at balancing out the risks in the face of these shocks. While the flexibility of the exchange rate may compound the risk of inflation and unstable money demand in the face of nominal shocks, fixing the exchange rate may lead to a loss of competitiveness and exacerbate the effects of real shocks absent flexibility to adjust real wages and relative prices in factor and product markets. The empirical evidence will aim at establishing evidence on the potential risk surrounding choices of the exchange rate regime.

To measure the degree of wage and price flexibility, we follow a sequence of empirical tests. First, we measure the degree by which wages vary in close relation to prices in the long-run. Second, we determine the effects of national income, transportation cost, the exchange rate, GDP in Israel, and global conditions (GDP in the U.S.) on cyclical fluctuations in wages and prices. The results identify factors that determine relative cyclicality in wages and prices and, in turn, impact on real wages.

To illustrate cyclical fluctuations in the trade sector, we estimate empirical models that explain exports and imports as a function of domestic price relative to price in Israel, the real effective exchange rate in Israel, real GDP or GNI in WBG, and GDP in Israel.

To measure the stability of money demand, we estimate an empirical model that explains total deposits in three currencies as a function of the interest rates on deposits, relative exchange rates, and GNI in WBG.27

Flexibility of nominal wages, prices, and real wages

As indicated above, flexibility of real wages and relative prices would reduce the risk of a fixed exchange rate on the real economy. There are two dimensions to judge this flexibility: (i) how close is movement in wages and prices in the long and short-run, and (ii) the relative cyclicality of wages and prices in the face of various shocks.

First, we test the evidence of co-integration between the nominal wage and price in each of the West Bank, and Gaza. Following evidence of co-integration, we test close adjustments of wages and prices in the short-run. There is evidence of co-integration (long-run association) between the nominal wage and price in the West Bank. Similarly, wages and prices for Gaza are co-integrated. Evidence of co-integration establishes co-movements between wages and prices and, therefore, the stability of the real wage in the long-run.28

Imbalances in the labor market are attributed to specific shocks (domestic and external) impinging on the Palestinian economy. It is important to evaluate the relative flexibility of wages and prices in the face of specific shocks. Table 6A presents the evidence of determinants of the cyclical behavior of wages and prices in each of the West Bank and Gaza. In equilibrium, the nominal wage is determined by demand and supply factors. On the demand side, the empirical model captures three factors: real GNI in WBG, GDP in Israel (a major source of employment and remittances), and GDP in the U.S. (a proxy for global conditions). Wages and prices are expected to increase in response to a higher demand. On the supply side, two factors are likely to determine wage and price inflation: a transportation price index, and the sheqalim price of the U.S. dollar (an increase indicates depreciation). Both factors are likely to increase the cost of output, forcing higher inflation of wages and prices.

Table 6A.

Cyclicality of Wages and Prices in the Face of Various Shocks

article image
article image

10 percent significance

5 percent significance

Method of estimation is OLS unless endogeneity was found then instrumental variables/two-staged least squares estimation results are reported.

Variable key:

DL

DL before each variable is the first difference of the log of that variable

DLWWB

nominal average daily wages in the West Bank in NIS

DLWG

nominal average daily wages in the Gaza Strip in NIS

DLRWWB

real average daily wages in the West Bank in NIS

DLRWG

real average daily wages in the Gaza Strip in NIS

DLCPIWB

CPI for West Bank

DLCPIG

CPI for the Gaza Strip

DLTranCPI

transportation price index, a component of CPI, for the West Bank and Gaza

DLRGNI

real gross national income (includes transfers and remittances) for the West Bank and Gaza

DLNIS$EX

Israeli sheqalim to US Dollar exchange rate

DLGDPI

nominal gross domestic product of Israel

DLGDPUS

nominal gross domestic product of the USA

Each of nominal wage inflation, price inflation, and real wage growth is regressed on its own lag, and the current and first lagged values of each of transportation price inflation, growth of real national income in the WBG, the change in the sheqalim price of the US dollar, growth of domestic demand in Israel, and growth of GDP in the U.S. Accordingly, the empirical models are specified as follows, where D(L.) is the first-difference of the logarithmic value:

DLWt=F(DLWt1,DLTransCPIt,DLTransCPIt1,DLRGNIt,DLRGNIt1,DLNIS$EXt,DLNIS$EXt1,DLGDPIt,DLGDPIt1,DLGDPUSt,DLGDPUSt1)(1)
DLCPIt=F(DLCPIt1,DLTransCPIt,DLTransCPIt1,DLRGNIt,DLRGNIt1,DLNIS$EXt,DLNIS$EXt1,DLGDPIt,DLGDPIt1,DLGDPUSt,DLGDPUSt1)(2)
DLRWt=F(DLRWt1,DLTransCPIt,DLTransCPIt1,DLRGNIt,DLRGNIt1,DLNIS$EXt,DLNIS$EXt1,DLGDPIt,DLGDPIt1,DLGDPUSt,DLGDPUSt1)(3)

Table 6A demonstrates the cyclicality of nominal wage inflation, price inflation, and real wage growth in the West Bank. The negative and significant response of nominal wage inflation to its lag indicates lack of persistence in cyclical fluctuations. Following a cyclical shock, wages revert quickly to their long-run equilibrium. Several factors have contributed positively to higher nominal wage inflation in the West Bank: higher inflation of transportation price lagged, depreciation of the sheqalim relative to the dollar, and higher domestic demand in Israel lagged.

In panel A, a one percent increase in transportation price inflation (lagged) leads to 1.5 percent increase in wage inflation in the West Bank. Transportation cost increased in the wake of higher security constraints and significant closures, forcing an increase in the wage cost. A one percent depreciation of the sheqalim relative to the dollar leads to 0.6 percent increase in nominal wage inflation in the West Bank. The sheqalim depreciation increases the cost of imports, forcing an increase in the cost of living and, in turn, wages in the West Bank. A one percent increase in GDP in Israel increases wage inflation in the West Bank by 1.3 percent. Higher demand in Israel has a positive spillover effect on economic activity, increasing labor demand in the West Bank.

In panel B, only sheqalim depreciation is relevant to price inflation in the West Bank. A one percent depreciation of the sheqalim relative to the dollar increases price inflation in the West Bank by 0.2 percent. Sheqalim depreciation increases the cost of imports through Israel and, therefore, price inflation.

Since prices are relatively more rigid, compared to nominal wages, the real wage, in panel C, increases significantly in the face of aggregate demand in Israel. A one percent increase in aggregate demand in Israel increases the real wage by 0.9 percent in the West Bank. Higher real wages may have contributed to the severity of unemployment among Palestinians in the West Bank (23.6 percent in 2004/Q2, see Table 5).

Table 6A, presents the results of estimating the model explaining nominal wage inflation in Gaza. In panel D, cyclical fluctuations lack persistence, as evident by the negative and statistically significant response of wage inflation to its lag. Two major factors have fueled wage inflation in Gaza: higher growth of real national income (including remittances and transfers) lagged, and the depreciation of the sheqalim relative to the dollar.

A 1 percent growth in real GNI results in 0.6 percent increase in nominal wage inflation in Gaza. The impact of remittances and transfers appears, therefore, more evident on wages in Gaza compared to the West Bank. A one percent depreciation of the sheqalim relative to the dollar increases the cost of imports through Israel and results in 0.6 percent increase in nominal wage inflation in Gaza. In contrast, improved demand in Israel (higher GDP) has depressing effects on wages in Gaza. A 1 percent growth in demand in Israel results in a cumulative reduction in nominal wage inflation that equals 1.32 percent in the current and lagged quarter. Higher demand in Israel transfers economic activity and increases workers’ mobility, decreasing the demand for labor in Gaza.

Table 6A illustrates the effects of cyclical factors on price inflation in Gaza in panel E. In contrast to the positive effects on wage inflation (evidence of nominal wage flexibility), price inflation decreases significantly in the face of higher growth of real national income, signaling price rigidity. A 1 percent growth in real GNI correlates with a 0.3 percent reduction in price inflation in Gaza—supply-side factors may be more dominant on price inflation. In contrast, improved global conditions, as approximated by higher growth in US GDP, raise price inflation in Gaza. A 1 percent growth in GDP in the U.S. increases price inflation in Gaza by 2.2 percent. Given the small volume of trade, the effect of global conditions is likely to be transmitted through the inflow of foreign aid to Gaza.

Despite differences in cyclical adjustments in wages and prices, cyclical fluctuations of the real wage, in panel F, are insignificant in the face of various factors in Gaza. This is evident by the insignificant cyclical response of the real wage to various factors. Lack of cyclicality in the real wage signals concerns about potential failure to insulate the real sector from external shocks under a fixed exchange rate system, given the high unemployment rate in Gaza (39.7 percent in 2004/Q2, see Table 5). Overall, the thorough analysis produces robust results that reject wage and price persistence and illustrate flexibility in the face of various shocks. Cyclical fluctuations appear to be of short duration in wages and prices.29 A number of cyclical factors have affected wages and/or prices significantly in the short-run.30 Nonetheless, the behavior of the real wage appears, in general, rigid in the face of various shocks. More importantly, the real wage does not vary significantly with fluctuations in the sheqalim/dollar exchange rate. Given that the sheqalim has been fluctuating lately and wages are earned in sheqalim, the real wage does not appear to be flexible in the face of external shocks. Absent flexible adjustments of the real wage, the effect of the various shocks could have a serious long-lasting effect on the real economy in the WBG under a fixed exchange rate system.

Next, we study the specifics of the labor market in the WBG a bit closer. It has been argued that wages for workers in Israel and settlements push up wages in Gaza and the West Bank,31 and may have contributed to the rigidity of the real wage, despite high unemployment rates. To illustrate, Table 6B shows the results of regressing nominal wage inflation on the change in unemployment and wage inflation for Palestinians working in Israel and settlements.

Table 6B.

Variation in Wages in WBG with Unemployment and Wages in Israel

article image

In panel G, wage inflation in the West Bank does not vary significantly with unemployment. A 1 percent wage inflation for Palestinians working in Israel and settlements results in a 0.92 percent wage inflation with a two-quarter lag, in the West Bank.

In panel H, wage inflation in Gaza increases despite higher unemployment. A 1 percent increase in unemployment correlates with 0.26 percent increase in nominal wage inflation in Gaza. The latter, however, does not vary significantly with wage inflation for Palestinians working in Israel and settlements.

The significant share of employment for the Palestinian Authority (PA) may have contributed to sustaining nominal wage inflation, despite higher unemployment. However, this is not deemed to be the major source since, as shown in Table 5, the share of employment for the PA was 28 percent in 2002/Q4, and more recently is 22 percent in 2004/Q2.

To further illustrate the rigidity of the real wage, Table 6B illustrates the results of regressing real wage growth on distributed lags of unemployment in WBG. In panel I, real wage growth in the West Bank does not vary significantly with the unemployment rate. In panel J, real wage growth in Gaza increases significantly despite a higher unemployment rate. A 1 percent increase in unemployment correlates with 0.25 percent concurrent quarterly increase in the real wage in Gaza.

The apparent rigidity of the real wage may have exacerbated the real effects of economic slowdown and the severity of unemployment among Palestinians in the WBG. The downward rigidity of the real wage supports the need for a flexible exchange rate to moderate the effects of external shocks on the real economy.32

Determinants of fluctuations in trade balance

How dependent are exports and imports on exchange rate fluctuations in the WBG? Given the high share of imports to GDP, high fluctuations of imports in the face of exchange rate fluctuations would support stability under a fixed exchange rate regime. In contrast, high fluctuations of exports in the face of exchange rate fluctuations would support exchange rate flexibility to boost competitiveness. The WBG has been running a large trade deficit. Imports are likely to support growth in the absence of domestic substitutes. It is, therefore, necessary to have an export-oriented strategy in evaluating options for exchange rate regimes.

We estimate an empirical model that explains cyclical fluctuations in exports, and imports.33 Each dependent variable is regressed on its lag, current and lagged value of domestic price relative to price in Israel, real GDP in Israel, real GDP or real GNI in WBG,34 and the real effective exchange rate in Israel.35 On the demand side, exports may decrease in response to a higher real effective exchange rate of the sheqalim and a higher relative domestic price. Exports may increase in response to a higher real GDP in Israel. On the supply side, exports may increase with domestic real GDP. On the demand side, imports my increase in response to a higher real GNI and decrease in response to a higher real effective exchange rate of the sheqalim. Imports may decrease in response to a higher relative domestic price as imported substitutes become cheaper. Alternatively, higher price may decrease real standard of living and make imports less affordable. On the supply side, imports (primarily from Israel) may increase with higher real GDP in Israel. Given non-stationarity, the empirical models are specified in first-difference form, as follows:

DLEt=F(DLEt1,DLPrWBG/Isrt,DLPr WBG/Isrt1,DLPr WBG/Isrt2,DLREERIsrt,DLREERt1,DLRGDPWBGt,DLRGDPWBGt1,DLRGDPIt,DLRGDPIt1)(4)
DLIt=F(DLIt1,DLPr WBG/Isrt,DLPr WBG/Isrt1,DLPr WBG/Isrt2,DLREERIsrt,DLREERIsrt1,DLRGDPWBGt,DLRGDPWBGt1,DLRGDPIt,DLRGDPIt1)(5)

Table 7 summarizes the results. In panel A, exports grow with higher real GDP growth in Israel. A 1 percent growth of real GDP in Israel results in 2 percent growth of exports in the current and lagged quarter. An appreciation of the real effective exchange rate in Israel decreases competitiveness for exports of WBG. A 1 percent appreciation of the real effective exchange rate leads to 0.67 percent reduction in export growth in the current and lagged quarter. A 1 percent higher relative inflation results in a cumulative increase in export value that equals 0.94 percent in the current and lagged quarter. This pattern is reversed in the second lagged quarter: An increase in relative price inflation by one percent decreases export growth by 1.97 percent. A 1 percent growth in real GDP in the WBG results in 1.7 percent growth in exports.36

Table 7.

Determinants of Fluctuations in the Trade Balance

article image

10 percent significance

5 percent significance

Method of estimation is 2SLS using instrumental variables, since endogeneity was found for one variable using OLS.

Variable Key:

DL

DL before each variable is the first difference of the log of that variable

DLPrWBG/Isr

CPI of WBG over CPI of Israel

DLREERlsr

real effective exchange rate of Israel

DLRGDPWBG

real gross domestic product of WBG

DLRGDPI

nominal gross domestic product of Israel

DLRGNIWBG

real gross national income of WBG

DIE

nominal total exports

DLI

nominal total imports

In panel B, a 1 percent appreciation in the sheqalim real effective exchange rate leads to 0.69 percent reduction in import growth in the current and lagged quarter. Sheqalim appreciation increases the cost of imports from Israel. A 1 percent growth in real GNI in WBG results in 1.5 percent increase in imports. An increase in relative price inflation by one percent results in a cumulative 2.7 percent reduction in imports in the current and two lagged quarters. Real purchasing power declines in response to a higher relative domestic inflation.37

Overall, the evidence supports the need for exchange rate flexibility. An appreciation of the sheqalim real effective exchange rate decreases exports. Fixing the exchange rate against the sheqalim could adversely affect competitiveness if the sheqalim appreciates relative to the dollar or the euro. On the other hand, the negative dependency of imports on sheqalim appreciation indicates the adverse effects on stability should a decision is reached to fix the exchange rate against the dollar or the euro. Fixing against a basket of currencies would require identifying the weights of individual currencies to mitigate the adverse effects of fluctuations against individual currencies on trade.38

Determinants of fluctuations in money demand

Nominal shocks could pose a serious threat to the stability of the money demand function under a flexible exchange rate system. Currently, three currencies are accepted as legal tender in the Palestinian economy. Is there any evidence of stable money demand in the face of exchange rate fluctuations?

The model in Table 8 explains the growth of total deposits (in US dollars, Israeli sheqalim, and Jordanian dinar) as a function of its lag, the change in the interest rate on each currency, the change in the sheqalim-dollar exchange rate, and the change in the sheqalim-euro exchange rate, as follows:39

Table 8.

Determinants of Fluctuations in Money Demand

article image
**10 percent significance

5 percent significance

Method of estimation is OLS. Serial correlation is corrected using heteroscedasticity consistent standard errors.

Variable key:

DL

DL before each variable is the first difference of the log of that variable

DLD

total deposits as valued in US$ by the Palestinian Monetary Authority and composed of Israeli sheqalim, Jordanian dinar and US dollar deposits

DLNIS$EX

Israeli sheqalim to US Dollar exchange rate

DLNI$€EX

Israeli sheqalim to the euro exchange rate

DLRJDD

nominal interest rate on deposits in JD

DLR$D

nominal interest rate on deposits in US dollar

DLRNISD

nominal interest rate on deposits in NIS

DLDt=F(DLDt1,DLRJDDt,DLRJDDt1,DLR$Dt,DLR$Dt1,DLRNISDt,DLRNISDt1,DLNIS$EXt,DLNIS$EXt1,DLNISEuroEXt,DLNISEuroEXt1)(6)

All coefficients in the empirical model are statistically insignificant. Money demand appears stable in the face of various shocks to the exchange rate and the interest rate.40 Also Figure 3 above illustrates developments in total deposits and deposits in each of the three currency denominations. In general, deposits appear to be stable over time, except for sheqalim deposits in 2000, which marked the start of the second Intifada. As agents were panicking, they perceived deposits in sheqalim as the easiest to access cash transactions, which are predominantly in sheqalim. This phenomenon was temporary as the peak lasted during the second and third quarters of 2000. It is likely that the economy would remain dollarized even if a new currency is introduced. The credibility of the new currency would require initially flexibility to exchange the three existing legal tenders for the new currency at a fixed rate. Absent evidence of unstable money demand in the face of exchange rate shocks, exchange rate flexibility may not adversely affect the stability of the money demand function. More importantly is to gradually develop confidence in underlying economic fundamentals and prudent policies that support credibility of the new currency and reduce incentives for dollarization.

IV. Conclusions

The analysis in the paper has provided fresh empirical evidence that sheds light on the characteristics of the Palestinian economy and unveils interesting implications for the choice of the exchange rate regime following the introduction of a national currency. Previous studies have argued in favor of a currency board arrangement on the grounds that this would be the only arrangement that would bestow the new currency with the needed credibility for the Palestinian public to accept it quickly. Nonetheless, the risk of misalignment of the exchange rate under such an arrangement poses a real threat. Would a fixed rate be consistent with the structure of the Palestinian economy and the likely shocks to which it would be subject? Our analysis has evaluated the evidence of potential risk against the advantages of fixing the exchange rate.

We found that several characteristics suggest that the Palestinian economy would benefit more from exchange rate stability (rigidity) than from monetary independence. In introducing a new currency, the primary objective is to establish its credibility, so that people will hold it willingly. Stability in the exchange rate is an important contributor to credibility; hence the advantages of a fixed exchange rate. Moreover, a fixed exchange rate regime would provide an anchor for monetary policy and inflationary expectations. Since the economy is open, with a high share of imports in the Palestinian consumption basket, exchange rate stability would clearly be an option for achieving price stability.

Institutional capacity for both fiscal and monetary policy argues for simpler and stricter choices of exchange rate rigidity such as a transparent peg. The PMA has struggled to exert its influence and has yet to establish a solid reputation and build up sufficient capacity to fully supervise the banking sector. Accordingly, the PMA’s autonomy is questionable as it remains, for the time being, under the control of the budget-constrained Palestinian Authority (PA).

The high level of dollarization of deposits in the banking system may signal the need for a fixed exchange rate of the new currency relative to the dollar to maintain stability of money demand and reduce pressure on the limited international reserves. However, in order for the PMA to assume a LOLR role, foreign exchange reserves would need to be in excess of the monetary aggregates backed. Given the current level of dollarization or transactions in sheqalim, adopting either currency might seem attractive. However, neither offers seigniorage or LOLR facilities.

Despite plausible arguments in favor of a fixed exchange rate regime, key characteristics of the Palestinian economy may favor exchange rate flexibility. First is the issue of fiscal discipline. Credibility cannot be maintained without fiscal discipline, which is necessary for financial and nominal stability regardless of the exchange rate regime. Nonetheless, the PA has a limited track record, and it is by no means assured that it will continue to adhere to this; particularly if foreign assistance to finance the budget continues to fall behind or if the transfer of revenues collected by Israel is threatened (by a change in the customs union agreement with Israel). Failure to maintain fiscal discipline under potential structural shocks that lie ahead would increase the risk of misalignment under a fixed exchange rate system. Moreover, under a flexible exchange rate system, the fiscal imbalance will be transparent; in contrast, it might be disguised under a fixed exchange rate system absent market signals and adequate information on the level of international reserves. Such transparency would increase pressure on the PA to maintain fiscal discipline and increase confidence in the stability of the new currency under a flexible exchange rate system.

Second, a question would remain as to which foreign currency the domestic currency should be pegged, the U.S. dollar or the currency of one or more neighboring countries (probably the sheqalim or the euro, since the dinar is less important and is pegged to the dollar). Only limited information is available regarding the composition and direction of trade. Further, trade through Israel dominates the current trade pattern, with a large part of exports is re-exported to other countries and a large part of imports is from outside Israel. Fixing the exchange rate against the U.S. dollar may result in a real appreciation over time against neighboring countries (particularly in the euro area), adversely affecting export competitiveness. Fixing against the currencies of neighboring countries (i.e., the sheqalim or the euro) could adversely affect stability—since the sheqalim has fluctuated a great deal over the last few years. Imports are highly dependent on the sheqalim real effective exchange rate, and domestic substitutes are not available for imported inputs. Consistently, there is evidence that export growth is adversely affected in the face of an appreciation in the sheqalim real effective exchange rate. Fixing against a basket of currencies would imply that the national currency would still move against individual currencies, losing the stability and simplicity of a peg against a single currency.

Third, the economy will likely undergo large structural changes should reconstruction take hold after more than 50 years of conflict. On the one hand, this would be accompanied by large foreign exchange inflows, from both donors and repatriation of funds by Palestinians, which may cause the real exchange rate to appreciate. On the other hand, given political instability, capital outflows, may pose a serious risk of real depreciation. At the present time, it would be very difficult to form any firm idea as to what the appropriate exchange rate level would be in a fixed regime.

Fourth, the vulnerability of the banking system to incipient runs could increase should the PMA not fully assume the role of LOLR. This risk would be larger in a country such as the WBG with weak banking supervision. The fragility of the banking system along with the limits and vulnerability of international reserves call for flexibility. Foreign exchange reserve losses could be large should the need to defend the currency against speculative attacks arise. While the inflow of remittances and foreign aid may strengthen the ability of the PMA to defend the peg, cyclical disturbances in these flows and the risk of outflows may threaten the sustainability of the peg.

Fifth, the economy is very vulnerable to shocks, both external and domestic. These shocks include inter alia trade and labor market shocks and political instability. Under a fixed regime, labor and products markets would need to have a high degree of flexibility to absorb such shocks. While the evidence indicates some short-term flexibility in nominal magnitudes, it is unclear whether product and labor markets have sufficient degrees of flexibility to absorb the potentially very large shocks and structural changes in the ensuing period. Moreover, a substantial degree of downward wage rigidity persists. The real wage, in general, is rigid in the face of a variety of domestic and external shocks, and average wages have remained remarkably stable despite soaring unemployment rates. Persistent unemployment would benefit from some exchange rate flexibility.

On balance, the current economic conditions appear to favor a floating exchange rate regime over time. In the near term, however, the credibility arguments should dominate the choice of the exchange rate for a new currency. Therefore, a fixed exchange rate (maybe even a hard peg) is a good way to start off. All four currencies-the U.S. dollar, sheqalim, dinar as well as a newly introduced national currency-could, in principle, circulate for a predetermined interim period until all of them, bar the national currency, are redeemed. Such redemption should develop voluntarily over time as the public becomes increasingly confident in the credibility of the new currency. The authorities would have to announce a redemption commitment while adhering to a fixed exchange rate system to avoid speculative attacks. Monetary policy may be used in the short run to keep the exchange rate in line with the objectives of gaining credibility for the newly introduced national currency.

However, several major issues would need to be addressed before a move to a fixed-type regime could be made: the authorities would first need to have (i) a track record of fiscal discipline, (ii) a better understanding of the appropriate anchor currency and the exchange rate level, (iii) a strong international reserve position, and (iv) demonstrated ability of the monetary authority to supervise and regulate the banking sector.

Once the credibility of the national currency is established and the economy has undergone structural changes inherent in the resettlement and reconstruction process, the choice of the exchange rate system can be revisited. A move toward more flexibility should be preceded by a thorough evaluation of the adequacy of the institutional capacity to manage an independent monetary policy. With technical assistance, countries have managed to build up capacity relatively quickly in order to manage a quantified monetary program and to set up foreign exchange auctions.

Setting the Stage for a National Currency in the West Bank and Gaza: The Choice of Exchange Rate Regime
Author: Ms. Magda E. Kandil and Ms. S. Beidas