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1 Recent Developments in the Palestinian Economy

Author(s):
International Monetary Fund
Published Date:
August 2001
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Author(s)
Ulric Erickson von Allmen

The turmoil that erupted in the fall of 2000, and the closures that followed, have caused a sharp decline in economic activity in the West Bank and Gaza, not only dashing the prospects of a fourth consecutive year of rising per capita income but also rolling back most of the gains made in the previous three years. The shock is the worst experienced by the Palestinian economy in 30 years. Up until the crisis, the Palestinian economy was enjoying fairly solid economic growth and some positive policy developments had taken place with the Palestinian Authority (PA) making progress in improving economic governance. The fragile fiscal situation before the crisis—mainly because of weak expenditure control—worsened considerably in the aftermath of closures and turmoil.

This chapter provides an overview of recent economic developments, with a focus on macroeconomic developments and policies in 1999–2000. The overview is brief and issues will inevitably be glossed over, but many of them are dealt with in greater detail in subsequent chapters.1 The chapter is divided into two parts.

The first part discusses economic and policy developments up until the crisis, and the second part discusses the turmoil and closures and the outlook for 2001. For completeness, the first part will in some places provide data for 2000 as a whole, but the specific discussion of how the closures and turmoil have affected the Palestinian economy is reserved for the second part. The chapter also discusses policy issues in those areas, such as money and banking, that are not discussed at length in subsequent chapters.

Macroeconomic and Policy Developments Before Crisis

Economic Developments

Before the turmoil that began in late September 2000, the Palestinian economy was benefiting from relative political stability and reasonable optimism regarding the future.2 It was set to enjoy its fourth consecutive year of positive per capita income growth, even though growth had decelerated from its peak in 1998 as the recovery effects from the recession in 1995–96 (also induced by closures) petered out. In 2000, the gross domestic product (GDP) was projected to grow at about 5 percent and gross national income (GNI) at 4.5 percent, both in real terms (Table 1.1).3 While these growth rates would have allowed per capita income to rise, they were nonetheless well below the historical average for the Palestinian economy and also below the growth rates required to ensure a reduction in unemployment at growing real wages over the medium term (see Chapter 2).4 Also, despite the recovery, the Palestinian economy had not recuperated the loss in output in 1995–96, as most clearly seen in the output per worker ratio in Figure 1.1.

Table 1.1Selected Macroeconomic Indicators, 1994–2001
199419951996199719981999Proj.

2000a
Proj.

2000b
Proj.

2001
Real GDP growth18.5-2.4-3.24.87.06.05.0-1.5-4.0
Real GNI growth10.9-4.3-4.67.611.97.24.5-4.9-12.9
Real GNI per capita growth1-4.9-9.6-9.03.47.73.30.8-8.3-16.0
Consumer price inflation (year-on-year)114.010.08.47.65.65.53.22.82.4
Unemployment rate214.818.223.820.613.211.810.014.129.1
Nominal GDP (NIS millions)10,214.310,854.311,571.013,205.414.901.217,473.118,864.717.535.017,138.4
Sources: IMF staff estimates and projections based on data from the Palestinian Central Bureau of Statistics.Note: 2000a refers to the IMF staff projection made before the onset of the crisis: 2000b are the revised projections. The difference between 2000a and b is not entirely due to the effects of the crisis, but also reflects updated information. This is particularly the case for inflation. The projection for 2001 assumes that closures and turmoil end in the second part of the year

Change in percent from previous year.

In percent of labor force, annual average.

Sources: IMF staff estimates and projections based on data from the Palestinian Central Bureau of Statistics.Note: 2000a refers to the IMF staff projection made before the onset of the crisis: 2000b are the revised projections. The difference between 2000a and b is not entirely due to the effects of the crisis, but also reflects updated information. This is particularly the case for inflation. The projection for 2001 assumes that closures and turmoil end in the second part of the year

Change in percent from previous year.

In percent of labor force, annual average.

Figure 1.1Output Per Worker, 1970–99

(1970=100)

Sources: IMF World Economic Outlook database: and IMF staff calculations.

1 Trend computed with HP filter for 1970–93, and extrapolation through 1999.

The economic expansion is most clearly evidenced in the labor market data from the Palestinian Central Bureau of Statistics (PCBS): the unemployment rate fell to 10 percent in September 2000, from 11.6 percent one year earlier and from over 28 percent in the first quarter of 1996 (Table 1.2 and Figure 1.2).5 It is significant that this sharp decline in unemployment was accompanied by an increase in the average labor force participation rate, a fall in underemployment, and a rise in real wages (in the West Bank). The unemployment rate has been lower in the West Bank than in the Gaza Strip throughout the period (7.5 percent versus 15.5 percent in September 2000) and real wages have grown considerably faster (Figure 1.2). The decline in the unemployment rate from its peak in 1996 was mostly on account of a strong recovery in the number of Palestinians working in Israel, but there was also significant, albeit uneven, job growth in the Palestinian private sector (Table 1.3). Out of total employment creation in the period March 1996–September 2000, employment in Israel and the settlements accounted for 43 percent, the private sector in the West Bank and Gaza for 34 percent, and the PA for 23 percent.6 Although PA employment did not constitute the most important source of employment creation, its growth has been very high from a fiscal perspective and has become a major burden on the budget (see below).

Table 1.2Palestinian Labor Market Developments, 1994–2000
1994199519961997199819992000 1

Q3
20001

Q4
(In thousands)
Labor force464485522554576599637615
Employment2394397398439500S29573441
Unemployment37088124114767164174
In percent of the labor force1518242113121028
Palestinian employment by sector2394397398439500529573441
Agriculture89496059616773
Construction102756480110118124
Manufacture60716772808286
Commerce69989210611511498
Other services75105115122134148192
Employment in Israel and the settlements7164567510812212740
Agriculture8968IIIIII
Construction47282941616970
Manufacture512910131618
Commerce710811151617
Other services464481010
Employment in the West Bank and Gaza323333342364392406447401
Agriculture81405351505661
Construction55473539494954
Manufacture55585961676668
Commerce62888495999781
Other services7099111118127138182
PA employment43152708191100112115
(Annual change in percent)
Unemployment141.826.240.6-8.0-33.5-7.0-1.217.3
Employment-1.90.80.110.513.8S.77.4-20.7
Palestinian employment in Israel and the settlements-33.5-9.4-12.834.044.312.70.7-13.6
Employment in the West Bank and Gaza9.53.02.66.67.63.86.7-7.2
PA employment4n.a.66.234.316.411.910.02.70.3
Memorandum item:
Private sector employment in the West Bank and Gaza5292.1281.0272.1283.2301.1306.7334.0286.0
Change in percentn.a.-3.8-3.24.16.31.93.9-7.5
Sources: Palestinian Central Bureau of Statistics, and IMF staff estimates.

The change in percent is from September and December 1999, respectively.

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

Excludes workers no longer seeking a job due to discouragement.

Central government only.

Includes employment in local authorities and public enterprises.

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

The change in percent is from September and December 1999, respectively.

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

Excludes workers no longer seeking a job due to discouragement.

Central government only.

Includes employment in local authorities and public enterprises.

Figure 1.2Selected Economic Indicators

Sources: Palestinian Central Bureau of Statistics (PCBS), UNSCO, PCBS, and IMF staff estimates.

1 No data available for September 1997.

Table 1.3Composition of Labor Force Growth, 1994–2000(In percent of previous year’s labor force)
1994199519961997199819992000

Sep.1
2000

Dec. 2
Labor force784.6736.14.14.03.0-0.2
Unemployment9.54.07.4-1.9-6.9-0.9-1.318.2
Employment-1.70.60.18.011.05.04.3-18.5
Israel-8.3-1.4-1.73.76.02.40.7-13.9
West Bank and Gaza6.52.11.84.35.02.63.6-4.6
PA4.43.72.21.71.62.41.8
Private-2.4-1.82.13.21.01.2-6.4
Source: IMF staff estimates based on data from the Palestinian Central Bureau of Statistics.

Change from September 1999.

Change from December 1999.

Source: IMF staff estimates based on data from the Palestinian Central Bureau of Statistics.

Change from September 1999.

Change from December 1999.

The economic expansion is also reflected in PA fiscal revenue, bank deposits and bank credit. In 1997–99, fiscal revenue increased by an average of 17 percent a year in nominal terms, rising from 19 percent of GDP in 1996 to 23 percent of GDP in 1999. In the first nine months of 2000, fiscal revenue growth decelerated to 12 percent due to a combination of factors (discussed below), one of which was the slowdown in economic growth (Tables 1.4 and 1.5).7 Similarly, bank credit to the private sector (in dollar terms) increased by 22 percent a year on average in 1997–99 (from 11 percent of GDP at end-1996 to 22 percent of GDP at end-2000), while private sector deposits in the banking system (also in dollar terms) expanded by 15 percent on average in that same period (from 39 percent of GDP at end-1996 to 77 percent at end-2000) (Figure 1.3 and Table 1.6). In the twelve-month period that ended September 2000—that is, up until the crisis—bank credit rose by 29 percent and bank deposits by 37 percent, both in dollar terms. In all, these brisk growth rates over the past few years in fiscal revenue and monetary aggregates reflect improvements in tax administration (through 1999), the continued process of financial re-intermediation, as explained in Palestinian Authority (2000), and the dynamism in economic activity in that period.

Table 1.4Fiscal Operations of the Palestinian Authority, 1996–2000(In millions of NIS)
199619971998Jan.-Sep.

1999
1999Voted

Budget

2000
Prel.

Jan.-Sep.

2000
Prel.

2000
Revenue12,1852,8483,2802,9034,0934,0683,0713,806
Domestic8461,1361,2201,0871,5081,1621,422
Tax5717288527651,037783970
Nontax274408368322472379452
Revenue clearance1,3391,7122,0601,8162,5841,9092,384
Current expenditure (on a commitment basis)2,6472,9943,1882,6423,9023,9683,6014,891
Wage bill1,2861,6221,7741,5602,1472,3711,8582,537
Nonwage1,2041,3521,4121,0651,7321,5971,7432,354
Foreign financed157202172300
Recurrent balance (commitment basis)-462-14692261191100-530-1,085
PA financed capital expenditure000001003055
Recurrent balance plus PA financed capital expenditure (commitment basis)-462-146922611910-560-1,140
Change in the stock of arrears018288-96420254268
Recurrent balance plus PA financed capital expenditure (cash basis)-462-1283801652330-307-872
Foreign financed capital expenditure7739058965529911,6881,0431043
Overall balance (cash basis)-1,235-1,033-516-387-758-1,688-1,349-1,915
Financing required1,2351,0335163877581,6881,3491,915
Financing available1,4528617916026602,5352,263
Borrowing from the banking system, net 2255-18321362-2901,4721,107
Foreign financing1,1971,0439077611,0141,0431,043
Net revenue diversion-329-221-3250-138-138
Excise revenues diverted4375485984616160203203
Excise revenue transferred back26924029006565
Financing from purchase tax advances (net)00000015929
Exceptional financing from EU000000098
Exceptional financing from Arab states0000000123
Residual-274980-1,186-348
Memorandum items:
Stock of expenditure arrears (excluding arrears on VAT refunds)0.018.0305.92103348.00.0601.8616.0
PA employment (thousands, end-of-period)75.083.192.497.6103.6103.0112.7114.9
Revenue, in percent of GDP18.921.622.023.421.621.7
Recurrent expenditure, in percent of GDP 322.922.721.422.321.027.9
Of which: Wage bill11.112.311.912.312.614.5
Recurrent balance, in percent of GDP3-4.0-1.10.61.10.5-6.2
Overall balance, in percent of GDP4-10.7-7.8-3.5-4.3-8.9-10.9
Sources: Palestinian Authority and IMF staff estimates.

For the 2000 budget, net of VAT refunds estimated at NIS 150 million in the budget Includes revenues transferred to accounts outside the control of the Ministry of Finance, prior to the consolidation of revenues.

The institutional coverage of the monetary accounts is broader than that of the budget.

Commitment basis. In percent of annual GDP

Cash basis.

Sources: Palestinian Authority and IMF staff estimates.

For the 2000 budget, net of VAT refunds estimated at NIS 150 million in the budget Includes revenues transferred to accounts outside the control of the Ministry of Finance, prior to the consolidation of revenues.

The institutional coverage of the monetary accounts is broader than that of the budget.

Commitment basis. In percent of annual GDP

Cash basis.

Table 1.5Fiscal Revenue Structure of the Palestinian Authority, 1996–2000
19961997199819992000
(In millions of NISI)
Total Revenue2,1852,8483,2804,0933,806
Domestic tax revenue5717288521,037970
Income tax168228260310278
VAT210259306372373
Customs duties737692150106
Property tax32266
Excises117164192199207
Other taxes00000
Revenue clearances 11,3391,7122.0602.5842.384
Taxes on imported goods22774957821,0901,048
VAT691747768966824
Petroleum excises320384406417380
Income tax1318352630
Health fees2028353629
Other clearances1940334972
Nontax revenue274408368472452
Transportation fees72112110117117
Health insurance4044558375
Health fees3035393840
Other132217164234220
Memorandum items:(In percent of revenue)
Domestic tax revenue2626262525
Revenue clearances6160636363
Nontax revenue1314111212
Sources: Palestinian Authority, Ministry of Finance in Israel, and IMF staff estimates.

For 2000, the structure is based on the composition of clearance revenue In January–October.

Including VAT and purchase tax on imported goods.

Sources: Palestinian Authority, Ministry of Finance in Israel, and IMF staff estimates.

For 2000, the structure is based on the composition of clearance revenue In January–October.

Including VAT and purchase tax on imported goods.

Figure 1.3Credit and Deposit Ratios in the West Bank and Gaza and Comparator Countries

(End-1999;in percent)1

Source: Palestinian Monetary Authority (PMA); IMF, World Economic Outlook database: International Financial Statistics; and IMF staff estimates.

1 2000 for the West Bank and Gaza.

Table 1.6Consolidated Banking System Data, 1996–2000
1996

Jan.
1996

Dec.
1997

Dec.
1998

Dec.
1999

Mar.
1999

Sep.
1999

Dec.
2000

Mar.
2000

Sep.
2000

Oct.
2000

Nov.
2000

Dec.
2001

Feb.
(In millions of U.S. dollars; balances at end-of-period.)
Net foreign assets1,0121,3751,4851,6691,7021,9381,9722,0742,3882,2992,3012,3132,334
Central bank087109182193178184199285286268275282
Commercial banks1,0121,2891,3761,4871,5091,7611,7881,8752,1032,0132,0332,0372,052
Net domestic assets1871263315476076236437271,118829864962968
Net claims on the non-financial public sector-27-184-167-75-49-71-1032426679116235278
Net claims on the PA-35-44-97-41-20-26-49731355101223311
Deposits3862176136138138157134107119121120103
Loans319793457363778668688100132
Overdraft000616276716435488134243282
Net claims on local government-12-21-24-17-14-13-13-17-16-14-13-12-16
Deposits12212417141313171614131216
Loans0000000000000
Overdraft0000000000000
Net claims on nonfinancial public enterprises20-119-46-17-16-31-4234-31382824-16
Deposits01235121193548395753606478
Loans202321133355555
Overdraft0222223402086838356
Credit to the private sector2514095637337808319138951,074984970927926
Loans20128191299326372402374474447442416394
Overdraft[96252324381398400453447519454446429446
Other34294854575957738282828285
Other items (net)-37-99-65-112-123-137-167-192-223-234-222-200-236
Liabilities to the private sector1,1991,5011,8152,2162,3092,5612,6152,8013,5063,1283,1663,2743,302
Demand deposits485543605638685673715868771735808757
Time and savings deposits1,0171,2731,6111,6711,8761,9422,0862.63723572,4312,4662,545
Memorandum items:
(In percent)
Currency composition of deposits 1100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0
U.S. dollars34.339.344.660.662.161.062.462.457.262.162.061.762.6
Jordan dinars44.742.338.425.423.424.423.723.921.022.722.221.621.7
New Israeli shequels19.717.615.813.313.713.913.012.720.613.913.814.914.7
Other1.30.81.20.70.80.80.91.01.21.31.91.91.0
Currency composition of credit1100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0
U.S. dollars35.222.632.942.542.950.652.652.557.356.957.958.242.3
Jordan dinars53.745.532028.529.226.823.423.421.521.921.221.730.0
New Israeli shequels11.131.834.027.426.921.022.223.220.020.220.019.026.9
Other0.00.11.11.61.01.51.70.81.21.11.01.10.7
Credit to the private sector as a share of total deposits20.927.231.033.133.832.434.931.930.631.530.628.328.0
Source: Palestinian Monetary Authority.

Private sector only.

Source: Palestinian Monetary Authority.

Private sector only.

Economic growth since 1997 appears to have been fairly broad, although labor market data suggest that the construction and commerce sectors (retail and wholesale trade, hotels, and restaurants) were the main sources of economic growth. Construction investment was not only driven by the need to improve the infrastructure but also from rising housing demand from the rapidly growing population. In 1996–99 there was also substantial investment in the tourism industry with the number of hotels in the West Bank and Gaza increasing by almost 50 percent between early 1996 and late 1999 and by another 25 percent in the first nine months of 2000 (see Figure 1.2). The booming investments in the tourism industry in 1999 and 2000 is further testimony to the sense of optimism that prevailed in that period. Data on external sector developments are scant, but both exports and imports of goods and services appear to have grown quite strongly in 1999 and in early 2000.

Consumer price inflation has been low in the West Bank and Gaza over the past two years (Table 1.7). The consumer price index (CPI), which is measured in new Israeli shequel terms, rose by only 0.6 percent during 2000, compared with 2.5 percent in 1999, down from almost 10 percent in 1998. Inflation in the West Bank and Gaza follows that of Israel—as is clear from Figure 1.4—where inflation decelerated in 2000 on account of the slowdown in the economy, high interest rates, and the appreciation of the shequel (the upper left panel of Figure 1.4). The reduction in the purchase tax in Israel on certain consumer goods in the summer of 2000 has also had a (one-time) downward impact on the CPI both in Israel and the West Bank and Gaza.

Table 1.7Consumer Price Developments, 1997–2000(Twelve-month change in percent)
1997

Dec.
1998

Dec.
1999

Mar.
1999

Jun.
1999

Sep.
1999

Dec.
2000

Mar.
2000

Jun.
2000

Sep.
2000

Dec.
2001

Mar.
CPI8.99.78.36.83.62.53.33.83.40.60.7
Excluding food7.56.57.47.15.54.14.94.43.52.71.4
Food2.214.59.66.41.00.21.02.93.4-2.7-0.4
Beverages and tobacco5.412.19.89.38.23.63.93.72.5-0.10.2
Textiles, clothing and footwear14.84.53.61.3-1.60.52.63.63.90.3-1.5
Housing5.27.18.28.25.56.412.48.58.66.0-0.1
Furniture and household goods and services10.07.69.08.97.22.7-0.3-1.8-2.2-4.2-3.9
Transport and communication5.42.77.510.69.910.28.56.95.011.29.3
Education2.74.34.43.91.83.54.15.24.60.12.0
Medical care8.76.86.66.29.14.23.02.20.80.81.3
Recreational and cultural goods and services7.64.6-2.8-6.0-11.012.8-9.6-7.1-7.4-7.5-1.3
Miscellaneous goods and services4.711.511.710.26.82.56.89.06.22.8-0.5
Memorandum item:
Israel CPI (12-month change) percent6.88.67.05.95.41.30.71.8-0.50.40.7
Sources: Palestinian Central Bureau of Statistics, Israel Central Bureau of Statistics, and IMF staff calculations.

Average monthly change in the CPI in the year of 1997, and for the respective quarters thereafter. For October 1999 and 2000, it is the percentage change in CPI from the previous month.

Sources: Palestinian Central Bureau of Statistics, Israel Central Bureau of Statistics, and IMF staff calculations.

Average monthly change in the CPI in the year of 1997, and for the respective quarters thereafter. For October 1999 and 2000, it is the percentage change in CPI from the previous month.

Figure 1.4Consumer Price and Exchange Rate Developments, 1997–2001

(Change in percent)

Source: PCBS; ICBS; Bank of Israel: IMF, International Financial Statistics, and IMF staff estimates and projections.

Economic Policies

Progress in economic policy reforms over the past seven years has been episodic and uneven. While the PA has made considerable progress overall in establishing a functioning economic administration, basically from scratch, much of the progress was achieved in the first years after the PA’s creation in 1994 when key policy institutions such as the Ministries of Finance, Planning, and Economy and Trade, and the Palestine Monetary Authority (PMA) were established and several important laws were approved, for example, the Organic Budget Law, the PMA Law, and the Company Law. More recently, the pace of reform has slowed down, despite considerable technical assistance provided by donor countries and international institutions. A case in point is the management of public finances. The PA has made good progress in tax administration, as evidenced by the growth in domestic tax collection, but it has proved difficult to achieve even modest improvements in expenditure management, as witnessed by regular expenditure overruns, arrears accumulation, and a deterioration in the composition of expenditure. Similarly, progress in reforming the legal and regulatory framework, including bank supervision, has generally been slower than warranted. The authorities’ lack of resolve with respect to some reforms has contributed to this outcome, but equally important, if not more so, is the virtually unique setting of the West Bank and Gaza, including its physical separation, political turmoil, multiplicity of jurisdiction, and lack of government experience. The slow progress in reforms in recent years should not, however, overshadow the fact that the PA has come a long way in the span of only seven years and under quite exceptional circumstances.

In late 1999 and in the spring of 2000, there seemed to be an important change in the PA’s policy orientation, with more priority given to economic policy issues, including governance. A Higher Council of Development was established in January to oversee and improve coordination of economic policy across PA institutions, and important measures were taken that improved economic governance. These improvements in economic policy management took place in the context of the PA’s elaboration of an economic policy framework with the assistance of IMF staff.

The Economic Policy Framework

In October 1999, at the meeting of the Ad Hoc Liaison Committee (AHLC) in Tokyo, President Arafat requested IMF staff assistance in developing and monitoring a comprehensive medium-term economic policy framework (EPF). The overall objective of the EPF was to help ensure that the economic policies pursued by the PA over the coming years would make a positive and significant contribution to overcoming the challenges facing their economy (see Chapter 2). Because of the still limited administrative and technical capacity of the PA, the EPF would initially concentrate on the most pressing matters, namely, the urgent need to enhance fiscal management and governance in the PA’s financial operations, improve banking supervision, and strengthen the legal and regulatory framework—all essential areas to create better conditions for private investment. In order to send a credible signal of a shift in policy orientation, the PA intended to take the following upfront actions before launching the EPF: (i) consolidation of all tax revenue under the control of the Ministry of Finance, and a commitment to transfer unretained profits from the PA’s commercial operations to the budget; (ii) transfer of the effective control of the Gaza payroll from the Gaza Personnel Council (GPC) to the Ministry of Finance (as is the case for the West Bank payroll); (iii) parliamentary approval of the budget for 2000 as submitted by the Ministry of Finance together with an upfront reduction in budgetary arrears; and (iv) inclusion in the EPF document of adequate information on the PA’s commercial operations.

These measures would address the factors that have most seriously impaired the management of public finances in the past: the uncontrolled expansion of PA employment and the diversion of excise revenue on tobacco, liquor, and petroleum to accounts outside the control of the Ministry of Finance. Revenue diversion is estimated to have totaled approximately US$160 million in 1998 and 1999, roughly 9 percent of total PA fiscal revenue in that period.8 PA employment growth has been excessive in the sense that, since 1997, it has been significantly higher than can reasonably be justified by increases in the range or quality of the PA’s services.9 Excessive growth in civil service employment has been particularly problematic in Gaza where the payroll has been the responsibility of the GPC, in direct contrast to what the Organic Budget Law stipulates. GPC operates without any regard for the PA’s budget constraint. In the early years, the negative effects on the budget from the PA’s employment growth were masked by the strong increase in tax revenue. Revenue regularly overshot the budget forecast, but in the last two years, as revenue stabilized, it has prevented the PA from spending adequately on nonwage recurrent expenditure (including operations and maintenance) and from making a domestic contribution to the development budget. It has also contributed to the accumulation of budgetary arrears (mostly to suppliers) and more general concerns over governance. The rapid expansion in PA employment has also made it very difficult for the PA to afford adequate remuneration of its staff.

The PA has made important progress with respect to the remaining upfront actions. First, the budget for 2000 was submitted to and approved by the Palestinian Legislative Council (PLC) in a timely manner. It represented an important break from the past since it was prepared in a medium-term macroeconomic framework as well as being fully financed, albeit under the critical assumption that the stock of arrears would be eliminated using previously diverted excise revenue.10 An effort was also made to better integrate the recurrent and development budgets, although more is needed in this area. The budget targeted a surplus on the recurrent balance equal to 0.5 percent of GDP, which would allow a domestic contribution to public investment for the first time. Second, in April 2000, the PA ended the long-standing practice of diverting the excise revenue mentioned above to accounts outside the budget, a measure that improved budget management and governance. Third, the Palestinian Commercial Services Company (PCSC)—the PA’s main vehicle for investments and commercial operations—was audited and the results were made public. Furthermore, the PA began preparing new structures for managing its financial assets to ensure transparency and accountability, and began developing a comprehensive privatization strategy.

There was no reduction in the stock of budgetary arrears carried over from 1999, however, and the control of the Gaza payroll was not transferred to the Ministry of Finance (and has not been to date). Also, the expansion in PA employment, rather than slowing down, actually accelerated in late 1999 and 2000, contributing to a major deterioration in the fiscal situation. Under these circumstances, it was not possible to launch the EPF at the AHLC meeting in Lisbon in June 2000. Instead, a status report on the discussions of the EPF was presented (Palestinian Authority, 2000).

Fiscal Policy

Since its creation in 1994, the PA has been successful in increasing revenue collection, which reached 22 percent of GDP in 2000 from less than 8 percent of GDP in 1994 (see Table 1.4). In the first nine months of 2000, the growth in PA revenue slowed to 6 percent (12 percent if adjusted for a one-time early transfer of clearance revenue in December 1999 instead of January 2000), broadly in line with the projection in the 2000 budget and reflecting, among other things, the full effect of the tax reform in 1999 (see below), the slowdown in the economy, more adequate refunding of VAT (which is netted out of revenue), and increased use of tax incentives granted under the Law on the Encouragement of Investment (1998). For 2000 as a whole, though, revenue declined (by 6 percent) because of the negative effects on the tax base from closures and turmoil in the fourth quarter and on the PA’s ability to collect taxes (discussed in more detail in the third section of this paper). The revenue from the clearance system—that is, revenue collected by the government of Israel on behalf of the PA—continued to account for more than 60 percent of revenue in 2000 (see Table 1.5).

Recurrent expenditure (on a commitment basis) hovered at 21–22 percent of GDP between 1996 and 1999, up from less than 9 percent of GDP in 1994, but it increased sharply in 2000. In the first nine months of 2000, recurrent expenditure increased markedly (30 percent), because of the strong growth in the wage bill, but also because of very rapid expansion in nonwage expenditure in the second and third quarter of the year. The latter expansion coincided with an improvement in the liquidity situation of the Ministry of Finance following the consolidation of tax revenue in April and the transfer of an advance on purchase tax from Israel in June (the recurrent budget showed a surplus for that period, despite the growth in spending).11 For the year as a whole, recurrent expenditure (on a commitment basis) increased by 25 percent in nominal terms, compared with the 2 percent growth envisaged in the budget. Recurrent expenditure on a commitment basis equaled 28 percent of GDP in 2000, compared with 22 percent in 1999. PA employment increased to 115 thousand persons at the end of 2000, from less than 104 thousand one year earlier (see Table 1.4).

A major fiscal policy achievement by the PA since 1996 is the turnaround in the recurrent budget balance (on a commitment basis) to a surplus of roughly 1 percent of GDP in 1999 from a deficit equal to 4 percent of GDP in 1996. This turnaround was prompted by the phasing-out of general budgetary support provided by donors—since 1998, no such support has been provided until the latest crisis—and it was made possible by the strong growth in revenue together with some constraint in overall recurrent expenditure. In 2000, because of the very strong growth in recurrent expenditure and the decline in revenue in the fourth quarter, the recurrent balance (on a commitment basis) is estimated to have shown a deficit equal to 6.2 percent of GDP. At the end of 2000, the stock of budgetary arrears stood at about US$155 million, or 3.6 percent of GDP, up from 2 percent of GDP at the end of 1999.

The evolution of the overall fiscal deficit balance has broadly mirrored that of the recurrent balance, and averaged about 6–7 percent of GDP in 1994–99, although the data on donor-financed investment are weak (see Box 1.1). In 2000, the overall fiscal deficit widened to an estimated 11 percent of GDP, which was financed by donors, including through a resumption of general budgetary support, and through heavy borrowing from the domestic banking system. The PA’s loans and overdraft with the banking system rose to 8 percent of GDP at the end of 2000, compared with 2.5 percent one year earlier.12

Structural reforms in the fiscal area in the past few years have focused on tax administration, expenditure management, and treasury operations. As mentioned, important progress was made in the preparation of the 2000 budget, but more needs to be done to integrate development expenditures. Further progress is also needed in the area of budget implementation and treasury operations. For example, it is important that financial pay orders be based on cash flow projections and that the number of officials who exercise discretionary control over payments be reduced. Budget management would also improve with better reconciliation of revenue and expenditure data and budget financing, the establishment of a system for detecting and monitoring the accumulation of budgetary arrears, and with better collaboration between the Treasury and Budget departments. On the revenue side, income tax rates were reduced by a presidential decree on January 1, 1999, as envisaged in the draft income tax law dating back to 1997, which has yet to be approved by the PLC (see Table 1.8). The tax base was also broadened to some 70,000 taxpayers in 1999. Progress with reform in other areas of tax administration has been delayed, since the reform measure required a significant departure from the existing management of tax administration. In particular, the current tax administration with its separate field offices and different directors, tends to increase the cost of administering the tax system and to undermine the objectives of improving taxpayers’ compliance and increasing revenue collection. Outstanding tax arrears are estimated to equal roughly 9 percent of GDP.

Table 1.8Income Brackets and Tax Rates
Income Brackets and Tax Rates in 1995–98
The Annual Taxable income by NIS
No.FromToRate
114,2005%
24.20110,50010%
310.50116.80015%
416,80129,40020%
529,40150,40030%
650,40184,00035%
784,001147,00040%
8147,001and above48%
The corporate tax rate was 38.5 percent in the West Bank and 37.5 percent in Gaza.
Income Brackets and Tax Rates After the Reform in 1999
The Annual Taxable income by NIS
No.FromToRate
1127,5005%
227,50166.00010%
366,001110,00015%
4110,001and above20%
The corporate tax rate is 20 percent in both the West Bank and Gaza.
Source: Ministry of Finance.
Source: Ministry of Finance.

Box 1.1.Data on Aid Disbursements and Public Investment

The West Bank and Gaza receives considerable amounts of foreign aid assistance each year. In 1999, total disbursements of foreign aid was estimated at about US$612 million (14 percent of GDP), if UNRWA’s operational budget of US$160 million is included, or roughly US$220 per capita. MOPIC collects data on disbursements from donors and compiles a quarterly report on commitments and disbursements broken down by various categories. In the absence of direct data on public investment, this donor database has been used to derive estimates of public investment. There are important weaknesses, though, since the categories used in the MOPIC reports do not match the definitions used in the national accounts, balance of payments, or in fiscal accounts. During 2000, staff from MOPIC, PCBS, PMA, PECDAR, the World Bank, and the IMF worked together to revise the donor questionnaire so that the database could be used by the PCBS, the Ministry of Finance, and the PMA in constructing national accounts, balance of payments, and fiscal data, including more accurate debt data. A better estimate of public investment is also crucial for the PA’s budget preparation to ensure adequate provision for operations and maintenance. Specifically, the revised questionnaire would allow the data on disbursements reported by donors to be translated into disbursements to the West Bank and Gaza on a balance of payments basis (some disbursements go to trust funds of international institutions), and from there on to an estimate of actual disbursements on the ground (used for national accounts). Furthermore, the questionnaire would allow a breakdown between foreign financed current and capital expenditure. Finally, the questionnaire will allow better cross checking of data for consistency and accuracy.

Other Economic Governance Issues

The PA took important steps to improve governance during the spring of 2000 in the context of its discussions with IMF staff on the EPF. As mentioned, in April, the PA consolidated all tax revenue under the Ministry of Finance, and in a step toward further improving transparency and governance, the PA made public, in June, key information from an audit of the PCSC by an internationally known accounting firm. A complete list of the PCSC’s assets, estimated at US$345 million (including equity holdings of some US$292 million at the end of 1999), was disclosed in the status report on the EPF discussion (Palestinian Authority, 2000). This action improved greatly the transparency in PA’s financial operations. The PA has also created the Palestinian Investment Fund (PIF), which will replace the PCSC and will be in charge of managing all the PA’s investments and other assets. With the help of an international consultancy firm, the structure and operational guidelines of the PIF are being prepared with a view to ensuring that they comply with the highest international standards for transparency and accountability. Furthermore, in consultation with the private sector, the PA has begun developing a comprehensive privatization strategy.13 Together, the creation of the PIF and the development of a credible privatization strategy will be important elements in a strategy to develop a market economy with a level playing field and with a more clearly defined role for the PA.

Banking Sector Developments

An encouraging development in the past seven years is the emergence of the banking system. The number of banks operating in the West Bank and Gaza has increased to 23 (with a total of 114 branches by mid-2000) from only a few banks in 1993. In this period, there was also a surge in bank credit and deposits (see Table 1.6). The share of deposits lent to the private sector has increased steadily to 35 percent in 1999 from 18 percent in 1994. It declined to 31 percent at the end of September 2000, as the strong growth in deposits outpaced the substantial growth in credit in the first nine months of last year. The ratio also fell toward the end of 2000, when the economy was affected by the aforementioned closures and turmoil.

The PMA was created in 1994 and has made considerable progress in the areas of accounting, statistics, bank licensing and regulation, and in the clearing and payments system. There has also been some progress in bank supervision, which, in the absence of monetary policy, is the main task of the PMA today. Promoting and safeguarding the soundness of the Palestinian banking sector is the most important contribution the PMA can make to economic and financial development. Conducting effective supervision of a rapidly expanding banking system is a challenging task for any supervisory authority, particularly for an inexperienced one like the PMA. The PMA now conducts both on- and off-site inspections and has conducted on-site examinations of most banks, including branches of foreign banks. The PMA has also issued regulations covering the most important prudential areas, although in several areas regulations still need to be brought in line with international best practices. All banks report monthly to the PMA on assets and liabilities, the liquidity situation, and the currency positions.14 Banks also report quarterly on income, capital adequacy, large exposures and the sectoral composition of lending. However, progress in bank supervision has been undermined by the PMA’s own hesitations in applying existing regulations and in allowing foreign bank supervisors to conduct on-site inspection (together with PMA officials) of foreign bank branches in the West Bank and Gaza, and also because the PMA has not always succeeded in insulating itself from political interference. Despite all of this, the PMA has achieved important progress, and its stature in the banking system has grown, especially after its resolute handling of some problem banks in 1999 and 2000.

Also, further improvements in bank supervision will require more training of PMA staff, in particular on-the-job training for on-site inspection and in analyzing banking data. The PMA also needs to step up efforts to fill managerial positions within the PMA and appointing a board in accordance with the PMA Law (promulgated in late 1997).

The rapid growth in credit to the private sector over the past seven years raises concerns over whether the nascent banking sector—especially the new, small local banks—can effectively intermediate such credit expansion without compromising the quality of its loan portfolios. The experience from other countries is that high credit growth over several years significantly increases the risk of bank problems, especially when economic growth weakens. This is a concern in the West Bank and Gaza where bank supervision is still underdeveloped and where banks usually do not have reliable financial statements from the prospective borrowers on which to base their lending decisions.

Despite the rapid credit growth, the ratio of credit to deposits is still low by international standards (see Figure 1.3). Most credit is also short term, including consumer loans, and there is little credit for long-term investment. Banks require substantial collateral for most loans, in some cases even for overdrafts. This situation has led to comments that the banking system is overly risk averse and that banks should be encouraged, if not urged, to increase their lending. These concerns are misplaced. To start with, given the generally unfavorable climate for private investment, with extraordinary uncertainty, political risk, uncertain titles to land ownership, closures, and changes to the legal and regulatory system, it is an open question whether there is actually investment demand for long-term credit that is not being satisfied at prevailing real interest rates.15 For these same reasons, it is to be expected that banks would be reluctant to extend long-term credit, except on the basis of their client’s well-established reputation or substantial collateral, or both. In addition, bank lending is negatively affected by the weak judiciary for enforcement of debt contracts and the lack of accounting and audit standards. The absence of such standards makes it impossible for banks to make sound and sensible credit risk assessments and forces them to rely on collateral and the client’s track record. This naturally puts new enterprises at a disadvantage.

Thus, what the PMA—and the PA more generally—could do to encourage private sector long-term investment and bank lending for such investment is to concentrate on correcting these shortcomings rather than focus on ways to induce banks to increase lending further. The PMA should rescind its requirements on banks to lend at least 40 percent of their deposits and to limit their foreign assets to 65 percent of total assets. Even if the PMA does not strictly enforce them, the mere existence of these regulations raises questions about the PMA’s priorities, how it sees its role in the economy, and its resolve to withstand populist pressures. The fact that these regulations can also be flouted openly without repercussion—indeed with the tacit consent of the PMA—undermines the status of bank regulations in general.

In terms of structural reforms over the coming years, it will be important for the PMA to institute policies and procedures that control relatedparty transactions to ensure the soundness of banks’ lending operations, given that many Palestinian banks are controlled by one or more families who generally take an active role in the bank’s management. A strategy for dealing with problem banks should also be developed, that should include a system for identifying problems at an early stage, prompt corrective actions, and create a complete set of tools such as conservatorship and receivership. Establishing a rule-based supervisory regime where corrective actions are enforced according to clearly established procedures, would help ensure the integrity of the PMA in enforcing regulations. With respect to the PMA’s investment policy, currently the PMA invests part of its reserves in the domestic banking system—a practice generally considered unsound for a central bank. Regarding the payment system, the establishment of a Lombard facility would allow the PMA to stop assuming the settlement risk in inter-bank settlements.

Legal and Regulatory Reforms

Modernizing and harmonizing the legal system for the West Bank and Gaza and strengthening the judiciary are crucial reforms to improve the investment environment and long-term growth prospects of the Palestinian economy. The current legal and regulatory system is a mongrel, consisting of old Egyptian and Jordanian laws, newly drafted laws, as well as regulations and restrictions arising from the Interim Agreement, and it is not uniform in Gaza and the West Bank. The PA has undertaken a major effort to revise the legal and regulatory framework in the economic and financial area—a task that has strained the rather limited capacity of the PA and the PLC to draft and review laws. Even if extensive technical assistance from international experts can alleviate some of the domestic shortage of trained and experienced legal expertise, the PA still needs to ensure the internal consistency of the various draft legislation, and better coordination among donors in this area is probably warranted. Equally important as strengthening the capacity to draft and review laws is the need to accelerate the process with which laws are submitted to and approved by the PLC, and subsequently ratified by the president.

A large number of laws have been drafted and are now awaiting decisions in the PA Ministry of Justice, the PLC, or the presidency. As of early 2001, the company, competition, and the secured lending and leasing laws were with the Ministry of Justice for consideration. The securities/capital market authority law was recently submitted to the PLC, and the banking and income tax laws are still with the PLC. The first part of the intellectual property rights law (dealing with copyrights) and the arbitration law were approved by the PLC in 2000. The second part of the intellectual property rights law (dealing with industrial property rights) is expected to be submitted to the PLC in 2001. A modern bankruptcy law is being prepared in the Ministry of Economy and Trade. The approval of these laws and the adoption of necessary regulations will greatly improve the legal and regulatory environment in the West Bank and Gaza. In order to ensure the effective implementation of the laws and regulations, it is important that the capacity—including more trained judges and attorneys—and independence of the judiciary system be strengthened. An important step in this direction was taken with the approval of the law on the independence of the judiciary by the PLC in 2000. This law is awaiting ratification of the president, but it is apparently already being partially implemented.

The Impact of the Turmoil and Closures in 2000 and the Outlook for 2001

In addition to the heavy humanitarian toll, the turmoil and closures that began in late September 2000 have caused a very sharp decline in economic activity and income in the West Bank and Gaza. Under the closures, Palestinian workers are not allowed to enter Israel, and exports and imports, if not outright blocked, are highly restricted. The movement of goods and people between the West Bank and the Gaza Strip, as well as within the West Bank and the Gaza Strip, is also subject to restrictions. There has also been damage to Palestinian infrastructure and private property.

The turmoil and closures affect the Palestinian economy through a variety of channels. The loss of employment and income for most of the 130,000 Palestinians (20 percent of the labor force) that before the crisis commuted daily to work in Israel and the settlements obviously represents one of the major effects.16 Other effects stem from the disruption of exports and tourism earnings, the decline in investment demand due to increased risk, the blockage of intermediate imports, and the general disruption of economic activity that arise from the turmoil and closures, especially in some key commercial centers like Hebron, Ramallah, and Nablus. The Gaza Strip has been effectively delinked from the West Bank, and villages and cities in the West Bank have been under extensive internal closures, during which Palestinians do not have access to the main road network. Even the Gaza Strip has been subject to these so-called internal closures, which have divided Gaza into three isolated parts, in addition to being cut-off from the West Bank and the rest of the world. According to UNSCO the internal closures are the most severe ever implemented.17 There has also been considerable damage to physical infrastructure and private property, including leveling of agricultural land and destruction of buildings and roads.18 The impact on the economy is likely to have become proportionally more severe during the period of closures and turmoil because of the fairly limited scope for consumption and output smoothing.

Supply-side effects are difficult to analyze because they are likely to cause a shift in the production function as well as a change in its slope, and for that reason, we must first identify the source of the disturbance. In the West Bank and Gaza, one key source of supply disturbance is the blockage of imports used as inputs for domestic production and investment, notably construction material (e.g., cement) and machinery and equipment.19 The disruptions and, on occasion, complete blockage of imports since early October 2000 have caused considerable harm since the West Bank and Gaza relies heavily on imports for much of its manufacturing production and investment, including construction.

The demand-side effects are, in principle, somewhat easier to handle because once the disturbance is translated into an impact on expenditure, the effects can be analyzed independent of the source of the disturbance. At the same time, there are important differences among the various demand-side effects. For example, the loss of labor income from Israel is permanent, while at least part of the loss of export earnings might be recoverable once the situation returns to normal. Exports are affected in three different ways. For some goods, closures may cause a delay in the delivery until the closure is lifted. For these exports there is only a delay in earnings, so the loss is temporary and fully recoverable (although it might take some time). This could be the case for stone and marble exporters. For a second category of products, like perishable goods, export earnings are permanently lost, but once the closure is lifted exports could in principle go back to their normal level, although the destruction of land used for agriculture will make the recovery slower in this sector. Finally, for a third category of goods, exports might not recover to their normal level, at least for some time. In today’s world economy of small stock holdings, an exporter of manufactured goods is likely to lose clients if it fails to assure timely deliveries. In general, the longer the conflict and closures last, and the more physical capital is damaged, the slower will be the economic recovery.

Many factors affect both supply and demand, and attempting to distinguish between the two channels is not only difficult but in some cases not very meaningful. For example, private investment might decline during closures either because key inputs to investment, such as imported machinery and equipment are blocked, or because investment demand falls with the reduced outlook for profitability. There is a clear danger of double counting when aggregating anecdotal evidence into estimates of the impact on GDP.

Nevertheless, while it is almost impossible, at this stage, to estimate the magnitude of the decline in GDP and GNI with reasonable confidence, there can be no doubt that the combination of turmoil and very extensive closures represents the most damaging shock that the Palestinian economy has experienced over the past 30 years. According to data from the PCBS, the unemployment rate jumped to 28 percent in the fourth quarter of 2000, from 10 percent in the previous quarter. Several reports describe the economic impact of the closures and turmoil in detail and suggest that the fall in GDP might be as high as 50 percent during the period of closures and that there has been a sharp rise in poverty.20 (Before the crisis, one salary supported five people on average, so the 130,000 workers in Israel supported 650,000 people, more than 20 percent of the population.) The crisis also has caused a major deterioration in the PA’s fiscal position, mainly because of the loss of revenue. Indeed, fiscal revenue is one of the few available indicators of economic activity in the fourth quarter of 2000.21 Because of lags, the full effect on PA revenue was not felt until December 2000 when fiscal revenue was running at about US$49 million, or about 55 percent below normal (not taking into account the suspension of clearance transfer during the latter part of that month).

A decline in fiscal revenue of 55 percent cannot, however, be taken as prima facie evidence of a decline in GDP of a similar magnitude. First, the decline in tax revenue is not entirely due to a shrinking tax base. Some of the decline reflects difficulties in collecting taxes during closures.22 Second, and more important, the loss of labor income from Israel has induced sharp reductions in GNI, private consumption, and imports that are far greater than the loss in GDP. (The fall in disposable income has led to a sharp drop in private consumption, but because of the very high import propensity, the multiplier effect on GDP is more limited.) The second point can be illustrated in a model that estimates the fiscal revenue effect of the loss of labor income from Israel.23 The dynamics from the loss of labor income are more tractable than those from other shocks, like blockage of intermediate imports, so the estimate provides us with a benchmark with which we can feel reasonably confident. A simple short-run (Keynesian) macroeconomic model is used where this labor income adds directly to GNI and households’ disposable income, which is saved or spent on domestically produced or imported goods.24 For simplicity, changes in GDP are entirely due to private consumption (less imports), thus assuming that investment, exports, and public consumption are unaffected by changes in labor income from Israel.25 In this model, the loss of labor income from Israel in the fourth quarter of 2000 would by itself lead to a reduction in annual GNI of about 6 percent in 2000 from the baseline scenario.26 The effect on GDP is more muted because of the high import propensity (0.6 with respect to GNI): annual GDP would decline by about 1 percent, bur the contraction in private consumption and imports would be about 4–5 times sharper, bringing about a fall in PA fiscal revenue of 20 percent in the fourth quarter, compared to a 3 percent drop in quarterly GDP.27

This exercise shows that the loss of labor income alone can explain a substantial part of the decline in tax revenue, even if it (as expected) cannot explain all of the 40–50 percent reduction in the tax base. It also shows that because of the high propensity to consume and import, the fall in tax revenue is consistent with a considerable reduction in GNI, private consumption, and imports, and with a more subdued effect on GDP.28 It also shows that an analysis based entirely on movements in GDP misses an important part of the effect closures have on households’ welfare (private consumption and imports).

For the purpose of discussing the economic outlook for 2001 and beyond, we assume that real GDP contracted by about 1.5 percent and real GNI by about 5 percent in 2000, compared with the growth rates in the baseline projections of 5 percent and 4.5 percent, respectively (see Table 1.1). This does not seem implausible judging from labor market data and how the various sectors of the economy appear to have been affected by the shock and taking into account that, except in certain areas directly affected by the conflict, economic activity was still going on even if on a limited scale. Because of the uncertainty over the situation on the ground and because of the imponderables more generally—for example, regarding the magnitude of the initial output decline and how the situation will evolve—the following discussion is intended merely to suggest the broad orders of magnitude that may be involved and should not be viewed as a forecast.

Once the turmoil and closures end, there are several possible paths of recovery that the Palestinian economy might follow. Economic recovery is usefully discussed in terms of how quickly the GDP or GNI can return to the level that prevailed before the crisis, or specifically, the speed with which the output gap is closed. Once the turmoil and closures end, one (optimistic) recovery path could entail rapid economic growth so that the output gap is closed in the span of a few years. This would be broadly consistent with what happened in 1997–99, when the economy recovered from the sharp closure-induced downturn of 1995–96. For example, if the conflict were to end, and the closures lifted, in the second part of 2001, GDP could be back at its precrisis level in 2003/2004. During this transition, GDP growth would be very high until the economy converges to its long-term steady-state growth rate. Under a more pessimistic scenario the economy could operate significantly below its long-term capacity for a prolonged period of time. For example, it would take until 2006 to close the output gap.

Several factors will influence how quickly the lost output can be recovered. One important factor is the extent to which the long period of extensive closures and turmoil has resulted in lasting damage to the export sector, the tourism sector, and the capital stock. Under a long and deep economic downturn, more businesses might have had to close down, rather than just reduce the scale of their operations. Also, lost export markets can take time to recapture. And tourists will return only once they perceive that the situation on the ground has improved sufficiently. Furthermore, with the increase in security risk, it might take some time for investment demand, domestic and foreign, to return, which would slow the speed of recovery. The damage to infrastructure and productive capacity will also delay the recovery in many sectors, in particular in sectors such as agriculture. Another crucial factor is the extent to which Palestinian workers will be allowed back to Israel once the situation on the ground improves.

A return of GDP to its precrisis level over the span of a few years, moreover, would still leave GDP per capita and, even more important, GNI per capita well below their precrisis levels, because of the rapid population growth (3.8 percent a year). GNI per capita is the most relevant national income concept in the West Bank and Gaza given the size of labor income from Israel (equal to roughly 20 percent of GDP before the crisis). For example, if, once the turmoil and closures end, only 45,000 Palestinian workers are allowed into Israel, compared with roughly 130,000 before the crisis, a return of GDP to its precrisis level by 2003/2004 would still leave GDP per capita about 10 percent and GNI per capita about 20 percent below their levels before the onset of the precrisis levels (in dollar terms). Under the assumptions laid out above, GDP growth would have to average 25 percent a year in order to bring GNI per capita back to about US$1,900 by the end of 2003. It should be recalled that GNI per capita before the crises was still below its level in 1993 by about 8 percent.

Fiscal Effects

As mentioned earlier, the PA’s fiscal situation was already very fragile before the crisis—mainly because of weak expenditure control—and it has worsened considerably in the aftermath of the closures and the economic downturn in the fourth quarter of 2000. Fiscal revenue is severely affected by the economic collapse, the difficulty in actually collecting taxes during closures, and the disruptions in the transfer of clearance revenue from Israel. Income tax revenue is affected by the loss of employment in the West Bank and Gaza and in Israel, while VAT, excises, and import taxes are affected by the fall in private consumption and imports. As mentioned, in December 2000, fiscal revenue was 55 percent below normal. In the first quarter of 2001, monthly revenue was reduced further to US$25 million on average, as Israel suspended the transfer of clearance revenue. At the same time, in response to rising unemployment, PA employment was increased to 117 thousand at the end of March 2001, from 115 thousand at the end of 2000. The monthly fiscal deficit averaged US$75 million per month in the first quarter of 2001 and was covered in part by donor support, but the PA also resorted to significant arrears accumulation and heavy borrowing from the domestic banking system.

Increased pressures for fiscal expenditure have also arisen, especially in the health sector and for social outlays (because of the rise in casualties of violence and the rise in unemployment), but the liquidity situation and the possibility to reallocate spending priorities will dictate how much additional expenditure demand can be accommodated. Under the current circumstances, it is impossible to avoid large cuts in cash budget expenditure. At the same time, however, since the budget plays an important role in providing some positive aggregate demand in the economy, and with most capital projects on hold during the crisis, it would be desirable to protect productive expenditure, such as operations and maintenance, to the extent possible. Donor aid in the form of general budget support is crucial in this regard (see below).

In April, the PA Ministry of Finance adopted a six-month emergency spending plan, worked out with IMF staff, and for which it has received firm donor support. Under this plan, to avoid an accumulation of arrears, the PA has taken measures to reduce sharply current non-wage expenditure, limiting such expenditures largely to emergency outlays to deal with the adverse consequences of the turmoil on the Palestinian population, notably for health and social assistance. The plan also envisages a freeze in PA employment supported by a cut in the nominal wage bill for by 4 percent, in effect since October last year. These measures would keep the monthly deficit to US$47 million on average under the six-month period April-September 2000, on the assumption that the government of Israel would resume transferring the clearance revenue it collects on behalf of the PA. Donors have made commitments to cover these deficits.

Foreign aid for general budgetary support, which until the crisis had not been provided since 1997, has become instrumental in preventing a collapse of the PA. As of end-March, 2001, Arab states had disbursed US$70 million to the PA, the European Union (EU) euro 57.5 million (US$52 million) in connection with the suspension of and delays in the transfer of clearance revenue, and Norway US$10 million. With the adoption of the PA’s emergency spending plan, another euro 60 million is potentially available from the EU for general budgetary support, and about US$225 million in general budgetary support is expected to be provided for the period April-September by Arab states, in line with their commitment at the Arab Summit in late March 2001.

Other Effects—On the Banking system and Inflation

A prolonged closure can negatively affect the banking system in several ways. It might make money demand unstable, possibly causing a shift to currency from deposits, especially if there is a risk of liquidity shortages. Indeed, there were some initial reports of banks experiencing liquidity shortages as trucks carrying coins and notes could not enter the West Bank and Gaza, but this problem apparently has been resolved. Also, banks might experience some reduction in deposits as people draw down their savings to smooth consumption in response to a temporary loss of labor income, and there is some evidence of this in the first months of the crisis. At the same time, the problem for the banking system should not be exaggerated since the banking system in aggregate is very liquid and should be able to manage a reduction in the deposit base. Smaller local banks could face problems, though. A more serious concern relates to the asset side of banks’ balance sheets, in particular to the quality of their loan portfolios. Bad loans might increase because of the economic downturn and the closure, and this would be more of a concern for local banks, which have relatively larger loan portfolios (as a percent of total assets). Aggregate bank data from the PMA show that the growth in both deposits and credit to the private sector have slowed considerably since the onset of the crisis. Credit to the private sector, which peaked in September 2000 at US$1,074 million, had fallen to US$926 million in February 2001. The fall in deposits has been more subdued, and they fell from a high US$3.5 billion in September 2000 to US$3.3 billion in February 2001.

The effect on inflation from the turmoil and closures is ambiguous, ex ante, since the demand side and cost-push aspects affect prices in opposite directions. For example, the loss of labor income depresses domestic demand, causing downward price pressures, while import blockages could be expected to exert upward pressure on the prices of imported goods. Data from the PCBS shows that inflation has fallen further in the period October 2000-March 2001: the twelve-month rate of change of the CPI reached 0.7 percent in March 2001 (the same as in Israel), compared with 3.4 percent in September 2000, and the month-on-month rate of change in the CPI was consistently lower in this six-month period than in the same period one year earlier (See Table 1.7). To some extent these developments reflect the trend fall in inflation observed before the crisis, but they almost certainly also reflect the effects on prices from the weakness in domestic demand and the blockage of exports, which has led some goods (particularly agricultural products) that are usually exported to be sold in the local market.

1The other four studies produced by the IMF are: Recent Economic Developments. Prospects, and Progress in Institution Building in the West Bank and Gaza, by Zavadjil, Calika, Kanaan, and Chua (1997), The Economy of the West Bank and Gaza Strip: Recent Experience, Prospects, and Challenges to Private Sector Development, by Barnett, Calika, Chua, Kanaan, and Zavadjil (1998), and West Bank and Gaza Strip: Economic Developments in the Five Years Since Oslo, by Alonso-Gamo, Alier, Baunsgaard, and Erickson von Allmen (1999).
1FOR more extensive analyses of economic and policy developments in the West Bank and Gaza since 1994, see the IMF study in Alonso-Gamo, Alier, Baunsgaard, and Erickson von Allmen (1999), Fischer, Alonso-Gamo, and Erickson von Allmen (2001), and Philippe and Pissarides (1999).
2According to UNSCO (2000a), only seven work days were lost because of closures in 1999, and the number would probably have been roughly the same in 2000. In 1995, 1996, and 1997, 83.5, 89.5, and 57 work days were lost, respectively, because of closures.
3The projections arc from Economic Policy Framework: Status Report (see Palestinian Authority, 2000), which was prepared by the PA with the assistance of IMF staff, and is available on the PA’s website www.pna.net. The Palestinian Central Bureau of Statistics (PCBS) is working on establishing a consistent series of national accounts for 1994–99, including data in real terms (for the first time). This work had not been completed when this paper was finalized.
4The average real GDP growth rate was about 6 percent in 1970–99. For the medium term, real GDP growth will have to average 8 percent a year for the economy to absorb the expected inflows to the labor market while at the same time reducing unemployment significantly and allowing 1.5 percent annual growth in real wages, as explained in Chapter 2. Such growth rates have been achieved in the past in the West Bank and Gaza but to achieve them on a sustained basis in the future will require a considerable reduction in transaction costs and uncertainty, improved access to world markets, sound macroeconomic policies, improvements in the physical infrastructure, and legal and regulatory reforms.
5The unemployment rate was 8.8 percent in June 2000.
6What is referred to here as private sector is really domestic employment outside of the PA, and includes local governments and public enterprises. The data do not permit a more precise definition of the private sector. Data on PA employment come from PA Ministry of Finance and overall employment and unemployment data are taken from the PCBS.
7The 12 percent growth in revenue corresponds to the underlying revenue growth, alter correcting for an early transfer of VAT clearance revenue in December 1999 which usually would have taken place in January.
8The diverged revenue is included in the fiscal tables, appearing below-the-line is a (negative) financing item. The US$160 million is the diversion net of the amounts transferred hack to the Ministry of Finance, something that usually happened when the-liquidity situation became difficult. It is not clear exactly how the diverted revenue was used, bur a large part seems CO have been transferred to the Palestinian Commercial Services Company (PCSC) for commercial investments. To the extent that the diverted revenue was used for recurrent expenditure not reflected in the budget, the fiscal deficits reported in Table 1.4 are understated.
9The concern with the expansion of the PA payroll is as much related to the absolute numbers as it is to the way in which the hiring is undertaken. Most of the hiring in the past few years was not provided for in the budget and was not linked to the PA’s genuine hiring needs in the education, health, and judiciary sectors. Indeed, despite massive hiring by the PA, the staffing demands of these sectors were often left unsatisfied.
10The PA budget has always been prepared and executed on the basis that all revenue would be available to the Ministry of Finance. Some of the diverted revenue was spent on current expenditure, but the bulk appears to have been saved or invested through the PCSC. Using past revenue diversion to settle arrears made sense since the diversion was a major factor behind the accumulation of arrears in the first place.
11In June 2000, the PA received NIS 200 million from the government of Israel in purchase tax clearance revenue, of which NIS 50 million corresponded to a preliminary estimate of the amount owed to the PA for the period November 1999-June 2000 (November being the agreed upon starting point of such tax revenue transfers), and NIS 150 million represented an advance on future purchase tax revenue. Once the correct amount for November 1999-June 2000 was established, the PA would either repay or receive the difference, and preliminary information suggests that the PA has repaid NIS 29.5 million of the NIS 50 million. With respect to the NIS 150 million, it was agreed that it would be repaid in four equal installments of NIS 37.5 million beginning in September 2000 and that it would be netted out of VAT clearance revenue. The transfer and repayments are presented as financing items in Table 1.4. After the reduction in the purchase tax rates in Israel in the summer of 2000, the income from such taxes on imports of Israeli produced goods to the PA is estimated at about NIS 6–7 million per month.
12The large increase in PA bank borrowing in March-September 2000 recorded in the banking system data (see Table 1.6) is apparently a statistical problem and does not reflect actual borrowing by the PA. PA borrowing rose sharply again in November and December 2000, and seems more correctly to reflect reality.
13The so-called National Trade Dialogue.
14It is impossible to reconcile developments in the PA’s net position, vis-à-vis the banking system (as reported by banks), with the fiscal data from the PA, mainly because the institutional coverage of the monetary accounts reported to the PMA is broader than that of the budget.
15Chapter 4 in Alonso-Gamo, Alier, Baunsgaard, and Erickson von Allmen (1999) discusses the factors affecting lending for long-term investments.
16UNSCO (2001) estimates that Palestinian employment in Israel in October 2000-January 2001 was 75 percent lower than before the crisis.
17UNSCO (2001, p. 2.)
18During the intifada years (1988–92) there was turmoil and a loss of Palestinian employment in Israel, but there were no extensive closures on the movement of exports and imports. In those years, GDP growth was still positive, even if GNI growth slowed down (see Chapter 2). By contrast, in 1995–96 frequent closures (but less turmoil) threw the Palestinian economy into a deep recession, causing unemployment to exceed 28 percent in early 1996.
19In principle, the effect of the blockage of imports of machinery and equipment and intermediary goods could be assessed by adding such goods into a production function like Y=AKαLβM(1-α-β) where M stands for the imported intermediate goods, K for the capital stock, L for labor, and A is a measure of the state of technology (see Appendix I for a discussion of growth accounting). With K fixed in the short term, the reduction of M would reduce the equilibrium level of production for a given input of labor and capital, and in the new equilibrium, prices will have risen and output and employment fallen. The king-term outcome for employment is ambiguous ex ante since it would be negatively affected by the output decline but positively by substitution of labor for this intermediate import.
21Bank deposits and credit to the private sector also declined in the fourth quarter of 2000.
22Around 10 percentage points of the observed 50 percent drop in fiscal revenue might be the result of difficulties in collecting taxes, rather than the decline in the tax base.
23The loss of labor opportunities in Israel and settlements also has supply side effects: it represents a substantial outward shift of the labor supply curve for the West Bank and Gaza.
24The effect on GNI is computed as ∆GNI=(1+βτ1)δ∆YL and the effect on GDP as ∆GDP=(α-β)δ∆YL, where YL is labor income from Israel and the settlements, α and β are the average propensity to import and consume, respectively. τ1 is the effective tax rate for domestic revenue, and δ is the multiplier and is defined as δ=1/[1-β(1–τ1)+α]. The fiscal revenue (T) effect is computed as ∆T=(τ1(β–α)δ+τ2α(1+βτ1)δ+τ3)∆YL, where τ1, τ2, and τ3 are the effective tax rates for domestic revenue, clearance health and income taxes, and other clearance revenue, respectively. Consumers are liquidity constrained so consumption is solely a function of current income,
25In reality, the loss of labor income will also adversely affect private investment, especially residential construction.
26The baseline scenario is the projection made by IMF staff in August 1000, before the crisis (see Table 1.1).
27This is the fall in the quarterly revenue and GDP compared with the quarterly baseline values for these variables, respectively.
28It is possible, of course, that the propensities to consume and import change during a crisis.

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