In areas where government effectiveness matters most – security and justice; revenue and expenditure management; economic development; and service delivery – Palestinian public institutions compare favorably to other countries in the region and beyond. These institutions have played a crucial role in enabling the positive economic growth in the West Bank and Gaza in recent years.
Though significant, this growth has been unsustainable, driven primarily by donor aid rather than a rebounding private sector, which remains stifled by Israeli restrictions on access to natural resources and markets. Under these conditions, lower-than-expected aid flows in the first half of 2011 had an immediate impact on the Palestinian economy. Real GDP growth, steadily increasing in 2009-2010 and previously projected to reach 10 percent in 2011, is now expected to be 5 percent. The shortfall in external financial support in the first half of 2011 has also contributed to the current fiscal crisis facing the Palestinian Authority.
The situation underscores the interdependence of institution-building and sustainable economic growth in laying the economic underpinnings of a future state. To date, the Palestinian Authority has continued to implement its reform agenda, but a protracted fiscal crisis risks jeopardizing the gains in institution-building made painstakingly over the past years.
Ultimately, in order for the Palestinian Authority to sustain the reform momentum and its achievements in institution-building, remaining Israeli restrictions must be lifted. The resulting revival of the private sector can be expected to grow the tax base and gradually reduce dependence on external assistance. Until then, however, West Bank and Gaza will remain vulnerable to reductions in aid flow, and these will need to be managed carefully.