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Source: International Monetary Fund (IMF)
28 August 2001






West Bank and Gaza
Economic Performance, Prospects, and Policies
Achieving Prosperity and Confronting Demographic Challenges


Rosa A. Valdivieso, Ulric Erickson von Allmen, Geoffrey J. Bannister, Hamid R. Davoodi, Felix Fischer, Eva Jenkner, Mona Said


©2001 International Monetary Fund

August 28, 2001
Contents

Preface


List of Acronyms


Overview


1. Recent Developments in the Palestinian Economy
Ulric Erickson von Allmen

Macroeconomic and Policy Developments Before the Crisis
The Impact of the Turmoil and Closures in 2000 and the Outlook for 2001

2. Demographics and Long-Term Growth in the Palestinian Economy
Hamid R. Davoodi and Ulric Erickson von Allmen

Accounting for Growth, 1970–99
Projected Changes in Demographics, the Labor Force, Employment
Required TFP Growth Over the Next Ten Years
Factors for Long-Term Growth of the Palestinian Economy
Policy Implications
Concluding Remarks
Appendix I: Growth Accounting and Cross-Country Growth Regression: Methodology and Data Sources

3. Transactions Costs in the Palestinian Economy: A Microeconomic Perspective
Felix Fischer, Mona Said, and Rosa A. Valdivieso

The Role of Transaction Costs in the Economy
Rules and Restrictions Governing Domestic and External Trade
Reducing Transaction Costs and Promoting Trade
Concluding Remarks

4. Palestinian Trade: Performance, Prospects, and Policy
Geoffrey J. Bannister and Ulric Erickson von Allmen

Trade Performance and Prospects
Trade Policy for an Independent West Bank and Gaza
Concluding Remarks

5. Fiscal Policy: The Challenges from Demographic Dynamics and Other Medium-Term
Developments
Eva Jenkner

Fiscal Policy and Projected Demographic Dynamics
Further Fiscal Policy Challenges Over the Medium Term
Conclusion

6. The Choice of Future Exchange Rate Regime in the West Bank and Gaza
Ulric Erickson von Allmen and Felix Fischer

A Brief and Selective Overview of the Palestinian Economy
Choosing an Exchange Rate Regime
Going for a Currency Board
Two More Issues: Seigniorage and the Exit Option
Concluding Remarks

Bibliography


Overview

This study reviews the economic performance and examines the medium-term prospects for the Palestinian economy. Since October 2000, the economy has been severely dislocated by the Palestinian-Israeli conflict, causing a severe decline in income and output in the West Bank and Gaza. While this paper discusses the economic consequences of the conflict and related closures, it also looks beyond these immediate and severe problems to the challenges and opportunities that will face the Palestinian economy over the medium term, especially those arising from important demographic changes now underway. Although how and when the present conflict is resolved will have major implications for economic performance in coming years, addressing the policy challenges raised in this paper will still be crucial for the success of the Palestinian economy over the longer run.

The West Bank and Gaza has the highest population growth in the world, and over the medium term, fertility rates are projected to fall, causing a slowdown in population growth and an increase in its average age. The share of the population at working age is projected to rise steadily. These demographic changes can provide an important boost to per capita income growth, but they can also lead to a period of high unemployment or declining real wages, or both, and the outcome will be largely determined by policy choices and reforms of the restrictions that hamper trade and investment today. These issues form one important theme of this paper.

Chapter 1 surveys recent economic and policy developments, focusing on 1999-2000. It also discusses how the economy, including the outlook for 2001, is affected by the turmoil and the closures. In the years before the recent crisis, the Palestinian economy was doing quite well with robust economic growth and with progress on the economic policy side. Economic growth was projected at 5 percent for 2000 and unemployment had fallen to below 9 percent by the middle of the year. Inflation was below 1 percent during 2000. The turmoil that began in late September 2000 and the closures that followed have caused a sharp drop in income and output in the West Bank and Gaza, and while there is uncertainty surrounding the magnitude of the fall in output, it is clearly very large with the combination of turmoil and comprehensive closures representing the most serious adverse economic shock experienced by the West Bank and Gaza over the past 30 years. Unemployment rose to 28 percent in December.

Chapter 2 analyzes the Palestinian economy in a medium-term perspective. The West Bank and Gaza has the highest natural population growth in the world, at about 3.8 percent, but population growth is expected to slow significantly over the medium term, leading to a rise in the share of the working-age population. Under plausible assumptions regarding demographics and labor force participation rates, the labor supply would increase by 4.4 percent a year in 2001-10. For these inflows to be absorbed into productive employment, at the same time as the high unemployment rate is reduced, domestic employment must expand by about 6.5 percent annually. To achieve this employment target, while allowing for a modest increase in real wages (1.5 percent a year), will require annual rates of growth in real GDP of 8 percent and total factor productivity (TFP) of 1.2 percent. While this presents an extraordinary challenge for the Palestinian economy, such growth rates have been attained in the past. A detailed examination of the growth record shows that GDP growth averaged 6 percent and TFP growth 1.4 percent over the past 30 years, albeit with substantial annual variations. In order to gain insights into the ultimate factors behind the growth in GDP and TFP, the authors of the paper undertake a cross-country growth regression and include the West Bank and Gaza in the sample. For the future, they conclude that the initial conditions for medium-term economic growth are generally favorable: the population is young and relatively well-educated and the projected change to the age structure of the Palestinian population can be expected to provide an important (but temporary) impetus to long-term per capita income growth. If the political and security situation improve and if the main obstacles and distortions in the Palestinian economy are addressed, the economy should be able to enjoy an extended period of high growth, assuming supporting policies and continued improvements in infrastructure. The growth regressions show that the changing demographics can provide an important boost to growth in per capita GDP. But this boost is not automatic, and, as mentioned, there is a clear risk that the large inflows to the labor market lead to higher unemployment and lower real wages. The regressions also provide some insights as to what factors can help ensure a positive contribution from demographics on growth. While it is obviously essential to improve the political and security situation, sustained medium-term growth will also require better access to external markets, sound macroeconomic policies and governance, a competitive infrastructure, financial development, and a strengthening of the legal and regulatory framework.

In Chapter 3, the authors discuss transaction costs, which are usually considered to be very high in the West Bank and Gaza, to the point where they constitute a major impediment to trade, investment, and growth. This chapter explains the sources of the transaction costs that are unique to the West Bank and Gaza, particularly those relating to Israel's security arrangements. The chapter addresses in some detail the transactions costs that are created by the cumbersome transportation procedures and restrictions, security inspections and inspection fees, and permit requirements. It also discusses possible measures to reduce these transactions costs.

Chapter 4 focuses on trade performance and policy. Trade policy is one of the most important policy issues the Palestinian Authority (PA) will have to decide on in the future. To set the stage for a discussion of trade policy options, Chapter 4 estimates trade flows using a gravity model. The bulk of Palestinian trade today is with Israel, although the exact share is unknown because of data weaknesses. Israel's large share in Palestinian exports and imports is not in itself evidence of trade distortions, but a good case can be made that the security restrictions and complex and costly trade and transportation procedures have tended to lower overall trade and to skew its composition in favor of trade with Israel. The transactions costs that the impediments on the ground have caused can only lead to trade diversion not trade creation. However, the results from the gravity model find no significant evidence that trade, in 1995/98, between Israel and the West Bank and Gaza is higher than what might be expected given their proximity, GDP, population, and other variables. The results suggest that Israel will remain a key trading partner of the West Bank and Gaza under almost any type of trade arrangement between the two economies. The authors find evidence, however, that there is considerable scope for expansion of Palestinian trade with the rest of the world, in particular with the European Union and the United States. The authors take this to mean that a reduction in transaction costs and improved trade infrastructure and policy could be expected to lead to increased trade with the rest of the world without a (significant) reduction in Palestinian trade with Israel. With respect to the future trade policy, this chapter argues in favor of the PA adopting an open, nondiscriminatory and transparent trade regime characterized by the absence of quotas and trade monopolies. It also makes the case for the PA to adopt a low, uniform import tariff rate (5-10 percent) across the board.

Chapter 5 focuses on medium-term fiscal developments in the West Bank and Gaza. It first analyzes the fiscal challenges as well as opportunities arising from expected demographic dynamics. On the one hand, the chapter argues that a larger share of the population entering the workforce could create a window of opportunity for fiscal consolidation: the tax base would expand, and fewer school-aged children and retirees will require care in relation to the total population. The results from a simple accounting exercise and regression analysis support this point. On the other hand, the economy will have to grow significantly to absorb the additional labor without a reduction in real wages, and the right fiscal polices will have to be in place to allow these gains to materialize at all. For example, expenditure growth would have to be reined in, and expenditure priorities within the budget would have to be reconsidered to allow for greater social expenditures and higher contributions to capital investment. The chapter also discusses potential changes to the tax and trade regime, which can foster economic development.

Furthermore, Chapter 5 discusses the various tax policy options the PA would have if a customs border is established with Israel. Specifically, should the PA finally become fully responsible for collecting all of its revenue--which has not been the case under the current customs union--important issues in tax administration would have to be addressed. Finally, a permanent status agreement would also imply a permanent settlement of the refugee question, and subsequent migration. The resulting boost to population growth would amplify the demographic dividend mentioned above, but the challenges in terms of providing job opportunities and implementing growth-enhancing polices would also become even more pressing. In short, fiscal policy can be key in shaping the West Bank and Gaza's medium-term economic prospects. While potentially aided by demographic changes, the PA will have to follow good policies in order to confront the challenges of the next 10 years.

In Chapter 6, the authors discuss the possible introduction of a Palestinian currency, an issue that has received some attention and will surely receive further attention in the future. It is noted, however, that the present system with three currencies (the new Israeli shequel, the Jordanian dinar, and the U.S. dollar) circulating freely works quite well, and has provided a good degree of stability. If it were decided to go ahead with the introduction of a Palestinian currency, the authors argue that the new currency would stand the greatest chance of success--in the sense of receiving highest degree of public acceptance--if it were introduced under a currency board arrangement and if the introduction followed reforms to strengthen fiscal management and bank supervision. The case for a currency board is based on the need to bestow the new currency with highest possible credibility. Palestinian economic policy institutions, including the Palestine Monetary Authority (PMA), are young and many of them are still in the process of establishing themselves. In such an environment, it would be unreasonable to expect the Palestinian public to have, from the onset, the same degree of confidence in a new, untested Palestinian currency as it has in the three currencies now circulating in the West Bank and Gaza unless there is a transparent and simple institutional framework that effectively constrains the scope for discretionary monetary policy. A currency board provides such a framework. Introducing a Palestinian currency under any other form of exchange rate regime is likely to lead to a slower transition to the new currency and to a higher degree of currency substitution. The case for a currency board rests more on the issue of credibility than on the usual trade-off between fixed and flexible exchange rates. Indeed, a fixed exchange rate under a currency board is not without risks. One key concern is the risk of overvaluation of the real exchange rate. This risk can be mitigated by the choice of anchor currency or currencies and by supportive macroeconomic and incomes policies. Strengthening the PA's fiscal policy management and the PMA's bank supervision capacity would help reduce the risk that domestic policies cause an overvaluation of the fixed exchange rate. Deciding on the appropriate anchor currency for the West Bank and Gaza is perhaps the single most important question, but also the most difficult one, and there is no obvious and easy solution. The problem of identifying an appropriate anchor currency in the wake of what might be a process of fundamental transformation of the Palestinian economy provides a further argument for waiting with the introduction of a currency, especially since the current system does not represent a restriction on the development of the Palestinian economy over the medium term.


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