| 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.
|
