Liberty, Equality... and Solvency

With the potential declaration of a Palestinian state in September, experts are taking a look at whether the Palestinians are economically ready for independence.

By ZIV HELLMAN
May 19, 2011 12:09
Gazan Tomato Export

Gazan Tomato Export. (photo credit: Ibraheem Abu Mustafa/Reuters)

 
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IN THE DIPLOMATIC FLURRY taking place in the run-up to a possible unilateral Palestinian declaration of independence in September, the question of the condition of the Palestinian economy has taken on central importance. Without a sound economy capable of sustainable growth, along with high-quality economic leadership, a viable Palestinian state cannot truly emerge, threatening to leave any declaration of independence empty.

There was therefore great interest in two reports on the Palestinian economy issued in April, one by the IMF and one by the World Bank, both endorsing the possibility of Palestinian economic independence. The World Bank stated in its report that the Palestinian Authority (PA) is “well-positioned for the establishment of a state at any point in the near future.” The IMF said that “the PA is now able to conduct the sound economic policies expected of a future well functioning Palestinian state.”

These assessments were based partly on recent strong economic growth in the PA, with real GDP growth in the West Bank and Gaza Strip estimated at 9 percent in 2010, and a reduction of the PA’s recurrent deficit by nearly half. Both reports give much of the credit for Palestinian economic gains to a well-crafted and implemented program of reform carried out by PA Prime Minister Salam Fayyad.

“The Palestinian economy is strong enough to be the economy of an independent state,” says Hisham Awartani, professor of Economics at An-Najah University in Nablus. “It can be done. That does not mean that it will be an ‘independent economy’, but there are no independent economies, all economies depend on others.”

Looking ahead, however, the outlook is not necessarily smooth. The Palestinian economy, as is made clear in the IMF and World Bank reports, remains heavily dependent on international donor aid, unemployment is still at unacceptably high levels, and the industrialization base of the PA has even shown signs of shrinking. Many reforms, say the experts, must still be implemented.

Political issues may also have economic effects. Both the Hamas and Fatah movements, following their recent reconciliation agreement, are pressuring PA President Mahmoud Abbas to remove Fayyad from his office as prime minister, a move that could have repercussions for the economic and administrative reforms that Fayyad has led.

And of course, how Israel reacts to any future developments will have significant effects. The Palestinian economy remains highly dependent on trade with Israel, with Israel accounting for nearly 89 percent of the PA’s exports and 81 percent of imports. Both the World Bank and IMF reports point to Israeli restrictions on trade and the free movement of goods, most obviously in the closure imposed on the Gaza Strip but also in the West Bank, as one of the major impediments to Palestinian economic growth.



How important Israel is to the PA economy was underscored when Israel’s Finance Minister Yuval Steinitz decided in early May to suspend monthly payments of about 300 million shekels ($88 million) in taxes and customs fees to the PA until it could provide assurances that the money will not go to Hamas. In response, the PA stated that it would be unable to pay employee salaries.

“This in itself caused Palestinians to wonder about the possibility of economic independence,” says Pinhas Inbari, journalist and author of several books on the PLO and the PA. “In both Fatah and Hamas circles, this is prompting people to ask how the PA can claim that it is ready for independence if it can so easily find itself in a situation in which it cannot even pay civil service salaries?” (Israel subsequently released the funds.)

THAT THE PALESTINIAN ECONOMY would be in a condition to receive positive IMF and World Bank reviews seemed incredible as recently as five years ago. In 2007, the Palestinian economy was nearly in shambles, bearing the blows it had suffered during the violent Second Intifada that had raged from 2000 until it petered out in late 2005, hemmed in by an Israeli blockade of the Gaza Strip and choked by myriad Israeli military checkpoints in the West Bank. It was, moreover, still recovering from the disastrous economic legacy left by Yasser Arafat.

Whatever one may say politically or legally about the Israeli occupation of the Gaza Strip and West Bank that began in June 1967, from a purely economic perspective it was initially a boon for Palestinian employment and income. The sudden removal of the old barriers between Israel and the Jordanian West Bank and Egyptian controlled Gaza Strip meant that the relatively low-wage Palestinian workforce was perfectly positioned to supply expanding Israeli economic demand. Palestinian laborers were a common sight in Israeli construction sites, restaurants, car-repair garages, and similar unskilled and semi-skilled places of work. Palestinian agricultural produce filled Israeli supermarkets, and Israelis regularly went shopping for bargains on weekends in Palestinian marketplaces. According to the IMF, per capita output in the West Bank and Gaza Strip from 1968 to 1987 – “a period without conflict or restrictions” in the words of an IMF report – grew at an annual pace of 4.4 percent.

The outbreak of the First Intifada in late 1987 marked the end of that era. In reaction to the Palestinian uprising, barriers to the free movement of goods and workers from the West Bank and Gaza Strip into Israel began to be erected. The Palestinian Authority, established in 1994 following the Oslo agreement, initially ushered in a brief surge of economic activity, as private sector confidence rose in line with an immense transfusion of money flooding the Palestinian economy from donor countries propping up the Palestinian Authority. But the donor money could do little against the appalling economic shrinkage caused by the Second Intifada, when the Palestinian economy contracted by 17 percent in 2001 and a further 27 percent in 2002.

Even with all the impressive growth of recent years, the Palestinian economy has still not fully recovered from its losses in the beginning of the last decade. The IMF estimates that the West Bank and Gaza economy shrank overall from 1994 to 2010, at a trend rate equivalent to -0.6 percent per year. Its report states that had trend output growth since 1994 been the same as during 1968–1987, “real GDP per capita in 2010 would have been 88 percent higher than it actually was.” The peak year for Palestinian GDP per capita, in fact, remains 1992 – the year prior to the signing of the Oslo agreement.

THE UNDERLYING REASON FOR the Palestinian economic turnaround of the last few years, with real GDP growth estimated at a whopping 9 percent in 2010, ultimately lies not with Israeli policies or donor money, but a virtual revolution in the approach to running an economy at the highest levels of the Palestinian administration in Ramallah. The death of Arafat in late 2004 played no small part in that.

Arafat, the leader of the PLO and president of the Palestinian Authority from its inception in 1994 and until his death 10 years later, was fundamentally an “old school revolutionary” in ideology and temperament. This had critical implications for his approach to institutions and economic management. He opposed initiatives for the institutionalization of Palestinian rule, based both on an argument that the creation of institutions that were too stable prior to the creation of a Palestinian state would dull fervor for the fight for Palestinian nationalism, and because his grip on power depended to a large extent on bureaucratic chaos preventing the emergence of authorities independent of him. Transparency and accountability were foreign concepts for Arafat, who ran an economy with built-in corruption based on patronage, monopoly controlled industries and well-oiled kickback channels that trickled up bribes all the way to his cash-rich office.

The prevailing attitudes of the Palestinian Authority under Salam Fayyad as prime minister and finance minister since 2007 are so much the antithesis to previous Palestinian approaches that they have come to be regarded as a full-fledged political agenda, termed “Fayyadism.” Fayyad, who holds a PhD in economics from the University of Texas at Austin and has worked at the Federal Reserve Bank of St. Louis and the IMF, came to his position with a completely different background from those of old-guard PLO fighters, leading to a correspondingly different approach.

The new Palestinian strategy was partly born from studying what Zionism got right and the Palestinian movement got wrong in the 1940s. Everyone remembers David Ben- Gurion’s famous founding of the State of Israel in 1948, but Haj Amin al-Husseini’s declaration of an independent Palestinian state that same year has been relegated to the dustbin of history. The difference between the two lay in the fact that Husseini’s declaration was just that – a declaration with no substantive state to back it. Ben-Gurion, in contrast, had all the working elements of a full-fledged state under him the day he founded Israel.

In addition, waves of Jewish immigrants fleeing Europe in the 1930s and 1940s brought with them the know-how and understanding of running a modern economy. This meant that Israel began its existence with economic advantages over neighboring Arab countries from the start.

Fayyad and his staff came to the conclusion that instead of holding back the Palestinian liberation fervor, the slow and steady establishment of institutions was an essential requirement for attaining an independent state and for winning a seal of approval from international bodies. Stability and security for Palestinian citizens was also stressed. At the same time, getting the Palestinian economy into working order by adopting Western standards of running a modern economy was, in this view, just as important for Palestinian aspirations.

These views found concrete expression in a detailed working plan issued by Fayyad in August 2009 entitled “Palestine – Ending the Occupation, Establishing the State.” The two-year plan envisioned significant construction of state-like institutions in the Palestinian Authority, Western-styled separations of powers and a free market-orientated economy with transparency and accountability. It also called for the development of infrastructure necessary for establishing a de facto Palestinian state. The current drive to gather the endorsement of as many countries and international institutions as possible – such as the IMF and the World Bank – for the creation of a de jure Palestinian state, culminating in a planned appeal to the United Nations General Assembly in September, derives directly from Fayyad’s 2009 working plan.

TODAY, THE CITIES AND TOWNS of the West Bank are experiencing an economic boom. Consumers throng Ramallah, where new shopping malls are springing up. An entirely new Palestinian city, Rawabi, is in the construction stage, intended to provide up-scale housing for yuppie Palestinian families. It is no surprise that Fayyadism earns relatively high marks in both the IMF and the World Bank reports.

The IMF notes that real GDP growth in the West Bank and Gaza Strip is estimated at 9 percent in 2010, a large growth rate by any measure. The PA’s fiscal leadership has managed to reduce its recurrent deficit from 26 to 16 percent of GDP. The 2010 recurrent budget deficit was about $1.15 billion, almost 8 percent below the 2010 budget target, and total expenditures and net lending were more than 3 percent below budget projections and 8.4 percent below 2009 expenditures.

The quality, transparency and timeliness of economic and financial statistics collection and publishing has improved significantly. The steady reforms in the public finance management system, says the IMF, have enabled the PA to control expenditures, apply rigorous budget preparation procedures and establish fiscal transparency and accountability “in line with international standards.” This has enabled the PA to reduce its dependence on donor aid for recurrent spending, down from $1.8 billion in 2008 to $1.2 billion in 2010, with a view to a further reduction to less than $1 billion in 2011.

Commercial bank performance in the PA is given high marks by the IMF. The share of non-performing loans in total loans is on a downward trend, from 4 percent in 2009 to about 2 percent in 2010. Bank credit to the public sector, as a share of total assets, has declined from 10.4 to 9.7 percent in 2010. The banking has adequate liquidity and is well capitalized, in the assessment of the IMF, with private deposits in the West Bank in US dollar terms rising by 11 percent in 2010, reflecting strong private income growth. Even the decline in private deposits in Gaza by 14 percent is noted as a positive sign, indicating that cash was withdrawn to satisfy pent-up demand for consumer goods following the relaxation of import controls.

This has gone hand in hand with improvements in the financial market infrastructure including the establishment of a credit registry. Credit to the private sector in the West Bank has risen by 29 percent since 2009, and even in Gaza private credit rose by 17 percent, reversing a declining trend. A modern system to track bounced checks, in operation since 2009, has contributed to the decline in bounced checks by an estimated 25 percent. A bank deposit insurance scheme is being developed with World Bank assistance. The PA has completed the installation of an electronic payment system, to be augmented by a clearance house, significantly raising bank payments’ efficiency and reducing liquidity risk. The PA is even considering a small issue of treasury bills in 2011, amounting to about $3 million, by securitizing the existing PA debt owed to the Palestinian Monetary Authority.

The World Bank also accentuates many positive facts in its report. It notes that “education and health in the West Bank and Gaza are highly developed, comparing favorably to the performance of countries in the region as well as globally.” It goes on to state that trust in the justice system has increased, as witnessed by the increase in new cases registered at courts, and that service delivery in the PA compares favorably to countries in the region as well as middle-income countries in general. In addition, in 2009, roughly 22 percent of the Palestinian population lived in poverty, a nearly 4 percentage point improvement compared to 2004.

According to the World Bank, domestic tax revenues rose by nearly 50 percent compared to 2009 and exceeded 2010 budget projections by nearly 26 percent. In 2010, domestic tax revenues were equal to more than 15 percent of total spending, up from about 9 percent in 2009, with the PA ascribing this to increased enforcement and stronger collection efforts.

The World Bank report also gives high marks to perceptions of improvement in the security and justice sectors in recent years, with “anecdotal evidence from businessmen and lawyers highlighting the judicial performance in particular, specifically in the West Bank.” Anti-corruption efforts are also achieving successes, in the World Bank’s assessment. On the institutional side, the Palestinian Legislative Council has established a bureau to handle complaints from the public on a range of matters, including corruption.

GIVEN THESE FACTS AND FIGURES, both the IMF and World Bank give general seals of approval to the PA’s economic potential to create an independent state. Although neither organization was willing to answer questions from The Jerusalem Report for the record, officials pointed to the reports they issued as expressing their authoritative views.

The World Bank report, while noting that “no recipe for building a state exists,” cites a long list published by the OECD that identifies key functions that are strategically important for a successful state. These include providing security and justice, revenue management, and service delivery such as health, education, sanitation and infrastructure. With respect to these criteria, the World Bank report gives the PA high marks in achieving many of them, thus concluding that “if the Palestinian Authority maintains its performance in institution building and delivery of public services, it is well-positioned for the establishment of a state at any point in the near future.”

The IMF is just as emphatic in its assessment of “statehood readiness,” adding that it “considers that the PA is now able to conduct the sound economic policies expected of a future well-functioning Palestinian state, given its solid track record in reforms and institution-building in the public finance and financial areas.” In particular, the IMF report considers the Palestine Monetary Authority to now be in a position to carry out the functions of a central bank.

No one reading both the IMF and World Bank reports, however, can come away with a sense that all is rosy in the PA from the economic perspective. To the contrary, there are several warnings in the reports on disturbing trends.

Gaza’s economic recovery, for example, is described by the IMF as “mostly a ‘catch up’ from a very low base” following the tightening of Israeli-imposed import and export restrictions in 2006. Gaza’s output level is lower today than in 2005 by about 20 percent, and the unemployment rate remains high at about 38 percent. The divergence in output paths between the West Bank and Gaza is striking, reflecting the Hamas-Fatah split of the last four years and the closure imposed on Gaza. While the West Bank’s real GDP per capita has grown steadily since 2007, and is projected to be about 58 percent above its 1994 level by 2013, Gaza’s real GDP per capita has been on a downward trend since 2006, and began showing signs of recovery only in 2010.

The unemployment rate has been declining very slowly in both Gaza and the West Bank, especially among the young. During 2008-10, unemployment in the West Bank declined from 19 percent to 17 percent, and from 41 percent to 38 percent in Gaza – still very high unemployment percentages.

The situation in Gaza clearly depends on the extent of Israel’s closure, intended to isolate Hamas. The contraction of Gaza’s economy in 2007-2009, and the recent economic improvement there, mirror the imposition of the closure and the subsequent loosening of some import and export restrictions on the part of Israel. The closure has not, however, shaken Hamas’s rule in the Gaza Strip.

In the West Bank, lower-than-expected donor aid for both recurrent spending and development projects has led to a buildup of PA expenditure arrears and borrowing from commercial banks. Towards the end of phasing out donor dependence, the IMF recommends phasing out electricity subsidies and requiring municipalities to pay their electricity bills, reforming the public pension system to put it on a path of financial viability, initiating civil service reform to reduce the heavy public wage bill, and “strengthening the legal and regulatory framework to improve the investment climate for businesses.”

The World Bank expresses concern that growth in the PA does not appear sustainable, with growth reflecting recovery from a very low base reached during the second intifada, and still mainly confined to the non-tradable sector and primarily donor-driven. Its report states that “ultimately, sustainable economic growth [in the West Bank and Gaza Strip] can only be underpinned by a vibrant private sector. The latter will not rebound significantly while Israeli restrictions on access to natural resources and markets remain in place, and as long as investors are deterred by the increased cost of business associated with the closure regime.”

Furthermore, the World Bank notes that PA growth is “mostly confined to the nontradable sector and probably reflects the importance of donor aid in driving the Palestinian economy,” while the economy has experienced marked de-industrialization.

“There are problems with the economy,” says Awartani, the An-Najah professor. “Tourism and agriculture were doing fairly well until recently. The basic problems are psychological and political. No one is optimistic about the future. They are holding back spending. Israel is using trade as a way to pressure the Palestinians politically.”

THE CONSENSUS OF NEARLY all observers is that if the Palestinian economy is to capitalize on its current momentum in a sustainable growth pattern, it must continue implementing Fayyad’s reforms and expand its industrial and export sectors in order to increase employment. It must also reduce its dependence on donor aid. But achieving those goals will require political decisions and considerations, some of which may be at odds with purely economic goals.

The question-mark over the continuation of the reforms of the Fayyad administration following the Fatah-Hamas reconciliation agreement remains a source of uncertainty. “There is one thing that Fatah and Hamas agree on,” says Inbari, “and that is on getting rid of Fayyad as prime minister. There is a lot of pressure on Abu Mazen to remove Fayyad from his position. There is talk about perhaps Fayyad leaving the prime minister’s office while retaining authority over financial matters, but it is unclear whether this can really work.”

“If Fayyad is removed, which I doubt will happen, we could run into economic problems,” Awartani tells The Report. “He is a very good expert on financial matters, and I doubt any Palestinian faction can find someone with his expertise.”

Another looming question is what will happen in September. Will there be a unilateral declaration of a Palestinian state? If so, how will Israel react?

“Declaring a state is a political act,” says Ruth Lowenthal, a senior economist at Sadan-Lowenthal, a Tel Aviv economics consultancy firm, who has consulted for businesses working in the PA. “From the economic perspective, the question is what will Israel’s reaction be. If in response Israel will turn its back on the Palestinians, that will be very uncomfortable for the Palestinians. If, on the other hand, Israel says, ‘OK, you’ve got a state, we will continue to trade with you as before,’ the outcome will be very different.”

The fact, according to Lowenthal, is that the Palestinian economy is highly dependent on trade with Israel, and that situation is not expected to change in the short term, even though there is a lot of talk among Palestinian leaders about trying to dissociate economically from Israel.

“The Palestinians need Israel from an economic perspective, but Israel does not need the Palestinians,” continues Lowenthal. “Look at how easily Israel gave up on employing between 120,000 and 130,000 Palestinians [after the outbreak of the Intifada]. The Israeli economy adapted, while the Palestinians suffered from unemployment.”

Even the possibility of a new Palestinian state issuing its own currency seems remote at the moment. “If the Palestinians are truly ready for independence, then they should be ready to issue an independent Palestinian currency,” points out Inbari. “But behind closed doors, even the closest economic advisers to the PA are saying that doing so prematurely would be a disaster.”

“A new Palestinian state could issue its own currency. But for what purpose?” adds Lowenthal. “What would back that currency? Will they attain monetary independence, when they are so dependent on trade with only one country, Israel? It is not at all clear that a Palestinian state would be better off with its own currency.”

Awartani agrees with that assessment. “No one is talking seriously about an independent Palestinian currency,” he says. “I do not believe it serves the purposes of the Palestinians. We have other problems to deal with.”

Lowenthal stresses that the Palestinian economy does have good potential. “There has been progress in recent years, no doubt,” she says. “There are new laws regarding foreign investments – but where are the investments? Most of the money from abroad is donations, not investments. The Palestinian industrial sector is weakening, and the PA economy is too dependent on donations. Israel also took in foreign donor money for a long time, but the ratio of donor money to independent output has dropped dramatically over the years, because the country built up industry and trade with the world.”

“I hope, for their sake, that the Palestinians think in economic terms,” concludes Lowenthal, “not political terms alone. Politics is very, very important, and has to be given expression. But keep the economics in perspective as well.”

Awartani is, nevertheless, optimistic. “A Palestinian declaration of a state in September will not be a political tsunami,” he says. “It could be an opportunity for all of us, Palestinian and Israeli. A Palestinian state will be an accountable and responsible body. Economically, that is what is needed.”

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