Developing the Occupied Territories: an Investment in Peace – Vol II – The Economy – World Bank Report

DEVELOPING THE OCCUPIED TERRITORIES

AN INVESTMENT IN PEACE

Volume II: The Economy

The World Bank

Washington, D.C.

September 1993

Copyright (c) 1993

The International Bank for Reconstruction and Development/THE WORLD BANK

1818 H Street, N.W.

Washington, D.C. 20433, U.S.A.

All rights reserved

Manufactured in the United States of America

First printing September 1993

Second printing October 1993

The six-volume series, Developing the Occupied Territories: An Investment in Peace, is published to communicate the results of the Bank's work to the development community with the least possible delay. The typescript of this paper therefore has not been prepared in accordance with the procedures appropriate to formal printed texts, and the World Bank accepts no responsibility for errors.

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ISBN 0-8213-2689-9

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CONTENTS

PREFACE – vii

1. OVERVIEW & SUMMARY – 1

A. Introduction – 1

B. Past Patterns of Development in the Occupied Territories – 1

C. Post-Peace Economic Strategy – 3

D. Trade and Structural Policy Options – 4

E. Scenarios for the Interim Period and Beyond – 7

F. Implementation – 8

II. ECONOMIC HISTORY SINCE 1967 – 10

A: The Past Pattern of Growth – 11

B: Economic Relations, Policies and the Pattern of Development – 25

C: Shocks and Responses – 35

III: STRUCTURAL POLICY CHANGES FOR THE FUTURE – 45

A. Trade without Restrictions – 45

B. Trade Policy Choices – 47

C. Lifting the Regulatory Burden – 56

D. Public Spending & the Regional Pattern of Comparative Advantage – 56

E. Mobilizing Taxes – 57

F. Natural Resources – 58

G. Conclusion – 58

IV: MACROECONOMIC POLICIES FOR THE FUTURE – 59

A. The Scope for Public Policy Action on the Real Side – 59

B. The Potential for Seignorage Revenues – 62

C. Facilitating the Mobilization of Resources – 63

D. Provision of Liquidity and Supervision – 66

E. Speculating on the Choice of an Exchange Rate Regime – 66

F. Conclusion – 71

V: SCENARIOS FOR THE 1990s – 73

A. What Happens when Employment in Israel is Lost? – 73

B. Alternative Scenarios for a Peace Agreement – 75

C. Public Finance and Official Financing Requirements – 86

D. Conclusion – 89

FIGURES

1. Occupied Territories Unemployment – 12

2. Growth in the 1970s – 13

3. Per Capita Gross domestic Product and National Disposable Income – 15

4. Israel, Occupied Territories and Regional GNP Growth – 17

5. Investment as Share of GDP and GNP – 19

6. Composition of Fixed Capital Formation – 20

7. Share of Manufacturing in Gross Domestic Product, Various Economies – 21

8. Labor Productivity – 23

9. Employed West Bank and Gaza Residents by Place of Employment, 1970-91 – 29

10. Ratio of Palestinian to Israeli Daily Wage – 30

11. Wage Ratios of Palestinians in Israel and Occupied Territories – 31

12. Share of Industrial Product in Trade – 32

13. Inflation: West Bank, Gaza, and Israel – 37

14. West Bank Olive Production and Change in Olive Oil Stock, 1968-86 – 42

15. Occupied Territories: Change in Money Balances as Percent of GNP, 1980-90 – 43

16. Exchange Rates of New Israeli Shekel and Jordanian Dinar to US Dollar – 44

17. Alternative Options for International Economic Relations – 50-51

18. West Bank, Gaza Daily Average Real Wage Levels for Industry – 53

19. Unit Labor Costs – 54

20. Macro Policy With and Without an Independent Currency – 67

21. Choice of an Exchange Rate Regime – 70

22. Overview of Scenarios: Smooth Labor Cut-off – 81

23. Overview of Scenarios: Abrupt Labor Cut-off – 82

24. Baseline Scenario: Smooth Labor Cut-off – 84

25. Baseline Scenario: Abrupt Labor Cut-off – 85

TABLES

1. Growth in GDP, Factors and Total Factor Productivity – 22

2. Integrated Public Sector Finances – 34

3. Revenue and Expenditure Comparisons – 35

4. Predicted Shares of Occupied Territory Trade under Alternative Assumptions – 46

5. Actual and Predicted Israeli Export and Import Shares – 47

6. Seignorage in the Middle East – 64

7. Growth in GNP per capita under Six Scenarios – 80

8. Public Sector Finances, 1994-2003 – 87

9. External Financing Requirements, 1994-2003 – 88

ANNEXES

1. The Workings of the Labor Market in the Occupied Territories – 90

2. Public Finances in the Occupied Territories – 103

3. Trading Patterns in a Less Restricted World: Results from a Gravity Model – 122

4. Simulation Models – 130

5. Statistical Appendix – 132

REFERENCES – 171

Preface

1. At the request of the sponsors and organizers of the Middle East Peace Talks, the World Bank has been supporting the work of the Multilateral Working Group on Economic Development by providing analyses of the key economic issues and developmental challenges facing the Middle East region. At its second meeting in Paris in October 1992, the Working Group requested the Bank to expand its contribution to include, inter alia, an assessment of the development needs and prospects of the economies of the West Bank and the Gaza Strip (commonly referred to as the Occupied Territories). In response to this request, a Bank mission visited the Occupied Territories during the period January 21-February 24,1993. The mission comprised five teams focusing on the following areas: Private Sector Development, Agriculture, Human Resources, Infrastructure and Macroeconomics. Each team was in the field for about two weeks. The mission was led by Prem Garg who, together with Samir El-Khouri, stayed in the field throughout to provide continuity and guidance to the five teams. The staffing of the five teams was as follows:

Macroeconomics:

Michael Walton (Team Leader)

Samir El-Khouri (Fiscal Analyst)

Ishac Diwan (Macroeconomist)

Private Sector Development:

Albert Martinez (Team Leader)

Robert Mertz (Financial Sector Specialist)

Joseph Saba (Legal Specialist)

Dileep Hurry 1/ (Regulatory Environment and Tourism Specialist)

Agriculture:

Gert van Santen (Team Leader)

Ulrich Kuffner (Water Resource Engineer)

Merle Jensen 1/ (Horticulture Specialist)

Infrastructure:

Alastair McKechnie (Team Leader)

Ulrich Kuffner (Water Resource Engineer)

Lawrence Hannah (Urban Specialist)

Nail Cengiz Yucel (Transport Sector Specialist)

Ted Moore 1/ (Power Engineer)

Human Resources:

Fredrick Golladay (Team Leader)

Maureen Field 1/ (Education Specialist)

Radwan Ali Shaban 1/ (Human Resource Economist)

2. Mission members travelled extensively in the West Bank and Gaza, visiting municipalities, farms, businesses, industries, academic institutions, refugee camps and NGO-run facilities. Mission members also travelled in Israel, as needed, and paid several visits to Amman. The representatives of the key bilateral and multilateral donors in Jerusalem, Tel Aviv and Amman responsible for the Occupied Territories were kept briefed about the work of the mission. Close contact was also maintained with the field staff of UN agencies.

3. The Bank mission was received warmly by all sides, who took keen interest in the work of the mission and provided superb logistical and counterpart support for the field work. The main counterparts on the Israeli side were the Bank of Israel and the Civil Administration in charge of the Occupied Territories. On the Palestinian side, the main counterparts were the Technical Committees of the Palestinian Team to the Peace Conference, consisting mainly of Palestinians who are members of the bilateral or multilateral peace teams. The Ministry of Planning was the main contact on the Jordanian side. The Bank would like to thank all concerned parties, especially the Israeli, Jordanian and Palestinian hosts, for the excellent support and cooperation that the Bank mission received for this field work.

4. This report is based on the findings of the above mission. This report is in six volumes:

– Volume I provides a summary overview of the key findings and recommendations of the study. After commenting selectively on the current socioeconomic situation in the OT and its evolution over time, it discusses prospects for sustainable development in the future and outlines the priority agenda of policies and programs needed to promote such development.

– Volume II explores the strategic choices at the macro level that will be faced by the OT in the future and the implications for economic relations between the OT and the rest of the region. The study looks at the current situation and its evolution over the past 25 years. The study then examines several policy choices for the future affecting the structure of development in the OT. Finally, it outlines some illustrative scenarios for the future, focussing on the consequences of current developments in the region.

– Volume III reviews the performance of the private sector (including, in particular, the industry and tourism sectors) in the OT. The study assesses the environment in which the private sector operates and its future prospects and makes recommendations for accelerating private sector development in the future.

– Volume IV reviews the evolution and structure of the agricultural sector in the OT; analyzes its current characteristics; assesses OT competitiveness in the immediate and longer term; outlines the main policy options and their implications; and provides a preliminary assessment of sectoral financial and technical assistance (TA) needs.

– Volume V assesses the current situation in the infrastructure sectors (electricity, water supply and sanitation, transport, housing and solid waste services) in the OT; identifies the major issues confronting these sectors; and outlines priorities for TA and investment needs. As local authorities are major institutions in the delivery of public services in these sectors, the study also includes a review of their current situation and makes recommendations for improving the functioning of municipalities.

– Volume VI reviews the current status as regards human resource development; analyzes options for enhancing individual welfare and labor productivity in the OT; and outlines investment and TA priorities for strengthening existing programs and for laying the foundation for later reforms.

5. It is worth highlighting two limitations of this study right at the outset. First, a number of key issues bearing upon the future development of the OT (e.g., the allocation of land and water resources, the disposition of Israeli settlements in the OT, the future status of expatriate Palestinians, the territorial issues surrounding Jerusalem and, most importantly, the nature of the proposed "self-governing" arrangements for the OT) are the subject of ongoing bilateral negotiations between the Israelis and the Palestinians. The resolution of these issues is likely to be based primarily on political and security considerations. As the Bank mission to the OT was a technical mission, with neither the mandate nor the expertise to deal with political or security aspects, this study does not take any positions on issues that are on the agenda for bilateral negotiations. The focus instead is on policies, institutions and investments – where optimal choices are largely invariant to the eventual political arrangements to be agreed at the bilateral negotiations. Thus, for example, while analysing, where appropriate, the economic links between East Jerusalem and the West Bank and Gaza, the report avoids making any judgements regarding the future status of East Jerusalem.

6. Second, the study has had to cope with very serious data gaps and inconsistencies. Much of the data on the OT are, directly or indirectly, from official Israeli sources. There are, however, serious gaps in the OT data base. A population census has not been carried out in the OT for more than 25 years. As a result, most of the demographic and labor force data are based on extrapolations and on sample surveys, the reliability of which are undermined by problems of nonresponse, especially since the onset of the Intifada (popular uprising) in 1987. Data on East Jerusalem and on Israeli settlements in the OT, both of which are treated as part of Israel by the official Israeli sources, are mostly unavailable. Data available on trade between the OT and Israel and on the profitability and competitiveness of the agricultural, industrial and service enterprises are also very limited. Data on the OT from Palestinian and Israeli nonofficial sources are sparse and selective. Also, Palestinian data, when they exist, are often based on ad hoc surveys that do not lend themselves easily to cross-sectional or longitudinal comparisons. In many instances, data differ between sources, and, even when the same source is used, there are gaps and apparent inconsistencies. Given these data problems, the report uses estimates that appear most plausible in light of the mission's field observations. In cases where the data differences among various sources are particularly sharp (e.g., population, unemployment and social indicators), the report attempts, where possible, to examine the reasons for these differences and to indicate the implications of alternative estimates for the results of the analysis.

7. In view of the limitations on the mission mandate, the data difficulties and the time and resource constraints, this study can only be considered a beginning. The analysis in the study, especially for the longer term, is necessarily incomplete; as, and when, progress is made in the bilateral negotiations, the study will need to be updated and expanded to take account of the agreements reached. Also, notwithstanding the care exercised in locating and interpreting the data from various sources, the empirical underpinnings of this study leave something to be desired, and, therefore, the conclusions of the study should be treated only as indicative of broad trends and priorities. Further, in-depth studies and project feasibility work will be required before the findings of this report could be used to make operational decisions.

8. An earlier draft of this report was discussed with the Israeli, Jordanian and Palestinian authorities by a Bank mission to the region during July 12-26, 1993. Where appropriate, the report has been revised to incorporate the comments received by the mission during the July discussions.

_________________

1/ Bank consultant.

I. OVERVIEW AND SUMMARY

A. Introduction

1.1 The economy of the West Bank and Gaza is presently in a state of crisis. Following the Gulf war in January 1991 there was a substantial reduction in Palestinian employment in most Gulf states. With the partial closure of the border in March 1993 employment in Israel fell drastically and in June was still less than half of previous levels. Municipalities are starved of cash. Many public services are in disarray: power outages are frequent, drinking water is often below WHO health standards, and garbage rots on the streets in refugee camps in Gaza. Meanwhile, urban land prices have gone through the roof in West Bank towns and Gaza City.

1.2 The present crisis in the Occupied Territories is in sharp contrast to a history of large increases in incomes, which are now about three times the level of 25 years ago. Household conditions improved substantially, with a many-fold rise in possession of consumer durables (albeit many second hand) and in water and electricity connections, including in relatively disadvantaged refugee camps and villages. There was also a substantial reduction in infant mortality and rise in school enrollments. Since unskilled labor played a central role in past growth, it is almost certainly the case that the poor participated in the gains implying a large reduction in poverty.

1.3 This report attempts to analyze the issues and choices thrown up by the current state of development in the OT and the economic agreements that could emerge from the on-going peace negotiations. The report attempts to adhere to a strictly economic perspective, recognizing that many of the questions will be subject to bilateral negotiations between the Israelis and Palestinians. The companion volumes on economic infrastructure, human resources and social services, private sector development and agriculture examine sectoral conditions and policy choices. As with the other volumes, this report must contend with uncertainty surrounding the outcomes of present and future negotiations.

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