Long term policy options for the Palestinian Economy – World Bank study

Long-Term Policy Options

for the

Palestinian Economy

July 2002

The World Bank

West Bank and Gaza Office

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Table of Contents

List of Figures, Tables and Boxes – vii

Acronyms and Abbreviations – ix

Executive Summary – xi

Chapter 1. Introduction – 1

Inadequate development outcomes in the West Bank and Gaza – 5

Current crisis – 6

Overlap of politics and economics – 8

Lessons from civil conflict – 9

Study objectives – 12

Chapter 2. Existing Trade Distortions and Future Policy Options – 15

Israel’s trade regime – 17

Pros and cons of a customs union with Israel – 19

Free trade area with Israel – 27

Conclusion on choice of trade regime: NDTP, FTA or CU – 31

Chapter 3. Labor Market Outcomes – 33

Historical labor trends – 33

Profiles of the employed and unemployed – 37

Modeling the Palestinian labor market – 44

Implications of labor market integration – 46

Chapter 4. The Business Environment and Private Sector Growth – 53

Unstable policy environment and crippling transactions costs – 55

High production costs – 56

Rule of Law – 58

Regulation – 60

Banking and financial intermediation – 60

Corruption, anticompetitive practices and lack of transparency – 62

Consultation with business – 64

Revenue administration – 67

Non-public delivery of public services – 68

Conclusions – 69

Chapter 5. Palestinian Economic Growth, Past and Future……………………………….. 71

Palestinian growth history 1968-2000 – 73

Oslo and the Paris Protocol – 74

Growth accounting – 76

Income convergence with Israel – 77

Palestinian growth potential 2001-2010 – 80

Conclusions – 95

Annexes – 101

Annex I. Transport Survey Results – 101

Annex II. The Impact of the Crisis on the Israeli Economy – 106

Annex III. West Bank and Gaza Imports of Services from Israel (US$000, 1998) – 114

Annex IV. Regression Results for Wage Determinants – 115

Annex V. A Model of the Palestinian Labor Market – 116

Annex VI. Estimates of Factor Accumulation and TFP Growth – 120

References – 123

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Executive Summary

Introduction

The Palestinian economy has been closely integrated with its larger and richer neighbor Israel since the 1967 Israeli occupation of the Palestinian Territories. Trade between the Palestinian Territories and Israel effectively became internal, reflecting a customs union trade regime, and a large share of the Palestinian labor force was employed by Israeli firms. The result today is a high degree of Palestinian dependence on the Israeli economy: trade volumes with Israel are very large – 96 percent of Palestinian exports are destined for Israel – and labor flows into the Israeli labor market account for nearly a quarter of total Palestinian employment. The main activities of the Palestinian economy are shaped by the nature of economic relations with Israel. Palestinian production is largely oriented toward providing inexpensive, low value-added products for Israeli consumption or re-export, and specialization in low-productivity construction and agriculture sector jobs.

The advent of the peace process in the early 1990s and the 1994 signing of the Paris Protocol formalized the Palestinian-Israeli economic relationship between two administratively and physically distinct entities, although considerable overlap remained. The Paris Protocol gave the Palestinians administrative autonomy over the Palestinian Territories in terms of public service delivery, and formalized policies of economic cooperation and integration with Israel relating to the exchange of goods, fiscal policy, currency arrangements, and labor services.

Economic outcomes post-Oslo. Despite high expectations for economic normalization and growth following the peace accord and Paris Protocol, economic performance was modest at best, and suffered periods of sharp decline. The deep recession of 1995-1996 was the result of Israeli security measures under which the West Bank and Gaza Strip were effectively cut off from Israel and from each other. The prospect and unpredictability of closures created an environment of uncertainty and risk. This in turn was compounded by extraordinarily high transactions costs and restrictions on access to alternative markets for import or export under the agreed trade regime. Domestic output and exports declined, private sector investment dried up, and labor flows to Israel were sharply curtailed, all of which contributed to joblessness and rising poverty.

When security measures eased, particularly in 1998, 1999 and the first part of 2000, the economy returned to its historical growth trend of 5 percent annual GDP growth. But the anticipated income convergence with Israel did not materialize for a variety of reasons. Although it provided preferential Palestinian access to Israeli markets, the customs union trade policy effectively limited Palestinian imports to relatively expensive Israeli goods. The net effect restricted domestic Palestinian productivity growth and hindered expansion of export products and markets beyond Israel. Palestinian and Israeli labor market integration produced mixed effects: whereas access to high-paying Israeli jobs increased Palestinian employment and household incomes, it also raised domestic Palestinian wages, dampening labor demand and diminishing Palestinian competitiveness on export markets. The uncertain business environment – exacerbated by closure policy and a weak institutional framework for promoting investment – discouraged investors due to the perceived risks. Together, these policies resulted in a development path of Palestinian economic dependence on Israel.

Although the Paris Protocol and the broader economic model of integration with Israel had many shortcomings, important progress was achieved during the Interim Period, generating optimism that a final status agreement based on the peaceful coexistence of two neighboring sovereign entities was attainable. But serious challenges emerged in 1999 and 2000 with the start of final status negotiations over the contentious issues of borders, Jerusalem, access to water resources, and the right of return of Palestinian refugees.

Negotiations broke down as tensions erupted into civil conflict in September 2000, plunging the Palestinians into political uncertainty and severe economic crisis that is ongoing today. Closures and confrontation resulted in a sharp drop in trade, employment, and investment, and a doubling of already high transport costs. Real GDP fell 6 percent for the year 2000 (despite robust growth during the first three quarters), and by an additional 12 percent in 2001, with critical implications for welfare: per capita income plummeted by 10 percent in 2000 and another 19 percent in 2001.

In light of deteriorating economic relations between Israel and the West Bank and Gaza, and suspended peace negotiations, it is timely at this juncture between the lapsed Interim Period and a final status agreement to examine past experience with a view to assessing the policy choices facing Palestinian policymakers in the future. The post-Oslo experience points to failed economic normalization and income convergence with Israel. Several reasons for these failures have been advanced, including poor implementation of the Paris Protocol, as well as fundamental flaws inherent to the protocol itself. For instance, loopholes in the trade rules for customs crossing procedures and inadequate dispute settlement mechanisms enabled Israel’s politically-motivated closure policy to circumvent the agreed economic objectives of cooperation and Palestinian development. Arguments that the protocol was destined to fail are based on continued Palestinian dependency and vulnerability doomed to generate poor growth outcomes due to low value-added activities and a lack of technology transfer, or simply the fact that the Paris Protocol represented a temporary agreement falling mid-way between sovereignty and full partnership, but with no Palestinian recourse to address shortcomings. In this sense, the protocol was an unenforceable and incomplete contract that worked to Israel’s advantage.

Overlap of politics and economics. The experience under the Paris Protocol illustrates the degree to which political and economic factors are intertwined; both types of factors need to be addressed in a comprehensive framework. The fact that political pressures from Israeli security concerns introduced severe economic hardship on the Palestinians and threatened newly-gained Palestinian autonomy contributed to the unraveling of the interim agreement. The economic environment of uncertainty, risk, costly transactions, and inadequate legal, regulatory and financial institutions hampered private sector development and especially Palestinian–Israeli partnerships and business networks at the firm level, effectively weakening an important tie that holds civil society together. These factors further undermined Palestinian economic growth, laying the foundation for political crisis and civil conflict.

Study objectives. Given the problems associated with the existing policy framework, this analysis examines alternative policy options that will face Palestinian policymakers in the event of a peace agreement with Israel. These future policy choices relate to trade, labor mobility to Israel, and the business environment and associated public-private interactions. In a first stage, each policy area is analyzed separately, that is, in a partial equilibrium context independent of the others without accounting for broader intersectoral relationships.

In a second stage, the analysis brings together these separate areas into an integrated framework. A range of assumptions vis-à-vis the nature of borders between West Bank and Gaza and Israel is delineated, tying together the trade, labor and private sector development considerations to measure their combined impact on growth prospects. The analysis develops scenarios to reflect different combinations of future policy options linked to the nature of borders with Israel. This simulation exercise illustrates the relative merits of each scenario, the associated trade-offs, and the prospects for economic growth in the event of a peace agreement and a completion of final status negotiations. Welfare implications and the capacity of the social safety net to address present and future Palestinian needs are critically important, and will be addressed in a companion World Bank study under preparation.

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