West Bank and Gaza macroeconomic and fiscal framework: Sixth review of progress – IMF report for AHLC

MACROECONOMIC AND FISCAL FRAMEWORK

FOR THE WEST BANK AND GAZA:

SIXTH REVIEW OF PROGRESS¹

STAFF REPORT FOR THE MEETING OF THE AD-HOC LIAISON COMMITTEE

New York, September 21, 2010

EXECUTIVE SUMMARY

The recovery of the West Bank and Gaza (WBG)’s economy has continued, with real GDP growth projected at 8 percent in 2010. In Gaza, growth was boosted by a gradual relaxation by the Government of Israel (GoI) of restrictions on imports, culminating in the lifting of import controls on consumer goods and inputs for donor-supervised projects. In the West Bank, growth has been driven by the Palestinian Authority (PA)’s security and public finance reforms supported by donor aid, and the easing of obstacles on internal movement of goods and people.

The economy is expanding from a very low base, especially in Gaza where living standards are well below those that prevailed in 1994. Gaza’s output per capita is today at only 60 percent of its 1994 level, and its unemployment is still above 35 percent, one of the highest in the world. The West Bank has fared better, but its recovery started only in 2007, following a slump, with Prime Minister Fayyad’s aid-supported reforms. Overall, the WBG’s overall growth performance since 1994, as indicated by its general trend and volatility, has been weaker than for countries that had a comparable GDP per capita in 1994.

For growth to be sustained, it is essential that the remaining restrictions on economic activity be lifted. Gaza’s recovery will wane unless the ban on exports and on imports of private sector capital inputs is removed. Similarly, the West Bank’s growth is bound to decline with the persistence of restrictions on movement and access, in particular those on exports to Israel and East Jerusalem, and on access by the private sector to about 60 percent of its territory (“Area C”). Removing these restrictions is also important for a more efficient pattern of output where trade-dependent sectors, including manufacturing, are no longer suppressed.

The PA has continued in 2010 to build institutions and undertake reforms as set out in its Palestinian Reform and Development Plan, but has been facing serious liquidity difficulties due to shortfalls in donor aid. Since 2007, sound and transparent expenditure management and enhanced tax administration have led to a decline in the share of wages and utility subsidies in the budget, a pickup in domestic tax revenue, and a reduction in the recurrent deficit and of donor aid needed to finance it from $1.8 billion in 2008 to $1.2 billion in 2010. Fiscal performance during January to July 2010 has been broadly as envisaged in the 2010 budget. However, lower-than-budgeted donor aid has led to substantial borrowing from domestic banks and the accumulation of payment arrears. There is an urgent need to secure additional donor assistance of $0.3 billion to cover the financing gap for 2010.

To support private sector expansion and further enhance public sector efficiency, it is essential for the PA to maintain its solid track record by accelerating key structural reforms. These reforms include enhancing the social safety net, privatizing electricity distribution, improving the legal and regulatory framework for businesses, restoring the viability of the public pension system, and implementing civil service reform.

I. RECENT ECONOMIC DEVELOPMENTS

1. The macroeconomic situation continued to improve in the West Bank and Gaza, with solid economic growth registered so far in 2010. Real GDP growth in the first half of 2010 (compared to the first half of 2009) is estimated at 9 percent for the West Bank and 16 percent for Gaza. In the West Bank, private sector confidence continued to be bolstered by good management and reforms by the Palestinian Authority (PA) supported by donor aid, improvements in security conditions, and fewer controls on internal movement of goods and people than in early 2009. The recovery in Gaza was driven by a gradual easing of the blockade. However, exports from the WBG to Israel, as well as imports by the private sector of capital inputs and raw materials, continue to be restricted.² The growth pattern continues to be heavily skewed toward services, while activity in sectors that depend on investment inputs and export markets, notably manufacturing, continues to be suppressed. Given the uncertain prospect for further easing of trade controls in the remainder of the year, real GDP growth for the WBG in 2010 is conservatively projected at 8 percent.

2. The sustainability of the strong growth performance for the remainder of 2010 and beyond is uncertain due to persisting restrictions on movement and access:

3. Given the uncertainty regarding its quality and sustainability, the WBG’s real GDP growth for 2010 as a whole is conservatively projected at 8 percent, despite the 10.5 percent growth estimated for the first half of the year. In Gaza, output had been highly suppressed in the first half of 2009 by the exceptionally tight blockade and impact of the war. The relaxation of import restrictions allowed the satisfaction of substantial pent up demand by consumers for goods and services that had hitherto been scarce. The extent of this pent up demand, and the duration of its impact on output, are still unclear. The absence of a significant decline in unemployment in Gaza (see below) is especially worrisome, as it could indicate that the rise in output took place on the basis of a better utilization of already employed resources, without significant investment and hiring.⁷  In the West Bank, there is a risk of continued donor aid shortfalls and consequent sharp curtailment of government expenditures in the remainder of 2010. This could dampen growth both directly and through reduced private sector confidence in the ability of the government to prevent further payment arrears.

4. Unemployment has been declining in the West Bank but virtually unchanged in Gaza. Unemployment in the West Bank has declined from an average of 18 percent in the first half of 2009 to 16 percent in the first half of 2010. However, Gaza’s unemployment has remained unchanged at about 37 percent in both periods. While in the West Bank

unemployment has been on a declining trend since 2002, Gaza’s unemployment rate has remained above 30 percent since then. Although the number of West Bank workers allowed into Israel has been rising since 2007, as a share of the labor force it has remained at about 11 percent, thus contributing little to the decline in unemployment.⁸ Unemployment should decline faster once controls on exports and on investment inputs are relaxed, uncertainty on the sustainability of growth diminishes, and the private sector becomes more confident of steady access to outside markets.

5. Inflation has been on a declining trend so far in 2010. The WBG’s twelve-month CPI inflation rate (assessed in NIS) fell from about 5 percent in January to 3 percent in July. The decline reflected lower inflation in Israel, the easing of import restrictions, as well as the fall in world food prices. While Gaza’s inflation had risen sharply above that of the West Bank as the blockade intensified during 2008, it has been on a declining trend following the end of the Gaza war in early 2009. By July 2010, inflation was significantly lower in Gaza (1 percent) than in the West Bank (3 percent), and East Jerusalem (5 percent), reflecting the marked relaxation of the blockade on foodstuffs and other consumer imports, as well as food’s higher weight in Gaza’s consumption basket compared to the other regions.

6. Commercial banks have not been significantly affected by the global financial crisis and are performing well. Overall, banks in the WBG continue to have very limited  exposure to global markets, and apply conservative lending practices domestically.⁹  In the West Bank, private deposits in U.S. dollar terms rose by 7 percent in the year to June 2010, in line with private income growth. In Gaza, private deposits declined by 9 percent, reflecting large cash withdrawals to satisfy pent up demand for consumer goods following the relaxation of import controls. Credit to the private sector in the West Bank rose by 40 percent mostly to finance internal trade and construction activities. In Gaza, banks’ prospects have improved as a result of the easing of restrictions by the GoI on the entry of consumer goods and bank-notes (see below), and as depositors have become increasingly confident in their ability to withdraw cash. While the restrictions on the entry of Jordanian dinars and U.S. dollars are still formally in place, their impact has been limited since June/July 2010 with the inflows of these currencies through crossings at which controls have been eased, as well as the facilitation by the GoI of their entry for the purpose of payments by international organizations. The improved conditions in Gaza led to a rise in private credit by 8 percent, reversing a declining trend since end-2007. However, the latter recovery is unlikely to last without a revival in private investment, which requires lifting restrictions on imported inputs.  The rise in credit in the WBG also stems from significant improvements in financial market infrastructure since 2009, including the establishment of the credit registry, which allows a better assessment of borrowers’ creditworthiness. The PMA continues to make progress in institutional reforms with intensive Fund technical assistance (Box 1).

7. The Palestine Monetary Authority (PMA) and the Bank of Israel (BoI) have been collaborating closely to facilitate cooperation between Palestinian and Israeli commercial banks. In 2009, large shekel cash surpluses had accumulated at Palestinian banks due to Israeli banks’ refusal to accept these cash deposits on concerns about legal implications. That problem was resolved in July 2010 through a special arrangement whereby the excess shekel cash is regularly deposited at Israeli banks’ accounts with the BoI. The BoI and PMA are currently working on ways to ensure the regular transfer into Gaza of cash amounts adequate to cover fully commercial banks’ needs, without pre-set limits on quantity or currency composition.¹⁰  Such flexibility has already allowed the transfer into Gaza, since July 2010, of cash amounts beyond the usual NIS 50 million per month limit, and the replacement of NIS 31 million in tattered bank-notes with new ones.

II. FISCAL DEVELOPMENTS IN 2010

8. While the PA’s fiscal performance during January to July 2010 has been broadly as envisaged in the budget—with the recurrent deficit still projected at 18 percent of GDP—shortfalls in donor aid have led to domestic payment arrears and borrowing from commercial banks:

9. Serious liquidity problems will emerge in the remainder of the year unless adequate donor aid is promptly disbursed. From January to early September 2010, about $0.67 billion has been disbursed, and another $0.25 billion was indicated by donors for the remainder of the year, yielding total financing already disbursed or indicated of $0.93 billion.¹⁴ Given the projected deficit of $1.24 billion, this yields a financing gap of about $0.3 billion for 2010. An improved donor coordination framework is needed to help ensure timely disbursements of committed aid, and allow the PA to better prepare for delays in disbursements.

10. The PA has continued to strengthen the Public Finance Management System, which has helped prioritize and raise the quality of public expenditures. The implementation of measures since mid-2007 to increase transparency and accountability has greatly facilitated the disbursement of donor aid directly to the PA budget. Expenditure management was further enhanced in 2010:

11. The PA is considering a gradual approach toward the issuance of Treasury Bills.  Development of a Treasury Bills market would have a number of benefits including promoting the money and interbank markets, fulfilling the need for collateral in the new Real Gross Time Settlement System (RTGS, see Box 1), and can potentially lower the cost of funding for the PA. The authorities recognize that current conditions are not appropriate for a full scale issuance program, given the need for further progress toward fiscal sustainability. A recent IMF technical assistance mission has recommended a gradual approach, starting with a program to enhance the institutional and operational aspects of a Treasury Bills market, including through training and capacity building. Follow-up IMF missions will assist in such training, and assess the practicality of securitizing small amounts of existing nonbank debt into short-term marketable debt. The option of a broader issuance of securities should await further reductions in the government’s financing requirements. A stable and predictable issuance policy is required for the success of even a small scale Treasury Bills market. Timely disbursements by donors are also essential to ensure that liquidity conditions can be accurately forecast.

III. MACROECONOMIC OUTLOOK

12. The revised macroeconomic framework continues to assume that all parties (PA, the GoI, and donors) pro-actively push the peace process forward and take measures to support the WBG’s economic development. In particular, it assumes that the easing of restrictions on movement and access that has continued in 2010 will accelerate. In Gaza, the further easing of the blockade will allow steadily rising imports of the investment inputs required by the private sector and relaxation of the ban on exports. In the West Bank, lifting of remaining internal restrictions will be complemented by removal of obstacles on external trade, in particular on exports to Israel, as well as on access of private investors to “Area C”. The PA will continue a prudent fiscal policy and structural reforms to enable a sustained reduction in the recurrent budget deficit. Donors will disburse aid on time to cover both the narrowing budget deficit and expanded public investment and reconstruction needs.

13. Given the above assumptions and policy expectations, growth—led by the private sector—would rise significantly, while under a pessimistic scenario it would significantly slow down. Under the baseline scenario, the expansion of private sector activity and external trade enabled by continued easing of restrictions would support a rise of real GDP growth from 8 percent in 2010-11 to about 10-12 percent by 2012-13.  The recurrent deficit would decline to a sustainable rate of 3 percent of GDP, with a shift in the composition of spending from wages and subsidies to public investment. This in turn would allow a shift in the composition of donor aid from recurrent budget financing to development projects, gradually moving back to the situation which prevailed in the mid-1990s when the bulk of the budgetary aid went to finance development expenditures (see Figure 2). This scenario is subject to the risk that the peace process would stall and that

the easing of restrictions would slow. In the pessimistic scenario, real GDP growth would wane to an average of about 4 percent over the medium-term. Budgetary revenue would be lower, while emergency spending and arrears accumulation would be high, thus slowing the pace of fiscal adjustment, with the deficit remaining above 14 percent of GDP by 2013.

14. The regional paths of real GDP per capita and unemployment are projected to start converging over the medium term:

15. Key structural reforms will need to be stepped up in the remainder of 2010 to ensure steady progress toward fiscal sustainability and reduced reliance on recurrent budgetary aid, in line with the vision toward statehood presented in the “Program of the Thirteenth Government” and elaborated in the 2010–11 plan “Homestretch to Freedom”:15

16. The preparation of the 2011 budget is underway taking into account the baseline macroeconomic outlook and structural reforms, as described above, with a view to its submission to the Cabinet by mid-ovember 2011. In July 2010, the MoF received feedback from line ministries to guide the MoF’s allocation of the overall expenditure envelope, including detailed inputs on: (i) ministries’ core objectives for 2011–12, with a focus on 2011; and (ii) the financial resources required for the fulfillment of those objective. Preliminary work has started on setting targets for the budget’s broad line items:

IV. ASSESSMENT

17. IMF staff considers that the PA has successfully implemented core institution-building and public finance reforms set out in its Palestinian Reform and Development Plan (PRDP) for 2008–10. These reforms, supported by generous donor aid, have supported the revival of private sector activity and recovery of economic growth. Investor confidence has been reinforced by the PA’s track record of establishing security in the West Bank, and its sound economic management including restraint on the public sector wage bill, reduced utility subsidies, prioritized public expenditures, transparent government finances, and enhanced tax administration. These reforms have also enabled a major stride toward fiscal sustainability despite recurrent delays in aid disbursements. It is essential for the PA to sustain this solid track record by accelerating key structural measures, including enhancing the social safety net to better target assistance to the poor, commercialization of electricity distribution to phase out subsidies, implementation of the plan to restore the viability of the public pension system, and steps toward civil service reform.

18. Concerted actions by the PA, the GoI, and donors are essential to stem substantial risks to the hitherto strong economic performance:

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¹This report was prepared by a team comprising Oussama Kanaan (Chief of Mission), Javier Gomez, and Mariusz Sumlinski. The macroeconomic and fiscal framework set out in the Palestinian Reform and Development Plan (PRDP) was assessed by IMF staff in “Medium-Term Macroeconomic and Fiscal Framework for the West Bank and Gaza,” issued on December 5, 2007. Staff reports on the West Bank and Gaza are published on the IMF website (www.imf.org/wbg).

²Based on data from Israel’s Central Bureau of Statistics, exports of goods and nonfactor services from the WBG to Israel are estimated to have contracted by 18 percent in real terms in 2009, followed by a further decline of 1 percent in the first quarter of 2010.

³The GoI’s new policy is based on the application of a “negative list” of prohibited imports that covers (i) weapons; and (ii) items that could potentially have a dual military/civilian use, except imports destined for donor-supervised public investment and reconstruction projects. Since investment inputs, including construction materials, are classified as “dual-use” items, the policy in effect maintains the ban on imports of private investment inputs. The policy did not lift restrictions on exports and movement of Gazans across external borders.

⁴Changes in the number of truckloads of imports into Gaza, which are monitored by the Palestine Trade Center, give an indication of the impact of the new policy for Gaza. The weekly average number of trucks during January to June 2010 is estimated at 553. The average number rose by about 66 percent to about 920 in July, following the implementation of the policy. Nevertheless, the new level is well below the 2005 weekly average of about 2800, before the onset of Gaza’s blockade in 2006. Two factors explain the difference. First, unlike in 2005, construction inputs and raw materials to the private sector are not allowed in. To illustrate, while inputs and raw materials accounted for 65 percent of the total volume of an average truckload in 2005, in July 2010 they represented only 4 percent. Second, today there are significant capacity constraints at the Gaza-Israel borders, which did not exist in 2005. See “Gaza Strip Crossings Bi-Monthly Monitoring Report, June–July 2010,” see www.paltrade.org.

⁵According to the UN Office for the Coordination of Humanitarian Affairs (OCHA), the number of obstacles to movement within the West Bank declined from 626 obstacles at end-March 2009 to 505 obstacles as of end-March 2010. For updates, see www.ochaopt.org.

⁶For details of the restrictions on investment in “Area C”, see the report by OCHA, “Restricting Space: The Planning Regime Applied by Israel in “Area C” of the West Bank,” December 2009. For details on the physical obstacles and non-trade barriers to the access of goods from the West Bank to Israel see the World Bank’s report “An Analysis of the Economic Restrictions Confronting the West Bank and Gaza,” published on www.worldbank.org. For a description of non-physical restrictions see “Movement of Goods from the West Bank to East Jerusalem and Israel,” January 2010, by the Palestine Trade Center, published on www.paltrade.org.

⁷The hiring of workers by Gaza businesses could be indirectly constrained by the restrictions on private sector imports of capital goods and raw materials, depending on the extent of capital-labor complementarity in production.

⁸The restrictions on the number of Palestinian workers allowed into Israel since 2000 have been much tighter in Gaza than in the West Bank. While about 27,000 workers were allowed from Gaza in 1999, or 13 percent of its labor force, the number over the past decade has been negligible. In the West Bank, the restrictions led to the decline in the number of workers from 108,000 in 1999, or 19 percent of the West Bank’s labor force, to an average of 54,000, or 11 percent of its labor force, during 2001-06. While the number of West Bank workers in Israel has increased since the advent of Prime Minister Fayyad’s government in 2007, reaching an average of about 80,000 in the first half of 2010, as a share of the West Bank’s labor force it has remained at the 2001–06 average of 11 percent.

⁹The share of non-performing and watch list loans in total loans continued its downward trend, falling to 3.1 percent at end-June 2010, from 11.0 percent at end-2008 and 3.7 percent at end-2009.

¹⁰An informal agreement was reached in 2009 between the PA and Israeli authorities to allow the passage of 50 million shekels per month. The agreement does not cover the entry of Jordanian Dinars or U.S. dollars.

¹¹Clearance revenue from taxes on fuel and other petroleum products has also been lower than usual in the first half of 2010 due to the decline in the quantity of fuel and other petroleum products imported into Gaza, including as a result of the increased substitution of fuel from Israel with cheaper fuel from Egypt.

¹² The MoF is currently taking stock of arrears owed by the government on pensions. These arrears consist of two broad categories (i) arrears related to employee service performed for the PA since 1994; and (ii) arrears related to employee service performed for the PLO prior to 1994. A preliminary estimate was made by the MoF for the stock of arrears in the first category, at $410 million as of end-July 2010 (out of which $41 million was accumulated during January to July 2010). The calculation of arrears for the second category is expected to be completed before end-2010.

¹³ The average interest rate charged by domestic banks on commercial loans, the bulk of which is owed to the Arab Bank and the Bank of Palestine, is about 5 percent (an interest rate of 4 percent is charged on PA loans denominated in dollars, and 7 percent on loans denominated in shekels).

¹⁴ Net bank borrowing for 2010, estimated at about $200 million as of end-July 2010, is envisaged to be fully repaid by end-2010 in line with the budget law.

¹⁵The documents are published on the PA’s Ministry of Planning website http://www.mop-gov.ps/new/index.php?langid=2.

¹⁶ The staff of the IMF and World Bank, on the basis of the macroeconomic framework in this report, have jointly produced preliminary estimates of the impact of the different components of pension reform on the “implicit pension debt” defined as the present value of the pension system’s projected liabilities to current and future pensioners. Assuming constant government real wages, the elimination of the early retirement option (for both the civil service and security schemes) yields an implicit pension debt of 28 percent of GDP, compared to 61 percent of GDP in the no-reform scenario. The increase in the retirement age yields an implicit pension debt of 32 percent of GDP, compared to 69 percent in the no-reform scenario. Under the assumption of declining government real wages, pension debt declines by even greater amounts.

¹⁷ The average public real wage rate is estimated to have declined by a cumulative 9 percent during 2008–09, and is projected to decline by a further 1 percent in 2010.

¹⁸ These laws include the New Companies Law, that removes the bureaucratic red tape faced by new companies; the New Investment Law and the New Industry Law, both of which ensure a fair treatment of private companies independently of the sector of operation; and the Movable Assets Law which facilitates access to bank finance by enabling the use of movable assets as collateral.

¹⁹ For details of the measures needed to improve the legal and regulatory environment for the private sector, see the World Bank Economic Monitoring Report to the Ad Hoc Liaison Committee, September 21, 2010, “The Underpinnings of the Future Palestinian State: Sustainable Growth and Institutions.”