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

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MACROECONOMIC AND FISCAL FRAMEWORK

FOR THE WEST BANK AND GAZA:

FIFTH REVIEW OF PROGRESS¹

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

Madrid, April 13, 2010

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EXECUTIVE SUMMARY

Economic growth in 2009 picked up significantly in the West Bank, but conditions in Gaza remain difficult. The Palestinian Authority (PA) has continued to build a solid track record in institution-building and economic and security reforms, supported by generous aid. The Government of Israel (GoI) has relaxed some restrictions on movement and access in the West Bank during 2009. However, there has been no additional significant easing of the West Bank’s restrictions so far in 2010, and economic activity in Gaza remains severely constrained by the persisting blockade. Real GDP growth in the West Bank and Gaza (WBG) is estimated at 6.8 percent for 2009, consisting of 8.5 percent growth in the West Bank and 1 percent in Gaza.

The PA’s 2010 Budget builds on the progress made last year in institution-building and public finance reforms. In 2009, the war in Gaza has imposed a burden on the budget as it required substantial non-wage emergency spending. The 2009 recurrent deficit on a cash basis was in line with the budget target. However, non-wage expenditure commitments were above budgeted amounts, and there was a shortfall in donor aid relative to the budget’s external financing requirements including Gaza’s emergency spending, which led to the accumulation of non-wage arrears. The 2010 Budget envisages a tightening of the fiscal stance to reduce the recurrent deficit to $1.24 billion from $1.59 billion on a commitment basis in 2009. Toward that end, it is important to step up structural reforms, including implementation of a social safety net and electricity sector reform, and to enhance commitment controls and cash management to minimize further arrears accumulation and recourse to bank borrowing.

There is an urgent need to secure adequate donor assistance to finance the 2010 recurrent financing requirements. A front-loading of that assistance is especially important given the aid shortfalls during the first quarter of the year. External recurrent financing requirements for April to December 2010 are projected at about $1.1 billion, given the $174 million already disbursed in the first quarter of 2010. The $1.1 billion is in addition to about $0.7 billion needed for public investment in the Palestinian territories in 2010.  

Concerted actions by the three parties (the PA, the GoI, and the donor community) are critical to sustain the economic recovery and reduce significant risks to the economic outlook. Perseverance by the PA in institution-building, reforms and good governance, supported by adequate and timely donor aid, is needed to achieve increased self-reliance and sustain private sector confidence. A breakthrough in the peace process and removal of restrictions on a wider scale are essential for a durable and regionally balanced growth in the Palestinian territories. This requires action on three fronts. First, lifting Gaza’s blockade is essential to stem the continuing decline in Gazans’ living standards. Second, removing impediments to private and public investment in the West Bank’s Area C, which represents about 60 percent of its territory, is needed to tap the West Bank’s full growth potential. Finally, lifting restrictions on the Palestinian territories’ external trade, especially on exports to Israel, is key to a sustained rise in real GDP per capita and a balanced growth pattern.

I.  RECENT ECONOMIC DEVELOPMENTS

1. In 2009 the macroeconomic situation continued to improve in the West Bank, but in Gaza conditions remain difficult due to the blockade. In the West Bank, three key factors contributed to continued strong growth performance. First, private sector confidence has been bolstered by the Palestinian Authority (PA)’s track record in institution-building and reforms in particular in the security, public finance, and governance areas. Second, these reforms have been supported by generous donor budgetary aid, equivalent to about 22 percent of GDP in 2009. Third, some restrictions on movement and access have been relaxed, especially on movement of goods and people between major urban centers in the West Bank. While in Gaza the entry of humanitarian goods has been facilitated, persistent restrictions on capital inputs, raw and building materials have impeded the post-war private sector recovery as well as the reconstruction efforts. Real GDP in the West Bank and Gaza (WBG) is estimated at 6.8 percent, consisting of an estimated 8.5 percent growth in the West Bank and 1 percent in Gaza.

2. Remaining restrictions on movement and access still constrain internal economic activity and external trade, and distort the pattern of growth and its regional distribution.²

 The persistence of internal restrictions on Palestinian investment in Area C, which represents 60 percent of the West Bank’s territory, constrains the West Bank’s growth performance.³ In addition, obstacles on movement among various West Bank regions significantly raise transportation costs.⁴

The WBG’s exports to Israel have been constrained in recent years by Gaza’s blockade as well as the steady tightening of the Separation Barrier between the West Bank and Israel.⁵ In Gaza, tight restrictions remain on the entry of building materials and supplies for donor-financed projects, including electricity and water supply projects. The Separation Barrier has had a particularly adverse impact on East Jerusalem, whose economy has traditionally relied heavily on its trade links and client base in the West Bank.⁶

The trade restrictions have adversely affected the private sector in general and in particular the sectors producing tradable goods. The graph below depicts the evolution of the sectoral shares in GDP relative to their level in 1994. A major shift in the production structure has taken place since 1994, as the combined share of agriculture and manufacturing declined from one third of GDP in 1994 to about one fifth of GDP over the past five years. At the same time, the share of public services rose markedly. The share of private sector services, which are mostly traded within the WBG and are less vulnerable to the border restrictions, has fallen by much less than the shares of agriculture and manufacturing. Overall, there has been a shift in the pattern of private sector production reflecting the degree of restrictions rather than the WBG’s comparative advantage in external trade. In 2009, while private sector services and construction surged, the share of manufacturing was unchanged, and that of agriculture declined.

3. The 2009 unemployment rate in the WBG is still high at 25 percent, with only a modest decline in the West Bank. While there was no significant decline in the West Bank’s unemployment rate in the first half of the year compared to the same period in 2008, it declined from about 20 percent to 18 percent in the second half of 2009, reflecting the pickup in growth during the year. The lag between unemployment decline and output growth will likely diminish as the private sector gains confidence in the sustainability of the improved economic and trade conditions. In Gaza the unemployment rate remained virtually unchanged at about 39 percent, reflecting the still suppressed economic activity. While there has recently been some easing on an ad hoc basis for pre-approved batches of commercial goods and building materials, there are few indications for private investors of better near-term prospects for Gaza.

4. Inflation declined significantly in 2009, despite some rebound in the second half of the year. The twelve-month CPI inflation rate, after falling from 12 percent in mid-2008 to 2 percent in mid-2009, rose to 4 percent by end-2009, and further to 5 percent by February 2010. The CPI fluctuations during 2009 reflected largely changes in world petroleum and food prices. The variation in inflation during the year was much larger in the WBG than in Israel, given food’s higher weight in the former’s consumption basket. The depreciation of the shekel vis-à-vis the dollar by an average of about ten percent in 2009, despite a partial reversal later in the year, reinforced the favorable impact of the fall in inflation on real incomes, given the importance of dollar-denominated sources of income including donor aid and remittances.

5. Domestic banks have not been significantly affected by the global crisis and private sector deposits and credit continued to grow in the West Bank, but not in Gaza.   Overall, banks in the WBG have had very limited exposure to global markets, and applied conservative lending practices domestically. The non-performing loans (NPLs) and watch list loans⁷ fell as a share of total bank loans from 11 percent at end-2008 to 3.6 percent at end-2009. In the West Bank, private sector deposits and credit rose by 5 and 23 percent (respectively) in real terms in the year to December 2009, reflecting the improved economic conditions and better investment climate. The rise in credit also reflected the increased supply of loanable funds as the Palestine Monetary Authority (PMA) lowered the limit on bank deposits placed abroad from 65 percent to 55 percent of total deposits. In contrast, in Gaza deposits remained broadly stagnant over the same period, while private credit contracted by about 17 percent, reflecting the limited recovery in economic activity and weak private investment. The PMA has made good progress in institutional reforms with intensive Fund technical assistance (Box 1).

6. Limits on the inflow of cash in shekels into Gaza have eased, but other restrictions remain. An agreement between the Israeli authorities and the PA in 2009 has allowed monthly shipments of shekels into Gaza, but not Jordanian dinars and U.S. dollars. The removal of the remaining restrictions is important to ensure sound exchange risk management by banks and settlement of non-shekel transactions and salaries. Another problem faced by the PMA and banks has been the accumulation in 2009 of large shekel cash surpluses in Palestinian banks due to Israeli banks’ refusal to accept their cash deposits on concerns about possible legal implications. This is lowering Palestinian banks’ interest income and raising their insurance costs. The cash surplus lessened temporarily in 2009 when Israeli banks accepted, on an ad hoc basis, deposits of limited amounts of shekels.

II. FISCAL DEVELOPMENTS IN 2009

7. The recurrent fiscal deficit on a cash basis for 2009 is estimated at 22 percent of GDP, slightly below the budget target. However, the deficit on a commitment basis was higher than budgeted due to non-wage expenditure arrears accumulation.

a. Domestic tax revenue rose from 4.5 percent of GDP in 2008 to 4.9 percent in 2009, mainly because of an increase in domestic tax revenue by 37 percent in the second half of the year, compared to the same period in 2008, due to improved tax enforcement and compliance.

b. Total clearance revenues declined slightly in 2009 as a share of GDP from 18.4 percent to 18.0 percent. Clearance revenue performance in Gaza has been especially weak due to repressed economic activity and imports, while in the West Bank performance has picked up significantly in the second half of 2009.⁹ 

8. 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.¹⁰ Expenditure management was further enhanced in 2009:

III. MACROECONOMIC OUTLOOK

9. The macroeconomic framework assumes that the PA, the GoI and the donor community would take concerted actions to support the Palestinian economy. In particular, it assumes, first, a steady removal of remaining obstacles on movement and access in the West Bank, including Palestinians' access to Area C, as well as the lifting of Gaza's trade restrictions especially on the entry of capital goods and raw materials. Second, the PA would continue with a prudent fiscal policy underpinned by institution-building measures, structural reforms, and sound public expenditure management, in line with the Thirteenth Government's vision toward statehood. Third, donors would continue to provide adequate and predictable financial assistance for the recurrent budget and public investment.

10. Under the baseline scenario based on the above assumptions, real GDP growth would continue at about 7 percent in 2010, and rise gradually to 10 percent by 2012-13.  With population growing at about 3 percent per year, real income per capita would rise by about six percent per year over 2010-13, while the unemployment rate would decline from 25 percent in 2009 to 15 percent by 2013. Reflecting a prudent fiscal policy and acceleration of structural reforms, the recurrent budget deficit would fall as a share of GDP from 22 percent in 2009 to 6 percent by 2013, which would give room for a substantial rise in donor-financed public investment. The expansion of the private sector, in particular in export-oriented activities, would lay the foundations for longer-run growth.

11. Under a "pessimistic" scenario real GDP growth slows down to 5 percent in 2010 and remains at around 4 percent over the medium term. This results in real per capita GDP stagnating around its current level in the West Bank, and a continued decline in Gaza. The scenario assumes no progress in the peace process and only ad hoc and limited further easing of restrictions in the West Bank and of Gaza's blockade. Exports and investment opportunities would remain constrained, inhibiting private sector recovery. As indicated by past experience, restrictions on the movement of project personnel, raw materials, machinery and equipment tend to considerably slow the implementation of public investment and reconstruction projects, most of which are financed by donors. External aid for public investment would thus be substantially lower than in the baseline scenario. Budgetary revenue would also be lower, while social transfers and emergency spending would be higher, thus reducing the pace of fiscal consolidation.

12. In the baseline scenario, the path of Gaza's real GDP per capita will begin to converge toward that of the West Bank over the medium term, while in the pessimistic scenario the divergence will continue. The graph below depicts the paths of real GDP per capita of the West Bank and of Gaza in relation to their 1999 levels, just before the onset of the second Intifada and sharp intensification of restrictions on movement and access. From 2000 to 2002, the two paths were broadly aligned. From 2003 to 2005, real GDP per capita recovered in response to the limited relaxation of restrictions, especially in Gaza. In 2006, with the onset of the blockade, Gaza's real GDP per capita started on a downward trend. In contrast, the West Bank's real GDP per capita has grown steadily since 2007 with the advent of Prime Minister Fayyad's government, reflecting the influence of factors discussed in Section I above. The West Bank's real GDP per capita recovered to its 1999 level in 2009, and under the baseline scenario by 2013 is projected at about 26 percent above that level. However, in the pessimistic scenario it would be at only 10 percent above it. For Gaza, in the baseline scenario, GDP per capita by 2013 would be about 30 percent below its 1999 level, and about 50 percent below it in the pessimistic scenario.¹¹

13. The structural reforms initiated in 2009 need to be stepped up to ensure steady progress toward fiscal sustainability and reduced reliance on recurrent budgetary aid in line with the baseline scenario:

14. The 2010 Draft Budget was submitted to the Cabinet in mid-March 2010, and is expected to be approved by the President in April. The budget envisages enhanced revenue mobilization, a continued shift from recurrent spending toward public investment, more efficient targeting of social transfers, and measures to minimize arrears accumulation. The recurrent budget deficit on a cash basis would decline as a share of GDP from about 22 percent to 18 percent. Given the limited scope for domestic bank financing for 2010¹⁴, that deficit, projected at $1.24 billion, would be financed entirely by donor aid. The budget has the following key features:

15. Out of the $1.24 billion required to finance the recurrent deficit in 2010, only about $174 million has been disbursed by donors in the first quarter of 2010, resulting in a shortfall of about $45 million per month. Preliminary data for January and February indicate that while revenues and expenditures have been broadly in line with the 2010 budget, the aid shortfall resulted in additional nonwage arrears of about $24 million and additional borrowing from domestic commercial banks by about $44 million during January-February 2010. Prompt disbursement of aid for 2010 is critical to prevent a further rise in domestic debt and interest payment obligations, which would further increase the budget's future external financing requirements.

IV. ASSESSMENT

16. IMF staff considers that institution-building and public finance reforms undertaken so far by the PA are in line with the Palestinian Reform and Development Plan (PRDP) and the vision toward statehood set out in "Program of the Thirteenth Government" for 2010-11. The PA should persevere with these reforms to reinforce the private sector's confidence and reduce its reliance on donor recurrent budgetary aid. It is particularly important, as envisaged in the 2010 budget, to continue to improve the quality and efficiency of public spending while shifting its composition toward growth enhancing public investment. Toward that end, key structural measures need to be accelerated in 2010, including the implementation of a social safety net to better target assistance to the poor, electricity sector reform to further reduce utility subsidies, and steps toward comprehensive pension and civil service reforms. It is also important for the PA to continue to widen its responsibility for the management of public investment in collaboration with donors, including community-based projects.

17. Concerted actions by the three parties (the PA, the GoI, and donors) are essential to sustain the economic recovery and reduce significant risks to the economic outlook:

Notes

¹ This report was prepared by a team composed of 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. The report on the fourth review of progress in implementing the framework was issued on September 22, 2009. Staff reports on the West Bank and Gaza are published on the IMF website (www.imf.org/wbg).

² To place recent developments in perspective, it is important to recall that the WBG, from the onset of occupation in 1967 until the early 1990s, enjoyed mostly free and unhindered trade with Israel. During that period the WBG’s exports of goods and services, which went mostly to Israel, expanded rapidly and by the 1980s represented over half of its GDP. This expansion reflected the much larger size of the Israeli economy (over twenty times as large), complementarities in resource endowments, as well as weak transport links with Egypt and Jordan, and the absence of a seaport or airport within the WBG. The increased restrictions on the movement of goods and people across the Israel/WBG borders since the mid-1990s, culminating in the blockade on Gaza and completion of the Separation Barrier, led to a decline in exports to less than 15 percent of GDP in recent years.

³ For details of the restrictions on investment in Area C, see the report by the UN Office for the Coordination of Humanitarian Affairs (OCHA), “Restricting Space: The Planning Regime Applied by Israel in Area C of the West Bank”, December 2009, as well as the Report on the Work of the Office of the Quartet Representative (June 30, 2009 to February 28, 2010).

⁴ According to OCHA, while the Israeli authorities have substantially eased restrictions on movement and access in the West Bank during 2009, there are still 550 remaining obstacles in the West Bank as of end-2009, compared to 630 obstacles at end-September 2008. These obstacles significantly lengthen travel time for most Palestinians. For updates, see www.ochaopt.org.

⁵Exports of goods and non-factor services from the WBG to Israel are estimated by the Israel Central Bureau of Statistics to have declined in 2009 by 23 percent in dollar terms and 16 percent in shekel terms. Exports to Israel alone are estimated at about three fourths of the WBG’s total exports.

⁶ 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 (PALTEL) published on www.paltrade.org.

⁷The ratio of non-performing loans to total loans fell in the same period from 6.9 percent to 3.1 percent. Watch-list loans are defined as loans in arrears on interest or principal for 30 to 90 days. Non-performing loans are those in arrears for over 90 days.

⁸ One-off items were lower than budgeted due to postponement in the transfer of dividends by the Palestine Investment Fund. The latter was only partly offset by higher-than-budgeted license fees from Jawal and Zein telecommunications companies.

⁹ While the West Bank’s clearance revenues, in shekel terms, increased by 14 percent in 2009, they declined by 13 percent in Gaza.

¹⁰ For details on the reform of the public finance management system since 2007, see the IMF reports on reviews of progress on www.imf.org/wbg.

¹¹ The outlook for real GDP per capita in the pessimistic scenario is especially worrisome given the high incidence of poverty in the WBG, in particular in Gaza. According to a 2007 household survey for Gaza, about 80 percent of households in Gaza lived below the poverty line in 2007, compared to 45 percent in the West Bank. The poverty line for a six-person household in the household survey was set at NIS 2,363 in monthly expenditures per household. See the report by UNRWA, "Prolonged Crisis in the Occupied Palestinian Territory: Socio Economic Developments in 2007", July 2008, published on http://www.unrwa.org

¹² For civil service reform options, see the World Bank's "West Bank and Gaza-Public Expenditure Review, Volumes I and II," February 2007, published on www.worldbank.org.

¹³ In particular, the current target of 3,000 new employees per year may not be suitable for 2011-13 given the changing needs of different sectors since 2007.

¹⁴ The stock of public debt to commercial banks is estimated at about $750 million as of end-February 2010.

¹⁵ The 4 percent increase in the average wage rate consists of the 1.25 percent automatic annual wage increase, and 2.75 percent adjustment to partially compensate for the decline in public sector real wage rates since 2007. While the PRDP envisaged an average yearly inflation rate of 3 percent for 2008-10, the currently projected average inflation rate for that period is 5 percent per year. The average public real wage rate has declined by a cumulative 9 percent during the two years 2008-09. Given the envisaged 1 percent increase in the average real wage rate for 2010, it is projected to decline by a cumulative 8 percent during 2008-10.

¹⁶ The implementation of revenue administration measures will be done with technical assistance from the IMF and USAID. An IMF technical assistance mission set out an action plan for the second half of 2010 and the medium-term, which includes the establishment of a large taxpayer multi-revenue unit, a strategy to improve taxpayer compliance, and adoption of modern information technology. Progress in revenue administration is expected to be supported by regular IMF peripatetic missions starting in mid-2010.