IMF Assesses Palestinian Economic Potential

by Colin MacKinnon

"We've had deterioration in many ways in the last two or three years, but on the other hand, the economy does have potential," says Milan Zavadjil, an economist with the International Monetary Fund and lead author of a recent, basically somber, IMF report on the West Bank and Gaza and Palestine's economic prospects.* "It has an open trading relationship with IsraelIsrael can generate a lot of demand for Palestinian goods. The population of the Palestinian territory is comparatively well-educated and there's lots of entrepreneurial talent. There's also a banking system that is very liquid, that can potentially supply a lot of funds.

"These are all positives for the future, if this on-off system of border closures is lifted," says Zavadjil. "At the moment, Palestinian employment in Israel is exceeding 50,000, which is another positive."

1996 a Year of Gloom

Last year was indeed a bad one in the Palestinian territory. The borders to Israel were sealed off much of the time. The closure drastically cut the number of Palestinians working in Israel, disrupted trade, delayed projects, and generally weakened investor confidence, both Palestinian and foreign.

By the second half of 1996, per capita income was 20 percent lower than in 1993 (the year the Oslo accords were signed), unemployment was 16 percent higher, and private investment had fallen after a construction boom in the previous two years.

Not everything was negative. Despite the revenue losses caused by the border closures (and the costs of getting an administration going), the Palestinian Authority (PA) kept its budget deficit in bounds 3.5 percent of Gross Domestic Product. While PA wages were higher than expected, revenues were also over target, by 21 percent. The IMF gives the PA high marks for improving tax collection and for being able to prioritize expenditures during difficult times.

Another positive last year: the banking system expanded strongly. Despite the political and other uncertainties, the banking system saw sharply higher deposits and net foreign assets. Deposits increased some $550 million during 1996. There's a down side here, since domestic loans increased by less than a fourth of that amount. People are putting money in local banks now, which is good, but are not borrowing it for investment, which is bad. Still, there's a great deal of money sitting right now in Palestinian banks ready to finance investment.

The economy rebounded in the latter part of 1996 and this year, says Zavadjil, the economy is showing signs of further improvement.

"The numbers are turning out a little better than anticipated in the report," says Zavadjil. "It seems that the average number of workers [working in Israel] could be above 35,000, from developments we have seen that run through the end of May. So this is positive. Goods seem to be flowing, too. There are still difficulties, but they seem to be flowing."

The IMF and the Palestinian Authority

The IMF has been a quiet but effective force in constructing the Palestinian Authority's financial administration. Like the World Bank, the Fund was established just after World War II. Its original function was to promote international monetary harmony by monitoring the exchange rates and monetary policies of member nations and by bailing out members when they got into balance-of-payments trouble.

Over time the Fund has taken on a reformist role and now presses governments to liberalize their trade, tax and investment regimes.

The Fund also has a research function and gives advice to member governments. The Palestinian Authority is not a member, and so the IMF has restricted itself to giving "technical assistance" mostly advice. In the beginning, the PA needed help in setting up key economic and financial institutions, especially the Ministry of Finance and the Palestinian Monetary Authority, and the Fund sent advisers to help it do so.

Since then the Fund has helped the PA in a variety of areas: revenue administration, expenditure management, reforming the pension system, banking management, and compilation of statistics, and has given advice on formulating macroeconomic policy. Fund staffers have helped Palestinian officials prepare their budgets, monitor budgetary performance, report to donors, and look for capital.

What the PA Will Do

Here are some of the policies the IMF thinks the PA will or should follow in the coming months.

Tackle unemployment. This will be the main aim of the PA. One-third of Palestinians are unemployed. The labor force, like the population, is growing at 4 percent a year. If the Palestinian territories don't see strong economic growth, unemployment will rise. That means investment will have to rise from its current level of 18-19 percent. The PA won't be able to do this with donor money; there just isn't enough around. Somehow or other, the PA will have to attract private investment.
Increase savings and investment. The PA will have to introduce structural changes to increase investment and savings. The IMF, as always, recommends a tight fiscal policy to promote private-sector activity and confidence. Deficits should be kept low in 1997 and 1998, and down the line the PA should try to run surpluses.
Improve tax collection and administration. The basic tax collection structure is in place, and the PA can now focus on enforcement. A major step forward, says Zavadjil, has been the creation of investigative units that will focus on large taxpayers, many of whom have been getting past the tax authorities. This should help tax collection, including the VAT. The Ministry of Finance was supposed to centralize under its authority all revenue collection, expenditure and external financing by March 1 this year. That hasn't happened. Supposedly all the preparations are ready, though, and Palestinian administrators say they will do it shortly.
Increase exports. The PA should encourage production of exportable goods and services. This means reform of all the laws that regulate private-sector activity. Whether the PA will manage to reform its investment code remains to be seen. Critics see the code currently in use, which has never been legally promulgated, as a throw-back to a period when developing countries were often hostile to foreign capital. "It's a Nasserite document," says one World Bank expert. "If you want to discourage foreign investment, this code is how you do it."
Dismantle the PA's pernicious system of import monopolies. Fat cats and cronies are doing well by having exclusive control over imports of such commodities as petroleum, cement, tobacco and electronic products. This system should be ended. Palestinian officials have repeatedly told the Fund that the monopolies will be eliminated by 1998. Maybe they will.
Finally, go after donors. In November last year donors pledged another $880 million to support the PA's public investment program. To turn those pledges into reality, the PA will have to follow up by proposing and designing projects and doing other preparatory work.

Outlook

The IMF hopes for a modest recovery in Palestinian exports and private investment this year. Real GDP is projected to rise 5 or 6 percent this year and unemployment should fall to 31 percent or so, still very high. The PA will restrain its current budget even after hiring 3,000 new policemen and 3,700 new teachers and health personnel.

All this is modest of course, and as the IMF report stresses again and again, even such modest gains depend on the touchy Israeli-Palestinian political climate. More border closures or some kind of long-lasting disruption in public order in Gaza or the West Bank could send Palestine's fragile economy spinning downward again.

*Recent Economic Developments, Prospects, and Progress in Institution Building in the West Bank and Gaza Strip, IMF, Washington, DC, 1997.