A year ago, many observers predicted that the Palestinian economy was on the brink of collapse but, despite the battering it has taken, the economy still functions, mainly as a result of donor funding of the PA. (In 2001, donor disbursements doubled from pre-Intifada levels to US$929 million, and in 2002 rose again to US$1 billion.) Over 120,000 people still receive a regular monthly salary and provide essential services to the population. The PA employs a third of those people still working, and pays half of all wages earned in the West Bank and Gaza. This in turn supports the other two-thirds who are still employed.
Another factor contributing to the economic survival is Palestinian society's resilience. Despite the violence, economic hardship and daily frustrations of living under curfew and closure, lending and sharing are widespread. Even with a dependency ratio of over 18 in Gaza and a dearth of formal safety nets, outright destitution is limited - those who have income generally share it with those who do not. The West Bank and Gaza have absorbed levels of unemployment that would have destroyed the social fabric in many other societies.
The rate of economic decline is slowing, but the combination of political insecurity and closure continues to choke the economy and makes recovery more difficult. Industrial and human capital continue to erode, impairing longer-term competitive prospects. Total investment has contracted from about US$1.5 billion in 1999 to US$140 million in 2002. Declining health and educational standards are eroding the skills base of Palestinian youth.

Impacting on Ordinary Palestinians

Many families have been without an income for an extended period, and despite various employment-generation efforts of the PA, donors and NGOs, are now dependent on food aid for survival. The World Bank estimated that 21 percent of the Palestinian population was living under the US$2-a-day poverty line on the eve of the Intifada. That figure had increased to about 60 percent, or just less than two million people, by December 2002. In Gaza, more than 75 percent of the population now lives below the poverty line. The poor are also getting poorer. Average daily consumption has fallen to the equivalent of US$1.32 per day, from US$1.47 in 1998. This situation is exacerbated by the high rate of Palestinian population growth (4.35 percent per annum).

Challenges for the Palestinian Authority

Even if donor disbursements doubled to US$2 billion in 2003, by 2004 the poverty rate would still be around 54 percent. An agreed framework for political progress is indispensable for the resumption of economic and social development in both Israel and the Palestinian territories. The main service providers - the Ministries of Health and Education, and the municipalities - have maintained a basic network of public services despite curfews, closures, periodic violence and severe fiscal compression. But the PA has not managed to communicate to the public how it is coping with the crisis, and its efforts are being undervalued. The PA needs to develop a National Emergency Plan to energize a collective social effort to cope with continuing crisis.
A key difference from a year ago is the PA's adoption of a serious program of reform to weed out corruption and build a modern, meritocratic civil service. Considerable progress has been made, particularly in the management of the PA's finances, and much has been done to repair the credibility of the PA in the eyes of the international community. Having acknowledged the need to combat corruption, the PA must deliver a successful reform program or lose its legitimacy.

Challenges for Donors

Under the Bank's base case economic projection for 2003, donors should aim to disburse at least US$1.1 billion, (slightly more than in 2002). The bulk of these funds is needed for PA budget support (US$574 million) and for other emergency and humanitarian programs (US$375 million). An early estimate suggests that firm commitments amount so far to some US$700 million, with a total of US$1.5 billion in commitments expected. This level of commitments should make a US$1.1 billion disbursement target feasible.
Most critical of all is adequate support for the PA budget. The 2003 target is ambitious - US$450 million was disbursed as budget support in 2002, and there are signs of donor fatigue. While budget support is politically controversial and traditionally unpopular (it is seen as a diversion of funds from growth-oriented investment), it remains the most essential contribution that donors can make to sustaining the economy and the structures needed to build a Palestinian state. Donors should not abandon medium-term development programs, and should continue to do what they can to help create the institutions and infrastructure of a future state. Indications of intent for 2003 show that donors wish to commit at least US$335 million in medium-term assistance. If these plans can be realized, they will arrest a worrying decline in donor developmental expenditure.

Challenges for Israel

The actions of the Israeli government are crucial to the success of the Palestinian economy in 2003. As long as Palestinian internal economic space remains as fragmented as it is today, and as long as the economy remains subject to extreme unpredictability and elevated transaction costs, domestic economic activity will suffer and Palestinian welfare will continue to decay.
The Israeli government's recent decision to resume the transfer of the PA's monthly clearance revenues is an important initiative. If these flows are re-established on a regular basis, they will play a vital part in stabilizing the Palestinian economy. If the Israeli government also repays the stock of withheld arrears, this will permit the PA to clear its debts to the domestic private sector. This cash injection will exert a far greater effect on the failing Palestinian private sector than any other measure.
Donors need the Israeli government to do more to facilitate the work of humanitarian agencies, be they donor, UN or NGO. They have also asked the Israeli government to permit freedom of movement for Palestinian officials critical to the implementation of the Palestinian reform program, consistent with Israel's own call for the reform of the PA. In addition, it is important that the Israeli government facilitate meetings of the Palestinian Legislative Council to enable the passage of critical reform legislation and to enable an oversight of the reform process.

Looking Ahead

Short-term recovery depends on lifting the closures, but this will not suffice to put the Palestinian economy on a sustainable growth path. Long-term growth potential for the Palestinian economy has been stunted by pressure on domestic Palestinian wages created by salaries paid to Palestinian workers in Israel. Domestic wage increases have exceeded any underlying growth in productivity, and have undermined Palestinians' ability to export competitively-priced goods to the rest of the world. The World Bank recommends a proactive policy of export development in which a less discriminatory trade regime is adopted, which would result in higher incomes by 2010, rather than a return to previous levels of employment in Israel.
Between 1968 and 2000, Palestinians in the West Bank and Gaza exported labor rather than goods. In June 2000, three months before the current Intifada began, 21 percent of all employed Palestinians worked in Israel, mainly in low-skilled construction and agricultural jobs. Net incomes from abroad provided more than 22 percent of Palestinian GDP, making it one of the most remittance-dependent economies in the world. The Intifada has demonstrated the vulnerability of this strategy.
Gains from trade would take time to materialize, and restoring access to the Israeli labor market would certainly be a quicker way to boost incomes for a large number of ordinary Palestinians - but a return to pre-September 2000 employment levels for Palestinians in Israel seems unlikely. It would risk perpetuating a high level of Palestinian economic dependence on Israel, and hinder the emergence of a more diversified development strategy. Such a policy shift will require the active cooperation of Israel to succeed, and is thus part and parcel of a political rapprochement.