Stuck Why the Palestinian Economy Lags, and What Could Be Done About It by paul rivlin 60 The Milken Institute Review
In a word, the Palestinian economy is a mess. Yet it has significant potential potential to grow rapidly, to tap an underemployed work force and to generate a living standard superior to that of other Arab states that don t happen to sit on top of oceans of oil. Here, I offer an outline of the basics, followed by some educated speculation about how the economy could be remade if peace with Israel were achieved. in the beginning By Palestine, I mean the current West Bank territory, along with Gaza. From 1948 (the year of Israel s independence) until the Six-Day War in 1967, the West Bank was occupied by Jordan. In 1950, it was annexed, and its 400,000 residents were given Jordanian citizenship. Despite this, the economy of the area was neglected; Jordan s development efforts were concentrated on the east bank of the Jordan River. The Gaza Strip, an enclave carved from the desert, was occupied by Egypt in 1948 after the Israeli war of independence; its development was equally neglected. By 1950, it had a population of 200,000. As a result, when Israel occupied those areas in 1967, it took over a Palestinian economy that was wretchedly poor with Gaza in even worse shape than the West Bank. Refugee camps in both, occupied by Palestinians who had fled from the area that became Israel in 1948, created a formidably Gaza City apartments rise beyond the broken gates of a waterfront restaurant. The beach once bustled with fishing boats and cafés, but the Israeli naval blockade, sewage and lack of resources for rebuilding have taken their toll. Fourth Quarter 2013 61
palestine economy large dependent population with few resources and an enduring distrust of Israel. Thereafter, the little economy was increasingly integrated with that of Israel, which supplied nearly all its imports and, after 1970, provided employment to increasing numbers of less-skilled Palestinians. Some of the jobs were legal, with Palestinians receiving Israeli work permits and social security benefits; some were undocumented and thus unregulated. Between 1967 and the outbreak of the first intifada (the uprising against Israel) in 1987, the Palestinian economy grew far faster than the population: GNP per capita in the West Bank nearly quadrupled (from $550 in 1968 to $2,070 in 1993 in inflation-adjusted terms), while in Gaza it nearly tripled (from $375 to $1,090). But the Palestinians also paid a price for economic domination by Israel. Largely because of Israeli policies, little was invested in infrastructure, and manufacturing that did not mesh with Israel s needs was discouraged. That left the economy completely exposed when, during the 1990s, Israel began to close its labor market to Palestinian workers. It also meant that the role of the middle class in developing the economy was very limited. The Palestinian Authority replaced Israeli rule in many respects in this state-in-themaking in 1994, and the business class counted for little. Those close to the leadership were granted monopolies and more preferential regulatory treatment, discouraging genuine entrepreneurship in favor of crony capitalism. Yet despite conflict and massive emigration in search of jobs, population growth in the territories was the fastest in the world. In 1967, when the Israeli takeover began, the population of the West Bank was 586,000 and that of Paul Rivlin is a senior fellow at the Moshe Dayan Center for Middle East and African Studies at Tel Aviv University. Gaza 381,000. By 1993, the last year of full Israeli rule, the combined population exceeded 1.8 million an increase of 85 percent in the West Bank and 96 percent in Gaza. Indeed, natural population growth in Gaza rose to the dizzyingly high rate of six percent a year in 1992 and 1993, a time in which population growth was falling precipitously in most of the developing world. Between 1967 and 1993, net emigration was 174,000 from the West Bank and 110,000 from Gaza. Emigration was particularly rapid from 1975 to 1981, when the demand for foreign labor in Persian Gulf countries (fueled by high oil prices) grew rapidly. Thereafter, net emigration slowed, and reversed from 1990 to 1992. And without the safety valve of emigration, the population machine continued in high gear: between 1995 and 2005, the combined population increased by 44 percent, reaching 3.5 million. The economy, therefore, needed to grow by over 3 percent a year just to maintain living standards. just the facts Palestine is, of course, divided politically as well as geographically. The Palestinian Authority, created in 1993 following the Oslo Accords with Israel, is based in Ramallah in the West Bank, and is dominated by the secular Fatah political movement. The Oslo Accords gave the Palestinian Authority control over both security-related and civilian issues in Palestinian urban areas and civilian control over Palestinian rural areas. These areas account for 40 percent of the West Bank. What was left, which includes Israeli settlements, the Jordan Valley and bypass roads around Palestinian communities, remained under Israeli control. (East Jerusalem was excluded from the Accords.) In 2005, Israel withdrew its settlers from Gaza and in 2007 the Islamic fundamentalist group Hamas wrested control previous page: paolo pellegrin/magnum 62 The Milken Institute Review
UN partition, 1947 post six-day war, 1967 expansion continues, 2012 Jerusalem Jerusalem Jerusalem Gaza Gaza Gaza Israel Palestine Israel Palestine Israel Palestine digital journal of it from the Palestinian Authority. While the traditional source of income in Palestine was farming, the terrain is unpromising except for a few fertile plains in the north of the West Bank and in Gaza. Just one-sixth of the land is cultivated (mostly with olive trees), and just one-third of that sixth is good enough to support intensive agriculture at costs that make it competitive in export markets. Consider, then, the economy s formidable liabilities. It suffers from a lack of territorial contiguity (both between the West Bank and Gaza and within the West Bank), which is reinforced by the deep political divisions between Fatah and Hamas. It is also affected by scarcity of water and fertile land, and limited freedom of movement (Israeli checkpoints), not to mention foreign trade restrictions resulting from the economic accords signed with Israel. Political instability and heavy regulation discourage market-driven foreign investment. Meanwhile, the one-two punch of high birth rates and rising life expectancy leave it with an exceptionally high (37 percent) dependent population. Not surprisingly, then, foreign aid and remittances go a long way toward explaining the fact that, in most years, living standards have nonetheless risen. Palestinians are the world s largest recipients of foreign assistance Fourth Quarter 2013 63
palestine economy With Gaza blockaded, most livestock comes in by tunnel from Egypt. in per capita terms. In the past 15 years, they have received some $20 billion, including $500 million a year from the UN Relief and Works Agency. This financing has certainly made life easier for poor Palestinians (and for the Palestinian bureaucracy that absorbs a good chunk of it). But it has encouraged dependence, arguably reducing the pace of economic development. One manifestation is the huge construction and services bubble in Ramallah, the capital of the Palestinian Authority, while the rest of the West Bank economy remains in dire need. In 2011, the GDP was nearly $10 billion, with another $2 billion brought into the economy by donors and Palestinians working abroad. The West Bank has a much stronger economy than Gaza s, which is reflected in its income per capita of about $3,400, compared with $1,900 in Gaza. But the economy is plainly on a roller coaster. West Bank GDP growth fell from 9 percent in 2010 and 2011 to 5.5 percent in 2012; in Gaza, growth fell from 15 percent to 7.7 percent. And the economy remains weak this year. Unemployment is near 19 percent in the West Bank; in Gaza, it s 31 percent among the highest rates measured anywhere in the world. Wait, it gets worse: unemployment among 15- to 29-year-olds is 31 percent in the West Bank and 48 percent in Gaza. The unemployment problem has grown substantially since 2000, the year the second intifada broke out and Israel further restricted Palestinians access to commuter jobs. In 2000, one-fifth of Palestinians working were employed in Israel; today, the figure is roughly half that. Moreover, in a scenario familiar all over the Middle East, the structural problems underlying the labor market have been growing less tractable as the number of students graduating from universities far exceeds the growth in demand for white collar labor. The Palestinian Authority s budget deteriorated sharply in 2012 it ran a deficit of $1.7 billion and remains in large deficit. This is mainly due to higher than expected expenditures (12 percent above forecast), lower than anticipated revenues (6 percent below forecast) and a long-term decline in donor funding. Foreign aid fell to $932 million from a peak of $1.4 billion in 2009. Along with run- paolo pellegrin/magnum 64 The Milken Institute Review
ning up the public debt, the Palestinian Authority s fiscal difficulties also caused frequent delays in the disbursement of civil servants salaries, which has led to work stoppages and a decline in the quality of public services. Another major fiscal problem has its origin in the dispute between the Palestinian Authority and Hamas in Gaza. Gaza still accounts for 48 percent of the Palestinian Authority s expenditures, but only 4 percent of its revenues. Since Hamas controls the territory, the Palestinian Authority is unable to collect taxes there, and Hamas has no interest in remitting any of the taxes it collects to Ramallah. In 2010, after the European Union stopped paying for Gaza s electricity, the Palestinian Authority stepped in to help. Ironically, the modest sums that the Palestinian Authority does receive from Gaza come courtesy of Israel, which transfers the taxes it collects on goods imported into Gaza from Israel. Fourth Quarter 2013 65
living with goliath The Palestinian economy functions within the framework of the economic agreement between Israel and the Palestine Liberation Organization signed in Paris in April 1994. That agreement was largely determined by the political framework, which effectively limits the economic options. A common free trade agreement, under which each party maintained its own external tariff, would have required a border between the two parties to prevent imports into the territory with the lower external tariff leaking into the one with the higher external tariff. As no border was fixed in the earlier Oslo Accords, that option was rejected. Another option would have been complete separation. That would have prevented Palestinians from working in Israel, something that the Palestinian negotiators in Paris were anxious to avoid. Under the hybrid deal made in Paris, the Palestinian Authority was allowed to import mutually agreed upon goods at customs rates differing from those prevailing in Israel and to import goods from Arab countries, subject to agreed-upon limits. The pact provided for the free movement of manufactured goods between the territories and Israel. With a few exceptions demanded by Israeli interests, agricultural produce can enter Israel freely. Tourism, too, was to be unrestricted. The Palpalestine economy That said, much of the money that the Palestinian Authority spends in Gaza has little impact on public services. Six years after Hamas took over Gaza, for instance, the Palestinian Authority still pays tens of thousands of its former employees to sit at home and do nothing in order to discourage them from working for the Hamas government. Indeed, Gaza accounts for 40 percent of the 150,000 people on the Palestinian Authority s payroll. The Palestinian Authority s budgetary problems, it should be noted, have also been affected by Israel s failure to pass on all the funds it collects on the Authority s behalf while the governments wrangle over debts owed to the Israel Electric Corporation. The economic situation in Gaza is much worse than in the West Bank, largely because of the severity of conflict. Since Hamas took over, there have been two military confrontations with Israel, and Israel has greatly restricted the movement of goods in and out of Gaza. In response, Hamas encouraged trade through tunnels to the Sinai in Egypt and used the revenues it received to help finance its military. But earlier this year, relations between Hamas and the fundamentalist Morsi government in Egypt soured, and Egypt flooded most of the tunnels. Egypt s reversion to military rule after Morsi s ouster in July will only reinforce Hamas s isolation. The most recent Palestinian balance-ofpayments figures, for 2011, show a large increase in the current-account deficit, to $2.2 billion, compared to an annual average of $700 million in the preceding three years. Short-term factors an increase in imports and a fall in aid and household remittances largely explain the discontinuity. But the deficit is chronic, reflecting the long-term stagnation in exports. The cost of living in the Palestinian territories is close to that in Israel, although the average wage in the West Bank is less than a quarter of the Israeli average, and in Gaza it is even lower. As a result, Palestinian income per capita, when adjusted to local purchasing power, is lower than that of neighboring Arab countries, and is only a little higher than that of very poor countries in the region like Sudan and Yemen. 66 The Milken Institute Review
Jenin reliefweb estinian Authority was allowed to establish a monetary agency that could regulate banks, but could not create a separate currency. Israeli shekels are the medium of exchange. The accord also gave the Palestinians discretion to manage their policies on direct taxation. Israel, moreover, agreed to remit 75 percent of the taxes collected from Palestinians employed in Israel. Israel continued to collect import duties on goods destined for the Palestinian Authority, but was obligated to turn over the funds to the PA. A value-added tax was authorized, with rates up to three percentage points higher or lower than in Israel. Finally, Israel agreed to maintain access for Palestinian workers, though it reserved the right to restrict it for security reasons. The agreement, it should be understood, reflected the unequal balance of political and economic power between the parties and effectively froze them in that situation. It did not take into account Palestinian political aspirations and set custom duties at rates that suited Israeli rather than Palestinian interests. More generally, the regional economic dominance of Israel and the uneasy security relationship between Israel and the territories has created major barriers to development. The competitiveness of the Palestinian economy is greatly affected by the costly back-to-back trucking system imposed at crossing points. West Bank exports to Israel must use one of five authorized crossings on the Separation Barrier, which will eventually extend 430 miles. Goods must be shipped on pallets according to strict regulations and are subject to delays that risk damage to perishable produce; opening hours at the crossings are limited. West Bank producers are free to trade via the Allenby Bridge to Jordan and beyond. But traffic remains modest because Israel buys the lion s share of total Palestinian exports. In Tulkarm West bank barrier Constructed Proposed Hebron Ramallah Jerusalem Nablus Tubas 1949 Armistice Under construction Settlements Jericho 2011, less than 5 percent of exports went to markets in Asia and Europe. Imports are not quite as concentrated. But with about threequarters coming from Israel, Palestinian dependence on Israel as a partner is still great. Exports from Gaza were effectively ended with the imposition of a blockade after Hamas took control in June 2007; in 2012, a mere 210 truckloads of goods exited the territory. These Dead Sea Agricultural gates Fourth Quarter 2013 67
palestine economy contained mainly agricultural produce as well as a few small consignments of textiles and furniture. High water salinity in Gaza has lowered agricultural productivity and the production of specialized high-value crops is no longer viable. Exports of cut flowers to Europe are running just one percent of their pre-blockade level. Employment of Palestinians in Israel, as noted above, is now very limited. But jobs within the territories are beyond scarce. Since the Paris Accord took effect, the Palestinian economy has deindustrialized, with the share of manufacturing in GDP falling from 18 percent in 1995 to 11 percent in 2011. One reason is that productivity has fallen, thanks to Israeli restrictions on imports of raw materials and high-tech machinery. Today, manufactured products are mostly based on local natural resource endowments and yield modest valueadded items like processed stone, low-end furniture, packaging materials, ceramics and other products made with old technologies. worse before it s better? The share of goods exports in Palestine s GDP has declined from about 10 percent in 1996 to around 7 percent in 2011. Service exports are catching up with goods exports, which reflects the uncompetitive nature of manufacturing and agriculture rather than the strong performance of services. Goods and services exports together account for roughly 14 percent of GDP, which is strikingly low for a poorly endowed small economy that must exploit economies of scale if it is to be competitive in global markets. Private investment, which is essential for maintaining competitiveness, has also been anemic for a developing country, running about 15 percent of GDP for some time. Moreover, much of it has been channeled to the less-productive non-tradable sector dominated by construction. Foreign direct investment, which typically plays a big role in powering development, has averaged only one percent of GDP over the last decade. The only technologically advanced exports are pharmaceuticals, but they account for just 2 percent of total exports. Based on educational attainment and the ease of doing business which have been improving one would expect to see a substantially higher level of technological sophistication in the Palestinian export sector. There is a significant link between export diversification, both in terms of products and markets, and economic development. That s because heavy export concentration exposes countries to price and demand fluctuations for specific products or, in the case of geographic concentration, to macroeconomicdriven changes in demand in destination countries. Since the diversification of exports and markets involves structural change and requires significant financial resources and time, though, it is safe to say that the Palestinian economy will continue to be heavily exposed to fluctuations in the Israeli economy for many more years. The private sector is overwhelmingly dominated by very small, family-owned firms. In 2007 (the latest year for which data is available) the average West Bank business employed only three workers and the average for manufacturing was just 4.5. There were only 57 establishments with more than 100 workers in the entire West Bank and Gaza, and only 26 of them were in manufacturing. In 2009, internal trade accounted for more than 40 percent of employment. Services accounted for another 30 percent, while industry took only about 22 percent of employment. Little has changed since then. In 2011, 15 percent of the West Bank labor 68 The Milken Institute Review
The bright spot is its human capital: in comparison with other Arab countries, Palestinians have high education levels. force worked in the public sector, 71 percent in the private sector and about 12 percent worked in Israel or Israeli settlements in the West Bank. In Gaza, 40 percent of the labor force was in the public sector and 60 percent in the private sector. The very high share of the public sector in Gaza reflects the size of the Hamas security forces and the lack of alternative employment. what to root for How might the Palestinian economy develop? The bright spot is its human capital: in comparison with other Arab countries, Palestinians have high education levels. The number of university graduates has grown significantly, although the quality of their education has been problematic. There is also a large Palestinian diaspora numbering some six million inside and outside the Arab world. They include many who have created businesses, accumulated capital and built networks of commercial connections, all of which could be used to aid the Palestinian economy if and when conditions there permit. There are a number of promising sectors that could boost exports, employment and income. The first is high-tech: high rates of computer literacy and English-language skills (compared to Arab neighbors) offer significant advantages. In 2011, 51 percent of households owned computers, 30 percent had Internet access, 94 percent had satellite dishes and 95 percent had mobile phone access, which provides a healthy local market from which to launch export businesses. In this case, proximity to Israel is an advantage because it is fast becoming a global leader in information and communications technology. Indeed, multinational corporations with subsidiaries in the Tel Aviv area are beginning to outsource to the West Bank to take advantage of cheap labor there. Cisco Systems, the world s largest maker of networking equipment, along with its tech partners and the European Investment Bank, have invested $78 million in developing the nascent sector since 2008. By the same token, opportunities exist in the provision of architectural, design and other high-skill services to countries in the Middle East, especially in the Gulf. Much here depends on increases in investment in technical education. Palestine has mineral resources in the Dead Sea and gas reserves in the Mediterranean off the coast of Gaza. They could be exploited in the event of a détente with Israel. Finally, the West Bank has major tourism assets in particular, religious sites ranging from Bethlehem to Jericho that are currently underexploited because of political instability. Even Gaza has potential in the tourism sector: before the second intifada, Israelis took advantage of the locale s fine beaches. * * * The Palestinian territories are hardly unique in their economic woes. The development of other impoverished but promising places for example, Lebanon, Myanmar and Kashmir has been stymied by violence, political instability and bad government. But in the case of Palestine, the gap between actual and potential development is especially poignant. Peace with Israel is the key to progress. Yet the obstacles to a territorial settlement, which seemed so tantalizingly close in the 1990s, remain dauntingly difficult to surmount. m Fourth Quarter 2013 69