Uncertainty Deters Private Investment in the West Bank and Gaza Strip

• Author: Oussama Kanaan
• Position: Economist in the IMF's Middle Eastern Department

The accords signed by Israel and the PLO in 1993 and 1994 heralded greater prosperity for Palestinians. But an adverse external trade environment has discouraged private investment, and economic conditions have deteriorated.

IN SEPTEMBER 1993, Israel and the Palestine Liberation Organization (PLO) signed the Declaration of Principles on Interim Self-Governing Arrangements, which outlined the gradual handover to the Palestinian Authority of responsibility for the West Bank and Gaza Strip. The advent of self-rule and the easing of political and social tensions were expected to usher in a period of rapid economic growth and higher living standards for Palestinians. Expectations were buoyed by the Protocol on Economic Relations agreed in April 1994, which outlined the Palestinian Authority's responsibilities in key economic areas and envisaged close economic cooperation between Israel and the authority, as well as by the authority's commitment to institution building and to a private sector-led, outward-oriented development strategy. Donors pledged generous support, which was gradually to shift away from emergency aid and toward public investment projects.

[ SEE THE GRAPHIC AT THE ATTACHED RTF ]

The hopes aroused by the accords have been frustrated, however. Economic conditions in the West Bank and Gaza Strip have deteriorated sharply since 1993. The unemploymentrate for Palestinians has increased to about 30 percent; external trade has contracted; and the public investment program has been disrupted. By 1997, the unemployment rate was 13 percentage points higher, and real per capita income about 20 percent lower, than in 1993, and only modest efforts had been made to develop the domestic productive base and upgrade the physical infrastructure. Particularly disturbing is the erosion of confidence of the private sector, which was to have been the primary engine of economic growth. Between 1993 and 1997, private investment's share in GDP is estimated to have dropped from 19 percent to 10 percent (Chart 1). What went wrong?

History

The evolution and composition of private investment in the West Bank and Gaza Strip have, to a large extent, reflected changes in the volume and pattern of trade with Israel. After the Israeli occupation began in 1967, the West Bank and Gaza Strip's external trade, previously limited mostly to neighboring countries of comparable wealth and level of development, was swiftly reoriented toward Israel, an economically more advanced country with a GNP about 20 times as large. The opening of Israeli markets to Palestinian employment and, to a lesser extent, to commodity exports, was reflected in the West Bank and Gaza Strip's remarkably high rate of real GNP growth, which averaged 30 percent a year during 1969-79. This growth was accompanied by a rise in private investment as a share of GDP from about 14 percent in 1969 to 30 percent in 1979, with real private investment growing at an average of 25 percent a year.

Although the increase in private investment seems impressive, it was devoted almost entirely to residential construction, which represented, on average, 85 percent of total private investment over the period. In contrast, real investment in machinery and equipment grew by less than 1 percent a year, decreasing to 5 percent from about 10 percent of GDP.

The concentration of private investment in residential construction, along with the virtual stagnation of investment in machinery and equipment, suggests that, although investment was driven largely by growth, it contributed little to growth. The initial boost to growth provided by the "integration effect" tapered off (owing, in particular, to a slowing of the pace at which labor shifted from low-productivity agriculture to higher-wage employment in Israel), and real GNP growth slowed to about 5 percent a year during 1980-91. Private investment was virtually stagnant during this period, growing less than 1 percent a year, in real terms, and remained heavily skewed in favor of residential construction.

The skewed...