Rebuilding Palestine's economy

Claus Astrup, Supervisor, World Bank Operations in West Bank and Gaza, and Sebastien C. Dessus, WB Senior Economist, Project Syndicate

The economy of the West Bank and Gaza, like Yassir Arafat's headquarters at Ramallah, is a ruin. Rebuilding it will provide as challenging -- and urgent -- a task as the reconstruction of Palestinian political institutions now supposedly underway.

Due, primarily, to their bleak history since 1948, Palestinians in the West Bank and Gaza pursued a development strategy of exporting labor rather than goods. In June 2000, three months before the current intifada began, 21 percent of all Palestinians with jobs worked in Israel, mainly in low-skilled positions in construction. Net incomes from abroad amounted to more than 22 percent of Palestinian GDP, making it one of the world economies most dependent on remittances.

The blood-soaked politics that has prevailed since September 2000 exposed the extreme vulnerability of this development strategy, making urgent the need to rethink the economic foundations of the Palestinian territories. Israel's labor market is now sealed off to Palestinians and the prospect of it reopening soon is unlikely, to say the least.

Do viable alternative development strategies for the Palestinian economy exist? Do any of these offer a chance at growth at least as strong as what has been attained by exporting labor?

Of course, the Palestinian economy's dismal performance is not solely the result of the sharp reduction in the number of Palestinians working in Israel. Even more damaging are the restrictions imposed on the movement of goods and people within the West Bank and Gaza. The comprehensive curfews imposed on almost all large Palestinian towns in recent months effectively confine people to their homes, thus bringing the economy to a virtual standstill.

Moreover, trucks carrying goods between Palestinian towns and villages now must unload and reload their cargo before entering each town so as to allow the Israeli military to inspect the shipment. This hugely increases the cost of doing business, and contributes to a gradual, stealthy "cantonization" of the West Bank.

Although the current inability of Palestinians to work in Israel has had devastating economic consequences, there may be a silver lining: Over the longer term resources might be reallocated towards export-oriented activities, as lower employment in Israel and lower levels of remittances pull down wages, thereby improving export competitiveness. Emphasizing exports may in itself enhance the Palestinian economy's growth potential by increasing incentives to innovate, invest, and reduce inefficiencies.

We recently evaluated a Palestinian development strategy based on exports of goods against a continued reliance on exporting labor. We also attempted to identify policies that could ease the (possibly forced) transition towards this new model of economic development.

In one scenario, we assumed that the Israeli labor market will be progressively re-opened. In another we assumed that it will remain closed until 2010. Comparing the outcomes of these two simulations suggests that large export flows of Palestinian labor to Israel reduce the capacity of the Palestinian economy to export goods by putting upward pressure on wages, undermining competitiveness.

These simulations also suggested that continued reliance on the export of labor results in a lower growth potential for the Palestinian economy than a development strategy based on exporting goods. But the level of average incomes in the West Bank and Gaza will remain much lower under the latter strategy than in the situation where the Israeli labor market is gradually reopened for Palestinian labor. This confirms the huge short term welfare cost to Palestinian society of restricting Palestinian workers' access to the Israeli labor market.

What trade policies might boost exports of goods rather than labor? Palestinian officials argue that acceptance of the Paris Protocol, which formalized the de facto customs union with Israel that has existed since 1967, was conditioned on free access of Palestinian workers to Israel. That access was intended to offset the cost to the Palestinian economy of granting preferential access to Israeli goods.

But the Palestinian/Israeli customs union is extremely costly, because it impedes expanding Palestinian trade links with the rest of the world. If Israel's labor market remains closed to Palestinian workers, maintaining this regime will become increasingly counter-productive.

Adopting a more neutral trade regime, in which Israel is treated the same as any other trading partner, would then become more attractive. Our simulations indicate that a non- discriminatory trade regime would magnify the potential positive impact of depreciation in the real exchange rate (as a result of the reduction in wages) on Palestinian GDP.

Gains from trade would undoubtedly take time to materialize, and restoring access to the Israeli labor market would more quickly boost incomes for a large number of ordinary Palestinians than any effort to promote the export of goods. But a return of Palestinian workers to jobs in Israel is by no means certain. This makes adopting trade policies that facilitate Palestinian trade with Israel and the rest of the world even more crucial. Without such a global trade option, the West Bank and Gaza could be prevented from exporting both goods and labor, producing even more dire and tragic consequences for the Palestinian people.