The Palestinian Authority: friend or foe of private investors? (Kanaan: the Palestinian Authority and private investors).

Kanaan, Oussama

Policy makers in the United States are still reluctant to openly acknowledge the full extent of the damage suffered by the Palestinian economy since the onset of the border closures and internal blockade in September 2000. During 2001, per capita income in the West Bank and Gaza is estimated to have fallen by one third, the unemployment rate has tripled to over 30 percent, and the Palestinian Authority's (PA) budgetary revenue has collapsed due to the shrinkage in economic activity and the freeze by Israel in the transfer of tax revenue it collects on behalf of the PA. The donor community, notably Arab states and the European Union, was quick to provide some financial support for the PA budget and public investment, but it is now clear that this support provides only a temporary (albeit necessary) fix aimed at preventing an immediate financial crisis. At the same time, donors are well aware that in the longer run, the downward spiral of the Palestinian population's living standards cannot be reversed without a revival of private-sector investment, which in the past year has dried up in virtually all sectors in the West Bank and Gaza. Yet private investment will remain depressed as long as entrepreneurs continue to have little hope that the restrictions placed by the Israeli military on the movement of goods and people, both across external borders and within the Palestinian areas, will be removed any time soon.

Despite a general recognition of the need to directly address the root cause of the economic deterioration in the West Bank and Gaza, only timid efforts have so far been exerted by the international community to ensure a prompt lifting of the closures and blockade that are stifling private investment. In addition to the influence of the doctrine that such restrictions are necessary "for security reasons," donors' reluctance to exert the necessary pressures on the Israeli side can also in part be explained by the spread of an image that is getting increasing exposure in the media -- especially in the United States -- of a Palestinian authority that has done little to help the private sector, has worked against the free-market principles espoused by the donor community, and has no interest in improving the transparency and accountability of its fiscal and commercial operations. A message is thus subtly being imparted that, even if the closures and blockade are lifted, things would not be much better for the private sector, in view of its past experience with the PA. But how accurate is this image?

EXPERIENCE PRIOR TO THE PA

When the PA assumed its government responsibilities in 1994, private investment in the West Bank and Gaza was largely of the kind that was least conducive to long-run productivity growth, as it was concentrated mostly in residential construction, with little in modern farming and industry. Several important factors related to the Israeli military occupation explain this skewed pattern of investment: (1)

* The playing field in trade between the West Bank and Gaza and Israel was highly distorted. While there were no barriers to Israeli exports to the West Bank and Gaza, Palestinian exports of non-subsistence agricultural and industrial products were severely restricted. This stifled the development of an important part of the territories' productive base, while favoring the export of labor to Israel.

* Due to the unstable political and security environment, the financial sector in the West Bank and Gaza was underdeveloped, with private banks virtually absent for over 25 years. This encouraged the channeling of savings toward investment -- largely in residential construction -- that could be self-financed or financed by small groups of savers through informal channels, and away from larger-scale investments in sectors -- notably modern farming and industry -- that required longer-run risk capital.

* Public expenditure consisted largely of military and security-related current expenditure, and of assistance for the expansion of Israeli settlements, with little infrastructural support for outward-oriented indigenous private investment.

* Palestinian private investors were faced with an antiquated amalgam of previous occupiers' laws, in addition to Israeli-occupation laws that were frequently amended and suspended on an ad hoc basis by Israeli military orders. The prevailing legal and regulatory framework restricted the repatriation of earnings and capital and did not provide for adequate dispute-resolution procedures. The Israeli authorities also implemented a non-transparent system for allocating investment and import licenses, favoring those ventures viewed as furthering the military's interests. This encouraged low-key, household-based investments that required the least interaction with the military authorities.

THE PA'S ROLE

The PA thus had to overcome some important impediments to private-sector development inherited from the period of military occupation. Since 1994, this task was made particularly daunting by the regime of intermittent border closures, which was characterized by the imposition of strict controls on the movement of goods and labor to and from the West Bank and Gaza, with protracted periods during which virtual autarky was imposed on the Palestinians. The border closures substantially depressed the profitability of private investment in all sectors, in particular in the export sectors, through the rise in transportation costs, disruptions of production due to difficulties in importing capital goods and raw materials, and the need to continually adjust capacity and output levels to fluctuating demand. At the same time, however, the PA was active in implementing policies in coordination with donors that aimed at relaxing many of the constraints faced by the private sector:

* The PA sought the help of donors to eliminate the imperfections in credit markets and develop financial institutions. Up to the onset of the closures and blockade in September 2000, several projects were being implemented as part of the World Bank's Financial Sector Project, which had as a key objective the channeling of funds from donors to banks to be loaned out for long-term investments, and establishing facilities that would allow banks to refinance long-term loans. Another important component of these efforts was a project aimed at improving access to financing by small-scale private ventures, notably by assisting banks in screening and monitoring loans to micro-enterprises, while helping the latter to acquire the skills necessary to apply for loans and report to banks. The PA also sought to promote direct equity investment with the help of co-financing from the International Finance Corporation. One notable example of efforts in this area was the development of the Peace Technology Fund, which was designed to channel funds from Palestinian and Israeli entrepreneurs to small- and medium-scale industries in the West Bank and Gaza.

* The set of confusing laws and regulations that restrained private investment during the occupation period was gradually giving way to a transparent and supportive framework. Progress was achieved to ensure the effective implementation and enforcement of two important laws: an Investment Law that would eliminate delays in approving new investments through clear and straightforward procedures, with minimum discretionary power accorded to the government, and a securities-market law that establishes accounting and auditing standards for enterprises in line with international standards.

* The PA aimed at overcoming the constraints on external trade imposed by the regime of border closures by initiating projects to expand free-trade and industrial zones that would be subject to fewer security controls and trade restrictions. The PA also worked closely with donors to improve access to markets outside Israel through the development of seaports and airports, to strengthen transport links with Jordan and Egypt, and to promote the economic integration of the Palestinian territories through the establishment of a safe passage between the West Bank and the Gaza Strip.

TRANSPARENCY AND GOVERNANCE

Since it assumed power in 1994, the PA has taken certain actions that either directly interfered in the smooth operation of the market or had an indirect adverse effect on private investment by sending the wrong signals regarding the transparency of PA commercial and fiscal operations. These activities could be grouped in three broad categories:

* There were activities that could be generally labelled as "anti-competitive," consisting of granting monopoly powers and other privileges to a small circle of enterprises, in particular to companies in which the PA has a stake. This practice was in part related to the institutional environment that had prevailed during the occupation in which a few big business groups cooperating with the military establishment were favored over smaller, less-organized entrepreneurs. It was also partly the result of the limited access of the Palestinian economy to non-Israeli markets, and its high dependence for the provision of a range of capital goods and raw materials on a small number of Israeli monopolies and oligopolies. A prime example is the granting of the exclusive right to supply petroleum products to the West Bank and Gaza to the Israeli company Dor Energy.

* Tax revenue was diverted to bank accounts outside the control of the Ministry of Finance. During the period 1994-99, from 9 to 15 percent of each year's total budgetary revenue -- from excise taxes, primarily on imported petroleum products -- went to bank accounts outside the West Bank and Gaza and was partly invested in PA commercial operations, especially in the Palestinian Commercial Services Company (PCSC). Although there was no evidence that any of the funds were "pocketed," an impression was given that the PA was trying to avoid full accountability for its operations.

* Hiring of public-sector employees has expanded rapidly in recent years, with PA employment rising from 83,000 employees at the close of 1997, to about 120,000 by late 2001, or 17 percent of the labor force. This is high even by regional standards. While this expansion served to partially offset reduced access to employment in Israel, especially during periods of closure, it did not always take into account the PA's budget constraints, and prevented a rise in the average remuneration of employees. The excessive hiring was in large part due to decisions made though the Gaza payroll unit by the Gaza Personnel Council (GPC) without coordination with the Ministry of Finance.

Although it was difficult at first to overcome the power of rent-seeking interest groups and lobbies, in early 2000, the PA launched a bold program, integrated into a comprehensive Economic Policy Framework (EPF) designed with technical assistance from the IMF. The PA implemented core measures in this program at an impressive pace. In January 2000, Chairman Arafat created a Higher Council for Development and charged it with the implementation of the EPF measures. The PCSC was audited by an internationally recognized company in February of that year, and in May a list of all equity holdings of the PA was published. In April, all budgetary revenue was centralized in the single treasury account at the Ministry of Finance. In June, work started on establishing the Palestinian Investment Fund (PIF), charged with managing all of the PA's assets and investments. By July, the PA was working with PriceWaterhouseCoopers on developing the articles of association of the PIF so as to ensure consistency of its operations with internationally accepted standards of transparency and accountability.

In late September 2000, strict closures and an internal blockade (in which cities are besieged and main roads blocked) were imposed on the West Bank and Gaza, putting a halt to the implementation of the remaining measures in the EPF program. In addition to the direct impact of the restrictions on the profitability of investments as described above, private investors' cash-flow positions have also been severely affected indirectly by Israel's freeze on the transfer of tax revenues owed to the PA since December 2000. The loss of this tax money, which normally represents 60 percent of the PA's total budgetary revenue, led to an inability of the PA to pay a large share of its bills on basic goods and services provided by private-sector suppliers. (The stock of domestic payments arrears was estimated at about $425 million at the end of 2001, while the stock of withheld tax revenue was estimated at $360 million.)

CONCLUDING REMARKS

The full extent of the economic damage caused by the regime of closures and blockade, in particular through its impact on private investment, is by now fairly well documented. However, the arguments for the removal of the restrictions become even more powerful if full stock is taken of the PA's positive role in removing the impediments to private investment, especially given the handicaps passed on from the pre-1994 era of Israeli occupation. While slow progress was initially made with regard to governance and transparency, a remarkable turnaround in the PA's policy orientation in these areas took place in early 2000. Key measures were implemented that redressed some of the old ways of management inherited from the period of military occupation and armed conflict. It is important for the PA not only to remind donors of its achievements, but also to present them with a concrete "agenda for action" aimed at supporting the private sector, to be implemented as soon as the closures and blockade are lifted. This agenda should include a roadmap for the continuation of the core projects and policies that were frozen or aborted at the end of September 2000, due to closures and blockade. It should also make clear to donors that the PA has the experience, determination and strategy required for a solid and sustainable recovery in private investment.

(1) For an assessment of the impediments to private investment in Palestine in the past, see Oussama Kanaan, "Private Investment Under Uncertainty in the West Bank and Gaza Strip," The Economy of the West Bank and Gaza Strip, Middle Eastern Department (Washington, DC: IMF, 1998).

Dr. Kanaan is a senior economist at the International Monetary Fund (IMF). The views expressed in this article are those of the author alone and do not necessarily represent those of the IMF Please send comments to okanaan@aol.com