THE PEACE PROCESS, UNCERTAINTY AND PRIVATE INVESTMENT IN THE WEST BANK AND GAZA STRIP.

Kanaan, Oussama

In September 1993 Israel and the Palestine Liberation Organization signed the Declaration of Principles on Interim Self-Governing Arrangements, which outlined the gradual handover to the Palestinian Authority of responsibility over the West Bank and Gaza Strip. The advent of self-rule and easing of political and social tensions were expected to usher in a period of rapid economic growth and higher living standards for Palestinians. Expectations -- especially those of private investors -- 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.

The high hopes aroused by the accords have been frustrated, however. Economic conditions in the West Bank and Gaza Strip have deteriorated sharply since 1993. The unemployment rate 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 the confidence of the private sector, which was to have been the primary engine of growth for the Palestinian economy. Real private investment declined by an estimated 10 percent annually between 1993 and 1997, and private investment's share in GDP dropped from 19 percent of GDP in 1993 to 10 percent of GDP in 1997 (Figure 1). What went wrong?

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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 per year over 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 this increase in private investment appears impressive, it consisted almost entirely of increases in investment in construction -- primarily of housing. Investment in residential construction 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, while decreasing as a share of GDP from about 10 percent in 1969 to 5 percent in 1979.

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 as a source of growth. The initial boost to growth provided by the "integration effect" (in particular, the slowing of the pace at which labor shifted from low-productivity agriculture to higher-wage employment in Israel) tapered off, and real GNP growth decelerated sharply during 1980-91 to a yearly average of about 5 percent. Private investment was virtually stagnant during this period, growing less than 1 percent a year, while it remained heavily skewed in favor of residential construction.

The skewed composition of private investment can be attributed to several factors. The first and key factor was the absence of a level playing field in trade between the West Bank and Gaza Strip and Israel; there were no barriers to Israeli exports to the West Bank and Gaza Strip, but Palestinian exports of agricultural and industrial products to Israel were restricted. This suppressed the development of a large part of the West Bank and Gaza Strip's domestic productive base (agriculture and industry) while encouraging services. Second, the financial sector in the West Bank and Gaza Strip was underdeveloped, which encouraged the channeling of savings toward investments (e.g., residential construction) that could more easily have been self-financed or financed by small groups of savers through informal channels, and away from investments in sectors (notably, modern farming and industry) that required longer-term risk capital. Third, the Israeli authorities provided little support for private investment; public investment in infrastructure was inadequate, and a legal and regulatory environment favorable to private investment was not put in place. Fourth, uncertainty with regard to political stability further stifled private investment in the productive sectors.

THE PEACE PROCESS

The peace accords of the early 1990s promised to usher in an economic and political environment in which the constraints on private investment would be relaxed or eliminated. The trade regime envisaged by the Economic Protocol on Economic Relations would encourage the expansion and reorientation of the West Bank and Gaza Strip's productive base toward agricultural and industrial export production and gradually reduce dependence on the export of labor. From the viewpoint of private investors, one of the attractive features oft he Protocol was the removal of most restrictions on Palestinian commodity exports to Israel, which would increase the profitability of investments in agricultural and industrial production. The Protocol also gave Palestinians greater -- albeit still limited -- flexibility in determining their own import policies and tariff structures with regard to specific products and countries, including raw materials and capital goods from neighboring Arab countries, with potentially favorable effects on investment costs.

Despite these advantages, the Economic Protocol had a number of limitations. In addition to setting up an import policy with limited flexibility, it did not address important obstacles to external trade (in particular the absence of outlets, such as seaports and airports) or to trade within Palestinian areas, in particular between the West Bank and the Gaza Strip. Nevertheless, although consideration of such key issues was postponed until the permanent-status negotiations scheduled for 1996-99, expectations were raised simply by the fact that such issues were put on the negotiating table.

In addition to heralding a favorable trade environment, the agreements of 1993 and 1994 had the potential to open up business opportunities by removing impediments to private investment. First, because of the dearth of banks in the West Bank and Gaza Strip during the Israeli occupation, a large part of Palestinian households' savings had been held in financial institutions abroad, stored through informal domestic financial channels, or hoarded in cash. An improved trade environment and other positive changes likely to ensue from the accords were expected to lead to a boom in domestic private investment demand, creating lucrative domestic outlets for a large stock of savings (and, indeed, the banking sector and volume of banking deposits expanded very rapidly in the early stages of the peace process). Second, although physical infrastructure had become extremely dilapidated during the occupation, leading to higher investment costs, particularly with regard to transportation, these costs were expected to decline as a result of the public investment program, to which donors committed about $1.2 billion. Finally, the rapid progress of the peace process initially and the transfer of control over important economic spheres to the Palestinian Authority signaled improved prospects for political and economic stability.

DASHED HOPES

The peace accords did not represent a turning point for Palestinians, however. Private investment did not surge as expected, largely because of an extremely adverse trade environment. The situation was exacerbated by weaknesses in the financial sector, slow implementation of the public investment program, and an inadequate legal framework.

An adverse trade environment. Given the dominant role played by external trade in the Palestinian economy, the profitability of private investment is particularly vulnerable to changes in the external trade environment. Since 1993 movements of goods and labor into and out of the West Bank and Gaza Strip have been subject to strict security controls; on several occasions the border has been totally closed following security incidents in Israel, imposing autarky on Palestinians, who have few outlets to export markets other than Israel, for periods of uncertain timing and duration.

The border closures have had a dual effect: they have dampened average demand levels and caused production costs to increase while sharply increasing the variability of demand and costs. This dual effect is illustrated in Figure 2, which depicts the impact of the blockades on exports of labor to Israel in 1996 and 1997. First, the number of Palestinian workers in Israel has dropped from an average of more than 100,000 before the closures to an average of about 30,000 after them. Second, the blockades have introduced cyclical fluctuations in demand: the number of Palestinian workers in Israel declines to a negligible level during closure episodes, returns to peak levels when closures are lifted, and drops again when closures are reimposed.

[Figure 2 ILLUSTRATION OMITTED]

Viewed from the perspective of private investors, the border closures exert strong downward pressures on the net present value of investments. Producers' expected revenues are adversely affected by the decline in the average level of demand and the increased variability of demand, while higher transportation costs, disruptions of production caused by difficulties in importing inputs, and the need to adjust capacity and output levels to fluctuating demand have increased expected costs.

The adverse effect on the net present value of investments is especially strong in the export sector. In the import-substituting and nontradables sectors, downward pressures on net present value are tempered by relative price changes induced by a shift in domestic demand that favors domestically produced goods over imports. Thus, border closures both depress the profitability of investments in all sectors, with adverse effects on aggregate investment, and induce a shift in the composition of investment away from the export sector by changing the relative profitability of investments across sectors.

An underdeveloped financial sector. As anticipated, the West Bank and Gaza Strip's banking system expanded rapidly after the accords were signed; the deposit base rose from less than $500 million in early 1993 to about $1.9 billion by the end of 1997. Contrary to what was hoped, however, less than a third of these savings have been lent to the domestic private sector. Credit-worthy investors with good projects have often beet, unable to gain access to bank credit or nave found credit too expensive because of serious institutional weaknesses in the financial sector.

First, information on the risk-return profiles of investors was highly imperfect. This was due, in large part, to the virtual absence of banks in the territory for more than 25 years; the microenterprise nature of many potential borrowers, who had no previous experience in borrowing from banks; and the lack of a credit appraisal and rating system. Second, the legal framework did not encourage the use of collateral in bank lending. And third, the short-term nature of most bank deposits and the absence of secondary markets for long-term debt increased the liquidity risk of long-term lending. Moreover, equity markets, which could have been another source of long-term financing, are underdeveloped in the West Bank and Gaza Strip because of depressed private investment demand and the fact that most Palestinian enterprises are small, family-owned ventures.

Delays in implementing public investment projects. Private investors have been particularly disappointed by the sluggish pace of the public investment program: of the $1.2 billion committed by donors to public investment projects for 1994-97, only about $600 million has been disbursed. More important, there has been relatively little investment in physical infrastructure.

An inadequate legal framework The confusing array of laws that had characterized the occupation was expected to give way gradually, with the advent of self-rule, to a transparent and supportive legal and regulatory framework. However, until recently, a key component of the current legal framework was the Law on the Encouragement of Investment (the Investment Law), which introduced a great deal of uncertainty with regard to costs. In particular, the law granted considerable discretionary powers to the Palestinian Higher Agency for the Encouragement of Investment, including the approval of all investments through cumbersome and ill-defined procedures.

WHAT CAN BE DONE?

What can be done to reverse the decline in private investment and reduce the distortion in its sectoral allocation to promote the export sector? Clearly, one key to the improvement of investment incentives and the achievement of a more balanced pattern of investment lies in the stabilization and liberalization of the external trade environment. The border closures have had a particularly adverse impact, both because of their direct effect on investment incentives in the context of an already weak productive base, a small domestic market, and the weakness of trade links with non-Israeli markets, and because they divert attention from the other significant impediments to private investment in the West Bank and Gaza Strip and slow efforts by the Palestinian Authority and donors to address these impediments.

Improving the trade environment. Given the slow progress of the peace process, the prospects for an early lifting of the border closures and for the opening of outlets to external markets appear highly uncertain. Ways therefore need to be found to insulate, at least partially, the Palestinian economy from the current, very restrictive trade environment. For example, free-trade and industrial zones that are subject to fewer security controls and other trade restrictions could be set up. Private investors would benefit from a favorable legal and regulatory framework that would be easier to develop and administer, faster implementation of donor-supported public investment projects, and less exposure to weaknesses in the West Bank and Gaza Strip's credit markets, as the projects would initially be financed largely from external private sources. High priority should be given to improving access to markets outside Israel through the development of seaports and airports, to strengthening transport links with Jordan and Egypt, and to furthering economic integration of the Palestinian territories through the establishment of a safe passage between the West Bank and the Gaza Strip.

Accelerating the public investment program. In the presence of political constraints on liberalizing the external trade environment, it is especially important to implement economic policies and institution-building measures that can blunt the impact of trade constraints. An important immediate objective is the acceleration of the public investment program. The Palestinian Authority has recently prepared a detailed Palestinian Development Plan, which presents a coherent strategy for public investment for the years 1998-2000; donors have indicated their intention to commit $750 million in support of the plan, with $500-600 million expected to be disbursed in 1998. The pace of implementation could be accelerated by reducing disruptions caused by recurrent closures, improving coordination between the Palestinian Authority and donors, and having closer follow-up by the Authority of implementation, on a project-by-project basis.

Developing the financial sector. There is also an urgent need to eliminate imperfections in credit markets and develop financial institutions. To this end, a number of donor projects are currently being implemented, notably as part of the World Bank's Financial Sector Project. Several projects aim at channeling funds from donors to banks to be on-lent for long-term investments and at establishing facilities that would allow banks to refinance long-term loans. An important component of this project, undertaken by the International Finance Corporation (IFC), the private sector arm of the World Bank, is aimed at the microenterprise sector; IFC will assist banks in screening and monitoring loans to microenterprises, while helping the latter to acquire the skills required for applying for loans and reporting to banks. In parallel with efforts to develop the banking sector, donors should continue to promote direct equity investments; one recent example of this type of activity was IFC's start-up and partial financing of the Peace Technology Fund, which seeks to channel funds from Palestinian and Israeli entrepreneurs to small- and medium-scale industries in the West Bank and Gaza Strip. The establishment of a strong legal foundation for securities markets would also be helpful, in particular a regulatory framework that is consistent with international practice and establishes adequate accounting and auditing standards for enterprises.

Strengthening the legal framework. The IMF and the World Bank have been working with the Palestinian Authority on strengthening the legal and regulatory environment for investors and drafting a new Investment Law. In the meantime, to allay investors' concerns about the stability of the legal and regulatory framework, donors are establishing a Guarantee Trust Fund for Private Investments -- a project undertaken by another member of the World Bank Group, the Multilateral Investment Guarantee Agency (MIGA) -- whose purpose is to provide investors with guarantees, notably against the risks of expropriation and of breach of contract by the authorities.

It is important to stress, however, that investors will not be swayed by new laws and regulations, in particular those affecting private-sector activity, if government actions are not seen as being constrained by them. In view of the short track record of the Palestinian Authority, investors currently have limited information on the basis of which to form expectations on the scope and nature of future government interventions in private-sector activity. To reduce uncertainty, it is important for the Palestinian Authority to build a solid track record of working within the legal and regulatory framework and to avoid measures that would increase the perceived risk of future government meddling and arbitrary intervention in private activities.

ONLINE RESOURCE: www.palestinecenter.com

Dr. Kanaan is an economist in the Policy Development and Review Department of the International Monetary Fund (IMF).

The views expressed here are those of the author and do not necessarily represent those of the IMF. An earlier version of this article was published in Finance and Development. The article draws on a paper by the author entitled, "Private Investment Under Uncertainty in the West Bank and Gaza Strip," which appears in a book recently published by the IMF, The Economy of the West Bank and Gaza Strip, Middle Eastern Department (Washington: IMF, 1998).