jacob udell is a research analyst and glenn yago is senior director at the Milken Innovation Center at the Jerusalem Institute for Israel Studies. This article updates an earlier analysis published in the Review in the third quarter of 2005.
Illustrations by Hanna Barczyk
Published April 28, 2017
The Israeli-Palestinian struggle reached the front burner of global geopolitics once again this winter, when the departing Obama administration declined to veto a UN Security Council resolution condemning Israel’s settlement construction and the incoming Trump administration responded with a show of solidarity with the Netanyahu government. But, as this latest episode in more than a decade of diplomatic frustration since the 2005 disengagement from Gaza has illustrated once again, what happens below the diplomats’ radar may have more to do with eventual economic outcomes than the latest efforts to untangle the Gordian knot. Developments on the international stage have a way of distracting from pressing fiscal, trade, environmental, business and infrastructure issues that, if managed well, could improve daily life and even make a political deal more plausible.
Under the mantra of “nothing is agreed until everything is agreed,” economic development is given short shrift. Yet development through market building on the ground is central to the success of nascent states. Job creation and growth buttress diplomatic initiatives and provide incentives for negotiated solutions. More than ever, then, an economic plan laid out by common Palestinian and Israeli interests could make a bigger difference in building transactional trust than another roll of the political dice.
Addressing growth is long overdue for the Palestinian economy, which has experienced a lost decade. Since 2005, real average wages have decreased by some 10 percent, while unemployment remains at around one-quarter of the labor force, and average GDP growth lags behind population growth by 2.6 percent per year.
That last number is arguably most dispiriting. The Palestinian Authority’s economic performance is at the bottom of the Arab world and less than the average growth rate among what the World Bank defines as heavily indebted poor countries.
Donor and public sector expenditures — at the top of the agenda of ways to buffer the political pain of compromise for the Palestinians — are currently not designed to sustain economic expansion. International aid and donations shift rapidly from year to year, leading to uncertainty and inefficient allocation of funds. After the Israeli disengagement from Gaza in 2005, the rise in donor aid, which reached almost 32 percent of GDP in 2008, initially fueled rapid economic growth. However, the subsequent decline of aid and the failure to apply systematic efforts to replace it with market investment have exposed the fundamental vulnerabilities of the Palestinian economy. If donor grants simply fill the gap left by a lack of efficient market incentives, they do little to help private investors build management expertise or bring about sustainable job creation.
Exacerbating the instability, donor aid pledged to the Palestinian Authority often does not materialize. For instance, only 35 percent of the $3.5 billion in Cairo Conference funds promised to the Palestinian Authority for Gazan reconstruction have been delivered. Yet, overall, despite the shifts and shocks, foreign aid in 2015 continued to make up more than 30 percent of the PA’s $4.3 billion annual budget. This aid model distorts Palestinian economic development and hampers growth. Robust development requires investment, leveraged and strengthened by aid.
In the absence of a political breakthrough, investment — everything from housing to waste treatment — must propel aggregate demand and provide the base for economic development. The needs of the Palestinian economy are urgent and will only grow more intractable with delay.
Job Creation and Private Sector Finance
While the poverty rate in the West Bank and Gaza has fallen slightly in the past decade, the improvement is largely a result of public and private transfers, not job creation. Indeed, the West Bank and Gaza remain highly dependent on cash remittances from Palestinian workers in Israel and abroad, as opposed to local employment and production. From 1993 until 2013, remittances have run as high as 34 percent of the GDP, making this the economy with the second greatest reliance on cash remittances (as a portion of income) in the world.
Looking further, it’s worth noting that remittance inflows for investment amount to only about 13 percent of the total, whereas household transfers — money sent back home by family and friends for expenses — constitutes 30 percent, and workers’ compensation, which are paychecks from Israel or abroad used for domestic consumption, represents over half. These data illustrate the extreme dependence of residents of the West Bank and Gaza on work in Israel and financial support from family members living abroad for their basic consumption.
By the same token, a close look at labor statistics reveals a number of additional troubling trends. Though the labor force participation rate is currently at its highest since 2000 (at an unimpressive 46 percent), it has been accompanied by an overall spike in unemployment — implying that the net entry of job seekers into the market exceeds the ability of the economy to create employment.
Meanwhile, the Palestinian Authority has also become the employer of last resort, with 23 percent of the workforce on its rolls. The wave of youth entering the labor market in the past decade, coupled with the frictional and structural unemployment of the adult population and almost nonexistent job growth, has left youth unemployment at alarming levels. Since 2001, for instance, unemployment among males aged 15–24, which seems to function as a leading indicator of civil unrest, has averaged 35 to 40 percent and reached 43 percent in 2014.
Job creation remains the most pressing imperative to make up for the missed diplomatic opportunities of the past decades. As the IMF recently pointed out, the combination of volatile donor aid, political uncertainty and limited policy innovation is creating a situation in which likely growth (around 3 percent) remains insufficient to absorb the ballooning numbers of Palestinians of working age. The resulting rise in unemployment and fall in living standards can only complicate initiatives toward a political settlement. So improvements in Israeli-Palestinian economic cooperation should remain a high priority, whether one sees the goal as peace or just the improvement of Palestinian living standards.
One key to job creation is structural change in both capital and labor markets. As it currently stands, the Palestinian economy is driven mostly by consumption, which represented over 90 percent of GDP in 2014 — a disturbingly high figure by the standard of successful developing countries. Production, not consumption, is the true source of the wealth of nations, especially new ones, and the Palestinian private sector must create conditions in which businesses can accelerate wealth creation to finance future production. Yet the Palestinian financial sector, while expanding, does not have the depth or breadth to meet legitimate private credit demand. Private lending represents just one-quarter of total credit in the West Bank and Gaza, as opposed to three-quarters in Jordan and 95 percent in Israel. In fact, most of the growth in credit has consisted of loans to the public sector: the government relies upon the funds of the Palestinian banks to cover its budget deficits.
Separation Versus Integration
Oslo-driven visions of a Palestinian state as a viable economic entity were premised on the eventual integration of the Palestinian and Israeli economies. But the Second Intifada and the ill will built up over the past decade have led to a reconsideration of the united-we-stand/divided-we-fall assumption. In our view, it would serve neither Israelis nor Palestinians to cling single-mindedly to the goal of European-Union-style integration. Normalization of economic relations between Israel and an independent Palestinian state will surely depend on an agreement that facilitates trade and capital flows, but this need not imply full integration of labor or capital markets.
Focusing on the years of relative calm before the Second Intifada, it becomes clear that Palestinians’ economic dependence on Israel was a mixed blessing. During the Oslo period (1993–2000), the GDP of the Palestinian economy grew by 20 percent — a seemingly reasonable number until one remembers that truly explosive population growth led to a reduction in output per person of 8 percent. By the same token, the higher wages paid to Palestinians by Israelis certainly pleased the recipients. But it also put pressure on wages and prices in lower-productivity businesses in the territories, making it more difficult for homegrown Palestinian enterprises to take root or to compete on an arm’s-length basis in foreign markets. Gross capital formation, the key to productivity growth, remained dangerously low in the years since 2006 — between 20 and 25 percent of GDP.
The Palestinian territories’ trade deficit is also a product of dependence on Israel and a lack of diversification of its trade partners. Israel is the biggest market by far for Palestinian goods, accounting for some 85 percent of Palestinian exports, which highlights the lack of Palestinian business development in the markets of Europe and the rest of the Middle East. Israel is also the territories’ major supplier, accounting for 60 percent of total imports.
There is some evidence that local economic development built on sound institutions is possible. For instance, the Palestinian Investment Fund, a sovereign wealth fund with close to $800 million in assets, has become more transparent since it was mired in corruption scandals a decade ago. The fund has recently engaged in renewable energy financing, with the goal of investing $150 million in 10 solar plants in the West Bank and Gaza.
Nevertheless, investment figures remain discouraging. And while considerable sums flow into the territories from overseas Palestinians, there are no “diaspora bonds” or other vehicles to facilitate investment by Palestinian ex-pats (whose wealth estimates by the World Bank have varied from $40 billion to $80 billion). One mark of a lack of confidence in the economy: Palestinian investment abroad in 2015 was $5.9 billion — $1.3 billion more than foreign investment in Palestine.
An Economic Road Map for a Future Palestine
More than a decade ago, at the 2005 Milken Institute Global Conference in Los Angeles, we asked a spectrum of business and political leaders from the United States and the Middle East to brainstorm ways in which business could effectively privatize the peace process. Today, those ideas, together with lessons learned from economic development elsewhere, can still provide the outline of an economic road map for a future Palestine. We divide the strategy in three:
• Looking outward to its competitive advantages in the region
• Looking inward to locally led investment in key sectors
• Looking up to ensure that the financial infrastructure exists for private sector growth
Looking Outward: Sources of Competitive Advantage
A future Palestine could take a leaf out of Israel’s playbook, focusing on its strengths to overcome its weaknesses. Like Israel, Palestine lacks natural resources. But it does have a wealthy diaspora, a cultural commitment to education, and strong entrepreneurial and trading traditions vital to a modern, skills-based economy. Palestine could also capitalize on the good will and proximity of the Arab world; if it built efficient capital markets in a politically stable setting, Palestine could become a financial and commercial-services hub for the Arab East. It could also take advantage of historically low interest rates and the ability to leverage bilateral and multilateral guarantees to develop infrastructure in water, alternative energy, environmental protection, tourism, transportation and communications.
Consider, too, that the area has favorable conditions for developing high-value agriculture and agricultural technologies — fruits, vegetables, animals and high-value growing practices. Technology transfers from Israel, a country that has figured out how to grow food and fiber in unlikely places (in an environment similar to those found in Palestinian areas), could sharply improve Palestinian agricultural productivity. Currently, the average agricultural yield in the Palestinian Authority is just half of that in Jordan and 43 percent of that in Israel. The information and communications technologies sector, which has been a bright spot over the past decade, can continue to develop as a key driver of economic growth.
It’s important here to emphasize that developing strong economic ties between a new Palestinian state and Arab countries would serve the interests of the Israelis as well as the Palestinians, reducing the pressure on Israel to go out of its way to nurture the development of the latter. Arab states, along with the United States and Europe, could also offer preferential trade and tariff agreements to kick-start employment and production in special economic zones, as they have done in Jordan and Egypt over the past decade.
Tourism agreements between Israel and Palestine that make it convenient to visit both Israel and Arab sites in single trips could also play an important role in driving economic development. Tourism, especially high-value-added tourism, is, after all, a labor-intensive industry with great potential for absorbing the large and rapidly growing numbers of unemployed Palestinians.
Finally, industrial development inside Palestinian areas, including state-of-the-art industrial parks, incubators for tech startups and accelerators supported by international businesses, would facilitate technology transfers. Ideally, much of the effort would focus on intermediate and finished products with export potential.
Looking Inward: Local Investment in Economic Development
One approach to locally led economic development harks back to the investment-leveraged-by-aid model. The idea is to employ donor funds more effectively by using them to shelter private projects from the systemic risks inherent in operating in the region. Specifically, donors could provide credit enhancement and risk insurance, as well as underwriting the planning phase for private investment in a variety of important economic developments:
Water. A handful of specific river basin projects would have an immediate impact on living standards in Palestinian cities and villages, as well as provide water for higher productivity agriculture and industry.
Energy. Natural gas production, electricity cogeneration and alternative fuels production (solar, biomass renewables) would reduce the need to spend scarce foreign exchange on imports and in some cases have the potential to be highly profitable. These projects would also generate stable, predictable revenues that could be used to leverage added private fund-raising.
Trade, tourism and transportation. Here, we would include regional inter-urban rail, port and, eventually, air facilities, as well as destination tourism at religious, archeological and recreational sites. It could be time to revisit the RAND Corporation’s attempt in the Arc Project to plan infrastructure to support commercial and residential development in an increasingly urbanized country — and offer viable alternatives to continuing life in refugee camps.
Housing construction and finance. The expansion of markets for mortgages would stimulate homeownership and urban revitalization, as well as invigorate focus on green buildings and sustainable housing in this fragile semi-arid environment.
Looking Up: Capital Ideas
Even carefully refined projects designed to harvest the low-hanging fruit first will not get off the ground unless the drought of private-sector credit in the Palestinian territories ends. Though Palestinian banks have become more sophisticated in terms of underwriting standards and post-loan monitoring, they still lack tools needed to reach the scale of private sector credit available in other developing countries in the region.
By the same token, there has been little effort to employ the many successful models for raising investment funds in high-risk environments. Among the possibilities: partnerships with multinationals for private concessionaires to run public facilities, privatization of public utilities ranging from power generation and distribution to border-logistics management, and venture capital funds for targeted growth sectors like food processing.
Establishing a strong legal and regulatory infrastructure for the Palestinian Authority’s financial markets is, of course, a prerequisite for leveraging donor funds for project finance. And there is much to be done — for example, fewer than 50 companies are listed on the Palestinian Securities Exchange. Creating diverse securities that could be traded at low cost, possibly with enhanced credit via donor funding, would increase the total pool of cash for development projects. Note, moreover, that investors in Israel, Palestine and Jordan have generally responded favorably during periods of stable commerce.
The Window of Opportunity
Despite good intentions, donor-driven development in the context of constant political tension offers little evidence of progress. But, as we argued a decade ago, identifying and supporting specific projects provides a way to take concrete steps toward cooperation and stability. Success lies in the pragmatic use of the economists’ toolbox to facilitate growth, plus an understanding that the Palestinian economy must be able to stay afloat without tethers to Israel. Ultimately, the past two decades have proved that only by structuring shared economic interests will a political solution become feasible. And when the history of this long, grinding phase of the Israeli-Palestinian conflict is written, the accounts could emphasize how economic strategy, financial leverage and the creation of jobs and income help manage disruptive forces in the effort to form a new state.