Attachment_J_4_-_IMF_report_to_the_AHLC.pdf

WEST BANK AND GAZA

REPORT TO THE AD HOC LIAISON COMMITTEE1

KEY ISSUES

Mounting political frictions are overshadowing attempts to revive peace talks.

Details of a path forward on the peace process remain elusive and attention has shifted to preventing further violence after tensions flared in July. Domestic political frictions have deepened and Hamas did not participate in the May 2017 municipal elections in the West Bank. The difficult decision by the PA to reduce expenditures in Gaza has intensified tense domestic relations amid regional complexities.

The economic outlook is increasingly fragile. Deteriorating infrastructure and recent expenditure cuts point to lower growth in Gaza. Persistent instability and conflict have eroded the economy’s productive base and stunted growth potential.

GDP growth is projected to slow to 3 percent over the medium term, too low to remedy economic imbalances and meaningfully improve living standards. Elevated—and tightly coupled—risks could jeopardize the outlook, including: increased fragmentation, deepening political divisions, steeper declines in donor support, strained correspondent bank relations, and rising discontent that could fuel unrest.

The central challenge is to revive growth and generate sufficient jobs for a burgeoning population. Continued fiscal adjustment is needed to narrow persistent financing gaps and create space to help rehabilitate the economy’s productive capacity.

The priority in 2017 is to reduce the nearly $600 million financing gap by consolidating revenue gains and containing non-priority recurrent spending. Over the medium term, public financial management reforms can help sustain efforts to reduce the recurrent deficit. Engagement by Israel and increased donor aid remain vital to striking a balance between achieving fiscal sustainability and investing in growth. Reducing the fiscal financing demands on banks, together with proactively managing financial risks, will enable the financial sector to better support private sector activity.

1 The IMF provides technical services to the West Bank and Gaza, including policy advice in the macroeconomic, fiscal, and financial areas, as well as technical assistance, with a focus on tax administration, public expenditure management, banking supervision and regulation, and statistics. See www.imf.org/wbg for recent reports.

August 31, 2017

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Approved By Juha Kähkönen (MCD) and Sanjaya Panth

(SPR)

Discussions were held in East Jerusalem and Ramallah during July 11–20, 2017, and the report was updated to reflect subsequent developments. The staff team comprised Karen Ongley (head), Gregory Basile, Priscilla Toffano, Jean van Houtte (all MCD), Ragnar Gudmundsson (IMF Resident Representative), and Hania Qassis (IMF Resident Representative Office). The mission met Finance Minister Bishara, Palestine Monetary Authority Governor Shawwa, other senior officials, donors, and private sector representatives. The mission prepared a concluding statement and issued a press release. Cecilia Pineda and Mustafa Farzad also contributed to producing this report.

CONTENTS

POLITICAL SETTING ______________________________________________________________________________ 4

RECENT DEVELOPMENTS ________________________________________________________________________ 5

OUTLOOK AND RISKS __________________________________________________________________________ 10

POLICY DISCUSSION—SHARING THE CHALLENGE OF DEVELOPMENT

WITH THE PRIVATE SECTOR ___________________________________________________________________ 11

A. Unlocking Private Sector Growth _____________________________________________________________ 11

B. Taking Steps Toward Fiscal Sustainability ____________________________________________________ 13

C. Managing Risks to Ensure Sound Financial Intermediation __________________________________ 16

STAFF APPRAISAL ______________________________________________________________________________ 20

BOXES

1. Demographic Challenges and Opportunities in West Bank and Gaza ________________________ 12

2. Reassessing Rapid Credit Growth in West Bank and Gaza ___________________________________ 17

3. Reforming West Bank and Gaza’s AML/CFT Framework _____________________________________ 19

FIGURES

1. Recent Economic Developments, 2007–17 _____________________________________________________6

2. Fiscal Sector Indicators, 2005–17 _______________________________________________________________8

3. Financial Sector Data, 2000–June 2017 _________________________________________________________9

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TABLES

1. Selected Economic Indicators, 2015–22 ______________________________________________________ 22

2. Central Government Fiscal Operations, 2015–20 _____________________________________________ 23

3. Central Government Fiscal Operations, 2015–20 (GFSM 2001) _______________________________ 24

4. Financial Soundness Indicators, 2011–17 ____________________________________________________ 25

ANNEXES

I. Risk Assessment Matrix ______________________________________________________________________ 26 II. Debt Sustainability Analysis Update __________________________________________________________ 28 III. The Cost of Conflict and Political Uncertainty for the Economy’s Capacity to Grow _________ 34 IV. Technical Assistance by the IMF to the Palestinian Authority, 2012–17 ______________________ 40 V. Statistical Issues ______________________________________________________________________________ 44

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POLITICAL SETTING

1. Mounting political frictions and security concerns are overshadowing attempts to relaunch peace talks.

President Abbas’ visit to Washington in early May 2017, followed by President Trump’s visit to Israel and the West Bank later that month, helped revive the prospect of peace talks between the Government of Israel (GoI) and Palestinian Authority (PA). While details of a path forward remain elusive, other international stakeholders reiterated their commitment to a two-state solution. Notwithstanding UN Security Council resolution 2334, settlement activities have continued. Widespread support for a hunger strike by Palestinian prisoners in April/May illustrates the political fragilities and higher risk of social unrest. Attention has since shifted to preventing further violence after tensions flared over access to the Al Aqsa Mosque in July.

Deepening frictions between the PA and de facto authorities in Gaza cloud the domestic political environment. Hamas decided not to participate in the May 2017 municipal elections in the West Bank, which were characterized by a low overall voter turnout. Difficult decisions by the PA to reduce expenditures in Gaza have intensified strains amidst tense domestic relations and regional complexities. Reduced electricity supply and water shortages have exacerbated the alarming humanitarian situation in Gaza.

2. The PA and GoI have resumed high-level discussions on economic issues. Following the May Ad Hoc Liaison Committee (AHLC) meeting, the Ministers of Finance met to exchange views on promoting growth and fiscal sustainability, with subsequent meetings involving the PA’s Prime Minister.

Senior technical discussions between both ministries are now slated to take place monthly and have begun yielding some results, with Israel transferring health stamp and equalization levy payments accumulated since September 2016. They also made some progress in the energy sector (the Jenin interim power purchase agreement) and water sector (signing the Red Sea-Dead Sea pipeline project).

Other contentious issues include: (i) settlement expansion, including the first official settlement since 1992 at Amihai; (ii) movement and access restrictions in the West Bank; (iii) the near-total blockade of Gaza; and (iv) the PA’s payments to families of prisoners and ‘martyrs’.

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RECENT DEVELOPMENTS

3. Economic growth slowed in the first quarter of 2017. While trade helped growth in the West Bank, slowing private consumption—the lion’s share of GDP—saw growth ebb to

0.8 percent (year-on-year) in 2017Q1. Growth in Gaza dipped to 0.4 percent (year-on-year) as donor-funded reconstruction decelerated sharply.

4. Labor market conditions remain bleak, reflecting demographic pressures and economic slack. After easing in late 2016, the unemployment rate in the West Bank increased by almost 4 percentage points to 20.5 percent at end-June, despite the large number of Palestinians employed in Israel and settlements (18.6 percent of West Bank employment). In Gaza, where 70 percent of the population depends on international assistance, unemployment edged up further to 44 percent and youth unemployment is stubbornly high (approaching two-thirds). The overall participation rate remains low, with a large gender gap (over 70 percent for men, but under 20 percent for women).

5. Inflationary pressures remain subdued.

Following deflation in 2016, inflation moved into positive territory in early 2017, before returning to deflation mid-year. Overall prices declined by

0.7 percent in June (year-on-year), reflecting food prices and deflation in Israel driven by the appreciating shekel. The real effective exchange rate continued to appreciate, adding at the margin to the non-price factors (ongoing restrictions and political uncertainties) that dominate competitiveness concerns.

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WBG

WB

Gaza

Real GDP Growth, 2012–Q1/17 (In y-o-y percent change)

Sources: Palestinian Central Bureau of Statistics; and IMF staff estimates.

1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

Unemployment Rate (LHS) Labor Force Participation Rate (RHS)

Labor Market Developments (In percent)

Sources: Palestinian Central Bureau of Statistics; and IMF staff estimates.

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Effective Exchange Rate (Index, Jan 1996 = 100)

Notes: An increase indicates appreciation. Weights based on 2015 trade data.

Sources: Haver Analytics, Information Notice System; and IMF staff calculations.

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Figure 1. West Bank and Gaza: Recent Economic Developments, 2007–17

Sources: Palestinian Central Bureau of Statistics; and IMF staff estimates and projections.

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2010 2011 2012 2013 2014 2015 2016 2017 Proj.

Net exports of goods and services Gross fixed capital formation Changes in inventories Final consumption GDP growth

Contribution to Real GDP Growth (In percent)

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2010 2011 2012 2013 2014 2015 2016 2017 Proj.

Export Growth (In percent) Import Growth (In percent) Current Account Balance Balance On Goods And Services

Trade

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Proj.

West Bank and Gaza West Bank Gaza

Unemployment Rate (In percent)

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Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Mar-17

Israel West Bank and Gaza West Bank Gaza

Inflation (In y-o-y percent change)

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6. Fiscal performance was better than expected in the first half of 2017. Total revenues held up well relative to the same period last year. Ongoing efforts to improve tax administration bore fruit, with higher domestic taxes compensating for weaker non-tax revenue (excluding an exceptional payment for the new telecom license). Transfers of clearance revenues (CRs) increased by almost 6 percent relative to 2016H1, excluding the ad hoc settlement of clearance revenues in both March 2017 (NIS 130 million) and March-April 2016 (NIS 570 million). Recurrent spending was about 3 percent lower than the first half of 2016, reflecting late approval of the 2017 budget and the initial impact of decisions to limit payments to Gaza. This includes rolling back allowances for PA employees, retrenching more than 6,100 civil servants, and reducing subsidies for electricity Israel provides Gaza.

Thus, the overall deficit declined to an annualized 6.7 percent of GDP, lower than the budgeted deficit.

7. However, budget financing remained tight. The authorities continued efforts to clear the stock of arrears to private sector suppliers, with gross payments of around NIS 1 billion. At the same time, low external budget support (in line with the budgeted 20 percent decline compared to 2016) and high amortization of domestic debt, saw the recurrence of arrears. Net arrears accumulation reached NIS 373 million at end-June.

West Bank and Gaza: Fiscal Performance, January–June 2017 (In millions of NIS, unless otherwise specified)

Budget in m. NIS year / year (%)

Net revenues 13,276 13,451 6,487 7.3 Gross domestic revenues 4,701 5,041 2,240 17.3

Tax revenues 2,392 3,141 1,486 12.6 Nontax revenues 2,309 1,900 754 27.9

Clearance revenues 8,930 8,780 4,429 9.6 Less tax refunds 355 370 182 27.6

Recurrent expenditures and net lending1 16,137 16,147 7,809 (5.6)

Wage expenditures 7,837 8,093 3,953 1.7

Nonwage expenditures 7,270 7,104 3,309 (9.0)

Net lending 1,029 950 546 8.3

Development expenditures1 1,287 1,639 460 (10.8)

Overall balance1 -4,148 -4,335 -1,782 (16.5)

Total financing 4,148 4,335 1,782 N/A

External Financing 2,848 2,496 1,158 (16.9)

Domestic financing 1,300 1,839 624 N/A

Net domestic bank financing -415 0 151 (15.5)

Net arrears 1,697 -1,170 373 N/A

Residual/financing gap 18 3,009 99 N/A

Sources: Ministry of Finance and Planning; and IMF staff projections.

1 Commitment basis.

January-June execution

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Figure 2. West Bank and Gaza: Fiscal Sector Indicators, 2005–17

Sources: Ministry of Finance and Planning; and IMF staff estimates and projections.

Current spending

Capital spending

Revenue and donor aid

Expenditure (In percent of GDP)

Grants Domestic revenue Clearance revenue Domestic non-tax revenue Public spending

Revenue and Donor Aid (In percent of GDP)

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2009 2010 2011 2012 2013 2014 2015 2016 2017 Proj.

Donor aid Banks Arrears (net) Financing gap Overall deficit

Budget Financing (In percent of GDP)

2009 2010 2011 2012 2013 2014 2015 2016 2017 Proj.

Public domestic debt Foreign debt Arrears

Public Debt (In percent of GDP) pension fund liability adjustment

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Figure 3. West Bank and Gaza: Financial Sector Data, 2000–June 2017

Source: Palestine Monetary Authority.

Capital adequacy ratio: tier I capital to risk-weighted assets Non-performing loans to gross loans, before collateral Non-performing loans to gross loans, after collateral

Capital Adequacy Ratio and Nonperforming Loans (In percent)

2009 2010 2011 2012 2013 2014 2015 2016 Jun.

In millions of dollars

In percent of banks' equity (RHS)

Public Credit

To central government

To private sector

Credit (In percent of GDP)

10000

12000

Credit

Deposit

Deposits and Credit (In millions of U.S. dollars)

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8. Financial sector strains are becoming more evident. Credit to the private sector continues to grow rapidly (22 percent year-on-year through June), and is concentrated in consumption, construction, and trade. Banks’ lending to the PA remains below the regulatory limit, although credit to PA employees and holdings of promissory notes almost double banks’ exposure to the public sector. Prudential ratios comply with international standards, although NPLs have increased slightly (averaging 2.4 percent of total loans) and the capital adequacy ratio continued its steady decline (reaching 16.2 in 2017Q2). The new Central Bank Law, drafted in consultation with IMF staff, is awaiting Presidential approval, and a new Electronic Transaction Law was approved in July. Banks operating in the West Bank continue to experience challenges in managing excess liquidity, with Israeli banks providing limited cash services and limits on transferring shekel cash to the Bank of Israel (BoI).2

9. The authorities are continuing work to preserve Israeli-Palestinian correspondent bank relationships (CBRs). As part of a wider agenda to strengthen WBG’s anti-money laundering and combating the financing of terrorism (AML/CFT) regime, the authorities have: (i) made further amendments to the 2015 AML/CFT law and related regulations, guided by IMF technical assistance (TA); (ii) launched a National Risk Assessment (NRA), with World Bank support; and (iii) published a manual to help banks and money changers identify AML/CFT risks. The temporary financial and judicial assurances proposed by Israel in January to help preserve CBRs are not yet in place.

OUTLOOK AND RISKS

10. WBG’s growth potential is stunted by a dearth of productive capital. Protracted periods of instability and conflict-related destruction have eroded the capital base, most profoundly in Gaza, and the inhospitable investment environment has impeded the economy’s ability to recover (Annex III). With public investment among the lowest in the world and private investment directed largely toward construction, the economy faces an enormous challenge in expanding its productive base and raising growth potential.

11. Moreover, recent events point to a more difficult outlook. The situation in Gaza has become increasingly challenging—against the backdrop of deteriorating infrastructure and weak provision of social services, recent expenditure cuts point to lower growth of around 4 percent in the medium term. While lower growth in 2017Q1 and recent tensions underscore uncertainties, the West Bank is still projected to grow by 2.7 percent, buoyed in part by consumption of workers

2 The BoI sets monthly limits on the amount of NIS cash transfers it accepts from banks operating in the West Bank, with the stated goal to combat money laundering and the financing of terrorism. However, the BoI periodically accepts amounts above this limit in response to requests by the PMA.

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Projection West Bank Gaza (RHS)

Capital-Labor Ratio (In y-o-y percent growth)

Sources: Penn World Table, UNRWA, and IMF staff calculations.

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earning salaries in Israel. Given the larger weight of the West Bank economy, staff estimate overall GDP growth to ease to around 3 percent over the medium term (down from 3.3 percent as projected in April), too low to remedy economic imbalances or meaningfully improve living standards.

12. Elevated—and tightly coupled—risks could further jeopardize the outlook (Annex I).

Increased fragmentation among WBG’s regions could further constrain economic activity.

Deepening political divisions and recent Gaza-related measures could exacerbate tensions, with possible financial and economic spillovers into the West Bank. A steeper decline in donor support could compromise fiscal sustainability, public investment, and service delivery. Finally, severing CBRs could undermine the functioning of the payment system and economic activity. Amidst these pressures, rising discontent could fuel increased unrest and immobilize the economy.3

POLICY DISCUSSION—SHARING THE CHALLENGE OF

DEVELOPMENT WITH THE PRIVATE SECTOR

Years of conflict and political uncertainty have had a profound effect on WBG’s growth potential.

Reviving the economy’s productive capacity and raising living standards for the growing population will require closing the investment gap. While lasting improvements in the investment climate ultimately require progress towards peace, discussions focused on the mix of policies within the authorities’ control that could lay the foundation for stronger private sector-led growth. The authorities and staff also discussed the role Israel and donors can play, including facilitating access to markets and alleviating constraints on public investment.

A. Unlocking Private Sector-led Growth

13. Staff and the authorities agreed it is imperative that the private sector becomes a stronger driver of growth and jobs. The authorities noted the opportunities inherent in a young and educated population, while acknowledging the daunting task of generating sufficient jobs for the burgeoning workforce (Box 1). Staff underscored the need for comprehensive reforms to improve the investment climate, rather than relying on targeted incentives. Staff and the authorities nonetheless recognized that political uncertainty remains the top obstacle to boosting private

3 The possible impact of an illustrative unrest scenario was outline in Box 1 of IMF staff’s April 2017 Report to the

AHLC.

2014 2015 2016 2017 2018 2019 2020 2021 2022

Baseline (Current)

Unrest Shock (Current)

Baseline (April 2017)

Unrest Shock (April 2017)

Real per Capita Income (In U.S. dollars)

Source: IMF staff calculations.

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investment.4 Ventures that require significant upfront physical investments and take decades to break even (e.g., electricity generation) are particularly vulnerable. Fully unlocking the potential of the private sector depends on a breakthrough on the peace process.

Box 1. Demographic Challenges and Opportunities in West Bank and Gaza

The projected doubling of WBG’s population to 10 million by 2050 poses a significant challenge.1 With almost 40 percent of the population currently under the age of 15, the working age share of the population will continue to rise to around two-thirds.

The economy will need to generate more than 2 million jobs by 2050 to absorb new entrants to the labor market.2 While this implicitly assumes higher female labor force participation, it does not account for people currently unemployed. Existing labor market rigidities magnify this task. Unemployment is stubbornly high at 29 percent (and nearly 40 percent for young people), despite low participation (46 percent overall in 2016).

Failure to generate enough new jobs will heighten risks.

Insufficient job growth could compound the already high unemployment, increase poverty, and exacerbate social and economic strains. Revenues foregone from lack of job creation would add to fiscal pressures, compromising the PA’s ability to invest in health and education just as needs are rising.

However, a scenario where all new labor entrants find a job could boost GDP per capita—up by 50 percent by 2030 and nearly tripling by 2050.3 The higher share of working age population and lower projected dependency ratios could provide the basis for increased savings and investment.

To capitalize on WBG’s demographic dividend, policies should focus on creating the conditions for private sector-led growth. Re-orienting the budget from current to capital spending will be essential to facilitate investment in infrastructure and more effective service delivery (including health). Improving the quality of education spending will also be crucial to equip the growing workforce with the skills required by the market. Reforms to improve the business environment can help reduce obstacles to investment (foreign and domestic), and better position the private sector to create jobs. A package of such policies will be instrumental in improving the prospects for inclusive growth and managing the demographic change under way, particularly if combined with an easing of restrictions or progress toward peace.

Prepared by Hania Qassis.

1 United Nations Department of Economic and Social Affairs, World Population Prospects, July 2015. Based on the UN’s medium fertility scenario.

2 UNFPA, Palestine 2030: Demographic Change: Opportunities for Development, December 2016.

3 IMF, How to Assess Fiscal Implications of Demographic Shifts: A Granular Approach, How-to-Note 16/02, August 2016.

4 European Bank for Reconstruction and Development, European Investment Bank, and World Bank, 2016, What’s Holding Back the Private Sector in MENA? Lessons from the Enterprise Survey, Washington DC.

0-14

15-64

65+

SWAP (RHS)

Note: SWAP = Share of working age population.

Sources: United Nations' Department of Economic and Social Affairs, Population Division (2015); World Population Prospects: The 2015 Revision, DVD Edition; and IMF staff calculations.

Population Structure, 1950-2100 (LHS = population in millions of people; RHS = in percent of total population)

500 300 100 100 300 500

0-4 5-9

10-14 15-19 20-24 25-29 30-34 35-39 40-44 45-49 50-54 55-59 60-64 65-69 70-74 75-79 80-84 85-89

90+

Population Structure, 2015-2050 (In thousands of people)

Source: United Nations' Department of Economic and Social Affairs, Population Division.

Male Female

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14. Improved access to goods and markets is critical to private sector development.

Geographic fragmentation and restrictions have made the movement of people and goods—both within, and to and from, WBG—particularly cumbersome. The authorities pointed to difficulties in obtaining inputs to production, particularly as Israel’s “dual use” list has expanded over the past decade. Even without a final peace outcome, there is scope lessen these obstacles with support of the GoI. Examples of where progress could be made include efforts to develop an industrial zone near Hebron and operationalize a new Israeli-run scanner on the Jordanian border.

15. Staff stressed that the PA can also take action to improve the conditions for private activity and lay the ground for bigger gains once the political horizon brightens. In addition to legal and institutional considerations, policies to improve fiscal sustainability and maintain financial stability can have a major bearing on the private sector’s ability to flourish.

Modernizing the regulatory environment, where unclear land titling, restrictive tenancy laws, and onerous requirements for starting a business are prominent impediments.5 The authorities underlined that the Companies Law—on track to be adopted later this year—will simplify the process of incorporating businesses. They are also working to reform the tenancy, competition, and industrial property rights laws.

Further developing institutions to facilitate trade and investment (such as the Palestine Standard Institute and Palestine Investment Promotion Agency), and ensure more efficient transactions with the public sector (e.g., public procurement, contract enforcement, and clearing arrears).

Continuing fiscal and financial reforms to: (i) shift the composition of public expenditure to create space to invest in education and infrastructure (including energy and water, for which donor support will be crucial); (ii) address the build-up of arrears and the associated costs for private suppliers; and (iii) promote sound, market-based access to finance.

Staff noted the mooted electricity sector reform covers most of these points to varying degrees.

They urged the authorities to finalize a new electricity provision and distribution agreement to complement the recent Jenin sub-station interim power purchase agreement.

B. Taking Steps Toward Fiscal Sustainability

Measures to Shrink the 2017 Financing Gap

16. Staff welcomed the stronger-than-anticipated budget performance so far this year, but noted there will likely be a sizeable financing gap for 2017. The authorities emphasized their determination to outperform the budget this year, pointing to the Gaza-related measures. The cuts are projected to shave 1.5 percentage points of GDP off the 2017 deficit, and recurrent spending and net lending. Staff and authorities agreed that improvements in income tax and customs administration would endure. However, constraints on expanding the tobacco marketing scheme to

5 World Bank, 2017, Doing Business 2017: Equal Opportunity for All, Washington DC.

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Gaza could limit the gains in excise taxes to a ½ percentage point of GDP this year. With the large ad hoc revenues from 2016 (about 2½ percentage points of GDP) not expected to recur, total revenue will likely decline from 25.5 percent of GDP in 2016 to 23.7 percent in 2017. On this basis, staff projects a recurrent deficit of 8.4 percent of GDP. Yet, with donor financing on track to fall by 20 percent compared to 2016 (as projected in the 2017 budget), the financing gap would still reach around 4 percent of GDP. The authorities were more optimistic, suggesting the financing gap could be closer to 3½ percent of GDP, two percentage points of GDP lower than budgeted.

17. Discussions focused on ways to contain the financing gap. While additional measures could only go so far during what remains of the year, action where feasible in the near term would help lessen the gap.

A prudent approach to spending would be vital given the possibility that Gaza-related measures could be reversed. The authorities plan to lock-in wage bill savings by maintaining a zero ceiling on net hiring. Staff encouraged them to further contain spending, focusing on reducing the cost of health referrals, continued wage bill restraint, stronger controls and targeting of social transfers to the poorest, and eliminating remaining fuel subsidies. Cooperation from the GoI would also be instrumental in the PA’s ability to enhance cost recovery for key public utilities (i.e., electricity, water and sanitation).

The authorities focused on options to boost revenues, such as raising property tax collections based on updated valuations. They also pointed to plans to raise government fees, while streamlining the overall fee structure to reduce the administrative burden on the private sector. While too soon to assess the potential revenue gain, it is unlikely to materialize before end-2017. While staff favors restoring the 20 percent corporate income tax rate and introducing a 10 percent dividend withholding tax, the authorities pointed to concerns about potential strains on the private sector.

The authorities underscored the potential to further reduce revenue leakages through deeper dialogue with the GoI. Staff welcomed the reduced volatility in CR transfers in the first half of 2017 and the resumption of high-level ministerial meetings. With CRs representing around 70 percent of PA revenues, action to reduce leakages (including scaling back the associated 3 percent administration fee) offers significant upside. Staff encouraged further progress to achieve tangible results based on fair and transparent discussions.

Additional donor support would be instrumental in further narrowing the financing gap and limiting the accumulation of arrears. Staff pointed to unforeseen interest payments as indicative of the unpredictable cost of short-term financing, including through arrears. Developing a

Fiscal Measures Proposed by Staff

Measures NIS million % GDP

Identified financing gap in 2017 2,165 4.0

Total proposed measures 502 0.9

Return to 20 percent income tax rate 200 0.4

Introduce a 10 percent dividend withholding tax 194 0.4

Eliminate fuel tax subsidy 108 0.2

Other unidentified measures/new financing 1,663 3.1

Source: IMF staff calculations.

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comprehensive arrears strategy, including accounting for all arrears and agreeing terms for their repayment, could help provide more certainty and generate a longer debt maturity profile.

The Payoffs of Medium-Term Fiscal Reforms

18. Large financing gaps continue to dominate the medium-term fiscal outlook, despite recent expenditure cuts. While the projected financing gaps are, on average, 1½ percentage points of GDP lower than staff’s previous AHLC report, they still hover above 3 percent of GDP.

Achieving fiscal sustainability remains a challenge. Even with the improved baseline, public debt will continue its upward trajectory and lower growth will make fiscal adjustment more difficult (Annex II).

Moreover, important fiscal risks remain, including the possibility of constraints in fully implementing the Gaza-related measures or steeper declines in donor support.

19. The authorities and staff discussed the need for sustained fiscal adjustment. Based on measures already in place, the recurrent deficit is projected to decline by around 0.2 percentage points per year. However, staff suggested that additional measures could achieve an average annual reduction of a ½ percentage point of GDP and achieve a financing gap of under 2.5 percent of GDP in 2020. Focusing on reducing the recurrent deficit—through a mix of revenue and recurrent spending adjustments—is consistent with the need to shift toward donor-financed investment (particularly in infrastructure) and to limit the impact on growth.

20. It will be important for revenue reforms to focus on their effect on equitable, private sector-led growth. The authorities noted that small firms account for over half of all employment and operate mostly in the informal sector. Staff suggested that simplifying the tax treatment of small and medium-sized enterprises (SMEs) could help broaden the income tax base. Based on IMF TA, options could include: a basic presumptive “lump sum” tax for microbusinesses, a flat rate turnover tax for SMEs, and a standard set of information to be shared based on the single taxpayer identifier number (TIN). Staff cautioned against using tax holidays to incentivize foreign investment, and suggested accelerated capital depreciation as a preferred approach that promotes re-investment. Finally, while efforts to collect VAT and improve the valuation of goods imported from Israel are essential to raise CRs, any longer-run plans to transfer customs functions from the GoI to the PA will require close attention to capacity-building and regulatory reform.

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2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

Arrears Domestic Debt Donor Aid Overall Deficit (May AHLC baseline) Overall Deficit

Deficit and Financing (In percent of GDP)

Sources: Ministry of Finance and Planning; and IMF staff calculations.

2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

Projections Current baseline Current baseline + new arrears formalized May AHLC baseline May AHLC baseline + new arrears formalized

Gross Nominal Public Debt (In percent of GDP)

Sources: Ministry of Finance and Planning; and IMF staff calculations.

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21. The authorities and staff agreed there is significant scope to control structural drivers of public expenditure over the medium term. This will involve addressing complex policy issues (e.g., the health care referral system), and fundamental institutional reforms of the civil service (beyond the recent Gaza measures) and the public pension regime. Staff recommended reviewing the actuarial model underpinning the public pension scheme, particularly given WBG’s rapidly changing demographic structure. Staff also encouraged the authorities to limit the risk of contingent liabilities stemming from losses in key public utilities by: (i) reforming the regulatory framework; and

(ii) better targeting remaining subsidies. These reforms could help shift the composition of expenditure toward capital spending and help rehabilitate WBG’s capital stock. The authorities also pointed to the importance of donors funding public investments to improve the composition, and effectiveness, of public expenditure.

22. Staff commended the authorities for finalizing the new public financial management (PFM) strategy. By helping to improve the allocation and control of resources, and the efficiency of public spending, stronger PFM systems will be instrumental in supporting fiscal adjustment. The authorities highlighted their commitment to improve PFM, including limiting the number of bank accounts and monitoring arrears. The authorities also pointed to ongoing work to complete the State Audit and Administrative Control Bureau’s audits of financial statements for 2013-15. Key outstanding PFM issues include commitment controls, the accounting treatment of expenditures for commitment and accrual purposes, payment programming, debt management, and arrears recording and clearing. As the strategy’s success will depend on effective implementation, coordination with, and technical and financial support from, donors will be crucial. To this end, IMF TA is planned to help develop a priority action plan and the World Bank is preparing a PFM project.

Staff encouraged finalizing the re-organization of the ministry to clarify accountabilities in implementing the strategy. In that connection, staff called for clearly designating the macroeconomic forecasting function and adequately staffing the Macro-Fiscal Unit.

C. Managing Risks to Ensure Sound Financial Intermediation

23. Staff emphasized the importance of continuing to strike the right balance between financial stability and inclusion. The authorities pointed to progress in improving financial access to remote clients and increasing credit to SMEs (up from $500 million in 2013 to $1.5 billion in 2016). Staff welcomed these efforts, while highlighting the potential macro-financial stability risks of persistent rapid credit growth. While there is no conclusive evidence of excessive leverage, declining prudential buffers and limited policy options give little room to respond if faced with a financial shock (Box 2). The Palestine Monetary Authority (PMA) noted action under way to replenish banks’ capital buffers to a minimum of $75 million by July 2018. Staff supported these efforts and suggested that further strengthening capital buffers could help manage possible shocks, including potential spillovers from Gaza. Finally, staff and the authorities agreed that the PMA’s significant investments in risk-based supervision would position them well to take a more proactive stance on macro- and micro-prudential supervision.

INTERNATIONAL MONETARY FUND 17

Box 2. Reassessing Rapid Credit Growth in West Bank and Gaza

Sustained, rapid private sector credit growth in WBG is not well explained by economic activity.

Bank credit to the private sector has grown by an annual average of 20 percent since 2009, more than double the rate of nominal GDP growth. The pace of credit growth shows little signs of abating, expanding at nearly 25 percent year-over-year in 2016, widening the gap with nominal GDP growth.

Increased financial inclusion may explain some of this gap. For much of the past decade, WBG has also experienced rapid deposit growth and deepening financial markets. While domestic credit to the private sector as a share of GDP remains well below most regional peers, the difference has narrowed since 2013.

Yet, this does not preclude a buildup of macro-financial risks, including the potential emergence of a credit boom linked to excessive leverage and asset price bubbles, with attendant risks for macro-financial stability. Similar fears arose for regional peers during their phases of rapid private sector credit growth.1

There is no conclusive statistical evidence of a credit boom forming. Using an HP-filtered trend of credit to the private sector, staff find that the rise of credit to the economy is not out of line with the trend growth. However, this analysis is sensitive to the sample period, with the strong growth of the past 4 years pulling up the trend. Excluding these years from the trend calculation would produce less favorable results.

However, this provides limited comfort about potential risks, as statistical analysis is known to miss credit booms associated with financial crises. In WBG, private sector credit remains highly concentrated in a few sectors, with a significant share financing consumption and other non-productive activities.

-20

-10

Private Credit

Nominal GDP

Sources: National authorities; and IMF staff calculations.

Growth of Private Credit and Nominal GDP (In y–o–y percent change, US$)

Launch of the Credit Registry

26.3

75.0

95.2

81.9

80.7

40.7

45.7

26.10

Egypt Jordan Lebanon Morocco Tunisia WBG West Bank Gaza

Credit to the Private Sector (In percent of GDP)

Source: IMF staff calculations.

6.25

6.75

7.25

7.75

8.25

8.75

Actual Credit

Credit Trend

Sources: National authorities; and IMF staff calculations.

Growth of Total Credit Relative to Trend (In millions of US$, log transformation)

Lack of strong divergenc

18 INTERNATIONAL MONETARY FUND

Box 2. Reassessing Rapid Credit Growth in West Bank and Gaza (concluded)

The erosion of banks’ buffers and WBG’s limited policy options, therefore, warrant active risk management. Sustained credit growth has seen a commensurate steady decline in capital adequacy to a 10-year low. The banking sector also remains heavily exposed to the public sector. With no independent monetary policy, no access to capital markets, and ongoing fiscal constraints, there is little ability to recapitalize the banking system in the event of a shock. In this context, the PMA’s efforts to raise minimum bank capital—first to $75 million and eventually $100 million—and give more attention to financial stability are well placed.

Prepared by Gregory Basile and Priscilla Toffano.

1 Morocco Article IV (2009) and Tunisia Article IV (2009).

24. Discussions also focused on risks from credit concentration and banks’ exposure to the PA. Staff and authorities agreed that the large direct and indirect exposure to the public sector remains a dominant prudential risk. Together with the large share of bank credit for consumption and construction, this could impinge on banks’ ability to support productive private sector investments. Faced with large and persistent financing gaps, it will be important to ensure that banks continue to observe the regulatory limit. The PMA noted the recently introduced 5 percent risk weight for loans to the PA, and plans to increase it steadily to 20 percent by 2020. In addition to monitoring credit concentration limits, staff suggested that non-bank lending, and the relationship between credit and informal activity in the construction sector warrant close attention. The PMA’s efforts to use the credit registry more efficiently should help.

Ju n-

De c-

Ju n-

De c-

Ju n-

De c-

Ju n-

De c-

Ju n-

De c-

Ju n-

Consumption Local and Foreign Trade Finance Real Estate and Constructions

Concentration of Private Credit (In percent of total private credit)

Source: Palestine Monetary Authority.

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Egypt Jordan Lebanon Morocco Tunisia WBG

Capital Adequacy Ratio (In percent)

Source: Regional Economic Outlook.

INTERNATIONAL MONETARY FUND 19

25. The integrated nature of the Palestinian and Israeli financial systems pose two additional unique risks.

The authorities noted that Israeli-Palestinian CBRs remain under threat. Given the potential adverse economic impact,6 staff welcomed the authorities’ sustained efforts to enhance the AML/CFT regime with ongoing IMF TA (Box 3) and by accelerating work on the NRA in preparation for the MENAFATF evaluation scheduled for 2020. While acknowledging ongoing work to finalize details of the Israeli authorities’ temporary solution to strained CBRs, staff cautioned the PA to avoid providing financial guarantees that could jeopardize fiscal sustainability—particularly given interconnected sovereign and financial risks. Staff support the ongoing dialogue between both parties to find a long-term solution.

Box 3. Reforming West Bank and Gaza’s AML/CFT Framework

In recent years, the WBG authorities have accelerated efforts to reform their AML/CFT framework.

With a view to adhering to international standards, WBG adopted in 2015 a new AML/CFT law (replacing the 2007 AML law) and a decree to implement targeted financial sanctions. They also joined the regional Financial Action Task Force-style body (MENAFATF). As Israeli-Palestinian correspondent bank relations became increasingly strained in 2016, the WBG authorities stepped up these reform efforts, with further updates to the AML/CFT law and instructions for reporting entities, and requesting its first AML/CFT assessment (scheduled by MENAFATF for 2020).

The authorities have engaged international partners to bolster these reforms. The IMF commenced a multi-year technical assistance (TA) project in mid-2016 to help further strengthen WBG’s CFT legal framework. The authorities also initiated in early 2017 a National Risk Assessment (NRA), with support from the World Bank.

There has been good progress under the IMF TA, the scope of which includes reviewing the CFT legislation, the framework to implement targeted financial sanctions and the instructions on preventive measures. The authorities produced draft amendments of the 2015 AML/CFT law and relevant CFT provisions in the penal code. In 2016, they issued new AML/CFT instructions for reporting entities, with a guidebook and a reporting form to be used upon ML/TF suspicion. IMF staff reviewed the AML/CFT law, the amendments to the penal code, and the decree to implement targeted financial sanctions. At a workshop in Jordan in May 2017, staff and the authorities discussed further possible refinements to these documents, including: criminalizing terrorist financing; implementing the United Nations Security Council Resolutions 1373 and 1267 on targeted financial sanctions and the designation process; preventive measures;

operational independence of the financial intelligence unit; cross-border declarations; and confiscation measures, as well as priority areas for further enhancing the framework.

Prospects for a more robust AML/CFT framework in the medium term are encouraging. Following the Jordan workshop, the authorities are continuing to actively engage with IMF staff on legislative drafting, and their NRA work will help map AML/CFT vulnerabilities and identify priority areas for risk mitigation. The authorities’ work plan includes two key actions for 2018: enacting a new AML/CFT law, and adopting new regulations on targeted financial sanctions.

Prepared by Arz El Murr and Anusree Garg (both LEG).

6 See Annex V of IMF staff’s August 2016 Report to the AHLC.

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The PMA emphasized that limits on transferring shekel banknotes continue to create liquidity risks and opportunity costs associated with the excess cash building up in banks. Staff supported joint work by the PMA and BoI toward revising the monthly cash transfer limit from banks operating in the West Bank. Staff analysis also suggests that the sources of cash flowing into the West Bank provide a basis for raising the limit. The new Electronic Transaction Law should help alleviate cash pressures by providing the framework to promote cashless transactions. However, as this will take time to bear fruit, staff saw more near-term promise in efforts to introduce electronic wage payments for Palestinians working in Israel, but noted implementation delays in the Israeli payment system.

STAFF APPRAISAL

26. Prolonged periods of conflict and political uncertainty have taken a toll on WBG’s development prospects. The erosion of the capital stock has stunted the economy’s growth potential. Moreover, recent developments have made the economic outlook increasingly fragile, particularly with deteriorating infrastructure and recent expenditure cuts pointing to lower growth in Gaza. Over the medium term, stagnating GDP growth will remain insufficient to generate job opportunities or meaningfully improve people’s lives, particularly with looming demographic challenges. Not only have risks become more elevated, but there is an increasing likelihood of risks fueling one another. Along with other economic and political risks, rising discontent could fuel unrest and immobilize the economy.

27. Transitioning from public sector to private sector-led growth will be critical to capitalize on WBG’s demographic dividend. A breakthrough on the peace process will be needed to fully unlock the potential of the private sector. However, steps toward improved access to goods and markets could be possible, if restrictions were eased with the cooperation of the GoI. The PA can take independent action on several fronts to begin building the foundation for stronger and more inclusive growth, including: (i) modernizing the regulatory environment; (ii) further developing institutions to facilitate trade and investment; and (iii) continuing fiscal and financial reforms.

28. Despite stronger-than-expected fiscal performance in the first half of the year, a sizeable financing gap will remain for 2017. With tax administration reforms bearing fruit, together with Gaza-related spending cuts (projected to save 1.5 percentage points of GDP this year), the overall deficit is anticipated to reach 8.4 percent of GDP, lower than previously projected.

However, with donor aid on track to decline—as budgeted—by 20 percent compared to 2016, a financing gap of 4 percent of GDP will remain in 2017. While there is a limit to how much progress can be made during the remainder of the year, additional measures in the near term can help narrow this gap. Efforts to contain spending could focus on reducing the cost of health referrals, continued wage bill restraint, and better targeting of social transfers. This could be complemented by restoring the top corporate income tax rate, introducing a dividend withholding tax, and eliminating fuel tax subsidies. Given broader fiscal risks, the authorities are also working on plans to boost revenues through reforming the government fee structure and property tax collections.

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29. Continued reforms will be essential to secure fiscal sustainability over the medium term. Further fiscal adjustment—through a balanced mix of revenue and spending measures—can help narrow persistent financing gaps and create space to invest in rehabilitating the economy’s productive capacity. It will be important to supplement tax administration efforts with judicious tax policy reforms (e.g., simplifying the tax treatment of SMEs). Plans to step up PFM reforms can bolster these efforts by improving the allocation and efficiency of public spending. Moreover, rebalancing spending will require broad civil service and pension reforms, beyond the cuts and retrenchments in Gaza. While the impact of this mix of reforms may only be visible over time, they can also amplify efforts to support private sector-driven growth. In this respect, the PA can leverage PFM reforms to catalyze donor support that can underpin the shift toward investment spending, particularly in energy and other infrastructure. Close cooperation with Israel is vital to enable the PA to strike a balance between achieving fiscal sustainability and investing in growth.

30. While financial sector policies are broadly sound, the evolution of certain prudential ratios…