OREANDA-NEWS. 1. The Palestinian economy is likely to have contracted by nearly 1 percent in 2014, the first such contraction since 2006. As a result of last summer’s conflict, economic activity in Gaza collapsed, with preliminary data suggesting a contraction of real GDP amounting to 32 percent in the third quarter of 2014, and an estimated decline for the year of 15 percent. In the West Bank, growth is estimated to have reached around 4? percent in 2014, with a sharp deceleration in the third quarter. The unemployment rate is now close to 20 percent in the West Bank, and it is estimated that more than 60 percent of the youth in Gaza are without a job.

2. Various headwinds will prevent an economic recovery in 2015. The suspension of clearance revenue—which could last three to four months according to the authorities—will lead to severe fiscal strains and adversely affect the broader economy. Partial wage payments and other public spending cuts will lead to a sharp reduction in private consumption, and confidence effects related to the fiscal crisis will limit private investment. In addition, Gaza reconstruction is proceeding much slower than expected, mostly reflecting unfulfilled donor pledges from the Cairo conference amid a lack of progress in Hamas-Fatah reconciliation. While lower oil prices should provide consumers with some relief, real GDP will rise only modestly in 2015, with a 10 percent rise in Gaza from a low base and a drop of nearly 2 percent in the West Bank. Over the medium term, growth will remain insufficient to absorb the rising labor force and unemployment will continue to grow, unless there is an improvement in the political climate that would lead to a lifting of Israeli restrictions in the West Bank and the blockade in Gaza.

3. Despite the difficult economic and political situation in 2014, the fiscal authorities maintained their efforts to deliver lower deficits. Revenue performance was broadly satisfactory over the past year. Clearance revenue growth outpaced budget projections, helped by a sharp rise in excise revenue collection. Reflecting mainly the authorities’ commendable efforts to improve tax administration, there was also some improvement in domestic revenue performance. In addition, tax refunds declined markedly, reflecting lower fuel subsidies helped by declining global fuel prices. On the other hand, growth in spending was high, especially on the wage bill, which exceeded budget projections. The authorities also managed to reduce some arrears to the private sector, though new arrears accumulated reflecting the combined impact of higher spending and lower donor budget support.

4. The ongoing fiscal crisis brought on by the suspension of clearance revenues is likely to deepen over the next few months. While the authorities believe that suspended clearance revenue is likely to be repaid in April or May, the mission’s analysis of the monthly cash flows indicates a progressively worsening liquidity squeeze in the interim. Even with a sharp curtailment in wages, the PA will need to compensate for the absence of clearance revenue by further expenditure cuts (especially in allowances and operational spending), additional borrowing from the banking system, or arrears accumulation. In rationing expenditure, the authorities should safeguard transfers for poor and vulnerable households. The authorities should also mobilize front loaded budget support from donors to facilitate the adjustment. Additional borrowing from the banking system may be a possibility, but would test the PMA’s indicative prudential limits, and implies increased debt levels and interest costs, which are already projected to rise substantially in 2015. Arrears accumulation would undermine the private sector and efforts to boost revenues.

5. For 2015 as a whole, the mission projects another large financing gap, which calls for a prudent fiscal stance and continued reforms to preserve credibility. Our baseline scenario assumes that clearance revenue transfers resume in the spring. Our preliminary projections for 2015 imply an overall fiscal deficit of 15 percent of GDP, nearly 3 percentage points higher than in 2014, and a financing gap of nearly \$450 million, assuming total external support of about \$1.5 billion, including \$400 million earmarked for Gaza reconstruction. Given the intense fiscal strains that are likely over the next few months, the mission agrees with the fiscal authorities’ intention to operate on the basis of cash rationing, while finalizing the 2015 budget. The cut in salary payments during the first few months of the year should come in the form of equal payments to all civil servants so as not to disadvantage lower income earners. For the year as whole, next to limiting wage growth to 2 percent, the budget should reduce the fuel subsidy and net lending, while development spending in Gaza should be linked to the availability of donor aid pledged at the Cairo Conference.

6. The fiscal crisis represents an existential threat to the PA if left unchecked. Strong efforts by the PA can only go so far to contain the crisis for a few months. The situation will become increasingly untenable, with partial wage payments potentially leading to social unrest and strikes, and expenditure rationalization undermining the PA’s ability to provide public services and ultimately its viability. To prevent such a scenario, the Israeli authorities should urgently resume transfers of clearance revenue. In case the suspension of clearance transfers extends beyond a few months, or donor aid fails to meet even the modest baseline projections, the authorities will have to consider even stronger measures, including a freeze on wages, allowances and promotions, rationalization of transfers, immediate withdrawal of fuel subsidies, a further reduction in tax incentives, an increase in government fees, and an increase in dividends from the Palestinian Investment Fund. The economic and social impact of such measures would be severe.

7. Moves towards a more sustainable fiscal position should be buttressed by renewed emphasis on fiscal structural reform. Progress in this area is essential not only to promote gradual fiscal consolidation, but also to signal progress to donors and ensure their continued support, including for Gaza reconstruction. Recent efforts to better identify the stock and flow of arrears, to publish the 2011 audited financial statements, and to finalize the 2012 and 2013 audited financial statements in 2015 are welcome as they will contribute to greater fiscal transparency. Further progress in the area of public financial management is necessary and should focus on improving commitment controls and accounts payable management. Revenue-enhancing reforms could focus on strengthening procedures and practices in audit, enforcement, and litigation, in the LTU in particular and developing a simplified tax regime for small and micro-businesses. Our analysis suggests that significant potential exists for additional revenue over time, both through base broadening and reducing leakages. Eventually, revenue collection in Gaza will need to be stepped up.

8. In a volatile environment, safeguarding financial stability will remain a priority. The PMA has made considerable progress in the area of risk-based supervision, upgrading its stress-test methodology, and enhancing crisis preparedness. In addition, it has recently launched a financial inclusion strategy that bodes well for efforts to enhance access to credit on more affordable terms to a wider share of the population, including small- and medium-sized businesses. Moreover, preparations are being made for the launch of a National Switch this year aimed at reducing the use of cash in the economy, and a new central bank law that will provide for greater independence in the conduct of monetary policy is expected to be finalized in 2015. While the financial system is sound and well capitalized, the mission notes that private credit growth remains high for an economy that is slowing sharply. Structural factors such as the use of credit bureaus partly explain this, but emerging risks should be closely monitored, particularly in the real estate sector where much of the increased private credit is concentrated in form of loans to PA employees. The high exposure of the banking system to the PA and its employees calls for vigilance, especially in light of the clearance revenue suspension.

9. Heightened risks and a significantly worsened outlook call for stronger reform efforts to improve economic outcomes. Notwithstanding current constraints, particularly Israeli restrictions, medium-term fiscal reforms should be complemented by structural reforms to improve the investment climate and support a resilient private sector. We welcome the authorities’ successful elimination of the minimum capital requirement and the simplification of business registration. Additional efforts should now focus on harmonization of business regulations in the West Bank and Gaza, and enacting the Law on Secured Transactions. Inclusive, job-creating growth would allow for a reduction in aid dependency, supported by an improved national development plan formulation, implementation and monitoring, aligned with donor support and assistance. Ultimately, prospects for the Palestinian economy rest on an easing of Israeli restrictions, strong revenue performance, and a shift in the composition of expenditure to productivity raising investments.

10. Efforts to enhance data quality and strengthen the coordination between relevant institutions should be intensified. We encourage the authorities to persevere in their efforts to improve the quality of the national accounts statistics and to enhance fiscal reporting, as this is essential to support macroeconomic forecasting, budget preparation, and policy design. Prompt implementation of the recommendations of recent TA missions is encouraged.