It soon became apparent that creating Palestinian institutions and, more generally, improving economic management and governance presented greater challenges than envisaged. The initial high expectations were tempered somewhat following the difficult negotiations of the Economic Protocol in 1994 and were thwarted further in 1996 by the deteriorating security situation, which was accompanied by frequent closures and subsequent losses in labor income, trade, and production. As a result, the Palestinian economy entered a recession in 1995­96, and unemployment rose sharply. Economic activity has recovered in the last two years, especially in 1998, and the rate of unemployment has fallen markedly from its peak in 1996. For the period 1994­98 as a whole, however, economic growth has been sluggish, and per capita income has declined.

While overall macroeconomic developments in the last five years may seem disappointing, especially when compared with the high expectations that prevailed at the time of the signing of the peace accords, there has nonetheless been noticeable progress in important areas. With substantial donor assistance, the physical infrastructure in the West Bank and Gaza has improved considerably. The improvements in infrastructure have helped mitigate the effects of declining income on the standard of living. Also, important policy institutions have been created, and many laws and regulations have been adopted or are waiting to be adopted. In the fiscal area, the PA has been very successful in securing a solid revenue base within the constraints placed by the Oslo Accords, and managed to balance the recurrent budget in 1998, despite continued strong increases in current expenditure. There has also been important progress in the area of banking, including the creation of the Palestinian Monetary Authority (PMA) in late 1994. At the same time, much remains to be done before the policy and regulatory framework can be described as truly supportive of private investment and economic development. There is an urgent need to strengthen governance and institutions, and to articulate more clearly a view on the role of the PA in economic activity.

This paper assesses macroeconomic developments and progress in institution building during 1994­98. The five-year interim period envisaged in the peace accords has come to an end, and it would now seem important and timely to take stock of what has happened in this period. The paper, which was prepared in the spring of 1999 and draws on work done by IMF staff visits to the West Bank and Gaza in the fall of 1998 and spring of 1999, analyzes developments in a number of areas and draws lessons for the future.