The World Bank warned today that continued Israeli economic restrictions are severely limiting the potential of the Palestinian economy and leaving Palestinians more dependent on foreign aid than ever.

In a report to be delivered to international donor governments this month, the World Bank acknowledges that Israel has lifted some roadblocks in the occupied West Bank but it says the impact is limited. It says continued discussions about removing individual checkpoints and roadblocks have become a "distraction" from the bigger issues.

The International Monetary Fund says the Palestinian economy shrunk by 0.5% last year and will grow by only 0.8% in 2008, a long way short of the Palestinian Authority's own forecast. It says there was a clear lack of investment and some industries have been badly hit: the construction industry is now less than a fifth the size it was in 1999. Foreign aid has become ever more important: this year the Palestinians will require around $1.9bn in budget support, equivalent to nearly a third of their gross domestic product.

The criticisms are striking because as part of the year-long peace negotiations between Israel and the Palestinians, Israel and the west have spoken of making significant improvements to the Palestinian economy, particularly in the West Bank, to encourage popular support for moderate positions and continued negotiations. The World Bank report demonstrates how little has been achieved.

"Israel has announced a series of steps to remove a few physical obstacles within the West Bank, which will only have an impact insofar as it is scaled up in number and the scope of the restrictions being addressed," the report says.

"The challenge moving forward with the removal of economic restrictions is to go beyond isolated gestures towards a profound revision in the fundamentals of the Palestinian economy. It is thus essential to convert these initiatives to a new status quo, rather than a series of isolated exceptions that are consuming a substantial amount of time by all players, and that are a distraction from dialogue on longer-term issues."

The World Bank says aid and reform without improved access are unlikely to revive the economy. It says that although Israel has legitimate security concerns, in fact most of the restrictions in the West Bank are near Jewish settlements.

"Overwhelming evidence suggests that the current restrictions correlate to settlement locations and expansions," the report says, adding that there is evidence economic restrictions could be removed without risk to Israeli citizens.