A viable state requires public institutions that create an enabling environment for private sector-driven growth, manage public finances efficiently, and are able to deliver effective services to the population. The Palestinian Authority (PA) is making steady progress on implementing its reform program and building the institutions required by a future state: the PA has strengthened its public financial management systems, improved service delivery, and made significant reforms to increase security and shore up its fiscal position. However, only a dynamic private sector can generate the jobs required by a young and growing population and furnish the resources needed to provide basic services to citizens. While recent economic resurgence is a cause for optimism - with Gross Domestic Product (GDP) growth in 2009 reaching about 6.8 percent coming on top of nearly 6 percent in 2008 – the situation remains precarious. Most growth is in the West Bank, while Gaza continues to experience falling per capita GDP. Furthermore, growth is driven by a combination of large inflows of donor assistance, PA government reforms that have increased investor confidence, and the loosening of some Israeli security restrictions. Sustainability of the growth, given the reliance on donor assistance, is a cause for concern.

Sustained private sector growth requires a shift from public sector-driven investment to a real takeoff in private sector investment. Part of this can be achieved by the PA continuing and accelerating its reforms. However, the largest impediment to private sector investment in the West Bank and Gaza remains the restrictions on movement and access to resources and markets imposed by the Government of Israel (GoI). Sustained growth is dependent on the GoI further easing restrictions it has already taken loosened - particularly through increased Palestinian access to the land and resources in Area C, access to markets in East Jerusalem and Israel, and by creating a higher level of predictability on movement and access.

The PA will continue to be dependent upon donor financing of its operating budget for some time to come, while it implements an ambitious reform agenda. The international community should commit to continuing to support this agenda including through more predictable flows of financing. In 2009 the PA’s recurrent budget deficit rose to nearly US$1.6 billion compared to US$1.3 billion in 2008. This was mostly due to the need to respond to the emergency situation in Gaza. The PA recognizes that it cannot sustain such a high deficit and that while donor funding has been generous it will not remain at such a high level. The 2010 budget commits the PA to reducing its recurrent deficit to about US$1.2 billion while also increasing development expenditures to US$670 million. Nearly US$350 million of these expenditures will be committed to community development projects that are a central part of the PA’s strategy to spur development and meet the needs of the population. The PA reports that it has already completed 1,000 of these demand driven projects and aims to complete another 1,000 by the end of 2010. Lack of predictability in external financing jeopardizes the ability of the PA to efficiently manage its expenditures and thus consolidate the gains made to date.

Critical elements of the PA’s reform and institutional development agenda focus on improving public financial management and strengthening its fiscal position. The Ministry of Finance (MoF) continues to steadily improve its public financial management system. It has linked all ministries to the new computerized accounting system, closed non-zero balance bank accounts, and introduced new methods of commitment control. The 2008 financial statements have been compiled and submitted to the external auditor. Public procurement remains an important issue that the Government is pursuing with a new law drafted but not yet adopted. The PA plans to refine the current draft and adopt it in 2010, which will allow the establishment of a new public procurement system based on international best practice.

For fiscal strengthening, the PA is concentrating on pensions, net lending, electricity distribution and municipal finances, which have substantial effects on the budget. The PA has committed to reform the public pension system and is currently working on a plan to move forward, but the pace of reform needs to be stepped up. On net lending the results are encouraging -- the PA was successful in reducing net lending by over 30 percent between 2007 and 2009 and some 80 percent of the remaining sum was in Gaza, where the PA has little ability to take action. On electricity there is some progress -- a new electricity regulator is operational and the systems for the Northern Electricity Distribution Company are being established. However, more sustained efforts are needed to effectively tackle this issue in the West Bank by transferring electricity distribution from local governments to commercially run distribution companies, as required by the Electricity Law.

The reforms of the electricity distribution system are interwoven with the broader agenda of municipal finances. In a highly decentralized system, local government units are responsible for delivering extensive services and have a large impact on the PA’s fiscal position though net lending and other transfers. Thus, improving the fiscal sustainability and efficiency of service delivery of local government units is a priority. In addressing the net lending issue, the PA has analyzed local governments’ fiscal operations and is developing plans to address identified constraints. Important steps, such as increasing and extending property tax collections and creating incentives to improve accounting systems, have been taken. In the longer term, the PA plans to address the inefficiency of the large number of small government units by moving to a more viable structure.

By many measures the PA is well on the way to delivering on its promise to create a Palestinian state that can deliver services and economic prosperity to its population. Nonetheless, this is not the time for complacency. Concerted action on creating the enabling environment for private sector growth is needed. This implies continued easing of movement and access restrictions by GoI, perseverance on the reform agenda by the PA, and sustained and predictable support by the international community. This period represents an opportunity for all parties – Palestinians, Israel, and the international community -- to rise to the challenge and ensure that the underpinnings of the future state are as solid as they can be.