RAMALLAH, West Bank, Sept 12 (Reuters) - Progress made by the Palestinians in building institutions for statehood could be undermined by a fiscal crisis caused by a shortfall in foreign aid, the World Bank said on Monday.

In a report released just a week before the Palestinian leadership goes to the United Nations to press its claim for statehood, the World Bank said Israeli restrictions on the Palestinian economy must be lifted to allow sustained reform.

It said the Palestinian Authority had made "substantial progress" toward implementing the objectives of a two-year plan to build institutions ready for statehood by September of this year.

"To date, the Palestinian Authority has continued to implement its reform agenda, but a protracted fiscal crisis risks jeopardizing the gains in institution-building made painstakingly over the past years," the report said.

The success of the state-building plan led by the Western-backed Prime Minister Salam Fayyad is one of the reasons cited by Palestinian officials for their decision to go to the United Nations, despite U.S. and Israeli opposition.

The Fayyad plan aimed to ready the Palestinians for the establishment of an independent state in the West Bank, the Gaza Strip and East Jerusalem -- territories occupied by Israel in the 1967 Middle East war.

But the U.S.-backed peace process which they hoped would yield their independence has ground to a halt -- another reason Palestinian officials give for pursuing their diplomatic step at the United Nations.

The World Bank, in the report prepared to be presented to the Palestinians' international donors, said Palestinian public institutions now compared "favorably to other countries in the region and beyond".

But the Palestinian Authority, which exercises limited self government in parts of the Israeli-occupied West Bank, is still reliant on foreign aid to fill a deficit projected at $900 million this year.

Policymakers have blamed a shortfall in aid from Arab states for the PA's current fiscal crisis. In the last three months, the authority has twice failed to pay salaries to its 150,000 employees on time and in full.

The World Bank report said "lower-than-expected aid flows in the first half of 2011 had an immediate impact on the Palestinian economy".

The forecast for real gross domestic product (GDP) growth in 2011 had been cut to 7 percent from 9 percent, it said.

Significant Palestinian economic growth in recent years had been driven mainly by donor aid rather than the private sector, "which remains stifled by Israeli restrictions on access to natural resources and markets", the report said.

"Ultimately, sustaining the PA's reform momentum and maintaining its achievements in institution-building is dependent on the revival of the private sector," Mariam J. Sherman, World Bank country director for the West Bank and Gaza Strip said in a statement.

"This would grow the tax base and gradually reduce dependence on external assistance. Until then, the PA remains vulnerable to reductions in aid flow, and this needs to be managed carefully," she said.

The United States said last week for the first time it would veto any Palestinian bid for full U.N. membership.