The economic and political environment in the West Bank and Gaza has been less
favorable than hoped for in the Palestinian Reform and Development Plan (PRDP). The
Government of Israel (GoI) has tightened restrictions on movement and access in the
West Bank based on security concerns, and Gaza remains isolated, dampening private sector
growth. A surge in inflation has further eroded household incomes and raised production
costs. Other external factors have also had an adverse impact, including the slowdown in the
Israeli economy and the sharp appreciation of the shekel vis-à-vis the dollar. These
constraints have offset other positive developments, including significant flows of external
budgetary assistance, as well as improved confidence following the deployment of
Palestinian security forces in major cities of the West Bank.

Despite the difficult conditions on the ground, the PA has continued with prudent fiscal
policies and reforms. A strict government employment policy has been followed, wage rates
have been virtually frozen, and a range of measures have been implemented to improve utility
bills payment. The Public Financial Management System has been strengthened further, which is
helping prioritize and raise the quality of spending. Reflecting higher inflation, some
expenditures in the first half of 2008 were higher than anticipated in the budget, and wage arrears
were repaid at a faster pace, which helped cushion the erosion of employees’ real incomes.
Nevertheless, expenditure increases have been below the inflation rate, implying a retrenchment
in real terms. The recurrent fiscal deficit (on a commitment basis and excluding one-off revenue
items) is projected to decline from 27 percent of GDP in 2007 to about 23 percent in 2008. The
2009 budget currently under preparation envisages continuation of PRDP reforms, which would
reduce the deficit further to about 17 percent of GDP.