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                                                                                   November 27, 2000


Main Remarks


The growth rate in the first three quarters of 2000 was one of the fastest observed in the past decade.
In the third quarter of 2000, GDP expanded by 9.1 percent and GDP of the business sector advanced
even more vigorously, at 12.6 percent.
Economic activity in the first three quarters of 2000 was driven by exports—high-tech, start-up
companies, and tourism services—the last-mentioned of which attained new pinnacles in the
millennium year. Private consumption also increased rather vigorously after three years of lethargy.
The acceleration of economic activity was manifested in very rapid job creation—about 95,000 new
jobs in the year ending in the third quarter of 2000—but not in a decline in the unemployment rate,
which remained stable at a very high 9 percent. This seeming contradiction was occasioned by an
upturn in the labor-force participation rate, prompted by growth, as the stronger likelihood of finding
a job led to a higher proportion of jobseekers.


The foregoing picture remained valid until the fourth quarter of 2000.
The degree of impact of the recent weeks’ events will depend on future developments; predictions in
this matter lie outside our purview. Even now, however, the loss of GDP in 2001 is estimated at about
1 percent (roughly $1 billion). This forecast will be updated in the next months in accordance with
geopolitical developments and other economic developments that are unrelated to the events. For
example, the continuation or acceleration of steep declines in share prices in the United States will
have a significant adverse effect on several domestic industries. If the American economy comes in
for a "not so soft landing," as a growing number of forecasts suggest, the Israeli economy will be
substantially affected. A highly negative development that will also affect economic growth in Israel
in 2001 is the current political situation, which, among other things, has prompted individual members
of the Knesset to submit private members' bills that carry direct and indirect costs in billions of
sheqalim. If even a few of these bills—let alone most of them—pass, the budget dam will burst and
the fiscal policy will have severely different guidelines them those instituted by Israeli governments
since the 1985 Economic Stabilization Program. These bills will be more detrimental to the growth
rate today—at a time of political uncertainty—than in ordinary times. However, the revised forecast
will also take account of the economy’s rapid 9 percent growth in the third quarter and the
encouraging 6 percent level of growth excluding start-up companies.



                    MINISTRY OF FINANCE - ECONOMIC RESEARCH AND STATE REVENUE DIVISION
                                                  ECONOMIC OUTLOOK
                                                           2


Despite the intensity of the events that began in October, the Central Bureau of Statistics (CBS)
estimates the growth rate in 2000 all told at a very healthy 5.4 percent. Experience with past events of
similar nature shows that while their adverse repercussions are felt in all areas of economic activity,
the extent of the damage varies considerably: tourism and construction will absorb the brunt of the
blow; agriculture will be severely affected in the fourth quarter of 2000; and trade, personal services,
and various export industries will be perceptibly harmed. Although it is currently believed that the
economy at large will be dealt a rather severe blow, it is important to stress that the impact of such
events is less today than in the recent past. Growth today is no longer based on domestic demand;
Israel’s significant comparative advantage in high-tech industries has become real; the indicators of
economic policy—inflation, external debt, budget deficit, current account deficit—are all at levels
that point to economic stability; and Israel’s country rating is higher than ever. These factors show
that the economic damage will be somewhat smaller than the impact that would have occurred had the
Israeli economy been less robust than it is today.


Most of this edition of Economic Outlook analyzes the effect of recent events on various domestic
industries and describes relations between the Israeli and the Palestinian economies.
The discussion to follow ranks economic activities by the extent of relative harm that they will suffer
and explains the time horizon of the impact on each activity. Some industries—agriculture, for
example—will suffer only in the short-term even if the events continue. In other fields, e.g., trade, the
effect will diminish as time passes. Tourism, however, will continue to limp due to relatively scanty
inbound traffic for months after regional calm is restored. In several fields, the events have actually
had a positive effect (a decline in crime, for example).


A separate section of this publication relates to the implications the closure in the territories for Israeli
agriculture and construction. Until about two months ago, the 10,000 Palestinians who worked in
agriculture accounted for one-eighth of employment in this industry. Due to the small proportion of
Palestinians in agriculture and the fact that farm labor seldom requires experience, agriculture is
expected to suffer in the short-term only. A limited-scale government program is helping farmers to
replace the missing Palestinians by recruiting Israeli workers.
Palestinians are more prevalent in construction—about one-third of industry employment. Here the
situation has given us a golden opportunity to make the best of an adverse situation and change a
reality that has become entrenched in recent years, one that has severe social consequences—
crowding out of Israeli employed because of the preference of cheaper foreign workers. A determined




                     MINISTRY OF FINANCE - ECONOMIC RESEARCH AND STATE REVENUE DIVISION
                                                ECONOMIC OUTLOOK
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government policy that would prevent builders from replacing the missing territories workers with
additional foreign workers would leverage a series of favorable effects on unemployment and on
narrowing social disparities that would be felt for years to come.


After discussing the effects of the closure on several domestic industries—a discussion that
illuminates the extent of Israel’s economic dependency on the Palestinian economy—we examine the
degree of dependency of the opposite kind, that of the Palestinian economy on the Israeli. We
illustrate this dependency by noting the reasons for it. In contrast to forecasts that circulated before
the Paris and Oslo agreements were signed, the level of per-capita national income in the Palestinian
Authority areas is lower today than before these accords were concluded. Much of the explanation has
to do with non-economic factors; the ravages of the closures that have been applied after security
incidents or alerts in recent years are significant in the extreme. The severity of the recent events, and
the fact that the proportion of Palestinians who work in Israel (in total Palestinian employment) rests
at one of the highest levels ever (about 21 percent), mean that the ongoing events will have a drastic
effect on the Palestinian economy.




                    MINISTRY OF FINANCE - ECONOMIC RESEARCH AND STATE REVENUE DIVISION
                                               ECONOMIC OUTLOOK
                                                        4


The Latest Economic Indicators


At the present writing, few data have been released for October, the month when the recent events
began. Apart from inbound tourism—a 45 percent decline in October relative to September—the
figures released thus far give no evidence of the grave events of the past few weeks. State tax
revenues continued to rise swiftly, the export and import figures marched apace, the number of
jobseekers declined, and even foreign direct investment seemed largely unaffected. However, one
should not draw conclusions from these figures as to the overall situation. There is no doubt that most
areas of economic activity will be substantially affected, mainly in the fourth quarter.


The pace of growth of imports of goods, excluding diamonds, fuel, ships, and aircraft, continued to
grow and has accelerated in recent months. Imports of capital goods and raw materials have
accelerated with special vigor. Consumer goods imports rose by 15 percent (in annual terms) in the
past four months relative to the preceding four months—a pace similar to the growth rate recorded for
the year all told. The purchase-tax cut has left no imprints of consequence on the data for the past two
months.


Real tax receipts climbed by nearly 17 percent in the first ten months of 2000 over the corresponding
period in 1999. Tax revenues were 28 percent higher in October 2000 than in October 1999. State tax
revenues continued to rise in the three months ending in October at an annual pace commensurate
with the expansion of economic activity—about 6 percent. (The figures are not seasonally adjusted
and were affected by holidays that occurred during that time.) Tax-revenue data cannot reflect
accurately the change in the pace of economic activity in any given month, mainly because taxes are
collected one or two months after the taxed economic activity occurs. There are additional factors that
obscure the correspondence between economic activity and tax revenues in a given month: businesses
make advance tax payments on the bases of their activity in previous months, the level of tax refunds
is affected not only by economic activity but also by the level of advances paid, and some tax receipts
are derived from transactions that have nothing to do with economic activity (real estate, capital), etc.


Non-diamond industrial exports increased by 30 percent in annual terms in the six months ending in
October 2000 relative to the preceding six months. An annual growth rate of 30 percent is definitely
considered aberrant and does much to explain the rapid overall economic growth that has occurred
this year. Notably, the severe monthly volatility of these figures makes it hard to pinpoint the trend.



                    MINISTRY OF FINANCE - ECONOMIC RESEARCH AND STATE REVENUE DIVISION
                                               ECONOMIC OUTLOOK
                                                         5


Still, even swifter growth rates were recorded until a few months ago. That 30 percent rate is
composed of stability or small increases in the exports of traditional industries and higher growth
rates in high-tech, the share of which in non-diamond industrial exports has climbed to 70–75 percent.
The graph below alludes to a point on which we expand later on: the main factor that affects the level
of industrial exports is the economic situation in the countries to which we export, and not necessarily
the level of demand or the security situation at home.

                              Non-Diamond Industrial Exports
                                                 $ millions
 1900

 1800
                                                          impact of
 1700                                                    world crises

 1600

 1500

 1400

 1300

 1200

 1100

 1000
    1996               1997               1998                1999             2000
    Source: CBS



The population of jobseekers declined in October after rising gently in September and was stable in
the three months ending in October relative to the preceding three months. It is very difficult to
adduce anything about employment on the basis of these figures because of their sensitivity to factors
unrelated to economic activity. For example, greater stringency in recording jobseekers’ "refusal" to
accept jobs offered would reduce the numbers of jobseekers. Frequent labor strikes and lockouts at
employment exchanges also make it difficult to analyze the figures. Furthermore, the labor-force
participation rate (the percentage of the 15+ age group that seeks work) has risen very steeply in the
past year. Consequently, the unemployment rate has not declined despite the encouraging increase in
employment. Although 95,000 new jobs were created in the year ending in the third quarter of 2000,
the unemployment rate has held firm at 9 percent. The seeming contradiction between the rapid (4.5
percent) upturn in employment and the stable unemployment rate traces to the increase in labor-force
participation, from 53.8 percent in the third quarter of 1999 to 54.5 percent in the third quarter of
2000.



                    MINISTRY OF FINANCE - ECONOMIC RESEARCH AND STATE REVENUE DIVISION
                                              ECONOMIC OUTLOOK
                                                       6


The composition of the increase in employment in the year ending in the third quarter of 2000 is also
encouraging. Two-thirds of new hires during this time (66,000 people) joined industries that typically
pay below-average wages—business services (36,000 new jobs), trade and motor-vehicle repair
(17,000), and hotel and restaurant services (13,000). While computer people account for some of the
increase in business-services jobs, the other industries definitely belong to the "old economy." The
fourth-quarter figures will presumably show a decline in hotel employment.


Foreign investment came to $250 million in October as against a monthly average of $600 million in
the past half year. The decrease cannot be firmly attributed to the events of recent weeks. While
foreign direct investment increased by $280 million in October, portfolio investment declined by $30
million. Foreign direct investment is affected by long-term macroeconomic factors; portfolio
investments are more strongly influenced by factors such as the state of the domestic and the foreign
stock markets.


The Consumer Price Index climbed by 0.6 percent in October. This relatively steep upturn is typical
of October, in which the end of one season and the beginning of another prompt increases in the
prices of fruit and vegetables (4.6 percent in October 2000) and clothing and footwear (8.2 percent).
In contrast, transport and communications prices fell by 0.5 percent, for reasons including declines in
prices of motor-vehicle fuels and lubricants.
In the twelve months ending in October, the total CPI declined by 0.1 percent. The public's inflation
expectations for the next twelve months stand at 2.2 percent. Bear in mind that the government's
inflation targets are 3–4 percent in 2000 and 2.5–3.5 percent in 2001.


The level, rate of change and direction of change of inflation expectations, as derived from the
capital market, are among the most important variables that the Bank of Israel considers in its
monthly decisions on the key lending rate. The graph below, juxtaposing inflation expectations to
actual inflation, points to two phenomena. First, there has been a negative correlation between
inflation expectations and actual inflation for considerable periods of time. In other words, inflation
rose when the market thought it would decline, and vice versa. This occurred, for example, in the
middle of 1995 and from late 1992 to early 1994 (a period of time not shown on the graph). The
opposite situation, in which inflation declined while the market thought it would rise, occurred in
1994, 1996, late 1998, and early 1999. The market seems to predict the future inflation rate
(unsuccessfully, for the most part) on the basis of the past inflation rate. The level and trajectory of




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                                                ECONOMIC OUTLOOK
                                                          7


the inflation-expectations indicator closely resemble those in the previous twelve months. Still, the
fact that inflation expectations often prove to be poor predictors of actual inflation does not rule out
the use of this indicator among the numerous indicators and variables that should be examined when
monetary policy decisions are made. This is because businesses make decisions on its basis, at any
point in time.

                               Inflation Expectations Derived from the
                                  Capital market and Actual Inflation
14%

12%

10%                                                                       inflation expectations

  8%

  6%
                      actual inflation
  4%

  2%

  0%

 -2%
       1.95            1.96              1.97      1.98            1.99               1.00
 Source:CBS, Bank of Israel



The second phenomenon that the graph shows is that, since late 1998, inflation expectations have
been consistently higher than actual inflation. In the past twenty-four months, the average monthly
discrepancy has been 2.3 percentage points—quite a difference.
One may think of several explanations for this large and consistent discrepancy. First, the rapid
disinflation that has occurred may take the market by surprise each time anew. The second
explanation has to do with the way inflation expectations are computed, i.e., by comparing the yield
on a CPI-indexed bond with the yield on an unindexed bond of identical term (twelve months, in our
case). The problem is that for a market player to be indifferent about the type of bond to acquire—
CPI-indexed or not—he will demand a certain risk premium on the account of unknown inflation.
This requirement will be built into the definition of "inflation expectations" and will skew it upward.
Beyond these two explanations, the indicator known as "inflation expectations derived from the
capital market" has technical problems in the form of the low negotiability of several bond series, the
lack of appropriate bonds for every day in the year, etc. As with any other indicator, it is important to
acknowledge the limitations of this one.



                       MINISTRY OF FINANCE - ECONOMIC RESEARCH AND STATE REVENUE DIVISION
                                                ECONOMIC OUTLOOK
                                                             8


Despite these limitations, inflation expectations are an important tool in setting interest policy
combined with a set of indicators (exchange rate, capital flows, macroeconomic variables, the
Consumer Price Index, etc.).


The key lending rate was 8.6 percent in October and 8.4 percent in November—levels that reflect real
interest close to 7 percent. Commercial banks charge households and businesses 2–8.5 percentage
points more than the real key lending rate announced by the Bank of Israel.1




National Accounts Data for the Third Quarter of 2000

The rapid growth rate that the economy has displayed since qtr2 1999 not only persisted in the third
quarter of 2000 but also accelerated. Thus, the growth rate for the year ending in qtr3 2000 came to
7.3 percent (10.2 percent in the business sector), one of the highest rates achieved in the past decade.
Needless to say, the fourth-quarter data will show a different picture.


The exceptionally vigorous growth in the third quarter relative to the second quarter—9.1 percent (all
figures in annual terms) is the result of seriously unbalanced trends in various sources and uses, as
often occurs in quarterly data. The average growth rate of exports of goods and services, 48 percent
(!), traces to the recording of the sale of Chromatis, Ltd., to Lucent, Inc., of United States, as an Israeli
export and, concurrently and equivalently, as an amortization of inventory (in other words, a decrease
in net investment). Since the two items offset each other perfectly, the sale has no effect on the GDP
recorded for that quarter.2 The aberrant growth rate of this indicator and the reason for it mean that
this indicator will probably decline very steeply in the fourth quarter of the year (unless additional
sales of similar magnitude occur by that time).



1The  real key lending rate announced by the Bank of Israel is computed by subtracting inflation expectations for
the next twelve months, as derived from the difference in yields between CPI-indexed bonds and unindexed
bonds on the capital market, from the nominal key rate. The commercial banks add a margin to this interest rate,
depending on the types and default risks of their customers.
2The  August edition of Economic Outlook (http://www.mof.gov.il/hachnasot/e9_00) described in detail the logic
behind this non-intuitive method of recording. In two sentences: the R&D activity of start-up companies in Israel
contributes to Israel’s GDP even if the companies are not eventually sold, just as any inventory investment makes
a favorable contribution to economic activity. The sale of the companies (as opposed to their current activity)
affects the composition of uses—not their level.



                      MINISTRY OF FINANCE - ECONOMIC RESEARCH AND STATE REVENUE DIVISION
                                                   ECONOMIC OUTLOOK
                                                                              9



                                                  GDP Growth Rate
                                                          year on year
 8%
                                                                                                                                  7.3%


        5.9%                                                                                                          5.8% 5.9%
 6%                          5.8%

               4.9%

                                                  3.9%
 4%                   3.6%                 3.6%                 3.6%
                                    3.4%                                             3.2%                      3.1%

                                                                       2.3%
                                                         2.0%                                      2.1% 2.2%
 2%
                                                                              1.3%
                                                                                            0.9%


 0%
       1996                         1997                        1998                        1999                      2000
      Source: CBS




National Accounts Data
Each year vs. previous                                                                Each quarter vs. previous
                                              1998               1999                  IV-99      I-00       II-00                   III-00
                                                                                                  Annual terms
GDP                                          2.4%                2.3%                  7.3%      5.1%        7.8%                     9.1%
Business-sector GDP                          2.2%                1.7%                  9.5%      7.8%       11.0%                    12.6%
Per-capita GDP                               -0.2%               -0.3%                 44.0%     2.9%        5.5%                     6.5%


Private consumption                           3.6%               3.4%                   1.0%             5.5%            7.6%            7.9%
Public consumption                            2.0%               3.5%                   5.4%            -3.5%           -12.1%       17.2%
Fixed investment                             -4.0%                1.8%                 -10.1%           12.2%           -4.8%        -2.3%
Thereof: Residential                         -6.7%               -8.4%                  -7.3%            1.4%           -4.4%        -8.4%
 Nonresidential                              -2.7%                6.2%                 -13.3%           20.1%           -6.6%        -2.4%
Exports                                       6.3%               8.7%                   27.0%           33.0%           13.6%        47.6%
Imports                                       1.7%               14.2%                  10.1%           12.8%            6.8%        10.9%


Total uses                                   2.1%                5.6%                   8.2%             9.0%            6.2%        10.5%
Source: CBS


The 11 percent increase in imports of goods and services is unrelated to the growth rate of exports.
Usually, rates of change in these two fields correspond to some extent, for the simple reason that in


                         MINISTRY OF FINANCE - ECONOMIC RESEARCH AND STATE REVENUE DIVISION
                                                                 ECONOMIC OUTLOOK
                                                           10


order to export more one must import more inputs. The foregoing explanation for the steep increase in
exports of goods and services in the third quarter—a matter of technical record-keeping, occasioned
by a sale transaction—shows clearly why the relationship that usually exists between the rates of
change in exports and imports is not discernible here. Imports of consumption goods stood out during
this quarter. (Apparently, the lowering of tariffs in August did not make a significant contribution to
this increase.) Imports of raw materials and capital goods also expanded vigorously.


The rapid (17 percent) increase in public consumption should be viewed in consideration of the
decline observed in the second quarter. As stated, quarterly data are typically very volatile, sometimes
making it hard to identify trends. Public consumption was 3 percent lower in the two most recent
quarters (qtr2 2000 and qtr3 2000) than in the preceding two quarters.


The figures on fixed capital formation show a decline in both nonresidential and residential
industries. Again, the quarterly volatility in the data may make the trend difficult to discern. The rapid
increase in nonresidential investments in the first quarter of 2000 (20 percent) means that even after
the back-to-back decline over two quarters, nonresidential investments remained stronger in those two
quarters than in the two quarters preceding them. In residential building investment continues to
decline, as the level of construction activity adjusts itself to the level of demand.


As for the contribution of start-up companies, as stated, the sale of Chromatis, in itself, had no effect
on GDP in qtr3 2000 or at any other time. However, the activity (as opposed to the sale) of start-up
companies as a collective has a substantial effect on the Israeli economy. Although this part of the
economy accounts for only 3 percent of GDP, it has been the fastest-growing—70 percent or so in
1998 and 1999 and 170 percent in 2000. This sector is unique among economic sectors in that it has
the highest ratio of output to employee. Thus, a 70 percent increase output will not boost demand for
labor by 70 percent. However, the increase in demand for skilled labor in technology industries—and,
concurrently, the increase in labor supply in these industries (and in the number of young people who
choose to study these subjects3)—is definitely perceptible. Importantly, despite the emphasis on the
uniqueness of start-up companies, their activity contributes to GDP just like that of any other
economic industry.


3The  August edition of Economic Outlook presented a lengthy discussion of the issue of technological schooling,
in a chapter that presented our vehement stance against allowing the admission of foreign workers for jobs in
high-tech. <http://www.mof.gov.il/hachnasot/e9_00>.



                      MINISTRY OF FINANCE - ECONOMIC RESEARCH AND STATE REVENUE DIVISION
                                                  ECONOMIC OUTLOOK
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 GDP Growth Rates , Including and Excluding Start Up Companies
6%                          Influences
                                                                                   5.4%
                                          Total GDP
         5.0%
                4.9%
5%                                        GDP excluding Start -Ups


4%
                              3.3% 3.2%                                                   3.4%

3%
                                               2.4%                  2.3%
                                                      2.2%
2%                                                                          1.8%



1%

                                                                                    forecast
0%
              1996              1997              1998                 1999          2000
Source :CBS




                       MINISTRY OF FINANCE - ECONOMIC RESEARCH AND STATE REVENUE DIVISION
                                               ECONOMIC OUTLOOK
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The Effect of the Recent Unrest on Economic Activity


Several weeks after the current unrest began, the CBS estimated that the disturbances would reduce
GDP in 2000 by more than 0.5 percent, bringing growth for the year to slightly higher than 5 percent
as against a 6.4 percent pace in the first nine months of the year. The forecast for economic
developments in 2001, produced shortly before the unrest erupted, predicted a growth rate of 5
percent—slower than the brisk pace observed in the first nine months of 2000. This forecast was
based on the belief that the steep growth rates that several industries enjoyed in 2000 were unique to
2000 and should not be expected to recur in 2001. For example, we did not expect tourism to grow in
2001 at the double-digit rate observed in 2000, the millennium year. (Before the unrest began, a slight
decrease was expected.) Similarly, we did not expect industrial exports to continue to grow in 2001 as
in 2000 (25 percent in 2000, a prediction of 10 percent growth in 2001).


Several days after the unrest began, we adjusted the 2001 growth forecast downward.4 In our current
estimation, the Israeli economy will lose about 1 percent of GDP (about $1 billion) in 2001, bringing
growth next year to 4 percent. Importantly, developments in the months to come and in 2001 are
shrouded in such uncertainty that the forecast must be reviewed every few months. If the situation
continues to deteriorate, greater damage may be caused.


The experience accumulated in similar situations in the past makes it easy to pinpoint the industries
that are most sensitive to events of this kind. However, when we estimate the effects of today’s
turmoil, we should bear in mind that the "2000-model" Israeli economy does not resemble the 1991
model (the Gulf War), let alone that of 1987–1988 (the intifada years). Today’s economic growth,
based on exogenous demand for high-tech exports, is less sensitive to unrest, which will have most of
its effect on industries that thrive on domestic demand. The economic policy instituted in recent years,
which has lowered the inflation rate, the state-budget deficit, the current-account deficit, external
debt, and the national debt, has also helped to strengthen the economy and prevent the current unrest
from having more severe implications. This also shows the supreme importance of maintaining a
correct economic policy at this time. The implications of breaching the limits of the budget are even



4Within the framework of the National Budget, co-authored with the Bank of Israel and the office of the Prime
Minister and presented to the Knesset in late October each year along with the state budget books.
http://www.mof.gov.il/beinle/news.htm



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                                                  ECONOMIC OUTLOOK
                                                        13


more severe at such a time than in ordinary days, for now the negative reaction will be swifter and
harsher.


The remarks below were made by Moody's Investor Service upon its decision to raise Israel's country
rating (to A2) in July 2000:

             There are two primary factors moving the foreign currency ratings. First,
             Israel's diversified modern economy, dominated by high-technology exports,
             is now on a path of accelerated sustainable growth, accompanied by lower
             inflation, lower budgetary deficits, and lower debt issuance. Second, the
             improved creditworthiness implied by this performance is less and less
             sensitive to potential risks from a geopolitical environment that reflects
             Israel's relations with Middle Eastern states and with the Palestinian
             Authority.




The impact of the recent events is not occurring on a spot basis and is anything but slight. This fact
also explains why the government can provide assistance in a few cases only, on a spot basis and on a
very limited scale. Lest we forget, the sources that finance the government assistance come from the
business sector. When everyone is adversely affected, as in the current situation, long-term expansion
of assistance to additional industries and fields means foisting a heavier burden on the business sector
in order to assist the business sector.


The intensity of the blow that the economy will absorb depends on the way matters will develop in the
future—a field in which we lack forecasting expertise. However, irrespective of the intensity and
longevity of the events, one may sketch the implications for various economic activities in a declining
order of severity in 2000–2001. If we change the definitions that we use to measure the "severity" of
the events, we may obtain different rankings. For example, it is believed that although the unrest will
have no effect on agriculture in 2001even if it continues, agriculture will suffer considerably in the
fourth quarter of 2000. The overall damage will vary considerably, depending on the continuation,
escalation, or de-escalation of the unrest, but the gradation of the severity as shown in the table will
remain the same: Tourism will always be the most vulnerable industry and the activity of start-up
companies, relative to other industries, will always be the least.




                     MINISTRY OF FINANCE - ECONOMIC RESEARCH AND STATE REVENUE DIVISION
                                               ECONOMIC OUTLOOK
                                                                               14




                                          Economic Impact of the Recent Unrest—by Degree of Severity

                     Tourism          Exports to PA         Construction        Agriculture           Private              Non-             High-tech
                                           areas                                                  consumption         construction         exports and
                                                                                                    (trade and         investment            start-up
                                                                                                     services)                             enterprises
Share in GDP            3%                  2%                    8.5%               2.5%                 60%              11%             Approx. 20%
Change in 2001   Decline of more     20%–40%              Single-digit        No impact in       Slightly lower     Slight impact        Relatively slight
vs. 2000         than 20%            decline              decline             2001               rate of increase   only                 impact
                                                                                                 than without the
                                                                                                 events
Expected         Approx. half a      Until the            Impact will         Severe impact in   Diminishing        Temporary only.      Temporary.
duration of      year after unrest   Palestinian          diminish as         last quarter of    impact over time   When unrest
impact           ebbs                economy              alternatives are    2000                                  subsides, an
                                     recovers after the   found                                                     increase that will
                                     unrest ends                                                                    compensate for
                                                                                                                    the slowdown
                                                                                                                    will occur.




                                               MINISTRY OF FINANCE - ECONOMIC RESEARCH AND STATE REVENUE DIVISION
                                                                         ECONOMIC OUTLOOK
                                                             15


The schematic table and the rest of this chapter relate to the industries or economic activities that will
suffer the most evident damage. Obviously, other industries that are related to each of them will be
indirectly affected as well. Furthermore, the effect on each industry is expected to be most severe in
the fourth quarter of 2000, and, assuming that matters do not deteriorate further, it will diminish
steadily afterwards. The schematic presentation shows the industries (tourism, construction,
agriculture) and uses (private consumption, investment) that will be affected the most.5


Tourism—experience shows that the effect on inbound tourism is immediate and severe, and that it
persists for many months after regional calm is restored.
Incoming tourism is not one of Israel’s largest and most important industries; it accounts for only 3
percent of GDP. Even if we include related industries (tour guides, motor-vehicle rental, etc.), it does
not add up to a very large economic branch.6 However, it responds so immediately and fiercely to
political-security events that the total damage will definitely be felt at the macroeconomic level. In
the first month of the unrest, October 2000, incoming tourism by air declined by 45 percent relative to
September. Experience shows that tourists wait four to eight months after the events subside before
they return to Israel. For example, the Gulf War, which Israelis remember as an event that lasted one
or two months (from mid-January to March 1991), affected inbound tourism from August 1990 (when
Iraq invaded Kuwait) to the summer of 1991—about four months after Israel relegated the war to its
history books.
The years 1996–1999 provide another example of the severe and protracted effect of security events.
The series of terrorist attacks in Tel Aviv and Jerusalem in February–March 1996 caused inbound
tourism to plunge by 20 percent immediately and to remain at the new and lower level for several
months. Six months later, when the industry showed first signs of recovery, the opening of the
Hasmonaean tunnel in Jerusalem and pursuant events toppled the industry into a slump again.


At this point in time, it is not unreasonable to predict a decrease of more than 20 percent in inbound-
tourism revenue in 2001 relative to 2000. Depending on the direction of developments, the downslide
may become even steeper. Multiplying this rate of decline by tourism’s share in Gross Domestic
Product shows that the economy at-large stands to lose about 0.5 percent of GDP ($500 million) on
this account.


5Several categories are defined as both industries and uses (investment in construction, exports of start-up
companies). Consequently, there is some overlap between industries and uses; agriculture, for example, is
included both in exports to the territories and in private consumption.
6We   have not ignored the impact on these related industries; it is included in private consumption.

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                                                Tourist Arrivals
                                                      ,
                                    thousands per month Seasonally adjusted

 200                                                                    Terrorist            Pope
                                                                         Attacks              visit



 150




 100

                                                                                                          Oct. 2000
                                                                  Opening of                Threat of
                                                               Western-Wall tunnel         Iraqi attack
  50


                         Gulf War
   0
    1990        1991       1992     1993     1994   1995      1996     1997         1998      1999        2000
           Source: CBS



This part of the discussion refers to inbound tourism only, to the exclusion of domestic tourism. In
1996–1999, when nonresident person-nights in domestic hotels declined at a double-digit pace,
domestic-tourist person-nights climbed at a similar pace, meaning that person-nights in Israeli hotels
did not diminish in any year during that time. Thus, the industry does not suffer as badly as the graph,
which shows inbound tourism only, implies.


Changes in Inbound-Tourist and Domestic-Tourist Person-Nights in Israeli Hotels
            Inbound tourists        Domestic tourists      Total
1996             –6.1%                     12.2%           1.3%
1997             –7.6%                     9.4%            0.0%
1998             –6.0%                     14.0%           3.8%
Source: CBS


Exports to the Palestinian Authority areas exports came to $2 billion in 1999, about 5 percent of
Israel's total exports and 2 percent of GDP. Here, too, a hefty double-digit decrease is in the offing; its
extent will depend on the time it takes the Palestinian Authority to recover economically after the
unrest subsides. In each of the years 1993–1994, when the borders were closed for many days, Israeli
exports to the territories declined by more than 10 percent. In 1988, the year of the Intifada (uprising
in the Territories), they tumbled by 30 percent. (Notably, annual double-digit growth rates are also
not uncommon.) The decrease in exports this time will be caused mainly by an expected severe

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decline in the Palestinian standard of living, which will dampen demand for imports of whatever
origin. To a lesser extent, the decrease will reflect an increase in prices of trade (in both directions),
prompted by an upturn in security procedures. (Today, goods are transferred at crossing points using
the back-to-back method, i.e., from an Israeli truck to a Palestinian truck and vice versa.) Nearly half
of Israel’s exports to the PA areas are composed of goods that give Israel very little added value
(durable goods imported via Israel); thus, the decrease in Israeli exports to the PA areas is expected,
at this point in time, to harm Israel's total product by only a few mil. (We expand on this point
below.)


Construction—Unlike the two previously mentioned fields, in which considerable detriment will be
caused by declining demand, construction will be affected by a decline on the supply side—the
absence of Palestinian construction workers. This industry will suffer a unique kind of damage; only
in this field does the situation contain an opportunity for a positive macroeconomic turning point in
the medium and long terms: the possibility of luring Israelis back to the construction industry.
Construction (housing, infrastructure, public buildings, and commercial space) accounts for 8.5
percent of Israeli GDP. About one-third of persons employed in this industry until two months ago
(70,000) were Palestinians, of whom 20,000 are legal. These workers are irreplaceable in the
immediate term, and industry activity will undoubtedly decline at a double-digit rate for several
months after the beginning of the unrest. In the medium and long terms, however, the level of
construction activity should not be affected as the missing workers will be replaced by others.
(Concurrently, wages will rise and the building process will become more capital-intensive.) Insofar
as the import of foreign workers to replace the Palestinians is not authorized, the unrest will have a
favorable effect on the composition of employment and the domestic unemployment rate, since
Israelis who were dislodged from this industry in recent years will return. (See expanded discussion
in the section on the implications of the border closure for Israel.)


Agriculture—Here, too, the damage will originate in labor-supply difficulties. Since Palestinians
account for a smaller proportion of farm workers than of construction workers, agriculture will be
much less affected. Agriculture also generates a much smaller share of GDP, only 2.5 percent.
Agriculture is expected to suffer in the fourth quarter of 2000 in several respects: the citrus harvest,
the olive harvest, and exports of flowers. In the medium-term, Israelis will replace the Palestinians.
(Agriculture, unlike construction, requires no training.) (See expanded discussion below.)




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Trade and services—Trade and some service industries (restaurants, domestic tourism) are expected
to suffer due to the decrease in personal income relative to the level predicted only a few months ago,
and due to the effects of the consumer mood. The extent of the damage—in percent—will probably
be small (depending, of course, on the duration of the unrest), but private consumption in Israel
comes to 60 percent of GDP and even a decrease of only a few mil will be perceptible.


Non-building investments—These investments, mainly in machinery and equipment, account for 11
percent of Israeli GDP and will decline because of economic uncertainty, a sensitive issue in business
investment. The extent of the damage is expected to be rather slight for various reasons, including the
fact that most of the affected investments will be postponed, not canceled.


                       Nasdaq and Tel Aviv 100 Share Indices
                                     January 3, 2000 = 100
  130


  120
                                                              TLV 100
  110


  100


   90

                                                         NASDAQ
   80


   70


   60
   January         March          April           June            August       October



High-tech exports/activity of start-up companies—These two fields should hardly be affected,
relative to the potential damage that Israeli industries may suffer. They account for 20 percent of
Israeli GDP and have recorded double and triple digit growth rates in recent years. They are affected
more by conditions in their export markets and in the American capital market than by domestic
events. The graph illustrates this by showing how faithfully the Tel Aviv 100 Index follows
developments on Wall Street. Two months after the unrest began (by the end of November), the share
indices in Tel Aviv and on the Nasdaq exchange declined by an identical 20 percent. However, it
would be incorrect to claim that events in our region have no effect whatsoever on these industries.
Although they will suffer less than the industries discussed above since they are based on exogenous
demand, these industries also have more maneuvering room than other industries in terms of the

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country where they choose to set up and run their businesses. In this sense, the stalling of tax
legislation in the Knesset is probably more significant than the security situation. (To clarify this
point, it is worth noting that the country in which a company is registered, in contrast to the country
where it operates, has no direct effect on GDP.)
We should note en passant that the declines in share indices on Wall Street are themselves a source of
unease. The performance of these share indices will be taken into account the next time the forecast is
updated.


Exports to Arab countries will decline drastically but were scanty to begin with—no more than
$100 million per year. Therefore, the direct damage, the kind that can be easily measured, verges on
zero.




Areas in Which the Unrest Will Have Favorable Effects
Trade—The decline in domestic trade occasioned by the aforementioned factors will be partly offset
by a decline in competition from Palestinian merchants who had opened commercial centers along the
Israel–West Bank frontier (Bidya, Mas'ha, Jenin, Tulkarm) and had built up a turnover that
approached $500 million per year. In the recent past, Israeli merchants and manufacturers complained
about the brisk competition that these centers had created by offering low prices, selling poor-quality
merchandise, and exploiting the reputations of familiar brand names in Israel.


Crime—According to data from the Israel Police, property crime within the Green Line declined
significantly in October. Motor-vehicle theft plummeted by 34 percent in October relative to
September, falling to the lowest level in recent years. The rate of burglaries in private homes declined
by 19 percent relative to September. The police trace these decreases to the unrest in the territories,
which resulted in a border closure and a stronger presence of police forces along the Israel–West
Bank frontier.




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The Palestinian Authority Economy7
Per-capita GDP in the PA areas is about one-tenth of the Israeli level but slightly higher than the level
in Jordan and Egypt. The close economic relationship with the Israeli economy benefit the PA’s
economy. Examination of growth rates in the PA areas, however, brings a different picture to light.


In contrast to the conventional predictions when the Oslo agreement was concluded six years ago, the
PA economy has not blossomed and flourished in the intervening years. In fact, per-capita income8
was about 10 percent lower in 1999 than shortly before the agreement was concluded. The data for
2000 will show that the gap between the current level and that of 1993 has continued to widen. One
may suggest several reasons for this state of affairs, but undoubtedly the main factor is security.
Border closures in the PA areas in recent years, imposed because of security events or alerts, have
caused grievous damage. Additional factors of lesser impact include the PA's economic policies and
the way it allocates the capital that has been transferred to it by donor countries.


The severity of the recent unrest and the fact that the proportion of Palestinians who work in Israel is
at one of its highest levels ever (more than 21 percent of all Palestinians employed) indicate that the
current unrest will probably have a very acute effect on the PA economy.




7The  figures in this brief survey are based on several sources. Different sources sometimes present different
figures. Wherever one source was the Israel Central Bureau of Statistics, its figures were preferred:
1) CBS.
2 P. Alonso-Gamo, M. Alier, T. Baunsgaard, and U. Erickson von Allmen, West Bank and Gaza Strip, Economic
Developments in the Five Years Since Oslo, IMF, 1999.
3) Economic Monitor, Palestine Economic Policy Research Institute, Issue 6—2000.
4) West Bank and Gaza, Recent Developments in the Palestinian Economy, Secretariat of the Ad-Hoc Liaison
Committee, Lisbon, June, 2000.
5) West Bank and Gaza, IMF, June 2000.
6) The Impact on the Palestinian Economy of the Recent Confrontations, Mobility Restrictions and Border
Closures, 28/9 – 19/10.2000, UN, October 2000.
7) Trade Options for the Palestinian Economy: Some Orders of Magnitude, The World Bank, October, 2000.
8National  income figures are more appropriate than GDP figures in portraying the state of the Palestinian
economy, for two reasons. First, about one-fourth of Palestinians are employed in Israel. Their income, which
contributes to the PA standard of living, is included in the national-income figures but not in GDP. (Their output
is included in the GDP of the country in which they work—Israel.). Second, the financial assistance that the PA
receives is excluded from GDP figures but accounts for an important share of national income.

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Selected Economic Indicators—Israel and Palestinian Authority, 1999

                                                                  Israel           Palestinian Authority


Population (millions)                                              6.1                       3.1
Gross Domestic Product ($ billions)                               100.8                      4.8
Per-capita GDP ($)                                               16,500                     1,570
Per-capita GDP—annual average growth rate,                        1.4%                     -3.1%
1995–1999
Rate of population increase                                       2.5%                       4%
Sources and uses as percent of GDP
Fixed investment                                                  21.4%                    32.9%
Public consumption                                                28.3%                    30.1%
Exports*                                                          38.3%                    19.7%
Imports*                                                          46.3%                    72.1%
Labor market
Unemployment rate                                                 8.9%                     11.8%
Share of total population employed                                34.9%                    19.0%
Share of women in labor force                                     45.0%                    15.0%
Source: (1), (4)
* Among the copious statistical data on the PA economy, the export, import, and balance-of-payments
figures are considered the most problematic.

In 1993, a team at the World Bank sketched six possible scenarios, each based on different premises,
for rates of change in per-capita income in the West Bank and Gaza five years after the establishment
of the PA. The results ranged from an increase of 4 percent to a decrease of 3 percent per year over
five years. The graph below presents the most optimistic and the most pessimistic scenarios for the
forecast period, 1993–1998, and juxtaposes them to the actual trend in per-capita national income. As
one may see, the actual result closely resembles the most pessimistic scenario.
The scenarios were based on a combination of assumptions—optimistic and pessimistic—concerning
three parameters:
1. The economic policy that the PA will invoke—in the optimistic scenario, policy measures that
    would support economic activity and trade were assumed.
2. Capital inflows to the PA—in the pessimistic scenario, a weak and inconsistent inflow was
    assumed.




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3. Employment of PA inhabitants in Israel—in the optimistic scenario, it was assumed that the
      workers in Israel would be replaced gradually by Israelis. The pessimistic scenario presumed that
      Palestinians’ work in Israel would be subject to abrupt and frequent interruptions.


           Change in Per-Capita National Income in Palestinian Authority Areas
                                        Scenarios vs. actual growth
     130
           1993 = 100
     120
                                                 Optimistic Scenario

     110

     100
                                                      Pessimistic scenario
                                                                                    Actual growth
      90

      80

      70
              1993            1994        1995              1996             1997   1998            1999
 Source: IMF, World Bank




Impediments to the PA Economy
Half a decade after the establishment of the Palestinian Authority, it is possible to list the factors that
have thwarted the fulfillment of the promise that quite a few economists saw in the form of a small
and flourishing economy:


1.         Security considerations—any account of economic developments in the PA areas has a
close “Israel connection” for three reasons: the large share of employed Palestinians who work in
Israel, trade relations between the PA and Israel, and security restrictions that Israel has imposed due
to terrorist attacks and alerts (security inspections at transit points for workers and goods, transit
restrictions in the PA areas and between them and Israel, etc.). Although the economies are
interrelated, and although one might expect rapid growth in Israel to stimulate demand for Palestinian
workers and goods—and, consequently, to lead to rapid growth in the PA areas as well—PA
economic development in recent years has not only failed to keep pace with Israel’s growth rate but
has headed in opposite directions. This has to do more with the effect of political-security factors than
with that of economic factors. Thus, in 1995–1996, as the Israeli economy grew by an average of 6
percent annualy, national income in the PA areas declined by an annual average of 13 percent. During

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that time, a series of terrorist attacks prompted Israel to close its borders with the PA areas and to
reduce severely the number of Palestinians allowed to work in Israel. In 1998, in contrast, the number
of closure days decreased and, although the Israeli economy slumped (to a growth rate of only 2.4
percent), the Palestinian economy grew by a healthy 12 percent, for reasons including the gradual
resumption of Palestinian labor in Israel.



Days of Border Closure, Per Year

                        West Bank            Gaza


1993                         17               26
1984                         64               76
1995                         80               102
1996                         90               138
1997                         57               70
1998                         14               48
1999 (Jan.-June)              6                6
Source: (2)


Payment for Palestinians' labor in Israel in 1999 came to $1.1 billion, i.e., a lost day of labor costs
about $4 million (based on 277 days of labor per year, after the subtraction of weekends and Jewish
and Muslim holidays). This figure does not take account of GDP lost as a result of the steep decrease
in domestic demand in the PA areas, occasioned by the lost livelihood of persons who had been
employed in Israel.


2.        Cross-border trade—80–85 percent of PA imports originate in Israel, about 3 percent in
Arab countries, and some 9 percent in the United States and Western Europe. Israel's share in total
imports has been declining somewhat in recent years, for reasons including an increase in imports of
capital goods that are paid for by donor countries. Israel was the destination of 86 percent of exports
from the PA areas in 1999, as against 94 percent in 1997. The current-account deficit (about $800
million) is more than 15 percent of GDP—an unsustainable rate.9 The intermittent security
restrictions on movement of goods between the PA and Israel are manifested not only in interruptions



9As   stated, the balance-of-payments figures should be treated with caution.

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of trade and an increase in uncertainty but also in higher costs of trade in the form of delays at
crossing points.
The Paris Accord (April 29, 1994), which was integrated into the Interim Agreement ("Oslo II") that
was signed in Washington on September 28, 1995, allowed the Palestinians to benefit from Israel’s
Free Trade Area agreements with the United States (subsequently, a similar agreement was signed
between the PA and the European Union). The Paris Accord states that, because the two sides do not
wish to and/or cannot separate their economies physically, the nature of commercial relations
between them should be structured in the form of a "customs envelope." The main feature of the trade
regime set forth in the Paris Accord is that the tariffs applying to PA imports should approximate the
rates that Israel imposes on the same products, except for a list of goods on which the PA is allowed
to set tariffs at whatever levels it desires.10 Had this decision not been made, and since the possibility
of total physical separation of the economies was rejected when the agreement was signed, the
imports of both economies would very quickly have drained into the economy that had the lower
tariffs and would then have been smuggled into other economy.


              Change in GDP per Capita- Israel and Palestinian Authority
                                           Two year average*
 14%
             Israel
 12%
             Palestinian Authority
 10%

  8%

  6%

  4%

  2%

  0%

  -2%

  -4%

  -6%
             88-89            90-91           92-93            94-95            96-97            98-99
  Source: CBS , IMF
* The growth figures are shown in two-year averages in order to mitigate the single-year volatility of the
Palestinian Authority’s GDP that is caused by the alternating nature of olive crop and the relatively
large share of this activity in GDP (even though this share has been decreasing over the years).




10Most items on this list are consumption goods, on which quotas were imposed, and capital goods, toward
which an Israeli standards restriction was applied.

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Beyond the impediments to growth already discussed in this section, an additional barrier to greater
openness to direct imports (i.e., those not implemented via Israel) is the lack of adequate physical
infrastructure (Marine port, airport, and overland transport).


2.       Rate of population increase—The PA areas have one of the world’s highest rates of
population increase: about 4 percent per year. By comparison, Israel’s rate of population increase in
recent years has been 2.5 percent per year including immigration and 1.6 percent on account of
natural increase only—which itself is considered high in Western terms. A rate of population increase
as robust as the PA’s has several economic implications.
First, it means that the dependency ratio—the ratio of children and seniors to people of working
age—is rather high. Additionally, since employment among women in the PA areas is extremely low,
there is only one breadwinner per five inhabitants in the PA areas as against one for every 2.5 in
Israel. (Israel’s ratio of breadwinners is also considered low by Western standards.)
Second, an age structure of this kind means (everything else being equal) rather scanty tax revenues
and high social expenditure for welfare, health, and education.
Third, to achieve a positive rate of per-capita growth, the economy must grow by more than 4 percent
each year. For this to happen, capital must grow at a similar growth rate, as has not occurred in recent
years.


3.       General government and economic policy in the PA areas—the PA's main goal when it
was established in 1994 was to create a growth-supportive environment and to replace all Israeli
public mechanisms that had operated in its territory under the Civil Administration. Several years
have passed, and the PA has been impressively successful in establishing a tax-collection array
(mainly in direct taxation), a monetary authority, and a regulated banking system, although Israel still
collects indirect and import taxes. However, budget management is still beset with problems of lack
of transparency and failure to meet sound administrative standards. For example, the existence of a
labyrinthine system of PA authorizations and restrictions on a lengthy list of imported goods has
created numerous import monopolies and inflicted considerable damage on the Palestinian economy.


When the Israeli Civil Administration ran the West Bank and Gaza, current general-government
expenditure came to 12–14 percent of GDP. Several years later, the share of this type of expenditure
climbed to 25 percent of GDP. This abrupt increase, within four years, traces mainly to the steep
growth in employment in Palestinian general government and has less to do with the quantitative and
qualitative enhancement of services. The Palestinians themselves define double-digit growth rates in


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general-government employment as one of the PA’s most severe fiscal problems. Along with the
increase in public expenditure, the PA’s tax revenues have risen to approx. 25 percent of GDP—a
rate similar to collections in countries in the region (as opposed to Israel, where the rate stands at 42
percent).


4.      Capital flows from donor countries—the three previously mentioned factors have inhibited
economic growth in the PA areas. Were not for the fourth factor, the cumulative rate of decrease in
per-capita national income would be even greater. Nearly fifty countries have donated more than $5
billion to the PA since the statement of principles was signed in 1993. In the past few years, the share
of subsidized loans that the PA has received for specific projects, including those provided by the
World Bank and the EBRD, has risen. Concurrently, a change has occurred in the earmarking of
donations—instead of allocations to cover current PA expenditure, sums are now earmarked for
projects and investments.


In 1994–1996, the level of assistance came to 13 percent of national income on annual average, and
per-capita assistance was $200—two of the highest levels in the world. (The corresponding figures in
Israel are 4.2 percent of national income and $500 per capita.)
Originally, this foreign assistance was meant to establish an infrastructure for vigorous economic
activity in the business sector. This has not occurred. Private investment in the Palestinian economy
gravitates almost exclusively to homebuilding and is hardly evident in income-generating activities.
Furthermore, border closures and other restrictions have forced the donor countries to finance current
budget activity or ad-hoc assistance programs, such as make-work projects at times of the severe
economic slumps that are occasioned by the border closures.




Composition of the Palestinian Authority GDP—The most important industries in added-value
terms are services (including public services), agriculture, fishery, and trade. The economies of Gaza
and of the West Bank are quite different in composition: the share of agriculture and manufacturing is
greater in the West Bank, whereas that of services—including public services—is dominant in Gaza.
Another difference is rooted in relations with Israel: the Israel-Gaza border is sealed and well-
defined, whereas one cannot speak of similar orderly crossing points between Israel and the West
Bank towns. This difference is reflected in a larger number of undocumented Palestinians employed
in Israel from the West Bank than from Gaza. For the same reason, when border closures are in effect,



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goods and workers that cross into Israel from the West Bank are less affected than those that cross in
from Gaza.


Effect of Labor Relations with Israel on the Palestinian Authority


In recent years, as the table shows, the Palestinian and the Israeli economies have developed an
interdependency in labor relations:


Palestinians employed:
Thousands                      1994        1995           1996   1997    1998      1999     1-9/2000


In Israel*                      70          60             58     74      107      116        124
In PA areas                    325          343           342     364     387      415        444


Palestinians employed in Israel:
As percent of total            3.5%        2.8%       2.6%       3.3%    4.7%      4.9%       5.0%
employed in Israel**
As percent of total           17.7%        4.9%       14.6%      17.0%   21.6%    21.8%      21.8%
Palestinians employed
Source: CBS, IMF
Notes:
* The figures include undocumented workers in Israel.
** Total employment in Israel includes foreign workers.


The table shows that since 1996, when the most recent significant and protracted border closure was
imposed in the aftermath of the series of terrorist attacks and the events following the opening of the
Hasmonaean tunnel in Jerusalem, the share of Palestinians employed in Israel out of all persons
employed there has risen steadily, as has their share in total Palestinian employment. In other words,
the relative dependency of the Israeli economy on Palestinian labor has risen and that of the
Palestinian economy on labor of PA inhabitants outside PA areas has grown even more. (Needless to
say, the Palestinian economy is immeasurably more dependent on Israel than Israel is on the
Palestinians.) The PA’s labor dependency on the Israel economy is even greater than the table
suggests. About 22 percent of Palestinians are employed in Israel, but since Israeli wages are twice as
high as PA wages, income from labor in Israel accounts for a larger share—more than one-third—of
total labor income in the PA areas.
When an economy loses one-third of its labor income, its level of activity obviously faces immediate
and severe repercussions. The impact on private consumption, for example, is immediate. When the

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Israel–PA borders were closed in early 1996, for example, 60,000 Palestinians were denied entry to
Israel for several months. During that time, economic activity in the PA areas contracted so severely
that another 60,000 Palestinians—who worked in the PA territories—promptly lost their jobs.
This 1:1 ratio—in which every Palestinian worker in Israel "supports" a Palestinian worker in the PA
areas by means of his contribution to PA economic activity—is extraordinary. Presumably, the
consolidation of the Palestinian Authority since the 1996 border closure has helped to lower this
ratio. The Palestinian governing entity that exists today makes it easier to obtain grants and donations
when trouble strikes; it also means that the number of persons whose wages are financed from the PA
budget has grown. Their employment is less effected by volatility in economic activity in the PA
areas. The fraction of employed persons whose wages are funded by the PA exceeds 35 percent of
total employment in the PA areas and has been rising steeply and steadily.


The graph below provides a very convincing depiction of the strong negative correspondence between
the number of closure days per year and the rate of change in GDP and per-capita national income in
the PA areas. Since per-capita national income includes not only GDP but also the wages of
Palestinians working in Israel and foreign aid, it reacts in a more extreme way to increases and
decreases in the number of border-closure days.



             Border-Closure Days, Change in Per-Capita GDP, and Change in
                              Per-Capita National Income
   10%                                                                                                        150
                                                                                             Closure days :
    8%                                                                                       right axis
                                                                                                              100
    6%

    4%
                                                                                                              50
    2%

    0%                                                                                                        0

   -2%
                                                                                                              -50
   -4%
                                                                            Per-capita national income
   -6%
          Change in per -capita                                             Per-capita GDP                    -100
   -8%    GDP and income :
          left axis                                                         Closure days
  -10%                                                                                                        -150
                1993              1994        1995       1996        1997           1998             1999
 Source: (2), (5); closure days in 1999—January–June.




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The Effect of Events in the Past Eight Weeks on the Palestinian
Authority
 The number of persons employed from the PA areas has fallen from 120,000 to 20,000–30,000.
   This means a $20 million loss of labor income per week ($870 million per year).
 Commerce along the Israel–West Bank line is believed to have plummeted by more than 90
   percent in the past few weeks. Assuming that the turnover of this commerce was $500 million per
   year, as is estimated, the loss is $10 million per week.
 For a few days at the beginning of the unrest, the Palestinian Authority barred the movement of
   goods from Israel through the crossing points. The main result was a blow to the Palestinian
   economy. The PA lifted this closure several days after it imposed it. The current method of
   transferring goods—the “back-to-back” technique (from an Israel truck to a Palestinian truck, and
   vice versa)—inhibits trade. Trade between the PA and other countries has also been affected. The
   number of trucks that go through the Israel–Gaza crossing points has declined by 75 percent since
   the unrest began.
 The loss occasioned by the absence of pilgrim tourism to holy places in the PA areas. The decrease
   is estimated at 90 percent relative to the pre-unrest situation, meaning a loss of about $1 million
   per week.
 The casino in Jericho had estimated daily revenue of about NIS 2 million per day before the unrest.
 Basic commodities such as fuel, food, and medicines have not been withhold as a matter of
   deliberate policy. The delay in transfer, insofar as there is one, is the result of local difficulties
   occasioned by the deteriorating personal security of those who deliver the goods to the crossing
   points or as a result of security restrictions that make the back-to-back method necessary.
 Economic output in the PA areas has declined by an estimated 30–50 percent in the past eight
   weeks. The total output of the PA economy is about $5 billion. A cautious estimate would find that
   the PA has lost more than 10 percent of one year's output in the past eight weeks and that GDP in
   2001 will contract at an extent well up in the double digits.
 Tax clearances on account of imports to the PA areas, collected by Israel, have continued over the
   past few weeks, although technical and other delays have interfered with their regularity. (We
   discuss this greater length in the section on trade with the PA.)




                    MINISTRY OF FINANCE - ECONOMIC RESEARCH AND STATE REVENUE DIVISION
                                               ECONOMIC OUTLOOK
                                                       30


Implications of the Border Closure for Israel


The Palestinians’ 5 percent share in employment in Israel does not accurately reflect the extent of
Israel’s dependency on Palestinian labor. One may form an impression of the dependency, at least in
the short term, only by examining the share of Palestinians in employment in specific Israeli
industries that have a higher proportion of such workers.
Notably, despite the border closure, it is believed that 20,000–30,000 of the 120,000 Palestinians who
had worked in Israel until about two months ago are employed in Israel right now.
   Until the past few months, about 70,000 Palestinians (of whom 20,000 are documented) were
    employed in the construction industry, accounting for about one-third of total employment in
    construction.
   The 10,000 Palestinians in agriculture accounted for about one-eighth of agricultural
    employment.
   The proportion of Palestinians in restaurant and hotel services was similar, but the labor problem
    is not perceived there because the recent events have dampened not only labor supply but also
    demand for restaurant and hotel services.




Agriculture
Agriculture accounts for only 2.5 percent of Israel’s GDP. Until two months ago, about 10,000
Palestinians (7,000 documented) worked in agriculture, about one-eighth of total industry
employment. The absence of Palestinians in agriculture has caused the economy little harm, but the
effect on agriculture in the last quarter of 2000, when citrus fruit and olives are harvested and flowers
are exported, will be substantial. In the medium term, it should not be difficult to replace the
Palestinians with Israelis (unlike construction, in which training is needed). Since the population of
Palestinian farm workers is relatively small, increasing the daily working hours of others who are
currently employed in this industry should greatly alleviate the problem.


Market forces are solving part of the problem; the government is helping to solve the rest:
1. Since the missing Palestinians account for only 13 percent of employment in agriculture, the
    problem would be solved almost in its entirety if the remaining farm workers extended their
    working day by one hour.




                    MINISTRY OF FINANCE - ECONOMIC RESEARCH AND STATE REVENUE DIVISION
                                                ECONOMIC OUTLOOK
                                                         31


2. Market forces have been pushing up farm wages since the temporary shortage of working hands
    came about, thereby attracting foreign workers from other industries to agriculture.



Composition of Employment in Agriculture

Thousands                             1995        1996        1997      1998        1999     1-9/2000


Total industry employment              77.9       78.5        78.5       82.7       83.6       81.0
Thereof:
 Israelis                              56.8       50.4        48.2       47.5       49.6       47.1
 Foreign workers                       15.1       22.0        22.5       24.1        24        23.4
 Documented Palestinians               5.7         4.1        5.3        6.4         6.5        6.3
 Undocumented Palestinians*            0.3         2.0        2.5        4.7         3.5        4.2


% of Palestinians in total            7.7%       7.8%         9.9%      13.2%      12.0%      13.0%
employment
Source: CBS
* The CBS estimates the number of undocumented Palestinians working in Israel on the basis of
reporting by Palestinians themselves in a manpower survey conducted in the PA areas by the
Palestinian Bureau of Statistics.

The temporary nature of the problem in agriculture entailed two actions that are geared to the short
term:
3. In conjunction with the Ministry of Education, it was decided to reinstate an enterprise that was
    routine in the recent past—a week of farm labor by high-school students.
4. Despite the high unemployment rate among unskilled workers—who, as stated, should have
    provided an immediate reserve of working hands for agriculture—the government has decided to
    institute a small-scale wage subsidy program for Israeli farm workers who replace Palestinian
    workers. The level of the subsidy will be NIS 40 per person per day worked, plus NIS 10 for
    travel.




Construction
There is nothing new about the effect of border closures on the employment of Palestinians in
construction in Israel. In the early 1990s, construction activity almost doubled within one year after
mass immigration caused demand to skyrocket. Concurrently, several successive border closures were


                    MINISTRY OF FINANCE - ECONOMIC RESEARCH AND STATE REVENUE DIVISION
                                              ECONOMIC OUTLOOK
                                                             32


applied and Palestinian workers were barred for several weeks or months each time. Every time such
a closure occurred, the building contractors protested vociferously and, in response, the number of
permits for foreign workers was increased time and again. This is easily seen in the sharp angles at
the two curves of the graph below, which shows the number of labor permits issued to non-Israeli
workers.

                     Foreign and Palestinian Workers Employed in Israel
                               via the Payments Administration
 160
        Thousands
 140

 120

 100

  80

  60

  40
                         Territories Workers
  20                                                                              Foreign Workers


   0
    1990      1991      1992       1993        1994   1995   1996   1997   1998   1999     2000
 Source: Employment Service



The labor problem is different in construction than in agriculture because of the larger share of
Palestinians in employment in the former, and because construction work requires experience and a
period of training. A glance at the figures in the table below shows how groundless it is to allege that
“There are no Israelis with construction skills who can enter the industry at this time.” Nearly 40,000
Israelis, including many Israeli Arabs, have left the construction industry in the past four years. The
share of Israelis in total construction employment has declined steadily during this time. The table
tells the story clearly: foreign workers replaced Palestinians during the border closures; when the
unrest ended, Palestinians returned to jobs that had in the meantime been taken up by foreign
workers. The employers received the Palestinians with open arms and as they displaced their most
expensive employees—the Israelis. Thus, foreign workers who were brought to Israel to replace the
Palestinians temporarily eventually dislodged Israelis.
A decision to withhold additional labor permits for foreign workers is no simple matter but is easier
to make today than in the early 1990s. First, mass immigration peaked in the early 1990s,
construction activity was much greater than today and demand for new dwellings had climbed to


                       MINISTRY OF FINANCE - ECONOMIC RESEARCH AND STATE REVENUE DIVISION
                                                      ECONOMIC OUTLOOK
                                                         33


unprecedented levels. The absence of Palestinians caused much greater detriment then than the extent
damage predicted today.
Second, today’s decision-makers are aware of something that no one knew then: the oxymoronic
nature of the concept “temporary foreign worker.” The long-term social damage caused by the
importation of additional foreign workers (resulting from adverse exogenous effects and the fact that
these workers compete with poorly schooled Israelis) is already well known.
Now we have an opportunity to bring Israelis back to the industry and, concurrently, to reduce the
high unemployment rates and the extent of inequality.



Composition of Employment in Construction

Thousands                                1995        1996        1997       1998       1999       1-9/2000


Total industry employment                227.6      245.7       248.8       235.3      223.8        221.5
Thereof:
Israelis                                 144.1      150.5       146.7       131.4      120.3        113.1
Documented Palestinians                  18.3        14.7        18.4        19.9       17.9        20.2
Undocumented Palestinians*               19.7        18.4        24.0        40.5       46.7        37.7


Share of Israelis in industry           56.0%       55.2%       50.5%      40.6%       35.0%       28.1%
employment
Source: CBS
* The CBS estimates the number of undocumented Palestinians working in Israel on the basis of reporting by
Palestinians themselves in a manpower survey conducted in the PA areas by the Palestinian Bureau of
Statistics.


Two figures should be kept in mind in this context: (1) the departure of nearly 40,000 Israeli workers
from the industry within only four years and (2) the fact that the unemployment rate among the poorly
schooled remains very high (10–14 percent). Here, too, market forces can restore equilibrium. Here,
too, the government is acting to clear away market failures:
1.      Market forces can help to solve the shortage of Palestinian workers in the following way: the
        temporary labor shortage should push construction wages up, inspiring more Israelis to return
        to or to enter the industry. Concurrently, the increased labor expense will give employers an
        incentive to step up the industrialization of construction. The method of homebuilding today
        is typified by a very low capital-labor ratio and can be done profitably only because cheap
        foreign workers are available.



                     MINISTRY OF FINANCE - ECONOMIC RESEARCH AND STATE REVENUE DIVISION
                                                 ECONOMIC OUTLOOK
                                                         34


2.      Market forces will also raise the wages offered to illegal foreign workers. It is altogether
        possible that the number of illegal workers will increase in the next few months. To head off
        this eventuality, it was decided to apply tougher enforcement at Israel’s points of entry. The
        possibility of the entry of illegal foreign workers is a basic market failure that, as experience
        has shown, is very hard to cure.
3.      The Employment Service is striving to identify former construction workers among Israeli
        jobseekers. This points to another structural failure that will be even more necessary to cure
        in view of the labor distress in construction and agriculture: the preference among the jobless
        to stay jobless and to reject job offers.
4.      In response to the frequent border closures in the early 1990s, the government, in conjunction
        with the building contractors, sponsored intensive courses to attract Israelis to the industry
        (the “Construction Challenge” program). These courses are still being offered, and
        approximately 20,000 people have participated in them thus far.
        Participants in the courses receive three months of theoretical training and then take a three-
        month “internship” at construction sites. The following incentives are offered: minimum
        wage starting at the beginning of the course (funded by National Insurance, beyond
        unemployment compensation) and, in some groups, an additional sum (funded by the
        contractors) during the internship. Some courses were reserved for recently demobilized
        soldiers only. These soldiers received, in addition to the incentives mentioned above, an
        earlier discharge, the preferred-labor grant, and an additional NIS 10,000 grant at the end of
        their first year of work (funded by National Insurance and the Construction Industry
        Promotion Fund).
        Many of these courses failed, and a post-mortem explains why in rather simple terms. Most
        importantly, the set of incentives gave the contractors no reason to retain their Israeli workers
        and to prefer them over foreign workers or Palestinians. The graph showing the consistent
        increase in the number of foreign workers upon each border closure, and the table showing
        the uptrend in the population of construction workers from the territories and the concurrent
        downtrend in the number of Israelis, illustrate the main reason for the failure of the program:
        No program to bring Israelis into the construction industry can succeed as long as
        builders can employ foreign workers or Palestinians at lower cost.11



11One of the problems in this context is scanty enforcement of labor laws generally, and the Minimum Wage
Law particularly, among non-Israeli workers. The report of a public commission that examined the Minimum
Wage Law found that Israel has a very low rate of law enforcement and an even lower rate among non-Israeli
workers.

                     MINISTRY OF FINANCE - ECONOMIC RESEARCH AND STATE REVENUE DIVISION
                                                 ECONOMIC OUTLOOK
                                                      35


Summary

The issue of the impact of border closures on the Israeli economy is related to a policy decision about
replacing Palestinian workers with Israeli or foreign workers. There is no doubt that the construction
industry will suffer in the short and medium terms because of the Palestinians’ absence. (This damage
will be felt at the macroeconomic level as well.) However, Israel needs a policy that prefers long term
considerations and general economic well-being over short-term considerations. Solving the short-
term problem will aggravate the long-term economic and social problems that the substitution of
Israeli workers by cheap foreign workers has created. A policy that supports the return of Israeli
workers to the construction industry and the referral of Israelis to farm labor can bring the
unemployment rate down quickly and help reduce inequality in income distribution. The foreign
workers’ station at the bottom of the Israeli wage scale pulls the scale down and crowds Israelis out.
Now we have an opportunity to mitigate a sticky problem—that of the foreign workers—that Israeli
governments have been tackling since the border closures in 1993.
However, if the easy way out is chosen—allowing additional foreign workers to replace those from
the territories—the Israeli economy and society will pay dearly several years down the road.




                    MINISTRY OF FINANCE - ECONOMIC RESEARCH AND STATE REVENUE DIVISION
                                              ECONOMIC OUTLOOK
                                                       36


Israel–PA Trade


Israeli exports to the PA areas came to about $2 billion in 1999, 5 percent of Israeli exports. Imports
from the PA areas were $1.5 billion, of which $1.1 billion reflects payments for Palestinians’ labor in
Israel.

Exports to the PA Areas

When one discusses Israeli exports to the PA areas, one should differentiate between goods of high
added value to Israel and goods that the PA imports via Israeli ports, from which Israel derives very
little added value. In the latter category are Israeli sales of motor vehicles and wholesale trade of non-
Israeli manufactures. Insofar as the decline in the standard of living in the PA areas reduces sales of
these two types, Israeli exports and Israeli imports will decline to the same extent, resulting in a zero
effect on Israeli GDP.
Another field of exports that should be separated from the others is the supply and delivery of
electricity and water. The expected decrease in the standard of living in the PA areas will probably
not affect demand for these commodities, which are provided by the Israeli systems.
In previous years of lengthy border closures, Israeli exports to the PA areas declined by 10–30
percent. A double-digit decrease of this kind will presumably occur in 2001.
Although Israeli exports to PA areas account for only 2 percent of Israeli GDP, and although a large
share of these exports generate no added value, some enterprises and activities will definitely suffer
from the decrease in demand for Israeli goods. For example, about one-fourth of domestically
manufactured cement (at the Nesher plant) and about 10 percent of Israel’s agricultural exports reach
the PA areas. At the individual-enterprise level, there are additional examples of rather severe
detriment to profitability resulting from the impending decrease in demand from inhabitants of the PA
areas for Israeli goods.




Imports from the PA Areas

Israel’s $1.6 billion in imports from the PA areas account for less than 3 percent of total imports.
Although this small proportion attests to the limited macroeconomic effect that the decrease in
imports will have, some harm will be felt in specific fields, as in the case of exports. For example, the
PA is the exclusive exporter of various types of building stone that is quarried from deposits in the
PA areas.



                     MINISTRY OF FINANCE - ECONOMIC RESEARCH AND STATE REVENUE DIVISION
                                               ECONOMIC OUTLOOK
                                                            37


Israeli Sales and Purchases from the PA Areas, 1999

Industry                                                                         Sales                    Purchases
                                                                                          NIS millions
Agriculture                                                                      340.9                      72.1
Manufacturing and mining                                                        2,413.7                     433.5
Thereof:          Processed foods and beverages                                  611.1                      27.6
         Chemicals and chemical products                                         207.8                       5.5
         Nonmetallic minerals                                                    396.2                      37.5
Electricity and water                                                             397                        3.3
Thereof:          Production and distribution of electricity                     319.6                       2.3
         Production and distribution of water                                     77.5                       1
Construction                                                                     170.9                      454.3
Wholesale and retail trade and motor-vehicle repair                             3,895.9                     720.4
Thereof: Motor vehicles                                                          212.2                       0.4
           Wholesale trade (excluding motor vehicles)                           3,230.5                     440.4
           Retail trade                                                          444.4                      257.2
Hotel and restaurant services                                                      3                         0.6
Transport, storage, and communications                                           322.6                      120.8
Banking, insurance, and finance                                                   22.8                       9.1
Real estate and leasing activity                                                  127                       61.1
Public services                                                                   0.2
Education                                                                         0.4                        0.6
Health, welfare, and nursing services                                             8.3                       13.1
Community, social, and personal services                                          92.3                       7.9
Personal household services                                                       0.2                        0.1


Total                                                                           7,803.2                    1,916.9
Source: Customs records; the figures are similar but not identical to those provided by the CBS.
The data on purchases from the PA do not include transfers on account of Palestinians’ labor in Israel.



The figures on Israeli imports from the PA areas, shown in the table or in the CBS data, do not
include trade that took place until two months ago in commercial centers along the Israel–West Bank




                      MINISTRY OF FINANCE - ECONOMIC RESEARCH AND STATE REVENUE DIVISION
                                                   ECONOMIC OUTLOOK
                                                            38


frontier, e.g., Bidya and Mas’ha. This trade, estimated at $500 million, is additional to the $1.1 billion
in recorded imports12 and has virtually dried up in the past few weeks.




Israel-PA Tax Clearances
In accordance with the Paris Agreement, Israel collects domestic VAT, income tax, fuel excise, and
purchase taxes for the Palestinians on account of goods destined for the PA areas and transfers this
money to the PA each month. In 1999, Israel cleared more than NIS 2.5 billion to the PA in this
manner. These clearances finance about 60 percent of the PA budget. In January–September 2000,
NIS 1.8 billion was cleared.
The tax clearances have continued since the unrest began, but there have been some delays for several
reasons:
   In the first three weeks of the unrest, clearing and processing of checks drawn on accounts in the
PA areas were delayed. The delay was organized and carried out officially by the Association of
Palestinian Banks, with the approval of the Palestinian Monetary Authority. Consequently, goods
moved from Israel to the PA areas (and were paid for with checks that were not honored) and Israeli
vendors paid indirect taxes on account of the transaction but did not receive financial consideration
from Palestinian buyers. This situation, created under PA guidelines, led to an absurdity in which
tax moneys were cleared to the PA a while payment for the goods was not received.
   Checks have continued to bounce in recent weeks—although not on an unorganized fashion—
either due to the economic hardships that Palestinian businesses face at the present time or
intentionally, to exploit the situation to renege on bills.
   At the institutional level, there are still delays in paying bills to Israeli institutions such as Bezeq,
hospitals, and the Israel Electric Corp. The debts to state-owned companies and to individuals entail
numerous time-consuming examinations that have the effect of delaying the clearances.




12Thus,  Israeli imports from the PA areas break down as follows: $500 million in goods and services, $1.1
billion in wage payments to Palestinian workers in Israel, and $500 million in trade along the line between the
West Bank and Israel.

                      MINISTRY OF FINANCE - ECONOMIC RESEARCH AND STATE REVENUE DIVISION
                                                   ECONOMIC OUTLOOK

				
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