Document of The World Bank FOR OFFICIAL USE ONLY INTERNATIONAL DEVELOPMENT ASSOCIATION PROGRAM DOCUMENT FOR A PROPOSED GRANT

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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Document of The World Bank FOR OFFICIAL USE ONLY INTERNATIONAL DEVELOPMENT ASSOCIATION PROGRAM DOCUMENT FOR A PROPOSED GRANT IN THE AMOUNT OF US$40 MILLION TO THE PALESTINE LIBERATION ORGANIZATION (FOR THE BENEFIT OF THE PALESTINIAN AUTHORITY) FOR A PALESTINIAN NATIONAL DEVELOPMENT PLAN DEVELOPMENT POLICY GRANT IV Social and Economic Development Group West Bank and Gaza Country Department Middle East and North Africa Region February 1, 2012 Report No WG This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

2 WEST BANK AND GAZA - GOVERNMENT FISCAL YEAR January 1 December 31 CURRENCY EQUIVALENTS (Exchange Rate Effective as of May 12, 2010) Currency Unit New Israeli Shekel (NIS) US$ WEIGHTS AND MEASURES (Metric System) ABBREVIATION AND ACRONYMS CAS Country Assistance Strategy CTA DFID Central Treasury Account Department For International Development ESSP Emergency Services Support Program EU European Union EUMP Electric Utility Management Project GCI General Control Institute GDP Gross Domestic Product GNP Gross National Product GOI Government of Israel ICA Investment Climate Assessment IDA International Development Association IEC Israeli Electric Company JD Jordanian Dinar IMF International Monetary Fund LDP Letter of Development Policy MDLF Municipal Development and Lending Fund MOF Ministry of Finance MOH Ministry of Health MOPAD Ministry of Planning and Administrative Development MOSA NDP Ministry of Social Affairs National Development Plan NIS New Israeli Shekel PA Palestinian Authority NGO Non Governmental Organizations PalTrade Palestine Trade Center PCBS Palestinian Central Bureau of Statistics PENRA Palestinian Energy and National Resources Authority PER Public Expenditure Review PERC Palestinian Electricity Regulation Committee PFM Public Financial Management PIF Palestinian Investment Fund PLC Palestinian Legislative Council PMT Proxy Means Test PNCTP Palestinian National Cash Transfer Program PPA Palestinian Pension Agency PRDP Palestinian Recovery and Development Plan PRDP DPG Palestinian Reform and Development Plan Development Policy Grant PRDP-TF The Palestinian Reform and Development Multi-Donor Trust Fund SAACB State Audit and Administrative Control Bureau SHC Special Hardship Case SSNRP Social Safety Net Reform Project TFGWB Trust Fund for Gaza and West Bank UNRWA United Nations Relief and Works Agency WB&G West Bank and Gaza WFP World Food Program Vice President: Country Director: Sector Director: Sector Manager: Task Team Leader: Inger Andersen Mariam Sherman Manuela Ferro Bernard Funck Nancy Benjamin

3 WEST BANK AND GAZA PALESTINIAN NATIONAL DEVELOPMENT PLAN DEVELOPMENT POLICY GRANT IV TABLE OF CONTENTS GRANT AND PROGRAM SUMMARY... 1 I. INTRODUCTION... 3 II. WEST BANK & GAZA CONTEXT... 4 A. POLITICAL CONTEXT... 4 B. RECENT ECONOMIC DEVELOPMENTS... 4 C. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY... 9 III. THE GOVERNMENT S PROGRAM FOR A. GOVERNANCE B. SOCIAL DEVELOPMENT C. ECONOMY D. INFRASTRUCTURE E. PUBLIC ACCOUNTABILITY F. CONSULTATIONS IV. BANK SUPPORT TO THE GOVERNMENT S PROGRAM A. LINK TO INTERIM STRATEGY B. COLLABORATION WITH THE IMF AND OTHER DONORS C. RELATIONSHIP TO OTHER BANK OPERATIONS D. LESSONS LEARNED E. ANALYTICAL UNDERPINNINGS V. THE PROPOSED PALESTINIAN NATIONAL DEVELOPMENT PLAN DEVELOPMENT POLICY GRANT IV A. OPERATION DESCRIPTION B. POLICY AREAS VI. OPERATION IMPLEMENTATION A. POVERTY AND SOCIAL IMPACTS B. ENVIRONMENTAL ASPECTS C. IMPLEMENTATION, MONITORING AND EVALUATION D. FIDUCIARY ASPECTS E. DISBURSEMENT AND AUDITING F. RISKS AND RISK MITIGATION ANNEXES ANNEX 1: LETTER OF DEVELOPMENT POLICY ANNEX 2: OPERATION POLICY MATRIX ANNEX 3: WEST BANK & GAZA PRDP DPG I, II AND III PRIOR ACTIONS ANNEX 4: IMF RELATIONS NOTE ANNEX 5: PUBLIC FINANCIAL MANAGEMENT AND FIDUCIARY ARRANGEMENTS ANNEX 6: COUNTRY AT A GLANCE MAP MAP 1: WEST BANK AND GAZA: DEVELOPMENT POLICY GRANT IV BOXES BOX1: PRDP MACROECONOMIC PROGRAM IMPLEMENTATION AND RESULTS... 23

4 BOX 2: PRIOR ACTIONS FOR THE PNDP DPG IV BOX 3: GOOD PRACTICE PRINCIPLES FOR CONDITIONALITY TABLES TABLE 1: SELECTED ECONOMIC INDICATORS, TABLE 2: WEST BANK AND GAZA: CENTRAL GOVERNMENT FISCAL OPERATIONS, The PNDP Development Policy Grant IV was prepared by a core team consisting of Nancy Benjamin, Team Leader; John Nasir, Lead Country Economist; Behdad Nowroozi, Senior Financial Management Specialist; Nikolai Soubbotin, Senior Counsel; Mark Ahern, Senior Public Sector Specialist; Samira Hillis, Senior Operations Officer; Soraya Goga, Senior Urban Specialist; Husam Mohamed Beides, Senior Energy Specialist; Lina Tutunji, Procurement Specialist; Gustavo Demarco, Senior Pensions Specialist; Abdalwahab Khatib, JPA (MNSPR); Yasmine Rouai, consultant, and Syviengxay Creger and Dalila Bouna, Program Assistants. Guidance has been provided by Mariam Sherman, Country Director; Bernard Funck, Sector Manager; Dina Abu-Ghaida, Country Program Manager; Udo Kock, International Monetary Fund (IMF) Resident Representative; and Mariuz Sumlinski of the IMF Mission. The team wishes to thank Ministry of Finance and other staff who have contributed to the preparation process.

5 GRANT AND PROGRAM SUMMARY WEST BANK AND GAZA PALESTINIAN NATIONAL DEVELOPMENT PLAN DEVELOPMENT POLICY GRANT IV Borrower Implementing Agency Financing Data Operation Type Main Policy Areas KeyResults Indicators Program Development Objectives and Contribution to CAS Risks and Risk Mitigation Palestine Liberation Organization (PLO) (for the benefit of the Palestinian Authority (PA)) Ministry of Finance (MOF) of the Palestinian Authority Terms: Grant from the Trust Fund for Gaza and West Bank (TFGWB) Amount: US$40 million The proposed operation is for budget support and is a follow-up to three previous Palestinian Reform and Development Plan Development Policy Grant (PRDP DPGs) approved by the Board on June 5, 2008, April 28, 2009 and September 14, The proposed grant would be disbursed in a single tranche upon satisfactory completion of the prior actions. The PNDP DPG IV will support the PA as it implements the National Development Plan (NDP) The PNDP DPG IV continues to focus support on two areas: (i) strengthening the PA s fiscal position; and (ii) improving public financial management. The PNDP DPG IV is designed to help the PA strengthen its fiscal position by increasing domestic revenues to about 24 percent of Gross Domestic Product (GDP) by 2012 and managing the share of the public sector wage bill to keep it in line at about 20 percent of GDP. The PNDP DPG IV also supports the PA s efforts to improve public financial management. Key indicators for this are greater transparency in budget reporting of development and transfer spending, stronger oversight for public procurement through new and better-trained institutions, and publicly available audited accounts. The proposed operation will help the PA to implement the new National Development Plan. Like the PRDP DPGs I-III, the PNDP DPG- IV will specifically support efforts to improve the fiscal position and increase government transparency and accountability. The NDP s success depends on parallel actions by the PA, the Government of Israel (GOI) and the donor community. The key risks are: (i) The highly volatile political situation could deteriorate, with the consequence of stalled reforms. If the security situation deteriorates, private sector confidence and investment will decline, public revenues will fall and government reforms may stall. What is

6 2 critical at this juncture is that the PA has continued to implement structural reforms despite the highly difficult economic environment and fiscal pressures, and remains committed to continued reforms. The PA has successfully mobilized popular support for its actions in the West Bank through its extensive consultations on the development of the NDP. (ii) The PA is striving to improve its fiscal position, but for the foreseeable future they will remain dependent upon high levels of aid. While the PA has charted a course toward lesser dependence on external aid and is actively undertaking the relevant reforms, it will take many years for the PA to achieve fiscal sustainability and that will only be possible if there is a political settlement that allows the economy to flourish. (iii) The PA will not be able to meet its fiscal goals without substantial economic growth. However, under the recent political uncertainties, the relaxation of movement restrictions slowed down whereas this relaxation had proved vital to fostering new economic growth in 2010 as did disbursements of donor commitments. The international donor community is continuing to monitor the closure system and its economic impact. The Bank and other development partners will continue to monitor progress in the reform agenda, and the transparency of public expenditures. This proposed fourth DPG sends a strong signal to donors that the World Bank places great importance on progress on the NDP and that donors should continue to support it. Operation ID P123437

7 3 PROGRAM DOCUMENT PALESTINIAN NATIONAL DEVELOPMENT PLAN DEVELOPMENT POLICY GRANT IV TO THE WEST BANK AND GAZA I. INTRODUCTION 1. This document proposes the fourth Development Policy Grant (DPG) to the Palestinian Authority (PA) in support of the new National Development Plan After a successful episode of implementing the Palestinian Recovery and Development Plan (PRDP ), the caretaker government put forward the new National Development Plan (NDP ). Under the earlier PRDP , the caretaker government set out towards restoring the basic operating systems of the PA while reforming and creating stronger public institutions that will form the basis of a future Palestinian state. The current NDP aims to move the PA fiscal and institutional performance beyond recovery and towards sustainability, by gradually reducing dependence on foreign assistance while continuing to improve the welfare of citizens. 2. In February 2011 the PA cabinet resigned with the expectation of formation of a new cabinet within five weeks. This did not happen and the existing cabinet has continued in an acting capacity. On May 4, 2011, the PA in the West Bank signed a reconciliation agreement with the leadership in Gaza, calling for the formation of an interim unity government and announcing a plan to hold national elections by The interim unity government was expected to be composed primarily of politically independent professionals and technocrats and to continue to implement the NDP. However, since this announcement no progress has been made on forming a new cabinet, and the current cabinet continues to operate. This highlights the uncertainty and fluidity in the broader environment. Until an agreement is reached regarding the composition of a new cabinet, the current Caretaker Government will continue to perform its tasks. 3. Since 2008, the PA has maintained a momentum of reform and streamlining both on the fiscal and institutional aspects of governance. Economic growth in 2010 closely matched projections of the development plan, while fiscal performance was as planned in the 2010 budget, with a reduction in the recurrent deficit as a percentage of GDP to 16 percent from 26 percent the year before. However, in 2011, delays and shortfalls in disbursements of foreign aid led to a liquidity crisis and severe fiscal pressure. The consequent fiscal retrenchment along with the slower easing of GOI restrictions in 2011 have caused economic growth to slow to an estimated 7 percent for the year. 4. Providing a DPG in WB&G continues to be a risky prospect. Success for DPG IV in assisting the PA to achieve the goals set forth by the new National Development Plan will depend on the PA, GOI and donors all continuing to play their parts. While public sector reform, along with donor aid has underpinned growth and recovery, this momentum will be unsustainable unless private sector growth rises to the level needed to support basic services for the Palestinian population. And while this is partly dependent on the PA improving business environment and lowering risk, private sector growth also hinges on the GOI continuing to relax economic and movement restrictions. 5. With numerous developments in the region rendering the political circumstances in West Bank and Gaza ever more complex, the easing of restrictions from the closure regime has not been sustained. Nevertheless, the NDP and ongoing caretaker government reforms present a credible agenda worthy of continued budget support. Given the Bank s role in encouraging donor funding of the Government s

8 4 recurrent budget, the Bank s endorsement of the new NDP and the PA s reform efforts will have a significant impact. A. POLITICAL CONTEXT II. WEST BANK & GAZA CONTEXT 6. Since the collapse of the power-sharing government in 2007, the Caretaker government has been administered by the Palestinian Authority. In May 2011, the PA and the leadership in Gaza began discussing a unity cabinet composed of politically independent technocrats. However, since this announcement no progress has been made on forming a new cabinet, and the current cabinet continues to operate. Until an agreement is reached regarding the composition of a new cabinet, the current Caretaker Government will continue to perform its tasks. Under the Israeli restrictions on the West Bank, a number of controls have been imposed limiting internal and external mobility. These controls include barriers at all international borders and numerous check points and barriers hindering internal transport of goods and people. The controls also block access to some 60 percent of land in the West Bank and most natural sources of water. The Government of Israel (GOI) prevents movement between Gaza and the West Bank and strictly controls the population registry. These controls and barriers have a major impact on cost of production and cost of living in WB&G, on economic growth and investment, and on employment, wages and poverty. 1 The easing of restrictions by the Government of Israel in 2009 probably had a positive impact on the Palestinian economy as well, but there has been little further easing since At present, the lack of engagement under a specific peace negotiations calendar, coupled with the broader Arab Spring revolutions in the region, has substantially increased political tensions and uncertainty. The Ministries of Finance of Israel and the Palestinian Authority have held technical discussions on linking PA and Israeli authorities on VAT, customs, release of clearance revenues, and sharing of fees from the Allenby Bridge. A political decision to implement agreed steps that could enhance revenue mobilization and budget execution in WB&G is awaited. Clearance revenues collected by GOI on behalf of the PA were delayed in May 2011, though were ultimately transferred, and again in October If the security situation deteriorates and hostilities resume, private sector confidence and investment will decline, public revenues will fall and government reforms may stall. Equally, stability can continue to strengthen Palestinian public institutions and revive the private sector to enable positive economic growth. B. RECENT ECONOMIC DEVELOPMENTS 8. Output, Prices and Labor: In 2010 WB&G experienced a third consecutive year of real economic growth. Exceeding the projected 8 percent growth, the Palestinian Central Bureau of Statistics (PCBS) estimates real GDP growth in WB&G to have reached 9.3 percent. The Gaza economy rebounded sharply during 2010 seemingly due to the partial opening of the crossings to more goods, achieving real growth exceeding 15 percent, twice the growth experienced in the West Bank, which experienced approximately 7.6 percent according to PCBS estimates. With per capita GDP growth at 6.2 percent, 2010 is the fourth consecutive year of per capita GDP growth, signalling that the WB&G economy is beginning to recover after years of decline. However the extent of this recovery remains unknown, as early macroeconomic estimates suggest a slowdown in real GDP growth to an estimated 7 percent during World Bank, The Underpinnings of the Future Palestinian State: Sustainable Growth and Institutions, September 2010; World Bank, Coping with Conflict? Poverty and Inclusion in the West Bank and Gaza, June 2011; Sharma and Vishwanath, Mobility Restrictions and Labor Market Dynamics in Conflict Affected West Bank and Gaza, World Bank, January 2011; Mandy Turner, Challenges of Implementing the State-building Programme Presentation to the UN Seminar on Assistance to the Palestinian People, Helsinki, April The GoI cites overriding security concerns that restrict its ability to continue to ease or lift restrictions on WB & G.

9 5 9. While growth is decelerating on the West Bank, Gaza is exhibiting signs of a sharp recovery, albeit from a very low base. However, the territory s economy remains precarious. The main drivers of growth are a combination of PA government reforms that have increased investor confidence, the loosening of some Israeli security restrictions, but more importantly, the substantial and sustained inflows of donor assistance supporting the recurrent PA budget and financing various development projects. In 2010, the PA received approximately US$1.243 billion in budget support coming on top of US$1.355 billion in 2009, US$1.8 billion in 2008 and almost US$1 billion in In addition to these aforementioned sums, hundreds of millions more in aid entered the economy over the past few years through the UN and from bilateral assistance programs for development projects. The large amounts of budget support have allowed the PA to maintain expansionary fiscal policies to support growth. In 2010, total PA commitments were equivalent to around 43 percent of GDP, with wage expenditures alone at around 21 percent of GDP. 10. Recovery in the private sector continues to lag behind the public sector. Between 1999 and 2009, manufacturing output was flat and its share in GDP fell from 12.5 percent to 11 percent. Output in agriculture fell by 47 percent during the same period and its GDP share declined from 10.4 percent to 4.8 percent. The PA s reforms that have improved security and provided more efficient service delivery along with the GOI s loosening of its security restrictions have no doubt increased investor confidence, but there is not yet any sign of a large scale revival of private investment in the productive sectors of the economy. As of 2010, among the fastest growing sectors in the WB&G were hotels and restaurants, which grew by 46.3 percent, followed by construction at 35 percent. Finally, as a part of the reform agenda since 2007, public administration and defence continued to expand by 6.4 percent in On the other hand, estimates of manufacturing output show a drop in output by 6 percent, which leaves current output levels more than 10 percent below their 1999 level.

10 6 Table 1: Selected Economic Indicators, Projections Estimated Output and prices (Annual percentage change) Real GDP (2004 market prices) West Bank Gaza CPI inflation rate (end-of-period) CPI inflation rate (period average) Investment and saving (In percent of GDP) Gross capital formation, of which: Public Private Gross national savings, of which: Public Private Saving-investment balance Public Finances 1/ (In percent of GDP) Revenues Recurrent expenditures and net lending Wage expenditures Nonwage expenditures Net lending Recurrent balance (commitment, before external support) Recurrent balance, cash (before external support) Development expenditures (In millions of U.S. dollars) ,095 1,295 Overall balance (before external support) External recurrent budgetary support (in billions of U.S. dollars) Total external support, including for development expenditures (In billions of U.S. dollars) Domestic Financing (in billions of U.S. dollars) 0.5 Monetary sector 2/ (Annual percentage change) Credit to the private sector Private sector deposits External sector (In percent of GDP) Exports of good and nonfactor services Import of goods and nonfactor services Net factor income Net current transfers Official transfers Current account balance (excluding official transfers) Current account balance (including official transfers) Memorandum items: Nominal GDP (in millions of U.S. dollars) 6,247 6,764 8,124 9,686 10,608 11,751 13,001 Per capita nominal GDP (U.S. dollars) 1,633 1,719 2,007 2,323 2, ,857 Unemployment rate (average in percent of labor force) Al Quds stock market index (annual percentage change) Sources: Palestinian authorities and IMF staff estimates. Commitment Basis 2 End-of-period; in U.S. dollar terms. 11. The PA is making efforts to help revive the private sector, but sustained private sector growth will require a takeoff in investment, which will only happen when Palestinian enterprises have better access to markets in Israel, East Jerusalem, and elsewhere, as well as have access to land and resources in Area C, the area restricted from Palestinian use for reasons of GOI security concerns. The GoI still prevents all exports from Gaza except for a limited amount of agricultural goods. These goods are not allowed to be shipped to the West Bank or Israel but must be directly exported beyond. 12. The PCBS estimates that growth in Gaza was 15 percent in 2010, a sharp improvement compared to 2009 with an estimated growth rate of 1 percent. While growth in Gaza may appear impressive, much of

11 7 it represents a catch up of real GDP following a sharp contraction by a cumulative 30 percent during Even when taking into account the sharp rise of output in 2010, Gaza s real GDP remains 20 percent below its 2005 level. 13. Positive growth alone does not signal that the Gaza economy is on the road to recovery. Since the GOI s decision in July 2010 to allow more imports into Gaza, early signs point to an aid driven recovery. The private sector may take longer to pull out of its state of near total collapse. Given Gaza s economic isolation from the West Bank, maintaining Gaza s recovery momentum will require the lifting of the ban on exports as well as imports of private investment inputs. As it currently stands, the vast majority of Gaza s private sector remains moribund and the economy is sustained by government spending and humanitarian assistance. While the opening of the Rafah crossing will help ease movement restrictions on people, the crossing does not serve as a port for goods, therefore its effects on trade and the private sector will be minor. 14. Prices in WB&G were relatively stable in 2010 and inflation continued to decline partly due to the relaxation of some movement restrictions. The Consumer Price Index (CPI) increased on average by 3.75 percent in 2010, primarily driven by prices in East Jerusalem and the West Bank, where percentage CPI change was 5.25 and 4.24 respectively. CPI in Gaza grew by a mere 1.72 percent, most likely due to falling prices from the loosening of movement restrictions on consumer goods. 15. While economic growth figures signal a recovery in WB&G economy, unemployment rates remain high and are not declining as fast as expected given the high growth in the both the West Bank and Gaza. Unemployment rate remains particularly high among Gaza s youth 3. The muted response of unemployment to high growth suggests that recovery has taken place through a more efficient utilization of previously employed resources, with little rise in business investment and hiring. In order for unemployment rate to decline faster, the private sector needs a lower risk environment and stable access to outside markets. During the period of , unemployment in the West Bank and Gaza dropped from 19 percent to 17 percent and from 41 percent to 38 percent respectively. Among Gaza s youth, unemployment rate remains disturbingly high at 53 percent, even with an economic growth rate of 15 percent. 16. Labor participation rate tells a similar story regarding the recovery. The labor participation rate remains low at 44.5 percent in West Bank and 36.3 percent in Gaza. Both employment and participation rates are significantly lower among youth under the age of 30, which is the largest demographic segment of the Palestinian population. Though work opportunities for West Bank residents in Israel have risen slightly from an average of 10 percent of the labor force ( ) to 12 percent (2010), it is far from the 19 percent experienced prior to the second intifada (2000). In Gaza, the share of the labor force working in Israel dropped from 13 percent before 2000 to a negligible segment in the past few years. 17. Fiscal Developments. The 2010 recurrent deficit on a commitment basis was budgeted at 16.8 percent of GDP, but the actual deficit was lower at 15.6 percent of GDP, or US$1.14 billion. On the revenue side, Gaza clearance revenues were less than budgeted due to lower energy imports 4. This decrease was offset by better tax compliance as well as repayment of tax arrears owed since 2007 in the West Bank 5. Despite increased tax revenues, the Ministry of Finance (MOF) faced deficits in both recurrent spending and development projects. To counteract this, the MOF kept ministries non-wage expenditures lower than the pro-rata budgeted amounts. As a result, non-wage recurrent expenditure commitments were US$143 million dollars less than budgeted in In the first three quarters of 2011, wage expenditures have exceeded the budget by about 1 percent, mostly due to adjustment of allowances to certain employees. Authorities were on track to limit new public sector employees to less than 3, Age group: With cheaper fuel available now from Egypt, Gaza is starting to rely on Egypt as a source of cheaper fuel. 5 About $50 million in income tax arrears had been owed to the PA by large enterprises since 2007.

12 8 18. The PA is plagued by delays in disbursement of donor aid, including those for development projects, and usually resorts to borrowing from domestic banks to close the financing gap. The amount of donor aid that was projected to fund the 2010 recurrent budget was of US$1.243 billion, but the disbursed amount was US$1.147 billion. Moreover, actual disbursed aid for development projects was US$130 million against a total commitment of $299 million. Recurrent spending budget were compressed below commitment levels in order to balance the shortfalls in aid. Despite a lower deficit and due to shortfalls in aid, there was an increase in net domestic bank financing of US$84 million, bringing stock of debt to banks at the end of 2010 to US$0.84 billion. Development expenditures were lower than budgeted, which partly reflects the restrictions on import of investment inputs in Gaza but mostly the shortfall in donor aid. 19. Trade. Israel remains WB&Gs largest trading partner. Despite a slight climb in exports to Israel during 2010, the overall trade figures in WB&G since 2008 have been declining. International Monetary Fund (IMF) estimates a 5 percent uptick in the exports of goods and services from West Bank to Israel during 2010; however, this slight rise followed a contraction between 2008 and 2009 by approximately 15 percent due to the construction of the separation barrier. When comparing the drop in exports from WB&G to Israel, to the drop in imports from Israel to WB&G, it is clear that the impact of the separation barrier on trade was asymmetric: imports from Israel dropped by 10 percent between 2008 and 2009, reflecting the much tighter Israel restrictions in WB&G on exports than on imports. 20. Naturally trade restrictions created a distortion among Palestinian sectors, favoring services and non-tradable goods such as construction over tradable sectors such as agriculture and manufacturing, which have shrunk considerably since the establishment of trade restrictions, which continue to impact the competition and access to the procurement market. According to the IMF, 6 having patterns of production in the WB&G economy driven by trade restrictions rather than comparative advantage, especially in the absence of a local seaport or airport, continues to have a substantial impact on economic growth since Banking/Financial regulation. The Palestinian banking sector remains strong and liquid, though highly conservative. Banks in the WB&G are regulated by the Palestinian Monetary Authority (PMA), one of the strongest and most capable institutions in WB&G and among the best managed monetary institutions in the region. Relying on technical assistance from the IMF and the World Bank Group including IFC, the PMA is moving steadily to improve its systems and build the capabilities required by a central bank for a future Palestinian state. 22. Following steady institutional reforms since 2007, the PMA developed the capacity to supervise a rigorous regulatory framework applicable to all banks in the West Bank and Gaza. Due to strides on the institutional reform agenda, the banking sector experienced a rise in private bank credit in 2010, mainly stemming from reforms in the financial market infrastructure implemented during Credit to the private sector rose by 29 percent in the West Bank, and 17 percent in Gaza. This rise in domestic credit was also fuelled by increase in the minimum share of assets that Palestinian Banks must keep in WB&G to 45 percent. 23. Currently, the PMA carries on in advancing its regulatory framework towards full implementation of Basel II standards, which are expected to be achieved by mid In the interest of raising transaction efficiency and reducing liquidity risk, the World Bank is assisting the PMA in developing a bank deposit insurance scheme, which is expected to be ready in early Furthermore, the PMA is in the final stages of installing an electronic payment system, which should further raise transaction efficiency. On the legal front, a banking law was enacted in November of 2010 to strengthen the financial sector s legal framework, 6 According to the IMF, manufacturing and agriculture sectors shrunk from 33 percent of trade in 1994 when trade with Israel was unrestricted, to 19 percent in 2010 with trade restrictions in place

13 9 and a new Central Bank Law guaranteeing the independence of the PMA is expected to be approved later this year. 24. One of the most pressing issues facing the Palestinian banking system is maintaining its relationship with Israeli banks. Israeli banks have broken all relations with banks in Gaza and have quit accepting cash deposits from most counterparts in the West Bank. They had indicated their desire to also end relations with West Bank banks. This led to a build-up of cash in Palestinian Banks in the West Bank, which significantly raised their insurance expenses, and resulted in significant losses due to forgone interest. In July 2010 a special arrangement to address this problem was achieved through cooperation between the PMA and the Bank of Israel (BoI), which resulted in an agreement to have excess NIS cash being regularly deposited at Israeli banks; however this arrangement is no longer practiced. WB&G uses the New Israeli Shekel, US Dollar, Euro and Jordanian Dinar (JD) as its currencies, though most transactions are conducted in Shekels. Thus the PMA does not control monetary policy or exchange rate policy. 25. Poverty. According to a recent World Bank poverty assessment report, 7 as of 2009, approximately 22 percent of the Palestinian population lived under the poverty line. Over the past 8 years, there was an overall improvement in poverty by 4 percent. However, improvement in poverty incidence was limited to the West Bank. Since 2004, poverty in the West Bank steadily declined from 23 percent to 16 percent in 2009, which stands in contrast with poverty in Gaza rising from 30 to 33 percent during the same time period (spiking at 50 percent in 2007). 26. Improvement in poverty incidence in the West Bank can primarily be attributed to recent institutional reforms and increased donor aid. While poverty incidence in Gaza shows a net increase since 2004, the most recent data for the years showed a slight reduction in poverty, primarily due to increased donor funded assistance. The aforementioned Poverty Assessment states that as of 2009, approximately 71 percent of Gaza s population reported receiving at least one form of social assistance, compared to only 12 percent of households in the West Bank. 27. Corruption. As is documented in the World Bank s recent report on corruption in WB&G, 8 during much of the first decade of the PA, government systems were fragmented, informal and gave considerable discretion to the office of the president and political leaders. This resulted in wasteful expenditure and leakages of public funds. From this starting point, the PA has worked to strengthen economic governance and combat corruption, both essential to sustained economic growth and improved delivery of public services. The report finds the PA has made significant progress in its public institutions, establishing a strong governance environment in many critical areas. But it also identifies areas where reforms are underway but incomplete or, in some areas, not yet under consideration. 28. Consistent with the improvements in Palestinian government institutions are the report s survey results, showing that public sector corruption is not viewed as among the most serious problems facing Palestinians; very few Palestinians experienced corruption when accessing public services. C. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY 29. Real economic growth was originally projected to reach 9 percent in 2011 with even higher growth rates expected in However, the latest estimates indicate a slowdown in economic growth in 2011 in part due to a slowdown in external assistance and consequently in fiscal spending. The macroeconomic outlook remains precarious due to restrictions on movement of people and goods and access to resources in both Gaza and the West Bank. Since July 2010, the easing of Gaza s blockade as 7 Coping with Conflict? Poverty and Inclusion in the West Bank and Gaza (2011) 8 West Bank and Gaza: Improving Governance and Reducing Corruption (2011)

14 10 well as the easing of the restrictions in the West Bank has facilitated the resumption of economic growth. The June 2011 opening of the Rafa crossing of the Gaza border with Egypt for people but not yet for goods will have some positive economic impact over time. The growth in the West Bank has continued to reap the benefits from higher private sector confidence which has been possible through good management and reforms by the Palestinian Authority (PA). Growth in Gaza has benefited from the consumer goods and humanitarian assistance that has been able to enter the territory; although goods, especially production inputs, are still constricted. However, Gaza output levels still remain 20 percent lower than those of The original growth projections assumed the continued relaxation of restrictions on West Bank and Gaza and continued political stability; however these assumptions have not been realized. With uncertainties remaining from the announced reconciliation agreement, easing of restrictions has halted; economic growth has also slowed with consequent fiscal impact. Current estimates suggest a slowdown in economic recovery, with the estimated growth rate dropping to 7 percent in Inflation fell to about 3 percent in 2010 but is estimated to have risen to 4 percent in 2011 due to the increase in world food and fuel prices. 31. The 2011 budget approved by the cabinet at end-march provided for a decline of recurrent budget deficit on a commitment basis to 13 percent of GDP in 2011 (compared to 17.5 percent of GDP the previous year), allowing the PA to meet its target of no net domestic bank borrowing, except for short-term loans, and no net arrears accumulation. Net lending was projected to decline by 1.3 percent of GDP. The budget also called for the PA to slightly reduce non-wage expenditures after they increased in the last three years, including by 35 percent in The wage bill was budgeted to reflect the adjustment of 3.5 percent in the wage rate to offset 2010 inflation, as well as the automatic 1.25 percent yearly increase and the increase of net employment by 3,000 employees. 32. Furthermore, the authorities continued to pursue the expenditure reform agenda defined in their National Development Plan, including: (a) Full implementation of reforms associated with the creation of the Palestinian National Social Safety Net Program (PNSSP); (b) Complete transfer of responsibility for electricity distribution from municipalities to commercial utility companies. Such a transfer was implemented in the northern West Bank in 2010 and continues with the regions of Qalquiya and Tulkarm. (c) Implementation of the adopted 2010 action plan to reduce pension liabilities and ensure long-term fiscal sustainability of the Unified Pensions Scheme; (d) Development of a medium-term plan for civil service reform, including a review of the Law of Civil Service. 33. The fiscal outturn for 2011 is now estimated to have been less favourable than originally expected. First, with slower growth, revenues have fallen short, causing the overall deficit to shrink only to an estimated 16 percent of GDP for the year. At the same time, total donor contributions, including disbursements from the Palestinian Reform and Development Multi-Donor Trust Fund (PRDP-TF), amounted to just over $1 billion in 2011, as compared to $1.3 billion in Contingency plans involving more contractionary measures and increased domestic financing were activated to compensate for the shortfall in donor contributions. 34. Projections for economic growth in 2012 are similar that of 2011, with 5 percent growth expected in West Bank and 7 percent overall for West Bank and Gaza. The broad outlines of the 2012 budget project faster growth for revenues than recurrent expenditures, allowing for a continued decline in the recurrent

15 11 fiscal deficit. With slower growth for the public wage bill and lower levels of net lending, more resources will be available for reducing domestic arrears, and allow for development expenditures to rebound. 35. The macroeconomic framework, though difficult, is deemed appropriate for the purpose of this operation. In the future, improved donor coordination framework and revenue transfer arrangements would help the PA better to plan its cash position.

16 Table 2: West Bank and Gaza: Central Government Fiscal Operations, Projections Estimated (In millions of US dollars, unless otherwise stated) Total net revenues 1,597 1,927 2,106 2,363 2,738 Gross domestic revenues ,028 Tax revenues Nontax revenues (accrued) Nontax revenues (cash) Clearance revenues (accrued) 1,103 1,259 1,474 1,651 1,845 Clearance revenues (cash) 1,090 1,242 1,547 1,651 1,845 Clearance revenues (net arrears) Tax refunds Total recurrent expenditures and net lending (commitment) 3,190 3,076 3,282 3,327 3,430 Wage expenditures (commitment) 1,467 1,613 1,887 1,967 2,065 Wage expenditures (cash) 1,423 1,564 1,887 1,967 2,065 Wage expenditures (net arrears) Nonwage expenditures (commitment) 1,349 1,227 1,235 1,260 1,285 Nonwage expenditures (cash) 1,142 1,156 1,235 1,310 1,335 Nonwage expenditures (net arrears) Net lending (commitment) Net lending (cash) Net lending (net arrears) Recurrent balance (commitment, before external support) -1,592-1,149-1, Recurrent balance (cash, before external support) -1,371-1,083-1,118-1, Development expenditure (commitment) ,095 Development expenditures (cash) ,095 Development expenditures (arrears) Overall balance (cash, including development expenditure) -1,771-1,358-1,518-1,614-1,838 Total financing 1,771 1,358 1,518 1,614 1,838 Net domestic bank financing Other domestic financing 301 External financing for recurrent expenditures 1,355 1, , External financing for capital expenditures ,095 Net external debt -4 Financing gap Memorandum items: (In percent of GDP; unless otherwise stated) Revenues Recurrent expenditures and net lending Wage expenditures Nonwage expenditures Net lending Recurrent balance (commitment) before external support Recurrent balance (cash) before external support External support (recurrent) in millions of US dollars 1,355 1, , Development expenditures (cash) Overall balance (cash) Total external support (in millions of US dollars) 1,755 1,277 1,117 1,614 1,838 Nominal exchange rate (average NIS per US dollar) Nominal GDP (in millions of US dollars) 6,764 8,124 9,686 10,608 11,751 Sources: Ministry of Finance; and IMF staff estimates.

17 13 III. THE GOVERNMENT S PROGRAM FOR The PA s new National Development Plan (NDP) for , approved and published in April 2011, builds upon and the Palestinian Reform and Development Plan (PRDP) of The NDP outlines the government s policy agenda, macroeconomic and accountability framework. The PA is looking forward to future statehood and forging ahead with improving institutions, and with 23 new sector strategies that were developed through numerous consultations with many stakeholders such as the Non Governmental Organizations (NGO), civil society organization, international organizations as well as the private sector and local government actors. The government s program is complete with targets and sector objectives in order to guide implementation and allow monitoring. 37. The NDP has been written with the purpose of establishing a solid foundation for the future creation of a State of Palestine in the periods. Authorities goal is to provide a framework that is able to rise to the challenge of providing its citizens with adequate service delivery. In line with the recommendations of the 2011 World Development Report titled Conflict, Security, and Development, the NDP maintains the PA s commitment to developing public institutions and local communities towards dampening the ramifications of the ongoing conflict on the economies of the West Bank and Gaza. The NDP also strives to improve upon the social disparities among its citizens that have been adversely affected by the closure regime. Authorities hope that this policy agenda will consolidate institutions which will spur investment and a vibrant private sector. This NDP has four major sector strategies which include: governance, social development, economy and infrastructure. A. GOVERNANCE 38. The authorities have been improving their institutional capacity since the 1990 s. The authorities, through consultations with relevant ministries and non-governmental agencies and stakeholders, have laid plans to continue to build institutions for the public expenditure and governance component of the NDP. Governance policy has been broken down by sectors: justice and rule of law, security, international relations, administrative development, local governance & administration, public financial management, public information, statistics and research, and land management. 39. The NDP has outlined several strategic objectives for the governance sector: (a) To provide national security and public safety throughout the country This objective builds upon the successes of the PRDP in imposing public order and rule of law and building infrastructure for the security sector. For the NDP, authorities have outlined priority policies to provide that all citizens are ensured the fundamental right to safety and security. (b) To deliver justice and the rule of law for all citizens This strategy envisions improving the institutional capacity of the justice sector over the next three years. The justice sector objectives build upon the reforms outlined for the PRPD of (c) To modernize and streamline public administration This objective has been developed around a framework which outlines a unified approach to upgrading the organizational structure of ministries and agencies, as well as strengthening institutional capacity. (d) To empower local government and bring public services closer to citizens In order to tackle the fragmentation of service delivery, authorities have put in place a strategy to build local government units (LGUs) capacity to provide adequate service delivery to local municipalities. (e) To attain financial independence and economic stability The PA is committed to continuing the prudent fiscal policy measures such as were outlined in the PRDP , with the goal of increasing growth and in due course, sustainable financial self-sufficiency.

18 The objectives have all been developed with quantifiable goals in order to measure the improvement or deterioration of specific reforms. This will ensure authorities have a clear framework to monitor and evaluate progress of the proposed programs. B. SOCIAL DEVELOPMENT 41. The PA s aim with the social sector is to improve service delivery among its citizens and to reduce disparities that are occurring in service delivery to certain groups. The authorities intend to work with private sector and non-governmental organization to guarantee more effective and higher quality service delivery. The PA is also striving to preserve its cultural heritage and creating new employment opportunities for all citizens. Specifically, these objectives include: (a) To support and empower the poor and other vulnerable citizens and their families This objective outlines a continuation to the refinement and implementation of the Palestinian National Social Safety Net Program (PNSSP). The authorities plan to offer more development assistance to the poor as well as implement appropriate legislation for the protection of vulnerable populations; (b) To prepare children and youth for a fulfilling life and productive work This commitment to shaping and molding human capital by preparing them for work with either the private or public sector will ensure quality education is provided to citizens; (c) To restore excellence in higher education and academic research In order to meet the demands of the labor market, the PA is committed to provide education that will prepare its students to be able to have up-to date skills including the existing vocational educational curriculum. This will ensure the progression into a knowledge-based economy as well as create prosperity; (d) To promote and sustain a healthy society Public investment in the health sector has allowed better service delivery in the sector. Thanks to external financing the health sector has been able to improve many facilities. The authorities aim to establish an affordable healthcare system for its citizens; (e) To safeguard and renew Palestinian heritage and culture The PA has established a Culture Fund in order to support and develop cultural centers across the WB&G as well as support events throughout the year; (f) To promote the full participation and empowerment of women in society The authorities strive to create an equitable society for all citizens, including women, to participate fully in the job market. As of now, female participation is rising but not quickly enough. The PA is committed to enforce laws that abolish discrimination based on gender and laws that punish violence against women; (g) To invest in youth to enable them to reach their full potential in their homeland The authorities are aware that with 30% of their population being aged between age 15 and 29, they must pay special attention to ensure youth s participation in the workforce by providing education that will develop their skills. The authorities also wish to ensure that the youth will participate in their political institutions. C. ECONOMY 42. The PA considers the economy and its development a high priority and would like to foster a vibrant, competitive economy. Given the logistical and political challenges that both the public and private sector face daily, it is paramount to have a sound economic policy that will foster growth. The authorities would like to counteract the constraints in order to be able to have a sustainable growth path. The authorities have outlined the following strategic objectives:

19 15 (a) To ensure a positive investment environment The authorities are aware of the importance of the private sector as a driver of growth and will continue to partner with them. The authorities are also aware of the legal and regulatory framework reforms that must be implemented; (b) To enhance the competiveness of Palestinian products and services The authorities strive to encourage investment in sectors that already enjoy a competitive advantage. This will not exclude other sectors that have high growth potential, which the authorities look to expand. These new sectors will not be ignored and will be supported; (c) To promote economic integration and access to external markets The authorities are consolidating the economic institutions that will be needed to manage the rapid economic growth that will ensue once Statehood is achieved. Authorities remain committed to pursue economic policies to promote investment and increase productivity and quality across sectors; (d) To ensure a vibrant labor market and combat unemployment The authorities are cognizant that skills are important for employment. They are determined to foster a capable, qualified workforce that can compete with outside labor markets as well as attract foreign investors to invest in WB&G. Authorities plan to integrate the education sector as an integral part of building a competent workforce; (e) To strengthen consumer protection institutions The goal of this strategy is to ensure public safety and the assurance of high quality goods to citizens. The authorities plan to ensure quality standards and enforce penalties on non-compliant parties. D. INFRASTRUCTURE 43. The authorities continue to build on the previous goals of connecting marginalized areas to the public infrastructure networks. The current program relies on community-based initiatives to provide service delivery. Due to the stalled political situation this sector has known setbacks as restrictions have long-delayed major public infrastructure projects. The authorities plan to continue the dialogue and consultation with international partners in order to achieve its strategic objectives. These include: (a) To develop integrated and sustainable national infrastructure networks; (b) To secure an adequate supply of energy and natural resources; (c) To protect the environment; (d) To maintain the long-term quality, affordability and safety of infrastructure systems; (e) To ensure adequate, safe and affordable housing. E. PUBLIC ACCOUNTABILITY 44. The authorities are committed to ensure adequate allocation of resources for quality public services, positive socio-economic outcomes and good governance for citizens. In order to improve accountability for the public interest, the NDP outlines four main elements: (i) transparency, (ii) performance, (iii) partnership; and (iv) oversight. These four elements are part of an institutional reform agenda which will allow the PA to build upon its recent achievements as well as improve on areas that still need attention. 45. The PA is looking forward to building and consolidating its capacity for governing its citizens in the wake of their independence and statehood. The NDP is a clear framework complete with tangible goals and objectives in order to keep the authorities accountable for their progress. This NDP has been conceived through dialogue and consultation with a multitude of stakeholders, both domestically and internationally. The document builds upon the previous PRDP and envisions more reforms to establish a good foundation for statehood in the near future.

20 16 F. CONSULTATIONS 46. The NDP is based on 23 new sector strategies that were developed through numerous consultations with many stakeholders such as NGOs, civil society organizations, international organizations as well as the private sector and local government actors. Then the NDP as a whole was the subject of further consultations. In sum, more than 240 consultation events have been conducted with over 2,000 participants representing various stakeholders. The government has also built partnerships with local communities through its program of Community-Based Projects which integrate community participation in to the identification of priorities and needs. Over the course of the plan s implementation, the government plans to use public consultation as a means to help with monitoring and evaluation. 47. One of the more sensitive reforms drawn from the NDP and included in the current operation is public procurement. The new procurement law was developed in a highly transparent and participatory process. Professional Associations such as the Palestinian Contractors Union, Engineers Association and the Lawyers Association have been involved in the dialogue with the PA for the reform of the country s procurement system and are supporting the enactment process of the new procurement laws and regulations. 48. In February and in June 2011, the Bank held consultations with PRDP-TF donors, specifically on the program to be supported by the DPG. IV. BANK SUPPORT TO THE GOVERNMENT S PROGRAM A. LINK TO INTERIM STRATEGY 49. Since WB&G is not a member country of the World Bank, there is no formal Country Assistance Strategy. Instead, the Bank relies on strategy notes to guide its work and keep the Executive Directors informed on activities. The latest Interim Strategy was developed simultaneously with the preparation of the PRDP DPG I. The strategy was presented to the Bank Board on April 22, 2008 and is designed to remain valid through A new interim strategy is planned for FY The proposed DPG IV is a key component of the WB&G ISN ( ). The current strategy emphasizes the Bank s desire to carefully target its limited resources to areas where the Bank can be most effective or can leverage additional donor funds. In addition to supporting the implementation of the PRDP through untied budget support, under the most recent replenishment, the Bank will devote additional resources to education, solid waste, municipal finance, community development and the NGO sector. The 2011 replenishment which went to the Board in March 2011 remains aligned with the strategy and the new strategy will build upon the NDP which is a marked evolution from the PRDP. 51. Along with grants, the strategy calls for the Bank to use its analytical ability and technical assistance to leverage other donor funds. The Bank is continuing its work monitoring restrictions on movement and access to resources and their impact on the economy. The Bank has completed major studies on access to water and poverty and governance issues in WB&G. The Bank continues to provide technical assistance to the Palestinian Pension Agency (PPA), the PCBS and PMA where it is helping the PMA team design, acquire and implement an electronic payments system as well as design a deposit insurance scheme. While the Bank will not be able to devote significant resources to all areas treated in its studies, this analytical work has mobilized support from other donors. In addition, the Bank has a dedicated advisor on public financial management and governance assigned to the Jerusalem field office. 52. The main effort of the Bank s strategy is to continue supporting the PA s implementation of the NDP as the successor to the PRDP through the proposed PNDP DPG IV as well as other complementary operations. The NDP s success depends upon three critical factors: (i) the PA effectively carrying out

21 17 promised reforms; (ii) GOI relaxing the closure regime to allow private sector growth; and (iii) the international donor community providing full support for the PA s recurrent budget. There is little the Bank can do on the second factor, which is a purely political problem. Consequently, the Bank is focusing its efforts on the first and third factors. The Bank continues to provide significant amounts of technical assistance to help the PA implement its reforms. Through its ongoing policy dialogue, it is providing the government with advice and encouragement to remain on track. But the Bank s most effective efforts are directed at encouraging donor funding of the recurrent budget. The Bank, in consultation with the (IMF), produces quarterly reports on reform progress that provide donors comfort to increase their support through the Central Treasury Account (CTA). This has been a successful effort as the PA received nearly US$1.15 billion in budget support in 2010, over US$220 million of which was provided through the Bank managed PRDP-TF. The PRDP-TF has provided US$635 million in support to the PA in its less than four years of existence. This proposed fourth DPG is designed to both help the PA close its fiscal gap and to encourage donors to continue to provide untied budget support through the CTA. B. COLLABORATION WITH THE IMF AND OTHER DONORS 53. The Bank works closely with the IMF and other donors to support the PA s implementation of the NDP. As mentioned above, the Bank consults with the IMF when it issues quarterly reports assessing the PA s progress on implementing the NDP. To enable this, the IMF team was closely involved in the development of the policy matrices for the Bank s DPGs including DPG IV. In WB&G, the IMF and World Bank have a complementary division of labor and constantly share information and consult on policy advice to the PA. The IMF monitors the macro framework and helps the PA produce accurate and timely accounts. The Bank also monitors the overall macro environment, but it concentrates on helping the PA address the underlying structural issues such as what is driving net lending, transfer payments or pension arrears. 54. The IMF has resumed full contact with the PA following the establishment of the Caretaker Government in June 2007 and is providing technical assistance on a variety of issues. The IMF helped the PA produce the macroeconomic framework used in the NDP and continues to work with them to regularly update the macro-economic projections. The IMF also provides technical assistance to strengthen public financial management and in doing so works closely with the Bank s resident Public Financial Management (PFM) expert and draws on analytical work done for the Bank s Public Expenditure Review (PER). The IMF is providing technical assistance to the Palestinian Central Bureau of Statistics (PCBS) to help them develop better basic statistics. Here again, the Bank and the IMF collaborate closely. Good basic economic data is essential to monitor progress of the PRDP reforms. Therefore, the Bank has provided funding to support building the capacity of the PCBS. In this effort, the Bank is coordinating closely with the IMF statistics team to identify exactly how the funds are best utilized. 55. The aid coordination structure in the West Bank and Gaza was set up following a decision made at the December 14, 2005 meeting in London of the Ad Hoc Liaison Committee (AHLC) with the aim of improving the effectiveness of aid coordination structures in providing coherent technical assistance and financial support based on national priorities to the Palestinian people in line with the OECD-DAC Paris Declaration on Aid Effectiveness. The AHLC is chaired by Norway and brings together in a meeting on a semi-annual basis several donors as well as the PA and the Government of Israel. The Bank acts as Secretariat to the AHLC, submitting a report prior to every meeting that updates on recent economic and fiscal trends, in addition to providing timely analysis on current economic and institutional developments in WB&G. The Bank s report has often helped to set the agenda and frame the discussion at the AHLC meeting. 56. At the local level, the donor coordination structure comprises the Local Development Forum (LDF), four strategy groups (SGs), each one supported by roughly five sector working groups (SWGs).

22 18 The LDF includes representation from the PA as well as all donor and aid agencies. The four SGs cover the clusters of economic policy, governance, infrastructure, and social development, and are intended to focus on overarching issues such as policy formulation and programmatic coordination. Each of the SGs and SWGs is co-chaired by a PA agency and a donor agency, and the Bank acts as co-chair of the Economic SG (together with the PA s Ministry of Finance) as well as the Private Sector Development and Trade SWG (together with the PA s Ministry of National Economy). C. RELATIONSHIP TO OTHER BANK OPERATIONS 57. The Bank s ongoing portfolio consists of 14 projects which include education, social and urban development as well as water management and electricity, with commitments in the amount of $213 million. In addition to this proposed PNDP DPG IV, there are seven other operations in the pipeline, including: Education to Work Transition Project - (US$5 million). This operation will provide funding to the education program, especially in developing and implementing education-to-work proposals in partnership with the private sector. West Bank Waste Water Management (US$10 million). This operation has the objective to finance the construction of a regional waste water plant and associated trunk sewerage to manage the wastewater of Hebron City and neighboring municipalities. In addition it will aid in the management of both industrial and human waste water. Municipal Development Project - Additional Financing (US$2 million). This Municipal Development Project has been conceived to improve municipal management practices for better transparency. Furthermore, the additional funding will ensure improved service delivery in the subsequent phases of this project. 58. Another project in preparation is focused on private market development through promotion of small and medium scale enterprises, innovation and capacity building to support private sector development. While the proposed DPG-IV does not specifically target the private sector, it includes one measure the new procurement law, which improves the regulatory regime for private suppliers, and a second measure aimed at improving the efficiency of infrastructure services in the energy sector. 59. The proposed DPG IV s policy matrix complements the other Bank projects which are ongoing in WB&G. For example, the provisions on net lending are in line with the proposals of the Electric Utility Management Project (EUMP), and measures in municipal development likewise support the program in the new Municipal Development Project. The Capacity Building Project directly supports the PPA and will assist the Palestinian Authority in implementing its pension reform plan. It also helps develop the PA s ability to monitor its economic performance. 60. The Bank s analytical and policy work has from the outset laid the basis for its role in WB&G. Without large resources of its own, the Bank seeks to leverage other donors funds and one of the primary ways of doing so is by producing high quality analytical work and technical assistance. In the past, this has been particularly important for generating budget support. The Bank s support to the PMA has helped give donors confidence to use the banking system and consequently the CTA. Technical assistance to the Palestinian Pension Agency has assisted the PPA in producing an action plan of reforms that was endorsed by the Council of Ministers. More importantly, the Bank s robust technical assistance program on municipal finance has been instrumental in helping the PA solve complicated issues around transferring electricity distribution from local governments to the distributions companies. In addition, the Bank projects such as the Social Safety Net Reform Project (SSNRP) and Electric Utility Management Project have helped improve internal PA capabilities thereby increasing donor s confidence to use PA systems.

23 19 D. LESSONS LEARNED 61. The PNDP DPG IV draws on lessons from the Bank s extensive experience of providing budget support to the PA. The most recent experience comes from the PRDP DPGs I-III, which were disbursed in June 2008, July 2009 and October 2010, respectively. The Bank continues to manage the PRDP-TF, through which donors provide budget support based on the Bank s monitoring of the PA s progress in implementing first the PRDP and now the NDP reform program. 62. The positive experience of broad consultations for development of the PRDP and the NDP has been reflected in the development of the new procurement law. The law was developed in a transparent way over several years with broad consultations. The lesson for the Bank was that working closely with the client over several years and providing appropriate technical assistance with broad-based consultations was a successful pathway to the adoption of a substantial reform with significant impact on the private sector and on public financial management. 63. A second lesson comes through the experience of donor coordination in working with the multidonor Trust Fund in support of implementing the NDP. Collaboration with other donors, especially through the Trust Fund, helps focus the dialogue with the authorities on key issues considered critical for reform. This collaboration provides significant weight to common points in the reform agenda and therefore should be maintained and enhanced. 64. The highly volatile political situation makes it difficult to hold the PA to specific benchmarks set years in advance. If the political situation deteriorates and violence resumes, government reforms may stall, the private sector will again fall into decline and the PA will not be able to meet its fiscal targets no matter how committed to reform. For example, under the uncertainties related to the reconciliation agreement, the reduction of movement restrictions may slow down. Since the announcement of the reconciliation agreement, passing legislation has become even more difficult, and the pace of presidential decrees has slowed. Given these challenges, recent experience suggests that the best approach is to select a mix of measures to deepen reform and to remain engaged in major reform areas. While quantitative goals should be set, the PA should be assessed on its progress towards achieving overall reform goals in view of the current political situation and not be tied to specific quantitative benchmarks that it may fail to meet due to circumstances beyond its control. E. ANALYTICAL UNDERPINNINGS 65. The World Bank s commitment to a better understanding of the West Bank and Gaza s context has been evidenced by numerous studies done in recent years. These studies cover many facets, including an investment climate study, a public expenditure review as well as a study of the fiscal management of local government. 66. In September 2011, a comprehensive poverty assessment report titled Coping with Conflict: Poverty and Inclusion in the West Bank and Gaza was released. The report concluded that the labor market outcome is one of the strongest drivers of poverty in the WB&G, with the unemployed facing the highest risk of poverty. The report also notes that public sector employment is increasingly playing the role of a safety net in combating poverty, especially in Gaza. 67. In May 2011, the WB&G Improving Governance and Reducing Corruption study was issued. This report is the first to assess governance reforms, measure corruption in the delivery of public services as well as shed light on weaknesses that need to be addressed in order for the WB&G to further reduce corruption as well as build sound institutions for good economic governance and a favourable investment climate for businesses.

24 This study shed light on experiences with corruption in the territory as well as on perceptions of corruption. The report concluded that Palestinian perceptions of corruption were much higher than actual experience in the access of public services. It also found that WB&G ranks well compared with other countries in the region in the forms of corruption affecting business activity. The report identifies a range of major improvements to the way that the PA manages resources and oversees private sector activity. However, it also cites a number of reform areas, most notably: management of state land assets, transparency in licensing and business rights, and public access to government information. Some of the areas identified in the report for further attention are covered by the current operation including procurement reform. 69. In April 2011, the draft Forward-looking Priorities for Investment Climate Reform in the West Bank & Gaza built upon the results of the earlier 2007 Investment Climate Assessment (ICA), analyzing the main constraints that impede the private sector in the WB&G. Given the lack of political certainty as well as limited trading partners, the private sector in WB&G remains fragmented and not very dynamic. Many businesses lack adequate access to land, water which restricts growth and investment opportunities. The report recommends that the PA remain forward looking by instituting reforms that could stimulate investment in WB&G. These reform areas include: access to water, electricity, telecommunications; improvement of infrastructure; and creation of a legal framework that will spur investment. According to the study, the highest priority for the PA should be access to land for both public and private purposes. The authorities should ensure transparency in the land acquisition process as well as completing the registry of public and private land in WB&G. These reforms will ensure that when the restrictions are lifted, WB&G can catch up on growth as well as fulfil its export potential. 70. Building upon the recommendations of the 2007 PER of controlling the wage bill, the World Bank produced, in September 2010, a report on Governance and the Wage Bill. This report was produced in order to assess the effectiveness of the existing systems for controlling the payroll. This report also identifies future measures to support aggregate fiscal control and more effective human resource management. 71. The World Bank issued the Report on the Observance of Standards and Codes (ROSC) Accounting and Auditing in September 2010, which analyzed the corporate sector accounting and auditing practices in WB&G using the International Financial Reporting Standards (IFRS). This study was limited by the blockade in Gaza and therefore focused more on the West Bank and its practices. In spite of the difficult political environment, the authorities have been able to offer a financial sector with most services available: banking, securities, and insurance. The Palestinian Monetary Authority (PMA) has acted as the Central Bank of WB&G, and due to its high level of technical competence it has been making great strides with improving the financial sector. The recommendations of this ROSC were for authorities to improve ethics, quality control and professional standards to be consistent with international practice. The World Bank also recommends that the accounting and auditing professionals have adequate training and capacity to carry out their functions and that a properly funded system of monitoring and enforcement should be established. 72. February 2010 s report Checkpoints and Barriers: Searching for Livelihoods in the West Bank and Gaza Gender Dimensions of Economic Collapse highlighted the economic strains that the restrictions have placed on both men and women in matters of employment. This study surveyed women and posed questions on their changing roles because of high male unemployment. Women have been able to secure jobs in both the formal and the informal sector in order to prevent poverty as well as to prevent aid dependence. Unfortunately, women have had to take low-status, unprotected jobs. This has led to changed roles in gender relations, which has led to tensions in the household due to women s increased role in public life. The World Bank made certain recommendations to the PA in order to provide better economic opportunities for both men and women. These include: (i) create and support enabling environments for safe and decent work; (ii) support quality youth employment, (iii) facilitate social cohesion, especially in

25 21 Area C and others isolated by movement and access restrictions; and (iv) collect better data on genderdisaggregated economic participation. 73. In February 2010, the World Bank produced the report Rationalizing Pensions for Government Workers in West Bank and Gaza, a first systemic quantitative analysis of the main obstacles to long term sustainability of the current pension schemes. The report includes recommendations of short, medium, and longer term pension reform options to ensure fiscal sustainability of the new pension scheme during the transition period until its maturity and the phase out of old schemes. Parametric reforms recommended included increasing retirement age, reducing accrual rates, adjusting indexation mechanisms and eliminating early retirement. While the report did not include an assessment of the old (transitional) schemes, it suggested some actions to be included in the preparation of the short term pension reform action plan. It was also suggested that a second study should include the quantitative analysis of the transitional schemes. 74. In January 2010, the World Bank conducted a study on the Municipal Finance and Service Provision in order to better understand the challenges of local government and municipal finance in West Bank and Gaza. This study showed how the PA and its local governments could improve service provision. The main conclusion was to impose and enforce user fees and tax levies for roads, water, solid waste disposal and electricity. The report does point out that certain local governments lack basic local taxes and therefore should consider the implementation of a property tax. Finally, it recommends that municipalities implement a Municipal Fiscal Restructuring Program (MFRP). This program would allow municipalities to address numerous financial and fiscal issues. 75. The World Bank s Public Expenditure Review (PER) was completed in early It takes a strategic view of Palestinian public finances and addresses two fundamental issues that confront the PA and its partners. The first is the challenge of bringing aggregate expenditure closer to likely revenues and available financing. Second is the issue of the composition of expenditure and its overall efficiency. In addition, the PER provides an in-depth analysis of the public financial management system and provides specific policy recommendations, many of which have been incorporated in the PRDP. While it may seem somewhat dated, it remains highly relevant. There has been a large amount of follow up work by both the Bank and the IMF and the main findings of the PER still serve as a good guide to policy. V. THE PROPOSED PALESTINIAN NATIONAL DEVELOPMENT PLAN DEVELOPMENT POLICY GRANT IV A. OPERATION DESCRIPTION The proposed operation will help the PA continue to implement the NDP. Following on the DPGs I, II and III, PNDP DPG-IV will also support efforts to improve the fiscal position and increase government transparency and accountability. 76. The proposed operation is designed to support the PA as it builds on the successful implementation of the PRDP and implements the reform program detailed in the NDP, by supporting actions in two policy areas: (i) strengthening the fiscal position, and (ii) improving public financial management. The PA implemented the PRDP throughout and largely met the targets set in the plan. As detailed in World Bank monitoring reports, the PA is making adequate progress. 9 To have the largest impact, the proposed PNDP DPG IV maintains the focus on the same two policy areas supported by the previous operations. These are critical building blocks for the government of a future independent Palestinian state and are also crucial for attracting continued international donor support. The Bank s involvement in monitoring and providing technical assistance for the reform agenda described in previous operations 9 See Box 1. Progress on the PFM agenda is discussed in section VI below and in Annex 5.

26 22 policy matrices has helped strengthen the PA s capacity to achieve its desired reforms and to also build the required support among donors. This fourth operation is expected to have a similar impact. 77. The Bank supports the NDP process in two complementary ways. First, it administers the PRDP- TF, as requested by the trust fund donors. Second, it will provide additional budget support with its own funds through the proposed PNDP DPG IV. The PRDP-TF is operating successfully and since its inception has disbursed over US$635 million in untied budget support to the PA Central Treasury Account (CTA). The PNDP DPG IV is a single tranche operation for which the related funds will be released on completion of the prior actions discussed below. Releases from the PRDP-TF are made on a quarterly basis, provided the Bank is satisfied with the PA s progress towards the NDP s reform goals, which are evaluated by the Bank in consultation with the IMF currently on the basis of indicators of progress for the PRDP DPG III and on the associated Letter of Development Policy (LDP), and going forward, on the basis of indicators set out in the policy matrix for the PNDP DPG IV attached as Annex 2 to this report, as well as the respective LDP. 10 Additional disbursements from the PRDP-TF may be made on the written request of the PA in extraordinary situations which, in the opinion of the Bank, would justify additional disbursements. It is envisioned that if the PA continues to make progress on their reform agenda and there is available funding, then the Bank may be asked to provide additional DPGs. However, given the unstable nature of the political environment and the uncertain size of future Trust Fund for Gaza and West Bank (TFGWB) replenishments, this remains a single tranche operation. 78. At the request of the PA, the Bank, in consultation with the IMF, will continue to provide reports detailing the status of the reform process, based on its assessment of PA reports. These reports are used not only by the Bank to determine whether to release the funds from the PRDP-TF, but also by a variety of other donors to inform their decisions on support to the PA. The PA has also committed to strengthening the PFM system by improving the standard accounting system used across all ministries, producing budgets in a transparent manner, improving commitment controls, and continuing to publish accounts that are subject to external audit. 10 Regarding fiduciary standards for the PRDP-TF, it is subject to two types of audits: 1. The main PRDP-TF is audited by external auditors following normal World Bank TF management practice. 2. External auditors also examine the following: a) The amounts disbursed by the Bank are paid into a designated Deposit Account of the PA kept exclusively for this purpose. b) No amounts are kept in or paid into the Deposit Account other than those disbursed by the Bank for the purposes of this particular operation. c) All withdrawals from the Deposit Account for payments are for eligible expenditures, following procedures established by the PA Ministry of Finance. d) The Ministry of Finance follows adequate disbursement procedures as per PA and governmental standards including accuracy of exchange rate conversion. In order to satisfy the Bank that the PRDP Trust Fund has been used to finance eligible expenditures, the Ministry of Finance must demonstrate and the auditor to certify that the sum of eligible expenditures is greater than or equal to the amount withdrawn from the Deposit Account.

27 23 Box1: PRDP Macroeconomic Program Implementation and Results Overall, the macroeconomic performance of the WB&G through 2010 matches projections made by the PA at the early stages of the PRDP implementation. Preliminary 2011 indicators suggest a decline in revenue and expenditure below projected estimates. In terms of economic growth, the WB&G exceeded projected growth estimates during 2008, 2009, and 2010 though the gap between projected and actual growth rate is shrinking. The PA s recurrent budget deficit peaked at over 25 percent in 2009 (7 percentage points greater than the projected 18 percent deficit), followed by a drop to 15.5 percent in Under the current National Development Plan, projections point to a decline in the recurrent deficit to approximately 4 percent of the GDP by Net lending as a percentage of GDP has been steadily declining since 2008, reaching 3.2 percent in 2010, two percentage points lower than projected by the PRDP. Further details on the full scope of PRDP implementation can be found in the Monitoring Report of the Palestinian Reform and Development Plan (PRDP) issued by the Ministry of Planning and International Cooperation in April Macroeconomic framework Baseline Scenario Public Finance Proj. Act. Proj. Act. Proj. Act. PRDP IMF PRDP IMF PRDP IMF (In Percent of GDP) Revenue Expenditure and net lending Wage expenditure Non-wage expenditure (incl. minor capex) Net lending Recurrent balance - before external support Investment (In Percent of GDP) Public capital formation (gross) Private capital formation (gross) Output and Prices (Annual percentage change) Real GDP CPI inflation rate (end of period) B. POLICY AREAS i) Strengthening the Fiscal Position Prior Action 1. A separate macro-fiscal unit with a composition and terms of reference satisfactory to the Bank has been established within the Ministry of Finance of the Palestinian Authority. (Status - Met) Rationale 79. The National Development Plan states the objective of maintaining sound macroeconomic and fiscal policies aimed at economic growth, reducing fiscal deficits, containing the wage bill and public pension liabilities, eliminating subsidies of energy consumption, and completing reforms of the social safety net. The government also commits in the NDP to establish a more robust institutional framework to

28 24 develop and implement monetary and fiscal policy. In line with its public commitments, the PA expects to continue to make significant strides towards controlling its budget deficit by controlling the wage bill and improving the planning and reporting of development expenditures. Policy 80. In the interest of this latter objective, government has set up the macro-fiscal unit, housed in the Ministry of Finance, for the purpose of improving fiscal planning and budgeting and evaluation of fiscal policy. The unit has started planning for the 2012 budget and has prepared quarterly reports on budget execution during Prior Action 2. A new payroll system has been introduced in the Ministry of Finance and the Ministry of Detainees and is functioning in a satisfactory manner. (Status -Met) Rationale 81. The NDP fiscal objectives specifically target the wage bill, the largest expenditure in the PA budget and until recently, its fastest growing component. To strengthen the fiscal position, it is essential to control the public work force. The PA has made progress and has brought the share of the wage bill down from more than 25 percent of GDP in 2007 to about 22 percent in The NDP targets further constraints in the share to 20 percent in 2011 and to 17.4 percent by To maintain progress and to bring the wage bill in line with the NDP plan, the PA must keep a tight lid on new hiring. In order to further strengthen the control of the payroll, the PA has developed a new payroll system that will allow payroll data entry to be carried out by the relevant line ministry under MOF supervision. The initiative aims to eliminate the delays and data entry errors associated with the current manual transfer of files for MOF updating. Policy 82. The new payroll system will eventually be integrated with a new human resource system to create a comprehensive personnel management system for the PA. The Ministry of Finance has completed the piloting of a new payroll system in two budget units, and it will be rolled out to other line ministries progressively over the coming months. 83. The 2011 budget maintains the commitment to hold new hires to 3,000 annually. The 2011 budget also respects the Minister of Finance s indication that the PA will continue to follow a policy of providing small annual general salary increases. Prior Action 3. The PPA has established and strictly followed the practice that all new categories of workers joining the public pension system pursuant to agreements between the PPA and their employers are allowed to retroactively pay pension contributions for up to five years, or for the entire term of their service under the current employer, whichever is less. (Status-Met) Rationale 84. The PA public pension system is extremely generous and represents one of the PA s largest and most rapidly growing liabilities. Currently, it is unfunded and effectively operates as a pay-as-you go system where current employees contributions are used to support payments to retirees. The obligations building up under this regime were not considered sustainable, and consequently in July 2010, following widespread consultations with all stakeholders, the Council of Ministers adopted a public pension reform action plan that seeks to limit the growth of pension liabilities. To improve the sustainability of the pension system, the Council of Ministers endorsed the action plan in However, most of these changes require legal amendments to the civil service and pension law. Given the uncertainties arising from the May 4

29 25 reconciliation agreement, approvals of such legal amendments has come to a near halt. Nevertheless, the authorities have the ability to implement the pension reform plan provisions regarding new entrants to the pension system. Applying these provisions, and limiting the purchase of years of service by new entrants to sustainable level need to be carefully monitored since they will help protect the Palestinian Pension Agency from taking on an inappropriate level of financial obligations regarding prior years of service for new entrants. Policy 85. Agreements signed with new entrant institutions from the private sector and local governments to the public pension system will respect the provisions in the pension reform plan, particularly those regarding new entrants. In addition, PPA should adopt a methodology to assess that the sustainability of the scheme will not be compromised by any of the new agreements. Expected results 86. The PA expects to reduce its dependence on donor assistance by reducing the recurrent budget deficit to 13 percent of GDP and by reducing the wage bill to 20 percent of GDP, and the institutional measures above supported under this grant will contribute to helping the PA achieve that goal Given the current political and economic uncertainties, the attainment of quantitative targets remains risky, although such targets continue to serve a useful purpose. In addition, the PA aims to improve the sustainability of the pension system and avoid adding unsustainable commitments by applying new provisions to new entrants to the system. 87. Agreements to extend the coverage of the Palestinian Pension Scheme to workers in the private sector and local governments should not compromise the current or long term balance of the scheme. In order to assess this, PPA will adopt a methodology to project costs and revenues associated with each new agreement. PPA will pay particular attention to provisions regarding purchase of years of contribution at the time of joining the system. Net Lending Prior Action 4. Financial and technical performance targets satisfactory to the Bank have been set by the Palestinian Electricity Regulation Committee (PERC) for West Bank electricity distribution companies. (Status - Met) Rationale 88. Net lending is an item in the budget, which refers to where the PA has made a payment on behalf of another body and is expecting to be repaid by that body. Its largest component is the cost of electricity delivered to the municipalities from the Israeli Electric Company (IEC) for distribution to consumers but not paid for by the municipalities. This debt to IEC is deducted by the GOI from the tax revenues they collect for the PA. In the interest of fiscal strengthening and as a part of the National Development Plan, the PA has been making a concerted effort to control it. Because of the PA s reforms, net lending has declined from around US$535 million in 2007 to US$237 million by Net lending has also declined in 2011, largely due to the transfer of electricity distribution from municipalities in the north to NEDCO, increased collection efforts in both the West Bank and Gaza and partly due to the PA stopping the payment for fuel destined for Gaza.

30 26 Box 2: Prior Actions for the PNDP DPG IV Prior Action 1. A separate macro-fiscal unit with a composition and terms of reference satisfactory to the Bank has been established within the Ministry of Finance of the Palestinian Authority. (Status - Met) Prior Action 2. A new payroll system has been introduced in the Ministry of Finance and the Ministry of Detainees and is functioning in a satisfactory manner. (Status -Met) Prior Action 3. The PPA has established and strictly followed the practice that all new categories of workers joining the public pension system pursuant to agreements between the PPA and their employers are allowed to retroactively pay pension contributions for up to five years, or for the entire term of their service under the current employer, whichever is less. (Status-Met) Prior Action 4. Financial and technical performance targets satisfactory to the Bank have been set by the Palestinian Electricity Regulation Committee (PERC) for West Bank electricity distribution companies. (Status - Met) Prior Action 5. The Customs Court of Appeal has been established in accordance with the provisions of the Customs Law to handle disputes related to customs duties and the value added tax on imported goods. (Status - Met) Prior Action 6. The new policy of unification of the value added tax and income tax services for large taxpayers has been implemented on a pilot basis for at least 200 companies for purposes of better cross-checking of records and improving the efficiency of audit. (Status - Met) Prior Action 7. The guidelines on how to improve revenue generation have been issued by the Municipal Development and Lending Fund for amalgamated municipalities in West Bank and Gaza and the field testing of these guidelines started in at least four such municipalities. (Status - Met) Prior Action 8. The Ministry of Finance of the Palestinian Authority has started the practice of publishing of improved monthly fiscal reports that (i) separate investment projects funded by other donors from the projects initially financed by the Treasury; and (ii) include expenditure breakdown for major projects and major project categories. (Status - Met) Prior Action 9. A new Procurement Law has been adopted by the PA which includes provisions for setting up the Higher Council for Public Procurement Policies. (Status - Met) Prior Action 10. The Palestinian Authority s financial statements for 2009 fiscal year have been audited by the Palestinian Authority s State Audit and Administrative Control Bureau (SAACB) and financial statements for 2010 fiscal year has been prepared and submitted for the Palestinian Authority s State Audit Administrative Control Bureau for an audit. (Status - met)

31 27 Policy 89. PERC will set performance targets, developed by the Palestinian Energy Authority, for West Bank electricity distribution companies on financial and technical performance. Such indicators will help guide the PERC in its regulation of the sector and ensure efficiency of distributor operations. PERC indicated that it is also planning an incentive program to encourage improvement in the performance of the utilities and will also establish a monitoring system to improve the performance of the utilities as required under their licenses. PERC will, for example, be setting allowable yearly benchmarks of losses and collection. Revenues obtained from losses and collection better than their yearly benchmark values could be retained by the utilities as incentives to improve their operations. Expected results 90. Net lending is expected to be reduced below $200 million in 2011 and electricity tariffs are expected to reflect performance improvements according to the new targets. Improve targeting of social safety net to ensure the most vulnerable populations are protected 91. The PA is continuing to improve its ability to effectively target and deliver social assistance, and is preparing relevant policy measures for the coming year. In 2010 the Social Safety Net Reform Project (SSNRP) and Special Hardship Case (SHC) cash assistance programs were merged into the Palestinian National Cash Transfer Program (PNCTP) using a single payment modality in the West Bank. The new system uses a revised Proxy Means Test (PMT) formula that established new cut-off points based on information from the 2007 Palestinian Expenditure and Consumption Survey (PECS). The new PMT formula requires that Ministry of Social Affairs (MOSA) revisit households in the database and update their data in the targeting database, while at the same time visiting new homes. Updating MOSA s database will enable better targeting of social assistance to the poorest households in Gaza. In 2010, over 50,000 households in the West Bank were visited for verification using the new PMT, and in the first three quarters of 2011, over 30,000 additional households were visited and entered into the database. Those above the absolute poverty line will be phased out of the system and replaced by households who fall below. Ultimately, only households below the absolute poverty line will be receiving cash transfers while those with higher incomes will receive assistance from other programs. The total number of households below the deep poverty line and receiving benefits amounts to 32,400. Efforts are underway to increase the number of household visits in Gaza so as to update the database there. 92. The push to increase electricity collection rates raises the risk that the most vulnerable households will not be able to afford electricity. However, the PA has committed to ensuring that all households will have access to a basic level of service. Currently, no households are disconnected for non-payment and households in refugee camps are still exempted from payment. PERC has now completed a new unified tariff structure where a basic amount of domestic consumption is billed only at cost. This first block of the new tariff structure was designed in consultation with the Ministry of Social Affair (MOSA), allowing for basic electricity consumption at a lower price. Some of the local governments have already established programs to assist the poor with electricity payments. Improve Domestic Revenue Collection Prior Action 5. The Customs Court of Appeal has been established in accordance with the provisions of the Customs Law to handle disputes related to customs duties and the value added tax on imported goods. (Status - Met) Prior Action 6. The new policy of unification of the value added tax and income tax services for large taxpayers has been implemented on a pilot basis for at least 200 companies for purposes of better cross-checking of records and improving the efficiency of audit. (Status - Met)

32 28 Prior Action 7. The guidelines on how to improve revenue generation have been issued by the Municipal Development and Lending Fund for amalgamated municipalities in West Bank and Gaza and the field testing of these guidelines started in at least four such municipalities. (Status - Met) Rationale 93. The NDP commits the government to increase public revenues through broadening the tax base and reforming tax administration. The NDP further targets specific reductions in the fiscal deficit, including through increasing revenues, and targets a proportionate reduction in reliance on donor aid. At 26 percent of GDP, tax revenues are already at a comparatively high level. However, analysis of the tax system indicates that both the administration and the incidence of tax compliance measures could be made more efficient. 94. In the interest of these objectives, the government has taken three new measures to improve the tax system. Analysis conducted by the MOF indicated that the customs service was missing customs and VAT revenues from unrecorded imports. In order to handle these cases, the government has established a customs court to handle disputes on payment of customs duty and VAT on imported goods. 95. Analysis conducted by the IMF concluded that the share of tax revenues coming from the large taxpayer unit was suboptimal and that administrative and enforcement efforts should focus on these large taxpayers. The audit report for FY 2008 identified problems in the reliability and completeness of tax information and the need to upgrade the tax systems to provide better accounting and reporting of tax revenue. A large taxpayer unit was set up in 2009 and in 2011 MOF announced and initiated the policy of unifying the VAT and income tax services for large taxpayers for the purpose of better cross-checking of records and improving the efficiency of audits. 96. Finally, at the local level, in order to support both local revenues and municipal amalgamation, the Municipal Development and Lending Fund (MDLF) has provided manuals with guidelines to amalgamated municipalities on how to improve revenue generation and has started field testing the guidelines in four municipalities. Amalgamation of municipalities is an important initiative of the PA, intended to raise efficiency in the provision of local services. 101 municipalities have populations of less than 25,000 and therefore do not have the economies of scale to provide required services. Ensuring sufficient revenues for the planned amalgamated services is a critical factor for success of this initiative. 97. After a new Financial Management System was rolled out to all line ministries in 2009, an integrated financial management system is now being installed at the local government level, with support from a Bank project. The project is being piloted in five local government units and will eventually roll out to 32 local governments in phase one. This system will be capable of interfacing with the central government system through the Ministry of Local Government. Policy 98. In the interest of increasing domestic capacity to raise revenues and administer tax systems efficiently, the authorities will undertake policies suggested by recent analysis of the tax system. They will establish a customs court for handling tax obligations on unrecorded imports and raise the focus of audits on large taxpayers. Further, in view of the critical role of municipalities in providing public services and the efficiencies sought from amalgamating local services, a manual providing guidelines for financing amalgamated services was produced and is now being piloted.

33 29 Expected results 99. As a result of these measures, gross domestic revenue collection is expected to reach 26.5 percent of GDP while the efficiency of tax administration and targeting of audits and compliance measures will increase. ii) Improving Public Financial Management Prior Action 8. The Ministry of Finance of the Palestinian Authority has started the practice of publishing of improved monthly fiscal reports that (i) separate investment projects funded by other donors from the projects initially financed by the Treasury; and (ii) include expenditure breakdown for major projects and major project categories. (Status - Met) Rationale 100. The PA publishes its annual budget on the website of the MOF in a manner accessible to the public. The PA continues to place Public Financial Management reforms among the top priority of the government reform agenda, and it remains one of the main pillars of the proposed PNDP DPG-IV. The NDP commits the government to continue to implement the program of public financial management reforms, with reforms expected in all elements of the budget cycle and capacity building of the public oversight institutions Producing annual budgets in a transparent manner is a key component of the reform program. The MOF developed a new budget classification for the preparation of the 2011 budget that is aligned with the economic classification based on the IMF s Government Financial Statistics Manual 2001 structure. 11 The PA has also made progress with introducing a program focus to the budget. This initiative started in 2009 with a programmatic presentation of the budget but in 2011 it was extended to the execution phase of the budget. The reform is still at an early stage and further improvements are expected in future budgets One area where the PA is attempting to improve transparency is in development expenditures. While the 2011 budget does not provide detailed financial information for all major development projects, increased disclosure is occurring in budget reports. The improvements in the financial management system and the chart of accounts have allowed the government to increase the transparency of development expenditures in monthly reports to separately identify tied donor projects from projects financed initially by the treasury; and including in fiscal reports the expenditures on major projects and major project categories. In the first quarterly report of 2011, the MOF provided increased details on development expenditures, but improved and regular reporting from donors of their development expenditures will be key to providing a comprehensive report. For example, it reported a breakdown of cash development expenditures for buildings, roads and maintenance, fixed assets and community projects, youth centers, parks and playing fields. Beginning with the reports for June 2011, these and further details appeared in the monthly reports and subsequently will be updated on a quarterly basis. In the coming year the MOF intends to further improve budget transparency with an initial focus on increasing the information on transfer expenditures. Policy 103. The MOF will use detailed data provided by the new financial management information system to publish details on development project expenditures in monthly reports on budget execution. The MOF further plans to increase the level of detail on development projects in preparation of the 2012 budget as a further step towards increasing budget transparency. 11 While GFSM 2001 is an accrual methodology the economic classification will be based on the cash accounting system used in West Bank and Gaza.

34 30 Expected results 104. The clarity of budget expenditures and composition of fiscal balances will be improved. Palestinians will have better information on the use of budget resources, and donors also will receive information that is critical to their continued support of WB&G. Upgrade institutions to support PFM reforms Prior Action 9. A new Procurement Law has been adopted by the PA which includes provisions for setting up the Higher Council for Public Procurement Policies. (Status - Met) Rationale 105. As was explicitly stated in the NDP, reforming and strengthening the PA s public procurement system remains to be a key policy commitment. Public Procurement in West Bank and Gaza accounts for around 10% of the GDP. The public procurement system, which plays a cross-cutting role in achieving good governance and sustainable development for the PA, has been regulated by two separate laws: The first law governs procurement of goods and services, while the second one regulates procurement of construction. The Country Procurement Assessment Report (CPAR), prepared by the Bank in 2004, concluded that the existing procurement law and regulations were fragmented and incomplete and their implementation by various PA units inconsistent. Furthermore, the CPAR highlighted other shortcomings in the institutional setup, as well as in the capacity of the civil service procurement workforce, including: (i) lack of a single agency or central authority to lay down uniform and consistent policy, rules and procedures in public procurement, and ensure efficient oversight and clear and enforceable sanctions and enforcement mechanisms; (ii) absence of specific rules governing the procurement of consulting services; (iii) absence of rules and procedures providing access to the proper authority for bidders who want to lodge complaints, request reviews of procurement decisions and seek relief, at any point during the procurement process; (iv) lack of rules and procedures on dispute resolutions; and (v) lack of specific provisions on fraud and corruption in public procurement in WB&G. The CPAR provided recommendations to assist the PA develop its capacity to plan, manage and monitor public procurement effectively; improve accountability, integrity, and transparency; prevent corruption; harmonize the national procurement law and regulations with internationally accepted principles and practices; and increase opportunities for local suppliers, contractors and consultants to grow and prosper In response to the CPAR recommendations, the PA launched, with Bank support, the reform of the public procurement system by the drafting of the new public procurement law and detailed implementing regulations starting in early However, the changes in the Government since 2006 and the unstable political situation have delayed the enactment of the law and regulations and prevented successful completion of the other reform activities. In early 2010, the PA made another effort to proceed with the revision of the procurement law, and an inter-ministerial group of procurement experts representing major ministries of the PA was mobilized to revise the draft law. Analysis conducted by the Bank experts of the final draft of the law, prepared in May 2011, concluded that it reflects a balance between the current means of the country and the internationally recognized good practices as they were in particular stated in the 1994 version of the UNCITRAL Model Law on Procurement. 12 It lays down an acceptable institutional and organizational set-up for public procurement; provides comprehensive provisions on procedural matters and sets out provisions on transparency and accountability. The new law establishes a procurement policy entity, the Higher Council for Public Procurement Policies that will assume an oversight role of all public procurement activity and ensure compliance with public procurement law and regulations. This entity would also be responsible for the development of procurement systems, 12 United Nations Commission On International Trade Law, Model Law on Procurement (1994)

35 31 procurement documentation, guidelines and manuals, training and public awareness campaigns. The new law also establishes a complaint mechanism and a dispute review body. To ensure transparency and efficiency, the law provides for routine dissemination of information on public procurement, including advance information on upcoming procurement, advertising specific procurement opportunities, and the results of bidding processes The synergies between public procurement reform, which is already underway, and other targets of the NDP cannot be overstated. The new public procurement law creates new responsibilities and sanctions for civil servants involved in procurement, which will contribute to improved public accountability. By mandating the publication on a website of all documentation, legal text and data available, it promotes transparency and access to information. It contributes to the improvement of the institutional framework by creating new institutions, particularly the independent Higher Council for Public Procurement Policies. Moreover, a new legal framework for procurement, and anti-corruption and conflict of interest measures which are part of the new law will increase transparency and confidence in the system for private sector and investors. Policy 108. In July 2011 the PA adopted the new procurement law and is now setting up the Higher Council for Public Procurement Policies. Expected results 109. Once implemented, the new law will form the basis for a more effective and transparent public procurement function. However, the enactment of a good procurement law is only a first step in the development of a sound procurement system; other critical components of the procurement system need to be put into place. The PA will need to proceed with further steps, including enacting the supporting regulations for the new law, establishing an independent public procurement policy body, implementing national standard bidding documents -- which have been recently initiated, instituting a training program of the procurement workforce, and taking additional measures necessary to make the law effective. Strengthen PFM auditing, reporting Prior Action 10. The Palestinian Authority s financial statements for 2009 fiscal year have been audited by the Palestinian Authority s State Audit and Administrative Control Bureau (SAACB) and financial statements for 2010 fiscal year has been prepared and submitted for the Palestinian Authority s State Audit Administrative Control Bureau for an audit. (Status - met) Rationale 110. Auditing and reporting remains an important feature in the PA s plan to strengthen accountability. Benefiting from the new financial management system the MOF submitted the FY 2008 financial statements for audit after a very difficult process to establish the opening account Administrative Auditor- General issued his audit report on the FY 2008 financial statements in September 2010 in which he identified a number of problems with the accounts but no audit opinion was provided on whether the financial statements present fairly the financial condition of the government The FY 2009 audit has moved at a faster pace due to the experience gained from conducting the FY 2008 audit. A Bank review found that the note disclosures for FY 2009 were very comprehensive and complied with the IPSAS cash basis standard. The 2009 financial statements were presented to the SAACB in January The SAACB has completed the audit of the FY 2009 financial statements and, following the exchange of comments, has sent the final audit report to the Ministry of Finance. The IPSAS cash basis

36 32 was used for drafting the 2009 financial statements and will also be used for the 2010 financial statements. The 2010 financial statements have been drafted and audit of those statements has begun. Policy 112. The MOF plans to maintain this pace of completing financial statements within six to eight months after the end of the fiscal year and completing the audit within the following year, even though these time periods are less than the current legal requirements. Expected results 113. A regular pace of central level audits should increase public accountability regarding the budget. Adherence to international standards will improve communication and confidence in the statements for both Palestinians and development partners. Box 3: Good Practice Principles for Conditionality Principle 1: Reinforce ownership As with the PRDP, the NDP was developed through wide consultations both within the Caretaker Government and with elements of civil society and is therefore fully owned by the PA. The policy actions supported by the operation focus on key measures that the Caretaker Government believes are necessary and politically possible for the success of the NDP. Principle 2: Agree up front with the government and other financial partners on a coordinated and accountability framework The policy matrix attached to this document was discussed and coordinated between the PA, the IMF, the Bank and other key stakeholders. The matrix reflects the Government s priorities, progress made in the last year and lesson learned from the DPGs I-III. Progress will continue to be monitored through quarterly reports detailing progress that the IMF and the Bank will review. Principle 3: Customize the accountability framework and modalities of Bank support to country circumstances The reform program supported by the DPG IV focuses on strengthening the fiscal stance of the PA. This will require continued support from the donor community and political commitment on the part of the authorities. The Bank is supporting these efforts by maintaining the PRDP-TF and through the proposed PNDP DPG IV. Principle 4: Choose only actions that are critical for achieving results as conditions for disbursement The NDP is wide ranging and covers many sectors. However, the PA has asked the Bank to maintain its focus on two critical areas: 1) strengthening the PA s fiscal position and 2) improving public financial management. This focus allows the Bank s efforts to be more effective and to determine specific conditions that are both critical to the success and can be effectively monitored. Principle 5: Conduct transparent progress reviews conducive to predictable and performance-based financial support The PA has committed to providing quarterly progress reviews that will be reviewed by the Bank in consultation with the IMF. Tranche releases from the PRDP-TF will be based upon these reviews. However, in exceptional circumstances when the PA requests it and the Bank agrees, emergency release may be made. Other donor agencies will also use the quarterly reviews to inform their own funding decisions. An important component of the NDP is improving the PA s budget process and establishing a monitoring and evaluation program linked to the budget. This will allow predictable and performance based financial support.

37 33 VI. OPERATION IMPLEMENTATION A. POVERTY AND SOCIAL IMPACTS 114. A recent poverty assessment report 13 by the World Bank concluded that one of the strongest drivers of poverty in the WB&G is labor market outcomes, with the unemployed facing the highest risk of poverty. Furthermore, the report states that public sector employment is increasingly playing the role of a safety net, especially in Gaza. The PA recognizes these risks and drivers of poverty, and as a part of the NDP , it set a target of lowering poverty incidence from its current level of 22 percent to 13 percent by The World Bank, through DPG IV, will support the two main pillars of the PA s National Development Plan: First, while the operation does not specifically target the private sector, the program should contribute to improving the environment for private sector development. A new and comprehensive procurement law will result in a more open and equal distribution of business opportunities, allowing for more small and medium firms to compete with the more established private sector actors. Ongoing banking sector reforms with the goal of lowering transaction costs and raising lending by local banks are expected to promote local investment. Second, the World Bank is working closely with the Ministry of Social Affairs (MOSA) to improve the targeting and efficiency of social assistance programs, including integrating the findings of the recent poverty analysis. Significant progress has been made in developing a transparent targeting mechanism as part of MOSA s Cash Transfer Program (CTP) More recently, discussions by the World Bank energy team with the MOSA resulted in the Ministry agreeing to adjust its social transfers targeting formula, to include factors such as energy consumption expenses as determinant for CTP eligibility. This will help direct aid to the most vulnerable households. A new electricity tariff has been developed by PERC, taking into account the potential harms of collection rates hike on vulnerable households. In cooperation with MOSA, PERC set the first block of this new tariff to be billed at cost, thus providing poor households a basic amount of electricity consumption at a lower price. To improve PERC s regulatory capacity, new performance indicators are being instituted in evaluating West Bank electricity distributors. These measures take into account both technical and financial performance indicators and are designed to ensure the efficient provision of energy to customers Moreover, DPG IV will facilitate a series of public financial management reforms aiming to raise effectiveness of public resources. The recent poverty assessment, in combination with increased transparency of development expenditures, monthly reporting of tied donor projects, and finalizing the 2009 audit and 2010 accounts by international standards and good practices will inevitably improve the efficiency and effectiveness of public resources in the delivery of development services. B. ENVIRONMENTAL ASPECTS 118. The PNDP DPG IV operation will not have significant effects on the country's environment, forests and other natural resources. The environmental and natural resource implications are driven to a large extent by the nature of an operation. In the proposed operation, none of the prior actions as listed in the policy matrix will have environmental impacts or risks. C. IMPLEMENTATION, MONITORING AND EVALUATION 119. As discussed above, the PA has asked the Bank to monitor progress on the PRDP and the Bank will continue to do so based on the reforms described in the attached policy matrix. The PA has been producing quarterly reports, which the Bank reviews in consultation with the IMF. The Bank focuses on progress on structural reforms while the IMF provides detailed input on fiscal and PFM issues. In the previous Reform 13 Coping with Conflict? Poverty and Inclusion in the West Bank and Gaza,

38 34 Trust Fund, monitoring proved to be a major challenge. Many of the benchmarks had been developed without input from the PA line ministries and the Bank team was located in Washington. However, in PRDP DPG I - III, the policy matrix was taken directly from the PRDP, which was developed after wide consultation throughout the PA and among other stake holders. The policy matrix reflected what all parties not only thought important but also achievable and what could be monitored. The PNDP DPG IV continues this approach. The matrix is drawn from the NDP and reflects lessons learned from the last operation The Bank team managing the PNDP DPG IV is located in WB&G and is thus able to have daily contact with their PA counterparts. The Bank team continues to include a Governance Advisor who is a PFM expert to the Jerusalem office to work alongside the Country Economist monitoring the PNDP DPG IV. The task team leaders for the social safety net reform and municipal finance assistance are also resident in the WB&G office. The main ministries responsible for implementing the reforms supported by the PNDP DPG IV are the MOF, PPA, MOSA and Palestinian Energy and National Resources Authority (PENRA) with which the Bank has developed a strong relationship. The IMF has recently appointed a resident advisor to the MOF s macro-fiscal unit and the Bank team works closely with him and the rest of the IMF mission to both provide assistance to the MOF and monitor progress on budget related and PFM issues The MOSA must report on its achievements in building the social safety net as a part of the SSNRP and the Bank team managing that project closely monitors these activities. For the collection of utility fees, data must be collected from the regional distribution companies and from PENRA. The Bank s power team works with these parties as part of the Electric Utility Management Project (EUMP) and will thus be able to collect the required data and assess progress. The combination of close cooperation with the IMF and other donors, the leveraging of other projects and careful consultation in the preparatory phase PA eliminated many of the difficulties monitoring progress that are encountered in the previous budget operation. This will be continued for the PNDP DPG IV. D. FIDUCIARY ASPECTS Public Financial Management System 122. The PA continues to have Public Financial Management (PFM) reforms at the top of the government s reform agenda. There has been considerable progress with several areas of strength, although there remain weaker areas where the reforms are underway and need to be further developed and enhanced. PFM reforms are pillars of the proposed DPG series. The DPG sets out to provide a development policy grant to the PA which will be executed through the Government s PFM systems According to the Bank, IMF, and other donors reports on PFM, including the fiduciary report on PFM assessment conducted during the appraisal of this operation, the Palestinian PFM system is deemed to be adequate insofar as the Bank s criteria and standards for approval of development policy operations are concerned. The 2004 CFAA had concluded that the fiduciary risk level in the Palestinian PFM system was significant due to weaknesses in the PFM systems. Recent IMF and Bank reports state that the PA s PFM system has improved considerably since then Notable improvements in PFM include the following: a. Launch of the new financial management information system that will help consolidate budget implementation processes, strengthen payment controls and improve fiscal reporting. This system has been rolled out to line ministries. b. Transformation of line ministry and agency bank accounts into zero-balance accounts.

39 35 c. All PA revenues are now paid into the CTA. d. An orderly system of budgetary appropriation is now in force. e. MOF is exercising firm control over budget expenditures, has imposed strict limits on non-wage expenditures and makes adjustments as needed, with funds often being released by MOF on a daily basis. f. Since the MOF established its financial controllers in each ministry, the controllers have gained considerable experience and credibility within the line ministries. g. MOF established a central internal audit function, which initially compensated for the weakness in external audit. With the creation of the State Audit and Administrative Control Bureau (SAACB) in 2007, the internal audit department s role has evolved in line with international standards and is now in the process of being decentralized from MOF to the line ministries. h. The SAACB is also receiving substantial technical support to develop its capacity as an external audit agency. i. Control over the civil service payroll has improved significantly. MOF has taken charge of the central payroll system from the General Personnel Council (GPC, the PA s central personnel agency), and is now in a position to monitor new recruitment and pay all public sector salaries, and thereby to contain civil service hiring. j. Since 2005 the salaries of the PA s civil and security servants have been paid through direct deposit into personal employee bank accounts. k. The establishment of the Palestine Investment Fund (PIF) has brought all PA equity holdings, including virtually all state-owned enterprises (SOEs), within a centralized and commercially-oriented management framework. PIF has annually been publishing its annual report and audited financial statements (for 2003 and after), and these are available on its website However, more remains to be done to further consolidate progress and address the challenges facing the PFM. As part of the NDP process a PFM strategy was developed by the PA. Key elements of the strategy with respect to fiduciary control include: Further developing cash management by strengthening cash forecasting and improving the link with the commitment control system. Building capacity for financial management at both MOF and the line ministries. The development at line ministries is particularly important given the objective of devolving more financial management responsibility from MOF. Further enhancing the internal audit function and continuing the decentralization of the function to line ministries Strengthening accounting and reporting by fully adopting international public sector accountings standards and increasing budget transparency. Continuing to build the capacity of the SAACB audit capacity and legislative framework. Ensure better integration of donor programming into the annual development budget In light of the above, the fiduciary risks related to this operation are considered to be significant. In view of the fact that the fiduciary risk is assessed as significant and that reform is ongoing, the Bank will require an audit of deposit account, which is consistent with the standard requirements for such level of fiduciary risks.

40 36 E. DISBURSEMENT AND AUDITING 127. The Bank would sign a Grant Agreement with the PLO for the benefit of the PA, which would include the prior actions listed in the attached policy matrix for tranche release The PNDP DPG IV is a single tranche operation. The amount of the PNDP DPG IV will be disbursed in one tranche comprising the full amount of the grant, against satisfactory implementation of the development policy program Flow of Funds. Upon effectiveness of the grant and provided the World Bank is satisfied with the program being carried out by the Recipient and with the appropriateness of the Recipient s macroeconomic policy framework, the World Bank would disburse funds into a US Dollar Deposit Account maintained under the Central Treasury Account (CTA) of the MOF. As the Palestinian Monetary Authority does not yet function as a full-fledged central bank, the Deposit Account would be held with a commercial bank (i.e. Bank of Palestine), as is currently the case with the CTA. Within one week of the receipt of funds in the deposit account the MOF will convert the US$ amount into New Israeli Shekels (NIS) at the going exchange rate and transfer them to the MOF treasury account. The PA will provide confirmation to the World Bank that an amount equivalent to the grant proceeds has been credited to the CTA and the exchange rate applied and the date of the transfer. This confirmation will be provided within 30 days of the funds being received in their account. If the proceeds of the grant are used for ineligible purposes as defined in the Grant Agreement, the World Bank will require the Recipient to refund an amount equal to the amount of said payment to the World Bank. World Bank DPG IV Diagram 1: Flow of funds arrangements for PNDP DPG IV MOF Deposit Account for DPG IV Foreign Currency (US$) MOF Treasury Account NIS Account Budget Financing Activities Reform Plan Auditing 130. As discussed before, the concluded fiduciary risk level in the Palestinian PFM system is considered significant. Accordingly, beyond the auditing arrangements for the PRDP-TF already described (see footnote 10 on page 22), the PA will hire an independent external auditor acceptable to the Bank to perform an audit of the PNDP DPG IV Deposit Account at the MOF. As was the practice with previous DPGs, this audit will be conducted in accordance with terms of reference acceptable to the Bank. The auditor will be selected from a short list of qualified auditors established by MOF and acceptable to the Bank. When the audit is completed, it will be reviewed by the Government and then shared with the Bank. The audit will comply with international standards and be completed and submitted to the Bank within six months from the release of the single tranche payment. The audit will be financed by the PA. The audit would cover and ensure the following: Validate and certify the transfer and deposit transactions relating to the grant and confirmed by PA MOF mentioned above; Verify the extent to which the Bank s requirements under the grant agreement are being met, and whether the PA s procedures are adequate to achieve this result;

41 37 No funds are kept in or paid into the relevant Deposit Account other than those disbursed by the Bank for this particular operation; All withdrawals from the relevant Deposit Account for payments are for legitimate budgetary purposes, following procedures established by the PA's MOF; The MOF follows adequate disbursement procedures as per PA and governmental standards including accuracy of exchange rate conversion. F. RISKS AND RISK MITIGATION The NDP s success depends on parallel actions by the PA, GOI and the donor community The NDP continues the path set out in the PRDP towards greater fiscal stability, higher investment and domestic revenues and a lower share of contribution from external support by While the PA has charted a course toward lesser dependence on external aid and is actively undertaking the relevant reforms, it will take many years for the PA to achieve fiscal sustainability and that will only be possible if there is a political settlement that allows the economy to flourish. To maintain the support it needs, the PA must make rapid and steady progress on the announced reforms The highly volatile political situation could deteriorate and violence could resume, with the consequence of stalled reforms. The two instances of withheld clearance revenues in 2011 illustrate one type of risk from the political situation. Political uncertainty has led to a slowdown in the removal of restrictions on movement in 2011, removals that were so vital in fostering new economic growth in The uncertainty may also lead to delays in donors fulfilling commitments, which could hamper government activities and increase domestic banks exposure to short term public debt. In addition, depending upon the nature of any interim government, some donors could reduce funding, which would make it difficult for the PA to continue implementing its ambitious reform plan. However, reconciliation might also attract donations from sources that have been less willing to give due to the split The announcement of the reconciliation agreement in early May has introduced new uncertainties. The current PA administration retains its political authority during the reconciliation process, which process is expected to eventually generate a technocratic cabinet of political independents until elections can be held. This government will govern with the same legal authority as the current Caretaker Government. The reopening of the Palestinian Legislative Council (PLC) after elections will require that all legislation that was passed by presidential decree in the previous years, be revisited and passed by the PLC. This could lead to a slowdown in passing new legislation and possibly the undoing of some previous legislation. However, given the wide spread support for the current reform process it is not expected that there will be major changes to the NDP that this operation supports The prospect of reconciliation may also raise questions about maintaining transparency and progress in public financial management reforms. The PA continues to increase the transparency and detail in its budget reporting in a number of ways. For example, the PA has placed some categories of public expenditures into projects, such as putting social safety net payments into the Social Safety Net Reform Project. This will ensure the full safeguards of donor-funded projects are applied to these transfers and help attract donor project funding for recurrent public expenditures within the framework of a project. The proposed PNDP DPG-IV also supports a measure that would provide further reporting details on all major investment projects The PA is striving to improve its fiscal position, but for the foreseeable future they will remain dependent upon high levels of aid. Specifically, it will require large amounts of untied budget support that will enable it to pay wages and the other basic operational costs. Without such support the PA will not be

42 38 able to deliver basic services let alone achieve the popular support required to undertake the most politically difficult actions The issues of movement and access and economic restrictions are fundamentally political issues that the Bank has little influence over. However, the Bank has taken a number of steps to mitigate the risks associated with the donors not providing enough timely support or the PA not following through with its reform plan. These actions include: 137. The PRDP-TF provides donors a convenient mechanism to provide such untied budget support where they can be assured that their funds will be closely monitored. The PNDP DPG IV, by risking the Bank s own money, signals the Bank s continued trust in the PA s financial controls and will also increase donor willingness to participate; 138. The quarterly monitoring by the Bank in consultation with the IMF will quickly detect if the reforms are off track or if funds are being improperly allocated. This frequent monitoring gives donors comfort to increase their disbursement and use the CTA; 139. The Bank has established a website to keep donors, NGOs and the public apprised of reform progress Finally, the Bank and the IMF are providing significant technical assistance to help the PA implement its planned reforms. The IMF is active in the PFM areas while the Bank is providing assistance in a wide variety of areas including: PFM, power sector, payments system, municipal finance, public pensions and social sectors, and continues to monitor developments in the telecoms sector. As mentioned above, the Bank maintains its field-based staff to improve its monitoring and delivery of assistance WB&G is an unstable and high risk environment. But this country risk affects all projects in the portfolio and is not unique to the proposed PNDP DPG IV. Because the PNDP DPG IV provides untied budget support, the Bank engages in quarterly monitoring and continuous policy dialogue between the PA, the Bank and the IMF. The success of the previous DPGs and the continued development of the PA s internal capabilities indicate that these risks are declining. Despite the risks associated with this project, it is a high value operation that the Bank should support. The Caretaker Government has demonstrated its deep commitment to reform and has been able to galvanize international support. The GOI has reduced some of the movement and access constraints and is willing to do more within the parameters of their security requirements. These factors create an important opportunity for the Bank to make progress on its agenda in WB&G. Continuing support of the Caretaker Government and its reform program will help the PA to strengthen institutions that will be needed by a future Palestinian State. Any withdrawal of budget support would send a strong negative signal to other donors and could imperil the years of successful reforms carried out by the PA.

43 ANNEX 1: Letter of Development Policy 39

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49 45 ANNEX 2: Operation Policy Matrix Objectives Prior Actions By July 2011 West Bank & Gaza PNDP DPG IV Policy Matrix Status Results in Next 12 Planned Actions in Next Months 12 Months ( ) ( ) Medium Term Objectives (PNDP Goals) I. STRENGTHEN THE PA FISCAL POSITION I.1 Strengthen the macro/fiscal framework Prior Action 1. A separate macro-fiscal unit with a composition and terms of reference satisfactory to the Bank has been established within the Ministry of Finance of the Palestinian Authority. (Status - Met). Met Recurrent balance on a commitment basis reduced to 13 percent of GDP (baseline=14.1% in 2010) Maintain sound macroeconomic and fiscal policies aimed at growing the economy and reducing the budget deficit, including measures to contain the wage bill and public pension liabilities Prior Action 2. A new payroll system has been introduced in the Ministry of Finance and the Ministry of Detainees and is functioning in a satisfactory manner. (Status -Met) Met Public sector wage bill is less than 20% of GDP (baseline=20.0% in 2010) PA implements integrated payroll and human resource system Position structures are introduced for each line ministry to improve establishment control. Modernize human resources management policies, practices and systems Prior Action 3. The PPA has established and strictly followed the practice that all new categories of workers joining the public pension system pursuant to agreements between the PPA and their employers are allowed to retroactively pay pension contributions for up to five years, or for the entire term of their service under the current employer, whichever is less. (Status-Met) Met Increase the number of years for calculating pensions from 3 to 5 years Set up an integrated financial management information system for pensions The PA is implementing a strategy including the necessary parametric reforms to gradually put the PA pension schemes on a path towards financial sustainability

50 46 I.2 Reduce net lending by improving collection by electricity distribution companies Prior Action 4. Financial and technical performance targets satisfactory to the Bank have been set by the Palestinian Electricity Regulation Committee (PERC) for West Bank electricity distribution companies. (Status - Met) Met Collection of the electricity companies is increased and network losses are reduced according to the agreed performance indicators 85% of electricity services of municipalities and villages in the North are operated by NEDCO 75% of electricity services of municipalities in the South are operated by SELCO Net lending is reduced below $200 million (baseline=$237million in 2010) The PA contribution to the joint cash transfer program is institutionalized to promote its sustainability PERC issues a new electricity tariff utility action plans updated for meeting new performance indicators cash transfer programs accounts for recipients affordability of electricity Electricity collection rates are improved and losses reduced according to the agreed performance indicators All electricity distribution in West Bank done on a commercial basis and local governments no longer accumulating arrears to PA or electricity I.3 Improve targeting of social safety net to increase efficiency and ensure the most vulnerable populations are protected [Results are expected from ongoing reforms and dialogue as new measures are being prepared.] MOSA implements the exit strategy by removing from CTP 9,000 noneligible households Transfers that are outside the safety net regime are reduced A fully functioning targeting database with at least 70,000 verified households guides all assistance programs no matter what the source of funding The PA institutes a Social Protection Reform and Integration Program that coordinates all social protection initiatives and ensures uniform payment modalities and amounts.

51 47 I.4 Improve domestic revenue collection Prior Action 5. The Customs Court of Appeal has been established in accordance with the provisions of the Customs Law to handle disputes related to customs duties and the value added tax on imported goods. (Status - Met) Met PA gross domestic revenue collection rises to 24 percent of GDP (baseline=23.7 percent in 2010) Increase practice of riskbased auditing Increase public revenues, broaden the tax base and strengthen tax administration Prior Action 6. The new policy of unification of the value added tax and income tax services for large taxpayers has been implemented on a pilot basis for at least 200 companies for purposes of better crosschecking of records and improving the efficiency of audit. (Status - Met) Met Complete unification of VAT and income tax services for large taxpayers Prior Action 7. The guidelines on how to improve revenue generation have been issued by the Municipal Development and Lending Fund for amalgamated municipalities in West Bank and Gaza and the field testing of these guidelines started in at least four such municipalities. (Status - Met) Met Establish a fiscal framework for amalgamated municipalities PA municipalities operating on a sustainable financial basis without diverting electricity revenues

52 48 II. INCREASE GOVERNMENT TRANSPARENCY AND ACCOUNTABILITY THROUGH IMPROVED PUBLIC FINANCIAL MANAGEMENT II.1 Improve efficiency and transparency of the budget process Prior Action 8. The Ministry of Finance of the Palestinian Authority has started the practice of publishing of improved monthly fiscal reports that (i) separate investment projects funded by other donors from the projects initially financed by the Treasury; and (ii) include expenditure breakdown for major projects and major project categories. (Status - Met) Met PA budget presented in a transparent manner with greater clarity of development and transfer spending, and accounts are comparable on an international basis Fiscal reports are further enhanced with a particular focus on increasing the transparency of transfer expenditures. Establish a government wide system that will allow annual budgets to be developed on time in a transparent manner and with a performance focus that encourages an effective allocation of resources II.2 Establish upgraded institutional and regulatory procedures to support PFM reforms Prior Action 9. A new Procurement Law has been adopted by the PA which includes provisions for setting up the Higher Council for Public Procurement Policies. (Status - Met) Met Institutions for oversight of public procurement are strengthened through new and better-trained institutions. Finalize and enact Supporting / Implementing regulations to the Public Procurement Law Initiate training of staff in line ministries on implementation of the new procurement regulations Public procurement conforms with international good practice II.3 Strengthen PFM infrastructure, including, cash management, reporting, and auditing functions Prior Action 10. The Palestinian Authority s financial statements for 2009 fiscal year have been audited by the Palestinian Authority s State Audit and Administrative Control Bureau (SAACB) and financial statements for 2010 fiscal year has been prepared and submitted for the Palestinian Authority s State Audit Administrative Control Bureau for an audit. (Status - met) Met Audited accounts are made publicly available and easily accessible according to the time frame stipulated in law Implement capacity building plan for the SAACB audit staff based on a comprehensive needs assessment (supported by the European Union (EU) IPSAS2 compliant 2010 financial statements prepared and audited by December 2011 Internal audit function is instituted in all line ministries A strong Central Treasury Account continues to operate with full implementation of the Single Treasury Account concept. Have a functioning cash planning and management system that ensures that cash is available to meet expenditure needs and minimizes debt servicing costs PA prepares financial accounts in line with international standards in a timely manner PA has an effective and independent external audit function consistent with international good practice

53 49 IFMIS (Free Balance) system is fully functional at all municipalities. PA has an effective and modern internal audit function in the line ministries consistent with international good practice 2 International Public Sector Accounting Standards

54 50 ANNEX 3: West Bank & Gaza PRDP DPG I, II and III Prior Actions Objectives Prior Actions DPG I Prior Actions DPG II Prior Actions DPG III PNDP DPG IV I. STRENGTHEN THE PA FISCAL POSITION I.1 Control Public Sector Wage Bill Initiate civil service reforms to bring public sector payroll to levels compatible with the fiscal targets of the PRDP for the period A control system through which the Ministry of Finance ensures that public sector hiring is in line with the Palestinian Authority s budget is being implemented Budget law includes provisions to ensure that all promotions in the PA are supported by adequate budget allocations Council of Ministers adopted a plan for pension reform that seeks to control growth of pension liabilities Council of Ministers issued decisions to ensure that PA employees may not draw pensions until they reach statutory retirement age and have worked the minimum number of years to receive benefits as required by law Prior Action 1. A separate macrofiscal unit with a composition and terms of reference satisfactory to the Bank has been established within the Ministry of Finance of the Palestinian Authority. (Status - Met) Prior Action 2. A new payroll system has been introduced in the Ministry of Finance and the Ministry of Detainees and is functioning in a satisfactory manner. (Status -Met) Prior Action 3. The PPA has established and strictly followed the practice that all new categories of workers joining the public pension system pursuant to agreements between the PPA and their employers are allowed to retroactively pay pension contributions for up to five years, or for the entire term of their service under the current employer, whichever is less. (Status-Met) I.2a Reduce net lending by increasing electricity collections an transferring all electricity supply Initiate a program to gradually reduce net lending associated with the cost of provision of electricity services Establishment of the Northern Electric Distribution Company A new electricity law was enacted on 23 April, 2009, establishing, inter alia, the Palestinian Energy and Regulatory Commission (PERC) as the regulatory authority for the power sector and providing the Electricity distribution in the municipality of Nablus transferred to NEDCO and NEDCO is effectively operating Prior Action 4. Financial and technical performance targets satisfactory to the Bank have been set by the Palestinian Electricity Regulation Committee (PERC) for West Bank electricity distribution companies. (Status - Met)

55 51 Objectives Prior Actions DPG I Prior Actions DPG II Prior Actions DPG III PNDP DPG IV and distribution to distribution companies established in accordance with the Companies Law I.2b Improve targeting of social safety net to increase efficiency and ensure the most vulnerable populations are protected I.3 Improve domestic revenue collection Verification of 4,500 households in the targeting database for social assistance. Initiation by the Ministry of Social Affairs of regular assistance payments to 2,100 households verified in the targeting database through the new social safety net pilot program Palestinian Energy and Natural Resources Authority (PENRA), with the authority to set tariffs and to license electricity distributors The Council of Ministers has issued Resolution number 51/98/12/m.w/s.f of 2009 which provides support on a declining schedule to local governments distributing electricity that demonstrate that they have paid the Israeli Electric Company (IEC) in full The Council of Ministers has issued Resolution number 08/96/12/m.w/s.f of 2009, which integrates all cash assistance programs into the Ministry of Social Affairs SSNRP and SHC cash assistance programs merged into the PNCTP that is operating using a single payment modality in the West Bank In 2009, the PA expanded the number of municipalities in which it collects property tax property tax from 25 to 34 municipalities Prior Action 5. The Customs Court of Appeal has been established in accordance with the provisions of the Customs Law to handle disputes related to customs duties and the value added tax on imported goods. (Status - Met) Prior Action 6. The new policy of unification of the value added tax and income tax services for large taxpayers has been implemented on a pilot basis for at least 200 companies for purposes of better cross-checking of records and improving the efficiency of audit.

56 52 Objectives Prior Actions DPG I Prior Actions DPG II Prior Actions DPG III PNDP DPG IV (Status - Met) Prior Action 7. The guidelines on how to improve revenue generation have been issued by the Municipal Development and Lending Fund for amalgamated municipalities in West Bank and Gaza and the field testing of these guidelines started in at least four such municipalities. (Status - Met) II. INCREASE GOVERNMENT TRANSPARENCY AND ACCOUNTABILITY THROUGH IMPROVED PUBLIC FINANCIAL MANAGEMENT II.1 Improve efficiency and transparency of the budget preparation process Approval of the 2008 budget by the cabinet of the PA and commencement of publication of monthly expenditure and revenue statements by the MOF The 2009 annual budget law has been approved which, inter alia, introduces the use of a program structure to make a combined presentation of the recurrent and development budgets for each line ministry Developed a new economic and administrative budget classification for use in the preparation of the 2011 budget aligned with the economic classification based on the GFSM 2001 structure 14 Prior Action 8. The Ministry of Finance of the Palestinian Authority has started the practice of publishing of improved monthly fiscal reports that (i) separate investment projects funded by other donors from the projects initially financed by the Treasury; and (ii) include expenditure breakdown for major projects and major project categories. (Status - Met) II.2 Establish upgraded institutional and regulatory procedures to support PFM reforms Passing of amendments to the Basic Law (Law No. 7 of 1998 on Budget and Financial Matters) establishing an Accountant General Department (General Accounting Department) in the Ministry of Finance The Council of Ministers has issued Resolution number 51/103/12/m.w/s.f of 2009, which amends the financial regulation 43 for the year 2005, to provide the regulatory backing for the new computerized accounting system All line ministries connected to the new computerized financial management system Prior Action 9. A new Procurement Law has been adopted by the PA which includes provisions for setting up the Higher Council for Public Procurement Policies. (Status - Met) 14 While GFSM 2001 is an accrual methodology the economic classification will be based on the cash accounting system used in West Bank and Gaza.

57 53 Launch of a new computerized accounting system in the MOF II.3 Strengthen PFM infrastructure and improve auditing functions The PA has prepared and submitted to the Bank an annual cash plan to guide budget execution in 2009that incorporates actual monthly cash flows and updated forecasts New module for commitment control introduced into the MOF s computerized accounting system to provide more control over capital expenditures 2008 PA Financial statements prepared and sent for audit to the PA s external auditors Prior Action 10. The Palestinian Authority s financial statements for 2009 fiscal year have been audited by the Palestinian Authority s State Audit and Administrative Control Bureau (SAACB) and financial statements for 2010 fiscal year has been prepared and submitted for the Palestinian Authority s State Audit Administrative Control Bureau for an audit. (Status - met) II.4 Increase financial accountability through improved and more transparent municipal accounts Establishment of a Unified Chart of Accounts for municipalities. Finalization of a budget manual and fixed assets registration manual that are being used by municipalities in the West Bank The board of directors of the MDLF has adopted clear criteria for performance based transfers of monetary grants to municipalities. A management letter has been submitted by the MDLF, confirming that the MDLF has completed the pilot phase of the new financial management information system for small, medium and large municipalities in eight municipalities 2 International Public Sector Accounting Standards

58 54 ANNEX 4: IMF Relations Note West Bank & Gaza Assessment Letter to the World Bank September 1, 2011 Contact person: Mr. Oussama Kanaan, (202) , BB (202) Economic Conditions and Outlook The Palestinian economy is facing increased risks, with a significant slowdown of growth in the West Bank. The West Bank s strong performance from 2008 to 2010 has been enabled by sound economic management and reforms supported by donor aid, and the easing of Israeli internal barriers. However, the West Bank s real GDP growth declined from 8 percent in 2010 to 4 percent in the first half of 2011, with an unemployment rate unchanged at 16 percent since mid The slowdown is due to continued fiscal retrenchment, declining aid from regional donors and a consequent liquidity crisis, as well as no significant easing of Israeli restrictions over the past year. Gaza s output continued to recover from a highly repressed level following the easing of some import controls in mid-2010, with real GDP estimated to have risen by 28 percent in the first half of 2011 and unemployment declining to 28 percent in the first half of 2011 from 37 percent last year. Gaza s recovery is also bound to wane without an easing of import controls on private investment inputs. The unemployment rate has declined very slowly in the West Bank, and remains high in Gaza, especially among the young (below the age of 30). In the West Bank, unemployment declined sluggishly from 19 percent in 2008 to 16 percent in the first half of 2011 which is about the same level as in the first half of Similarly, youth unemployment in the West Bank remains high at about 26 percent in the first half of 2011, about the same level as the same period last year. In Gaza, unemployment remains very high, although it declined in the first half of 2011 from 37 percent to 28 percent reflecting the marked recovery, and from 51 percent 43 percent for the young. Persistent shortfalls in donor aid during 2011 have led to a liquidity crisis. Aid disbursements thus far in 2011 have been far below the expected amounts ($0.4 billion disbursed as of end-august compared to $0.7 billion envisaged for that period). The impact of the aid shortfalls on liquidity has been compounded by the appreciation of the shekel, and budgetary revenue has been lower-than-expected. This has led to the accumulation of substantial domestic payment arrears, including on wages for the first time since 2007, and borrowing up to the commercial banks limits. Inflation has remained low so far in The WB&G s CPI inflation rate (in NIS) was 3.1 percent in June 2011, compared to 3.6 percent in mid Inflation was significantly lower in Gaza (0.1 percent) than in the West Bank (4.4 percent), reflecting the relaxation of the blockade on imports of consumer goods and foodstuffs, as well as food s higher weight in Gaza s consumption basket compared to the West Bank. The impact of the rise in the West Bank s inflation, reflecting rising world food and fuel prices, has been tempered by its decline in Gaza following the easing of Gaza s import restrictions. While Gaza s inflation had risen sharply above that of the West Bank during the blockade, it has been on a declining trend since 2009 following the end of the Gaza war. The commercial banking system continues to perform well, with very limited exposure to global markets and conservative practices in private sector lending. The share of non-performing loans in total loans continued its downward trend, from 4 percent at end-2009 to just below 3 percent at end-june,

59 The banking sector continues to have adequate liquidity and is well capitalized. In the West Bank, private deposits in U.S. dollar terms rose 14 percent in the year to June 2011, reflecting private income growth. In Gaza, private deposits in U.S. dollar terms declined by 7 percent, as cash was withdrawn to satisfy pent up demand for consumer goods following the relaxation of import controls. Gaza banks prospects have improved due to the easing of restrictions by the GoI on the entry of consumer goods and bank-notes. While the restrictions on the entry of Jordanian dinars and U.S. dollars are still formally in place, their impact has been limited since mid-2010 with the inflows of these currencies through crossings at which controls have been eased, as well as the facilitation by the GoI of their entry for the purpose of payments by international organizations. Risks and Challenges To stem the risks of a major slowdown of economic growth and a deepening liquidity crisis, concerted actions are needed by the PA, the GoI, and donors: The PA has established a solid track record during in reforms and institution-building in the public finance and financial areas, which enables to conduct the sound economic policies expected of a future well-functioning Palestinian state. In the context of shortfall in donor aid, it is essential for the PA to fully deploy that institutional capacity to prudently manage the current liquidity crisis and step up the implementation of structural measures as set out above. To maintain the growth momentum, rebalance the composition of output, and accelerate the statebuilding process, it is essential for the GoI to phase out all economic restrictions as soon as possible. In Gaza, where living standards still lag far behind those in the West Bank, a lasting recovery in private sector investment and employment will require a removal of the ban on exports and private sector imports of investment inputs. Fully tapping the West Bank s potential and sustaining its growth will require a broad-based removal of barriers on exports to Israel, of imports of machinery and equipment, as well as allowing Palestinian economic activity in Area C. The shortfalls and delays in disbursements have imposed a significant cost on the PA in terms of interest payments and additional premia required by private suppliers of goods and services. They also risk, even with prioritization efforts by the PA, to curtail much needed social or other essential spending. Sustained donor aid during supported the successful implementation of the Palestinian Reform and Development Plan for , presented at the Paris Donors Conference in December 2007, was essential is essential to sustain orderly reforms and fiscal adjustment. The latter in turn enabled the PA to reduce the aid needed to finance the recurrent budget deficit, from $1.8 billion in 2008 to $1.2 billion in In the same vein, timely and adequate aid in support of the NDP for will allow sustained reforms and adjustment which in turn will enable early self-reliance by the PA for its recurrent spending, with donor aid increasingly focused on growth-enhancing development projects. Status of IMF Relations WB&G is not a member of the IMF and therefore not eligible for financial assistance. Since the 1993 Oslo Accord, the Fund has been providing policy advice and technical assistance in the macroeconomic, fiscal, and financial areas. IMF staff is producing regular reports on implementation of the PA s PRDP fiscal plan and public finance reforms. Together with World Bank reports focused on structural reforms, the assessment of overall reform progress will be taken into consideration by donors in their disbursement decisions.

60 56 ANNEX 5: Public Financial Management and Fiduciary Arrangements (July 2011) 1. The proposed DPL series operation sets out to provide general budget support to the PA and will be executed through the Government s public financial management (PFM) systems. In order to assess the attendant fiduciary risks with respect to the proceeds of this operation, this annex summarizes the current state of certain aspects of these systems as well as ongoing reform efforts to further enhance them. This annex builds upon current analyses and previous reports, including the IMF and several PFM related assessments reports, and particularly the fiduciary assessment which was conducted by the World Bank in January The PA continues to have the PFM reforms as the top priority of the government reform agenda. There has been considerable progress in the PFM reforms in the PA, though challenges remain. Efforts are underway to further develop and enhance the PFM system. Public Financial Management reforms are one of the pillars of the proposed DPG series. 3. According to the Bank, IMF, and other donors reports on PFM, including the fiduciary report on PFM assessment conducted during the appraisal of this operation, the Palestinian PFM system is considered to be reasonably adequate as far as the Bank s criteria and standards for approval of a general budget support operations are concerned. 4. The following description of ongoing reform activities provides a more detailed assessment of the certain aspects of PFM reform in West Bank and Gaza. EXTERNAL AUDIT 5. The State Audit and Administrative Control Bureau (SAACB) is the supreme institution for oversight and external audit over actions of all entities receiving funding from the Palestinian National Authority. 15 The SAACB is in the process of adopting the international auditing standards issued by the International Organization of Supreme Audit Institutions (INTOSAI) and the International Federation of Accountants (IFAC). Over the past few years, Norway has provided technical assistance to build audit capacity within the SAACB. Last year, SAACB received a grant from GTZ to support the audit of 2008 financial statements, through advisory contract with Deloitte who helped the SAACB during the audit process and on the job training for the SAACB staff. 6. With respect to the audit standards, Deloitte helped draft a Palestinian version of external audit standards, these standards are tailored to the Palestinian specifications, and they are based on the INTOSAI standards with supplement from IFAC standards. The draft standards were reviewed by the Norwegian SAI and cleared for publication. Standards were issued in Nov FY 2009 financial statements have been drafted by the MOF and submitted to the SAACB for audit. SAACB has completed the FY 2009 audit and currently (June 2011) waiting for MOF comments on the draft audit report. Though according to the law, MOF has 1 year after year end to draft the FS, and in turn the SAACB would have also another year to conduct the audit (a total of two years). There is a concern with the slow process regarding the timeliness of issuing the draft FS and audited FS, and that the benchmark standards need to be shortened to the 9 Months in total for drafting FS and auditing them. 15 The SAACB is the responsible party for the external audit of the public institutions including NGOs and local government entities including Municipalities. A total of more than a 1000 institutions fall under the SAACB mandate. SAACB is responsible for three area of audits; operational, financial, and compliance.

61 57 8. Currently, the EC is providing funding for an audit advisor which is the firm of PKF. The PKF audit advisors have started their three year contract which will require them to achieve the following objectives (a) build audit capacity, (b) improve the management structure of SAACB, (c) conduct a legal review of laws and regulations to identify areas for improvement, and (d) address the shortage of IT skills within SAACB. In addition they will provide technical advice for the FY 2009 and 2010 financial audits. 9. Going forward, there are several major challenges that need to be addressed by the SAACB to be fully operational in accordance with international standards. These are as follows: Independence. There is a lack of independence by SAACB which is critical if the organization wants to comply with international standards and also if they want to be seen as a creditable audit organization. They currently report to Parliament and the PA President, although only to the President while Parliament is suspended. The SAACB also lacks financial independence, although the SAACB budget has expanded substantially in recent years and there is no indication that their operations are specifically compromised by being part of the budget process. Still, both financial and administrative independence could be strengthened. Staffing and administrative issues. SAACB has approximately 150 staff. SAACB staff are part of the civil service and thus their salaries are paid centrally from MOF. SAACB is working on hiring and capacity building efforts to enhance the staff capacity and conduct the required audit as per their mandate. EC is providing considerable support in this area. They are starting to have a shortage of auditors. As auditors leave for other agencies, they take their positions with them. Therefore, SAACB cannot hire someone to replace the person who left since there is no longer a position authorized in SAACB. Also, in Gaza there are 50 auditors who cannot perform their duties since the government in Gaza will not allow them to conduct audits. They are paid but have to stay home. SAACB personnel are under the civil service regulations and their budgets are under the MOF. This creates problems with staffing and also having sufficient budget to perform their mandated responsibilities. These human resources and administrative issues are being addressed through a review of the civil service law and work on position structures for all PA institutions. Mandate and scope of work. This issue deals with the scope of their authority. The current mandate requires them to audit all organizations that receive funding from the PA and NGOs. They do not have the staffing to conduct all those required audits, therefore, they need to develop alternative ways to meet their mandate and start to modify the audit law to narrow the scope of their responsibilities. Membership of INTOSAI. The SAACB currently is not a member of INTOSAI. The Bank needs to facilitate the process for membership so that SAACB can benefit from INTOSAI in areas such as knowledge sharing, peer review, etc. 10. During the past few years, several donors have been involved with SAACB which has resulted in not providing assistance in the most efficient way. Now with the EC program in place for the SAACB this issue should be addressed appropriately. In addition, the World Bank plans to start to consider the SAACB as a potential external auditor for Bank-financed project. A plan should be developed that would provide the SAACB an opportunity to start auditing small Bank projects in order to evaluate their work. At the same time, a peer review should be conducted to evaluate the operations and capacity of the

62 58 SAACB. This would be a start to adopting a country system which is consistent with the Bank s objectives. FINANCIAL CONTROLLERS 11. A key component in the MOF internal control framework is the function of the Financial Controller. This is the traditional ex-ante model (pre-audit) used by governments They are appointed by the Accountant General and are employees of the MOF. There are currently 90 Controllers assigned to the various line ministries. Their primary duty is to review a payment transaction to ensure that there is available budget, it complies with laws and regulations and all source documents have been submitted. Once this review is completed, the Financial Controller will approve the payment transaction for payment. As the Financial Management System has been rolled out to the line ministries, it is timely to consider that the Financial Controller function also be decentralized. 13. EC has been providing support to the Financial Controllers function with E&Y as the consultant. In March E&Y submitted a five year implementation plan for the Financial Controller function. MOF has delayed the implementation of the plan at this time because they believe that the capacity in the line ministries is not adequate at this time. A key element in the E&Y plan is that within five years the Financial Controllers will report to the line ministries minister and not to MOF. This recommendation will need more discussion within the government as well as the donor community. 14. Going forward, it is important to have a strategic framework and design for the internal control framework at the MOF and line ministries, of which the internal audit and financial controller will be important components. This framework should include the elements of a modern internal audit function, and how and to which extent various elements of a modern internal controls framework interact with and complement each other. INTERNAL AUDIT 15. The Internal Audit Department (IAD) was created in 2004 in MOF and the manager reports to the Deputy Minister, while the unit sends its reports to the Minister of Finance. Currently there are 22 staff members in IAD. During the past year IAD issued 26 audit reports and will share their reports with SAACB on a request basis. In addition to the audits, they have conducted risk assessments on the various ministries which will be used in planning their audits. IAD was recently established at the MOF level. It is meant to perform internal audit function centrally at MOF and other line ministries. 16. EC has been providing support to the internal audit with E&Y as the consultant. E&Y is now in the third stage of the project and their work included theory training and on the job training. E&Y provided training to the internal audit staff in the areas of financial regulations, commitment control, and computerized accounting system. The capacity building for internal audit staff is top priority of the government at this stage. 17. IAD adopted the international internal auditing standards published by the Institute of Internal Auditors (IIA). Further training on the IIA standards will be required. 18. E&Y has supported drafting of an internal audit manual for IAD and also has been providing training to the staff on the manual. The IAD structure and the audit manual are largely consistent with 16 As per the discussion with Deputy Prime Minister in early 2011, a review of the financial controllers scope and coverage is underway; and E&Y has been asked to provide insight on this area and to provide training to the financial controllers.

63 59 IIA concepts and standards. The audit manual was revised due to the decentralization of the internal audit from MOF to line ministries. This revised manual should be available in the near future. The decentralization of the internal audit function will create a need for a harmonization unit to be established within the MOF that will coordinate the internal audit activities. Although the line ministries currently have internal audit units, they do not perform the duties and responsibilities that would meet international standards. The E&Y project will upgrade these units to meet international standards. The internal audit function in the line ministries will report to the Minister in the line ministry. 19. The Internal Audit Charter was drafted with the help from E&Y and is now at the Cabinet of Ministers for approval. The Charter was revised to include the decentralization arrangements of the internal audit function into line ministries and includes the appropriate sections for a modern IAD. 20. To fully implement the decentralization process, some regulatory changes seems necessary. For example, Financial Regulations Law and Budget Law will need to be revised to reflect the decentralization. Decentralization is expected be rolled out as a pilot stage to 3 line ministries. Following up on the status and progress will be critical. IAD already existing at line ministries will be reactivated, and trained on the MOF internal audit methodology and manuals, it will include as well on the job training by MOF internal audit staff. ACCOUNTING AND REPORTING 21. The Accounting Department submitted the FY 2008 financial statements for audit after a very difficult process to be able to establish the various account balances. The Auditor-General issued his audit report on the FY 2008 financial statements in September 2010 in which numerous problems with the accounts were reported. In fact, no audit opinion was really provided on whether the financial statements present fairly the financial condition of the government. The FY 2008 financial statements followed the IPSAS cash basis format but the auditors found transactions on the accrual basis recorded in the accounts. Therefore, the statements were not compliant with the IPSAS cash basis. The notes to the statements were very brief and generally not in full compliance with the IPSAS requirements. As noted below, the notes for FY 2009 were much improved. 22. An IPSAS Cash Basis Financial Statement Guideline was prepared to facilitate the presentation of the FY 2009 financial statements. Templates were prepared for the cash basis statements, mandatory note disclosures and voluntary disclosures. The FY 2009 financial statements have been submitted to the Auditor-General for audit, and the draft audit report has been prepared. The Auditor-General expects MOF comments on the draft audit report in order to finalize the audit within the next few months. 23. Per MOF request, the World Bank reviewed the FY 2009 financial statements for compliance with the IPSAS cash basis with respect to the note disclosures. The Bank provided comments by March, The review found that the note disclosures for FY 2009 were fairly comprehensive and complied with the IPSAS cash basis standard. The notes covered both the required notes and the optional notes. The reporting unit in MOF stated that there is a need for IPSAS training at the line ministry level since they will be required to prepare financial statements at that level. 24. The multi-currency issue that has been a problem for the accounting staff is now resolved. The problem was that that the budget was prepared in Shekel and the financial reporting was in dollars. MOF has adopted the concept of a functional currency and a reporting currency, in which they made the Shekel the functional currency and the dollar or any other currency the reporting currency. This will now enable them to issue a budget to actual report on the same currency basis.

64 The Chart of Accounts (COA) is now compliant with the GFS requirements. The COA is an integrated chart of accounts reflecting the concept of a uniform account code structure. This incorporates both the budget structure and accounting structure. As the government moves towards program budgeting, this will require some modification to the COA. MOF is executing the budget on a program basis in FY At the present, the basic weakness in the financial system is on the revenue side. In the audit report for FY 2008, the auditors cited this as a significant problem that the government needs to address in the very near future. The auditors stated that the problem was the reliability and completeness of tax information. There is a need to upgrade the tax systems to provide better accounting and reporting of tax revenue and also provide the ability to be able to accrue tax revenues as the government moves towards accrual accounting in MOF has implemented a fixed asset register which reflects the government assets and their valuation. A policy was to be developed by the Fixed Asset Committee but that was not completed. It is essential that MOF completes this policy statement along with the manuals since they are in the process of rolling out the accounting system to the line ministries. 28. The MOF has implemented commitment control/accounting to provide additional controls over the budget as well as provide information for cash management. The government has implemented a policy that will fund outstanding commitments at year-end in the following year budget. This is an acceptable international practice. Therefore, the commitments will roll over to the next fiscal year. However, there is another issue that will need to be addressed by the budget department in the use of commitments. Allotments are provided quarterly, and commitments sometimes go beyond the current quarter. Therefore, there needs to be flexibility in the issuing of allotments by the Ministry of Finance to allow for longer term commitments. 29. There is a need to develop a road map to move to accrual accounting. It has been recommended that MOF should prepare a work sheet that would list all 31 standards and identify the requirements in those standards. This would provide the MOF with a work plan to move forward to accrual accounting. This is an activity that needs to be completed soon if the government expects to adopt accrual accounting in 2012 or Fiscal Year 2011 is the first year program budgeting and program budget execution is fully implemented in the system. The accounting system is now set up to handle program budgeting. Further training is still needed on program budgeting. 31. In the same context, line ministries are still in need for additional training on the program budgeting, and program budget execution. Also, further training is required on commitments control and accruals. MOF plans to have the FY 2010 financial statements ready by August IMPLEMENTATION OF IFMIS 32. The government is in the process of developing an Integrated Financial Management System (IFMIS). This system was based on a system developed for the Ministry of Education by Bisan, a local software firm. The system is evolving as new requirements are identified. This is due to the fact that there was never a blue print (system architecture) developed for the system. The IFMIS has been rolled out to all line ministries. Transaction will be entered by the line ministries with approval for the transaction by Financial Controllers who also have decentralized to line ministries. 33. The system is a data-based system that uses a uniform account code structure, which is a single coding structure for all financial information. This is the brains of the system, and as a result, the quality of management reporting has improved. This system in the near future has the potential to be used by all

65 61 Bank projects which will meet the Bank s objective of using country systems. However, there is a need for a system audit to be conducted that would address the controls within the system and the integrity of information provided by the system. Such a review was conducted by an accounting firm a few years ago and reported many findings regarding control weaknesses. The government has stated that corrective actions to address those weaknesses have been taken. There is a need to independently confirm this. 34. At the local government level, there is a Bank financed project that is supporting implementation of the FreeBalance software package. It is also a database system that uses a uniform account code structure. The project will roll out this system to 32 local governments in phase one with five local governments being pilots. This system will be capable of interfacing with the PA accounting system at the Ministry of Local Government. USE OF COUNTRY SYSTEMSFOR BANK FINANCED PROJECTS 35. At the present, all Bank financed projects are being audited by private external auditors due to the capacity concerns of the state audit. 36. The Bank fully relies on the Financial Controllers (FC) review before disbursement work for Bank financed projects related disbursements. For Bank financed projects, the Bank uses these aspects of country systems: Financial Controllers and Central Treasury System (opened bank account by MOF under the central system). External audit and internal audit are still aspects to be considered for future utilization for Bank financed projects. 37. It seems that the SAACB is willing to audit Bank financed project. They have conducted an audit of the Russian grant last year. The SAACB is willing to start auditing donor funded projects specifically the World Bank funded projects. The SAACB capacity constraints and the lack of experience in this area remain as a constraint. It is suggested that a few number of projects be selected as a pilot for now, to build capacity and gain more expertise in this area. In the long run, SAACB s target is to audit all Donors funded projects. The World Bank in partnership with other donors needs to support this effort. SINGLE (CENTRAL) TREASURY SYSTEM & BANK FUNDED PROJECTS 38. Due to the fact there is no central bank yet for West Bank and Gaza, MOF created a single treasury account for revenues at the Bank of Palestine, and also created a single treasury account for all disbursements at the Bank of Palestine, with sub accounts for every ministry and disbursing unit, and in different currencies upon need: A total of main and sub accounts of more than 200 bank accounts. 39. As a means for decentralization and cash management of the MOF to the line ministries, the zero balance account concept was introduced. A sub account was created for every disbursing line ministry with a disbursement ceiling based on their operational budget, and whatever the ministry disburses is deducted from their ceiling, until the next allotment is made. By the end of the day, the ceiling is closed in the main account of the MOF. Bank reconciliations and consolidations are done every day at the ministries level and at the MOF cash management level. 40. At the present, World Bank funded projects as well as all donor funded projects use the separate designated account mechanism. A special account is opened under the MOF central treasury system specifically for the designated project funds receipts and disbursements. This donors practice needs to change when PA fully implements the STA. 41. MOF uses a central treasury system rather than single treasury systems per se. Bank funded projects related designated accounts are opened by MOF under the central treasury system. Each implementing Ministry has the management responsibility of the account for disbursements on project-

66 62 related disbursements. Withdrawal applications are reviewed and signed by MOF before submitting to the Bank. 42. The MOF has requested that the Bank funds be treated the same way and concept of the zero balance account be followed. The purpose is to fully utilize the central treasury system at the MOF and enhance cash management even at the project levels. This was agreed to be discussed further. 43. In relation to other Projects, the Bank opens separate designated accounts for each project, to which the advance payment and replenishment are made. Due to the cash management concerns at the MOF and the dependency on donor funds to cover their operational budgetary needs, it will be worth consideration not to separate the Bank funds from the government funds to enable better cash management, and to have the funds for projects when needed. CORRUPTION OVERVIEW 44. The 2010 Global Integrity Report indicates that there has been little improvement in addressing corruption in the West Bank over the past two years and reconfirms the West Bank s low ranking on its Grand Corruption Watch List among all countries surveyed. 17 The Report states cites a poor regulatory framework and enforcement environment that undermine the accountability and transparency mechanisms in government. The ratings on access to government information, conflict of interest safeguards and checks and balances across government were quite low. 45. However, the report indicates some positive actions that have been implemented recently. There is now an anti-corruption law and a fairly new Anti-Corruption agency. These two events will need some time to have an impact on the corruption perception. Another positive note is that CSOs and media play a very important role. This is critical in addressing corruption issues. 46. A recent World Bank study summarizes the progress made and challenges ahead in this areas as follows: First, the PA has made significant strides to improve economic governance over the past decade. Second, reform efforts have achieved varying degrees of success and the PA needs to prioritize and address the ongoing challenges. Finally, the PA should take a more proactive approach to investigating and prosecuting corruption, as well as communicating its anti-corruption activities to build public confidence in government accountability. 18 MANAGEMENT OF FOREIGN EXCHANGE 47. There is no fully functioning Central Bank for West Bank and Gaza yet. The Palestinian Monetary Authority (PMA) act as and has the mandate of a central bank with the exception of issuing currency. PMA regulates the banking system in West Bank & Gaza, in terms of capital adequacy, reporting, etc. IMF and the World Bank are providing extensive support and capacity building and technical assistance for the PMA. Banking system in West Bank and Gaza are considered efficient and well regulated through the PMA according to well accepted international standards and benchmarks. All of the Banks operating in West Bank and Gaza have to submit regulatory reports to the PMA, including the annual report and annual audited financial statements. 48. Due to the fact that there is no Central Bank for Palestine, the foreign currency management is carried out through the Ministry of Finance. The funds from this DPG will be deposited in a bank account held at commercial bank (i.e. Bank of Palestine), which is regulated by the PMA. 17 West Bank and Gaza Global Integrity Report, May Improving Governance and Reducing Corruption in West Bank and Gaza, the World Bank, May 2011.

67 Bank of Palestine audited financial statements and semi-annual reports are published on their website. The annual report for the year 2010 included audited financial statements and auditor s report audited by Ernest & Young, who provided an unqualified opinion on the financial statements. SELECTED KEY AREAS FOR FUTURE ACTIONS 50. More remains to be done to further improve the PFM system. This includes the following key actions: Complete the process for full implementation of the Single Treasury Account (STA), and the transformation from the CTA system to the STA. Ensure better integration of donor programming into the annual development budget. A clear action plan with commitments by all parties should be developed by the Ministries of Planning and Finance as part of the ongoing effort to develop a medium-term planning process. Roll out the Integrated Accounting System to line ministries already conducted will require parallel capacity building at both MOF and at line ministries level to train the designated staff on the new financial system. Fully implement internal audit function. Significant effort is already underway, but it will need considerable effort and support from the donor community and continued ownership and commitment from the PA to enhance the internal audit function in the WB&G and continue the decentralization plan into line ministries Although external audit development has started, building the capacity of the institution to a satisfactory level will require more extensive and well-monitored capacity development. Improve cash management and forecasting, while recognizing the fact that it is challenging under current emergency conditions. It should be noted that these measures have already been identified by the PA as PFM reform objectives in the PRDP and are being supported by this proposed DPG IV. CONCLUSION 51. In recent years WB&G has made significant progress in reforming PFM. This progress includes the partial implementation of the TSA Concept, the development and implementation of GFMIS, implementation of initial steps toward program budgeting. While the effectiveness of SAACB is being strengthened with donor support, this effort is a work in progress. There is significant effort underway to improve internal controls and implement modern internal audit, but much remains to be done in terms of implementation. While these reforms are underway, the tangible benefits of these reforms are not yet fully realized, particularly with respect to weak capacity at both the MOF and line ministries and the internal control framework not being fully implemented. Also, SAACB needs much additional work to carry out external audits of government s programs according to international standards. 52. In light of the fact that the fiduciary risk is assessed as significant and that reform is ongoing, the Bank does not propose putting in place any additional fiduciary measures beyond standard requirements for such level of fiduciary risks.

68 ANNEX 6: Country At A Glance 64

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