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 REFORM AND DEVELOPMENT PLAN DEVELOPMENT POLICY GRANT III Social and Economic Development Group West Bank and Gaza Country Department Middle East and North Africa Region August 18, 2010 Report No GZ This document is being made publicly available prior to Board consideration. This does not imply a presumed outcome. This document may be updated following Board consideration and the updated document will be made publicly available in accordance with the Bank s Policy on Access to Information.

2 WEST BANK AND GAZA - GOVERNMENT FISCAL YEAR January 1 December 31 CURRENCY EQUIVALENTS (Exchange Rate Effective as of May 12, 2010) US$1.00 New Israeli Shekel (NIS) 3.75 WEIGHTS AND MEASURES (Metric System) ABBREVIATION AND ACRONYMS CAS Country Assistance Strategy ESSP Emergency Services Support Program EU European Union EUMP Electric Utility Management Project GCI General Control Institute GDP Gross Domestic Product GFSM Government Financial Statistics Manual 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 Ministry of Social Affairs 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 Regulatory Commission 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 Reform and Development Plan PRDP DPG Palestinian Reform and Development Plan Development Policy Grant PRDP-TF Palestinian Reform and Development Plan Multi-Donor Trust Fund 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 WBG West Bank and Gaza WFP World Food Program Vice President: Country Director: Sector Director: Sector Manager: Task Team Leader: Shamshad Akhtar Mariam Sherman Ritva S. Reinikka Simon C. Bell John L. Nasir

3 WEST BANK AND GAZA PALESTINIAN REFORM AND DEVELOPMENT PLAN DEVELOPMENT POLICY GRANT III TABLE OF CONTENTS GRANT AND PROGRAM SUMMARY... i I. INTRODUCTION... 1 II. COUNTRY CONTEXT... 2 Recent Economic Developments in West Bank And Gaza... 2 Macroeconomic Outlook and Debt Sustainability... 7 III. THE GOVERNMENT S PROGRAM AND PARTICIPATORY PROCESSES A. Governance Fiscal Reform Accountability and Transparency Administrative and Civil Service Reform Local Government Reform B. Social Development Social Protection Education, Health and Empowerment C. Economic and Private Sector Development D. Public Infrastructure Development E. Consultations IV. BANK SUPPORT TO THE GOVERNMENT S PROGRAM Link To CAS Collaboration With The IMF And Other Donors Relationship To Other Bank Operations Lessons Learned and Reform Progress Analytical Underpinnings V. THE PROPOSED PALESTINIAN REFORM AND DEVELOPMENT PLAN DEVELOPMENT POLICY GRANT III Operation Description Policy Areas VI. OPERATION IMPLEMENTATION Poverty And Social Impacts Environmental Aspects Implementation, Monitoring And Evaluation Fiduciary Aspects Disbursement and Auditing 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: FUND RELATIONS NOTE ANNEX 5: PDO INDICATORS FROM DPG I AND DPG II ANNEX 6: COUNTRY AT A GLANCE (INCLUDES COUNTRY MAP)... 71

4 BOXES Box 1: Bank Disclosure Procedures and Consultations Box 2: Prior Actions For the PRDP DPG III Box 3: Good Practice Principles for Conditionality FIGURES Figure 1: Economic Growth Figure 2: Unemployment Rate TABLES Table 1: West Bank and Gaza: IMF Estimates of Central Government Fiscal Operations, Table 2: West Bank and Gaza: Comparison of Baseline and Pessimistic Scenarios Table 3: Monitoring Reform Progress The PRDP Development Policy Grant III was prepared by a core team consisting of John Nasir, Team Leader and Lead Economist; Suhair Musa, Financial Management Specialist; Hyacinth Brown, Senior Finance Officer; Nikolai Soubbotin, Senior Counsel; Mark Ahern, Senior Public Sector Specialist; Eileen Murray, Lead Operations Officer; Meskerem Brhane, Senior Urban Specialist; Husam Mohamed Beides, Senior Energy Specialist; and Steve Wan, Operations Analyst. Guidance has been provided by Mariam Sherman, Country Director; Simon C. Bell, Sector Manager; Elena Kastlerova, Country Program Coordinator; Oussama Kanaan, IMF Resident Representative; Javier Gomez; and Mariuz Sumlinski of the IMF Mission. The team wishes to thank Mr. Mazen Jadallah, Director General, International Relations Department, Ministry of Finance and other individuals who have contributed to the preparation process.

5 GRANT AND PROGRAM SUMMARY WEST BANK AND GAZA PALESTINIAN REFORM AND DEVELOPMENT PLAN DEVELOPMENT POLICY GRANT III Borrower Implementing Agency Financing Data Operation Type Main Policy Areas Key Outcome Indicators Program Development Objectives and Contribution to CAS Risks and Risk Mitigation Palestine Liberation Organization (PLO) (for the benefit of the Palestinian Authority) Ministry of Finance (MOF) of the Palestinian Authority Terms: Grant from the Trust Fund for Gaza and West Bank Amount: US$40 million The proposed operation is for budget support and is a follow-up to two previous PRDP DPGs approved by the Board on June 5, 2008 and April 28, The proposed grant would be disbursed in a single tranche upon satisfactory completion of the prior actions. The PRDP DPG III will continue to support the PA as it implements the Palestinian Reform and Development Plan (PRDP). The PRDP DPG III focuses its support on two areas: (i) strengthening the PA s fiscal position; and (ii) improving public financial management. The PRDP DPG III is designed to help the PA strengthen its fiscal position by reducing its public sector wage bill to less than 23 percent of GDP and Net Lending to less than 5 percent of GDP by The PRDP DPG III also supports the PA s efforts to improve public financial management. Key indicators for this are producing a timely budget, providing 2009 accounts to its external auditors and implementing commitment controls. The proposed operation will help the PA continue to implement the PRDP. Like the PRDP DPG I and DPG II, the PRDP DPG III will specifically support efforts to strengthen the fiscal position and increase government transparency and accountability. The PRDP s success depends on parallel actions by the PA, the Government of Israel (GOI) and the donor community. The key risks are: (i) The PA must maintain strong political support for the PRDP in order to take actions such as maintaining the public sector wage bill at an affordable level, moving electricity generation from local governments to commercial distribution companies, initiating reform of the public pension system and reforming public procurement. The PA has successfully mobilized popular support for its actions in the West Bank and because of the success of the reforms supported by the previous DPGs, it is expected to continue to gain support.

6 - ii - (ii) The PA will not be able to meet its fiscal goals without substantial private sector growth. However, since the PRDP was announced in late 2007, the GOI has only marginally relaxed its movement restrictions and continues to restrict access to resources such as land and water. The PA is continuing to attempt to address the GOI s security concerns. In addition, the international donor community is continuing to monitor the closure system and its economic impact. (iii) Donor support is the third determinant of the PRDP s success. The PRDP assumes high and sustained donor assistance during the plan s life. In the long run, the PA is striving toward fiscal sustainability, but until they reach this goal, they will depend upon large amounts of untied budget support that will allow it to pay wages and basic operational costs. Because of the PA s commitment to reform, donors provided about US1.355 billion in budget support in 2009, less than in 2008 but still substantial. To encourage continued high levels of budget support, the World Bank will continue to operate the multi-donor trust fund it established in In addition, this proposed third DPG sends a strong signal to donors that the World Bank considers progress on the PRDP adequate and that donors should continue to support it. Operation ID P118593

7 PROGRAM DOCUMENT FOR A PROPOSED PALESTINIAN REFORM AND DEVELOPMENT PLAN DEVELOPMENT POLICY GRANT III TO THE WEST BANK AND GAZA I. INTRODUCTION 1. Since the establishment of the Caretaker Government in mid-2007, the Palestinian Authority (PA) has not only rebuilt its basic operating systems that had decayed during the previous government but has made significant progress in creating new and stronger institutions that will be needed by a future Palestinian state. In December 2007, the PA presented its Palestinian Reform and Development Plan (PRDP) to donors at the Paris Donor Conference. This comprehensive plan lays out a three-year program of reforms to help re-start economic growth and improve the welfare of citizens. Despite enormous political challenges, the PA has steadily implemented the plan and will soon issue a new national plan that builds on the PRDP. Gaza continues to be split from the West Bank, ruled by another government and isolated by Israeli closures. The peace process is moribund. However, the PA has been able to gain widespread public support for its reform program and has made significant strides improving the efficiency and transparency of its operations. It has been particularly successful in strengthening its fiscal position and improving public financial management - the areas supported by the World Bank s Development Policy Grants (DPGs). 2. The PA s success has attracted large amounts of international aid, including substantial amounts of budget support. Untied budget support is essential for the PA to function. Total expenditures and net lending were US$3.189 billion in However, domestic revenues are estimated to have only covered about 50 percent. The biggest expenses include salaries (including pensions) and net lending, much of which are payments by the central government to the Israel Electricity Company for power supplied to Palestinian municipalities and other distributors. The PA has been taking steps to control spending but there is limited room for further reductions. Consequently, until economic growth recovers enough to allow the PA to substantially raise domestic revenues, there will remain a need for large scale external financing. It is critical that this external support be provided through the PA s Central Treasury Account (CTA) because using the CTA helps the PA develop budget discipline and strengthen its public financial management systems. 3. Given the importance of untied budget support, the Bank has made helping the PA raise budget support a major focus of its work in West Bank and Gaza (WBG). The Bank has directly provided two DPGs of US$40 million each in 2008 and In addition, the Bank manages the PRDP Multi-Donor Trust Fund, (PRDP-TF) which disburses untied budget support based on the PA s progress on implementing the PRDP reform agenda. Since its inception in 2008, the PRDP-TF has disbursed nearly US$500 million. But the Bank s contribution goes beyond directly providing budget support. The Bank s quarterly monitoring of the PA s performance in

8 - 2 - consultation with the IMF gives other donors confidence to provide budget support on their own account. The provision of this third DPG will send a strong signal that the Bank believes that the PA s reforms are on track and that other donors should have confidence to continue to using the PA s CTA. 4. With support from the Bank DPGs, the PA has made significant progress towards strengthening its fiscal position and improving its PFM system. However, providing budget support in WBG continues to be a risky prospect. For the DPG III to be successful in assisting the PA to maintain the reform momentum and develop institutions required by any future Palestinian state, the PA, GOI and donors must all play their part. The PA must maintain the political will and popular support to implement difficult but necessary reforms. It will not be possible for the PA to become fiscally sustainable unless private sector growth rises to the level needed to support basic services for the Palestinian population. This will require the PA to continue to improve the business environment especially through increased security. But private sector growth mostly hinges on the GOI continuing to relax its economic restrictions in response to an improving security situation. Finally, the entire reform agenda depends on the readiness of the donor community to provide sustained high levels of budget support while the PA implements its reforms and the Palestinian economy recovers. II. COUNTRY CONTEXT RECENT ECONOMIC DEVELOPMENTS IN WEST BANK AND GAZA 5. Growth in WBG accelerated in 2009 and initial estimates suggest real growth reached 6.8 percent, well above the 5 percent projected in the PA s 2009 budget. Most of the growth was in the West Bank, where the IMF and Palestinian Central Bureau of Statistics (PCBS) estimate real GDP growth was 8.5 percent. However, despite the continued closure of Gaza, growth there was estimated to be positive at about 1 percent. 1 Initially PCBS estimated real growth for WBG in 2008 at 2.3 percent, which would be a real per capita decline in GDP. However, they have recently issued revised estimates that put real growth at about 5.9 percent implying an increase in per capita GDP. Thus, the 2009 performance is the third consecutive year of per capita GDP growth and may signal that at least the West Bank economy is beginning to recover after years of decline. But growth is still less than what might be expected from an economy recovering from such a low base. Initial estimates for the first quarter of 2010 indicate that real GDP increased by more than 12 percent compared to the first quarter of Thus, it appears that growth in 2010 is on track to exceed that of 2009 and meet or exceed the baseline scenario proposed by the IMF and MOF. 6. The revival of growth in the West Bank is impressive, but it is also precarious. It is being driven by a combination of large sustained inflows of donor assistance, PA government reforms that have increased investor confidence and the loosening of some Israeli security restrictions. 1 PCBS does not publish quarterly GDP estimates for West Bank and Gaza separately. However, these figures were presented by PA officials in meetings with donors.

9 - 3 - However, the high level of external assistance over the past three years is probably the most important factor. In 2009, the PA received more than US$1.355 billion in budget support coming on top of US$1.8 billion in 2008 and almost US$1 billion in This does not consider hundreds of millions more in aid that has flowed into the economy through the UN and from bilateral assistance programs. The large amounts of budget support have allowed the PA to maintain expansionary fiscal policies to support growth. In 2009, total PA commitments were equivalent to around 52 percent of GDP, with wage expenditures alone around 24 percent of GDP. The importance of government spending in the economy is evidenced by the changing composition of GDP. The share of the mostly government funded sectors: Health and Social Work, Water and Electricity, Education and Public administration and Defence, rose from less than 21 percent in 1999 to almost 30 percent in In absolute terms, Public Administration and Defence expanded more than any other sector in this period. The first quarter of 2010 shows a similar pattern. 7. In contrast to the public sector, important parts of the private sector have not been as robust. 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 share declined from 10.4 percent to 4.8 percent. The PA s reforms that have resulted in improved security and more efficient service delivery along with the GOI s loosening of its security restrictions have no doubt increased investor confidence. In widespread discussions with private businesses, they reveal the importance they place on these measures. But there is not yet any sign of a large scale revival of private investment in the productive sectors of the economy. Since 2007, real output in the Manufacturing and Hotels and Restaurants categories of GDP have increased by 7.3 and 8.5 percent respectively, well below the overall increase of GDP of 13 percent. The biggest jump in private sector activity has been in the Construction and Real Estate Service sectors, which have gone up by nearly 28 percent. Much of the investment in these sectors is going to provide much needed housing. But according to interviews with financial institutions, PA civil servants and NGO employees form the backbone of this market, which again points out the importance of donor aid in driving the economy. The PA is making efforts to revive private investment (see paragraph 45 below), 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 and East Jerusalem and access to land and resources in Area C The IMF estimates that growth in Gaza was 1 percent in 2009 despite the ongoing blockade, but this still indicates falling per capita GDP. However, as mentioned above, estimates from the first quarter of 2009 indicate that growth has picked up substantially. However, positive growth does not signal that the Gaza economy is on the road to recovery. It is still too early to see the effects of the GOI s decision in July 2010 to allow more imports, and the private sector remains in a state of near total collapse. The recent growth instead reflects the development of coping mechanisms that have allowed some economic activity to resume on a very limited scale. Until, the first of July 2010, the GOI restricted goods entering legally through 2 Area C is under full civil and military control by Israel.

10 - 4 - Israel to a small number of goods for humanitarian purposes and continues to prohibit all exports. However, they did make some concessions, including allowing the export of 21 truckloads of cut flowers and 29 truckloads of strawberries in December 2009 and the import of 103 truckloads of glass. But there is a sustained flow of goods arriving through tunnels from Egypt and via other avenues. Fuel is readily available and there is a supply of spare parts and limited inputs that have allowed some production to resume. In addition, store shelves are filled for those who have money to buy. 30 Figure 1: Economic Growth WBG WB Gaza 30 Source: PCBS and World Bank Staff Calculations 9. The improved availability of goods in Gaza has allowed some private sector activities to resume - albeit in the context of an unregulated economy. In some cases, even industrial production has restarted though on a limited scale and focused solely on the domestic market. Monitoring by PalTrade and local business organizations finds that employment in the industrial sector has increased from about 2,000 during 2008 to nearly 5,000 at the end of However, that is nowhere near the 35,000 employed in June 2007 before the total closure. It should also be noted that employment in 2007 was depressed because even then it was costly and difficult to import and export. Gaza businesses are just trying to survive until circumstances permit them to fully operate again. In many cases, enterprises have transformed themselves to offer different services, such as a construction firm opening a restaurant or changing markets from export to domestic. But most remain closed. A recent survey by the Palestinian Federation of Industries found that only 54 percent of industrial establishments destroyed in the December 2008 fighting were fully or partially rebuilt and only 23 percent of the work force was rehired. 3 The longer the closure goes on, the more difficult it will be for business to resume normal operations. Capital and infrastructure is deteriorating and customers have switched to new suppliers. One of the most difficult challenges is for firms to retain their skilled workers, when they are not operating. 3 PalTrade 2010: One Year After the Military Operation, An Outlook on: Gaza Strip Crossings & Damaged Industrial Establishments. p 9.

11 Despite the reported economic growth and recent easing of the Israeli restrictions on imports, the vast majority of the Gaza private sector remains moribund and the economy is sustained by government spending and humanitarian assistance. It is unclear how much spending the Hamas government undertakes, but they have a large security force and a substantial civil service. The PA regularly pays its more than 63,000 employees in Gaza, many of whom are unable to work because of the current situation. The PA also maintains its large system of social transfers to needy households in Gaza. In addition to this regular spending, the PA has also undertaken substantial emergency spending in Gaza to offset some of the effects of the recent fighting. In 2009, the PA detailed US$142 million in emergency spending to help families that had lost their homes, make repairs to utilities and for other emergency requirements. The international community continues to pour humanitarian aid into Gaza, led by UNRWA which provides services for the more than 950,000 registered refugees. The Gaza private sector is making a brave effort to survive, but it is only donor funded, government spending and direct donor assistance that is averting a humanitarian crisis in Gaza. 11. The resumption of growth in WBG indicates that there has been a pickup in investment in response to the improved business environment. It is not possible to know the precise level of public investment since most of it is project finance from external sources, which are often not reported to the Ministry of Finance. The 2009 budget called for US$503 million in development capital expenditures but only US$215.5 million was actually expended. In addition, the PA reports that there was another US$185 million in development projects funded directly by donors. There are no published estimates of private investment; however, monetary statistics suggest there has been an increase. Credit to the private sector at the end of December 2009 was almost 23 percent higher than in At the same time, deposits only increased by 5 percent, thus the Banking sector has increased intermediation and the productive use of available funds. There are other indicators that also suggest that investment has increased. For example, the number of business licenses issued in the West Bank in the fourth quarter of 2009 was more than 50 percent higher than in quarter four 2008 and the totalled licensed area was almost 54 percent higher. However, looking at which sectors are growing, indicates that much of this investment is in real estate, construction and the public sector, not in manufacturing, agriculture or high value added services such as tourism. 12. Trade with Israel reflects the increased inflows of donor assistance and economic growth. PCBS has not yet produced recent balance of payments and trade data. However, the vast majority of trade is with Israel in 2007 Israel accounted for 88 percent of WBG imports and 72 percent exports for which the Israeli Central Bureau of Statistics provides some information. Official merchandise exports from Israel to WBG jumped by 25 percent between 2007 and 2008 reflecting the pent up demand when donor aid was cut off and PA salaries were not being paid. But they fell by 15 percent in 2009, which partially reflects the cut off of fuel shipments to Gaza in the first quarter of 2009 and the global decline in fuel and food costs. However, they were still 6 percent above 2007 levels. In 2009, merchandise imports from WBG were nearly 27 percent lower than they were in 2008 and 22 percent below the 2008 figure. This may partially reflect the increased difficulty Palestinian food producers have in entering the Israeli and East Jerusalem

12 - 6 - markets. Falling exports to Israel is also consistent with the fact that most of the WBG growth has been in government services and non-tradables such as construction. 13. In 2009, inflation was lower and the NIS exchange rate stabilized. Falling global food and energy prices along with the relaxation of some movement restrictions have helped reduce prices in WBG. The Consumer Price Index (CPI) increased on average by 2.75 percent in In the remainder of the West Bank where most of the PA s expenditures are made, it increased by only 0.6 percent. 4 However, inflation was much higher in East Jerusalem and Gaza, where the CPI increased by 3.5 percent and 4.4 percent respectively. Compared to 2008, the exchange rate was relatively stable during 2009 starting the year at about NIS 4 to the US Dollar and dropping to about NIS 3.8 to the US Dollar. 14. The Palestinian banking sector is highly conservative and was untouched by the world financial crisis. Palestinian banks are strong, liquid and well regulated by the Palestinian Monetary Fund (PMA). The PMA is one of the strongest institutions in WBG and among the best managed monetary institutions in the region. With assistance from the IMF and World Bank Group, the PMA is moving steadily to improve its systems and build the capabilities required by a central bank for a future Palestinian state. The PMA is acquiring a real time gross settlement system that is expected to be operational in Among other things, it is designing a program of deposit insurance, building its research capabilities and developing PMA certificates of deposits. Early in 2009, the PMA increased the share of assets that Palestinian Banks must keep in WBG to 45 percent. This has encouraged some additional lending and along with the improved investment environment has contributed to the increase in lending. The increase in lending has also been helped by two ongoing loan guarantee schemes that not only provide guarantees but provide technical assistance to banks to help them increase their lending to small and medium enterprises. WBG uses the New Israeli Shekel, US Dollar, Euro and Jordanian Dinar as its currencies, though most transactions are conducted in Shekels. Thus the PMA does not control monetary policy or exchange rate policy. 15. 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 have 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. In addition, the Palestinian lost a large amount in forgone interest. In September 2009, the PMA negotiated an agreement with the Bank of Israel to accept Israeli 300 million from Bank of Palestine to the Bank of Israel for credit with Bank Hapoalim. In December 2009, a second agreement was reached to transfer NIS 500 million to the Hapoalim and Discount Banks from the Bank of Palestine and the Arab Bank through the Bank of Israel. But this was not fully implemented and only NIS 150 million was transferred from the Bank of Palestine to the 4 Remainder of the West Bank excludes those areas of the West Bank annexed by Israel in 1967.

13 - 7 - Hapoalim Bank. This system of ad-hoc arrangements is inefficient and creates high levels of uncertainty in the Palestinian banking sector. 16. Unemployment in the WBG reflects the growth. In the West Bank, unemployment in the fourth quarter of 2009 fell to 18.1 percent from 19.8 percent in the same quarter of At the same time, the labor force participation rate rose from 42.8 percent to 44.1 percent. Unemployment also dropped in Gaza; falling from 44.8 percent in quarter four 2008 to 39.3 in the last quarter of However, part of this can be explained by the fact that the labor participation rate also dropped from 38.8 percent to 36.9 percent. Unemployment in Gaza has also been ameliorated by job creation schemes funded by donors. For example, in October 2009, UNRWA announced that it was doubling its program to create 14,000 job opportunities a month. The share of the West Bank work force employed in Israel and its settlements fell from 16.1 percent in quarter four 2008 to 13.4 percent in quarter four There are no recent poverty estimates for West Bank and Gaza. The PCBS, with assistance from the World Bank, is currently completing estimates. However, poverty levels are still high. A recent survey conducted jointly by FAO and WFP found that 61 percent of the Gaza and 25 percent of the West Bank population is food insecure. Figure 2: Unemployment Rate % 40% 35% 30% 25% 20% 15% 10% 5% 0% Source PCBS Quarterly Labor Survey unemploy. Rate WBG unemploy. rate Gaza MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY 17. Despite the continuing closure of Gaza, the IMF and PA have a baseline scenario where real growth is projected to be about 7 percent in 2010 rising to 10 percent by (Table 2). This assumes that the situation in Gaza will not deteriorate and that security will remain stable in the West Bank allowing continued growth. It also assumes continuing large inflows of external assistance. This results in reduced unemployment and at least in the West Bank, recovering real per-capita GDP. These are strong assumptions, but estimates of growth in the first quarter of 2010 indicate that the baseline growth rate will be attained or even surpassed. The IMF also presents a pessimistic scenario where growth slows to about 4 percent over the

14 - 8 - medium term. This would result in stagnating per capita income in the West Bank and a continuing decline in Gaza. The pessimistic scenario assumes no progress in the peace process and only ad hoc and limited further easing of restrictions in the West Bank and Gaza s blockade. Given the recent fall in oil and food prices along with the Bank of Israel s sound management of the money supply, the CPI inflation rate fell to about 4 percent in 2009 and is projected to hold steady in the 3-4 percent range in the medium term. 18. Despite the revival of growth and its extensive reform program, the PA s recurrent deficit increased in 2009, mostly as a result of emergency spending in Gaza in the aftermath of the large scale military operations at the end of The recurrent budget deficit on a commitment basis was nearly US$1.6 billion, up from US$1.3 billion in 2008 and almost US$143 million more than projected in the revised 2009 budget. Most of the deficit growth can be attributed to the emergency situation in Gaza, which forced the PA to add US$300 million to the budget midyear. In addition, about US$141 million in arrears were brought forward from 2008 and reported as 2009 commitments. Thus, commitments actually incurred in 2009 were below the revised budget. Nonetheless, wage expenditures exceeded the budget by about 2 percent, mostly due to compensation provided to public employees for the interest paid on loans they incurred in 2006 when the PA was unable to pay salaries. 19. The original 2009 budget called for donor support of US$1.15 billion to fund the recurrent deficit and another US$503 million for the development budget. It was hoped that there would be an improvement in the quality of the budget compared to previous years by beginning to shift donor funding from recurrent costs to development expenditures. In September 2009, the projected support necessary for the recurrent and development budgets was raised to US$1.45 and US$1.1 billion respectively to respond to the needs in Gaza. However, at the end of the year the recurrent deficit was nearly US$1.6 billion and including development spending made the overall deficit more than US$1.77 billion. Only about US$1.355 billion in budget support and another US$390 million in development financing materialized. Consequently, the PA was forced to turn to borrowing from local banks and accumulating arrears of US$221 million. Total domestic debt stood at about US$660 million at the end of 2009, up from about US$449 million in December External debt stands at about US1.1 billion, most of which is concessional debt incurred prior to 2000 and is not being serviced. Development expenditures through the Central Treasury Account on a commitment basis were only US$215 million. 6 Thus, because of 5 The detailed records on international debt were lost in Gaza and with the help of the World Bank and other donors the MOF is reconstructing them. The largest share of the debt is held by the World Bank, about US$320 million and Arab countries and the Islamic Development Banks at about $500 million. There is no indication that there is substantial international debt to private parties. 6 The MOF tables report only US$45 million in development financing and US$215 million in development expenditures. The MOF reports that US$10 million in community development projects were financed from the Central Treasury Account. The remaining expenditures were financed from aid received in previous years but not recognized in those years because previously the MOF only recognized development financing when it was spent. In 2009, the MOF changed to a practice of recognizing development financing when it is received. In addition, the PA estimates that there is US$185 million in development projects directly financed by donors.

15 - 9 - the emergency in Gaza, there was no significant shift of external resources from recurrent to development expenditures in The recently released 2010 budget commits the PA to resume the path to less dependence on donor support for recurrent expenditures. The budget predicts a recurrent budget deficit of US$1.24 billion and US$667 million in development expenditures. However, these projections are based on strong assumptions and will require discipline on the PA s part. The projections assume real GDP growth of 7 percent in 2010 and that the PA will be able to increase domestic revenues by almost 18 percent through improved tax collection. The budget calls for the PA to slightly reduce non-wage expenditures after they have consistently increased in the last three years including by 35 percent in It also assumes that the PA will be able to reduce net lending by 35 percent in Finally, the PA s decision to give a general 4 percent wage increase to public sector employees has increased the budget 7. However, the share of the wage bill in GDP is still expected to decline from 24 percent in 2009 to less than 23 percent in Table 1: West Bank and Gaza: IMF Estimates of Central Government Fiscal Operations, Budget Est. Projections Est (In millions of US dollars, unless otherwise stated) Total net revenues 1,568 1, ,927 2,296 2,594 Gross domestic revenues ,031 Tax revenues Nontax revenues 1/ Clearance revenues (accrued) 1,122 1,123 1,103 1,320 1,505 1,701 Clearance revenues (cash) 1,137 1,123 1,090 1,320 1,505 1,701 Clearance revenues (net arrears accumulation) Tax refunds Total recurrent expenditures and net lending (commitment basis) 2,886 3,080 3,190 3,164 3,286 3,380 Wage expenditures (commitment) 1,453 1,410 1,467 1,550 1,612 1,676 Wage expenditures (cash) 1, ,423 1,550 1,612 1,676 Wage expenditures (net arrears accumulation) Nonwage expenditures (commitment) 985 1,290 1,349 1,364 1,411 1,480 Nonwage expenditures (cash) 1, ,142 1,364 1,411 1,480 Nonwage expenditures (net arrears accumulation) Net lending Recurrent balance (commitment basis, before external budgetary support) -1,317-1,450-1,592-1, add: expenditure arrears (net accumulation) subtract: net clearance withheld (+) or transferred from past collections (-) add: arrears on tax refunds The PA recognized that public sector wages were higher than in the private sector and unsustainable. To deal with this challenge, the PRDP committed the PA to having no general wage increase and allowing inflation to slowly lower real wages. However, due to unexpectedly high inflation of nearly 10 percent in 2008, the PA provided a 6 percent wage increase in Inflation in 2009 was only about 2.75 percent. The 4 percent general wage increase provides a real wage increase for most PA employees.

16 Budget Est. Projections Est (In millions of US dollars, unless otherwise stated) Recurrent balance (cash basis, before external budgetary support) -1,690-1,450-1,371-1,237-1, Capital expenditures 215 1, Overall balance (cash basis, including capital expenditures) -1,905-2,553-1,771-1,904-1,802-1,709 Total financing -1,905-2,553-1,771-1,904-1,802-1,709 Net domestic bank financing Other domestic financing External financing for recurrent expenditures 1,764 1,450 1,355 1,242 1, External financing for capital expenditures 215 1, Net external debt Residual Memorandum items: (In percent of GDP; unless otherwise stated) Revenues Recurrent expenditures and net lending Wage expenditures Nonwage expenditures Net lending Recurrent balance (commitment basis) before external budgetary support Recurrent balance (cash basis) before external budgetary support External budgetary support (recurrent) in millions of US dollars 1,764 1,450 1, ,242 1, Capital expenditures Overall balance (cash basis) Total external support (millions of US dollars) 1,979 2,553 1,755 1,909 1,808 1,716 Nominal exchange rate (NIS per US dollar) Nominal GDP (millions of US dollars) 6,108 6,318 6,117 6,940 7,774 8,862 Sources: Ministry of Finance and IMF staff estimates.

17 Table 2: West Bank and Gaza: Comparison of Baseline and Pessimistic Scenarios West Bank and Gaza: Comparison of Baseline and Pessimistic Scenarios Baseline Scenario Pessimistic Scenario Output and Investment Real GDP (percentage change) Real GDP per capita (percentage change) Gross capital formation (in percent of GDP) Of which: public investment (in percent of GDP) (In percent of GDP) Public finances 1/ Revenues Recurrent expenditures and net lending Recurrent balance (before external support) Recurrent balance, on a cash basis (before external support) Expenditure arrears accumulation Capital expenditures (In millions of U.S. dollars) , External recurrent budgetary support (in billions of U.S. dollars) Total external support, including capital expenditures (In billions of U.S. dollars) (In percent of GDP) External sector Exports of goods and nonfactor services Import of goods and nonfactor services Current account balance (excluding official transfers) Current account balance (including official transfers) Memorandum items: Unemployment rate (average in percent of labor force) Sources: Palestinian authorities and IMF staff estimates. 1/ Commitment basis, unless otherwise stated. III. THE GOVERNMENT S PROGRAM AND PARTICIPATORY PROCESSES 21. The PA presented a draft PRDP to the Paris Donor Conference in December 2007 and completed it in May The PRDP was developed internally by the PA, with limited input from the donor community. It reflects the Government s belief that it must act aggressively to control the budget and move towards greater self-sufficiency. During 2008, the PA made a concerted effort to begin implementing the plan s most important elements and in 2009 it continued to implement these reforms. In addition, it began developing a Palestinian National Plan that builds on the PRDP and when it is completed at the end of 2010, it will supersede the PRDP. The World Bank approved a Development Policy Grant (PRDP DPG I) in June 2008 and another (PRDP DPG II) in April 2009 to support the PA s reform agenda. The PRDP is a comprehensive and ambitious set of reforms that detail plans for spurring economic growth, establishing good governance and moving towards the ultimate goal of an independent Palestinian State. The focus of the PRDP is on improving the PA s fiscal position and

18 strengthening governance while directing the existing levels of expenditure and investment in the social sectors and public goods to priority activities and supporting the environment for private sector development. Because the PRDP was developed through widespread consultation across both the government and civil society, the PA has been able to make good progress towards the most significant goals. However, as the reforms have become more difficult and complex, the pace of reform has slowed. The following section discusses the PA s most important reform achievements over the past year and its goals for the immediate future. A. GOVERNANCE 22. While global governance indicators of WBG generally present a negative picture, 8 it needs to be recognised that WBG is not a state and many of the indicators are strongly affected by factors outside the direct control of the PA. These factors include the non-functioning of the parliament, and the expired mandates of the President and the parliament. Within this challenging context, the PA has taken a number of steps to strengthen governance. 23. Mindful of the need to restore the trust of citizens in its capacity to govern, the PA has concentrated on bringing safety, security and good governance to the territories under its control. While its ability to govern effectively in Gaza remains compromised by Hamas seizure of control and the continuing Israeli restrictions, the PA has made important progress in restoring law and order and better governance in the West Bank. But, they still have far to go to reach their goal of a secure and stable internal environment in which social and economic development can take place. 24. In its short existence, the PA has made significant progress in building institutions, required by any future Palestinian state, including passing progressive economic and social laws and conducting peaceful free and fair elections. The PA used 2008 as a time to restore and strengthen institutions that have been damaged by the withdrawal of donor assistance. In 2009, the PA went beyond restoration and made important strides on building new institutions and developing the capacity of existing ones. 25. Security is one of four national goals espoused by the PRDP, the others being: good governance, national prosperity and enhanced quality of life. Without first establishing security, it is unlikely that the other PRDP goals, including the ones supported by the Bank s PRDP DPGs will be attainable. In 2009, the PA made major progress in bringing safety and security to the West Bank. The PA deployed a large number of newly trained security forces throughout the major cities who have helped restore security and create a sense of normalcy. The improved security situation has led the GOI to reduce some of its internal security restrictions and is often cited by businesses as an important reason for the increasing economic activity. 8 The Global Integrity Report for 2008 identified a range of governance weaknesses many directly linked to the fact that the PLC is not functioning.

19 FISCAL REFORM 26. Fiscal reform is a cornerstone of the PRDP reform process and is directly supported by the Bank s development policy grants. As detailed above, over time, rising public expenditure has created serious fiscal problems. Rapid growth in the wage bill crowded out non-salary expenditures and the budget deficit had risen to unsustainable levels. Consequently, the PA has become heavily dependent on international aid to fund not only development expenditures but also much of the operating expenditures required to deliver basic services. In addition, a liquidity crisis, precipitated by economic sanctions during 2006, led to the accumulation of a large stock of arrears due to public sector employees (i.e., unpaid salaries) and to private sector suppliers, reaching a peak of US$1.3 billion during In 2008, through a program of reforms and substantial external aid, the PA was able to pay off the majority of the public sector arrears. 27. The PRDP calls for a number of policy actions to address the fiscal crisis and during 2009, the PA continued to take steps to improve its fiscal position. However, while the reform plan was implemented, the PA saw its fiscal position deteriorate because of unexpected costs arising from the military operations in Gaza at the end of Major actions called for by the PRDP to strengthen the PA s fiscal position include: i. Wage bill reduction In 2005, the number of public sector employees stood at just under 137,000. However, due to wholesale hiring during the run up to the 2006 elections and during the Hamas tenure, PA employment reached a peak of 189,000 in As a part of the PRDP, the PA committed to reducing its work force to 150,000 and then expanding by no more than 3,000 workers a year. These new hires would mostly be in the health and education sectors. Through strict implementation of civil service laws and elimination from the payroll of employees who were not legally appointed, the PA was able as of March 2010, to hold its work force to 149,5807 which is below the target. However, of the 6,643 net new hires between December 2008 and March 2010, 2,665 were in security and 672 were in the President s office while only 2,008 and 422 were in the education and health sectors respectively. The actual wage bill in the 2009 was about 2 percent higher than in the budget and about 12 percent more than in 2008, including a 4 percent general wage increase to make up for unexpectedly high inflation in By the end of 2009, the PA wage bill was 24 percent of GDP versus a budget target of 22.3 percent. However, the 2010 budget projects that the PA will achieve the PRDP goal of a public sector wage bill that is less than 23 percent of GDP. ii. Net lending The cost of subsidizing citizens consumption of energy and other utilities continues to represents a significant drain on government financial resources. This is primarily driven by the net lending phenomenon in the electricity sector which arises due to the noncollection (by utilities and municipalities) of electricity bills, and the diversion of utility revenues to fund municipal operations. This forces the central government to fund payments to the Israel Electricity Company (IEC) for bulk purchases of electricity in

20 order to avoid service disruption. Net lending began accelerating rapidly in 2006 and by 2007 was accumulating at a rate of approximately US$50 million per month; the PA and IMF estimate that it reached about US$535 million or nearly 11 percent of GDP for Under the PRDP, the Ministry of Finance (MOF) is working with local government officials on actions that will progressively reduce net lending to less than 5 percent of GDP by These actions, include enforcement measures such as requiring citizens to present a certificate of payment of utility bills in order to receive any municipal services and deducting overdue bills from PA employees pay, and financial incentives for municipalities to pay the IEC. Combined, these actions are aimed at progressively bringing an end to the non-payment of electricity bills. One of the main features of this plan is the distribution of pre-paid electricity meters. By March of 2010, the Palestinian Energy and Natural Resources Authority (PENRA) reports having installed 170,000 prepaid meters and is planning to begin sending them to Gaza. All of these actions are accompanied by provisions to ensure continued access to utilities services for those suffering extreme poverty. The Ministry of Social Affair s (MOSA) has expanded its poverty targeting database to assist the poorest households. In addition, the PA is investigating the feasibility of establishing a specific lifeline level of electricity which will be provided to ensure that poor and vulnerable families are not deprived of access. It is expected that this lifeline tariff could be introduced in Despite the actions listed above, net lending persists and was 6.1 percent of GDP in To eliminate net lending from electricity, the PA is pushing for utility provision to be based on economic principles and, within a finite timeline, provided under a full costrecovery basis. In actions supported by the previous DPGs, the Government established electricity distribution companies across the West Bank and Gaza that will be run on a commercial basis, and called for all local government electricity departments to be transferred to their control. In 2009, the PA passed a new electricity law that among other things established a regulator for the electricity sector. The regulator is using its authority to ensure that electricity distribution is in fact moved from local governments to the commercially run distribution companies. These companies, owned by the local governments, will ensure that debts are paid to the IEC before dividends are distributed to the owners. Once this process is finished, net lending caused by electricity subsidies in the West Bank should effectively be ended. iii. Tax administration reforms The PRDP calls for administrative reforms directed at further increasing the collection of tax and customs revenues. These include a variety of administrative and technical measures, including the creation of a Large Taxpayer s Office, focused inspections on fast-growing businesses with high cash incomes, strengthened supervision at crossings, automation of administrative procedures, and specialized training. In 2008, in order to provide a boost to the economy, the PA

21 increased the standard deduction for most taxpayers. However, because of increased collection efforts and economic growth in the West Bank, domestic tax collections in 2008 rose by 35 percent compared to 2007 and in 2009 they increased by more than 22 percent. 28. One of the most pressing problems facing the PA is the under-funding of public pension plans. In August 2008, the Palestinian Pension Authority began drafting a major institutional review. The review's structure and contents have been agreed with Bank staff. The stage focusing on legal and institutional arrangements and updating the medium-term financial and distributional projections of the pension system was ready in draft by March This document, together with the policy paper that was produced by Bank staff in October 2009, served as the basis for the Caretaker Government to compare reform options. It has helped the PA decide how it wishes to reduce the unfunded public pension liabilities while creating the preconditions to expanding system coverage. In addition to the policy dialogue, the Bank through the Financial Sector Reform and Strengthening (FIRST) Initiative is extending technical assistance for upgrading the regulatory framework for privately managed retirement products. ACCOUNTABILITY AND TRANSPARENCY 29. Improving accountability and transparency is one of the Caretaker Government s highest priorities and was another area of focused support under the PRDP DPG I and DPG II. Immediately after it came into office, the Caretaker Government made substantial efforts to restore accountability and transparency to public financial management through reconstituting the CTA, preparing budgets for 2007 and 2008, and preparing the PRDP. During 2009, the PA continued to make progress and the focus will remain on this area in the coming years. 30. In early 2008, the Caretaker Government appointed an Accountant General to supervise treasury, cash and debt management, budget execution, payroll, and accounting and financial reporting. It also established a new General Accounting Department to implement the improved accounting system. During 2009, the capacity of the department was further developed with a particular focus on the accounting function. In the course of preparing the 2008 financial accounts for audit, a number of weaknesses were indentified in the accounting procedures. While the weaknesses in the 2008 statements were addressed, remedial action was also taken to address these weaknesses as they affect future work. In addition, with the support of the United Kingdom s Department for International Development, the department has prepared a procedures manual to define the policies and roles and responsibilities of the various departments. The procedures will also support the transition from joint paper and electronic controls to a fully computerised expenditure control system. 31. The PA has introduced an upgraded computerized accounting system that is used for payments. The system, which has facilitated a move to decentralized budget execution (and hence greater accountability), has been rolled out to all budget institutions.

22 The PRDP details the Open and Accountable Government (OAG) program, which the PRDP DPG III will continue to support through its focus on public financial management. The OAG will consist of three sub-programs: System and process re-engineering including capacity-building in implementing integrated policy-making, planning, budgeting and accounting processes (from the Prime Minister s Office through to line ministries and agencies), capacity-building for the office of the Accountant General, implementation of a government-wide accounting and financial management information system, and strengthening of internal financial control functions; Building effective oversight institutions including capacity-building for independent audit functions and the Palestinian Legislative Council secretariat; and Monitoring and evaluation of government performance including capacity-building for a dedicated function at the center of government to monitor, evaluate and report on the efficiency and effectiveness of government performance and service delivery. 33..As indicated earlier, good progress was made in 2008 and 2009 on implementing a new government accounting system and building capacity in the Accountant General Department. Capacity building of the State Audit and Administrative Control Bureau as an external audit institution has also started, and will accelerate through a substantial project being started by the European Union. ADMINISTRATIVE AND CIVIL SERVICE REFORM 34. The PRDP contains the Efficient and Effective Government (EEG) program, which consists of three sub-programs: Reform of the public sector legislative framework drafting and upgrading laws and regulations that govern the mandates, structures and internal procedures of government bodies; Organizational and institutional development including detailed functional and strategic capacity building reviews of all ministries and agencies, organizational restructuring and streamlining of the public sector, the introduction of e-government, assistance to ensure that the Central Elections Commission is properly prepared to conduct forthcoming elections, and upgrading of the post office system; and, Civil service management including implementation of modernized human resources management systems and procedures, including merit-based appointments processes, employee performance evaluation mechanisms, reform of pay and grading structures, and leadership training. 35. Unfortunately, little progress has so far been made on most of these areas. However, in 2009, the PA identified human resource management as a priority for the coming three years. Containing the wage bill will require the PA to enhance the efficiency and effectiveness of the

23 civil service. Without an effective civil service system, it will be difficult for the PA to be able to resist pressure to increase hiring, raise wages and speed promotions. Consequently, civil service reform is an integral part of the fiscal strategy and the PRDP includes steps to enhance the efficiency and effectiveness of government by modernizing public administration and civil service management. Unfortunately, as long as the private sector is moribund, it is politically difficult to enact major reforms in this area. Consequently, the PA has not yet attempted a comprehensive civil service reform and is instead approaching it step by small step. Since 2008 a number of steps have been taken to strengthen the integrity of the payroll system and link it to the new accounting system. In 2009, the MOF introduced a system to ensure that all new hires by individual ministries were in line with the budget allocation for each ministry. In 2010, this system was expanded to include ensuring promotions also fall within budget. LOCAL GOVERNMENT REFORM 36. The Palestinian government system is one of the most decentralized in the region and the local governments are major service providers. They are also an important part of the net lending equation since many have not been paying their bills to the IEC. This can be explained by low collection rates and the fact that a handful of local governments are diverting the revenues collected to finance other expenditures. Thus, improving local government finances is essential for addressing the PA s own fiscal problem. The PRDP proposes the Accountable Local Government (ALG) program which would: (i) introduce new legislation to clarify and regulate the relationship between central and local government; (ii) establish a policy framework which promotes fiscal autonomy and discipline at the local level; and (iii) build the operational, administrative and financial management capacity of local government bodies. 37. The Municipal Development and Lending Fund (MDLF) was set up as an independent intermediary that channels funds towards municipalities for service delivery and also provides them with technical assistance. The MDLF works in close collaboration with the Ministry of Local Government, which is responsible for regulating the sector and setting policies. Furthermore, the MDLF has harmonized donor assistance (managing over US$100 million in funds over a 3-4 year period) to the municipal sector by applying for the first time, clear and transparent criteria for allocating development grants. Accordingly, the MDLF is the PA s preferred mechanism for channelling reform and development assistance to local governments and disbursements must be coordinated with the MOF. The MDLF is the primary source of development-linked assistance to municipalities, and to support the implementation of essential administrative and financial management reforms. Several donors have already committed significant assistance to the MDLF for a multi-phased Municipal Development Program, and are likely to increase their assistance over the coming three-year period. A core part of this assistance will include improving financial management practices and piloting different approaches for enhancing local revenue generation. The PRDP DPG I supported the first essential task of helping local municipalities develop modern accounting systems to allow them to produce transparent budgets. The PRDP DPG II extended this effort by supporting the implementation of the Integrated Financial Management System among pilot municipalities. It

24 also supported the design and implementation of a Grant Allocation Mechanism to municipalities based on the following criteria: 40 percent performance, 40 percent population and 20 percent need. Performance is measured against 12 indicators of commonly accepted good management practices addressing planning, financial accountability and management. Funds are allocated based on rank; cities with higher rankings will be eligible for more funding than those with lower rankings. B. SOCIAL DEVELOPMENT 38. The PRDP states that while the Caretaker Government is committed to pursuing a private sector-led approach to securing economic growth and social development for all its citizens, it is also mindful of the need to protect vulnerable groups, including women and youth, recognizing that it is essential that these groups are not left behind as the economy grows. Consequently, the PRDP calls for heavy investment in social development and efforts to scale up on-going effective social protection and social assistance mechanisms. The PRDP DPG I and DPG II supported this as a way to mitigate any risks associated with pursuing the PRDP fiscal goals and the PRDP DPG III will continue this support. SOCIAL PROTECTION 39. With the population growing at approximately 2.7 percent per year, and with unemployment and poverty rising, especially in Gaza, there is a pressing need to scale up effective and on-going social protection instruments and make better use of existing resources. This pressure to provide basic services and other assistance to the poor has distracted attention from the pursuit of more strategic development goals. The PRDP recognized the need to increase the efficiency and improve the management of social safety net systems and the PA has developed a Social Protection Strategy. 40. Social assistance in WBG is provided through a complex web of PA organizations, NGOs and other external agencies implementing a series of uncoordinated social protection initiatives. This has inevitably led to poor targeting and an inefficient allocation of resources. As a result, in 2009, the PA cabinet formally approved a merger of the two main on-going cash assistance programs the EU funded Special Hardship Case (SHC) with the World Bank funded Social Safety Net Reform Project (SSNRP) and their transformation to the Palestinian National Cash Transfer Program (PNCTP). This formal merger triggered the preparation of the PA s cash assistance strategy outlining the major orientations of the PNCTP, including a PNCTP targeting database based on a proxy means test (PMT), uniform payment modalities and amounts regardless of funding source, and sound PNCTP monitoring and evaluation arrangements, among other things. The PNCTP is expected to become fully functional in In this context, MOSA is preparing a detailed action plan with milestones in order to closely monitor PNCTP progress. In addition, there is a pressing need for MOSA to define clearly the PNCTP s operating modalities through an updated PNCTP operations manual. This manual would include detailed information on the PNCTP s updated poverty targeting formula methodology, household eligibility and benefit levels, duration of benefit payments, etc.

25 To improve targeting of its cash assistance, MOSA has updated the PMT formula, using data from the 2007 PCBS Household Budget and Expenditure Survey. As of end October 2009, the PA had re-screened 37,000 SHC and SSNRP households to ascertain their eligibility to continue to receive cash benefits under the updated PMT formula. 9 The PA estimates that there are about 160,000 households living below the extreme poverty line, and plans on screening about 5,000 households quarterly to ascertain their eligibility to receive cash assistance through the PNCTP. Unfortunately, the political situation in Gaza has prevented MOSA from introducing the new system there. However, MOSA expects to begin making new home visits in Gaza in Until that time, the current SSNRP and SHC programs continue to run in parallel. 42. During 2009, the Bank provided an additional US$5 million funding from the Global Food Crisis Response Trust Fund (GFRP TF) and another US$3.4 million from the GFRP TF was approved in April 2010 to provide extraordinary payments to about 25,000 households living below the extreme poverty line that were negatively affected by the recent fuel and food crisis. The PA has demonstrated to the international community that it is putting in place the necessary structures and systems to rapidly scale up its cash assistance and other safety net programs during crisis situations, using state of the art poverty targeting mechanisms. This is likely to provide further assurances to key donors to support the PNCTP. The Bank has been working closely with key donors including the EU, WFP, and UNRWA to ensure their continued support for the PA s targeting modalities. EDUCATION, HEALTH AND EMPOWERMENT 43. While the PRDP DPG III is focused on supporting the PRDP goals of strengthening the fiscal position, including reducing net lending, and improving public financial management, it also supports the social protection agenda. However, there are a number of other PRDP goals in areas that have important fiscal implications, such as health and education that the PRDP DPG III does not directly support. The PA sees education as a basic human right and seeks to guarantee citizens access to a comprehensive education system consisting of: pre-school, basic and secondary education; formal and non-formal education; technical and vocational education; and higher education. The PA s commitment to the education sector is illustrated by the fact that PRDP reports that education accounts for more than 30 percent of proposed budget support for recurrent expenditures and approximately 20 percent of donor support requested for the public investment program. With the necessary levels of support from donors, the PA believes it can modernize the education system in line with its vision of a future Palestinian state a state with a knowledge-based economy, connected to the global community that embraces humanistic values and is tolerant. The Ministry of Education and Higher Education (MOEHE) is implementing its five year Education Development Sector Plan (EDSP) for Donor commitment to the EDSP is strong: key donors have shown their willingness to support the EDSP through a Sector Wide Approach (SWAP) mechanism (through pooled or parallel funding arrangements) to continue empowering the MOEHE to manage the sector in the most effective manner. 9 About 2% were found to be non-eligible.

26 Until recently, Palestinians enjoyed a quality of health care that compared favorably to most middle income countries. Prior to 2000, the health care system recorded high levels of immunization, prenatal care and effective basic health services. However, strains on the system are reflected in declining health indicators in, for example, waterborne communicable diseases, access to vital services and substantial increases in malnutrition rates and conflict-related trauma. There is no doubt that the system faces a unique set of challenges related to occupation including, but not limited to, elevated levels of insecurity, fiscal pressures and restrictions on mobility. The Bank completed an in-depth review of health sector financing and is currently working with the MOH to disseminate key findings of this review such as a fragmented institutional framework, unpredictable health financing and donor dependence, and increased burden of disease. The MOH is in the process of preparing a Health Sector Strategy to address these issues and build a strategic management capacity to reform health financing among other things and increase the quality and affordability of public health care. 45. The PRDP recognizes an urgent need to implement proactive programs to empower youth and women in the Palestinian society and to help alleviate unemployment and poverty through employment generation initiatives. The PRDP calls for a Women s Empowerment (WE) program and a Youth Empowerment (YE) program to assist women and youth. These are supposed to be coupled with an Employment Generation Initiative (EGI) to provide productive, paid employment and micro-financing programs to unemployed and vulnerable people across the West Bank and Gaza. There has been little movement on this front; however the PA sees the small scale infrastructure projects supported by the community development grants as being linked to this agenda, as they are intended to be labor intensive. While these programs are important elements of the PRDP, they are not specifically supported by the Bank s DPGs. C. ECONOMIC AND PRIVATE SECTOR DEVELOPMENT 46. The PRDP envisions a dynamic private sector as the engine of economic growth in WBG. Private sector growth is necessary to provide jobs for the rapidly expanding population and tax revenues to support service provision by the PA. The PRDP contends that the Palestinian economy has enormous potential for future growth and a revival from its current condition is urgently needed. However, political uncertainty, combined with continued settlement expansion, restrictions on movement and trade, and restrictions on access to resources, have strangled investment and stripped the economy of the bulk of its productive capacity. In 2009, economic growth revived in the West Bank but much of this growth can be attributed to increased government spending instead of high levels of private sector investment. However, increased investment in construction, the recent start of operation by the second mobile operator and increased access of Israeli citizens to the West Bank are promising indicators of a slowly improving business environment. 47. Recognizing the centrality of private sector development, the PA is taking what steps it can to revive private investment. The PA and the private sector collaborated to highlight

27 investment opportunities in WBG in the second Palestine Investment Conference held in June, The new Minister of National Economy has made improving the business environment a high priority. In 2010, the PA amended the Companies law, passed a secured lending law and has taken steps to make business registration easier. In the coming year, the PA expects substantial support from USAID and other donors for its work on the business environment. The PA is also taking steps to spur growth by encouraging private public partnerships in infrastructure projects and in the housing sector. There are already a number of large housing projects being undertaken by private investors that are being facilitated by the PA. One of the most important recent developments has been the reorientation of the Palestine Investment Fund (PIF). Previously, this large investment fund held most of its assets outside of WBG and used its dividends for the benefit of the Palestinian people. However, now it has brought home much of its portfolio and is aiming to have up to 80 percent of its more than US$800 million in assets invested in WBG. Among other things the PIF has partnered in a large loan guarantee fund, an affordable mortgage and loan program, a number of housing projects and some smaller businesses. In the coming year, the PIF plans to launch the first private equity fund in WBG. Despite these substantial efforts, there is only so much the PA can do. Ultimately, private sector growth, and the sustainability of the PA will depend upon improvements in the security environment and the GOI reducing its restrictions. D. PUBLIC INFRASTRUCTURE DEVELOPMENT 48. After years of conflict and under-development, Palestinian public infrastructure networks and systems offer limited coverage, are poor in quality and are unaffordable for some vulnerable groups. Household connection rates to utilities are high compared to the regional average but actual consumption rates are low due to a combination of supply shortages and inefficient distribution systems. Accordingly, substantial investment in public infrastructure is required. Over the long-term, the PA will work towards ensuring that public infrastructure and utilities are managed on a commercially-oriented and financially viable basis and, over time, increase the level of private sector investment and participation in infrastructure and utilities. Again, this area is not directly supported by the Bank s DPGs beyond issues related to net lending; however, the Bank is active in a number of sectors including power, water and to a limited extent transport. E. CONSULTATIONS 49. The PRDP has been successful because it was developed through wide ranging discussions and consultations that included all stakeholders ranging from government agencies to civil society. Working groups, that included representatives for all major stakeholders were formed for different sectors such as health and education. The working groups drafted plans for the sectors, which were forwarded to the Ministry of Planning and Administrative Development (MOPAD). The MOPAD then pulled all of the sector plans together to complete the PRDP. Once the PRDP was drafted, it was widely circulated and commented upon before it was adopted. Because of the extensive consultations, the PRDP is generally accepted and has strong support across the full spectrum of Palestinian society and within the donor community. The PA

28 is currently taking a similar approach as it develops the new National Plan that will succeed the PRDP. 50. Many of the specific reforms supported by DPG III are quite sensitive. Therefore, the PA continued to hold consultations to develop popular support for specific actions. Municipalities were concerned that transferring electricity distribution would deprive them of funds they relied on to provide basic public services. To gain a better understanding of this issue and develop a strategy to address it, the Ministry of Local Government (MOLG), MOF and municipalities had many meetings and conferences. Often the MDLF and World Bank assisted this effort by holding workshops on the importance of electricity revenues for municipal finances and how could the negative impact of the transfer be mitigated. Specific consultations on the transfer of electricity distribution include: On November 16, 2009, the MOLG and the Bank presented the issue of municipal electricity arrears to the Municipal and Local Government Sector Working Group composed of key PA and donor actors in the municipal sector and discussed possible options/solutions. On February 17, 2010, the Bank team sponsored a large consultation with mayors, financial managers and directors of municipalities (over 50 participants attended) as well as representatives of the Palestinian Energy and Natural Resources Authority (PENRA), MOF, MOLG, MOPAD and donors. The consultation was based on the findings of Bank report which highlighted that electricity service provision places a soft budgetary constraint on municipalities: on average municipalities that provide electricity have fewer sources and collect less revenue than those which do not; they also tend to have higher deficits. This highlighted the need to establish hard budgetary constraints and to design policies that would mitigate the shock of transferring electricity distribution from local governments to commercially run companies. March 23 through March 25, 2010, the Bank team held bilateral consultations with seven municipalities (Jenin, Nablus, Beita, Ya bad, Al Yamoon, Anabta and North Aseera) that will be directly impacted by the transfer. The consultations were to help the municipalities develop measures to mitigate the negative impact of the transfer on service delivery. On April 27, 2010, the Bank team had consultations with MOLG, MDLF, PENRA, and MOF to explore options on electricity transfer with a goal of minimizing the cost of losing electricity cash flow. 51. In addition to the consultations listed above, the MDLF and Bank team sponsored additional workshops where recent studies on the impact of introducing prepaid meters and the importance of electricity revenues in municipal finance plans were presented. As the transfer of distribution moves forward, PENRA plans to continue holding workshops and public meetings.

29 The outcome of the consultation process on transferring electricity distribution has been the recognition by local governments that they cannot continue to rely on electricity revenues to support operating expenses. The PA in turn has developed a better understanding of the financial support required by local governments to help them transition from their reliance on electricity revenues. Many issues remain to be resolved including how to value electricity assets, deal with pensions for employees in the electricity sector, etc. But a robust consultation mechanism has been established that will allow these issues to be effectively dealt with. 53. Merging the cash assistance programs was another reform that the PA prepared for, by holding extensive discussions with stakeholders. MOSA held four consultation workshops across WBG to present the new cash transfer strategy. The workshops were held with relevant stakeholders from NGOs, the private sector, civil society, local governments and beneficiaries. MOSA supplied detailed minutes and recommendations from the workshops to the Bank team that was preparing the second global food price crisis response grant in February The consultations focused on explaining to the beneficiaries the new program benefit levels, how the PMT formula was updated, which variables were added, changed or removed, the overall merger with the EU program, and the reference to using 2007 PCBS households and expenditure survey. Most importantly, they also discussed the phasing out process for households above the extreme poverty line and the various programs into which they will be channelled, e.g. micro-finance. MOSA is continuing to hold consultations as it makes additional changes to its cash assistance programs. 54. The PA has held extensive discussions on pension reform and again the Bank encouraged and supported some of these. The MOF and Palestinian Pension Agency (PPA) technical staff met regularly to develop the plan. One major meeting took place in October 2009 where the Bank team presented its analysis on the sustainability of the current pension scheme and the impact of possible parametric changes. In addition, the Prime Minister s budget speech makes clear, that in lines with the PRDP, public pension reform is a high priority for the current government. On July 26, 2010, the MOF and PPA hosted a forum on the pension reform plan. In attendance were members of the Pension Governing Board, AMAN (local governance NGO), Public Workers Union, Retirees Association and other members of civil society. The PPA team made a presentation on the plan followed by open discussion, where a number of issues were raised including: Is the purpose of the reform to merely save government resources or in the interest of the retirees? The PPA team explained that it was the government s attempt to ensure the sustainability of the Pension Fund and to protect future retirees. The MOF team also added that the PA s fiscal situation requires some retrenchment in pension outlays, and that the reform was in line with best international practices. Some in attendance questioned the elimination of early retirement and the lengthening of the retirement age. The PPA team cited several examples on why that was necessary and added that a number of industrial countries are doing the same.

30 Another important point discussed was that the pension system is intricately linked with the Civil Administration Law. Some representatives argued that before moving on pension reform the PA should reform the Civil Administration procedures. The meeting also discussed and explained the proposal to move towards a Notional Defined Contribution in the proposal. By the end of the meeting, all who attended had a thorough understanding of the proposed plan the MOF and PPA were give significant feedback from the principal stakeholders. Box 1: Bank Disclosure Procedures and Consultations The World Bank is committed to providing timely and full disclosure of its projects and actions to all stakeholders. In September 2009, the MENA Region presented an action plan to the Bank s Board of Directors detailing renewed efforts to implement the Bank s policies on disclosure and consultations. Among other things, the Action Plan calls for the Bank to provide translation of core operational documents (PIDs, PADs and PDs) into Arabic in countries where Arabic is the main business language. Consequently, all of the relevant documents for the DPG III will be translated into Arabic and made publicly available. The action plan also calls for Country Directors, Country Managers and Task Team Leaders to strengthen outreach to civil society stakeholders. The Bank s West Bank and Gaza maintains a directory of civil society organizations to assist Bank project teams as they conduct outreach to local society. In preparation of the DPG III, Bank teams consulted widely with all major stakeholders in the areas supported by the operation, including social safety net reform, electricity sector reform and municipal finance. The Bank will continue to engage with civil society as it supports the PA s reform process. IV. BANK SUPPORT TO THE GOVERNMENT S PROGRAM LINK TO CAS 55. Since WBG 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 Note 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 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. 57. 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 recently completed a study on access to water in WBG and a major poverty study is ongoing.

31 The Bank continues to provide technical assistance to the telecommunications sector, PPA, 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 these areas, this analytical work has mobilized support from other donors. 58. The main effort of the Bank s strategy is to continue supporting the PA s implementation of the PRDP through the proposed PRDP DPG III. The PRDP s success depends upon three critical factors: (i) the PA effectively carrying out 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. 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$1.355 billion in budget support in 2009; over US$107 million of which was provided through the Bank managed PRDP-TF. This proposed third 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. COLLABORATION WITH THE IMF AND OTHER DONORS 59. The Bank works closely with the IMF and other donors to support the PA s implementation of the PRDP. As mentioned above, the Bank consults with the IMF when it issues quarterly reports assessing the PA s progress on implementing the PRDP. To enable this, the IMF team was closely involved in the development of the policy matrices for the Bank s DPGs including DPG III. In WBG, 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. 60. 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 PRDP 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 PFM expert and draws on analytical work done for the Bank s recent Public Expenditure Review. The IMF s report on PFM was instrumental in developing the PFM

32 section of the DPG III policy matrix. The IMF is providing technical assistance to 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. 61. The PA receives an enormous amount of external financial and technical assistance from a wide variety of sources. The PA prepares its budget based upon its needs and previous donor pledges. Throughout the year, the PA, along with the IMF monitors actual contributions and seeks to encourage donors to fulfil their pledges. To help coordinate these disparate efforts, the Bank participates in a robust system of donor working groups. The Bank co-chairs the Economic Sector Working Group, which seeks to harmonize and coordinate the activities of the various donors on all aspects related to public financial management, budget support, and fiscal policy. The single largest source of budget support comes from the EU Palestinian-European Socio-Economic Management and Assistance Mechanism (PEGASE) program and the Bank coordinates its activities closely with the EU and other providers of budget support through the working group. In addition, the efforts of the EU and other donors are informed by the Bank s quarterly reports on the PA s reform progress. RELATIONSHIP TO OTHER BANK OPERATIONS 62. The Bank s ongoing portfolio consists of 11 projects focusing on budget support, electricity, water and sanitation, education, solid waste, municipal finance, community development and the NGO sector with a net commitment amount of US$179 million. In addition to this proposed PRDP DPG III, there are four other projects either approved or in the pipeline for FY2010: Teacher Education Improvement Project. Objective: To improve the quality of teaching in general education schools in WBG and in doing so contribute to enhancing students learning. North Gaza Emergency Sewage Additional Financing II. Objective: to provide a longer-term solution to the treatment of wastewater for north Gaza. Capacity-Building for Palestinian Economic and Regulatory Institutions. Objective: to improve the economic management and regulatory capacity of key Palestinian public institutions. Palestinian NGO IV. Objective: To provide social services to those who are poor, vulnerable or marginalized through NGOs and to strengthen the institutional capacity of these organizations. 63. The proposed DPG III is integrally tied to the Bank s other projects in WBG and the conditionality called for in the policy matrix complements the other projects. For example, the provisions on net lending are in line with the proposals of the Electric Utility Management

33 Project and the actions on the social safety net conditions are likewise drawn from the Social Safety Net Reform Program. The Capacity Building Project directly supports the PPA and will assist the PA in implementing its pension reform plan. It also helps develop the PA s ability to monitor its economic performance. 64. The Bank s analytical and policy work has from the outset laid the basis for its role in WBG. 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. 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 Pensions Authority has assisted the PA in producing their action plan. 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 SSNRP and Electricity project have helped improve internal PA capabilities thereby increasing donors confidence to use PA systems. LESSONS LEARNED AND REFORM PROGRESS 65. The PRDP DPG III draws on lessons from the Bank s extensive experience of providing budget support to the PA. The most recent experience comes from the PRDP DPG I and PRDP DPG II, which were disbursed in June 2008 and July 2009 respectively. The Bank is currently managing the PRDP-TF, which allows donors to provide budget support based on the Bank s monitoring of the PA s progress on implementing the PRDP. Also, from , the Bank managed a multi-donor trust fund called the Public Financial Management Reform Trust Fund for the West Bank and Gaza ( The Reform Trust Fund ). This trust fund provided untied budget support that was disbursed based upon the satisfactory meeting of reform benchmarks agreed to between the donors and the PA. The DPG series has been successful at supporting PA structural reforms. As discussed in Section III above and seen in Annex?, the PA has made progress on controlling growth of the public sector wage bill, reducing net lending and increasing the efficiency of the social safety net. In addition, there have been substantial improvements in the PFM system. 66. The success of the proposed PRDP DPG III depends upon the PA being fully committed to the reform goals. The Bank has a large body of evidence accumulated over decades of development experience around the world, which shows that for successful reform, goals cannot be imposed from the outside or be established in response to donor pressure. The previous Reform Trust Fund was less successful than hoped because, while the benchmarks were negotiated with the MOF, there was less buy-in from other ministries. Learning from this experience, the MOPAD developed the PRDP in close consultation with all ministries and various advisory groups that included civil society and set goals that were expected to be politically and technically feasible. This careful preparation has paid off and over the past two years, the PA has made steady progress in implementing the PRDP reforms supported by the

34 PRDP DPG I and PRDP DPG II. They have also developed a system to keep donors regularly informed on progress, via regular reports and an improved MOF website. 67. The areas where the PA has had the most success are in controlling the wage bill and rebuilding financial management capabilities. Indeed, the PA held the wage bill below the 2008 budget target and barely exceeded the 2009 budget target. The MOF resumed publishing revenue and expenditure statements and introduced a number of other improvements in public financial management. The PA has also made progress on enhancing the social safety net targeting system. Net lending fell by nearly a third between 2007 and 2009 is projected to continue falling as the PA takes more actions in Gaza. The PA has been less successful at tackling particularly difficult issues such as pension reform. It is clear from past experience that this is something that has to be done on a step by step basis after careful preparation and consultation. Consequently, the newly adopted pension reform plan will be slowly implemented over the coming years. 68. 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. Passing legislation remains difficult as the Palestinian Legislative Council does not meet. Changes in the donors political views also affect their willingness to meet their pledges or to hold fast to specific benchmarks. Given these challenges, recent experience suggests that the best approach is to select a mix of measures to deepen reform while also taking advantage of quick wins. 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 they may fail to meet due to circumstances beyond their control. This approach was successfully used in the PRDP DPG I and DPG II and will be continued under the third DPG. 69. Experience from both the PRDP-TF and the previous DPGs has revealed that it is challenging to verify reform progress in a fully satisfactory manner. The management capacity in many ministries is still developing and in the case of the Reform Trust Fund, it was at times difficult for the PA to provide timely documentation to verify that they had or had not achieved their goals. Consequently, the Bank was more deeply engaged in the PRDP DPG I and DPG II. The leadership for the PRDP DPGs was located in the Bank s country office and the Bank brought in a PFM expert to be resident in the country office and work extensively on the policy dialogue. This same model will be continued for the PRDP DPG III. ANALYTICAL UNDERPINNINGS 70. The proposed PRDP DPG III is grounded in careful analytical work of which one of the most significant pieces remains the World Bank s Public Expenditure Review (PER). The PER was completed in early 2007 and details the PA s desperate fiscal position. It takes a more strategic view of Palestinian public finances and addresses two critical and fundamental issues that confront the PA and its partners. The first is the challenge of bringing aggregate expenditure

35 closer to likely revenues and available financing. Second, is the issue of the composition of expenditure, and hence 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 are still accurate and serve as a good guide to policy. For example ongoing analytical work on the civil service system is updating much of the PER and verifying that its main recommendations are still valid. 71. The IMF has done substantial analysis of the macro framework and the public financial management (PFM) system, which complements the findings of the PER. The IMF s analysis is summarized in bi- annual reports, the most recent of which was produced for the Ad Hoc Liaison Committee meeting in April The IMF reports that the Palestinian public financial management and procurement systems were restored to the level that they were prior to the Hamas government and that the PA has made a number of improvements beyond that. In December 2009, the IMF completed another PFM mission and in consultation with the PA, updated a detailed action plan to improve the PFM system. This action plan focused mainly on the accounting and budget execution systems and is reflected in the attached policy matrix. To support the plan, the IMF has conducted follow on missions to assist with the implementation of the new computerized accounting system and the introduction of cash planning. 72. In March 2009, the IMF conducted a mission which focused primarily on budget preparation issues but also reviewed progress on the earlier action plan. This mission gave particular attention to the way the budget preparation is organised by the Ministries of Planning and Finance, and the proposed budget program budgeting reforms. A further follow up mission took place in December The Bank has produced a number of other analytical pieces that inform both the PRDP and proposed PRDP DPG III. The Bank s power sector review has been used to help set the goals for reforming the power sector. In addition, Bank staff compiled all available information and produced a short report on how the PA can tackle the problem of unpaid utility bills and reduce net lending. 10 To extend this work, the Bank supported a report on the impact of pre-paid meters on municipalities and another paper that analyzes municipal finances and the importance of electricity revenues in municipal budgets for funding current operations. This paper reveals that electricity revenues are only important for a small number of local governments and the issue of unpaid bills is not as widespread as originally thought. In addition, the Bank supported a just completed paper that analyzes the major expenditures and sources of revenue for 10 Net lending refers to the PA s financial support to municipalities and other public entities, chiefly to cover utility expenses. These outlays are recorded as net lending because they notionally should be repaid and are therefore considered assets by the PA. Net Lending is conducted in two ways: 1) the PA provides cash to entities; and 2) GOI deducts from the tax clearance revenues what the municipalities owe in utility payments. The majority of net lending consists of payments for electricity, rebates to the Palestinian Petroleum Agency for part of the taxes it incurs on fuel purchases and purchases of fuel for the Gaza Power Plant.

36 municipalities. The PA will only be able to achieve budget sustainability if the private sector grows. To provide an understanding of the constraints to private sector growth, the Bank completed an Investment Climate Assessment (ICA) in The ICA, along with on-going analytical work on movement and access showed concretely the impact of the GOI s closure regime on the private sector. In October 2009, the Bank finalized a short paper on pension reform. This paper examined the current PA public sector pension system and analyzed possible parametric changes. The PA relied on this report along with supplementary analysis in developing its pension reform plan. 74. In 2004, the Bank and PA conducted the first Country Procurement Assessment Report (CPAR) for WBG. This report analyzed the public procurement system, including its policies, organizations, procedures and practices. The report also made a number of recommendations to assist the PA in improving its public procurement system. In June 2008, the Bank produced a Country Procurement Issues Paper (CPIP) to assess the current state of the system. The CPIP essentially confirmed the findings of the earlier. In 2009, the Bank initiated a Country Fiduciary Assessment that combines both the financial management and procurement assessment tools. However, in view of the large number of financial management reforms in the process of implementation, it was decided to postpone completion of the assessment till V. THE PROPOSED PALESTINIAN REFORM AND DEVELOPMENT PLAN DEVELOPMENT POLICY GRANT III OPERATION DESCRIPTION The proposed operation will help the PA continue to implement the PRDP. Following on the DPG I and DPG II, the DPG III will also support efforts to strengthen the fiscal position and increase government transparency and accountability. 75. The proposed operation is designed to support the PA as it continues to implement the reform program detailed in the PRDP, by supporting actions in two policy areas: (i) strengthening the fiscal position and (ii) improving public financial management. The PA implemented the plan throughout 2008, 2009 and the first half of As detailed in World Bank monitoring reports, the PA is making steady progress. To have the largest impact, the proposed PRDP DPG III maintains the focus on the same two policy areas supported by the previous operations. These are critical building blocks for the government of an 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 policy matrices has helped strengthen the PA s capacity to achieve its desired reforms and to also build the required support among donors. This third operation is expected to have a similar impact. The prior actions for the past two DPGs and how they relate to the prior actions for DPG III can be found in Annex 3.

37 The Bank supports the PRDP process in two complementary ways. First, it administers the PRDP-TF, as requested by the PA. Second, it will provide additional budget support with its own funds through the proposed PRDP DPG III. The PRDP-TF is operating successfully and since its inception has disbursed nearly US$500 million in untied budget support to the PA CTA. The PRDP DPG III 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 PRDP 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 II and going forward, on the basis of indicators set out in the policy matrix for the PRDP DPG III attached as Annex 2 to this report. Additional disbursements from the PRDP-TF may be made on the written request of the PLO 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. 77. 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. 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 donor community expects to see the PA continue to make significant strides towards controlling its budget deficit by controlling the wage bill and reducing net lending. The PA has committed to reducing the wage bill from around 27 percent of GDP in 2007 to less than 23 percent by The change in total net lending will depend on the cost of fuel, electricity demand and how soon the PA can regain control of Gaza. However, currently the PA is projecting that net lending will decline from around US$535 million in 2007 to about US$250 million by 2010 and to US$224 million in 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. POLICY AREAS i) Strengthening the Fiscal Position Prior Action 1: The 2010 Budget Law of the Palestinian Authority includes provisions to ensure that all promotions in the Palestinian Authority are supported by adequate budget allocations. 78. Wages and salaries are the largest expenditure in the PA budget and until recently were the fastest growing component of the budget. By 2007, wages and salaries for public employees exceeded total domestic revenues and were continuing to grow. Consequently, the Prime Minister and his team determined that to strengthen the fiscal position, it is essential that they

38 control the public work force. The PA has made progress and has brought the wage bill down from more than 25 percent of GDP in 2007 to about 24 percent in Continuing to hold the line on employment and the wage bill is a prerequisite for achieving the macroeconomic stability required by the PRDP. To gain control of the wage bill and bring it in line with the PRDP plan, the Caretaker Government has instituted a number of reforms. The 2010 Budget law includes provisions to ensure that all promotions in the PA are supported by adequate budget allocations. Later in the year, the PA plans to introduce a new integrated human resources and payroll system, which will streamline and automate personnel actions. These actions combined with earlier reforms will help control the wage bill and are substantial steps towards achieving the budget projections of reducing the public sector wage bill to less than 23 percent by 2010 and less than 19 percent in To maintain progress, the PA must keep a tight lid on new hiring and the 2010 budget commits the PA to hold to the PRDP commitment to annually make only 3,000 new net hires. Because of the sharp and unexpected rise in inflation in 2008, the PA was not able to stick to its PRDP commitment of no general wage increase and the 2009 budget provided a 4 percent increase. The 2010 budget also contains a 4 percent pay rise and the Minister of Finance has indicated that the PA will continue to follow a policy of providing small annual general salary increases. Prior Action 2: The Council of Ministers adopted a plan for pension reform that seeks to control the growth of pension liabilities. Prior Action 3: The Council of Ministers adopted decision to ensure that Palestinian Authority employees may not draw pensions until they reach statutory retirement age. 80. The PA public pension system is extremely generous and one of the PA s largest and 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. This is not sustainable and consequently in July 2010 the Council of Ministers adopted a public pension reform action plan that seeks to limit the growth of pension liabilities. To begin implementation of this plan, the Council of Ministers adopted a parametric change in 2010 that forbids drawing pensions before the statutory retirement age. The ending of early retirement is expected to save at least NIS21 million annually. Going forward, among other things, the action plan calls for an increase in the retirement ages, centralization of administrative records, and for the PA to investigate the options of converting to a Notional Defined Benefit system. Net Lending 81. Net lending is one of the largest single expenditures in the budget and its largest component is the cost of electricity delivered to the municipalities from the 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. This situation is very costly and the PA has been making a concerted effort to control it. Net lending dropped from NIS2.2 billion in 2007 to about

39 NIS1.9 billion in Because of the PA s reforms, it is projected to fall to NIS850 or about 2.5 percent of GDP in By 2007, a culture of non-payment had taken hold in large parts of WBG and over the past three years the PA has taken steps to increase collection rates for electricity and re-establish a culture of payment. The PA instituted a system of requiring citizens to show certificates of payment (COP) attesting that they are current on utility bills to receive some government services. The PA also began deducting utility payments from the pay checks of delinquent PA employees. By far, the most effective step has been the introduction of pre-paid meters and the PA reports that it has distributed nearly 170,000 in the West Bank and in 2010, began to send some for installation in Gaza. Collection rates in the West Bank are reported to have risen to as high as 80 percent in some local areas and PENRA sees little room to increase them as long as residents of refugee camps remain exempt from efforts to collect payment. Box 2: Prior Actions For The PRDP DPG III Prior Action 1: The 2010 Budget Law of the Palestinian Authority includes provisions to ensure that all promotions in the Palestinian Authority are supported by adequate budget allocations. Prior Action 2: The Council of Ministers adopted a plan for pension reform that seeks to control the growth of pension liabilities. Prior Action 3: The Council of Ministers adopted decision to ensure that Palestinian Authority employees may not draw pensions until they reach statutory retirement age. Prior Action 4: Electricity distribution in Nablus municipality transferred to NEDCO and NEDCO is effectively operating. Prior Action 5: SSNRP and SHC cash assistance programs merged into the PNCTP that is operating using a single payment modality in the West Bank. Prior Action 6: In 2009, the Palestinian Authority expanded the number of municipalities in which it collects property tax from 25 to 34 municipalities. Prior Action 7: A new economic and administrative budget classification has been developed for use in the preparation of the 2011 budget and is aligned with the economic classification based on the GFSM 2001 structure. Prior Action 8: All line ministries are connected to the new computerized financial management system. Prior Action 9: New module for commitment control introduced into the Ministry of Finance s computerized accounting system to provide more control over capital expenditures. Prior Action 10: The Palestinian Authority s 2008 financial statements are prepared and submitted for audit to the Palestinian Authority s State Audit and Administrative Control Bureau. 83. The problem of net lending for electricity will not be completely solved in the West Bank until electricity distribution is moved from local governments to commercially run distribution companies. In May 2009, the PA adopted a new electricity law that among other things established a new regulator and called for the transfer of electricity distribution to licensed distributors, i.e. distribution companies, by June Because of the difficulty to this

40 undertaking, the PA will not meet the mid target. However, led by PENRA, the PA is now moving steadily ahead on making the transfers. The first critical step was to appoint the members and activate the Palestinian Electricity Regulation Committee (PERC), which was done in February Among other things, PERC will set operating standards for licensed distributors and ensure they are operating on a commercial basis and not being used to subsidise municipalities current operations. Prior Action 4: Electricity distribution in Nablus municipality transferred to NEDCO and NEDCO is effectively operating. 84. In previous years distribution companies were created throughout the West Bank: the Jerusalem District Electricity Company (JDECO), the Southern Electric Company (SELCO), the Hebron Electric Power Company (HEPCO) and the Northern Electric Distribution Company (NEDCO). JDECO has been operating on a commercial basis for many years. HEPCO and SELCO are operational but not on a fully commercial basis. NEDCO, Northern Electric Distribution Company was established in 2008 to serve the northern West Bank but has not been operational. Local governments in the Northern West Bank account for the largest share of electricity net lending and this should cease once they all have transferred their distribution systems to NEDCO and it becomes fully operational. In April 2010, the Council of Ministers adopted a resolution directing that local governments transfer their electricity distribution and affirming that the PA will provide funds to help local governments transition from their dependence on electricity revenues. This has enabled the transfers to start. Nablus was the first city transferred and NEDCO began operating, issuing bills and distributing electricity to Nablus in June Over the next year to 18 months, PENRA expects to continue to supervise the transfer of electricity distribution from local governments to the commercial companies throughout the West Bank. This process will be done step by step beginning in the North and then moving to the South. Within a year, PENRA expects that 80 percent of electricity distribution in the Northern West Bank will be done through NEDCO. When the full transfer is completed, net lending from electricity in the West Bank is expected to cease and the remaining amounts will come from Gaza, where actions to reduce net lending have been hampered by the political crisis. Improve targeting of social safety net to ensure the most vulnerable populations are protected 85. The push to increase 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. Some of the local governments have already established programs to assist the poor but going forward the PERC has committed to working with PENRA to establish a lifeline tariff,

41 where a basic amount of domestic consumption is billed only at cost. This will allow for the provision of a basic level of service at a minimum price for the poorest households. 11 Prior Action 5: SSNRP and SHC cash assistance programs merged into the PNCTP that is operating using a single payment modality in the West Bank. 86. In addition to the lifeline tariff, the PA is continuing to improve its ability to effectively target and deliver social assistance. The SSNRP and SHC cash assistance programs have been merged into the Palestinian National Cash Transfer Program now using a single payment modality in the West Bank. The new system uses a revised Proxy Means Test (PMT) formula that was updated using 2007 PECS information and new cut-off points. The new PMT formula requires that MOSA revisit households and update their data in the targeting database, while at the same time visiting new homes. By June 2010, more than 40,000 households in the West Bank had been verified using the new PMT and entered into the database. By the end of the year another 15,000 are expected to be added. As households are verified, 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. In 2010, MOSA plans to begin payments to 4,000 new households that fall below the absolute poverty line the West Bank. Adopting the PNCTP will not bring savings to the PA budget as new households will be added, but it will improve efficiency and ensure that only the most needy are receiving cash benefits. The political situation has prevented the households in Gaza from being revisited and updated, however the MOSA hopes to be able to resume visits soon and by mid 2011, have recertified using the new PMT all 24,000 households that are currently in the database in Gaza. In the meantime, the old SSNRP and SHC systems continue to be implemented in parallel. Improve Domestic Revenue Collection Prior Action 6: In 2009, the Palestinian Authority expanded the number of municipalities in which it collects property tax from 25 to 34 municipalities. 87. The PA has made raising domestic revenue collection a key component of its strategy to move toward fiscal sustainability. The PA expanded the collection of property tax and in 2009 increased coverage from 25 to 34 municipalities. In 2010, property tax collection is expected to be rolled out to another 15 municipalities. At the same time that the coverage is being expanded, the MOF has initiated a program to re-value property and in 2009 it re-valued properties in 15 of the 25 municipalities originally covered by the tax. As a result of these actions, the MOF expects property tax collections to rise from JD13.5 million in 2009 to JD23 million in 2010 and JD30 million in The PA has committed to doing this previously. However, without the activation of the PERC it was not possible. Thus, it should be possible to do this within the next 18 months.

42 ii) Improving Public Financial Management Prior Action 7: A new economic and administrative budget classification has been developed for use in the preparation of the 2011 budget and is aligned with the economic classification based on the Government Financial Statistics Manual (GFSM) 2001 structure. 88. Improved public financial management and greater transparency are necessary to not only increase government s efficiency, but to attract donor support for untied budget support. This is a top priority for the PRDP and the proposed PRDP DPG III. The program begins with re-establishing basic controls and moves on to developing a system of internal and external audits. Producing annual budgets in a transparent manner is a key component and the PA has reestablished its budgetary system and is regularly producing budgets again. The MOF has also developed a new economic and administrative budget classification for use in the preparation of the 2011 budget that is aligned with the economic classification based on the IMF s Government Financial Statistics Manual 2001 structure. 12 In the next year MOF expects to include an annex to the 2011 budget that provides detailed financial information for all major development expenditures. Prior Action 8: All line ministries are connected to the new computerized financial management system. 89. The PA continues to strengthen its system of internal controls and improve the accounting system. The MOF has completed connecting all line ministries to its computerized accounting system. The completion of this system will allow the PA to both introduce new controls on spending by line ministries and with a new budget module to streamline the preparation of the budget. It is anticipated that the 2011 budget will be developed and adopted by January of In 2010, the budget was not finalized until the end of March and the PA operated for the first quarter of the year on the basis of the 2009 budget. 13 The MOF has also developed financial management policies and procedures for budget execution to support the new computerized financial system. The implementation of the computerized system has allowed the MOF to strengthen the CTA by closing all non-zero balance line ministry and agency bank accounts for recurrent expenditures not required by donor agreements. Prior Action 9: New module for commitment control introduced into the Ministry of Finance s computerized accounting system to provide more control over capital expenditures. 90. In the past, the MOF has not had mechanisms to control expenditures except for the annual budget. As a result when expected external support did not arise, arrears accumulated. Consequently the PA has had difficulty controlling growth in arrears, particularly in the capital budget. In 2010, a new module for commitment control of capital expenditures was introduced into the MOF s computerized accounting system. This will help limit accumulation of arrears by 12 While GFSM 2001 is an accrual methodology the economic classification will be based on the cash accounting system used in West Bank and Gaza. 13 Law number 7 of 1998 on regulating the Public Budget and the Financial Affairs allows the PA to operate on the basis of 1/12 of the prior year budget until the new budget is passed.

43 providing a mechanism for the MOF to restrict capital expenditures to available resources. Because the MOF has not had a strong system of controls, it has been difficult for them to accurately estimate arrears on a timely manner. For example, in 2009, more than US$142 million in arrears were unexpectedly brought forward from The MOF has still not finalized precise estimates of arrears for 2009 and thus it is not possible to specify how much the new controls will reduce arrears in 2010, especially as they only were implemented in the middle of the year. However, the new system should ensure that going forward, no commitments in the capital budget can be incurred without approval of the MOF and this should not only reduce arrears but also allow the MOF to report the position on a timelier basis. Prior Action 10: The Palestinian Authority s 2008 financial statements are prepared and submitted for audit to the Palestinian Authority s State Audit and Administrative Control Bureau. 91. Auditing and reporting remains an important feature in the PA s plan to strengthen accountability. In 2009, the MOF accelerated its program of internal audits and among others produced audits for Ministry of National Economy, Ministry of Social Affairs, and Bureau of the Chief Justice, the Ministry of Education and Higher Education, Ministry of Interior, Palestinian Land Authority, Ministry of Transportation and Palestinian Broadcasting Corporation. Most importantly, the MOF prepared its 2008 financial statements and sent them for audit to its external auditor - the State Audit and Administrative Control Bureau (SAACB). The SAACB is currently finishing the audit with the assistance of Deloittes accounting firm. Compiling the 2008 accounts took more time than expected and many issues were encountered. However, with the help of the United Kingdom s Department for International Development, the MOF has dealt with these issues and in the future the financial statements will be prepared on a much timelier manner. It is expected that the 2009 accounts will be prepared in line with the cash based International Public Sector Accounting Standards and the audit will be completed before the end of Principle 1: Reinforce ownership Box 3: Good Practice Principles for Conditionality Unlike previous reform plans, the PRDP 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 PRDP. 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 carefully 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 DPG I and II. 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 III 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

44 Bank is supporting these efforts by maintaining the PRDP-TF and through the proposed PRDP DPG III. Principle 4: Choose only actions that are critical for achieving results as conditions for disbursement The PRDP 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 PRDP 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. VI. OPERATION IMPLEMENTATION POVERTY AND SOCIAL IMPACTS 92. A major focus of the PA s plan is to control growth in the government work force and collect utility bills, both of which have the possibility of negatively impacting the most vulnerable parts of society. A large share of the Palestinian population depends on the wages of public employees. The dependency rate is estimated to be about 6-8 for each public employee and there are currently about 150,000 employees. Consequently, if the private sector remains stagnant and Israel does not allow increased employment of Palestinian workers in Israel, the inability to increase public employment could lead to increased poverty rates. The economic crisis has left many households in a position where they cannot pay their utility bills. As noted above, by some measures over half the Gaza households and nearly a quarter of the West Bank households are in poverty. Thus, increasing collection rates must be done carefully to not cause undue hardships on the most vulnerable groups. 93. The PA recognizes these risks, and as they pursue their PRDP goals, they will make protecting vulnerable groups their top priority. Consequently, the PRDP DPG III will continue to have social protection as one of its pillars. The PRDP DPG III actions are complementary to and will likely enhance the performance of other Bank projects and PA programs such as the SSNRP and the EUMP. 94. To ensure the protection of the most vulnerable households, which are often those headed by women, the PRDP DPG III is supporting the rapid expansion of the targeting data base and unification of the main cash assistance plans by the MOSA. The Ministry has verified the status of more than 40,000 households using the new PMT formula and is expecting to add another 15,000 in the West Bank and 24,000 in Gaza by mid This will help direct aid to the most vulnerable households to ensure that those that might suffer the most from any negative impacts

45 of the PRDP receive support. An accurate database and a unified system will help the PA provide assistance to reduce any gender disparities since female headed households appear to be one of the most vulnerable population groups. In addition, it is expected that the unified cash assistance plan, combined with an accurate targeting database, will attract additional financing from other donors. The implementation of the unified system will mean that some households that were previously receiving benefits will be dropped since they no longer meet the minimum requirements for cash assistance. To mitigate the effects of this, households will be provided payments as they are removed from the system over time. In addition, they may be re-directed to other social assistance programs including micro-finance, food assistance, temporary employment generation programs, or vocational training activities. 95. Efforts to collect electricity bills could negatively impact the most vulnerable groups. However, the PA, with Bank support, is working to mitigate this risk. The pre-paid meters are being installed in the more affluent areas first and no households are being disconnected for nonpayment. The Bank s team working on the power sector is ready to assist the PA to develop a pricing policy and methods of collection that will allow the poorest consumers to still obtain electricity while increasing collection from those more able to pay. The PA is investigating options such as establishing a lifeline tariff that provides for basic needs at a minimal cost or providing pre-paid cards to the poorest families. In the long run, as collection efforts increase, pre-paid meters may benefit the poor. In many countries, the poorest households cannot afford service on credit and the introduction of pre-paid meters actually increases access to electricity. 96. The Bank s social protection team is working closely with the PA to implement its Social Protection and Reform Integration Program. This program sets explicit quality and service standards for both governmental and non-governmental providers and ensures uniform payment modalities and amounts. Assessing the impact of PA programs requires good data on poverty levels. The targeting database, with its variables to measure consumption, is one source. But the PA needs the ability to asses overall poverty trends throughout WBG. The PCBS regularly conducts the Palestinian Expenditure and Consumption Survey (PECS), which provides an excellent source of information on household poverty including by gender. The Bank is providing technical assistance to the PCBS to help it increase the reliability and accuracy of its data; most notably it has an ongoing technical assistance program on poverty estimation. This will allow it to be used to help monitor whether the PRDP actions are having a negative impact on poverty and to target the social safety net to mitigate any such poverty increases. In addition, the Bank s Capacity Building for Palestinian Economic and Regulatory Institutions project is providing PCBS capacity building on its national accounts, data quality and agricultural census. ENVIRONMENTAL ASPECTS 97. The PRDP DPG III operation will not have significant likely 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.

46 Additionally, the proposed PRDP DPG III does not have any investment lending subcomponent involving physical investment. Although DPGs are not formally subject to Bank safeguards Policies, a review of the environmental implications of this operation concluded that the PRDP DPG III operation will not have significant effects on the country's environment, forests and other natural resources. IMPLEMENTATION, MONITORING AND EVALUATION 98. 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 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 and II, 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 PRDP DPG III continues this approach. The matrix is drawn from the PRDP and reflects lessons learned from the last operation. 99. The Bank team managing the PRDP DPG III is located in WBG 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 at the Jerusalem office to work alongside the Country Economist monitoring the PRDP DPG III. The task team leaders for the social safety net reform and municipal finance assistance are also resident in the WBG office. The main ministries responsible for implementing the reforms supported by the PRDP DPG III are the MOF, MOSA and PENRA with which the Bank has developed a strong relationship. The PFM expert works closely with 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 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 of the PRDP DPG I and II across the entire PA eliminated many of the difficulties monitoring progress that are encountered in the previous budget operation. This will be continued for the PRDP DPG III.

47 Table 3: Monitoring Reform Progress Actions Improving Fiscal Position Control of wage bill Reduction in Net Lending Increase in utility collection rates and commercialization of electricity distribution Social Safety Net issues Pension reform Improve domestic revenue collection Improving Public Financial Management How monitored IMF and Bank PFM expert working with MOF IMF and Bank PFM expert working with MOF Bank power team working with Palestinian Energy Authority as a part of the EUMP Bank HD team working with the Ministry of Social Affairs as they implement the SSNRP Bank HD team working with the PPA and the MOF IMF and Bank team working with the MOF IMF and Bank PFM expert working with MOF FIDUCIARY ASPECTS Public Financial Management System 101. According to the last Country Financial Accountability Assessment (CFAA) conducted in 2004, the Palestinian PFM system is judged to be adequate insofar as the Bank s criteria and standards for approval of a general budget support operations are concerned. The CFAA has also concluded that the fiduciary risk level in the Palestinian PFM system was significant due to weaknesses in the PFM systems. Recent IMF reports state that the PA s PFM system has improved significantly beyond the level that it was in prior to the most recent elections in early 2006 and the cut-off in direct aid The CFAA and later follow-ups (by the Bank and other donors) reported major improvements in the PFM systems of WBG. Notable improvements in PFM include the following: (i) (ii) (iii) (iv) (v) Launch of the new accounting system that will help consolidate budget implementation process, strengthen payment controls and improve fiscal reporting. All PA revenues are now paid into the CTA. An orderly system of budgetary appropriation is now in force. MOF is exercising firm control over budget expenditures and has imposed strict limits on non-wage expenditures. The MOF has placed financial controllers in each ministry.

48 (vi) A central internal audit department was established in MoF and there is now a program to create internal audit departments in line ministries in line with the devolution of the payment function. The central treasury account has been strengthened and zero balance bank accounts have been established for line ministries with all other accounts except those required by donors closed. (vii) The State Audit and Control Bureau is to receive substantial technical support to develop its capacity as an external audit agency as part of a new project of the European Union. (viii) Control over the civil service payroll has improved significantly. While there used to be separate payroll systems for West Bank and Gaza, and for civilian and security sectors these have now been consolidated. A link between the payroll and the accounting system has also been established allowing ensuring that all payments are checked against available budget. (ix) (x) System of direct salary deposit: The salaries of the PA s civil and security servants are all paid through direct deposit into personal employee bank accounts. The MOF is now exploring with the Palestinian Monetary Authority options to make non-wage expenditure payments through direct deposit. 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, much more remains to be done to further consolidate progress and address the challenges facing the PFM systems. The PA has recently prepared a PFM reform strategy as an input to the development of the Palestinian National Plan (a successor to the PRDP). The strategy identifies reforms in a range of areas including tax administration, budget preparation, budget execution and reporting, and audit: Further integration of donor programming into the annual development budget. Having donors channeling their funds through the CTA unless there are good reasons to the contrary, will require strong PA leadership and a much enhanced level of effort by donors to harmonize their planning, disbursement and procurement procedures with those of the PA. While the budget is now presented on the basis of ministry programs, the definition of the programs and their use for management and accountability purposes will need to be improved over time.

49 Although external audit development has started, building the capacity of the institution to a satisfactory level will require 2-3 years of well-monitored capacity development. Improved cash management and forecasting and improving the link between the forecasts and the commitment control system that has now been established It should be noted that these measures have all been identified by the PA itself as PFM reform objectives and are being supported by this proposed PRDP DPG III. DISBURSEMENT AND AUDITING 105. 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 PRDP DPG III is a single tranche operation. The amount of the PRDP DPG III will be disbursed in one tranche comprising the full amount of the grant provided the macroeconomic framework is satisfactory and the Bank is satisfied with the implementation of the program by the recipient Flow of Funds. The Bank would disburse funds into a GBP British Pound Deposit Account maintained under the 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, as is currently the case with the CTA. The MOF would convert the GBP amount into New Israeli Shekels (NIS) at the going exchange rate and transfer them to the MOF treasury account when needed to cover budgetary financing needs. World Bank DPG III Diagram 1: flow of funds arrangements for PRDP DPG III: MOF Designated Account for DPG II Foreign Currency MOF Treasury Account NIS Account Budget Financing Activities Reform Plan Auditing 108. As discussed before, the 2004 CFAA concluded that the fiduciary risk level in the Palestinian PFM system was significant. While, there has been progress since then, the risk remains significant. Accordingly, the PA will hire an independent external auditor acceptable to the Bank to perform a one-time audit of the PRDP DPG III Deposit Account at the MOF. The audits will comply with international standards and be completed and submitted to the Bank within six months from the release of the single tranche payment. These audits would be financed by the PA. The audit would cover and ensure the following:

50 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; 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 PNA and governmental standards including accuracy of exchange rate conversion In addition, a confirmation letter is required from the MOF that the funds have been received and deposited into the DA and that an equivalent amount has been transferred to the single treasury account. In this case, MOF needs to provide to the Bank (within 30 days) a written confirmation that this transfer has been completed, and provide to the Bank any other relevant information relating to these matters that the Bank may reasonably request Due to the progress in the PFM reforms summarized above, and with implementation of the additional fiduciary requirements proposed by the Bank, the Bank has a reasonable assurance of the reliability of the MOF PFM system for the use of funds under a budgetary support operation. RISKS AND RISK MITIGATION The PRDP s success depends on parallel actions by the PA, GOI and the donor community The PRDP calls for the PA to move towards fiscal stability, within the expected level of external support by However, 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. It is unlikely that the PA will continue to regularly receive the high level of support seen in the recent years. Thus, to maintain the support it needs, the PA must make rapid and steady progress on the announced reforms. The Caretaker Government has demonstrated its willingness to take politically difficult actions, including holding the line on the public sector work force, collecting utility bills, and implementing security sector reform. In addition, it has taken actions to extend its security control in some of the most problematic parts of the West Bank. The PA has increased its transparency and improved public financial management and is continuing to make steady progress on this front However, progress becomes more difficult as the reforms become more politically sensitive. Consequently, the PA will need to continue to maintain its strong domestic political support. Holding down the public sector wage bill will continue to be a difficult challenge given the slow growth in the private sector. The 2010 budget calls for all development expenditures to be donor financed and not funded by the CTA. However, in the absence of donor financing, the

51 CTA has been used to continue funding the community development projects. If the required donor finance does not come later in the year, this program could impose a large and unexpected burden on the PA s budget. The most demanding task facing the PA is to control the security environment. While the PA has made progress, so far, it has not made enough progress to lead the GOI to fully relax its closure regime The PA will not be able to meet its fiscal goals without substantial private sector growth, which will provide the jobs needed by the expanding population and the tax revenues required to fund government services. The PRDP was formulated on the optimistic assumptions that over the next three years, real growth will average more than 8 percent annually. However, sustained private sector activity is largely dependent on the GOI relaxing its closure regime and allowing Palestinian enterprises reliable access to markets. In the past year, the GOI has made some improvements including opening movement within the West Bank and allowing Palestinians from Israel to visit and shop in the West Bank. However, much of the recent growth has come from the donor supported public sector and conditions remain such that a sustained high level of private sector growth is not likely. If the security situation deteriorates, private sector growth and consequently the PA s fiscal position will suffer even more Donor support remains the third determinant of the PRDP s success. The PRDP assumes high and sustained donor assistance throughout the plan s life and continuing into the future. 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 able to deliver basic services let alone achieve the popular support required to undertake the most politically difficult actions. The donors have responded with exceptional generosity and total budget support in 2009 is estimated at US$1.355 billion. In 2010, the budget projects a need for about US$1.24 billion for recurrent expenses but there is no guarantee that this will be achieved. By the end of June 2010, the PA reported only having received US$525.1 million, nearly US$100 million less than needed during the period. As a result, the PA has once again had to resort to domestic borrowing and accumulating arrears. In addition, many donors front loaded their assistance in the early part of the year and it is likely there will be a larger shortfall in the last half of the year. Thus, if new sources of aid are not identified the PA will have to resort to additional borrowing and continue to build up arrears to the private sector. This could negatively affect growth and also jeopardize confidence in the PA. However as long as the PA maintains steady progress on structural reforms, it is expected that the budget deficit will continue to decline; falling to less than 9 percent of GDP in 2011 compared to 26 percent in Thus, the PA should be able to manage arrears and debt that it incurs in 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:

52 The Bank has worked with the PA to place some categories of public expenditures into projects such as putting social safety net payments into the Social Safety Net Reform Project. This will help attract donor project funding for recurrent public expenditures within the framework of a project; 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 PRDP DPG III, 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; 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; The Bank has established a website to keep donors, NGOs and the public appraised of reform progress and has a consultant dedicated to providing communications and outreach to all stake holders. 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, Telecoms, power sector, payments system, municipal finance, public pensions and social sectors. As mentioned above, the Bank maintains its field-based staff to improve its monitoring and delivery of assistance WBG is an unstable and high risk environment. But this country risk affects all projects in the portfolio and is not unique to the proposed PRDP DPG III. Because the PRDP DPG III provides untied budget support, there is a risk, not associated with other projects, that the funds could be used for purposes they are not intended for. However, this is significantly reduced by the quarterly monitoring and the 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 its 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 WBG. Continuing support of the Caretaker Government and its reform program will help the PA to create institutions that will be needed by a future Palestinian State.

53 ANNEX 1: LETTER OF DEVELOPMENT POLICY

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59 ANNEX 2: OPERATION POLICY MATRIX Objectives Prior Actions By July 2010 West Bank & Gaza PRDP DPG III Policy Matrix Results in Next 12 Planned Actions in Next Months 12 Months ( ) ( ) Medium Term Objectives (PRDP Goals) I. STRENGTHEN THE PA FISCAL POSITION I.1 Control Public Sector Wage Bill The 2010 Budget Law of the Palestinian Authority includes provisions to ensure that all promotions in the Palestinian Authority are supported by adequate budget allocations The Council of Ministers adopted a plan for pension reform that seeks to control the growth of pension liabilities PA 2010 wage bill does not exceed budget target of NIS6,053 million Public sector wage bill is less than 23% of GDP compared to 24% in 2009 PA implements integrated payroll and human resource system Records of all PA public pensions centralized with Palestinian Pensions Authority In 2012 the wage bill declines from over 27% of GDP to less than 19% of GDP The PA is implementing a strategy that will gradually put the PA pension schemes back on a path towards financial sustainability The Council of Ministers adopted decision to ensure that Palestinian Authority employees may not draw pensions until they reach statutory retirement age

60 Objectives Prior Actions By July 2010 Results in Next 12 Months ( ) Planned Actions in Next 12 Months ( ) Medium Term Objectives (PRDP Goals) I.2 Reduce Net Lending I.2a Reduce net lending by transferring all electricity supply and distribution to distribution companies established in accordance with the Companies Law Electricity distribution in Nablus municipality transferred to NEDCO and NEDCO is effectively operating In 2010 net lending falls to NIS950 million or less than 5% of GDP compared to 6.1% in 2009 At least 80% of electricity in Northern West Bank being distributed by the newly operational NEDCO PERC issues new electricity tariff PENRA supervising transfer of electricity distribution in both Northern and Southern West Bank to distribution companies In 2012 total net lending declines to about 2.5% of GDP Electricity collection rates rise to about 90% on average across the West Bank All electricity in West Bank done on a commercial basis and local governments no longer accumulating arrears to PA or electricity I.2b Improve targeting of social safety net to increase efficiency and ensure the most vulnerable populations are protected SSNRP and SHC cash assistance programs are merged into the PNCTP that is operating using a single payment modality in the West Bank All households receiving benefits under the PNCTP are below absolute poverty line MOSA conducts home visits, verifies the data and enters into the targeting database 55,000 households in the West Bank MOSA recertifies 24,000 households in Gaza Electricity distribution companies implement a lifeline tariff or other measure to ensure most 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

61 Objectives Prior Actions By July 2010 Results in Next 12 Months ( ) Planned Actions in Next 12 Months ( ) Medium Term Objectives (PRDP Goals) vulnerable households are able to access minimum level of electricity I.3 Improve domestic revenue collection In 2009, the Palestinian Authority expanded the number of municipalities in which it collects property tax from 25 to 34 municipalities Property tax collections rise from JD13.5 million in 2009 to JD23 million in 2010 and JD30 million in 2011 Expand property tax collection to 49 municipalities by end 2010 PA municipalities operating on a sustainable financial basis without diverting electricity revenues PA gross domestic revenue collection rises to 11% of GDP by 2012 II. INCREASE GOVERNMENT TRANSPARENCY AND ACCOUNTABILITY THROUGH IMPROVED PUBLIC FINANCIAL MANAGEMENT II.1 Improve efficiency and transparency of the budget preparation process A new economic and administrative budget classification has been developed for use in the preparation of the 2011 budget and is aligned with the economic classification based on the GFSM 2001 structure 14 PA budget presented in a transparent manner and accounts are comparable on an international basis Fiscal framework for 2011 budget aligned with framework for the Palestinian National Plan budget includes an annex that provides detailed financial information for all major development 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 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.

62 Objectives Prior Actions By July 2010 Results in Next 12 Months ( ) Planned Actions in Next 12 Months ( ) Medium Term Objectives (PRDP Goals) II.2 Establish upgraded institutional and regulatory procedures to support PFM reforms All line ministries are connected to the new computerized financial management system 2011 budget prepared and adopted by January 2011, compared ;to March in 2010 Develop capacity of staff in the new macroeconomic and fiscal forecasting unit New budget module developed for the computerized accounting system and used in preparing the 2011 budget A fully computerized accounting system used throughout the government, which will allow the PA to dramatically improve its accounting and reporting capabilities in line with acceptable international practice II.3 Strengthen PFM infrastructure and improve auditing functions New module for commitment control introduced into the Ministry of Finance s computerized accounting system to provide more control over capital expenditures The Palestinian Authority s 2008 financial statements are prepared and submitted for audit to the Palestinian Authority s State Audit and Administrative Control Bureau All purchase orders for capital expenditures subject to MOF control Implement capacity building plan for the SAACB audit staff based on a comprehensive needs assessment Adopt auditing guidelines for external audits IPSAS 2 compliant 2009 financial statements prepared and audited by December 2010 A strong Central Treasury Account continues to operate 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 PA has a strong system of external audits 2 International Public Sector Accounting Standards

63 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 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 The Council of Ministers adopted decision to ensure that Palestinian Authority employees may not draw pensions until they reach statutory retirement age I.2 Reduce Net Lending 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 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 Electricity distribution in the municipality of Nablus transferred to NEDCO and NEDCO is effectively operating

64 Objectives Prior Actions DPG I Prior Actions DPG II Prior Actions DPG III and distribution to distribution companies established in accordance with the Companies Law Establishment of the Northern Electric Distribution Company (NEDCO) the power sector and providing the 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 in full I.2b Improve targeting of social safety net to increase efficiency and ensure the most vulnerable populations are protected 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 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 I.3 Improve domestic revenue collection In 2009, the PA expanded the number of municipalities in which it collects property tax property tax from 25 to 34 municipalities

65 Objectives Prior Actions DPG I Prior Actions DPG II Prior Actions DPG III 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 A new economic and administrative budget classification developed for use in the preparation of the 2011 budget aligned with the economic classification based on the GFSM 2001 structure 15 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 Launch of a new computerized accounting system in the MOF 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 15 While GFSM 2001 is an accrual methodology the economic classification will be based on the cash accounting system used in West Bank and Gaza.

66 Objectives Prior Actions DPG I Prior Actions DPG II Prior Actions DPG III 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 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 2 International Public Sector Accounting Standards 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

67 ANNEX 4: FUND RELATIONS NOTE West Bank & Gaza Assessment Letter to the World Bank August 6, 2010 Contact person: Mr. Oussama Kanaan (okanaan@imf.org, telephone in Jerusalem ) Economic Conditions and Outlook The overall macroeconomic situation continued to improve in 2010 in the West Bank and Gaza (WBG), following solid growth in The Palestinian Authority (PA) has continued institution-building and economic and security reforms, supported by generous aid. The Government of Israel (GoI) has relaxed some restrictions on movement and access in the West Bank during In 2009, real GDP growth in the West Bank and Gaza (WBG) is estimated at 6.8 percent for 2009, consisting of 8.5 percent growth in the West Bank and 1 percent in Gaza. Real GDP growth in the first quarter of 2010 (compared to the first quarter of 2009) is estimated at 11 percent for the West Bank and 14 percent for Gaza. The solid growth reflects continued recovery of private sector confidence due to the Palestinian Authority (PA) s reforms supported by donor aid. Looking ahead, the strong growth outturn for the first quarter of the year, along with the recent GoI measures to relax Gaza s blockade, make projected real GDP growth of 7 percent for 2010 feasible. The unemployment rate in the WBG remains high at over 22 percent. In 2009, the unemployment rate averaged 18 percent in 2009, reflecting the pickup in growth. In Gaza, the unemployment rate in 2009 was unchanged at about 39 percent, reflecting the still suppressed economic activity. The WBG unemployment rate declined from 25 percent to 22 percent in the first quarter of 2010, and is expected to decline further in the remainder of the year, especially in Gaza with the relaxation of the blockade. The PA s 2010 budget builds on the last year s progress in institution-building and public finance reforms. In 2009, even though the war in Gaza burdened the budget with substantial non-wage emergency spending the recurrent deficit on a cash basis was in line with the budget target. However, non-wage expenditure commitments were above budget and a shortfall in donor aid, relative to the budget s financing requirements including Gaza s emergency spending, resulted in non-wage arrears. The 2010 budget aims to reduce the recurrent deficit on a commitment basis to $1.24 billion from $1.59 billion in Fiscal performance in the first half of 2010 has been broadly as envisaged in the 2010 budget, with the exception of a shortfall in non-tax revenue. Recurrent expenditures and tax revenue are in line with budgeted amounts, while non-tax revenue are somewhat lower than budgeted due to delays in the transfer of dividends to the budget from the Palestine Investment Fund (these are expected to be transferred by October). The annualized recurrent deficit on a cash basis for January to June is estimated at $1.3 billion compared to the budgeted $1.2 billion. Recurrent external aid disbursed during January to end-july 2010 is estimated at $0.5 billion,

68 about $200 million less than envisaged in the budget. The external financing shortfall (reflecting less-than-expected aid from Arab donors) has contributed to the accumulation of expenditure arrears, and an increase in net indebtedness to commercial banks by about $200 million. There is little scope for additional loans from commercial banks, given the already high level of indebtedness to banks, which has reached about $0.8 billion by August 4, There is thus an urgent need to raise external financing for the budget to allow the payment of salaries in early September (to cover the August wage bill). Despite the delays in aid disbursements, the PA has been pressing ahead with structural reforms and institution-building, which are expected to reduce external financing requirements for 2011 and beyond. The external financing shortfalls is not expected to adversely affect fiscal sustainability once adequate aid is disbursed as envisaged in the 2010 budget. Inflation declined during 2009, and has remained low so far in The twelve-month CPI inflation rate fell to 2 percent in mid-2009, rose to 4 by end-2009, and further to 5 percent by February Inflation decreased further to 3.7 percent by end-may The CPI fluctuations reflected largely changes in world petroleum and food prices. Domestic banks have not been significantly affected by the global crisis and private sector credit continued to grow in the West Bank, but has been subdued in Gaza. Overall, banks in the WBG have had very limited exposure to global markets, and applied conservative lending practices domestically. Non-performing loans (NPLs) and watch list loans fell as a share of total bank loans from 11 percent at end-2008 to about 3 percent at end-june In the West Bank, private credit rose by 23 percent in real terms in 2009, and by 34 percent in the first half of 2010, reflecting the improved economic conditions. The rise in private credit also partly reflected the increased supply of loanable funds as the Palestine Monetary Authority (PMA) lowered the limit on bank deposits placed abroad from 65 percent to 55 percent of total deposits. However, in Gaza real private credit contracted by 15 percent in 2009, reflecting subdued private investment, before rising by 5 percent in the first half of 2010 as conditions improved with a slight easing of import restrictions. Since 2008, the Palestinian Monetary Authority has been making steady progress in institutional reforms with intensive Fund technical assistance. Risks and Challenges Concerted actions by the PA, the GoI, and donors are essential to sustain the economic recovery and reduce risks to the economic outlook: To maintain the growth momentum in the West Bank, lifting remaining restrictions on movement and access is essential, including those on external trade, especially on exports to Israel, as well as on economic activity and investment in Area C. The impact of the war in Gaza and persistent blockade has worsened the humanitarian situation and severely restrained growth. The recent measures to ease restrictions on consumer imports and inputs for public reconstruction projects should help the recovery. However, it is important to also remove restrictions on imports of inputs for private investment, lift restrictions on exports and on the movement of people into and out of

69 Gaza. It is also important to lift remaining controls on entry of cash into Gaza, and reestablish correspondent relationships between Palestinian and Israeli banks. Given the difficult liquidity situation and its potential adverse impact on private sector and bank confidence, it is important for the PA to maintain a fiscal stance in line with the 2010 budget and for donors to ensure timely and predictable aid disbursements. It is important to prevent a repeat of the 2009 situation when expenditure commitments exceeded available cash, leading to significant arrears accumulation and domestic bank borrowing. Toward that end, the PA should continue to enhance commitment controls and cash management as well as strengthen tax administration. It is also important for the PA to make full use of the new computerized accounting system and undertake a careful prioritization of its planned expenditures with a view to postponing lower priority spending commitments. This could involve delaying recruitment of new public sector employees, or postponing lower priority investment projects. Donors, for their part, should urgently disburse the aid envisaged in the 2010 budget, especially in view of the limited scope for further bank borrowing by the PA. Status of IMF Relations WBG 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.

70 ANNEX 5: PDO INDICATORS FROM DPG I AND DPG II DPG I PDO Indicators (P111078) Indicator Indicator 1 : Value (quantitative or Qualitative) Baseline Value Control Public Wage Bill Public wage bill was 24.6% of GDP in 2007 Original Target Values (from approval documents) Target value was for the wage bill to be 24.3% of GDP in 2008 Formally Revised Target Values Actual Value Achieved at Completion or Target Years Wage Bill for 2008 was 22.4% of GDP Date achieved 12/31/ /31/ /31/2008 The PA s efforts to control the public wage bill were highly successful. The budget Comments target was to reduce the wage bill from 24.6% of GDP in 2007 to 24.3% in In (incl. % fact, the 2008 wage bill at end-2008 was more than 2% below the budget and was achievement) only 22.3% of GDP. More than 100% achieved. Reduce Net Lending: Institute measure to increase collection of utility bills from Indicator 2 : users Value (quantitative or Qualitative) The PA had distributed nearly 20,000 prepaid meters and required "certificates of payment" (COP) of utility bills to obtain government services PA distributes 40,000 new meters in 2008 and has successfully maintained the COP system PA has distributed nearly 45,000 meters by October 2008, above the 40,000 targeted for the year. It continues to require certificates of payments. Net lending fell by nearly 27% in 2008 Date achieved 05/30/ /31/ /31/2008 Comments (incl. % achievement) The PA continued measures to increase the rate of utility collections, while protecting the most vulnerable households. The Energy Authority is continuing to distribute prepaid meters and is above the targeted number. Indicator 3 : Reduce Net lending by removing municipal and local governments from electricity distribution business by forming commercial distribution companies Value (quantitative or Qualitative) Northern Electric Distribution Company formed and no plan to shift electricity distribution to commercial companies The PA produces a plan to shift municipal electricity distribution to new distribution companies The PA has produced no comprehensive plan Date achieved 05/30/ /31/ /31/2008 Comments (incl. % achievement) To reduce net lending, the PA planned to shift electricity distribution to commercially run companies. However, the most problematic municipalities have not joined the companies and some of the companies are not run on a commercial basis.

71 Indicator 4 : Value (quantitative or Qualitative) Improve targeting of social safety net to increase efficiency and ensure the most vulnerable populations are protected More than 32,000 Increased home households were in Verification of 4,500 visits to verify the database by the households in the targeting database to end of A rate targeting database 5,000 per quarter by exceeding 5,000 a end 2008 quarter Date achieved 05/30/ /31/ /31/2008 Comments The targeting database has been successful. By the end of 2008 more than 32,000 (incl. % households had received field visits and had been entered into the database. achievement) Increase financial accountability through improved and more transparent municipal Indicator 5 : accounts Value (quantitative or Qualitative) Palestinian municipalities had no unified financial management system Municipal Development Fund finalizes pilot financial management information for small, medium and large municipalities that will be tested and rolled out The MDLF had finalized the pilot stage of the financial information system Date achieved 05/30/ /31/ /31/2008 Comments The new financial management system has been successfully piloted and is being (incl. % rolled out in the West Bank. This target was 100% achieved. achievement) Indicator 6 : Establish upgraded institutional and regulatory procedures to support PFM reforms Value (quantitative or Qualitative) PFM system had broken down during the Hamas government and PA has few working financial controls The MoF approves a design paper for the new financial management information system and issues regulations to support it. It activates the new Accountant General Office The MoF approved a design paper for the financial management system. Regulations are not complete. The Accountant General Office is in operation Date achieved 05/30/ /31/ /31/2008 Comments (incl. % achievement) The MoF has made substantial progress in improving its PFM institutions. They introduced a computerized financial management system along with the design paper to support it. The MoF is also finalizing amendments to the financial regulations. Indicator 7: Improve efficiency and transparency of the budget preparation process Value (quantitative or Qualitative) The 2008 budget was Develop a combined approved by the Council presentation of the of Minister and signed by recurrent and the President. The MoF development The PA passed a 2009 budget that presents a combined development and

72 has resumed publication of monthly expenditure and revenue statements budgets for each line ministry for the 2009 Annual Budget Law recurrent budget for each line ministry Date achieved 05/30/ /31/ /31/2008 Comments (incl. % achievement) The 2009 budget made a combined presentation of the development and recurrent budgets using a program format. The PA has continued to publish monthly financial statements by the 15th of the following month. 100% achieved. Indicator 8: Strengthen PFM infrastructure and improve auditing functions Value (quantitative or Qualitative) Strengthen Central Treasury Account by closing non-zero balance line ministry and agency Non zero balance bank accounts for accounts open for line recurrent ministries. Ministries not expenditures. linked to MoF via a Prepare annual cash financial management plan. Develop information system internal audit plan and produce selected audits The PA has not closed all non-zero balance bank accounts and not yet produced a cash plan. The internal audit department of the MoF carried out a number of audits during 2008 Date achieved 05/30/ /31/ /31/2008 Comments (incl. % achievement) This indicator was not substantially met. The introduction of zero-balance accounts is linked with the roll out of the new computerized system. The delay in rolling out the system has resulted in a delay in closing non-zero balance accounts. (b) Intermediate Outcome Indicator(s) Indicator Indicator 1 : Value (quantitative or Qualitative) Date achieved Comments (incl. % achievement) Baseline Value Original Target Values (from approval documents) Formally Revised Target Values Actual Value Achieved at Completion or Target Years The PA is making efforts to reduce net lending. It is on track to be some 25% lower than last year. But it is still above the target set in the 2008 Budget

73 Indicator Indicator 1 : Value (quantitative or qualitative) Baseline Value DPG II PDO Indicators (P113621) Original Target Values (from approval documents) Formally Revised Target Values Actual Value Achieved at Completion or Target Years Control the public sector wage bill through limiting and targeting recruitment Target PA employment not to exceed 153,000 anytime in 2009; new Total PA employment recruitment mainly to was 143,937 at end-2008, be in health and and the public wage bill education sectors; was 22.2% of GDP target public wage bill is 22.3% of GDP in 2009 Total PA employment was 147,726, but net recruitment was largest in the security sector, followed by education, while health employment fell; 2009 public wage bill was about 24% of GDP. The overrun is explained by partial wage adjustments to account for high inflation, new recruitment, and exogenous factors Date achieved 12/31/ /31/ /31/2009 Comments (incl. % achievement) Public employment remained below the cap, but the PA wage bill overshot its target due to a 4% cost of living rise, a depreciating dollar, and interest on 2006 wage arrears wage bill only 1% higher than 2008 in US$ terms. Target 65% achieved. Indicator 2 : Reduce net lending by instituting measures to increase collection and payment of electricity bills Value (quantitative or qualitative) The PA had distributed nearly 45,000 prepaid meters and required "certificates of payment" (COP) of utility bills to obtain government services; net lending was 7.3% of GDP for 2008 PA distributes an additional 20,000 meters thru 2009 (for a total of 65,000) and maintains the COP system; targeted cap on net lending is 6% of GDP in 2009 A total of 156,000 prepaid electricity meters have been installed, and the COP system maintained; net lending was 3% below budget targets and 6.1% of revised GDP in 2009 Date achieved 10/31/ /31/ /31/2009 Comments (incl. % achievement) The PA increased collections while protecting vulnerable households. Energy Authority distributed prepaid meters far above the target, enforcement measures were introduced, and West Bank collection rates reached nearly 80%. Target more than 100% achieved. Indicator 3 : Reduce net lending by transferring electricity supply and distribution to distribution companies established in accordance with the Companies Law Value (quantitative or qualitative) New electricity law PENRA issues licenses enacted 23 April, 2009, for new distribution establishing power companies, and begins regulator, PERC, and implementing a timebound, comprehensive granting PENRA authority to set tariffs and strategy to transfer By December 2009, regulator had been appointed but was not in place, hence no licenses had been issued and little

74 license electricity distributors West Bank electricity distribution from local governments to distribution companies progress in transferring distribution from local governments to distribution companies Date achieved 04/23/ /01/ /31/2009 Comments (incl. % achievement) Key municipalities have not joined commercial distribution companies, and alternative funding sources for local governments have not been negotiated. Electricity Law implementing regulations were approved by the Council of Ministers and the President. Indicator 4 : Improve social safety net targeting to ensure that the most vulnerable populations are protected Value (quantitative or qualitative) Verification of 32,000 households in the targeting database as of end Increase home visits to verify an additional 18,000 households to reach 50,000 total in targeting database; two largest cash assistance programs SSNRP and SHC operate as a single PA-administered program Over 50,000 households were in the database by end-2009, and MoSA updated the eligibility criteria using 2007 household survey data to improve targeting; SSNRP and SHC have been combined into a single program, PNCTP Date achieved 12/31/ /01/ /31/2009 Comments (incl. % achievement) MoSA improved targeting by updating the database using a revised proxy means test on the basis of 2007 survey data. The strategy for rationalizing safety net programs was finalized and implementation was agreed with donors. Target 100% achieved. Indicator 5 : Improve efficiency and transparency of the budget preparation process Value (quantitative or qualitative) The 2009 annual budget introduced a Develop new economic programmatic structure and administrative combining the classification for use in presentation of recurrent preparing 2010 budget; and development budgets refine program for each line ministry, but structure to improve the programmatic consistency of structure does not presentation across correlate to budget ministries and execution, and alignment with PA consistency across accounting system ministries is lacking By end-2009, a draft 2010 budget had not been submitted to the Council of Ministers, and the new classification system was not complete, but budget preparation across ministries is being carried out using a more consistent format aligned with the PA accounting system Date achieved 02/28/ /01/ /31/2009 Budget preparation at the ministry level uses a revised program presentation to increase Comments consistency and improve alignment with the PA s accounting system. The new (incl. % classification system has been postponed until the 2011 budget cycle. Target 50% achievement) achieved. Indicator 6 : Establish upgraded institutional and regulatory procedures to support PFM reforms Value (quantitative or qualitative) PA accounting and financial control functions are disparate and not guided by a 10 line ministries use the new computerized accounting system 57 line ministries and agencies have been connected to the computerized

75 cohesive reporting structure; a new computerized accounting system has been developed but not launched in line ministries accounting system, 36 of which are fully implementing the system Date achieved 12/31/ /31/ /31/2009 Comments (incl. % achievement) The new computerized financial management system has been successfully rolled out to 57 line ministries and agencies, exceeding the target of 10. Target more than 100% achieved. Indicator 7 : Strengthen PFM infrastructure and improve auditing functions Value (quantitative or qualitative) Hundreds of non zero balance accounts remain open for line ministries; audit functions weak and carried out with significant delays; domestic debt data not reported on a regular basis; financial statements not prepared for audit since 2003 Close non-zero balance line ministry and agency bank accounts for recurrent expenditures for line ministries connected to computerized accounting system; introduce commitment control procedures; extend monthly reporting to include domestic debt; complete 2008 financial statement audits Most non-zero balance line ministry and agency accounts closed, commitment controls designed and will be effective in 2010 budget, domestic debt not yet included in monthly MoF reporting, MoF prepared final financial statements for 2008 ready for external audit Date achieved 12/31/ /01/ /31/2009 The PA closed all non-zero balance bank accounts except those required to be Comments maintained by donors, and consolidated cash balances to reduce debt servicing costs, (incl. % generating major savings. PA strengthened its internal audit capacity. Target 90% achievement) achieved. Increase financial accountability through improved and more transparent municipal Indicator 8 : accounts Value (quantitative or qualitative) The MDLF adopted clear criteria for grants to municipalities; MDLF finalized the pilot stage of the financial information system for municipalities 32 West Bank municipalities are using the new financial management information system; 35% of WB&G municipalities move up one rank on financial management effectiveness scale; PA designs a strategy for local government financial sustainability via broadening the local tax base New financial management information system functioning in 5 pilots, with another 26 municipalities using parts of the system; the ranking system and initial ranking were only completed in February 2009, with new ranking assessments planned for February 2011; no PA plan yet for local

76 government financial sustainability Date achieved 10/31/ /01/ /31/2009 Comments (incl. % achievement) Indicator 9 : Value (quantitative or qualitative) Technical difficulties caused delays. The new system is partly or fully functioning in 31 municipalities in the West Bank; 3 municipalities in the Gaza Strip stalled because the needed hardware was blocked from entry. Target 50% achieved. Establish a comprehensive public procurement system that is suitable for a market economy and introduces transparency, economy and efficiency The PA drafted a new public procurement law PA enacts new Public Procurement Law, and makes progress toward drafting supporting regulations, establishing an independent Public Procurement Unit, developing standard bidding documents, and instituting a national procurement training program The draft procurement law has not been passed, and Bank comments to strengthen the draft law have not been incorporated Date achieved 03/31/ /31/ /31/2009 Comments (incl. % achievement) Passing the law is a prerequisite for establishing a comprehensive public procurement system, thus little or no progress has been made on regulations, establishing a procurement unit, bidding documents or the training program. Target not achieved. (b) Intermediate Outcome Indicators Indicator Indicator 1 : Value (quantitative or qualitative) Baseline Value Original Target Values (from approval documents) Formally Revised Target Values Improve efficiency and transparency of the budget preparation process Refine program The budget s new structure such that programmatic structure budget controls are does not correlate to operating at the budget execution program level Actual Value Achieved at Completion or Target Years Date achieved 02/28/ /31/2011 Comments (incl. % achievement) The programs have been included in the accounting system but budget controls are not yet operating at the program level. Experience during 2010 will be used to refine the programs for use thereafter. Indicator 2 : Strengthen PFM infrastructure through improved auditing functions Value (quantitative or Weak state audit controls Develop a capacity with staff in need of skills building plan for qualitative) upgrading SAACB audit staff Date achieved 12/31/ /31/2010 Comments (incl. % achievement) A comprehensive capacity building program for SAACB staff is being finalized, and is expected to launch during the second half of 2010 with EU co-financing.

77 ANNEX 6: COUNTRY AT A GLANCE (INCLUDES COUNTRY MAP)

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80 WEST BANK AND GAZA: DEVELOPMENT POLICY GRANT III