Underlying the often-asked question of the economic viability of the future Palestinian state are its well-known attributes - its small size, both in terms of population and area; its territorial fragmentation between the West Bank and Gaza; and its lack of natural resources. But Norway, Ireland and Denmark, whose populations are hardly, or in any case not significantly, larger, have some of the highest per capita incomes in the world. Admittedly Norway has oil, but both Singapore and Israel, with similarly sized populations, have no natural resources to speak of. The territory of Singapore, whose per capita income is one-fifth higher than Israel's, is only one-ninth the Palestinians' and not even twice that of the Gaza Strip; and over a century since it gave up Zanzibar, Oman enjoys no territorial contiguity nor, for all practical purposes, does Australia.
We can, however, identify the necessary conditions of economic viability if we consider places or regions that obviously lost it, such as the "ghost towns" adjacent to exhausted mines or former road hubs bypassed by a new expressway. With the employment source gone, these towns are no longer economically viable and their inhabitants "vote with their feet" and move elsewhere. The failure of the economy to sustain peoples' standards of living - and in the post-World War II era, even to ensure their steady rise - will lead to emigration or, where this is impossible, to growing social and political unrest. This was the case in Ireland, the population of which shrank by half in the wake of the Potato Famine of the 19th century, and is the case in many African countries today. It also was the case in the West Bank under Jordanian rule, where emigration cancelled out four-fifths of the natural population increase.1

Specialization and Exchange

Thus, the question of a country's economic viability ultimately boils down to the conditions necessary to ensure that the pace of economic growth will satisfy its inhabitants' expectations. Some of the factors determining growth are interchangeable: Scarcity of natural resources might be compensated for by availability of physical capital - machinery and equipment - while the latter might be at least partly substituted by human capital, i.e., by education and training. But there is one factor for which no substitute exists: the ability to exchange with others. To grasp its full importance we only have to imagine how our lives as individuals would look if each of us were restricted to consuming only what we ourselves could produce. Exchange makes possible specialization, with people and countries producing those things they do best relative to others, and trading their products for those goods and services that they cannot produce themselves or are relatively inefficient in producing. The richest oil country would be very poor indeed, were it unable to barter or sell it in exchange for imports of the goods it cannot efficiently produce, and tried to produce them on its own.
Specialization and exchange are, of course, restricted by the size of the market. The larger it is, the greater the chance of being able to find takers for all of one's products and suppliers of all of one's needs. In big countries, the variety of climates and natural endowments, as well as of human gifts and tastes, makes it possible for much of the specialization and exchange to take place internally. Smaller ones have to look beyond their borders. That is why, contrary to the lingering popular image of imports as luxuries and therefore rising with income, the ratio of imports to the gross domestic product (GDP) in the United States in recent years was only 14%, while it was double that in Israel, more than four times as high in the Netherlands at 60%, and as high as 70% in the West Bank and the Gaza Strip (WBGS).
The corollary of this is that the smaller the economy, the more heavily it has to trade with the rest of the world in order to attain a given standard of living - i.e., to increase the prospects for its viability.

Table 1


(I) Average annual growth rate (%)

GNP per capita                   GDP per capita

WBGS         Israel         WBGS         Israel

                                5.7             2.4              4.2                2.8

(II) Ratio of 1992 per capita figures to 1968 figures

GNP per capita 1992                   GDP per capita 1992
GNP per capita 1968                   GDP per capita 1968

WBGS         Israel         WBGS         Israel

                                3.8              1.8              2.7              1.9

Sources: World Bank, An Investment in Peace, Vol. 2, Statistical Appendix Table 1; and Israel Central Bureau of Statistics (ICBS), Statistical Abstract of Israel, 1992, Table 6.1

The development of the Palestinian economy under Israeli occupation provides a striking example of this importance of the ability to trade, as well as of its loss. As can be seen from Table 1, between 1968 and 1992 income per capita in WBGS rose annually, by 5.7% on average in real terms. This was more than twice the annual income growth rate in Israel - quite high by international standards - which was "only" 2.4%. Admittedly, much of this rapid income growth represented wages earned by work in Israel - itself a form of trade, in this case in labor services. But the GDP, which measures only economic activity in the Palestinian territories themselves, also grew quite impressively, nearly tripling in this period, while in Israel it hardly doubled. And this, it should be stressed, despite the Israeli restrictions on the exports of certain farm produce to Israel (and similar restrictions on exports to Jordan) and on the setting up of industrial plants that might compete with Israeli ones, the appropriation of tax revenues that were sorely needed to prevent the deterioration of the infrastructure, and the investment-deterring uncertainty as to these territories' political future.

Access to Israeli Markets

The answer to this seeming paradox lies in the obverse of the occupation model. The effects of the restrictions listed above (without which growth would have been even more rapid) pale compared with those of the general removal of the insurmountable barrier to trade with Israel that existed until 1967. However small in world terms Israel's economy was at the time, it positioned a huge - in Palestinian terms - market at their doorstep. It was not merely the difference in size - Israel's economy was roughly 30 times as large as the economies of the WBGS combined - but also its being on the whole a complementary, rather than a competing, economy. The Israeli labor market soon siphoned off both the overt unemployment and the disguised one common in traditional family farming. And given the minuscule distances involved, even goods (and services) usually considered non-tradable internationally, such as building stone, found a ready market in Israel. The resultant prosperity soon checked the population outflow from the West Bank.
But beginning with the first intifada, and especially from the early 1990s on, the progressively deteriorating security situation caused Israel to impose successively more stringent restrictions on the physical access of Palestinians and of Palestinian goods to Israeli markets. This more than outbalanced the 1994 Paris Protocol's removal of economic restrictions on Palestinian exports to Israel and on the establishment of competing industrial plants. Altogether, the gradual restriction of physical access vitiated much of the advantages of the free economic access to Israeli labor and goods markets that the Palestinian economy used to enjoy, with few exceptions. The adverse economic effects were not slow to follow. They can be clearly read from Table 2, which expresses Palestinian per capita income as a percentage of the Israeli one at three selected points in time. As can be seen, this ratio more than doubled in the years of easy market access, but fell back to its 1968 level when this became curtailed.2

Table 2
The Size of the Palestinian Economy Relative to Israel (%)

At current prices. Data for later years still subject to revision.
Sources: Israel Central Bureau of Statistics (ICBS), Statistical Abstract, 1977, 1988, 2000 and 2005; and Alonso-Gamo, P. et. al., West Bank and Gaza Strip: Economic Development in the Five Years Since Oslo, Washington, D.C., IMF, 1999, Tables 3.1 and 3.2.
2004 Palestinian data - The World Bank, The Palestinian Economy and the Prospects for its Recovery, December 2005, Tables 1 and 3.

Table 2 also demonstrates that the virtually free access to Israeli markets carried with it a high price tag in terms of the Palestinian economy's exposure to unilateral Israeli decisions and, more generally, to shocks coming from that direction.3 Avoiding this exposure requires widening the range of Palestinian export markets, especially as with little prospect of re-establishing the broad access to the Israeli labor market, exports of labor services will have to be substituted by exports of the merchandise this labor will produce domestically. Both the EU and the U.S. may be expected to continue granting the future Palestinian state the privileges to which Palestinian exports are currently entitled there, providing them with potential markets of a totally different order of magnitude than the Israeli one, or that of the projected Greater Arab Free Trade Area (GAFTA), if it comes into being. Nevertheless, because of the high overheads of accessing these overseas markets, especially for small firms, and of its physical proximity, Israel may be expected to remain for a long time a major, if not the main, market for Palestinian goods. Thus, the type of economic arrangements that will regulate trade relationships with it could be of crucial importance for the economic viability of the Palestinian state:

1) Customs union. The most integrative of these arrangements is a customs union (CU), where both countries share the same external customs tariff - the "common customs envelope" regime of the Paris Protocol - and there is no customs border between them, although, unlike in the past, there may be a physical political one. Complaints about the drawbacks, from the Palestinian point of view, of the Israeli import regime aside, this is bound to be the arrangement most supportive of the expansion of Palestinian exports, as it preserves for them the Israeli market without substantially detracting from their access to the rest of the world.4 However, given the disparity in the sizes of the two economies, it is difficult to envisage a joint Palestinian-Israeli decision-making mechanism on issues binding on both of them, such as import policies and indirect taxation. And even with the Palestinian state being in control of its external borders, some tax clearance system would still have to be maintained - all of which may be politically unpalatable and, as mentioned earlier, could impair the viability of the Palestinian economy by making it vulnerable to shocks emanating from Israel.

2) Free trade area (FTA). Less restricting is an FTA agreement, under which each party has its own import and customs regime, but exempts from import duties goods produced in the other one. This leaves each party free to enter into preferential trade agreements, such as an FTA or even a customs union, with any partner of its choice and, as it necessitates a customs border between them, would also make it possible to dispense with the tax clearance mechanism required by a CU. However, because of the high import content in the manufacturing industries of a small economy, many Palestinian products would probably fail to satisfy the domestic value-added condition of the FTA "Rules of Origin" that would qualify them to be regarded as local products and, hence, exempt from duties in Israel. Thus, the FTA's reduced exposure to the risks of volatility emanating from Israel has to be balanced against a reduced expansion of exports, that is, of the engine of growth that has to ensure Palestinian economic viability.

3) Finally, there are the normal trade relations between countries not in a state of belligerency with each other, usually referred to as most favored nation (MFN) status. Under an MFN regime Israel and the Palestinian state would undertake not to discriminate against each other in their tariff regimes, except with respect to those third parties with whom they have some closer arrangement, such as a CU or an FTA. As a member of WTO Israel is already bound to grant such treatment to all members of that organization, which the Palestinian state may be expected to join soon after its establishment. In the absence of any other agreement between them, this condition would automatically regulate their trade relationship. As it would not provide Palestinian exports with any preferential treatment in the Israeli market, nor any compensation for this in others, this may be the least advantageous arrangement insofar as Palestinian economic viability is concerned.

It must be stressed that no sensible investor will invest without being assured of an uninterrupted supply of their material inputs and of their goods' ability to reach their markets and do so on time. Thus, irrespective of which arrangement is in place, for export growth to materialize and the Palestinian state to be economically viable, it has to have easy physical access to both Israeli and world markets.
Because of the disparity in their economies' sizes, arrangements that might be crucial for Palestinian economic viability are of only marginal importance for the Israeli economy as a whole. Therefore, it should be left to the Palestinians to decide which arrangement to opt for, in view of their relative economic benefits and political drawbacks. In the past many Palestinian spokespersons regarded any closer relationship as a concession to Israel, and some seem to hold this view even now. But given the development of the last seven years and the forthcoming completion of the barrier separating the West Bank from Israel, they might soon find out that the decision is no longer in their hands. While the growing separatist sentiment in Israel might be welcomed by some Palestinians on political grounds, it does not bode well for the economic viability of the future Palestinian state.

1 Derived from the figures provided by Antoine Mansour, in George Abed, ed., The Palestinian Economy, London: Routledge, 1988. Enjoying neither Jordanian citizenship status, like the residents of the West Bank, nor an Egyptian one, the emigration opportunities from the Gaza Strip were much more restricted.
2 The further fall in this ratio in the years following the outbreak of the al-Aqsa intifada was, to a considerable extent, due the restrictions imposed by the IDF on movement and access within the Palestinian territories, and thus can only in part be ascribed to the deteriorating access to Israeli markets. The difference in the ratios of income per capita and per person employed is due to the high proportion of children and of the low force participation rates of women in the Palestinian labor force. It suggests that even if Palestinian and Israeli labor productivity were equalized in 1986, Palestinian income per capita would not have exceeded 60% of that of Israelis.
3 The high proportion of Palestinian workers that used to be employed in the Israeli construction industry until 2000 also made the Palestinian economy highly vulnerable to fluctuations in this rather volatile Israeli industry.
4 The main potential loss would be the inability to accede to FTAs to which Israel is not a partner, such as the not yet fully established GAFTA. The inability to sign bilateral trade agreements with third parties sometimes mentioned in this context is probably of little significance, given the greatly reduced role of such agreements in international trade.
selected years
Gross Domestic Product
Gross National Product (GNP=GNI)
GNI per capita
GNI per person employed