Over the past four decades, the Palestinian markets in the West Bank and the Gaza Strip (WBGS) have been closely tied with Israel's. As a result, the performance of the Palestinian economy has been subject to Israeli economic forces, which have determined its level of macroeconomic variables, such as prices, wages, exports, imports, investment and employment. Also, Israeli security concerns have been used to justify the imposition of economic measures and sanctions against the Palestinian economy, creating an artificial economy in the WBGS resulting from trade between two unequal partners.
Since the early 1970s, the gap between Palestinian and Israeli wages has pushed more than one-third of the Palestinian labor force to seek jobs in Israel. Between 1999 and 2000, remittances paid to Palestinian workers in Israel accounted for more than 20% of the gross national disposable income (GNDI). Furthermore, the competition in WBGS markets between local and foreign products, primarily from Israel, has impeded the Palestinian economy's development. Production of food, farm produce and final manufactured commodities tended to decline from year to year, gradually being supplanted by imports, mainly from Israel, resulting in one-fourth of the Palestinian gross domestic product (GDP) going to the Israeli economy.
Free labor mobility from the WBGS to Israel, on one side, and flexible merchandise and service trade flows from Israel to Palestinian markets, on the other, have been viewed as the main pillars of Israeli-Palestinian trade. Some economists have regarded this type of trade relationship as a quasi-customs union; however, trade between unequal partners does not enable efficiency gains, technology transfer or growth.
The signing of the Paris Protocol (PP) in 1994 between the Palestine Liberation Organization (PLO) and the government of Israel had minimal impact both on reshaping economic and trade relations between Israel and the WBGS, and on restructuring the Palestinian economy. Since the mid-1990s, the Palestinian Authority (PA) has utilized trade policy to finance its current expenditures. In fact, trade deficits have been utilized to finance budget deficits. Importing from or via Israel has gradually increased tariff revenues, which have been collected by Israel on behalf of the PA. Annual tariff revenues averaged 60-70% of total Palestinian public revenues and around 15% of GNDI. In 1999, Palestinian imports peaked at $3 billion; they have been fluctuating ever since, but have not retrieved their 1999 level.
After a decade of trade relations following the PP, tax imports, remittances and donor disbursement have become the major sources of PA income. Therefore, any decline or restriction on the flow of these funds will debilitate the Palestinian economy through a rise in unemployment rates.
Since the fourth quarter of 2000, the WBGS have been experiencing the following macroeconomic imbalances: 1) persistent and continuous trade deficit; 2) a huge deficit in the public budget; 3) high rates of unemployment; and 4) rising inflation rates. Under the PP, the PA has little control over stabilization policies to allow it to correct macroeconomic imbalances. In fact, the PP granted the PA only limited authority to run the economic activities in the WBGS; for example, it did not give it control over fiscal, monetary or trade policies. A unilateral customs union envelope remains the major determinant of the economic and trade relationships between Israel and the WBGS. Consequently, the levels of most Palestinian macroeconomic variables, e.g., interest rates, exchange rates, price levels and unemployment rates, have been determined in accordance with Israeli economic conditions and interests. The adverse effects of the economic environment on trade can be summarized as follows:

1) High rates of inflation and interest rates and continuous devaluations of the Israeli currency in real terms, particularly during 1995-2005, have made investments for the purpose of expanding local production less attractive. Consequently, the number of laborers employed in farming, manufacturing and construction has declined by 8% - from 250,000 in 2000 to less than 230,000 by 2005. As a result, the local agro-industry and the manufacture of finished goods have been undercut by cheaper imports, mainly from Israel (Palestinian Monetary Authority, Tenth Annual Report, 2005).
2) Dependency on the trade deficit to finance the budget deficit has been implemented by providing facilities to importers to increase the imports of final goods to generate tariff and tax revenues. Consequently, the Palestinian economy has been gradually eroded over the past decade due to low productivity and high wages, concomitant with the low prices of imported goods (World Bank, 2006a; 2006b). The consequences of financing the budget deficit by creating a huge trade deficit are outlined below:

a) The persistent deficit in current public expenditures has limited allocations of public capital expenditures to reconstruct or build the infrastructure, e.g., electricity, water and telecommunication. Although the infrastructure remains below international standards, the costs of public utilities in the WBGS are higher than in neighboring countries. Furthermore, in recent years, high percentages of international donations - chiefly from the EU - have been directed to finance the current budget, mainly to cover wages and salaries for employees in the public sector. In fact, the wage bill accounts for more than 80% of the total current budget.
b) Exporting laborers, mainly to Israel, has become the engine of the Palestinian economy. Consequently, real growth rates in the Palestinian GDP tend to decline from year to year, particularly when remittances decreased sharply due to restrictions imposed on Palestinian labor mobility. This had several multiplier effects on consumption expenditures, GNDI, imports and public revenues.
c) The Palestinian economy and trade continue to suffer from three major distortions: smuggling, dumping and monopoly. These distortions have negatively affected the decisions of producers, investors, importers and exporters.
d) The development gap between the Palestinian economy and those of Israel and other regional countries has widened with time. During the last four decades, Israel's occupation of the WBGS has hampered the possibility of any economic development. Consequently, it has become a given that any real partnership, cooperation and development in the WBGS is not possible without ending the occupation.
e) Most of the WBGS' trade partners have ignored the unique situation of the WBGS economies. After four decades of isolation and disengagement from regional and international markets, a transitional period is required to upgrade and rehabilitate the Palestinian economy.

Since 1994, the PA has signed several bilateral agreements with regional and foreign countries, including Israel. The Palestinians anticipated that these agreements would achieve the following objectives:
* Expand Palestinian trade;
* Increase public revenues; and
* Promote employment.
So far, the benefits reaped from these bilateral agreements have not been evaluated in detail. Most studies have focused on analyzing the influence of non-tariff trade barriers (NTBs) and Israeli obstructions pertaining to the Palestinian economy and trade. Most bilateral agreements - as well as the PP - have ignored certain conditions that are vital for trade agreements to function properly:
* The full right of the Palestinian side to manage and use its human and natural resources without any interference from other parties; and
* The right of the Palestinian side to control border passages with Egypt and Jordan. Consequently, Palestinian trade should not remain subject to Israel's security interests and regulations. In fact, Palestinian trade flows, labor mobility and even personal travel have been highly restricted since the fourth quarter of 2000.

Since it occupied the WBGS, Israel has utilized trade as a means to restructure the Palestinian economy towards dependency on the Israeli economy, to serve its economic and security interests. Israel began by severing all economic and trade links between the WBGS and the rest of the world; the greater part of Palestinian trade was limited to Israel or to passing through Israel during the "open bridges" policy. Since 1995, border controls have been considerably tightened to the extent that now 90% of WBGS imports come from or through Israel, and 95% of its exports are destined for or pass through Israel. Palestinian exports to Israel are still very limited in terms of volume and variety compared with imports from Israel. This has impacted negatively on the performance of the Palestinian economy. The ratio of the trade deficit to the GDP was very high in 1995-2005 compared to previous periods and compared to Israel, Jordan and Egypt. Israel's monopoly over WBGS trade has been exacerbated by the flooding of the Palestinian markets with cheap and subsidized Israeli products, leading to a disintegration of the relationship between production and consumption as well as between supply and demand within the WBGS.

Evaluation of Trade Options

Any agreement for economic and trade relations between Palestine and Israel in the foreseeable future must correct the structural imbalances in the Palestinian economy. Therefore, any future economic and trade arrangements with Israel must strengthen the Palestinian capacity to implement the economic integration of the WBGS. The present separation and the existing disparities between their economies remain among the major challenges facing the Palestinian economy.
Regarding the type of economic and trade relations between the WBGS and Israel, i.e., a free trade area or a customs union, several factors must be taken into consideration, primarily because each option could have serious repercussions on Palestinian development strategies. A free trade area and customs union would not, under the current circumstances, contribute to the correction of the structural imbalances in the Palestinian economy but would only deepen them. Nevertheless, they should not be ruled out as possibilities in the long term, after the structural reform of the Palestinian economy has been completed.
Several studies conducted by this author indicate that the free trade area option called for by some Palestinians faces a number of structural problems and shortcomings. If the aim is to check the financial leakage from taxes and duties imposed on Palestinian imports from or via Israel, then this option would be of limited value. In spite of some potential financial gains, it would lead to the loss of sustainable development opportunities. It would also lead to one-sided customs union that would deepen the status quo through contractual agreements that would constrain the Palestinian economy at a time when the regional trend is inexorably towards free trade.
The other option is that of a customs union, advocated by the Israelis in return for guaranteed financial gains for the Palestinians. This option would deepen the phenomenon of polarization The Palestinian economy will continue to depend on exporting labor, on the one hand, and importing cheaper products from Israel. As a result, the Palestinian economy would be deprived of any future opportunity to benefit from spread effects with their potential positive repercussions on the Palestinian economy, such as the free movement of goods and services, or solid forward and backward linkages between economic sectors. The customs union would lead to restrictions on freedom of movement according to demand and supply and the level and direction of the overall economic variables in Israel.
During the past four decades, Israel has managed to forge economic and trade relations with the WBGS. These relations have become intertwined, as evidenced in the volume of the movement of goods, services and other financial flows between the WBGS and Israel and their influence on variables of GNP, GDP, consumption and rates of employment. The impact of closures and blockades, on one hand, and the effect of the open door policy in 1998 and 1999, on the other, reflect the performance of these variables and the extent of the Palestinian economy's reliance on that of Israel.
A third option currently under discussion is that of economic separation and disengagement. This is unrealistic and would prove costly for both sides, nor is it in the interest of either party. Evidence shows that Israel uses this option as a threat to put pressure on the Palestinian side. While it is true that separation would be more detrimental to the Palestinians, who must depend on Israel, it would also be very costly and, therefore, undesirable for Israel as well.
A fourth option is the formulation of Palestinian-Israeli trade relations, which paves the way for the establishment of a new relationship to respond to a settlement of the Israeli-Palestinian conflict. It is based on cooperation and takes into consideration the mutual interests of both sides. It would be achieved gradually and in a cumulative manner according to a five-year timeline. The results of this option should be defined and understood in advance. In other words, it is possible to change the volume of bilateral trade as well as its components and effects. This can be done through the substitution of polarization effects for spread effects to create reciprocal relations aimed at building desirable economic structures that depend on specialization.
It is possible to draw lessons from similar cases of countries that have won independence from colonial powers. These countries have later experienced fruitful cooperation instead of conflict. In the case of Palestine, the essence of the envisaged arrangements are:

1) Decreasing dependency on Israel of the surplus Palestinian labor force by increasing the WBGS' employment capacity;
2) Phasing out the current labor export and replacing it with labor-intensive products for export;
3) Increasing job opportunities by 10%; and
4) Restructuring the Palestinian economy, which would lead to the restoration of more than 25% of Palestinian GDP from the Israeli economy, particularly in the field of manufacturing products. With time, its effect on the macroeconomic variables would double, particularly in exports, labor imports and consumption. In light of these results, trade relations between the WBGS and Israel could move from being a skewed customs union, geared entirely towards Israeli interests, to more symmetrical relations based on a combination of a balanced customs union, a free trade area and other options.