DATA Studies and Consultations, Bethlehem.

The Israeli-PLO economic agreement worked out during the negotiations in Paris (1994), referred to as the Paris Economic Protocol (PEP), did not give the Palestinian Interim Self-Governing Authority the means of actually governing its own economy. Among other things, the PEP does not give the Palestinians the right to issue their currency. The Israeli position as expressed by the Israeli negotiators can be explained, but not justified, on political and economic grounds.1
Politically, the Israeli position stemmed from the desire to deny the Palestinians anything that could be considered "a symbol of national independence." A national currency is a symbol of an independent national state. But history tells us that this is not necessarily the case. Furthermore, it is really paradoxical to accept one symbol of national independence (namely, the Palestinian flag) and to refuse some other ones, such as a currency.

The Currency Board System

In British-Mandated Palestine, like in India and many other British colonies, a currency board system (CBS) was created and institutionalized by the British and had practically one function: to issue the local currency under certain rigid rules. The colonial power did this not as a "symbol" for an independent Palestine, but for sound economic reasons.
The Palestinian Currency Board (PCB) had no discretionary powers over the issue of currency since it was required to keep at the Bank of England a 100% sterling cover against its currency liabilities which consequently were convertible into sterling at all times. These sterling reserves were invested on the London Money Market and accumulated sterling investments served also as a backing for the Palestinian currency.
The major argument in favor of the CBS, in addition to the advantage of a sound local currency and full and free convertibility into sterling at a stable exchange rate, took the 100% reserve requirement as its point of departure. It is often argued that such a provision has been extremely effective in preventing governments from resorting to domestic borrowing in order to finance their expenditures and, hence, has contributed to the economic stability of countries under the CBS. Currency boards had neither the discretionary power to increase currency issues, nor were they allowed to furnish their own governments with loans. Government borrowing from commercial banks was almost impossible, not only because any such borrowing would have to be at the expense of loans to the private sector, but also because of the underdeveloped nature of the entire banking system. Furthermore, such borrowing, when it took place, had only limited inflationary consequences because the increase in the money stock resulting from larger government expenditures entailed a larger volume of imports which meant greater outflow, or at least a smaller inflow of foreign exchange and, thus, a decrease in currency issued.
Faced with such limitations, most governments in British-Mandated countries, even those which got independence but retained the CBS (e.g., Jordan until 1964), were forced to adopt balanced budget policies or to rely on foreign aid to cover any excess expenditure over domestic revenues. Consequently, most of the territories under the CBS were saved from a chronic problem of inflation resulting from budgetary deficits. Inflation or deflation did not originate domestically; safety and soundness were the hall-marks of the CBS.
There are, of course, from the viewpoint of the currency-issuing country, some disadvantages of adopting a CBS. The monetary authority would be deprived of any authority to issue currency on discretion, or to control the activities of commercial banks, since most of these would be in favor of keeping most of their deposits in foreign assets abroad. The 100% reserve requirement would also deprive the country of using its reserves abroad in executing development projects.
So, politically speaking, Israel could have resorted to the CBS while still militarily occupying the Gaza Strip and the West Bank (WBGS) without endangering its existence there. More importantly, Israel should not deal any more with symbols in the case of the Palestinian problem. Rather, it is the real economy that should matter now.
When he was foreign minister, Shimon Peres once stated: "We do not deal with symbols but with the real economy, and a Palestinian currency is economically superfluous. This obviously raises two important questions, the answers to which will elucidate the paradoxical Israeli attitude of accepting certain national symbols and rejecting others.

Does Israel Deal with the Real Economy of the Palestinians?

Israel, as mentioned above, did not resort to a CBS in the Palestinian territories since the beginning of the Israeli occupation in June 1967. Instead, the Israeli shekel was made legal tender, beside the Jordanian dinar, in the West Bank. In the Gaza Strip, only the shekel is legal tender, though the dinar is also widely used.
Most economists agree that this Israeli policy aimed to facilitate the process of integration of the Palestinian economy into that of Israel, not to mention the substantial seigniorage revenue Israel derives from the circulation of the shekel in the territories. Hence, by refusing the option of a Palestinian currency, Israel strove to perpetuate Palestinian economic dependency on the Israeli economy. There is a clear discrepancy in the Israeli stance: while Israeli leaders promoted the notion of international aid to rescue the Palestinian economy, they denied them the right to issue their own currency on the grounds that a Palestinian currency is "economically superfluous." Indeed, the argument presented here suggests that the Israeli policy sought to make the existence of a viable Palestinian economy superfluous and to perpetuate the past trends of dependency.
In the past, the Israeli government derived substantial seigniorage revenue from circulation of the shekel in the Palestinian territories. In years of hyperinflation, which Israel experienced in the seventies and the early eighties, this revenue was even greater due to another source of seigniorage, i.e., the inflation tax. Around U.S. $809 million worth of Jordanian dinars circulate in Palestine (about 31.3% of total dinar circulation in Jordan and Palestine), and around U.S. $977 million worth of Israeli shekels circulate in Palestine (about 25.4% of total shekel circulation in Israel and Palestine). According to World Bank estimates, Jordan would extract seigniorage revenue of about US $50 million per annum from circulation of the dinar in the West Bank and Gaza Strip depending on a scenario of a 10% nominal growth rate in the WBGS. This amount would be roughly 1% of the Jordanian GDP. Estimations of this source of revenue to Israel are not available. However, and due to a higher degree of integration between the economies of the WBGS and Israel, there is every reason to believe that seigniorage revenue which Israel derives from the West Bank and Gaza Strip would be not less than 1% of Israel's gross domestic product (GDP).
Had the Palestinian National Authority (PNA) the right to issue its own currency, it would have been able to generate about 45.2% of the GDP of the WBGS (according to statistics from 1991), by withdrawing the Israeli shekel from circulation in these areas in return for dollars by which it can finance the purchase of goods and services necessary to rebuild the infrastructure in the Palestinian territories. This process alone would allow the PNA to start implementing public projects of its own and to employ thousands of unemployed people without waiting for international aid. The PNA would then be able to levy taxes to generate revenues to partially cover the government budget. A national currency issued and controlled by the Palestinian Monetary Authority (PMA) is the only way out.

Is a Palestinian Currency Superfluous?

The answer, based on the above discussion, is negative. In a patronizing way, Israeli Finance Ministry officials have been talking about "saving Palestinians from themselves" and arguing that "a Palestinian currency would lead to spiraling inflation." Interestingly enough, in the first years of the State of Israel, the decision-makers held a rather different view of a national currency and its role.
Upon its creation in 1948, the State of Israel disposed of no more resources than the Palestinians do today. Yet, immediately upon the withdrawal of the last British troops, the Anglo-Palestine Bank in Tel Aviv was renamed the "Israel National Bank" and authorized by Ben-Gurion to issue bank notes. In the first four years after the establishment of the State of Israel, the population doubled through the waves of immigration; the economy was kept moving mainly through this new currency, which financed more than half of the government budget. Yet the inflation rate was lower than it is in today's Israel. In the first two years of its existence, revenue from taxes amounted to only a third of the total expenditures.
According to all international experience, economic development is subject to the self-supporting economies of agglomeration. In this process, core regions with the highest economies and technological potential tend to grow at the expense of the weaker regions which risk being marginalized. The absence of a Palestinian national currency would make the income distribution between the countries of the triangle [Israel/Jordan/Palestine] even worse than it is now. Such distributional problems do exist within the European Union (EU) and have been taken into consideration. Certain political decision-making routines have been established to maintain such distribution policies within the EU channeled through the European Regional Fund, the European Social Fund, and the European Investment Bank. These issues have not been considered in the PEP.
The fact that the dinar circulates in the Palestinian territories and Jordan, and the shekel circulates in the Palestinian territories and Israel, implies that the Palestinian territories cannot be isolated from price changes in Israel and Jordan. However, since most imported merchandise of the territories comes from or through Israel, prices there are highly correlated with the prices in Israel.

A Monetary Arrangement

The discussion above suggests that a Palestinian currency is optimal for Palestine. However, monetary management is crucial to a stable currency, without which a sound economy could not function. Therefore, two monetary arrangements should be discussed: one for the short run (up to five years), and the other for the long run (beyond five years).
A short-run monetary arrangement is the creation of a Palestinian currency board system (PCB). The Palestinians have established the Palestinian Monetary Authority (PMA) which, according to the PEP, is less than a PCB. Renegotiating the PEP to add the function of issuing a Palestinian currency to those functions of the PMA is a political and economic necessity. The proposed Palestinian currency should be explicitly linked to, and backed by, the Jordanian dinar or any other currency.
The withdrawal of the Israeli shekel will not lead to a fiscal crisis in Israel. On the contrary, withdrawing the Jordanian dinar from the West Bank and the Gaza Strip will have a more harmful fiscal effect on Jordan. To offset the fiscal effects on the Israeli economy upon the withdrawal of about U.S. $977 million from circulation, and the immediate request for foreign assets upon return of the withdrawn notes, could be absorbed by creating a "currency redemption facility" to help Israel overcome the harmful effects of such a withdrawal. The IMF and the World Bank should be able to help the creation of such a facility in case the Palestinians refuse to buy Israeli goods and services by the gained foreign exchange.
The historical experience of the CBS suggests that a stable currency would require a 100% reserve by the back-up currency. The PMA could maintain such a reserve at the Central Bank of Jordan (CBJ), for example, and could be able to issue Palestinian notes equal to those kept by the CBJ. This could be annually enlarged by an amount equal to the income earned on these reserves at the CBJ. In such a fashion, monetary expansion would not be inflationary.
This arrangement is called a pure CBS and it cannot provide the necessary conditions for the implementation of a discretionary monetary policy. However, it has some important advantages. First, if the dinar is stable, the Palestinian currency of the PCB will be equally stable. Secondly, a PCB can extract at least part of the seigniorage which otherwise will go to the CBJ. Thirdly, this arrangement would gain the confidence of the Palestinians in the PCB's notes and would reduce the possibility of capital flight.
When this system is established and proves efficient, it would be made more flexible by allowing the reserve requirement to be less than 100%. In such a case, the PCB, de facto the PMA, would be able to extend credit to banks and to issue notes with some discretion, i.e., the PCB would gradually turn into a monetary authority in the tradition of central banks. Even though such a flexibility of the PCB to create money would be limited, it would control inflation which prevents the need for devaluation and speculative attacks on the PCB's notes.
This monetary arrangement would allow an exchange rate of 1 Palestinian note to 1 Jordanian dinar, as long as the reserve requirement is 100%. This would ensure the trust in the new currency. Jordan's track record of macroeconomic arrangement has been good. The ability of Jordan to keep this record would add to the trust in the new currency. One should, however, be aware of the possibility of precautionary movements out of the dinar into the dollar. This is evident in the more rapid than anticipated depletion of reserves in the CBJ since January 1994, a few months before the creation of the PMA. To ameliorate this problem, the PMA should permit the Palestinians to keep their savings in dollars in the operating banks in the Palestinian territories. Another precautionary measure against an expected increase in the supply of the PCB's notes because of the "dollarization" could be the sale of Palestinian bonds, at positive real interest income for the public by which development projects could be partially financed.
In the long run, the PCB suggested here could move into a full sovereign monetary arrangement. Though this movement may depend on political circumstances, economic conditions in the region and the world would entail an appropriate arrangement. It is the responsibility of the PMA to be flexible enough to frequently identify and assess the situation. In any case, the PMA must try to be independent and not fall into the temptation of printing money to finance the PNA budget, for such a trap is simply inflationary. The motto of the PMA must always be "evolution rather than revolution."

1. Shortly after he was voted into office, Prime Minister Ehud Barak stated in a press conference that the Palestinians should have their own currency. However, this declaration has not had any official follow-up to date, nor has it led to a renegotiation of the economic agreement between Israel and the Palestinians.