monetary integration between israel

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Monetary Integration Between the Israeli,Jordanian and Palestinian Economies

Arie Arnon* and Avia Spivak"

DiscussionPaper No. 95.11

December 1995

An early versionofthis paperwas presented at the conference "Sustaining Peace inthe Middle East through Economic Cooperation" , Amsterdam, October 1994.

We would like to thank the participants in the conference for theircomments andLaurenceHarris, Raif Melnick, Daniel Gottlieb and Momi Dahan for helpfulsuggestions. SOAS provided an extremely productive environment forwriting theifrst draft ofthis paper. All errors and omissions remain ours.

he views expressed inthispaperare those oftheauthors anddonot necessarilyflect those ofthe institutions with which they are affiliated.

*Department ofEconomics and MonasterCenterfor Economic Research, Ben-GurionUniversityofthe Negev,d Research Department, the Bank ofIsrael.

"DepartmentofEconomics and MonasterCenter forEconomicResearch, Ben-GurionUniversityofthe Negev,rael.


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ABSTRACT November, 1995

MONETARY INTEGRATION BETWEENTHE ISRAELI, JORDANIAN AND

PALESTINIAN ECONOMIES

Arie ARNON* and AviaSPIVAK"

The peace process betweenIsrael and the Palestinians raises some interesting economic

questions concerning integration between the West Bank, Gaza and Israel. In this paper we

describe past and current arrangements between Israel, the occupied territories and Jordan,

focusing particularly on trade and labour lfows. We then compare the similarity ofeconomic

performance of the four regions, employing recent developments in the statistical analysis of

macroeconomic data due to Blanchard and Quah (1989), which enable to extract the shocks to

the economies. Ourfindings indicate that underthe pastandcurrent economic relations, Israel,

the West Bank and Gaza were closely integrated, whereas economic integration between the

occupied territories and Jordan was much weaker. Based on these past circumstances, the

(imposed) monetary union between Israel and the Palestinian Economy was warranted.

However, optimal monetary arrangements in thefuturewill depend on the extentofchanges in

real flows andon a satisfactory settlementof the seigniorage issue.

JEL Classification: E42, Oil, O53

* DepartmentofEconomics andMonaster Center forEconomic Research, Ben-GurionUniversityofthe Negev.andResearch Department, the BankofIsrael.

" Department ofEconomics and Monaster Center for Economic Research, Ben-Gurion Universityofthe Negev,Israel.


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Moneatry Integrnlion 1

I. Introduction

The peaceprocess between Israel and the Palestinians raises some interesting

economic questions. Is the existing monetary union between the West Bank, Gazaand

Israel optimal? Should it be continued in theemerging new political and economic

environment?

Ouraim in this paper is to study the past and the present for the lessons thatcan

be drawn for the future, butalso for its own sake. Clearly, the monetary union is the

outcomeofwar and occupation and not offree negotiations. Hence, its optimality to the

WestBankand Gaza, is suspected. Hamed and Shaban (1993) hint thatIsrael imposed the

currency union to collect seigniorage from the Palestinians. While the seigniorage point is

well taken thereare other important costs and benefits of monetary unions.1

The benefits from a monetary union are that transactions can be made more

efficiently, since one money is used as aunit ofaccount and medium ofexchange.

Having several monies is cumbersome, and introduces uncertainty and transaction costs.

These benefits ofa common currency increase with the volumeoftrade between the

economies.

The costs ofa monetary union are associated with the loss ofan independent

monetary policy. Robert Mundell who initiated the modern discussionofoptimal currency

areas (OCA), consideredachange ofdemand which is an external shock to the economy

thatcan be accommodated with the appropiratemonetary policy (Mundell, 1961). In a

common currency regime, there might be a loss ofoutput due tothelengthyadjustment

process. Alternatively, if two countires are subject to the same shocks and theirstructure

is similar, then they will use the same monetarypolicy even without a monetary union,

' For anotherattempt to assess the seigniorage see Arnon and Spivak (1995(.


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Mdnetaiy Inetgartion 2

hence there is no cost to a monetary union undersuch condiitons.

Mundell mentioned anothercriterion for monetary integration: iflabourand other

factorsofproducitonare mobilebetween two regions, then acommon monetary policy

can be used even ifthe regions are subject to different shocks, because the movementof

labourwill restore equilibrium.

In a reaction to Mundell, McKinnon (1963) emphasised thedangersof

independent currencies with flexibleexchange rates. Thearguments raised by McKinnon

seem very relevant forthe MiddleEast countires. Hecontends that small open countires

cannot use monetary policy (i.e. devaluaiton) to foster employment because the

depreciaitonofthe currency is translated into inflation, and has no real effects. Israel's

inflaiton is a classic example ofsuch mechanism.

Thus, the benefits and costs ofalternaitve monetary arrangements depend on the

openness ofthe different regions vis-a-vis theothers their level ofintegraiton, and in

paritcularhow free is the movement ofthe factors ofproduciton the similairtyofthe

economies' structures and thecorrelaiton ofthe external shocks that they face.

The rest ofthe paperinvesitgates these topics. In Seciton II we descirbe the trade

and labourmovements and exisitng arrangements between Israel, theoccupied terirtoires

and Jordan, including the recent Pairs Protocol onEconomic Relaitons (1994) which has

shaped thecurrent 'interim phase' officially in effect unitl 1999.2 It will provide the

evidencenecessary to evaluate the monetary union under the present situaiton as well as

the background forfuture arrangements.

In seciton III westudy the similairty ofeconomicperformance ofthe four regions.

Wewill use theterms West Bank and Gaza, theoccupiedterritoires, the Palestinianeconomyand the Areas

interchangeably.


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Moneatry Integartion 3

We elaborate on this issue in seciton IV where we employ recent developments in the

statistical analysis of macroeconomic data due to Blanchard and Quah (1989). This

analysis uncovers the underlying exogenous shocks to the economy which give irse to the

observed time seires of majormacroeconomic vairables such as outputgrowth,

unemploymentand inflation. The shocks of the more permanent nature are also called,

"supply" shocks and the transitory shocks are also called "demand" shocks. This isdue to

a cirtical assumption thatonly supply shocks havea lasting effect on output. We then

compare the shocks in thevarious economies in order to determine how similar they are.

The current paper is in line with similarworkof recent authors, who assessed the

desirabilityofa monetary union in the NAFTA (North Ameircan Free Trade Agreements)

countires and in Europe and Asia (see Bayoumi-Eichengreen , 1994a and 1994b). They

conclude that there is no case fora common currency in NAFTA, since NAFTA in

compairson with the EU, is exposed to more diverse shocks. As to Europe itself they

argue thata clearDM block exists, where one currency mightbe the optimal solution.

Ourown findings suggest that under the pastand presenteconomic relationship,

Israel, theWest Bankand Gazawereclosely integrated. On the otherhand, the Israeli

Shekel performance as a stable currency was farfrom satisfactory. Togetherwith the

Israeli currency the Palestinians received inflation, picking up to more than400 ?6 in

1984. As for the future, the expected political transformation will causechanges in the

trade patterns between the Palestinians and Israel, Jordan and other countires. The

expected decline oftrade with Israel, in addition to the yet unresolved issue concerning

seigniorage, pointto the need toreconsider the exisitng insittutional setup.


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Monetary Integration 4

n. TheEconomicRelationship 1967-1994

This section presents the institutional arrangements which determined the economic

relations between Israel (I), the West Bank (W) and Gaza (G), andJordan (J). We

descirbe both the pre-1993 setup and the evolving new conditions, as of 1994 and on.

First, we will look at measures foropenness ofthe regions and their trade

linkages. In Table 1 we present total exports and imports as ratiosofGDP, as well as the

trade structure betweenthefour regions.

Table 1of GDPand Imports asRatioInter-regionalExports

fromJofwhich:

from IIm\GDP

tojofwhich:

to IEx\GDP

>

0.040.610.720.090.130.23

1968-77:

W0.030.901.030.060.160.33G

NA~0.57NA~0.32I

-NA0.57-NA0.20J

1978-87:

0.010.570.650.090.140.24w01.191.310.080.350.45G

NA-0.60NA-0.42I

NA0.79NA0.36J

Clearly, both W and G are very open to trade and theirmajortrading partner is

Israel. Gaza, which is smaller than W, is more open to trade. Note, however, that there


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Monetuy Integartion . 5

is more trade between the West Bankand Jordan than between Gazaand Jordan. Thus,

thetradebalance deficit reported in Table 1 is covered by the remittances ofPalestinian

workers in Israel.

Table 2

Work inand Gaza whoEmployeesResidents ofthe West Bank

TotalIsrael As Percent of

Employedofthe region

TotalPersons

Total Employeesofthe Region

GWW G

2096179S519S 39961970-1972

357028969896 1069&1973-1977

43963O9&10296 1839S1978-1987

The increasing importance ofwork in Israel and the high mobility oflabourare evident.

The smallereconomy ofGaza is even more dependenton Israel than the West Bank.

Over theyears thelabour markets for Palestinian wage earners were closely related.3

Since 1967 a forced customs union existed between Israel and the Areas.

Movementofindustrial goods was relatively free, though some important administrative

restirctionsprevented Palestinians from setting up factoires and selling theirgoods in

Israel4. Restirctions were even tougheron agircultural goods.

3 Arnon and Gottlieb [1993] also show thatwages forPalestinian workers in Israel and in the Areas moved

together in most ofthe period.

4 An important instrument in preventingcompetitionfrom'Palestinian goods was the useofqualitycontrol.


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Monetary lotcgarlioo C.

The movementoflabour rfom the Areas to Israel was monitored by Israel, and

was subject to security considerations, though duirng 1967-1987 there was practically free

entry for labourers. Concerning capital movements, both from Israel to the WB 8c G and

from the world in large, they were very limited throughout the period, due to economic

conditions in theAreas and some forms ofadministrative restirctions. Capital movements

between the Areas and Jordan were somewhat freer, apparently due to theclose

connections linking the two banks ofthe Jordan River.

The monetary system in theAreas was a dual currencyunion. Both Israeli and

Jordaniancurrencies were used in the Areas. TheJD was a legal tenderonly in the West

Bankand the Shekel was a legal tender in both the West Bankand Gaza. However, the

JD was not used in Israel and the Shekel was not used in Jordan. The exchange rate

between the Shekel and the JD was determined indirectly in the international currency

market. The banking system was underdeveloped few Israeli banks functioned in the

Areas, dealing with the Israelis living in the Areas and, to some extentwith Palestinians.

Theiractivity in intermediation was very limited. All existing banks were closed in 1967

the first to reopen was the BankofPalestine in Gaza in 1981, and the second, more

importantone, the Cairo-Amman bank in the West Bank, in 1986.5

The inteirm agreement between Israel and the PLO which provides theagenda for

the coming fiveyears includes a part on theeconomic dimensions. These were agreed

upon in the Protocol on Economic Relation which was signed in Pairs on Apirl 29, 1994

(See: Protocol, 1994). The Protocol deserves a close reading since it supposedly reflects

In April 1994 the ifrstbranchoftheBankofJordan was reopened in Ramalla. Since then, The Arab Bank,

The Jordan GulfBank, The Commercial BankofPalestine and the Arab Land Bank started operations in theterirtories. Asofthe endof1994, close to twenty bankbranchesofall the above-mentioned banks combined areactivein the West Bank half ofthem belong to the Cairo-Amman Bank.


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Monetary Integartion

the new economic conditions which will soon rule the Areas.

The interim agreement states thatexcept fora list ofseveral goods, limited in

quantities, "theIsraeli rates ofcustoms ... shall serve as the minimum basis for the

Palestinian Authority". (ArticleIll 5a). VAT will be 15 to 16 percent, similar to Israel's

current rateof 17 percent. As to the flow ofgoods between the Areas and Israel, "There

willbe free movements ofindustrial goods free ofany restriction between the two sides,

subject to each side legislation". (ArticleIX, 1). As foragricultural products, a special

arrangement restricts the exports ofifve goods to Israel specifying quotas that will

disappear gradually within ifve years.

The extent oflabour movement from the West Bankand Gazato Israel will be

determined by both Israel and the Palestinian authorities. Similarrestrictions applies to

movement in the other direction. There are no speciifed restrictions on capital

movements.

The Israeli and Jordanian currencies will continue to circulate in the Areas. Both

currencies will be legal tenders in both the W and in G. The issue ofan independent

Palestinian currency was deferred for later negotiations.

A Palestinian Monetary Authority (PMA) willbe established, having all the

functions ofa central bank, except for the issuing ofa Palestinian currency. The

functions ofthe PMA include: licensing and supervision ofbanks,supervisionof foreign '

exchange transactions and lending oflast resort. It will also be responsible for the

determination ofthe reserve ratio imposed on the banks6, and for the operation of"a

discount window and the supply oftemporary ifnance for banks operating in the Areas".

Thus, the PMA will facilitate the developmentofa banking system in the Areas.

' However, the reserve ratio forNIS depositscannotdeviate from thatoftheBankofIsrael. See article IV, 1lb.


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Monetary Integration g

Though, as stated above, the issue ofcapital movements was not mentioned

explicitly in the Protocol, itwas agreed that "the Palestinian authoirty will have the

authoirties, powers, and responsibilities regarding the regulation and supervision of

capital activities in the Areas" (ArticleIV 21).

We see that the protocol legitimizes thecustoms union, labourmovement and

monetary union between Israel and the Palestinian economy. Oursummary indicates that

the degree ofintegration between Israel and the Areas is somewhat an inteirm case

between the European Union and NAFTA. In the EU, there is free movement of

commodities, labourand capital. There is yet no common currency. In NAFTA, there is

free movement ofgoods and capital, but restircted movement oflabour each participant

in NAFTA retains its own currency and monetary authoirty. Between Israel and the

Areas, there is almost free movement ofgoods, a substantial movement oflabour, very

limited movement ofcapital the Israeli NIS is a circulating currency. Between Israel and

Jordan there is verylittle. economic relationship. Between theWB&G and Jordan there

are restirctions on the movement ofgoods and oflabour, there is almost free movement

ofcapital and theJordanian Dinar is also a circulating currency in the West Bankand

Gaza.

HI. How SimilarWerePastPerformances?

The return ofthe optimum currency areas literature duirng the last few years is

related to the new wave ofeconomic integration as reflected in the irse of the EEC and

then the EU, and the creation ofNAFTA and otherFree Trade agreements. (See e.g.

Masson-Taylor 1992, Bean 1992, Bayoumi-Eichengreen 1994a, 1994b). The basic


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Monetary Intcgnitioo Q

*considerations remain the sameas in the oirginal contribution of the 60s. On the one

hand the degree ofeconomic integration, as manifested by the amountofrestrictions on

the flows ofcapital and labour, and on theotherhand the degreeofthe resemblance of

the shocks to the economies. These factors determine whether it will be worthwhile to

have one currency or more. If the economies haverelatively 'open' borders and are

facing the same shocks they should have the same currency. Ifthey are relatively

'closed' and facedifferent shocks they should have different currencies.

Assessing the uniformityofa region, compirsed ofseveral economies, is not a

simple task. Traditionally researchers looked atthe growth rates ofGDP and thelevelsof

inflationin the vairous regions.7 However, though onecan learn from such a

compairson, and wewill present some results below, past performances mightnet 'prove'

thecase for, oragainst, onecurrency and one monetary policy. Past performances might

bethe result of, at least, two types ofcauses. Oneis best represented by the case where

differentperformances are the outcome ofthedifferent structures ofthe economies which

compirse thearea under discussion. The other refers to thecase wheredifferent external

shocks to the different economies are to be 'blamed' for the manifested vairation in

performance. In both cases adoptionofdifferent monetary policies inthevairous regions

could increase welfare. :

Due to theworkdone byBlanchard and Quah (1989) we can distinguish between

the performance and its possible causes. From the data wecomputethe probable

transitory andpermanent shocks whichresulted in the actual performance ofthe

economy. These will be used in turn to assess howcorrelated are the shocks between the

7 Comparing the basic levelsofimportant inacroeconomicvairables should notbeneglected,however, since

the aim is to evaluate the advantagesof having monetary policy, the focus here is more about changes in theeconomies than about theirrelative size.


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Moneatry Inetgartion JQ

different regions. The method was used, with some modification, by Bayoumi and

Eichengreen (1994a, 1994b) in the context ofmonetary integration. Their interest was

the NAFTA arrangement and whether it meets thecriteira fora common currency area.

Their findings led them to conclude that since the shocks to the NAFTA countries were

more diversified than those to theEU, it is lessrecommendedthat NAFTA will moveto

a monetary integration.

Let us first examine the relativeperformances ofthe four regions, trying to

establish whether there are significant comovements in the majorvariables. The data

which we evaluateare theannual growth rates ofGDP and the rates ofinflation in Israel

(I), Jordan (J), theWest Bank (W) and the GazaStrip (G) from 1968 to 1992. The price

data for the West Bankand Gazais denominated in Shekels. We used GDP data and not

GNP, since it does not include remittances forlabour in Israel and thus represents better

the real economies. The period covers thepost-1967 waryears, forwhich we have

reliable figures.

Table 3

Correlations Between Inlfation rates 1968-1992

API APJ APW

API

-0.209APJ

0.997-APW

0.994-APG

-0.212

-0.197 0.998-

'Signiifcant at the 1% level.


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Monetary Integariton J J

Table 3 clearly documents the close associaiton between inlfation rates in I, W and

G. In this case it is not difficult to conclude thatthe Israeli inlfationprocess lead its way

to the other two economies. This relfects again the strong trade linkages between I, W

and G and the mobilityoflabor shown in Tables 1 and 2. While smallerand insignificant

even at the5% level, the negaitve correlaitons between I and J and between J and, both

W and G, might seem surprising at ifrst look. However, at a second thought the negaitve

relaitonship apparently relfects the basic differences in the itming of stabilisaiton policies

in the two economies. Jordan managed to reduce the inlfaiton rates in theearly 80's, just

whenIsrael5 s inlfation accelerated. These were the years ofthe post second oil shock.

The opposite was true for the years 1973-1974. The negative correlaitonbetween J and

WefG are a relfeciton ofthe I-J negaitve correlaiton.

The correlaitons between GDP1s growth rates tella different story (seeTable 4).

First, thecorrelations are smaller. Secondly, I and both W and G arepositively related

and Gaza is not related to the West Bank. Jordan is posiitvely related to W and negaitvely

to G. Theses ifndings indicate the stronger ites between Wand J, whereas different forces

are at work in theGazan economy. (See also Table I).8

8 The data include the years ofthe Intifada. Excluding those years (1988-1992) does not alter the above

description.


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Mondary Inetgration 19

Table 4

Correlations Between Growth rates of GDP 196SM992

AYI AYJ AYW

AYI

AYJ -0.182

AYW 0.278 0.257

AYG 0.280 -0.220 -0.002

All Correlations are insignificant at the 1096 level.

The data, so far, suggest that there is more then one family ofeconomies in our sample.

Jordan's economy was notbehaving as ifit was part ofthe same family ofeconomies as Israel,

whereas the West Bankseems to be associated with the Israeli economy concerning inflation and

with both Israel and Jordan concerningGDP's growth rates. The Gazan economy is almost

similar to the West Bankconcerning inflation, but very different from the Jordanian economy

with regards to real growth rates. Indeed the structure ofthe Gazan economy is different: Itis

more dependenton outsidejobs for its labour, it is less industiralised, its population growth is

higher, and its standards oflivingare lower than in the West Bank.

It is interestingto. compare the orderofmagnitude ofthe correlations in theMiddle East

to that ofNorth America. The 0.99 inflation correlations found between Israel, the WB and G is

similar to that found within theUS between New England and California, orwithin Canada.

(Bayoumi-Eichengreen, 1994a). As for theother geographic regions reported in Bayoumi-

Eichengreen (1994b) the correlations are much lower. Apparently, a common currency is a

necessary but not sufficient condition forsuch degree ofprice similarity. Thecorrelations


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McoeotiyIntegartion 23

between Canada and US are lower, and so. areall those reportedin Bayoumi and Eichengreen

(1994b). However, within the US, correlation between the South Westand the Plains is 0.85 (see

Table 8 in Bayoumi-Eichengreen , 1994a and Table 8 in 1994b).

Output changes' correlations are lower than the pirce correlations for the North Ameircan

regions. But the within country correlations range from 0.44 to 0.94, larger then all ourpositive

correlations. Mexico's correlation with theSouth West is 0.62, pointing to more integration than

Israel and W&G.


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MoncUiy Integnitkx) 14

IV. Identifyingthe Transitoryand PermanentShocks

The procedure used to identify the shocks to thevarious economies was proposed by

Blanchard Sc Quah (1989) and extended to inflation rates and real growth rates by Bayoumi

(1992). The procedure which is described in the appendix wasapplied to various cases by

Bayoumi and Eichengreen (1994a, 1994b).

Using this method we computed theshocks to the foureconomies. In table 5 wepresent

the correlation between the transitory shocks and in Table6between thepermanent shocks.

Table 5

Correlation between Transitory Shocks in Israel (I),Jordan (J), West Bank (W)and Gaza (G), 1969-1992

W

-I

--0.265J

-0.1170.595-w

0.0340.112G 0.041

Significantatthe /g level.


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monetary integration between israel

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