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WP/05/70 Setting the Stage for a National Currency in the West Bank and Gaza: The Choice of Exchange Rate Regime Samya Beidas and Magda Kandil ?

2005 International Monetary Fund WP/05/70 IMF Working Paper Middle East and Central Asia Department and IMF Institute Setting the Stage for a National Currency in the West Bank and Gaza: The Choice of Exchange Rate Regime Prepared by Samya Beidas and Magda Kandil1 Authorized for distribution by Edward Gardner and Samir El-Khouri April

2005 Abstract This Working Paper should not be reported as representing the views of the IMF.

The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. This paper sheds light on the quantitative behavioral responses of key economic variables in the Palestinian economy in the face of major economic shocks and draws implications for the choice of an exchange rate regime should a decision be taken to introduce a national currency. Time-series regression analysis shows that (i) wages and prices are flexible in the face of various shocks;

(ii) the real wage appears rigid in the face of various shocks and increases despite higher unemployment;

(iii) an appreciation of the new Israeli Sheqalim real effective exchange rate decreases exports and imports;

and (iv) money demand appears stable in the face of exchange rate shocks. Although a fixed exchange rate system may initially be desirable to establish credibility of the new currency, some flexibility of the exchange rate is desirable over time. JEL Classification Numbers: 011, J31, F41 Keywords: Exchange Rate Regime, West Bank and Gaza, Palestinian Economy, Sticky Wages and Prices, Trade Price Sensitivity, Currency Substitution Author(s) E-Mail Address: sbeidas@imf.org and mkandil@imf.org

1 The authors are an Economist in the IMF'

s Middle East and Central Asia Department and a Senior Economist in the IMF Institute, respectively. They wish to thank Samir El-Khouri, Andrew Feltenstein, Edward Gardner, Mohsin Khan, and Jo?l Toujas-Bernaté for valuable comments. -

2 - Contents Page I. Introduction

3 II. Choice of Exchange Rate Regime and Characteristics of Palestinian Economy.4 A. Characteristics Impacting the Real Economy

6 Flexibility of factor markets.6 Trade pattern and denomination

9 B. Characteristics Impacting the Nominal Economy.10 Degree of currency substitution.10 C. Other Characteristics.12 Capital account and transfers.12 Institutional considerations.12 III. Empirical Results.13 A. Data and Measurement Issues.13 B. Estimation Results.14 Flexibility of nominal wages, prices, and real wages.15 Determinants of fluctuations in trade balance

19 Determinants of fluctuations in money demand.21 IV. Conclusions.22 References.33 Tables 1. Developments in Real Average Daily Wages, 2000-Q2/2004

7 2. Fiscal and Balance of Payments Developments, 1998-2004.9 3. Currency Composition of Private Deposits, 1998-2004.11 4. Statistics of Average Daily Wages, by Region, 1998-2004.14 5. Palestinian Labor Market Developments, 2000C2004.26 6A. Cyclicality of Wages and Prices in the Face of Various Shocks

27 6B. Variation in Wages in WBG with Unemployment and Wages in Israel.29 7. Determinants of Fluctuations in the Trade Balance.30 8. Determinants of Fluctuations in Money Demand.31 Appendix Data Description and Sources.32 Figures 1. Developments in Average Wages, 1998/Q1C2004/Q2.7 2. Price and Exchange Rate, 1998/Q1C2004/Q2

8 3. Currency Composition of Total Deposits, 1999C2004

11 -

3 - I. INTRODUCTION The analysis of this paper sheds light on the quantitative behavioral responses of key economic variables in the Palestinian economy in the face of major economic shocks and draws implications for the choice of an exchange rate regime should a decision be taken to introduce a national currency. The paper does not debate whether introducing a currency is the right course of action. Rather it is assumed that this would be a political decision. The paper'

s objective is to show econometrically the responsiveness of the economy to shocks and to infer the optimal choice of the exchange rate regime for the newly introduced currency. The nexus of the credibility of the currency and the regime choice, given the changing environment (following separation from Israel) and since all currencies currently circulating are convertible and stable, has been examined in previous papers. To summarize,2 the successful introduction of the new currency in the West Bank and Gaza (WBG) will hinge on four factors: (i) organization of the foreign exchange market, including the choice of exchange rate regime, (ii) development of institutions to handle distribution of the new currency and ensure smooth transition given existing contracts, (iii) assigning the central bank the responsibility to vary the quantity supplied in line with the objectives of monetary policy, and (iv) coordination with the Israeli and Jordanian authorities to ensure smooth redemption of sheqalim and dinar in circulation. Previous studies suggest that a currency board anchored on one of the world'

s main currencies (rather than a basket) would ensure the highest credibility and lowest cost of the process and, hence, provide the most suitable monetary and exchange framework.3 They argue that the introduction of a local currency is a complex process, involving institutional changes and a range of economic choices. They suggest that the guiding principle in the process should be to ensure that the benefits associated with the current situation will be maintained, while the costs of setting up the new regime will be minimized. This would appear to require actions in at least three areas: (i) a macroeconomic policy framework consistent with monetary stability;

that is, a prudent budgetary policy and an efficient, market-oriented monetary policy framework;

(2) the choice of an exchange rate regime that maximizes credibility, while minimizing costs and potential disruptions associated with the new currency;

and (3) supporting structural policies in the areas of banking, financial markets, and labor markets. These recommendations were not based on quantitative analysis of the e........

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