The Palestinian Authority's fiscal situation is "increasingly precarious," the International Monetary Fund warned on Thursday.
The IMF called for urgent action to help it close a gaping budget deficit and to stabilize the economy.
In a report prepared ahead of a donor meeting in Brussels on March 19, the IMF said the Authority, which exercises limited self rule in the occupied West Bank, faced mounting debt on domestic payments, including on civil servant wages and rising domestic bank debt.
The aid-dependent Palestinian Authority (PA) has been in a financial crisis fueled by a drop in assistance from Western and wealthy Gulf backers, renewed tensions with Israel and a need to meet an expanding public sector payroll.
The IMF projected a financing gap of about $400 million for 2013, which includes expected donor budget support of $1 billion and payment of 2012 wage arrears. However, the funding shortfall could reach $700 million if donors fail to deliver on aid promises,the IMF said.
It urged the cash-strapped Palestinian Authority to draw up contingency plans that includes spending cuts. It also said the Authority should look at ways to boost growth, which is forecast at roughly 4.0 percent between 2013 to 2016.
The IMF said unemployment had increased to almost a quarter of the labor force by the end of 2012, with unemployment among the youth particularly high.
In the past few months, the Authority has failed to pay full salaries to its 160,000 employees in the West Bank and Gaza Strip, territory controlled by the rival Hamas Islamist movement.
"Domestic sources of financing are drying up, with both the bank and non-bank private sector increasingly reluctant to finance the government," the IMF said in a report prepared for a donor meeting on March 19.
"If left unchecked, these trends will ultimately lead some to question the legitimacy of the PA and undermine its ability to govern effectively," the IMF added.
The IMF suggested a cap on spending, including in the 2013 budget by freezing wages and promotions, postponing non-essential development projects, while expanding a cash transfer program to protect the poorest.
It said unemployment in the West Bank and Gaza rose to 23 percent in the fourth quarter of 2012, from 21 percent in the same period a year earlier. Meanwhile inflation remains low at less than 2.0 percent.
The IMF said Israeli restrictions on movement and access was virtually unchanged and continued to hamper growth. Meanwhile, political uncertainty has increased, with increased unrest across the region deepening the sense of gloom, the IMF added.