RAMALLAH, West Bank (Reuters) - The arteries of Gaza’s economy have collapsed as Egypt demolishes the smuggling tunnels along its sandy border.

A tunnel worker shovels sand outside a smuggling tunnel on the border between Egypt and the southern Gaza Strip October 8, 2013. REUTERS/Ahmed Zakot

Ancient stone villages in the occupied West Bank have become trapped in rural poverty, while investors and donors shy away from a zone of seemingly endless conflict.

The crackdown on the Gaza Strip and stagnation in the West Bank mean the Palestinian economy might shrink this year after average annual growth of about nine percent in 2008-2011.

The doldrums have dented a long-held belief amongst Israeli right-wingers that gathering Palestinian prosperity could achieve a de facto “economic peace” and provide a convenient alternative to a comprehensive two-state deal.

“Any talk of further developing the Palestinian economy without a lifting of Israel’s restrictions is just that, talk,” said the Palestinian minister for economic affairs, Jawad Naji.

“The international community urgently needs to intervene to pressure Israel to allow us access to our natural resources.”

Israel fears an economic downturn could provoke violence in the West Bank, with impoverished Palestinians feeling they might have little to lose by staging another uprising against the occupation.

The economy in the Israeli occupied West Bank shrank for the first time in a decade in the first half of 2013, according to a World Bank report this month which mostly faulted Israeli curbs on Palestinian movement and access to resources.

Contraction of 0.1 percent came as foreign donor aid to the West Bank’s puny economy fell by more than half in 2012.

Israel’s restrictions affect much of Palestinian economic life. It controls every access point, which enables it to oversee all imports and exports, creating bureaucratic hurdles that Palestinians say stifle or kill entrepreneurship.

The Israelis also impose strict limits on water supply, which affects industry and agriculture. Israel has not allowed Palestinians access to 3G mobile technology, citing security concerns, rendering many smartphone apps largely useless.

The impact from the slowdown is clear even in well-heeled Ramallah, the Palestinian Authority’s administrative capital which feels a world away from poorer, outlying areas.

“When I opened my restaurant eight years ago, I had five or six workers. Today I have three and if the situation gets any worse, that number might become two,” said Ahmed Kdour, owner of the Chicago restaurant.

“Many people have put their shops up for sale saying they are travelling or don’t have time for the business, but it is because of the economic situation,” he added.

FRUSTRATION

The West Bank’s woes were partially offset in the first half of the year by resilience in Gaza, thanks especially in the construction sector fed with cement from the tunnels.

But since Egypt’s military in July ousted the country’s Islamist president, a friend to the Hamas group that runs the coastal strip, it has demolished around 90 percent of the tunnels from which the Gaza government used to derive between 40-70 percent of its revenue.

Unemployment in Gaza and the West Bank was some 22 percent in June 2013, with exports making up just 7 percent of the total economy, according to World Bank statistics.

Israeli foreign ministry spokesman Yigal Palmor told Reuters a lull in Palestinian GDP was natural after a period of sharp growth, and defended continued Israeli curbs that bodies such as the World Bank say are smothering prospects for expansion.

“They are part and parcel of the existing situation, where there remains a permanent terror threat,” he said, adding that direct peace talks, which resumed in July after a three year hiatus, were meant to establish a definitive solution.

With Israel controlling more than 60 percent of West Bank territory, including the most fertile land, the Western-backed Palestinian Authority has grown dependent on foreign aid. This totaled $932 million in 2012, according to PA data, just under a third of all revenues and down from some $1.8 billion in 2008.

Deputy Prime Minister for economic affairs and head of the Palestine Investment Fund, Mohammed Mustafa, said that foreign donors were growing wary of subsidizing their economy without seeing “a political horizon” to end the conflict.

“They’re getting a bit frustrated with the political process ... they’re saying, look, we’re not providing support for continuing occupation, but rather to support establishing a Palestinian state,” he told Reuters in an interview.

Speaking in his sleek office, a wood and glass villa in the concrete jumble of Ramallah’s once robust but now crumbling building boom, Western-educated Mustafa sees the peace talks as a make-or-break moment for the economy.

Behind him sit posters of a rosy, purported future: computer-generated graphics of a leafy Palestinian megacity.

Propped next to them, stand maps showing the bleak reality, crosshatched with no-go zones for Palestinians and purple blotches marking widespread Jewish settlements.

Mustafa imagines an “exit strategy” from aid through the $4 billion investment and development plan, or “Economic Initiative for Palestine”, introduced by U.S. Secretary of State John Kerry this year and drafted by the Mideast Quartet of the U.S., Russia, European Union and United Nations.

The quartet’s interim report, which runs into hundreds of pages, provides details for investment and reform prospects in eight sectors from tourism to agriculture.

The research probed into the minutest information, for example whether certain tracts of land should be devoted to vegetables or fruit, and with sprinkler or drip irrigation.

“The initiative deals in facts, not dreams, and it takes into mind the status quo ... it’s about making the economy sustainable, not pouring money into a safe,” an adviser in the office of the Quartet representative in Jerusalem told Reuters.

While growth in recent years owed much to the easing of Israeli rules on movement, the quantum leap envisioned by the quartet plan is likely an all-or-nothing chance that depends on a successful conclusion to peace talks next spring - “high-stakes, but also high gains,” said the quartet adviser.

DREAMS

In a rolling West Bank landscape encrusted with olive trees, millionaire Palestinian businessman Bashar al-Masri is making a rare investment and growth success story come to life.

Whole neighborhoods of affordable housing for some 25,000 people, mosques, schools and parks are taking shape as part of the first-ever planned Palestinian city, a $300-million project with Qatari investment. But the dream is not yet reality.

Israel has not given final approval for the road to the new town, dubbed Rawabi or “The Hills”. Al-Masri also complains that access to water is not yet secure, saying that the supply allotted by Israel to the nearby Jewish settlement of Ateret alone would be more than enough for both towns.

“We’ve faced many problems from the (Israeli) occupation, and we still do. This is the nature of a military occupation, it’s what we expected,” al-Masri told Reuters.

While Ramallah’s economic and policy elites speak optimistically of a breakthrough, high prices and shrinking livelihoods weigh on many working-class Palestinians, for whom this month’s Eid al-Adha holiday was lean.

“This is the first Eid where there was not much activity,” said Ramallah resident Rami Bishara, ambling around the mostly empty jewelry and clothing stores in the city center market.

“I remember two years ago, there was a stream of people,” he added wistfully.