The economic outlook will brighten if peace talks succeed and a supporting economic package is implemented. This could attract investment and aid, boosting growth and employment and potentially easing budget financing.
The breakdown of peace negotiations with Israel in late 2010 ushered in almost three years of economic decline and political stalemate, the IMF said.
"This turn of fortune, combined with increasingly unpredictable donor aid, has reached a point where the early achievements in economic institution-building are being threatened," said the report, prepared for a semi-annual meeting of Palestinian donors.
The meeting of the donors group, known as the Ad Hoc Liason Committee, is set for Sept. 25 during the United Nations General Assembly.
The report said economic prospects for the West Bank and Gaza Strip are dim if Palestinians continue down the same path they are on. And there is a risk the situation could deteriorate further if aid falls short or political instability increases.
The Palestinians depend heavily on aid from donors about $1.3 billion this year or the equivalent of nearly 12 percent of annual gross domestic product. But the aid has been falling in recent years along with optimism over peace and it is unpredictable.
Duenwald said the IMF does not expect the aid to go up or down in the immediate future.
"It will depend on how peace talks evolve," he said.
With that uncertainty over aid, if Palestinians continue to run large budget deficit, they may not be able to fund them in the medium term, the IMF warned.
The political upheaval sweeping the Middle East only complicates Palestinian economic difficulties.
Donors are stretched even thinner by the conflicts in Egypt and Syria. Violence and instability is pushing oil prices up and they could still rise further.
Egypt, after the ouster of Islamist President Mohammed Morsi, is threatening to shut down all smuggling tunnels between the Sinai Peninsula and Gaza the main economic lifeline to the outside world for the impoverished territory.
"The impact on Gaza of these tunnel closures could be very significant," Duenwald said. "We are definitely concerned about it."
The IMF forecast that GDP growth for the territories will slow in 2013 to 4.5 percent from 5.9 in 2012 and fall further in subsequent years.
Slower growth is not generating enough jobs to bring down the high unemployment rate, which the IMF predicts will rise to 24 percent by the end of this year.
The report said the Palestinian Authority's budget targets appear out of reach and it should take steps to bring the budget back in line.
The report forecast an overall budget deficit of 15 percent of GDP this year. Most of that is expected to be covered by donor aid but the PA may come up with a shortfall of 3 percent of GDP.
The IMF recommended the PA reduce spending on civil servants and improve tax collection to raise revenues. It said public spending is tilted toward wages and pensions rather than much-needed investment in education and public infrastructure.
The IMF also expressed concern that rising levels of public debt may be unsustainable. That debt increased to 38 percent of GDP by mid-2013 up from 26 percent in 2010.
The report said Palestinian authorities expressed concern that the IMF's recommendations would be politically unpalatable.
