Two years after launching an ambitious plan to trim bureaucracy and root out corruption, Salam Fayyad's "good government" initiative aimed at preparing Palestinian institutions for statehood is stagnant and dying.

As the deadline to meet his goals came and went last month, a moment of pride for the Palestinian Authority prime minister and his attempt to foster Palestinian independence has become a disappointment.

Undelivered foreign aid began sending public finances into disarray. That forced deep salary cuts for tens of thousands of government employees, generating a knock-on effect that has spooked banks from lending and consumers from spending. Angry civil servants who once lauded their reform-minded prime minister are now threatening strikes against his government.

A report released by the World Bank yesterday warned that the "crisis risks jeopardising the gains in institution-building made painstakingly over the past years".

Meanwhile, Israel and its allies in the US Congress have threatened financial sanctions against Mr Fayyad's West Bank government for trying to win UN statehood recognition this month.

For many Palestinians, this has forced a reckoning of their prime minister and his attempt to battle Israel's military occupation by promoting internationally approved concepts such as law and order as well as economic reform.

"What Salam Fayyad has meant to us is an attempt to build institutions and rule of law, and I believe he did a good job," said Hatem Sabbah, the mayor of Tekoa, one of many West Bank villages that falls under direct Israeli military control.

"But the occupation is such a limit on this, on all of us. Israel can demolish all that Fayyad did over the last few years in just one second."

A hint of Israel's stranglehold over Mr Fayyad's domain came when the Israeli finance minister, Yuval Steinitz, temporarily withheld millions of dollars in tax revenues collected on behalf of the Palestinians in May. That decision nearly brought the Palestinian economy to its knees and, for some, further demonstrated that Mr Fayyad's strategy has offered little more than a mirage of stability.

"I think the fatal mistake in the agenda is the assumption that by building institutions, by building a modern economy, and by achieving growth in the economy, these conditions are sufficient for statehood building," said Nasser Abdelkarim, a professor of financial economics at the West Bank's Birzeit University.

"You can't just jump over the fact that Israel's occupation is virtually omnipresent and assume that by trying to build a state that you are actually doing so."

Irrespective of its long-term significance, Mr Fayyad's immediate impact on the ground has been unmistakable. His increasingly proficient security services fostered stability and generated the confidence necessary for respectable economic growth. Palestinians benefited from the three-dozen new schools that were built last year and newly paved roads in the West Bank.

It was all part of a two-year strategy that Mr Fayyad unveiled in August 2009 to show the world Palestinians could - and would - be ready for independence. It instilled confidence in Palestinians, who took out loans and began driving fancy new cars.

The international community, too, felt comfortable showering money on the increasingly transparent bureaucracy run by Mr Fayyad, a secular-looking former International Monetary Fund economist. For one thing, Mr Fayyad, who also runs the finance ministry, bolstered credibility by demonstrating his budget's dramatically decreasing reliance on foreign largesse.

Analysts say all this has proved invaluable in putting the onus on countries that publicly call for a Palestinian state to respond positively to Mr Fayyad's achievements, especially as peace talks with Israel collapsed last year because the Israeli prime minister, Benjamin Netanyahu, refused to stop building Jewish settlements.

"The brilliant thing about the programme is that it called everybody's bluff," said Hussein Ibish, a senior fellow at the American Task Force on Palestine, a research organisation in Washington.

He described Palestinian thinking behind it as: "OK, you say you want a Palestinian state, so we'll build one. And if you say you oppose this, then that shows you're not being sincere at all in your public pronouncements to the Palestinians."

The faltering Palestinian economy, however, appears to have affected Mr Fayyad's popularity, which Mr Ibish and others said is tied in the public mind to his ability to attract foreign money to build projects and pay salaries.

This has been imperilled by a drop in foreign aid this year, which has forced suspensions in salary payments and sent frustrations soaring.

A nurse at Bethlehem's Palestinian Authority-run Al Hussein Hospital, who gave his name as Abu Yousef, said: "Believe me, I want to say something about Fayyad, but that's a red line we're afraid to cross here."

Abu Yousef said he received only half his pay in July and nothing last month, forcing him to divert family savings to pay off a US$10,000 (Dh36,700) loan he took out this year.

"There's no governing authority, no money, no responsibility," he said. "If things go on like this, it will explode here."

Samir Abdullah, the general director of the Palestine Economic Policy Research Institute in Ramallah, however, described Mr Fayyad's development strategy as deliberately risking such popular anger if that meant demonstrating the Palestinians were ready for independence.

"The gains achieved by Fayyad were tactical gains. They do not bring sustained stability and development," he said. "He can't keep this development going without a political process that really makes these achievements have a meaning."

With a return to peace talks politically untenable since Israel refuses to stop building settlements, Mr Abdullah said the prime minister and Mahmoud Abbas, the Palestinian Authority president, are now forced to break the political deadlock by turning to the UN for statehood recognition.

"The legitimacy of Fayyad and Abu Mazen [Mr Abbas] is very much at stake now," he said.