While Israeli and Palestinian negotiators grope their way towards a US-sponsored peace meeting in Annapolis later this year, investors and economists are struggling with a different problem: how to justify the strength of the Israeli economy.

Last year’s botched war in Lebanon, the escalating conflict with Islamist militants in the Gaza Strip, the threat of Iran’s nuclear programme and the weakness of an unpopular and fractious government at home – nothing has so far managed to throw the economy off its high-speed track.

The country’s TA-25 index of leading shares touched record highs last week, and is now up more than a third since the start of the year. Economic growth is forecast to reach 5.2 per cent this year, fuelled by rising consumer spending, buoyant corporate investment and strong exports. Unemployment has fallen steadily, and now stands at just 7.8 per cent – down from almost 11 per cent four years ago.

In a radical break with the past, Israel today runs a surplus both in its current account and budget. This has allowed the government to tackle one of the few remaining blotches in Israel’s economic report card – the high debt accumulated during a two-year recession in 2001 and 2002.

Investment banks such as Morgan Stanley forecast that not even a slowdown in the US will stop the Israeli economy from “growing at a reasonably robust pace”.

The economic strength reflects two broad, long-term trends.

The first came in the form of tax cuts, lower welfare spending, privatisations and capital market reforms implemented when Benjamin Netanyahu took over as finance minister in 2003.

The second change has to do with Israel’s successful integration into the global economy – which has proved an increasingly receptive market for its exports of high-technology products, manufactured goods, pharmaceuticals and services such as consulting.

“We are reaping the benefits of something that has happened over the last few years, and that is how well the Israeli business sector has exploited globalisation,” says Leo Leidermann, chief economist at Bank Hapoalim, Israel’s largest commercial bank.

And while Israel’s over-reliance on software and information technology made the country a prime victim of the technology downturn in 2000, today’s export performance is far more balanced.

The country’s remarkable economic success has given a twist to the debate on the “peace dividend” – the additional boost that the Israeli economy could receive through striking a comprehensive peace agreement with the Palestinians and the country’s Arab neighbours.

While previous peace efforts were accompanied by offers to link the Israeli economy with its neighbours, economists today argue that regional integration would be of limited value to the country.

Israel is also no longer dependent on the Palestinian territories as a source of cheap labour. The country’s building sites and orange groves are today filled with workers from Asia and eastern Europe.

For Palestinians, an end to the heavy security measures that stifle economic activity in Gaza and the West Bank is crucial. Living standards there have plummeted as Israel has placed ever heavier restrictions on the free movement of goods and workers within and out of the territories.

Yet analysts agree that a durable peace would lift the Israeli economy. Tourism would benefit from a more benign security environment, as would foreign investment: no big foreign bank has yet set up a retail network in the country.

“If you had a peace treaty signed tomorrow we could reach annualised growth of 6.5-7 per cent owing to higher foreign investment, increased tourism and reallocation of defence spending,” Prof Leiderman says.

Whether failure at Annapolis dents the benign outlook, economists say, will depend on whether a diplomatic setback triggers another violent uprising by the Palestinians.

Serhan Cevik, an analyst with Morgan Stanley, points out in a recent report that global growth has so far offset all political shocks to the Israeli economy.

“But that does not mean full immunity forever,” he adds.