Simultaneously, the U.S. should be more mindful of the moral hazards created by its own long-standing aid program to Israel. U.S. political, security and economic guarantees to Israel, rooted in a variety of regional strategic interests, nonetheless have distorted how Israeli leaders calculate benefits and risks when it comes to building settlements in the Palestinian territories. There is little doubt that even modest conditionality would curb Israeli settlement activity–a necessary step for peace–as proposed by a long list of U.S. mediators, from James Baker to George Mitchell.

Foreign Conundrum
These refinements from the international aid community would help the situation considerably. Yet even without them, the post-Arafat leadership, recognizing that an effective and honest public administration is a prerequisite for political progress and economic growth, has embarked on a breakthrough reform effort. Political and security reforms have lagged, but important financial reforms, led by Finance Minister Salam Fayyad, have succeeded in boosting local revenue collection, enhancing local investor confidence and bolstering the Palestinian capital markets. The Palestinian stock market, based in Jericho, rose more than 158 percent in 2005. But foreign investment, the recognized engine for real growth, remains negligible. Profits are not reinvested locally and no new jobs are being created, despite unemployment levels of 40 to 60 percent.

TOP VIEW: While billions of dollars in foreign aid have flowed into the Palestinian Authority–Palestinians receive more aid per capita than any population in the world–its impact on efforts to build a viable nation is questionable, at best. Only when this aid regime is streamlined and coupled with investor-driven growth in the private sector will Palestinians be able to create a stable state.

Further complicating the investment situation, philanthropists have been unable to move forward the projects supported by foreign government aid agencies. The inherent limitations of public bureaucracies preclude deploying demand-driven solutions. Many viable private-sector projects have been languishing for more than a decade. One reason for this inertia is that few transactions arise organically from the private sector. Almost all such projects are donor-driven, which is hardly the most effective way to foster a community of investors, build an internal knowledge base, establish reporting standards, implement demand-based solutions, promote deal flow or add management expertise. The bureaucratic inefficiencies inherent in the donor organizations result in a poor, politically oriented distribution of funds. The continuation of business as usual flies in the face of the emerging consensus that creating durable jobs, spurring real economic growth and normalizing the economy are all necessary to the health of a viable state.

This unusual economic situation, however problematic, does present foreign investors with some opportunities that are not dependent on diplomatic progress. First, while government donors concentrate on large, politically dependent projects, considerable demand exists for investment in small and midsize businesses in most sectors. Israeli disengagement from Gaza also exacerbates the increasing need for basic goods and services. For example, the region is in dire need of professional financial products such as insurance, primary mortgages and leveraged loans. Local demand can support investment in basic economic infrastructure such as commercial marinas, warehouses, fisheries, waste management and enhanced industrial parks. Unique opportunities persist for brave financiers to set up potentially profitable public-private partnerships.

Entrepreneurial investors can also move into the vacuum created not only by the lack of a local investment fund sector, but also by the inability of local banks to leverage capital deposits and of institutional investors to deploy risk capital. Investors can obtain considerable leverage (taking advantage of high donor and public interest) by negotiating beneficial public-private partnerships and risk-sharing terms with local and international donor financial institutions. Local banks and international lending and export finance institutions, such as the World Bank, MIGA and OPIC, recognize the need for private-sector deal flow. Other Middle Eastern investors may also want to deploy capital from their oil-driven, liquid capital markets. The primary obstacles remain the Palestinian Authority’s lack of rule of law and an inability to enforce contracts. To mitigate this, contracts can be written to ensure that foreign courts have jurisdiction.

The convergence of positive indicators–the availability of risk capital, local economic demand, a business-friendly legal environment and extremely high international donor interest in supporting private sector growth–remains counterbalanced by political risk. But reticence by conservative investors makes for an opportunity for entrepreneurs interested in getting in on the ground floor in developing a new economy.

Looking back at Oslo, many observers find a certain irony that so much of the infrastructure in the Palestinian territories paid for with U.S. and international aid, often at Israel’s behest, was destroyed by Israel during the second Intifada. Before the police stations, government offices, roads and other facilities are rebuilt–most likely with large injections of international assistance–donors need to give more thought to protecting their investments. They must also learn to focus less on giving emergency assistance or budgetary support and more on promoting Palestinian enterprise and supporting the kind of risk-insurance regimes that will unleash not just private Palestinian capital, but capital from Middle Eastern investors and those in the West.

James Prince is president of the Democracy Council in Los Angeles, and Scott Lasensky is a senior research associate at the U.S. Institute of Peace in Washington, D.C. These views are their own.