JERUSALEM (Reuters) - A tiny country of 7 million people, with few natural resources and surrounded by enemies, Israel has against the odds built an economy that has achieved global status and growth of 5 percent a year since 2003.
A shift to free-market policies in recent years has helped, but much of Israel's growth has been based on entrepreneurs who start technology companies and then take them public or sell them, a model that may be reaching the limits of its economic potential.
Having come this far in the first 60 years of its existence, Israel is now seeking ways to capitalize on its innovative culture by marketing its technology more comprehensively overseas.
"Israeli entrepreneurs are good at playing in global markets because there is no home market," said Shlomo Kalish, founding partner of Jerusalem Global Ventures, one of Israel's oldest venture capital firms. "Globalisation works to our advantage."
China and India, competitors with Israel in the high-tech arena, are becoming fertile markets for its exports, said Zeev Holtzman, chairman of the Israel Venture Capital Research Center and Giza Venture Capital.
"Asia already has become more important as a market for Israeli high tech. But the level of innovative technology that is unique to the Israeli high-tech sector will continue to be the main factor that will keep Israel's edge," Holtzman said.
Israel's economy was established on socialist principles by its early immigrant leaders, mainly from Eastern Europe. The country was known for its kibbutzim -- self-contained collectives where residents worked primarily in agriculture and then in light industry, with just about everything shared.
For decades, Israel's export sector was based on agriculture, especially vegetables and citrus, such as Jaffa oranges. Such crops flourish in its arid climate with the help of home-developed drip irrigation technology, also in high demand worldwide.
It is burdened by heavy defense expenditures because of persistent tensions with its Arab neighbors, but has turned this to its advantage, keeping an edge in research and development for military hardware and software. Now shifting gears to produce more civilian products, its military sector succeeded globally with products ranging from the Uzi submachine gun to electronic surveillance systems and pilotless drone aircraft.
After the Yom Kippur War in 1973, Israel plunged into crisis and inflation breached 400 percent a year by the mid-1980s.
A stabilization plan in 1985 put the economy on a new track through a rare collaboration between labor unions, the government and the private sector that held the line on salaries and led to lower state spending. Inflation subsequently moderated to around 18 percent.
In the past five years, when the government adopted a series of free-market reforms, the state has slashed public debt, balanced the budget in 2007 and cut public spending to 45 percent of gross domestic product from 53 percent.
But experts believe the turning point in the economy came in the early 1990s, when Israel began absorbing immigrants from the former Soviet Union. Their numbers reached 1 million, many of them highly educated and highly entrepreneurial, jump-starting the high-tech sector.
"That really changed the course of Israel's economy, society and political system," said Jacob Frenkel, a former Bank of Israel chief and current vice chairman of insurance giant AIG.
"It changed the size of the population in a short time and the profile of a typical immigrant to one very rich in human capital," Frenkel said.
Many of the world's top companies -- Intel, IBM, Microsoft, Hewlett Packard, Yahoo, Google and Sun Microsystems -- now have development centers and other operations in Israel.
More than 75 Israeli companies trade on the Nasdaq stock exchange -- the most of any country after the United States.
Among them are Teva Pharmaceutical Industries, the world's biggest generic drugmaker and Israel's largest company, Check Point Software Technologies, a world leader in network security products, and defense contractor Elbit Systems.
Israeli companies lately have been increasing their focus on growing demand for emerging clean technologies.
In 2006, billionaire Warren Buffett paid $4 billion for an 80 percent stake in metalworking company Iscar for his first non-U.S. investment.
Last year foreign investors pumped more than $10 billion into an economy that has swelled to $200 billion -- about the size of the Czech Republic, Malaysia or Colombia.
With the United States, a key trading partner, in a downturn, Israel's economic growth is forecast to slow to about 3.2 percent this year, with inflation around 3 percent.
Some economists say Israel -- whose economy was unscathed by the Lebanon war in 2006 -- can weather this downturn by shifting much of its tech exports to Asia.
Bank of Israel Deputy Governor Zvi Eckstein believes consistent growth of at least 4 percent a year is possible if the government enacts policies that boost the work force and improve education.
Although accounting for more than half of Israel's exports, the high-tech sector employs only 8 percent of the work force. Business leaders like Teva Chairman Eli Hurvitz say Israel needs a plan to ensure the other 92 percent have viable salaries.
Israel's average salary is relatively low at around $2,000 a month.
One consistent drag on the economy has been low labor participation from ultra-Orthodox Jews and Israeli Arabs -- which combined comprise 30 percent of Israel's population and make do largely on state subsidies.
A newer problem is the emigration of entrepreneurs and tech talent to places like Silicon Valley.
Israel's business sector is hoping successful completion of peace talks with the Palestinians would open new markets in the Arab world.
But for now, Israel is looking past those markets to India, China and Eastern Europe.
Reporting by Steven Scheer; Additional reporting by Tova Cohen; Editing by Eddie Evans