With the rules of the Middle Eastern political and economic game fundamentally changed since the fall of Saddam, investors who are not persuaded by media herd behavior are valuing more highly than ever the prospects for regional reforms and future growth. The conventional wisdom about the Mideast is ubiquitous in the press, but largely unjustified from an economic perspective. A search of newspaper and magazine stories in 2004 reveals more than 3,338 articles including the words "Middle East" and "war and terrorism"; only 102 stories linking the "Middle East" with "growth" and "recovery" can be found.

Yet definitive policies to normalize the Middle East have made regional and global market investors bullish, repatriated capital exported (or that had fled) from the region, and encouraged a sea change in foreign direct investment. The end of Saddam's regime sent a major, unconfused market signal after the West's years of disinterest in the Middle East as a Levantine backwater. Subsequently, every major capital market index in the Middle East has risen.

Regionally, stock markets rose over 30% in 2004 and represent a market capitalization of $470 billion. This has been accompanied by a surge in regional property values and a higher number of tourists. The main Egyptian equity index has increased 165%, while that of Saudi Arabia has gone up by 158%. The Saudi market's stellar performance is especially striking given the great amount of attention paid at the moment to that country's security problems. Israel's leading index has risen by 32%, the benchmark index of Kuwait's exchange by 73%, Jordan's by almost 60%, and that of the United Arab Emirates by 110%.

This upsurge in capital investment extends to Iraq. Since June 24, 2004, the Iraq Stock Exchange (ISX) opened and replaced the old Baghdad Stock Exchange, which was government-run and characterized by corruption and irregularities. An independent securities commission and depository center were established accompanied by the early emergence of a fixed-income market. The old exchange's trading activity pales in comparison to the ISX's performance so far.

Saddam mortgaged his country's future to fund his tyrannical regime and delusions of regional grandeur. The World Bank estimates that Iraq currently has external debts of around $120 billion owed to other governments. With Iraq's GDP at $34 billion, debt is 350% of GDP. An economic stumbling block to development and reconstruction is a restructuring of that debt. With this in mind, former Secretary of State James Baker made the rounds of Iraq's creditors appealing for debt forgiveness with substantial results.

The Paris Club (consisting of sovereign creditors from Russia, the U.S., Western Europe and Japan) has already agreed to an 80% write-down of nearly $40 billion of debt. Another $50 billion was lent by members of the Gulf Cooperation Council comprised of Saudi Arabia, Kuwait, Qatar, the UAE, Oman and Bahrain. The two largest creditors, Kuwait and Saudi Arabia, have signaled that they will enter debt restructuring negotiations in the near future, the UAE and Qatar announced they plan to forgive the bulk of $7 billion owed their countries. In all likelihood, $80 billion to $90 billion of Iraq's total debt will eventually be forgiven. This good news is already being reflected in these markets.

The fall of Saddam was a harbinger for increased foreign direct investment into the Middle East as well. Until recently, the region attracted less than 1% of global FDI and only 4% of FDI directed at the developing world. The average annual amount of FDI for the three years preceding the war (1999-2002) was only $6.7 billion. According to our research, FDI for the entire Middle East since regime change in Baghdad will be up 76% or $4.8 billion to an average of $11.5 billion for the 2003-2005 period. Overall, Middle Eastern countries are striving to make their economies more attractive to foreign investment. Nowhere is this more apparent than in Iraq. A new foreign investment law was passed on September 2003 permitting 100% foreign ownership of firms in all sectors of the economy aside from oil and other mineral extraction. Profits from foreign investments into this previously highly centralized, state monopoly economy can now be repatriated freely from both tax and capital controls.

Skeptics might suggest that this is all due to soaring oil prices. This is only partially correct, as it is not just the stock markets of oil-rich countries that have appreciated, nor have they been the only ones benefiting from increased foreign direct investment flows. Most of the Mediterranean Middle Eastern countries are not energy rich, yet nearly all that have felt the heat, if not always happily welcoming the light of a changing Middle East, have displayed robust equity-market growth.

Neither is this performance simply based on expectations of growth. On the contrary, the entire region has seen generally robust growth after decades of economic stagnation. The per-capita income in Arab countries grew at an annual rate of 0.5% over the past two decades -- less than half the global average. Despite vast natural resources, a good educational system, adequate skilled labor and plenty of capital, which has largely been exported from the region, the standard of living in the Arab East has declined relative to the rest of the world. With very high birth rates, the region's labor force is increasing by over 3% a year -- the fastest rate in the world.

With 80 million people living in poverty and 15% to 20% unemployment rates, the urgency of economic growth and job creation to absorb the growing labor force is vital. This past year, Iran and Saudi Arabia -- the region's two largest economies by purchasing power -- grew by 6.2% and 6.4%, respectively, in real terms. The next largest economies, Egypt and Israel, also grew, but less rapidly at 1.8% and 1.3%. Israel's growth, while lower than some of its neighbors, is itself quite remarkable given its current security problems. Israel's recovery after two years of contraction bodes well for the Palestinian economy. The smaller economies of the region are also growing. Of particular note is the impressive performance of Kuwait and the UAE, both of which grew more than 6% last year in real terms.

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Of course, Middle Eastern economies, while improving, still lag other markets, especially in one key area: access to capital for entrepreneurs. IPOs have been few and far between, regional companies are overly dependent upon bank debt, secondary market conditions remain largely unfavorable, bond markets are embryonic and illiquid and venture capital is generally unavailable. If small and medium-sized businesses are to flourish, the control of capital by a small number of regional banks saddled with a high level of nonperforming loans will need to be decentralized.

The lack of access to capital reflects serious challenges that remain. But when one looks at the success these countries have had in growing their markets in the past two years, and the reforms they are starting to make to open up their markets, the news from the region is hopeful. Too much focus is spent on the challenges facing the region at the cost of realizing its potentials. Beyond the smoke and tears, a new Middle East may yet emerge through enhanced capital flows to finance a future for entrepreneurs with hopes and dreams to build their countries and create jobs to save their youth from terrorism.

Mr. Yago is director of capital studies and Mr. McCarthy a research analyst at the Milken Institute.