Bank of Israel Governor Stanley Fischer said on Sunday Israel could become a leading economy globally if a Middle East peace deal is reached but that the key challenges for now were to accelerate growth and cut poverty.

The Zambian-born, U.S. and British educated Fischer, in a speech after he was sworn in for a second five-year term as central bank chief, said economic success hinged on maintaining a strong military.

This economy, with its dynamism and creativity, could grow much faster if we were to achieve peace with our neighbors, said Fischer, 66, who is credited with helping to keep Israel's economy and financial markets afloat during the global downturn.

If we were to achieve it, we could within one or two decades find ourselves living in one of the most advanced economies in the world, he said.

Over the long term, Israel's economy needs to be as successful as being able to defend itself militarily, he said.

These two factors -- the economic and the military -- are intertwined, and their interconnections are very complex, Fischer said.

Fischer -- a former professor of Federal Reserve Chairman Ben Bernanke -- accepted a second term as head of the Bank of Israel in March after parliament approved a bill that makes the central bank's policymaking more transparent.

He had taken over as head of the central bank in 2005 when Israel's economy was recovering from a previous recession. The economy grew rapidly until mid-2008.

Under the new law, monetary policy decisions will be made by a six-member board. Until now, the decision has been made by the governor alone.

Finance Minister Yuval Steinitz said a committee to appoint the non-central bank members of the board should be ready by June.

RAPID ECONOMIC GROWTH

Despite a heavy dependence on foreign trade, Israel's economy was not hurt too badly due to the crisis. Growth in the second half of 2009 was strong -- the economy expanded at an annualized 4.8 percent rate in the fourth quarter and 0.7 percent for all of 2009.

The central bank predicts growth of 3.7 percent in 2010 and along with high inflation expectations, Fischer has raised Israel's key short-term interest rate by one full point to 1.5 percent since last August.

Still, Fischer said much is not well and we face many challenges, citing the implementation of the new central bank law, improving the educational system and reducing bureaucracy, poverty and social gaps.

I fear also that in years to come, we will do much worse on the corruption index, Fischer said in an apparent reference to a host of high-profile scandals that have rocked the country of late.

However, Fischer praised the government's disciplined fiscal policies as a main reason for a brief downturn.

Steinitz said the economic turmoil in Europe underscores the importance of keeping to fiscal discipline.

One thing we must do... is to continue opening Israel's economy to competition, said Prime Minister Benjamin Netanyahu, who was the architect of sweeping free market reforms as the country's finance minister from 2003 to 2005.

(Editing by Mike Nesbit)

Israel Zambia Ben Bernanke Inflation