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Q1 2015 - Everything Hinges On Nagorno-Karabakh

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  • Q1 2015 - Everything Hinges On Nagorno-Karabakh

    Q1 2015 - EVERYTHING HINGES ON NAGORNO-KARABAKH

    Business Monitor International; Fitch Group Co.

    Caucasus Business Forecast Report
    October 30, 2014 Thursday

    BMI View: Attempts to win back the Nagorno-Karabakh enclave will
    remain the defining issue of Azerbaijani foreign and domestic policy
    through the medium term. No quick resolution is likely and, therefore,
    heightened tensions with Armenia have the potential to result in
    further small-scale armed clashes, with escalation not ruled out. This
    will continue to weigh heavily on Azerbaijan's long-term risk profile,
    which will deter investment despite progress on other fronts.

    Despite a relatively strong short-term outlook, we remain cautious on
    Azerbaijan's long-term political risk outlook, given ongoing elevated
    tensions with neighbour Armenia over the Nagorno-Karabakh enclave.

    Since a war between the two countries in the 1990s (no peace deal
    has been signed), ethnic Armenian forces have held the territory in
    Nagorno-Karabakh in the Western part of Azerbaijan, establishing a
    government and holding regular elections.

    All Eyes On Nagorno-Karabakh Europe - Map Of Caucasus Region

    The issue remains - and will remain - a major impediment to the
    mitigation of political risk in the South Caucasus. The primary
    reason for this is the estimated 500,000 displaced Azerbaijanis, many
    of whom continue to live in temporary accommodation 19 years after
    the end of the war. This has resulted in intense domestic political
    pressure on the Azerbaijani government to take back the territory,
    exacerbated by the lack of open elections that means the leadership
    must be particularly sensitive to popular sentiment. Aggressive
    rhetoric from Baku is not uncommon and the government has ramped up
    military spending to US$3.7bn per year. Small-scale border clashes
    between Azerbaijani and ethnic Armenian forces - often resulting in
    multiple deaths - are not uncommon.

    Challenges And Threats To Stability

    Hot War: The major risk to political stability in Azerbaijan, and
    indeed in the wider Caucasus region, is the outbreak of interstate
    warfare with Armenia over Nagorno-Karabakh. Regular small-scale border
    skirmishes could conceivably escalate into something bigger, while
    aggressive rhetoric from both sides will ensure that tensions remain
    high. It is estimated that 20,000 combat-ready troops are deployed
    on each side of the border, often separated by just 50 metres,
    and the fact that the soldiers are raised on radically different
    interpretations of the region's recent history does not lend itself
    to moderation.

    That said, the outbreak of war remains outside our core scenario. One
    reason for this is the regular contact between the Armenian and
    Azerbaijani presidents since 2008 under the auspices of Russian
    President Dmitry Medvedev, and his predecessor and successor Vladimir
    Putin. The personal and public involvement of a powerful neighbouring
    country that has relatively strong relations with both countries
    (particularly Armenia) lends credibility to the peace process while
    also mitigating the risks of a major breakdown. More importantly
    than diplomatic initiatives, however, is the fact that the interests
    of major regional players - Russia and Turkey - are in line with a
    mitigation of tensions and the establishment of a lasting resolution.

    Following the 2008 war with Georgia, Moscow is keen to reinforce its
    credibility as a responsible actor in the region, while also seeking
    to improve relations with Baku for the purposes of energy security.

    For Ankara, a greater role in Caucasian security issues is a priority,
    while it is also keen to keep Baku on side, again for reasons related
    to gas. These factors should ensure that Baku feels it is getting
    a fair hearing, while also discouraging any pre-emptive attack on
    Nagorno-Karabakh.

    Ructions With Turkey: We believe relations between Azerbaijan and
    Turkey could deteriorate over the medium term, which would have
    the potential to harm Azerbaijan's economic and political risk
    profile, given the importance of its implicit backing from Ankara in
    international affairs. Traditionally, Baku and Ankara have enjoyed
    strong bilateral ties, symbolised by the popular slogan 'one nation,
    two states'. Indeed, the two have similar cultures and languages,
    and Ankara has had no diplomatic relations with Yerevan since 1993,
    in solidarity with Baku.

    However, an increase in tensions between the two has come about since
    Ankara decided to pursue better relations with Yerevan, culminating in
    the signing of two protocols on the re-establishment and development
    of diplomatic ties in Zurich in October 2009. Baku was incensed that
    Ankara had signed the protocols without demanding concessions on
    Nagorno-Karabakh in return and promptly threatened to hike prices for
    gas exports to Turkey. Turkish flags in Azerbaijan were also taken
    down. Although tensions have mitigated substantially since, with the
    signing of a key gas deal in Istanbul in June 2010 and the scheduled
    construction of the Trans-Anatolian pipelines (TANAP), we believe risks
    remain. Any perception that Ankara's support for Baku has weakened
    would potentially reduce the latter's clout in regional affairs.

    Relations With Iran: We expect relations with Iran to remain tense
    through the medium term for a number of reasons, which will further
    weigh on Azerbaijan's risk profile. Foremost among these is Iran's
    desire to increase its leverage over Baku both to increase access
    to Azerbaijani oil and to boost Tehran's leverage over Moscow -
    something that it currently lacks. In addition, Tehran will likely
    remain wary of Azerbaijan's potential ability to destabilise Iran,
    given the latter's large Azeri population (there are more Azeris
    in Iran than in Azerbaijan). A further major sticking point between
    the two is Israel, which will likely further fuel suspicion towards
    Baku in Tehran, given that Azerbaijan pursues strong relations with
    Israel. Tehran has accused Baku of allowing Israeli listening posts
    to be established along its border with Iran while, for its part,
    Azerbaijan has expressed discontent with Armenian-Iranian gas
    cooperation.

    Democratic Limitations: Despite major improvements in living standards
    on the back of rising oil revenues in recent years ( see chart),
    there are signs that popular discontent with the government remains
    fairly elevated.

    Living Conditions Improving Azerbaijan - Quality Of Life Indicators

    While no repeat of the violent protests of 2003 have yet been
    witnessed, the lack of a strong opposition in parliament and President
    Ilham Aliyev's strengthening hold on power have resulted in a number
    of street protests in Baku in recent years. The authorities' control
    on public gatherings outside the capital is much stronger, although
    the protests in Ismayilli presented a new challenge to Aliyev.

    Government critics are regularly harassed according to human rights
    gorups, while trade unions are weak and media freedom has been
    questioned by western observers. Although the government has so far
    managed to handle domestic opposition relatively easily, we do not
    believe democratic institutions are sufficiently well developed to
    handle major public protest at this juncture, should it come about.

    Corruption: Widespread allegations of corruption have helped to foster
    resentment against the government. Azerbaijan came in at 127th place
    out of 177 countries in Transparency International's 2013 Corruption
    Perceptions Index, well below neighbours Georgia (55 th) and Armenia
    (94 th). Given that those unhappy with government policy are often
    unable to channel their concerns democratically, we see the potential
    for further disenchantment to threaten political stability, curtailing
    the government's policy agenda and damaging investor confidence.

    Domestic Islamist Threat: Poverty, corruption and other concerns have
    contributed to a growing militant Islamist movement in Azerbaijan.

    While we see this as small at present, we nevertheless believe it has
    the potential to grow significantly, which would pose major risks
    to political stability. Although secular tendencies in Azerbaijan
    are among the strongest of any majority Muslim country (religious
    involvement with politics is forbidden by law), the militant minority
    is growing. In October 2007, the government claimed that it had
    thwarted a major attack against Western diplomatic missions in Baku,
    while three people were killed in an attack on a mosque in 2008.

    Rallies and protests using religious slogans have also become more
    common on the streets of Baku.

    Unclear Borders: The fact that Azerbaijan's borders with neighbouring
    states are often ill-defined will remain a risk to political
    stability. This is a particular problem given elevated regional
    tensions, while the unclear divisions between states make border
    controls difficult, limiting the government's ability to monitor the
    potential arrival of members of radical terrorist groups.

    Ratings: Stability Not Assured In Medium Term

    Our political risk ratings make a clear distinction between what we
    see as short-term stability and longer-term risks. In the near term,
    robust oil revenues will allow sufficient social transfers to maintain
    social stability, which will in turn provide the government with room
    to continue its reforms of the business environment and increase its
    attractiveness to foreign investors. Our short-term political risk
    rating for Azerbaijan is 70.3 (out of 100), one of the highest in the
    Central and Eastern Europe (CEE) region excluding the CE4. In line
    with our key views, Azerbaijan scores most strongly on the 'policy
    continuity' and 'policymaking process' components of our ratings -
    at 80.0 and 76.7 out of 100 respectively - while faring less well on
    'security and external threats', where it tallies just 46.7 out of 100.

    Over the longer term, we are less assured about political stability.

    Although we continue to expect a mitigation of regional tensions at
    some point, we believe the security situation in the Caucasus could get
    worse before it gets better. This would have a greater relative impact
    on political stability in Azerbaijan than in Georgia and Armenia,
    in our view, given that its institutions are less well prepared to
    handle the domestic implications of heightened tensions.

    Azerbaijan's long-term political risk rating of 49.0 out of 100 puts
    it lower down the CEE rankings, albeit still ahead of Georgia.

    Azerbaijan fares worst in our 'characteristics of polity' (30.8 out
    of 100) category due to the relatively underdeveloped and closed
    nature of its political and legal systems as well as the media. It
    also struggles on the 'characteristics of society' component (52.5
    out of 100), thanks to the potential for domestic opposition groups
    - particularly Islamists - to hamper the policymaking process and
    due to ongoing wealth disparities that have the potential to fuel
    disenchantment with the government.

    Our concern that Azerbaijan's institutions may be ill-equipped to deal
    with the emergence or escalation of internal and external threats
    relative to other CEE nations is demonstrated by the chart below,
    which indicates the difference between our long- and short-term
    political ratings. Aside from Turkmenistan and Kazakhstan, we believe
    Azerbaijan is the CEE country where the political risk situation has
    the greatest potential to deteriorate.

    Scenarios For Political Change

    While we believe domestic pressures from disenchanted groups could
    impact the policy formation process in Azerbaijan through the medium
    term, we forecast the major risk to political stability will come
    from outside the country. Specifically, tensions with Armenia over the
    disputed Nagorno-Karabakh enclave will dominate Azerbaijan's foreign
    and domestic policy as long as hundreds of thousands of internally
    displaced Azerbaijanis are unable to return to their former homes in
    the region.

    Best Case Scenario - Mitigation Of Regional Tensions: The best
    case scenario for Azerbaijan's long-term political risk profile
    is a resolution to its dispute over Nagorno-Karabakh. Any solution
    would be threefold, involving an agreement on the terms of a future
    referendum for the region's inhabitants, a roadmap for the return
    of displaced Azerbaijanis to their former homes under the protection
    of a multinational peacekeeping force as well as a mutually accepted
    decision on who will control the Lachin corridor, a land route between
    Armenia and Nagorno-Karabakh.

    This would require two things. First, the continued involvement of
    regional heavyweights Russia and Turkey, as well as major Western
    countries such as the US and France (which, along with Russia, make up
    the OSCE Minsk Group charged with coordinating discussions between the
    disputed parties). It would also require the involvement of the ethnic
    Armenian government of Nagorno-Karabakh - something that Baku may find
    difficult to stomach. Second, it would require a major investment of
    political capital by the presidents of Armenia and Azerbaijan. Both
    are under intense domestic pressure to ensure that their key goals
    are met over the enclave. Given that many of the countries' demands
    are incompatible (ie Baku wants Nagorno-Karabakh to remain part of
    Azerbaijan while Armenia wants the future referendum to include the
    possibility of full independence), this will require the presidents
    to go against popular domestic sentiment to secure a deal.

    Should this scenario play out, we would expect it to substantially
    improve Azerbaijan's political risk profile and significantly mitigate
    regional tensions. This would bolster investor confidence, paving
    the way for a ramping up on foreign direct investment, aiding the
    government's attempt to diversify the economy away from its dependence
    on oil and gas revenues.

    Intermediate Scenario - Tensions Kept In Check: A far more likely
    scenario is for tensions to be kept in check, without a major
    improvement in relations or significant progress towards a mutually
    acceptable solution on the enclave's future status. This would involve
    the two sides continuing to talk and for Russia, Turkey and key Western
    countries to maintain an important role in the dialogue. Under this
    scenario, a stable platform would be provided for the discussion of key
    sticking points, which would increase the chances of a breakthrough.

    The two sides continuing to talk would in itself increase investor
    confidence, as long as the meetings are conducted regularly and produce
    evidence of progress. In tandem with Azerbaijan's improving business
    environment, this would bolster investor sentiment. At this juncture,
    we see this scenario as the most likely to play out.

    Worst Case Scenario - War: While the outbreak of war is always
    difficult to predict, we believe that if war was to break out anywhere
    in CEE in the next five years, it will be in Nagorno-Karabakh between
    Armenia and Azerbaijan. As long as both sides continue to employ
    aggressive rhetoric and regular exchanges of fire occur on the border,
    there will always be the chance of a resumption of interstate war.

    We caution, though, that this is highly unlikely to happen. This is
    mainly because Russia - which still has 3,000 troops stationed in
    Armenia - would likely step in, while Turkey would also likely make
    a major effort to prevent an outbreak of fighting. The risk is that
    the number of troops stationed on the border in close proximity to
    each other could mean the situation would develop too rapidly for
    international actors to be able to influence events, meaning that by
    the time Moscow, Ankara and Western capitals were able to step in,
    the damage may have already been done.

    As long as the threat of war remains - and we fully expect it to -
    investor risk sentiment will remain elevated and Azerbaijan will
    struggle to attract the levels of foreign direct investment that it
    needs to diversify its economy away from energy export. This will
    keep it dependent on external demand, which poses the risk that a
    global slowdown in economic growth results in a stronger domestic
    opposition that could, in turn, hurt the government's reform agenda.

    An outbreak of interstate warfare would hammer investor confidence,
    leading to a massive withdrawal of funds from Azerbaijan and the wider
    region, as well as undoing much of the economic growth that has been
    achieved in the past 10 years. While Azerbaijan is not as dependent
    on foreign capital flows as Georgia, the latter's experience of the
    2008 war with Russia emphasises the extent to which warfare can damage
    investor sentiment.



    From: Emil Lazarian | Ararat NewsPress
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