Introduction

Stiftung Wissenschaft und Politik German Institute for International and Security Affairs Comments

The South and in the Post-Sanctions Era WP S Pursuing Greater Interconnectedness amidst Continuing Constraints and Scaled-down Expectations Andrea Weiss and Yana Zabanova

The lifting of international nuclear-related sanctions on Iran in January 2016 was en- thusiastically welcomed by the Islamic Republic’s neighbours in the South Caucasus. , , and have hoped that Iran’s rapprochement with the West and the unfreezing of some hundred billion dollars worth of assets abroad would lead Iran to step up its trade and investment activities in the Caucasus, especially in the energy and transport sectors. However, the anticipated benefits have been slow in com- ing, as Iran has shown reluctance to fund infrastructural projects in the Caucasus. On the other hand, there have been positive developments in trade and tourism flows and the power transmission sector. On the whole, although Iran is interested in closer economic cooperation with the South Caucasus, it relies on the ’s countries to provide the momentum and secure the resources necessary to achieve this goal.

The lifting of the sanctions on Iran on 16 proliferation of meetings at the ministerial January 2016 gave rise to varied expecta- and presidential levels, accompanied by tions in the South Caucasus. As congratu- the signing of numerous memorandums of latory messages flowed to from the understanding in key sectors. In a symbolic region’s capitals, pundits and observers gesture, in 2016 Georgia and Armenia lifted debated what Iran’s emergence from inter- the visa requirement for Iranian citizens. national isolation and its comeback to the In official statements, Iran and the South global economy implied for the South Cau- Caucasus countries often emphasise their casus. According to one widespread view, historical and cultural ties and friendly with Iran and growing closer to- relations. The territories of Armenia, east- gether, the South Caucasus could use its ern Georgia, and most of Azerbaijan were geographic position to transform itself into under Persian rule until the 19th century. a transit corridor for flows of goods and Iran is home to the ’s largest popu- energy resources between the two. In the lation of ethnic Azeris, numbering up to 25 past 1.5 years, the region has witnessed a million, as well as smaller populations of

Andrea Weiss and Yana Zabanova are former research fellows in the EU-funded project ISSICEU (Intra- and Inter- SWP Comments 24 Societal Sources of Instability in the Caucasus and EU Opportunities to Respond), which was completed in December 2016. July 2017 The views expressed in the article do not necessarily reflect the views of the European Commission.

1 ethnic Georgians (up to 100,000) and Arme- Armenia: nians (ca. 65,000). It was quick to recognise Iran’s complementary neighbour the three newly independent republics in Iran’s relations with Armenia – its closest 1991 and has been able to maintain a work- partner and ally in the South Caucasus – ing relationship with each of them. Iran’s remained largely unaffected by the in- policy in the South Caucasus has been prag- creasingly stringent international sanc- matic and stability-oriented, in sharp con- tions, which were progressively introduced trast to its ideology-driven policy in the from 2006 onward. Armenia refrained from . criticising Iran’s nuclear programme, using Despite the attention generated regular mutual high-level visits as occasions by ambitious cooperation plans, it is impor- to push for the expansion of bilateral ties. tant to keep in mind that Iran does not have Landlocked Armenia is under blockade significant economic clout in the South from two of its four neighbours, Azerbaijan Caucasus. If the lifting of the sanctions is and , and relies on Georgia and Iran, meant to be a game changer, it will have with which it shares a 219 km and 44 km to start from a very low base. Iran’s trade border respectively, for the transit of goods turnover with the entire region was only and energy. The link to Iran became $634 million in 2015, placing it far behind a lifeline for Armenia in the early 1990s top trading partners such as , the EU, during the conflict with Azerbaijan, as well China, or Turkey. Its official foreign direct as briefly in 2008 during the armed hostil- investment (FDI) in Georgia and Armenia is ities between Georgia and Russia. A close minuscule, although it has been more sub- relationship with Iran is meant not only stantial in Azerbaijan (mainly in the oil to counterbalance the strong Turkish-Azer- sector). The Caucasus countries’ aspirations baijani cooperation in the region (which to become a transit corridor between Iran often involves Georgia as a partner) but also and Europe would require enormous invest- sends a message to the domestic audience ments and a major shift in trading pat- that Armenia is not solely dependent on terns. Presently, Iran’s overland trade with Russia. Europe takes place through Turkey, there is As for Iran, strong ties with Armenia are no direct rail link between Iran and either important both for promoting stability in Armenia or Azerbaijan, and road connec- its Caucasus neighbourhood and to show- tions are poor. Due to US policies, Iran has case Iran’s ability to act as a responsible been excluded from major Western-sup- regional player. Directly bordering the un- ported pipeline projects in the region, which recognized Nagorno-Karabakh Republic, means that there is currently no infrastruc- Iran has sought peaceful settlement of the ture in the Caucasus to bring Iranian energy conflict, negotiating a short-lived ceasefire resources to European markets. Moreover, in 1992 and repeatedly offering mediation Iran is concerned about the uncertain services. Finally, Armenia could become future of the nuclear agreement under the Iran’s gateway to Georgia’s Black Sea ports, Trump Administration and, under the pres- and from there to . This sure of expectations at home, has chosen to would provide Iran with an alternative to prioritise domestic infrastructural develop- its main transport route through Turkey, ment. As a result, incremental changes in which has been fraught with many prob- Iran’s economic cooperation with the South lems, including a major dispute over transit Caucasus constitute a more likely scenario. fees, long queues at the border, and attacks on Iranian truck drivers.

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2 Ambitions on hold lion Southern Armenian Railway connect- Both Armenia and Iran acknowledge the ing to the border with Iran (2009), an Iran- mismatch between their close political Armenia oil pipeline (2011), and an oil re- partnership and the limited scope of eco- finery near Meghri to process Iranian crude. nomic cooperation. Indeed, bilateral trade turnover has hovered around a modest $300 million level, as Armenian producers Post-sanctions prospects find it difficult to access Iranian markets, When the sanctions on Iran were lifted which are protected by some of the world’s in January 2016, Armenia’s expectations highest import duties, whereas Iranian focused largely on the fate of the joint consumer goods in Armenia face stiff com- projects awaiting implementation. Accord- petition from the more affordable Turkish ing to one optimistic take, with its un- or Chinese alternatives. Tourism is a prom- frozen assets and an ability to export oil to ising sector though, with Armenia being Europe, Iran would be finally able to follow the region’s most popular destination for up on its investment promises in Armenia. Iranian visitors. The US Embassy in Yerevan A more sceptical view has cautioned that a is also one of the most accessible locations de-isolated Iran could opt for economically for Iranians to apply for a US visa. more attractive partners. Both Armenia and Iran stress the im- The sceptics seem to have a point. The portance of energy cooperation, although most prominent project announced already so far it has mostly been limited to the “gas in 2008 – the 305 km Southern Armenian for electricity” arrangement. The 140 km Railway – has failed to secure external fund- pipeline, which was officially inaugurated ing. Russia, which controls the Armenian rail in 2007, delivers gas from , Iran to network, has limited interest in the project, Armenia, where most of it is then converted as it would not connect Iran to Russia (this to electricity and transmitted to Iranian could only happen if Georgia agreed to northern provinces. Contrary to Iran’s allow rail transport through ). The initial plans, the pipeline cannot be used railway has thus essentially lost competi- for major exports beyond Armenia, as its tion to a rival Azerbaijani-Iranian initiative diameter was reduced under Russia’s pres- that has gained speed since 2016. However, sure. Today, the entire gas distribution Armenia is also implementing a major network in Armenia is controlled by Gaz- construction programme called prom Armenia, a full subsidiary of the Rus- the North-South Road Corridor, which is sian state-owned gas monopoly. financed by international donors and is Armenia has long wanted to vastly expected to nearly halve transit times and expand the scope of its cooperation with significantly improve road connections, Iran. While still under the sanctions, the both to Iran and Georgia. Although Iran latter faced a challenging situation: given stands to benefit from the project, it is not its forced isolation, Armenian initiatives involved in its funding. were attractive, yet the burden of the sanc- Having heavily invested in its domestic tions made financial commitments diffi- power-generation capacity in recent years, cult. As a result, there has been a glaring Iran seems to have lost interest in the disparity between the number of agree- Meghri Hydro Power Plant project, which ments and memorandums of understand- already had to be scaled down in 2014 for ing signed in the last decade – often to technical reasons. Also, now that Iran has great media fanfare – and the little to no access to European know-how, projects such progress made on the ground. This applies as having an oil refinery built in Armenia to such big-ticket infrastructural projects appear to be losing their rationale. as hydropower plants near Meghri on both The only project that has truly gained sides of the Araxes River (2007), the $3.2 bil- momentum since the nuclear agreement is

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3 the third high-voltage power transmission Finally, as the only member of the Eura- line between Armenia and Iran. In August sian Economic Union (EEU) that directly 2015, Armenia and Iran signed the contract borders Iran, Armenia has been actively for its construction, with Iran’s Export De- pushing for a free trade agreement between velopment Bank covering 77 percent of the the EEU and the Islamic Republic. Better investment costs. The line is expected to terms of trade between the two would in- more than triple the electricity exchange crease Armenia’s importance as a transit capacity between Armenia and Iran, which country and give it better access to Iranian have different seasonal peaks, creating pre- markets – something that Armenia had conditions for increasing Iran’s gas exports unsuccessfully been trying to negotiate for to Armenia as part of the “gas for electrici- years. Iran is interested in stronger links ty” deal. It will also connect to the grids of with the EEU but is treading cautiously, as Armenia, Georgia, Russia, and Turkey, re- it has no experience with free trade agree- flecting Iran’s ambitions to increase elec- ments. In the meantime, Armenia and Iran tricity exports to this region. are planning to set up a free trade zone According to some Armenian econo- near Meghri and signed a customs coopera- mists, the emphasis in Armenian-Iranian tion agreement in April 2017. relations should move away from a preoccu- pation with infrastructure towards a more skills-oriented approach. One popular pro- Azerbaijan: posal is for the country to capitalise on its Iran’s ambivalent neighbour liberal business climate and a developed IT Iran’s relations with Azerbaijan have been industry and to position itself as a business the most tension-ridden of all countries in hub for European companies wishing to do the South Caucasus, leading many observers business with Iran. For now, however, Euro- to expect Baku to be negatively impacted by pean companies’ interest in Iran remains Iran’s de-isolation. Azerbaijan has criticised thwarted by Western banks’ reluctance to Iran’s close ties with Armenia and accused fund such efforts for fear of US sanctions. Iran of trying to influence Azerbaijan’s Shia Banking is an area of cooperation that religious activists and the Talysh, an Ira- received a special mention during President nian ethnic group in the south. In turn, ’s official visit to Yerevan Iran has been apprehensive about Azerbai- in December 2016. In the past, Iran was sus- jan’s thriving military and security coopera- pected of using Armenian banks to evade tion with Israel and its perceived attempts sanctions, although allegations were never to stir discontent among Iran’s large ethnic substantiated. The Armenian branch of Azeri population. The two countries have Iran’s Mellat Bank, which mainly serves Ira- also disagreed about the way to delimit nian customers, has received an investment the with its valuable energy boost following the lifting of the sanctions. resources. Unlike Armenia or Georgia, Azer- The tourism sector is also continuing to baijan has kept its unilateral visa require- develop. Armenia hosted 189,000 Iranian ment for Iranians. tourists in 2016, a record number. The bilat- On the other hand, Azerbaijan, whose oil eral visa-free agreement that entered into production has been in decline since 2009, force in August 2016 is helpful, although is also seeking to develop its non-oil sector Iranians had already been able to obtain and become a regional transport hub. Co- Armenian visas on arrival for a small fee. operation with Iran is important to these Although Armenia might face stronger com- plans, and it has the added benefit of petition from Georgia now that the latter undermining similar initiatives by Arme- has dropped the visa requirement for Ira- nia. Iranian-Azerbaijani relations began nians, both might gain from Turkey’s di- to improve in 2013, after Rouhani became minishing appeal. president in Iran. Since then, President

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4 Ilham Aliyev and President Rouhani have With the -Rasht section to become met eight times. operational in 2017 and the Astara-Astara So far, trade between Iran and Azer- link completed, the crucial element is the baijan has been limited in scope, with the 175 km Rasht-Astara section, which would turnover standing at $229 million in 2015, cost ca. $1 billion and take some five years although it reportedly grew by 70 percent to construct. Azerbaijan has offered Iran in 2016. Iran’s National Oil Company holds a $500 million loan to help finance the a 10 percent stake in the development of project, but Iran has been slow in securing Azerbaijan’s Shah Deniz 2 gas field, and the the remaining funding (which may also two countries have had a small-scale gas- include Russian investment). Nevertheless, swap deal in place since 2005: Azerbaijan according to Iranian officials, construction pumps gas to Iran’s northern provinces is supposed to begin in 2017. through Astara, and Iran in exchange sup- While cooperating with Azerbaijan on the plies Azerbaijan’s exclave, Nakhchivan. North-South Corridor, Iran is increasingly For , especially those living in competing against it in the Caspian, where it border , Iran is an affordable visa- is trying to gain control over a greater share free destination for shopping and medical of shipping traffic currently dominated tourism. by Azerbaijan. Reflecting Iran’s growing cooperation with Russia and its interest in developing trade with Central , Iran Transport sector launched a new Caspian shipping line in Since the conclusion of the nuclear agree- June 2015, and Iranian companies purchased ment in 2015, Azerbaijan has greatly in- majority stakes in Russia’s ports of Makhach- tensified its efforts in pursuing a direct rail kala and Astrakhan in January 2017. link with Iran, which the two countries agreed to construct in 2010. It is currently the main missing element in a grand vision Iran and the Trans-Anatolian Pipeline for a 7,200 km North-South Transport Cor- Since the lifting of the sanctions, much ridor connecting Iran’s Persian Gulf port discussion has focused on the prospects of of Bandar Abbas with Iran’s potential gas exports to Europe. Iran through Azerbaijan and Russia, and pro- has the world’s second-largest gas reserves viding an alternative to the lengthy mari- but consumes almost 90 percent of its gas time route through the Suez Canal and the domestically. However, with its newly re- Mediterranean. The projected 375 km Iran- gained access to funding and Western tech- Azerbaijan railway, which is less expensive nologies, Iran is intent on increasing its and technically challenging than Armenia’s production volumes and becoming a major rival project, would run from Qazvin – a exporter. Azerbaijan has been interested in regional capital in – to Rasht Iran’s participation in its flagship project, and then to Iranian Astara at the border the Trans-Anatolian Gas Pipeline (TANAP), with Azerbaijan. From there, it would con- which is supposed to connect to the planned nect to Azerbaijani Astara through a bridge Trans-Adriatic Pipeline to deliver gas to and an 8 km section. Most construction southern Europe. TANAP will initially carry would take place on Iranian territory, which only Azerbaijani gas, but its capacity will be fits in with Iran’s strategy to develop its significantly expanded in the future, allow- domestic rail network. The railway has ing for the transit of gas from other sup- been at the top of the agenda of all recent pliers such as Iran. The EU, which is seeking official meetings between Iran and Azer- to diversify its supplies away from Russia, baijan, most prominently during the has welcomed this option. August 2016 trilateral presidential summit Iran first expressed its interest in TANAP of Azerbaijan, Iran, and Russia in Baku. in 2014, but its participation in the project

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5 is far from certain, especially amidst per- With its liberal business climate, lax resi- sistently low gas prices. One obstacle is the dency requirements, and geographic close- lack of suitable infrastructure for transport- ness, Georgia attracted many Iranian com- ing large amounts of gas from Iran’s rich panies during the sanctions period, especial- fields in the south to the north. It would be ly in the agriculture, food, and construction feasible to connect the Tabriz-Ankara pipe- industries. In official data, Iranian FDI has line used by Iran for its exports to Turkey never exceeded $1.8 million, although to TANAP, but this pipeline has faced these figures do not account for invest- serious security challenges, and its limited ments coming from expatriate Iranians. capacity would prevent Iran from exporting When Georgia lifted visa requirements in much. For now, Iran’s strategy seems to be January 2011, many Iranians relocated to to concentrate on developing its liquefied , registering companies in the Poti natural gas facilities for exports to Asian Free Zone on the Black Sea. Some were markets, with plans to expand to Europe fleeing Iran’s economic woes, whereas later on. others flocked in from Dubai – a popular destination for evading sanctions that was now tightening its regulations. In 2011– Georgia: Iran’s potential “gateway” 2012, three Iranian businessmen from Dubai to the West (later placed on the US sanctions list) estab- Georgia is the most removed from Iran lished a private airline and gained control among the South Caucasus countries, of JSC InvestBank. Soon, Iran’s business not only due to the absence of a common activities attracted media attention, with a border, but also due to its pronounced 2013 Wall Street Journal article reporting that Western orientation. On the other hand, more than 150 front groups linked to Iran’s Georgia’s proximity to the West – and, in Revolutionary Guards were active in the particular, the EU – has also served as a country. factor of attraction for Iran and Iranians. Under mounting US pressure, in July Generally, unlike Armenia or Azerbaijan, 2013 Georgia froze Iranian citizens’ and Georgia has lacked a consistent strategy businesses’ bank accounts with no prior on how to engage with Iran, at times intro- notice, suspended the visa-free regime, and ducing abrupt policy changes. unilaterally cancelled some earlier agree- Georgian-Iranian economic ties began ments and contracts. The restrictions were developing after the 2003 Rose Revolution, applied rather indiscriminately and affected with the Mikheil Saakashvili government many legitimate businesses, dealing a seri- viewing Iran as a useful (although not top ous blow to Iranian investors’ confidence priority) regional partner, especially as rela- in Georgia. Small and medium-sized enter- tions with Russia soured. When the latter prises were hit especially hard, whereas stopped gas deliveries to Georgia in the some larger businesses adapted by setting winter of 2006, it was Iran that filled the up front companies under Georgians’ gap. Trade turnover between Georgia and names through proxies. With Georgian Iran rose from $10.4 million in 2003 to banks fearful of US sanctions, some of the $176.8 million in 2013; in 2016, it stood restrictions remain in place, making it com- at $131 million. Currently, the main Geor- plicated for Iranian citizens to open a bank gian export good with relative potential account in Georgia, and especially to re- for growth is live sheep, whereas Georgia ceive bank transfers from Iran. This con- imports construction materials such as tinues to be a serious limitation on the bitumen from Iran. Given its structure and development of business ties between the low volumes, trade with Iran is unlikely to two countries. become a major driver of economic growth in the near future.

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6 Outlook post-sanctions process, as long as they meet the minimum Georgia has promoted its Black Sea ports as requirements on rules of origin, as stipu- part of the transport corridor connecting lated in the DCFTA. Iran to Europe, but this ultimately depends on the success of Iran’s transport coopera- tion with Armenia and Azerbaijan. In the Conclusions energy sector, in early 2016, Georgia – faced Contrary to initial expectations in the South with growing domestic demand for gas – Caucasus, the lifting of the sanctions on expressed interest in purchasing gas from Iran has not yet produced major benefits for Iran via Armenia. Azerbaijan, which sup- the region. The region’s small-sized econo- plies 90 percent of Georgia’s gas, reacted mies in themselves hold limited attraction by offering a large increase in exports and for the Islamic Republic unless they can reducing the price. In July 2016, Iran’s function as a gateway to larger markets National Gas Company signed a memoran- such as Russia or the EU. If successfully dum of understanding with a private Geor- completed, large infrastructural projects gian company on test deliveries of 40 mil- such as the Iran-Azerbaijan railway or the lion m³ of gas through Armenia over a four- Iran-Caucasus power market could increase month period. Deliveries are reportedly the region’s economic significance for Iran. expected to start soon, but there is still a Until now, however, with the exception lack of clarity regarding some technical of the power transmission sector, Iran has aspects of such a transaction. Georgia is been cautious about making major finan- also a partner in Iran’s plans to create a cial commitments due to its emphasis on large electricity-exchange market in the domestic infrastructural development and region. its interest in emerging opportunities in Although Georgian-Iranian economic other regions, such as Central and South relations have yet to fully recover from Asia. In the case of Armenia, the removal the damage inflicted by the restrictions im- of the sanctions has also eliminated the posed in 2013, the reintroduction of the rationale for some of the earlier coopera- visa-free regime in February 2016 was an tion plans with Iran. It would be wrong important step forward. Iranian tourism to say that Iran’s de-isolation has had no to Georgia has experienced strong growth positive impact on the Caucasus. On the over the years, strongly reacting to the whole, however, many constraints remain changes in the visa regime. The number in place, as both Iran and the South Cau- of arrivals increased from 21,000 in 2010 casus continue to prioritise relations with to 60,000 in 2011 and fell sharply in 2013, other partners. only to rebound to a record 148,000 in 2016. These data include not only recrea- tional visitors but also those involved in Recommendations for a multi-faceted small-scale shuttle trade and those coming EU engagement on multi-purpose visits. Although the EU and Iran have no experi- Georgia’s deep and comprehensive free ence of cooperation in the South Caucasus, trade agreement (DCFTA) with the EU, both are interested in the region’s stability which entered into force in 2014, can also and economic development and, unlike potentially increase the country’s attrac- in the Middle East, are not stymied by ideo- tiveness for Iranian investors wishing to use logical divisions. As the EU and Iran are it as a platform for tariff-free exports to the still in the early stages of institutionalising EU. Investors can assemble the entire prod- their relationship – including working uct in Georgia, taking advantage of com- towards establishing the EU’s first-ever petitive labour costs. Alternatively, they can delegation to Iran – they understandably move only the final stage of the production have many higher-priority issues on their

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7 agenda. In the medium term, however, the Armenia on nuclear safety standards or South Caucasus could become a promising facilitate Iran’s cooperation with Armenia area for EU-Iranian cooperation, with Iran and Azerbaijan on addressing environmen- eager to be recognised as a responsible tal issues in border areas, such as water regional actor. The South Caucasus nations, pollution in the Araxes basin. Another idea which have stressed their region’s role as a is to share the EU’s best practices on effi- bridge between Iran and Europe, are likely cient and citizen-friendly border manage- to welcome such cooperation as well. ment that could be applied at Armenia’s In the revised version (2015) of the Euro- and Azerbaijan’s border crossings with pean Neighbourhood Policy, the EU em- Iran. phasises the need for broader formats of In addition, the EU could promote soci- cooperation involving both EU partners and etal contacts by bringing together students, third countries where this is required by young professionals, and civil society rep- connections and interdependencies. For the resentatives from Iran and the South Cau-

© Stiftung Wissenschaft und South Caucasus and Iran, relevant issues casus to discuss issues of common interest, Politik, 2017 may include energy, transport, customs, including under-researched phenomena All rights reserved environment, education, and societal ties – such as small-scale cross-border trade. More These Comments reflect all areas where the EU is well-placed to play generally, the EU could act as a facilitator the authors’ views. the role of a mediator, a source of expertise, and donor to projects aimed at developing SWP or a donor. Promoting regional cooperation the Iranian-Caucasus border areas and cross- Stiftung Wissenschaft und is one of the main strands of work of the border ties by focusing on the impact of Politik German Institute for Iran Task Force – a special unit within the trade and transit on border communities. International and EU External Action Service that monitors Security Affairs the implementation of the nuclear agree- Ludwigkirchplatz 3­4 ment. The South Caucasus, Iran, and the EU 10719 Berlin all stand to benefit from closer economic Telephone +49 30 880 07-0 Fax +49 30 880 07-100 ties, greater mobility, and enhanced engage- www.swp-berlin.org ment and dialogue on various scales. This [email protected] type of cooperation would not only be valu- ISSN 1861-1761 able as a confidence-building measure, but it would also reflect the EU’s identity as a global actor advancing European values. There are a number of practical steps the EU could take, starting with building expertise on Iran’s relations with the South Caucasus. Whereas Iran has closely fol- lowed EU activities in the South Caucasus, the EU has viewed the region primarily through the post-Soviet prism, with the result that both the Task Force and EU delegations to Georgia, Armenia, and Azer- baijan lack a nuanced understanding of Iran’s role in the region. By stepping up its support for Iran’s membership bid in the World Trade Orga- nization, the EU would help promote a more transparent business environment in Iran that would benefit Iran’s partners, both in the EU and the South Caucasus. The EU could also cooperate with Iran and

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