Sub-Committee on East-West Economic Co-operation and Convergence Visit to Azerbaijan 12-14 May 1999 Secretariat Report This Secretariat Report is presented for information only and does not necessarily represent the official view of the Assembly. 8 September 1998 TABLE OF CONTENTS THE SECURITY LANDSCAPE IN AZERBAIJAN DEMOCRACY HUMAN RIGHTS AND RELATIONS WITH THE WEST PIPELINE POLITICS THE POLITICAL AND ECONOMIC FOUNDATIONS OF DEVELOPMENT MACRO-ECONOMIC CONDITIONS I. THE SECURITY LANDSCAPE IN AZERBAIJAN Azeri officials are acutely aware of their isolation from the West, and this deepens the rather persuasive sense of vulnerability that officials conveyed to the NATO Parliamentary Assembly delegation. Azerbaijan's isolation is further reinforced by the fact that both Armenia and Iran deny it access to their transportation networks. According to the Foreign Minister, Azerbaijan is dedicated to preserving its independence and sees the deepening of its relationship with NATO as critical to national security. The Speaker of the Azeri Parliament echoed this theme as well in his remarks and expressed a genuine desire to see the NATO Parliamentary Assembly grant the Azeri Parliament associate status. He noted that Azerbaijan can and should play a role as a link between Europe and Asia. (The NATO PA Standing Committee subsequently granted Azerbaijan observer status at its 1999 Spring Session in Warsaw.) Obviously, Azerbaijan's struggle against Armenia has proved to be its greatest strategic challenge. Twenty per cent of the country's territory is now occupied, and 1 million Azeris have been uprooted and forced into exile. The Speaker of the Parliament noted that the government is seeking to resolve this tough issue amicably and is willing to grant rights to Armenians living in Nagorno-Karabakh. There were very few ethnic Azeris living in Nagorno-Karabakh prior to the war, and most of the expulsions have occurred in the corridor of Azeri territory which Armenia captured. The Azeri government is also supportive of the Minsk Group's efforts, but some officials expressed frustration with the pace at which that group has worked. They also argue that Russia's contributions have not been particularly helpful given its role in supplying weapons to Armenia. Azerbaijan firmly rejects any plan to separate Nagorno-Karabakh from Azerbaijan although it is willing to grant it a high degree of autonomy. Azeri officials make no secret of their hope that NATO can help resolve this very difficult problem. Beyond issues related to the war with Armenia, Azerbaijan's relations with Iran and Russia are also particularly difficult, and in both cases, the security challenges are substantial. The government is determined to preserve its independence in the face of these much larger and more powerful neighbours, but feels it needs external support to make this determination credible. Deepening the relationship with NATO, the Azeris believe, will bolster their capacity to defend their sovereignty not only in the face of the Armenian incursion, but also vis-ˆ-vis the potential meddling of Russia and Iran. Russia's support for Armenia and their recent deployment of long-range SAM 300 missiles and Mig 29s have reinforced the perception that Russian authorities simply want to cut Azerbaijan off from the West and bring it back into the CIS fold. It is worth noting that Azerbaijan is the only CIS state to deny Russia bases on its territory, although the Russians do maintain a radar on Azeri territory. Finally, Russia has lost some of its lustre as a market for Azeri products because of its financial problems and domestic political chaos. Consequently the Azeris feel compelled to look westward to identify potential markets and new sources of political support. Azeri officials are to varying degrees sceptical about the degree of change in Iran and, at best, see that country as entering a very preliminary stage of perestroika. They worry about a fundamentalist backlash. The Foreign Minister noted, however, that Azerbaijan monitors developments there very closely. One party in Azerbaijan hopes to build a greater Azerbaijan by joining up with northern Iran. Such talk does not sit well in Baku and certainly not in Tehran, and President Aliyev has sought to squelch ruminations of this kind. Indeed the demographics of Iran create a sense of unease on both sides. There are more ethnic Azeris in northern Iran than in all of Azerbaijan, and this has inspired calls for a pan-Azeri movement - something both governments fear. More concerning still is that the Iranian state is providing free food and housing to Azeri refugees if they agree to sit in religious education classes. This is terribly worrisome to the Azeri government which fears radicalised Islamic movements. Seventy years of forced secularism has diminished the role of Islam in Azeri life; yet a religious reawakening is clearly taking shape. And while religion is now tolerated and Sunni mosques are attracting ever more worshippers, the government suppresses politically inspired religious movements. Finally one official suggested that Iran has been providing aid to Armenia, and this support makes it very difficult to improve relations with that country. Azerbaijan's relations with Georgia are very fruitful and a source of some hope for broader regional reconciliation. Georgia expects to derive some benefits in hosting pipelines that will move Azeri oil to market, and thus it shares an important set of interests with the government in Baku. The Azeri-Turkmenistan relationship is more problematic, and this rivalry is largely, though not exclusively, driven by conflicting claims on the Caspian seabed and an emerging rivalry over gas exports. The relationship with Turkey is extremely cordial, but not without some difficulties. The Turks moved very quickly to establish a presence in Azerbaijan after independence, but the Azeris are not always happy with what they get from the Turks. According to several analysts with whom the delegation met, some Azeris are not perfectly comfortable playing the role of little brother to Turkey, although undoubtedly Turkey has been enormously helpful. The Turks strongly support the Azeri position on Nagorno-Karabakh and have carried out a blockade along its border with Armenia. Turkey has also extended much needed military assistance to Azerbaijan. But Turkish companies, particularly in the energy sector, do not have the weight and resources to develop fully Azerbaijan's economic potential. This is one reason its government has looked beyond Turkey to western Europe and the United States. Inevitably, officials see this relationship with NATO as an element of their strategy to solve the problems in Nagorno-Karabakh. They stress that a Euro-Atlantic framework would make a "peaceful" settlement more easy to achieve. At the same time, officials do not hesitate to link the war in Kosovo with that of Nagorno-Karabakh and promptly remind visitors that all ethnic Azeris have been expelled from Armenian occupied territory. The Foreign Minister suggested that the scale of "ethnic cleansing" carried out by Milosovic pales in comparison to what has transpired in Armenian-occupied Azerbaijan. In this sense, he argued, Armenian tactics have been every bit as brutal as those of Milosovic. The government fully supported NATO actions against Yugoslavia and refused to sign the CIS statement opposing the bombing campaign, despite strong appeals from Serbia and Russia. Apparently President Aliyev reacted strongly to Mr. Chernomyrdin's attack on "NATO support for Kosovar Ôseparatism'" and responded angrily in a televised meeting that Chernomyrdin's criticism failed to consider the policy that Russia has supported in Nagorno-Karabakh. There is a sense in Baku, however, that NATO can help provide a framework for settling the drawn-out conflict with Armenia. Officials pointed out, not coincidentally, that at the Washington Summit, President Aliyev met with his Armenian counterpart, and there are some hopes that this could lead to renewed efforts to solve the heretofore intractable problem of Armenian occupation of Azeri territory. This might be interpreted as a case study in how Euro-Atlantic structures can be of some benefit to this remote region. Azeri officials expressed great satisfaction with the Partnership for Peace programme and feel that the various co-operative programmes and training opportunities have been most helpful. In the same way, Azeri parliamentarians indicated that their participation in Rose-Roth Seminars, NATO PA Sessions, as well as other NATO PA events, have been fruitful and are helping Azerbaijan reach out to the West. II. DEMOCRACY HUMAN RIGHTS AND RELATIONS WITH THE WEST Azeri officials also argue that NATO reluctance to deepen the relationship because of the war in Nagrorno-Karabakh seems strange given that the NATO relationship with Russia was deepening during its conflict in Chechnya. They feel that the rejection of their application to join the Council of Europe was more a function of the war in Nagorno-Karabakh than human rights deficiencies at home, and they see it as paradoxical that Russia was extended associate status in the Council of Europe while the war in Chechnya was unfolding. Officials acknowledge that more needs to be done in the human rights arena, but they maintain that progress has been significant and should be acknowledged in Europe. Azeri government officials are quick to point out that 1 million refugees, years of internal unrest, pervasive poverty, and a very brief experience administering a sovereign nation has made it particularly difficult to construct working democratic institutions and practices. The government hopes to join the Council of Europe and believes that membership might give a boost to democracy. Finally, the government and parliamentary leaders attach great importance to deepening the relationship between the Azeri Parliament and the NATO PA. The Speaker of the Parliament and the Foreign Minister appealed to the delegation to deepen this relationship. Western observers expressed a somewhat different view on human rights issues, and argued that there are legitimate concerns regarding human rights problems in Azerbaijan as well as the degree of democratisation. Western observers are particularly worried that President Aliyev has created a very powerful position for himself, but in so doing, he has avoided laying the ground for a succession, which could eventually prove a source of instability. These same observers, however, stressed that the best way to achieve improvements on these fronts is to engage the Azeris on these issues and not to isolate the country. Other non-Azeri speakers noted that Azerbaijan had experienced great instability after its independence and only Aliyev has been able to contain these problems effectively, but there has been a price in terms of human rights. III. PIPELINE POLITICS Security concerns tint virtually all aspects of Azeri public policy, and even oil issues bear an important security dimension. This helps clarify why the government, along with the Turkish and American governments, so adamantly support the construction of an inordinately expensive pipeline from Baku to Ceyhan. A western oil executive wryly noted that if those governments are so keen on this particular pipeline then they ought to finance it. Otherwise, the costs are simply too exorbitant, given current prices, to be absorbed by the oil companies. The Sub-Committee was shown a graph of the altitude changes that this pipeline would register between Baku and Ceyhan, and it was noted that the system would require a series of jet engines along its path to pump crude oil to higher altitudes. In the view of the Foreign Minister, Azerbaijan feels it is in its interest to have access to a multidirectional pipeline network including lines to Novorossiysk, Supsa and ultimately Ceyhan. Not only will this pipeline deliver Azeri crude to blue water, it will also further link the country - psychologically, economically and in security terms - to Turkey, Europe and, by extension, the United States. Azeri officials as well as Western oil spokesmen noted that while the current pipeline is sufficient for current oil production, any large increases of production would require new pipeline systems. The same logic is evident in Azeri resistance to temptations to use Iranian pipeline systems; the government feels that the security consequences of doing so are potentially far too grave to justify the potential economic benefits. A pipeline through Iran could make commercial sense. It would prove cheaper than other options. It would, for example, obviate the serious problems associated with shipping oil through the Dardenelles. The Turks, it should be noted, have unequivocally stated that the Straits cannot bear more tanker traffic. An Iranian option would also allow the Azeris to avoid shipping oil through southern Russia which has been very unstable. Indeed, the month before the visit the northern pipeline route was closed and, even when open, oil moving through it is frequently stolen as it passes through Chechnya. But the fact that Iran is considered a pariah state mitigates against any such development. The United States is also adamantly opposed to an Iranian option. A new pipeline to Supsa has been constructed by the AIOC consortium, but it experienced unanticipated cost overruns. It is now moving 70,000 barrels of oil per day to Supsa. One Western official noted that the pipeline system currently in place would probably not be able to move all the oil pumped from the Caspian after the year 2003 and either new pipelines have to be built or the rate of Caspian development will be slowed significantly. As mentioned in the Sub-Committee report [AS 82 EC/EW (99) 2], many exploration wells have apparently proved disappointing. Several firms have abandoned their Caspian activities both because of poor drilling results and the very low price of oil. It should be noted that oil prices rose considerably this summer. There have been substantial gas discoveries, but the problems of getting that product to market is great as it must travel directly to the end user by pipeline, and the infrastructure in place is inadequate. An additional problem which is of concern to drilling consortia are the conflicting claims of Turkmenistan and Azerbaijan on the Caspian sea bed. Until an agreement is reached, certain sectors simply will not be developed. Another problem is that the domestic oil business in Azerbaijan is quite inefficient. SOCCAR enjoys a monopoly on oil and gas production and sales. The absence of competition makes it particularly difficult to introduce new efficiencies. The company is very large and also runs scientific institutions, shipping companies and other related industries. Many of the companies with which SOCCAR contracts as well as some of its own subsidiaries are essentially bankrupt, and this means that they are not being paid for all their services. This additionally has led to problems of cross subsidisation which tend to obscure where financial losses are occurring. At the same time, Azerbaijan is a very inefficient consumer of its own energy and thus wastes much energy that could be exported to generate foreign exchange. Energy prices are subsidised and this only adds to the problem. Finally, the lack of investment capital in Azerbaijan constitutes a significant barrier to correcting many of these problems. Prior to 1994 there was virtually no foreign investment in Azerbaijan. The prospects of oil development, however, changed this situation. The signing of the "contract of the century" proved a genuine turning point. The deal granted an international consortium the right to develop an oil field off the coast of Baku. AIOC agreed to cover all investment costs and all development activities, and profits are then split with Azerbaijan. That project has brought significant additional investment to Azerbaijan as AIOC needed large improvements in existing infrastructure and equipment. This year roughly $3.9 billion in foreign direct investment is expected. Since the signing of the large AIOC contract, foreign direct investment began to flow into the country, although Azerbaijan unquestionably needs access to more resources. IV. THE POLITICAL AND ECONOMIC FOUNDATIONS OF DEVELOPMENT Corruption is a serious challenge, and officials from development agencies and Western embassies worry that if this problem is not dealt with promptly, potentially very large future oil revenues will be squandered and the hope for a more democratic future effectively extinguished. According to several observers who met with the delegation, Azerbaijan currently lacks the political, juridical and institutional foundations to engage in sustainable development. Building these foundations may prove its most important task over the coming years. It is certainly recognised by the IMF and the World Bank as instrumental to the country's democratic and economic future. Economic problems in Azerbaijan are very serious. The country must engineer a transformation away from the Soviet model and clear away much of the useless infrastructure of that period. The break-up of the Soviet Union wrenched apart the market for Azeri goods as well as many of the supply systems. This problem was compounded by the fact that production standards in Soviet companies were very low and not particularly attractive to potential Western consumers. This has gravely weakened the industrial sector of Azerbaijan which was specialised in producing oil production machinery. Large industrial units have lost a high percentage of their market share, and this has led to a genuine industrial crisis. The country has also confronted the twin burdens of war and refugees. Political stability has only recently been secured, but it is an uneasy situation fraught with problems. Moreover, Azerbaijan is a remote country, and getting any of its products and particularly oil and gas to market is expensive. Most speakers recognised the special role that the energy sector is playing in the national economy. It generates some 55% of GNP, and oil production is seen as the key to national development. How much oil revenues actually accrue to regional governments and ultimately to their people hinges partly on the future price of oil. At $25 a barrel Azerbaijan, for example, might generate revenues of $60-80 billion over the next twenty years, while a per-barrel price of $12 could bring in only $10 billion to national coffers. Some observers worry, however, that this intense focus on one sector could lead, and to a certain extent has already done so, to a degree of neglect for other sectors. According to one foreign observer, this problem would be exacerbated if the "Dutch Disease" were to set in; in other words, if high oil exports were to lead to a currency appreciation that would effectively price other Azeri goods out of world markets. The World Bank is also working with the Azeris to develop a framework to manage future oil revenues properly. Currently the institutional, juridical and market frameworks are very poorly articulated, a condition which increases the likelihood that large oil revenues might be squandered. Azerbaijan must move quickly to adopt both the form and the practices of a real market economy. This must also involve measures to fight corruption, collect taxes, control public spending and democratise political practices. The agriculture sector is particularly important, but it is operating in difficult circumstances. One foreign expert told the Sub-Committee that much of the land is fertile and the climate is conducive to long growing seasons, but markets in the region are largely shut off. Azerbaijan once supplied fruit and vegetables to southern Russia and western Siberia, but here again the Russian financial crisis as well as instability in the northern Caucusus has undermined Azeri aspirations. Moreover, the sector still must undergo a market transformation. There is also a lack of rural credit facilities although there is an effort underway to create a network of rural financial co-operatives to extend credit to farmers. Obviously the loss of territory to Armenian occupation has also hit agriculture as it has meant the loss of a significant proportion of the country's arable land while imposing new burdens on that land that has not been occupied. The IMF and the World Bank have begun to play an active role in supporting economic and political reform with a particular focus on institution building. The two institutions are working very closely together. The current priority is to assist the government to prepare itself for an oil boom. Over the medium term the goal is to restructure the central apparatus of the state, reform the legal and judicial system, and improve public expenditure management and auditing procedures. V. MACRO-ECONOMIC CONDITIONS After years of economic decline, Azerbaijan finally began to experience a degree of growth in 1997-1998. Inflation soared in the early years of independence, and prices rose as a result of shortages induced by the war with Armenia. In recent years, however inflation has fallen dramatically as a result of a very stringent monetary policy. Many prices have been liberalised in Azerbaijan, although oil prices are still subsidised. Unemployment is very high and much of it is hidden; for example, there is much underemployment in the state sector. Salaries in the state sector are extremely low and this, of course, raises the temptation for corruption. The budget, however, has been under great pressure although deficits have been reduced. The budget is highly dependent on oil sales (50% of last year's budget was financed by oil exports). The state has great difficulties collecting taxes. Industry, which is working at only 5-10% of capacity, in turn, does not pay all the taxes it owes. At the same time utilities are fully functioning but are unable to collect what they are owed. There are many Azeris who depend on the state to eke out a living. The state must also provide assistance to refugees who were forced to leave Armenian occupied territory and who now live in very tenuous circumstances. Social spending is highly inefficient and must be restructured but there are few resources to finance reform, social spending, and a much-needed environmental clean-up. One primary source of the budgetary problems has been the fall of oil prices since 1998. The Russian economic crisis also hit the Azeri economy, and by extension, the state budget. Azerbaijan remains linked to Russia, and any shock in Russia, like the rouble devaluation, is immediately felt. Yet, Azerbaijan did not suffer a genuine foreign exchange crisis as a result of Russia's problems. Expected oil price rises, however, promise to ease budgetary pressures, and the Deputy Minster of Finance expressed his hope that further privatisation might bring additional cash into state coffers. Another problem is tax evasion, although officials claimed that they are able to collect a higher percentage of owed taxes than Russian officials.

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