Armenia, which regained its independence in 1991 and won its 1992-1994 war with Azerbaijan, is at peace and rebuilding its economy but its stability is fragile. Nagorno-Karabakh remains an unsettled problem that easily could reignite, and the regional economic isolation that the war over it produced could become permanent if there is no resolution soon. Corruption and violations of democratic procedure have disillusioned a population half of which still lives below the poverty line. Armenia's friends in the West and in Russia need to work together to help it overcome old enmities with Azerbaijan and Turkey. Donors should do more to press for democratic reforms and good governance.

The past two decades have been turbulent. In 1988 a disastrous earthquake rocked the north of the country, killing at least 25,000 and affecting one third of the population. The collapse of the Soviet Union destroyed traditional economic ties and social texture and was followed immediately by the war over Nagorno-Karabakh. Ten years later the country is at peace and busy rebuilding its economy, though the legacy of the conflict and significant sources of insecurity remain.

The May 1994 ceasefire that ended the war marked a military victory for Armenian forces, but there is no real peace. There are no mechanisms on the ground to prevent the conflict from restarting, and the negotiation process is stalled. Now that Azerbaijan is drawing significant dividends from its oil industry and developing military partnerships with, among others, the U.S., Turkey and Pakistan, there is a temptation among certain forces in Baku to consider trying to retake the enclave. Such a conflict would have disastrous consequences for the entire Caucasus, perhaps even spilling-over to affect simmering disputes in South Ossetia and Abkhazia. Until Armenia and Azerbaijan solve the Nagorno-Karabakh problem peacefully (an issue to be addressed in a subsequent ICG report), it is unrealistic to talk about long-term stability and full economic cooperation in the region.

The March 2003 Presidential elections were a missed opportunity for the state to demonstrate in practice its commitment to democracy and the rule of law. An uneasy political stalemate has set in, with the opposition boycotting the Parliament and the government refusing to implement the Constitutional Court's recommendation to organise a popular referendum on the legitimacy of the 2003 elections. Opportunities to express political grievances freely -- through fair elections, an active parliament, and open media -- remain limited. Consequently many choose to disengage from politics or to migrate, while a handful resorts to street demonstrations or in some instances violence.

Internal stability was most recently shaken during several weeks of opposition protest in April 2004, which revealed the intensity of a segment of the population's dissatisfaction with the regime and its policies. Yet, the numbers that turned out were relatively small and did not represent the totality of those unhappy with existing economic inequalities, high unemployment, worsening access to social services, and corruption. While the present opposition -- divided and seen by many as more interested in regaining power than truly fixing the system -- does not have wide popular resonance, the situation could become much more explosive if a charismatic leader emerged.

Armenia has benefited from substantial macroeconomic growth in the past ten years. Gross Domestic Product (GDP) growth, currently over 10 per cent annually, is driven by the construction, manufacturing, food processing, diamond cutting, and tourism sectors. A large and committed diaspora and remittances from Armenians working abroad have guaranteed a steady influx of money. However, the fruits of development have been felt by only the relative few. Per capita monthly income remains under $80.

Armenia has difficult relations with its immediate neighbours, Azerbaijan and Turkey, while cultivating good ties with its larger partners, especially Russia, Iran, and the U.S. The Southern Caucasus badly needs economic integration to sustain its nascent growth but this is impeded by the Nagorno-Karabakh problem. Yerevan is excluded from participation in all major regional trade and East-West pipeline projects, mostly as a consequence of the unresolved conflict. There is a growing feeling in Armenia that as Turkey, Azerbaijan and Georgia link up, Armenia is being purposely isolated. Increased integration would not only help Armenia address economic inequalities within its borders but also promote regional confidence building and increase the chances of peaceful negotiations with Azerbaijan.

To guarantee its stability, Armenia needs to supplement economic success with robust democratisation and strengthened rule of law. By using force to stop street protests in April 2004, President Kocharian and his advisors showed they are unlikely to welcome calls to make Armenia a more tolerant, democratic and less corrupt state. Yet, as Western European institutions and the U.S. increase their engagement, they should condition additional support and funding on reform. Even as its co-operation with Russia and Iran increases, Armenia is aware that it cannot exclude potential partners and that it must extend its ties to avoid isolation. Ultimately this is most likely to occur when it sits down with Azerbaijan and finds the durable solution to the Nagorno-Karabakh conflict that is in both countries' fundamental interest.

Yerevan/Brussels, 18 October 2004