US-Iran Rapprochement Signals Low War Risks, For Now

BMI View: Latest developments point to a notable improvement in relations between Iran and the West. Although a major breakthrough in negotiations on the Islamic Republic's nuclear programme appears off the cards for the time being, risks of an Israeli military attack against Iran have declined significantly over the short term. W e have recently raised Iran's short-term political risk rating to 49.6 out of 100 from 42.5 previously as a result.

In our latest article on Iran's politics we wrote that, as a result of the victory of moderate cleric Hassan Rouhani in presidential elections held on June 14, Tehran would likely adopt more conciliatory tones towards the West. Therefore, we believed that confidence in the West for a negotiated solution to the stand-off on the Islamic Republic's nuclear programme would increase ( see 'Presidential Election: Improved International Climate', June 17). Indeed, Rouhani has repeatedly called for constructive interaction with the world, a significant shift in tone compared to the stridently anti-Western rhetoric of his predecessor Mahmoud Ahmadinejad. In the latest development, Rouhani vowed on September 18 that his government would never develop nuclear weapons, and reiterated that he has complete authority to negotiate a nuclear deal with Western powers. Importantly, Rouhani gave responsibility for nuclear negotiations to newly appointed Foreign Minister Mohammad Javad Zarif, a US-educated diplomat and former ambassador to the United Nations. Zarif is widely respected in Western diplomatic circles, and is seen as a credible partner to engage in negotiations.

Positive Signals From The Supreme Leader

A Well-Developed Programme
Iran - Main Nuclear Facilities

US-Iran Rapprochement Signals Low War Risks, For Now

BMI View: Latest developments point to a notable improvement in relations between Iran and the West. Although a major breakthrough in negotiations on the Islamic Republic's nuclear programme appears off the cards for the time being, risks of an Israeli military attack against Iran have declined significantly over the short term. W e have recently raised Iran's short-term political risk rating to 49.6 out of 100 from 42.5 previously as a result.

In our latest article on Iran's politics we wrote that, as a result of the victory of moderate cleric Hassan Rouhani in presidential elections held on June 14, Tehran would likely adopt more conciliatory tones towards the West. Therefore, we believed that confidence in the West for a negotiated solution to the stand-off on the Islamic Republic's nuclear programme would increase ( see 'Presidential Election: Improved International Climate', June 17). Indeed, Rouhani has repeatedly called for constructive interaction with the world, a significant shift in tone compared to the stridently anti-Western rhetoric of his predecessor Mahmoud Ahmadinejad. In the latest development, Rouhani vowed on September 18 that his government would never develop nuclear weapons, and reiterated that he has complete authority to negotiate a nuclear deal with Western powers. Importantly, Rouhani gave responsibility for nuclear negotiations to newly appointed Foreign Minister Mohammad Javad Zarif, a US-educated diplomat and former ambassador to the United Nations. Zarif is widely respected in Western diplomatic circles, and is seen as a credible partner to engage in negotiations.

A Well-Developed Programme
Iran - Main Nuclear Facilities

Positive Signals From The Supreme Leader

In Iran's political system, the Supreme Leader remains in charge of key decisions such as those relating to defence, foreign policy and the country's nuclear programme. This is not to say that the president does not have influence over Iran's foreign and nuclear policy. As the presidency of the reformist Mohammad Khatami in the 1997-2005 period showed, Iran can behave quite differently under individual presidents despite the same supreme leader. It remains unclear how much bargaining room Supreme Leader Ali Khamenei will give to Rouhani in negotiations. In a potentially significant development, Khamenei advocated flexibility in talks with major powers on September 17. The timing of his remarks, days before Rouhani and Zarif are set to meet Western officials on the sidelines of the annual UN General Assembly (which began on September 17), appears to signal that the West should expect a new desire to clinch a deal. Moreover, Khamenei's comments were made to an audience of the Revolutionary Guards, a powerful branch of Iran's military set up to protect the country's Islamic system. His comments might therefore be intended to signal to powerful security hardliners that they should not seek to undermine any forthcoming attempt at negotiations.

Sanctions Hitting Hard
Iran - Components of GDP (IRRtr) & Real GDP Growth

It remains unclear whether recent developments represent a change in negotiating tactics or a signal that Tehran is genuinely interested in new negotiations. That said, the likelihood that Iran may be eventually prepared to compromise on its nuclear programme is higher compared to a few months ago. The impact of international economic sanctions on Iran's hydrocarbon and banking industries has contributed to two consecutive years of recession in 2012 and 2013, according to our estimates. In particular, sanctions have hit the oil sector hard. Given that oil exports account for the large majority of Iran's exports, the country's external position has weakened significantly, resulting in a sharp drop of foreign reserves. The situation has exacerbated already elevated inflation rates, hindering Iranian's purchasing power ( see 'Rouhani's Election Bodes Well For Growth', July 7). Rouhani's landslide victory in presidential elections - he won the ballot in the first round with 50.7% of the vote - is a clear signal that Iranians have rejected Ahmadinejad's confrontational foreign policy stance and are ready to adopt more conciliatory tones with the West in exchange for an improvement in the country's domestic economy. Although a note of caution remains in our view necessary, it is possible that the economic circumstances may have led Iran's leadership to begin reassessing the costs and benefits relating to the nuclear programme. We have recently raised Iran's short-term political risk rating to 49.6 out of 100 from 42.5 previously as a result. Along with an improvement in the 'Security/External Threats' subcomponent of the rating, Rouhani's appointment as president is a positive development in terms of domestic political risks, as it signals that the popular will for change has been endorsed by the Iranian leadership. We have therefore increased the 'Policy-making process', ' Social stability' and ' Policy continuity' subcomponents of the rating as well.

Opening Met With Relative Optimism

The US, France, Britain and other Western countries reportedly saw Tehran's opening as an encouraging sign, albeit reiterating that more conciliatory language needs to be backed up with concrete action. In a sign that the governments of US and Iran are attempting to improve relations, the two countries confirmed in recent days that US President Barack Obama had exchanged letters with Rouhani after the victory of the latter in presidential elections. Rouhani also recently praised a recent letter sent to him by Obama as "positive and constructive". Moreover, the White House said on September 19 that it was possible that Obama would meet Rouhani in New York during the UN General Assembly. No American president has met a top Iranian leader since the 1979 overthrow of the Shah and the taking of American hostages at the U.S. Embassy in Tehran. Although we believe that an official meeting between the two leaders remains unlikely, as such development would be met with strong criticism from both American and Iranian conservatives, the change of rhetoric is a strong signal that the two heads of state appear willing to improve relations. In addition, the Syrian crisis has recently taken a turn away from US military action, following Damascus' acceptance on September 10 of a Russian proposal that Syria gives up its chemical weapons. Although we believe that challenges relating to the destruction of the latter country's chemical weapons arsenal are formidable, the Russian deal bodes well for a rapprochement between the US, which is supporting Syrian opposition groups, and Iran - an ally of the Syrian regime.

No Breakthrough In Negotiations...

Nonetheless, we do not believe that a major breakthrough is on the cards over the short term. The latest round of negotiations between the so-called 5+1 powers (the United States, Russia, China, France, Britain and Germany) and Iran, which took place in Almaty, Kazakhstan, in April, showed that the parties remain far apart in substance. Iranian negotiators did not accept the offer to give up its most sensitive uranium-enrichment work to allay concerns that Tehran is seeking the means to make atom bombs, in exchange for modest relief fro m crippling economic sanctions. Moreover, Obama recently reiterated the point that Iran's nuclear issue is far more important for the US than Syria's chemical weapons issue, and the threat of a military response to any Iranian attempt to build nuclear weapons has not weakened. As a result, we do not expect sanctions on Iran's banking and hydrocarbon sectors to be eased anytime soon. Indeed, the US Senate Banking Committee is expected to begin debating this month a package of additional sanctions, which was passed in the House of Representatives in July. The bill is designed to cut Iran's oil exports to global customers by an additional 1mn barrels per day.

...But Military Attacks Unlikely Short Term

Israel is much more concerned about Iran's nuclear programme than the US, due to Israel's proximity to Iran, Tehran's verbal threats against the Jewish state, and the latter's highly concentrated urban population. Israel met Iran's opening with scepticism. Israel's Prime Minister Benjamin Netanyahu said on September 17 that he would focus on halting Iran's nuclear programme in a meeting with Obama at the end of September and in his annual speech before the United Nations General Assembly. That said, improvements in the international climate for talks reinforce our core view that, barring dramatic progresses in Iran's nuclear programme or a sudden breakdown in negotiations, an Israeli attack on Iranian facilities is unlikely over the coming quarters. Washington will impress upon Jerusalem the undesirability of a military campaign at this time, and logistical and strategic challenges are likely to dissuade Israel from carrying out a solo strike against Iran's nuclear facilities.

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