The EU and the South Caucasus: Geoeconomics at Play

Russia’s full-scale invasion of Ukraine has catalyzed a major shift in both the geopolitics and the economic profile of the South Caucasus. This shift is transforming relations between the three countries of the region and the EU.

Since 2009, the EU has shaped its relations with the South Caucasus countries—Armenia, Azerbaijan, and Georgia—primarily through its Eastern Partnership (EaP), which also includes Belarus, Moldova, and Ukraine. The EaP focuses on bolstering governance, connectivity, people-to-people interactions, and sectoral and economic collaboration both among these nations and with the EU. Despite the union’s initial intent to cultivate a unified approach to its EaP neighbors, these countries developed divergent foreign policy trajectories, driven chiefly by security concerns.

Georgia, notably, signed an Association Agreement with the EU, including a Deep and Comprehensive Free-Trade Area (DCFTA), in 2014. Armenia initially aimed to sign such an agreement as well but veered toward joining the Russia-led Eurasian Economic Union (EAEU) instead because of security concerns over the conflict in the disputed region of Nagorno-Karabakh. That move led to a less ambitious accord with the EU, the EU-Armenia Comprehensive and Enhanced Partnership Agreement (CEPA). Conversely, the EU and Azerbaijan have faced challenges in formulating comprehensive trade and investment deals because of Baku’s divergence from the key European values of human rights, the rule of law, and democracy, which are pivotal for the EU’s comprehensive trade agreements.

Russia’s 2022 full-scale invasion of Ukraine placed the EU and its three South Caucasus neighbors in a new geopolitical reality, which led to significant shifts in their relations. Georgia received EU candidate country status in 2023 along with Ukraine and Moldova, although because of Georgia’s democratic backsliding, the country’s European integration is currently on hold. Armenia is reconsidering its foreign policy stance amid frustrations over Russia’s failure to provide Yerevan with security in its conflict with Baku. EU-Azerbaijan cooperation has focused primarily on the energy sector amid shifts in the EU’s decoupling from Russian energy supplies since the outbreak of the war in Ukraine. Additionally, as the Northern Corridor transportation route has been disrupted by Russia’s invasion, Azerbaijan and Georgia are becoming increasingly important for trade and transit through the Trans-Caspian International Transport Route, also known as the Middle Corridor.

Meanwhile, EU sanctions targeting Russian President Vladimir Putin’s efforts to keep funding Russia’s war have had a major impact on the economies of all three South Caucasus countries, as have disputes over regional trade routes. The intersection of geopolitics, security, and economics in the South Caucasus creates a dynamic and evolving landscape not only for the region but for the EU as well.

Georgia: Languishing Amid Untapped Economic Potential

The cornerstone of EU-Georgia relations is the Association Agreement that was signed in 2014 and came fully into force two years later. Before the DCFTA took effect, Georgia had pursued a unilateral trade liberalization policy with the EU and its other international partners. But from the EU’s perspective, trade with this small, open economy was and remains marginal: Georgia accounts for less than 1 percent of the EU’s external trade.

The DCFTA was supposed to have strong positive effects on Georgia’s economy by easing the country’s access to the European single market. Since the application of the DCFTA, EU-Georgia trade has increased in nominal terms. However, although the EU remains Georgia’s main trading partner, the union’s share in the country’s external trade has not grown, even after a decade of the free-trade area being in force.

Instead, the EU’s shares in both Georgia’s exports and its imports have fallen from pre-DCFTA levels. The EU’s share in Georgia’s exports declined from 22 percent in 2014 to 12 percent in 2023, falling behind the shares of Azerbaijan and Armenia, which took around 14 percent and 13 percent of Georgia’s exports, respectively, and nearing the shares of the EAEU countries, including Russia, which bought around 11 percent of Georgian exports each.

The DCFTA’s modest impact on Georgia’s exports can be attributed to several factors. First, Georgia’s limited production capacity does not support stable, large-scale export supplies to meet the demands of the European single market. Apart from raw materials, Georgian exports are limited in quantity; agricultural produce is available only in small amounts and is seasonal. This limitation hinders the country’s ability to scale up its exports to the EU. Second, Georgian exports face high compliance costs associated with EU standards on sanitary and phytosanitary (SPS) measures for agricultural products and technical barriers to trade (TBTs) for industrial goods. These nontariff barriers collectively create significant obstacles for Georgian goods entering the single market. Third, Georgia lacks engagement in regional and international value chains; coupled with high transportation costs, this poses a particular challenge because of the country’s absence of a land border with the EU and the undeveloped trade corridors via the Black Sea. Finally, Georgia’s exports to the EU lack diversification: primary goods, including ores, minerals, and mining products, accounted for around 65 percent of these exports in 2023.

At the same time, the EU remains the major supplier of Georgian imports, although the union’s share of these imports declined from 28 percent in 2014 to 25 percent in 2023. After the EU, Turkey is the largest source of Georgia’s imports, providing around 17 percent in 2023, followed by the United States, with 13 percent; Russia, with 11 percent; and China, with 9 percent. Georgia’s imports from the EU are much more diverse than its exports: manufactured goods make up approximately 75 percent of Georgia’s imports from the union. This category primarily includes transportation equipment, machinery, chemicals, and pharmaceutical products.

This trade structure highlights, on the one hand, Georgia’s limited production capacity and, on the other, the country’s reliance on imports of industrial and sophisticated goods from the EU and of other goods from China, Russia, and Turkey to fulfill further needs.

Russia’s invasion of Ukraine led to some increases in EU-Georgia trade—but in ways that should be concerning for the union. In 2022, EU exports to Georgia rose by 58 percent from the previous year, the largest annual growth in the past decade. In terms of specific product categories, there were significant increases in electronic components of machinery, transportation components, and automobile products, whose value doubled in nominal terms between 2021 and 2022. In parallel with this large growth in EU exports to Georgia, there was a considerable increase in the country’s exports of the same product groups to EAEU countries. Notably, preliminary data for 2023 show a remarkable 224 percent rise in Georgia’s exports of used passenger cars to Kazakhstan since the previous year and an impressive 767 percent increase in exports of such vehicles to Kyrgyzstan.

The growth in EU exports of machinery and equipment to Georgia is connected to the rise in Georgia’s exports of passenger cars to EAEU countries. Since the spikes in the data coincide with Russia’s invasion of Ukraine, the surge in Georgia’s trade with the EAEU reflects Russian demand for European goods that can no longer be sourced directly from the EU. In this context, Georgia serves as a trade corridor that enables the transportation of European goods into Russia.

The question is whether these reexports from Georgia could help Russia circumvent sanctions imposed by the EU. These sanctions cover a wide range of product groups, including cutting-edge technology, dual-use goods, luxury items, and other products that could enhance Russia’s industrial capacities. When it comes to cars, EU sanctions first applied to cars priced over €50,000 ($55,000). To increase the sanctions’ effectiveness, in 2023 the EU extended its restrictions to all new and old cars with engine sizes of 1.9 liters or more. Putting both sets of sanctions together, if the reexported cars from Georgia are worth less than €50,000, which is highly likely as Georgia’s reexports mainly include used cars, and have engine sizes of less than 1.9 liters, they do not fall under EU sanctions. The EU’s special envoy for sanctions, David O’Sullivan, noted during his 2023 visit to Georgia that the country had solid measures in place to prevent the circumvention of sanctions on the trade in goods, particularly thirty-eight types of product used on the battlefield, and financial services. However, the spikes in the trade data since 2022 indicate increased demand in the EAEU for the reexport of cars and machinery from Georgia, even if not all of these goods fall under sanctioned categories.

In addition to the reexport of EU goods to Russia, Georgia also reexports Russian goods, particularly oil products, to the EU and other countries. This is reflected in data that show a significant increase in Georgia’s imports of oil products from Russia as well as a surge in Georgia’s exports and reexports of the same product group.

The drastic increase in trade through Georgia has also led to greater demand for the Middle Corridor, which runs through the country. Given the trends, the increased trade appears to benefit Russian demand or create routes for Russian goods to reach other markets through Georgia. This situation raises concerns that Georgia could become a conduit for the circumvention of sanctions and a sanction-proof trade corridor with Russia.

Another effect of Russia’s invasion of Ukraine was the double-digit growth of Georgia’s GDP, which increased by more than 10 percent in 2022. This growth was fueled mainly by increased consumption, driven by arrivals of migrants and money transfers from Russia. However, this did not contribute to the sustainable growth of Georgia’s economy; instead of boosting the country’s production capacity, it further strengthened consumption-based structures. Additionally, this trend contributed to growing inequality in the country, as the sharp rise in aggregate demand and the drastic influx of money transfers caused spikes in inflation and living costs, such as rental prices.

Despite these challenges, the EU remains the largest provider of foreign direct investment (FDI) in Georgia, primarily in financial services, insurance, manufacturing, and energy. However, poverty remains a major concern: in 2023, 55 percent of the Georgian population could not afford to spend more than $6.85 a day and almost one in five people lived below the poverty line of $3.65 a day. Meanwhile, the influx of Russian money has benefited the owners of real estate and capital and, as a result, contributed to aggravating poverty and inequality rather than to promoting sustainable growth.

As the DCFTA has not resulted in major growth in EU-Georgia trade, the country’s further integration into the European single market will not boost the Georgian economy unless the country pursues a different economic policy. A change of approach should include promoting sustainable growth in the production capacity of Georgian enterprises; improving small and medium-sized enterprises’ access to low-cost, long-term finance; reducing nontariff barriers, such as SPS measures and TBTs; and developing trade corridors to lower transportation costs to the EU market. Additionally, Georgia will need to strengthen its economic governance and competitiveness by tapping into its comparative advantages and sectors that show promising growth rates, such as information and communication technology.

Given Georgia’s recent democratic backsliding, the country urgently needs to restore its international reputation. Tbilisi can achieve this by reducing informal governance practices and corruption and by undertaking comprehensive rule-of-law reforms. Strengthening the rule of law is essential not only for upholding democratic principles but also for ensuring a stable, predictable, and secure business environment. This, in turn, will bolster the country’s economic development in a sustainable manner and reinforce its commitment to European integration.

Armenia: Walking a Tightrope Between Russia and the EU

EU-Armenia economic relations have been significantly limited by Yerevan’s multivector foreign policy, which involves both the EU and Russia, and by its deep economic dependence on the latter. Armenia had intended to sign an Association Agreement with the EU and started negotiations toward this goal in 2010. However, amid a strong belief in Armenia that only Russia would support the country in its unresolved conflict with Azerbaijan over Nagorno-Karabakh, Yerevan yielded to pressure from Moscow. In 2013, Armenia announced its decision to abandon its planned Association Agreement and join the EAEU instead. Security concerns prevailed over the choice of a European future.

Being a member of the customs union established under the EAEU made it impossible for Armenia to sign any deep and comprehensive trade agreement with the EU. As a result, the parties settled for a less ambitious agreement, CEPA, which was signed in November 2017 and has been fully in force since March 1, 2021.

CEPA aims to enhance economic and political dialogue between the two parties in areas that are compatible with Armenia’s obligations and commitments to the EAEU. This includes EU support for Armenia’s efforts to develop its economic potential through international cooperation, improve the country’s business environment and investment climate, bolster connectivity, and promote cooperation with the EU in areas such as trade, energy, transportation, and the environment. Trade cooperation is governed primarily by Armenia’s membership in the WTO. In this sense, CEPA is a truncated version of the EU’s DCFTAs with Georgia, Moldova, and Ukraine.

Before negotiating CEPA with the EU, Armenia had benefited since 2014 from the EU’s Generalized System of Preferences Plus (GSP+). This scheme allowed Armenia to export goods under 6,400 tariff lines to the EU with zero or reduced tariffs. Given Armenia’s strong track record of economic growth, in 2020 the World Bank classified the nation as an upper middle-income country. As a result, since January 2022, Armenia no longer benefits from GSP+. With the enforcement of CEPA, Armenia’s access to the European single market now relies mostly on the WTO’s most-favored-nation principle, which forbids the organization’s members from discriminating among trading partners that are also WTO members.

The EU is Armenia’s second trading partner, after Russia, accounting for around 13 percent of Armenia’s total trade in 2023, while Russia’s share was more than twice as large, at around 35 percent. Like Georgia, Armenia also runs a large trade deficit with the EU: in 2023, the union’s exports to the country were around three times larger than the other way around. And like Georgia, Armenia has a marginal share of less than 1 percent in the EU’s external trade.

Armenia’s exports to the EU lack diversification and are dominated by semimanufactured goods, such as iron and steel, and primary products, like raw materials and mining products. EU exports to Armenia consist mostly of more sophisticated and diversified goods, such as machinery and transportation equipment, while agricultural exports account for a rather modest share. Although EU exports have remained relatively stagnant over the past decade at around €700 million ($776 million) annually, EU exports to Armenia experienced record growth of 149 percent in 2022, primarily because of increased exports of machinery and transportation equipment, which more than doubled compared with the previous year.

At the same time, Armenia’s exports of these products to Russia and the other EAEU countries saw rapid growth. These increases align with the trade trends observed in Georgia: imports from the EU of machinery and transportation equipment rose sharply, while the country’s exports of the same product groups to EAEU countries skyrocketed. Again, as with Georgia, this change in trade structure suggests a potential pathway for EU goods to enter the markets of EAEU countries, including Russia, through Armenia. Although there is currently no evidence that Armenia’s reexports include goods in the EU’s sanctions lists, they will surely feed Russian demand.

Trade in services between Armenia and the EU has a smaller nominal value than trade in goods but is notable for the country’s zero or positive trade balance with the EU. As for investment, around 35 percent of FDI in Armenia came from Russia in 2020, while the EU accounted for only 15 percent.

The invasion of Ukraine resulted in even larger numbers of migrant arrivals and money transfers from Russia to Armenia than to Georgia. For instance, in January–November 2022, individual cash remittances from Russia to Armenia rose fourfold, surging to nearly $3.2 billion. This large influx of money, coupled with a rise in aggregate demand, led to Armenia’s GDP growth reaching a record high of almost 13 percent in 2022.

Nevertheless, as in Georgia, this economic growth was driven by increased consumption rather than by enhanced production capacity, resulting in higher prices and living costs. In Armenia, both the consumer price index and the GDP deflator, two measures of annual inflation, surpassed 8 percent, twice the country’s inflation target of 4 percent. This situation exacerbates economic inequality and affordability challenges, predominantly for the poor.

Now, Yerevan, frustrated by Moscow’s failure to provide security support during the Nagorno-Karabakh conflict, is discussing the prospect of Armenia’s EU membership. This would signify a sharp U-turn from the foreign policy stance that the country adopted in 2013. However, Armenia would need to reconsider its EAEU membership to be ready to pursue deeper economic integration with the EU. To start with, being in the EAEU’s customs union is not compatible with integration with another customs union under the European single market.

In addition to its membership in the EAEU, Armenia’s deep economic ties with Russia make it economically challenging for the country to decouple from the Russian market. Russia has consistently been Armenia’s largest economic partner, accounting for around 35 percent of Armenia’s foreign trade in 2022, approximately 53 percent of all foreign investment, and about 62 percent of remittances. Moreover, Yerevan is heavily dependent on Moscow for strategic sectors and products. In the energy sector, over the past five years Armenia has imported about 70 percent of its oil and 85 percent of its natural gas from Russia. More than 90 percent of Armenia’s wheat is imported from Russia, the country’s aluminum industry relies entirely on raw materials from Russia, and most of Armenia’s agricultural goods are exported to Russia.

While decoupling from the Russian market would be economically painful for Armenia, transitioning to the European single market would present its own set of challenges, with its higher trade barriers. Even if tariff barriers were removed, nontariff barriers could still impede Armenia’s access to the EU’s internal market, as Georgia experienced. Furthermore, existing political and security ties, including Yerevan’s membership in the Collective Security Treaty Organization (CSTO), would complicate efforts toward deeper integration with the EU.

Azerbaijan: Forging a Path Ahead Through Energy Cooperation

Relations between the EU and Azerbaijan are based on the EU-Azerbaijan Partnership and Cooperation Agreement, which has been in force since 1999. The two parties launched negotiations on a new and comprehensive agreement in 2017 but have not yet reached a deal. This is mainly because Azerbaijan is an authoritarian regime not interested in pursuing democratic reforms and European values. Nor is the country a member of the WTO, which could provide a common set of trade rules and standards to ease negotiations for a trade deal.

In 2018, the EU and Azerbaijan agreed on a set of Partnership Priorities, which included strengthening institutions and good governance, economic development and market opportunities, connectivity and mobility, and people-to-people contacts. These priorities mainly reflected the focus areas of the EaP and did not go beyond sectoral cooperation.

Azerbaijan’s energy production exceeds its energy consumption four times over, making the country one of the most energy self-sufficient nations in the world. Energy also dominates EU-Azerbaijan trade relations. The union is the country’s main trade partner, making up around 49 percent of Azerbaijan’s external trade in 2023 owing to large volumes of energy supplies. In 2022, 65 percent of Azerbaijan’s exports went to the EU. Gas exports amounted to around 12 billion cubic meters (bcm), of which roughly 10 bcm went to Italy, about 1 bcm to Greece, and approximately 0.5 bcm to Bulgaria.

These energy exports make Azerbaijan the only country in the South Caucasus to have a trade surplus with the EU. In terms of Azerbaijan’s imports, the EU accounted for around 17 percent in 2023, compared with Russia’s share of 18 percent and China’s 17 percent.

After the EU began to decouple from Russian energy supplies, total trade between Azerbaijan and the union more than doubled from 2021 to 2022. In particular, EU imports from Azerbaijan, almost all of which came from energy supplies, grew by 136 percent in this period. EU exports to Azerbaijan also increased, albeit at a much more modest rate of 39 percent. The major product group among EU exports to Azerbaijan is manufactured goods, which accounted for 86 percent of the total in 2023; half of these goods consisted of machinery and transportation equipment.

Russia’s invasion of Ukraine gave new momentum to EU-Azerbaijan relations. In 2022, the two parties signed a Memorandum of Understanding on a Strategic Partnership in the Field of Energy, which aimed to double the capacity of the Southern Gas Corridor and deliver at least 20 bcm of natural gas to the EU by 2027. However, meeting this target requires Azerbaijan to increase its gas production and expand the corridor’s pipelines. This, in turn, needs substantial investment, which the EU cannot finance because of its concerns about long-term gas sales and its constraints on providing funding for fossil-fuel infrastructure.

The war in Ukraine has also led to a substantial increase in energy trade between Azerbaijan and Russia. This shift reflects Moscow’s loss of access to the European market and Baku’s strategy of boosting its own gas exports while using Russian gas to meet domestic demand when necessary, particularly in the winter. Beyond energy trade, Azerbaijan also enables the transit of goods to and from Iran and the Persian Gulf ports, making Azerbaijan an essential economic partner for Russia.

When it comes to investment, the EU officially accounted for around 19 percent of the FDI in Azerbaijan in 2023. However, more than half of the EU’s FDI came from Cyprus, reflecting the broader use of the island by European and global companies as a hub for tax optimization and investment management, rather than direct investment by domestic Cypriot businesses in Azerbaijan. Another major FDI partner in Azerbaijan is the UK, which provided 28 percent of all FDI in the country in 2023. The UK’s investments are mostly in the energy sector, and oil and gas company BP has been very involved in Azerbaijan’s energy industry since the early 1990s. The UK is followed by Turkey, with a 20 percent share of FDI in Azerbaijan, and Russia and Iran, with around 9 percent and 6 percent, respectively.

Although Azerbaijan’s economy relies heavily on oil and gas exports, global trends and the EU’s ambition to achieve net zero greenhouse gas emissions by 2050 highlight the need for the country to adopt a forward-thinking approach by focusing on cleaner and more sustainable energy production.

The shift toward green energy is already reflected in EU-Azerbaijan energy cooperation: in March 2024, the Azeri Renewable Energy Agency and the European industry association WindEurope signed a memorandum of understanding on wind energy cooperation. As European Commissioner for Energy Kadri Simson pointed out, while the Southern Gas Corridor was initially foreseen only for gas supplies, it can also provide a basis for cooperation on renewables and electrification.

Besides enhancing cooperation with the EU, expanding green energy sources is also in Azerbaijan’s own interest to maintain the country’s energy independence and self-sufficiency in the longer term. Volatile oil prices underscore the importance of diversifying economic activities and boosting productivity, led by the private sector. To this end, Azerbaijan should invest in developing and using renewable energy sources and building the necessary infrastructure.

Conclusions

The EU’s economic relations with the South Caucasus countries are shaped mostly by political developments and the foreign policy stances of these states.

Under the EU’s EaP, the three South Caucasus countries have pursued distinct paths for cooperation with the EU. Georgia chose a European future, while Armenia opted to join the EAEU. Meanwhile, Azerbaijan, lacking convergence with European values, focused purely on developing energy cooperation with the EU. The Second Nagorno-Karabakh War in 2020 and subsequent fighting as well as the war in Ukraine that began in 2022 have changed the region’s political landscape. These conflicts have put security concerns at the heart of the strategies of all three countries, which are now balancing between the EU, Russia, and other big powers.

While the South Caucasus countries may have relatively small economies with limited direct economic appeal for the EU, their geopolitical significance cannot be overstated. The region serves as a crucial gateway between Europe and Asia at the intersection of major global trade routes. Russia’s invasion of Ukraine has highlighted the importance of the Black Sea region and connectivity for maintaining regional trade. The conflict has also underscored the EU’s search for more diversified energy supplies and the role of the South Caucasus countries in either enforcing or circumventing EU sanctions against Russia. The drastic changes in the region’s trade structures have exposed potential pathways for EU goods through the South Caucasus to the Russian market and for Russian energy to Europe, effectively avoiding EU sanctions.

For Georgia, as an EU candidate country, it is important to align with the EU’s Common Foreign and Security Policy, including the union’s sanctions policy toward Russia. Moreover, Georgia should seriously monitor and address its expanding trade with EAEU countries. Increasing economic relations with the EAEU does not align with Georgia’s European aspirations, but first and foremost, it does not serve the country’s security interests, especially at a time when economic ties and trade dependencies can be weaponized by Russia. Additionally, to reap the benefits of deeper integration with the EU, Georgia should implement different economic policies to increase its production capacity instead of relying on consumption-based growth fueled by remittances or international arrivals, mostly from Russia, which does not serve sustainable economic growth.

For Armenia, while boosting trade with its EAEU partners is a natural development, the country’s economic dependence on Russia still poses security risks, especially if Yerevan is seriously considering a possible European future. The government is reassessing Armenia’s membership in the CSTO. However, making another U-turn away from the EAEU and back to deeper EU integration would be economically very painful for Armenia and require the country to sever its economic, political, and security ties with Russia. Given these substantial challenges, many doubts remain about whether Armenia is truly prepared to take such a drastic step.

For Azerbaijan, cooperation with the EU in the energy sector is strategically important and mutually beneficial, especially as the union decouples from Russian energy supplies. Yet, to remain a strategic energy partner of the EU in the medium to long term, Azerbaijan should keep investing in sustainable and green energy sources to fulfill its commitment to reducing its greenhouse gas emissions and align with the EU’s energy policies.

Finally, as the three South Caucasus countries navigate complex choices about their future paths, it is important that the EU recognizes the region’s immense geostrategic importance. For the EU, strengthening its partnerships with these nations is not just an option but a necessity to secure its influence and safeguard its access to key transit routes between Europe and Asia. Losing access to this critical gateway would significantly weaken the union’s position in regional and global affairs, while by investing in these partnerships, the EU can tap into the broader network of trade beyond these small economies themselves.