30 July 2014 | Vol. 5, № 27.

From the Editor’s Desk

Dear FDI supporters,

Welcome to the Strategic Weekly

Analysis.

We begin this week’s edition in Iraq, with

an assessment of the importance of the

country’s dams in the strategy of the

Islamic State militia group.

Next, we look at relations between India

and Nepal from two perspectives. First,

we analyse the significance of the visit to

Nepal of Indian Prime Minister Narendra

Modi. Then, we consider whether growing

economic support from Beijing may, in

fact, lead to Kathmandu enhancing its ties

with China instead.

Moving to Mauritius, we explore the

interest being shown there in offering

Sharia-compliant financial instruments to

international investors from the Gulf

states.

Our next piece analyses the ramifications

of the Kenyan Government’s plans to

reform aspects of its national security

architecture.

We conclude our coverage this week with

an examination of resource nationalism in

Indonesia following a deal between the

government and mining company

Freeport, which will see many of the

country’s largest mines resume

production.

I trust you will enjoy this edition of the

Strategic Weekly Analysis.

Major General John Hartley AO (Retd) Institute Director and CEO Future Directions International

*****

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Controlling the Iraqi Dams: the Key to Controlling the Country

Jihadist militia group “The Islamic State” is progressing towards control of key Iraqi dams.

These developments in the conflict pose significant threats to the food and water security,

and to the lives, of the entire Iraqi population.

Background

In a recent statement, the Special Representative of the United Nations Secretary-General

for Iraq, Nickolay Mladenov, warned against the use of dams as ‘an instrument of terror’ in

the current conflict. As rebels from the Islamic State militia group, formerly known as the

Islamic State of Iraq and the Levant (ISIL), are getting closer to the Mosul Dam – the most

important dam in Iraq – the situation is becoming more and more dangerous.

Comment

As part of the national infrastructure, dams in Iraq are highly strategic military targets; even

more so than its oil refineries. The country relies on its dams for all of its agricultural, water

and electricity supplies. Controlling the flow of water resources from these points means

controlling the surrounding region.

Since January 2014, the Islamic State (IS) in Iraq has succeeded in taking control of several

dams. To date, the group controls the Haditha Dam (the second-largest in the country), the

Samarra Barrage and the Nuaimiyah Dam. Between January and April, the IS also controlled

the strategic Fallujah Dam.

The dams are an essential element of the group’s military strategy. The IS has already

proved its determination to use the dams as a weapon by deliberately drowning government

forces around the Nuaimiyah Dam. When in control of the Fallujah Dam, the group closed

eight of the ten doors of the dam, reducing water levels in the south and flooding land

upstream.

The latest concern is the security of the Mosul Dam and what IS control of this infrastructure

would mean for the Iraqi people’s food and water security. The IS has been gaining strength

in the Mosul area and is increasingly in a position to launch an attack on the dam. If this

were to occur, access to water would be compromised and the country would face massive

electricity shortages. Agriculture could also be threatened if the crops upstream were

destroyed by flooding and downstream by a lack of water.

There are further concerns about the condition of the Mosul Dam, as disrepair and faulty

construction threaten its overall stability. If the dam were to collapse, it would cause

disastrous events, including the flooding of Baghdad, destruction of villages, a high

humanitarian cost and droughts upstream.

The strategic nature of water in Iraq has a long history. The Euphrates and the Tigris have

regularly been at the centre of conflicts in the region. In the 1990s, Saddam Hussein drained

the Mesopotamian marshes in an act of revenge against Shia rebels. Turkey also created a

conflict with Iraq by reducing the flows in the Euphrates and the Tigris rivers by eighty per

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cent. In 2003, control of the Haditha Dam, which provides 30 per cent of Iraq’s electricity,

was a priority for the US forces.

The situation could quickly deteriorate if no effective action is taken to regain control of the

dams and to stem the progress of the IS. The nature of the crisis, however, makes it difficult

for Iraq to decide on long-term strategies. In the future, alternative ways of providing water,

such as reusing water for irrigation purposes, combined with different ways of producing

electricity, such as solar and wind power, will be necessary to diminish the country’s

dependence on its dams and reduce its vulnerability.

Soazic Heslot Research Assistant Global Food and Water Crisis Research Programme

*****

India Attempts to Renew Ties with Nepal

Narendra Modi’s visit to Kathmandu provides India with various economic and political

opportunities to strengthen its ties with Nepal. More than diplomatic visits will be needed,

however, and there are doubts as to whether those opportunities will be followed through.

Background

Indian Prime Minister Narendra Modi is expected to visit Kathmandu during early August, in

an attempt to renew ties with Nepal. The visit comes soon after Modi led the Hindu

nationalist Bharatiya Janata Party to a landslide victory in the May 2014 elections. Modi's

visit to Nepal – his third foreign visit since taking office – will take place after a visit to

Kathmandu by Union External Affairs Minister, Sushma Swaraj. India hopes that this visit will

serve to ease some of the friction that has developed between the two countries and

strengthen their relationship.

Comment

Nepal is currently in a fragile condition, having been plagued by political unrest since a

decade-long civil war, led by Maoist rebels against the monarchy, ended in 2006. It is also

economically unstable and heavily dependent on Indian foreign aid and trade. This highlights

India’s responsibility to its neighbour, especially as the UN estimates that 40 per cent of

Nepalese live in poverty. Although the Nepalese embassy in New Delhi cites India’s

significant contributions to the socio-economic development of Nepal, the benefits it

accrues from various concessions under their bilateral trade treaties, are transitory in

nature.

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This is where Modi’s visit presents an opportunity to highlight India’s efforts in developing

Nepal’s economy; efforts that go beyond trade agreements. This is especially pertinent to

the health sector in Nepal, where both governments have co-operated in building hospitals

and medical education facilities, and conducting preventive and treatment programmes.

Moreover, there is also an opportunity for India to invest in Nepal’s huge, 44,000

megawatts, hydropower potential, which can only be harnessed with India’s co-operation.

Strained relations between India and Nepal have previously held back this potential, giving

Modi further incentive and opportunity to address the issue. Such economic

co-operation by India increases the possibility of improved relations between the two states.

There is also an opportunity to resolve the issues surrounding the 1950 India-Nepal Treaty of

Peace and Friendship. A primary characteristic of this treaty is the open border policy

between India and Nepal. This policy has created a number of problems, including the

smuggling of arms and illegal drugs, illegal immigration, the entry of terrorists into India and

the growing issue of human trafficking.

Another outcome of the open border policy is the degree to which changes in the Indian

economy influence the Nepalese economy. These issues have the potential to create

political deadlock in the relations of the two countries. A solitary visit by Modi is not enough

to address all of these issues, but it will highlight the importance of continued diplomatic

relations between India and Nepal. Therefore, if Modi and Swaraj continue to set the

precedent for future Indian government officials, there is hope that issues such as this can

be resolved more effectively in the medium- to long-term.

There is little doubt that these visits can provide opportunities to further Indian-Nepal

relations, but there is still doubt about whether India’s foreign policy towards Nepal will

change. It is seen by many Nepalese as interventionist and unfair, despite Modi’s

sympathetic views towards the predominately Hindu Nepalese.

Many believe that Modi’s Hindu nationalist stance will not be reflected in Indian foreign

policy. Lokraj Baral, executive chairman of the Nepal Centre for Contemporary Studies,

noted Modi’s transition from Hindu nationalist to a more moderate stance during the

election campaign. If this transition is permanent, it is likely that Modi will wish to focus on

the opportunities for economic and political co-operation.

The Prime Minister’s visit to Kathmandu is a step in the right direction towards mending

Indian-Nepalese relations. This particular visit highlights the opportunity for cooperation in

the economic, medical and cross-border security sectors, which hopefully will help to

appease Nepalese distrust towards India. It will, however, require more than one visit every

seventeen years by an Indian prime minister to fully mend relations with Nepal. Regular

diplomatic efforts, along with long-term economic co-operation, may be better suited to

creating a path towards a stronger relationship.

Jarryd de Haan Research Assistant Indian Ocean Research Programme

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*****

Nepal-India Joint Commission Talks Part of Larger

Geo-Strategic Imperatives

India hopes to use the Nepal-India Joint Commission talks to re-invigorate its ties with

Nepal. But will growing economic support from Beijing lead Kathmandu to enhance its

China ties instead?

Background

Indian Prime Minister Narendra Modi arrived in Kathmandu ahead of the third Nepal-India

Joint Commission talks, set for 26 July. Modi’s visit takes place against the backdrop of a

Sino-Indian power struggle for influence in Nepal and South Asia generally. This raises two

questions. Is Modi’s visit aimed more at countering China’s growing influence in South Asia?

Is India’s economic co-operation with Nepal, therefore, merely an instrument in an Indo-

China power play?

Comment

The Indian delegation to Kathmandu will face Nepali reservations surrounding the drafting of

the Power Trade Agreement (PTA). Although Nepal has granted approval to twenty-seven

Indian energy companies to develop hydro-power facilities in Nepal, production has not yet

begun. The nationalist wing of the majority party, the Nepali Congress (NC), and the Maoist

branch of the Communist Party have used the occasion to raise anti-Indian sentiment. They

claim that Nepal should end its dependence on Indian investment. In addition to Nepal’s

concerns over the lack of immediate Indian action on these infrastructure development

projects, Chinese interest in Nepal’s hydro-power industry will further pressure Modi to take

fast action.

India’s renewed push to maintain its traditional ties with Nepal comes in the wake of Nepal’s

move towards closer ties with China. A speech on Sino-Nepalese relations, made in Beijing

by the leader of the Marxist-Leninist wing of the Communist Party of Nepal in May,

confirmed Indian concerns over China’s intentions to break into its sphere of influence.

Despite this shift towards China, the upcoming talks are expected to be successful, provided

Modi can ensure a significant commitment to an investment model that benefits Nepal. On

the other hand, the example of Tibet is very prominent in the minds of Nepal’s Hindu

majority when establishing bilateral ties with China.

To rival Chinese development proposals, and in the wake of the decision to establish a BRICs

Bank, Indian officials have announced their intention to establish a South Asian Bank. It will

differ from the BRICs Bank model and aim to gradually include the other South Asian

Association for Regional Co-operation (SAARC) states: Nepal, Pakistan, the Maldives, Sri

Lanka, Bangladesh, Afghanistan and Bhutan. The Indian Commerce Minister has announced

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India’s intention to discuss the issue at the next South Asian Free Trade Area (SAFTA)

meeting on 24 July, two days before the Nepal talks.

For Nepal, closer ties with Beijing would definitely shift its economic focus away from India.

Those ties would concentrate on investment in tourism, agriculture and energy generation.

Economic ties with India, however, are too deep to be immediately severed; they range from

the free movement of labour, free trade and a bilateral currency agreement. On the other

hand, it is possible that Nepal will see increased investment by the China-led BRICs bank,

which could be rivalled by the suggested South Asian Bank fronted by India, if that entity

eventuates.

Modi and the Indian delegation must understand that they must contend with the current

unfavourable Nepali perceptions of India, which is reflected in the attempts to shift Nepal’s

political direction. The reality of Sino-Indian rivalry will no doubt underscore the nature of

the talks. For India, this will require a strong demonstration by its delegation to reaffirm

their intention to develop Nepalese hydro-power infrastructure and not lose investment

opportunities to Beijing. Questions will also arise on whether India can match China’s

growing input to support the Nepali Maoists. Modi’s challenge will be to match India’s

strategic requirements with Kathmandu’s political sensitivities, to recover India’s

relationship with Nepal.

Michael Petrut Research Assistant Indian Ocean Research Programme

*****

Mauritius to Become a Centre for Islamic Finance?

As part of its plans for greater economic diversification, this budding financial hub has the

potential to benefit considerably from offering Sharia-compliant financial instruments to

international investors from the Gulf states.

Background

Mauritius is seeking to broaden its economy by offering more investment options; beyond

agriculture and tourism. Building upon its success as a financial hub is one option available

to the Indian Ocean island state. Including Islamic finance options is a good policy choice, as

Mauritius occupies the same time zone as the Persian Gulf and is close to the economic

opportunities increasingly becoming available in East Africa. The island has low tax rates and

applies no capital gains tax, making it attractive to foreign investors. The governor of the

Bank of Mauritius, Rundheersing Bheenick, has long advocated an Islamic form of bonds,

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known as sukuk. His enthusiasm for those financial instruments had previously met with

opposition from the former finance minister, Xavier Duval. Now that Duval has retired, an

opportunity has arisen for the island nation to reconsider the market for new financial

instruments, such as sukuk.

Comment

Sukuk are financial certificates, widely seen as similar to bonds in Western finance, which

comply with Islamic law (Sharia). In their simplest form, sukuk are certificates that prove the

ownership of assets. Under Sharia law, the trading of debt is not permissible and, therefore,

the payment of interest on borrowings is also not permissible. Sukuk, therefore do not

accrue interest. In lieu of interest, a rental fee is attached to each certificate. The investor

then rents it back to the issuer for a fee. The issuer also makes a contractual promise to buy

back sukuk at a future date, at par value. Sukuk may be issued on existing assets or those

that could become available at a later date.

Islamic investors are most likely to utilise the sukuk offered by Mauritian banks, as they will

be seeking investments that comply with Sharia law. As returns on investments in Gulf

countries are shrinking and Africa presents good opportunities to increase yield, foreign

investors may be attracted to the prospects offered there. Regional, as well as international,

investors displayed interest in purchasing sukuk in an earlier, four-year deal, offered by

banks in Senegal, worth US$200.5 million ($213 million). Half of that subscription was

purchased on the first day of trading. The annual profit from the Senegalese bond is pegged

at 6.25%, based on the returns of the underlying asset. The global market for sukuk reached

a record issuance level of US$46.5 billion ($49.4 billion) in 2012. In July 2012, Sudan raised

955 million Sudanese pounds ($175.4 million) by selling Islamic debt. Following the success

of the Senegalese offering, other regional countries, most notably South Africa and Kenya,

have expressed interest in issuing sukuk.

Mauritius has a solid reputation as an investment hub and many factors make it attractive to

foreign investors. According to the London-based Institute of Economics and Peace, the

island state is the most peaceful country in Africa. It has good governance, a stable economy

and political transparency. The island also has a sizeable Islamic demographic, with 17% of

the population professing to adhere to that religion. This demographic is, however, not as

large as those in Senegal and Sudan, suggesting that sukuk may not be as popular in

Mauritius as in those countries.

Economic growth in Mauritius slowed to an annual rate of 2.4% during the first quarter of

2014; the worst first quarter performance in the last five years. These results have led the

central bank to revise yearly economic growth forecasts to 3.4-3.6%; down from the April

forecast of 3.7-4.0%. These figures are slightly better than the 2013 growth rate of 3.2%. The

lower figures are attributable to lower than expected growth in the textile and information

and communication sectors. Real economic growth is slowing, compared to the average of

five per cent achieved between 1970 and 2009.

Economic diversification is a key goal of the Mauritian Government and, with an economy

dependent upon the earnings of the tourism and textile sectors, expanding the financial

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sector makes good sense. Since Mauritius occupies the same time zone as the Persian Gulf,

it also makes sense for it to offer financial instruments that appeal to international investors

from that region.

Mervyn Piesse Research Assistant Indian Ocean Research Programme

*****

National Security Reform in Kenya: An Opportunity to

Strengthen US Ties

President Uhuru Kenyatta is seeking to centralise the operations of some government

departments under the Police. This could be a bid to reassure voters of his commitment to

fighting departmental corruption and domestic terrorism, or part of a larger plan to

strengthen Kenya-US relations in security and investment

Background

Kenyatta recently issued an executive order to put various operations of the Kenya Wildlife

Service, Kenya Forestry Service and the National Youth Service under the Department of the

Inspector-General of Police, David Kimaiyo, in a bid to centralise and strengthen Kenya’s

national security. With the terrorist operations of the al-Shabaab group, the successful

hacktivist hijack of the Kenyan Defence Force’s Twitter account and public disapproval of the

Kenya Police Service (KPS), reforming security is a key issue for Kenyatta ahead of the talks.

Comment

Controversy has surrounded the KPS recently, with reports that it had caused about seventy

per cent of the total of 1868 gunshot deaths over the past five years. Furthermore, the

Kenya Defence Force’s (KDF) Twitter account was attacked by hacktivist group Anonymous

on July 20, with a post reading ‘account hacked by the people for the people’. Additionally, a

recent vote of no-confidence in the standard of recruitment for the force claimed that high

levels of corruption at the recruitment stage correlated to a high rate of corruption in

graduates, further stressing the need for reforms.

Kenyan officials have used the Bush Administration’s Homeland Security model, established

after 9/11, to make the case for reforms. They state that Kenyans should get behind the

government’s programme, like the citizens of the US did in 2001. The Somali insurgency

group al-Shabaab, which attacked the Westgate Shopping mall in Nairobi on

21 September 2013, has now claimed twenty-nine lives in two separate raids. One was on a

Hindu trading centre and another on a police station, where the terrorist group proceeded

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to release Muslim prisoners suspected of involvement in the recent Mpeketoni attacks. Al-

Shabaab is consequently a primary target for Kenyan security forces.

These incidents have been exacerbated by recent reports that the KDF has colluded with al-

Shabaab in its illegal trade in coal in Somalia and beyond. Somali coal, which is derived from

Acacia trees, is sought after for cooking purposes in countries like Oman and the UAE, and

constitutes al Shabaab’s main source of income, which was used, in turn, to finance the

attack on the Westgate Shopping Mall. The accusations against Kenyan military personnel,

who operate under the African Union Mission to Somalia, were initiated by a UN Security

Council report in 2013 and reinforced by the Washington-based Institute for Defence

Analysis. Kenyatta will need to reassure the international community that any collusion, if

confirmed, will be halted and future incidents prevented.

The US-Africa Leaders’ Summit, set to take place on 4 August, provides an opportunity for

Kenyatta to refine and enhance the economic and security ties already in place with the US.

Despite President Obama stating earlier this month that the US has ruled out military

operations in Africa, Kenyan leaders plan to push the issue of stabilising the neighbouring

failed state of Somalia, which is central to al-Shabaab’s terrorist operations. Western leaders

have routinely stressed that intervention will be limited to training, intelligence gathering

and the strengthening of domestic forces in the region.

A second key focus for Kenyatta at the talks will be strengthening US investment in Kenya,

using the national security reforms to reinforce the safety of foreign direct investment. The

talks are expected to include meetings with key US-based CEOs, from Microsoft, Pfizer and

Coca-Cola, to demonstrate the enthusiasm of US business leaders for investment in Kenya.

World leaders will look to the US-led talks as an indication of developments in the region,

making Kenyan national security reform a predominant issue. Outrage over al-Shabaab’s

attacks has provided Kenya with an opportunity to capitalise on global attention by moving

to eliminate corruption and strengthen cohesion in the security departments. Since 2007,

the US has committed US$820 million to AMISOM efforts to combat al-Shabaab; Kenyatta

will be anxious to convince it that the foreign aid is being properly utilised and is free from

corrupt departments.

Michael Petrut Research Assistant Indian Ocean Research Programme

*****

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Back in Business: Indonesian Mines to Resume Production

after Deal is Struck

A deal between the Indonesian Government and mining company Freeport will see many

of Indonesia’s largest mines resume production. While the news is a win for the

government, the outlook for mining companies once president-elect Joko Widodo takes

office in October is not yet assured.

Background

Indonesia has reached a deal with PT Freeport Indonesia, one of the country’s largest

miners, on export taxes and royalties, allowing the US giant to resume exports. The 25 July

agreement comes after a controversial ban on raw minerals exports and an extremely steep

tax on metal concentrates, implemented in January this year, saw much of the country’s

mining sector come to a standstill. Though the two agreed to a memorandum of

understanding (MOU), it remains to be seen whether other firms can reach similar deals

with the government, especially once incoming president Joko Widodo takes office in

October.

Comment

PT Freeport Indonesia, Indonesia’s largest taxpayer, has finally reached an agreement with

the government, allowing it to resume export production. The move comes after the mining

giant was forced to drastically reduce its operations after the government imposed strict

restrictions and duties, including a ban on raw mineral exports and a hefty tax on other

metal concentrates. Under the new MUO, Freeport will pay a significantly reduced export

duty between 2014 and 2016 but higher royalties on copper and gold sales. It will also have

to pay an assurance bond of US$115 million for the development of a smelter, Freeport

Chief Executive Richard Adkerson said. It now looks set to resume exports of gold and

copper by early August.

Other mining companies have been offered a similar deal by the government, which has

decided to revise its regulations relating to rates and smelters. It now says that the tax levied

on mineral exports will be reduced, provided that firms pay an assurance bond for the

construction of a smelter, such as the one recently outlaid by PT Freeport Indonesia. The

new policy, set to be officially announced in early August, will give companies building a

smelter generous tax breaks. Initially, they will have to pay a reduced rate of 7.5%, although

that would be reduced as smelter development progresses and completely waived once it

reaches the 30 per cent threshold; previous taxes on mineral concentrates had been set at

25% and were set to rise to up to 60% by 2017. Like Freeport, however, businesses will have

to pay increased royalties. Importantly, any deal reached before Joko Widodo, universally

known as Jokowi, is sworn in as president will be respected, with the 52-year old recently

assuring investors that he will uphold any current contracts in place.

The deal is an encouraging development, especially with Jakarta paying a heavy financial toll

for the controversial reforms. Colorado-based Newmont Mining Group, the country’s second

largest copper miner, is said to be considering following suit. Such a shift would be

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welcomed by Indonesian officials. While Freeport had engaged in intense behind-the-scenes

negotiations, Newmont suspended its operations and filed for international arbitration,

drawing a sharp rebuke from the Indonesian Government. Together, the two companies

account for roughly 97% of Indonesian copper production.

Yet, the future of the remaining companies remains unclear. Although incoming president

Joko Widodo has promised to sit down with the miners, some will find continuing

production too costly, especially given the requirement to build a smelter. Constructing a

smelter can take years and upwards of US$1 billion to build. Small- to medium-sized firms,

therefore, are likely to shy away from investing so much capital in Indonesia, especially as its

mining sector is regularly ranked as one of the worst in the world in which to do business.

Critics, including the World Bank, have said that the new policies make little financial sense.

But Jokowi is still unlikely to try to repeal or significantly alter the laws. The rules may not

make sound economic sense, but they are popular among ordinary Indonesians, many of

whom still view multinational mining companies as a symbol of the privileges enjoyed by

foreigners under the rule of former President Suharto’s rule. Resource nationalism,

therefore, is in vogue, while Jokowi, having to soon cut the popular but hugely expensive

fuel subsidies, will be loath to attract further public scorn. Indonesia’s mining industry may

be back in business, but it shows little signs of improvement.

Andrew Manners Research Analyst Indian Ocean Research Programme amanners@futuredirections.org.au

*****

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Any opinions or views expressed in this paper are those of the individual authors, unless stated to be those of Future Directions International. Published by Future Directions International Pty Ltd. 80 Birdwood Parade, Dalkeith, WA 6009 Tel: +61 8 9389 9831 Fax: +61 8 9389 8803 E-mail: lluke@futuredirections.org.au Web: www.futuredirections.org.au

What’s Next?

Peace talks mediated by the Intergovernmental Authority for Development and aimed at finding a political solution to the seven-month conflict in South Sudan are scheduled to resume in the Ethiopian capital, Addis Ababa, on 30 July.

US Secretary of State John Kerry will travel to New Delhi for the fifth US-India Strategic Dialogue, which he will co-chair with Indian Minister of External Affairs Sushma Swaraj on 31 July. While in New Delhi, Secretary Kerry will also meet with Prime Minister Narendra Modi.

The Lok Sabha, the lower house of India’s Parliament, must pass its annual budget by 31 July.

The forty-fifth Pacific Islands Forum leaders’ summit is underway in Palau until 1 August. The theme of this year’s forum is “The Ocean: Life and Future”. Deputy Prime Minister Warren Truss is leading the Australian delegation.

Japanese Prime Minister Shinzo Abe is to conclude his Latin American tour on 1 August with the signing of a number of oil deals between Brazil and Japan.

Thai and Burmese authorities will meet in the southern Burmese city of Mergui on 1-3 August to discuss the potential repatriation of Burmese refugees living in Thailand.

Indian Prime Minister Narendra Modi will begin a two-day visit to Nepal on 3 August.

The twentieth United States-Singapore joint Co-operation Afloat Readiness and Training (CARAT) exercise continues until 8 August.