Armenia2020_presentation_Yerevan

Key Levers for Productivity Improvement in Armenia

Pierre Gurdjian, Andr Andonian, McKinsey &Company Presentation on Armenia 2020 Conference Yerevan, October 25, 2003
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Armenia2020_presentation_Yerevan

ARMENIA'S ECONOMY HAS RECENTLY GROWN AT HIGH RATES, HOWEVER IT STILL REMAINS WEAK BOTH IN ABSOLUTE AND RELATIVE TERMS
US A German y China India Russia Turkey Israe l Iran Singapor e Romani a Sloveni

PPP GDP per capita Real GDP CAGR Nominal GDP 2002, USD 1999 - 2002, percent 2002, USD billions 10,445.0 2.14 36,146
1,989.0 1,237.0 5,540 3,135 6,114 6,800 1.38 1.78 4.07 27,361 3,730 17,225 12,130 2,924 2,900 3,200 3,850 3.58 9.11 4.19
1

24,317

1.35

7.72
4.70 6.03

514.0
349.0 182.0 102.0 91.0 88.0 45,0 21.0 6.3

16,724
5,608

3.39 4.21 3.58 5.93 0.03 10.35

a Estoni a Paraguay 5.4 Azerbaijan 6.2 Georgi a Armenia Average

Source: Global Insight; EIU

3.4 2.4

8,280

Armenia2020_presentation_Yerevan

ARMENIA'S RECENT ECONOMIC GROWTH WAS LARGELY DRIVEN BY CONSTRUCTION AND RETAIL, FUELLED BY EXTERNAL FINANCING
Real CAGR Percent

USD millions
2,117 1,899 1,847 1,911

2,367

Total GDP Construction

7.8 23.0 12.3

379 237
547 485 170 599

160 162
586 410
97

174 164
469 398 138 503 442

209 176
430 421 133 543 452

227 209
530 429 159 567 392

Retail and wholesale

Agriculture Industry Transport and communication Other services

3.6 7.3
5.3 7.8

483 445

348

External financing* As a percent of GDP

2

1998

1999

2000

2001

2002

23.4

23.9

23.6

18.5

14.7

* Without FDI, includes remittance, grants, concessionary lending and limited capital transfers Source: McKinsey

Armenia2020_presentation_Yerevan

ARMENIAN EXPORT HAS GROWN SIGNIFICANTLY TOO, ALTHOUGH FROM VERY LOW STARTING LEVEL AND ON A NARROW BASE
USD millions
294 Total exports Precious stones and articles* Food products Textile and apparel Real CAGR Percent 12.6

247

46
59 29 45 44 56
15 2002 12.9 84.5

60.1
34.6 16.0 3.0 7.0 3.4 -6.9

16
197 183 7 161 8

51 27 43 41 41 28
2001 11.7 63.0

18 16 40 33 49

13
18 16 25 40

30 16 44 41 36 22 2000
10.3 43.7

20 1998
9.6 41.1

23 26
1999 8.7 36.7

Base metals Mineral and chemical products Machinery & equipment Other

Exports as percent of GDP Exports as percent of external assistance

3

* On a net basis, given that the industry performs only intermediate processing Source: IMF,Armenia National Statistics Service, 2002

Armenia2020_presentation_Yerevan

FOUR DISTINCT MODELS CAN SERVE AS DEVELOPMENT PATTERNS

"Singapore" model

"Ireland" model

"Israel" model

"Paraguay" model

Initially cheap labor Extensive

investment in education Economic liberalization Strong role of the centralized state High rates of investment in infrastructure Large transit trade and intermediate processing

Integration to more
developed EU Consistent economic liberalization Relatively cheaper, but productive labor Strong driving role of the private sector Investment in education Democracy and civil development parallel to economy

Highly educated
workforce Large Diaspora and foreign assistance Investment in education and science, but Chronic hostility with neighbors High rates of immigration, requiring extensive resources for job creation

Exploration of
hydro energy resources Centralized (dictatorial) state Highly informal economy and weak rule of law Cheap labor and high reproductive rates

Source: McKinsey

Armenia2020_presentation_Yerevan

ARMENIA'S PROSPERITY LEVEL IN 2020 WILL STRONGLY DEPEND ON ITS CURRENT CHOICES
PPP GDP per capita/USD
15
12,560
6,1 Singapore model: Armenia becomes an integration champion and business hub for the region % Real growth CAGR, 2002-2022

10,340

10
8,340 6,600 5,040 5 4,460 2,690 3,850 6,900 7,920

Ireland model: Armenia 9,270 consistently integrates with European structures, attracts increasing foreign investment 4,5 Israel model: Armenia relies 6,410 mainly on Russia, sees slow growth of traditional sectors and 2,6 little foreign investment

5,900 5,580 6,040

4,860

5,260

5,300

5,090

4,690
0,1 Paraguay model: Regional and internal instability stalls growth, some traditional sectors decline due to increasing competition

2,120
1990 1994 1998 2002 2006 2010 2014 2018 2022

Source: McKinsey

Armenia2020_presentation_Yerevan

THE WELL-BEING OF ORDINARY ARMENIAN CITIZENS WILL VARY EVEN MORE PRONOUNCEDLY DEPENDING ON THE CHOSEN PATH
Average nominal monthly salary,USD
600
460
Singapore model: Becoming masters of own life Average Armenians afford modern housing conditions Armenia becomes predominantly middle class society Quality of education is among the best in the world Armenians return massively from Russia Ireland model: Living like in Eastern Europe Average Armenians afford buying furniture and cheap cars Large middle class emerges, both in foreign and local companies Quality of education moves towards European standards Emigration is reversed Israel model: Living like in a backward Russian province Average Armenians work in small factories and shops Some middle class emerges, mainly in Russian-owned industries Quality of education like in Soviet times Best and brightest still emigrate Paraguay model: No change for better Average people barely make their basic ends Unemployment is pervasive, especially in rural areas Quality of education deteriorates Population emigrates massively

400
260

200

120 100 60 50

45

2002
Source: McKinsey

2020

Armenia2020_presentation_Yerevan

ACHIEVING THE AMBITIOUS GROWTH TARGETS WILL BE POSSIBLE THROUGH IMPROVING PRODUCTIVITY* OF ARMENIAN COMPANIES

Labor productivity of Armenia's economic agents will be the main engine for wealth generation

Greater surplus Productivity

Surplus distributed

Impact on economy

Growth in
company x

Higher value
added Lower labor/ capital expenses

Customers
(lower prices) Employees (higher salaries) Owners (higher profits)

Higher demand
Lower prices Higher salaries Net jobs created Higher investments Higher profits Higher demand Higher exports Lower unit costs Innovative products
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* Productivity is defined as total value added divided by number of employees participating in value creation Source: McKinsey

Armenia2020_presentation_Yerevan

DRIVERS OF UNEQUAL ECONOMIC GROWTH

Macro-political economic
instability

Must fix but far from enough

Poorly educated workforce Poor infrastructure Rigidities in labour and capital

markets Culture and religion

Much less important than suggested by conventional wisdom

Poor micro-economic
policies Unequal enforcement of micro-economic policies

By far the most important barriers to higher economic growth in all studied countries

Source: McKinsey global institute, findings from 30 countries

Armenia2020_presentation_Yerevan

WHILE ACHIEVING SIGNIFICANTLY HIGHER PRODUCTIVITY WILL BE POSSIBLE THROUGH FOCUSED INITIATIVES IN PRIORITY SECTORS
2003-2010
High (>10% CAGR)
Real productivity growth potential* 12 9 8 13 3 15 1 11 5 9 10 16 7 5 6 Construction Banking and insurance Food processing Textile and apparel Industrial machinery 6 1 2 3 Mining Metals Telecom Tourism and restaurants

Medium (5-10% CAGR)

14

7
8

10 Electronics and precision 11 Construction materials Low (0-5% CAGR) 12 Health care 13 Retail and wholesale

Negative (-5-0% CAGR)

Low (0-5% CAGR)

High (5-10% CAGR)

14 Jewelry and diamonds 15 Transportation 16 Software and IT Services 9

Sector Employment growth potential* * Compared to current employment/productivity in the sector Source: Team analysis; World Bank; UNDP

Armenia2020_presentation_Yerevan

WHILE ACHIEVING SIGNIFICANTLY HIGHER PRODUCTIVITY WILL BE POSSIBLE THROUGH FOCUSED INITIATIVES IN PRIORITY SECTORS
Sectors with highest total growth potential

2003-2010
High (>10% CAGR)
Real productivity growth potential* 12 9 8 13 3 15 1 11 5 10 16 7 6

1 2 3

Mining Metals Telecom Tourism and restaurants Construction Banking and insurance Food processing Textile and apparel Industrial machinery

4
5 6

Medium (5-10% CAGR)

14

7
8 9

10 Electronics and precision 11 Construction materials Low (0-5% CAGR) 12 Health care 13 Retail and wholesale

Negative (-5-0% CAGR)

Low (0-5% CAGR)

High (5-10% CAGR)

14 Jewelry and diamonds 15 Transportation 16 Software and IT Services 10

Sector Employment growth potential* * Compared to current employment/productivity in the sector Source: Team analysis; World Bank; UNDP

Armenia2020_presentation_Yerevan

SOFTWARE AND IT SERVICES SECTOR: GDP* SHARE NOMINAL

Percent

8.62

3,99
Software and IT Services sector plays important role in Armenia's economy

2,20 1,38

2,00 1,71

0,53 0,11
US Germany Ireland Israel India Russia Estonia
CIS countries

0,09
Armenia Georgia

0,22
Iran
Neighbor countries

0,01
Turkey

Western Countries

IT high growth countries

* GDP 2002 data consistently from Global Insight Source: US Census Bureau, RUSSOFT, NASSCOM, Enterprise Ireland, IASH, Bitkom, ANCI, ASIROS, Bilisim, Datamonitor, Sanaray, Global Insight

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Armenia2020_presentation_Yerevan

ARMENIA IS ALREADY AT A GOOD STARTING POINT FOR GROWTH IN SOFTWARE AND IT SERVICES AS PRIORITY SECTOR
Productivity PPP - Percent of US level
180 172

100

90

Armenia with good performance given quite young and rather fragmented sector
44 38 23

n/a US Germany* Ireland** Israel** India* Russia* Estonia Armenia**

Western countries IT high growth countries CIS countries

* MGI values: Germany scaled with GDP PPP = 2.06, India and Russia from in-depth MGI studies ** Ireland scaled with GDP PPP = 0.84; Israel playing equally on global market with US PPP=1, Armenia: Exports at PPP = 1.5, domestic at PPP = 5.6 Source: US Census Bureau, RUSSOFT, NASSCOM, Enterprise Ireland, IASH, Bitkom, Datamonitor, Global Insight, MGI

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Armenia2020_presentation_Yerevan

BOTH FOREIGN SUBSIDIARIES AND DOMESTIC COMPANIES ALREADY REACH GLOBALLY COMPETITIVE LEVELS OF PRODUCTIVITY
ESTIMATES
Foreign owned companies Only comparison of programming productivity possible (at PPP) (further value creation steps executed abroad) 40 12 20 8 Armenia Tax, programming admin productivity and regulatory issues* 50% value proportional to salary difference Process US manageprogramming ment** productivity and staff qualification

Productivity split Programming productivity

40% 60%

Product generation and marketing/ sales productivity

Domestically owned companies Comparison of total productivity (at PPP)

20 15 10 15 15 10

100 15

Armenia Tax, Process programming admin manageproductivity and ment** regulatory and staff issues* qualification
* ** *** Source: Including Armentel monopoly Scarcity of experienced group leaders (project management skills) Little incentive for value maximization due to predominantly one-person-ownership structure McKinsey, Company interviews

Armenia Product product mix (small generation domestic and market) marketing/ sales productivity

Strategic Branding US total manage- discount productivity ment (including ownership issues***)

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Armenia2020_presentation_Yerevan

LEARNING FROM SUCCESSFUL COUNTRIES IN SOFTWARE AND IT SERVICES SHOWS FOUR COMMON KEY FACTORS FOR GROWTH
India Ireland Israel

Leverage country advantages

Talent high quality, English

speaking at low-cost

English speaking, low- cost

talent pool Geographical proximity to EU

High quality talent (some

Sophisticated demand for
security systems Strong R&D base Assistance by Jewish entrepreneurs immigrating)

Attract foreign investment

MNCs build offshoring credibility

and skills, e.g., TI (1983), Citibank (1985), GE Capital (1996) Supported by strong industry association NASSCOM

Large investments by Dell

(exports of 1 billion) built skills and reputation

Microsofts first international

center in Israel

Focus on target segments

Offshoreable segments, e.g.,

customized application development Offshored business processes

Offshored business
processes

Security software

Provide government support

Created Software Technology

Parks (with optimal infrastructure) Subsidizing technical education Provided fiscal incentives Cooperated with NASSCOM

Created IDA*, an agency for Creation of three-phase

attracting and facilitating overseas investments Provided fiscal incentives

funding and support mechanisms for new companies High spending on R&D and education 14

Source: NASSCOM, Enterprise Ireland, IASH, McKinsey analysis

Armenia2020_presentation_Yerevan

TWO TARGET SEGMENTS HAVE BEEN IDENTIFIED AS MOST PROMISING IN THE GLOBAL EXPORT MARKET
IT services 1 2 High 3 4 5 18 20 Attractiveness of industry segment Global market size Market growth rate Industry profitability 2/10 16 9 8 3 7 17 21 15 4 1 11 5 19 12 6 22 6 7 8 9 13 10 11 12 13 14 15 Low Low Armenia's ability to be a significant player (scale indicates "absolute" ability) Technical skills Customer relationship/marketing skills Market concentration (only Packaged Software) Language skills High 16 17 18 19 20 21 IT consulting

Suggested first priority areas

Systems integration Networking consulting and integration Customized applications development IT education and training Software support and implementation Hardware support and implementation IT outsourcing Network infrastructure management services

14

Processing services
Applications outsourcing Business Process Outsourcing (BPO) Vertical business applications Cross industry business applications Consumer applications Information and data management Application design and construction tools Network management and security Systems management Operating systems Middleware and serverware Embedded software

(Packaged) software

22

Note: Size of bubble indicates global market size Source: McKinsey

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Armenia2020_presentation_Yerevan

FOUR ADDITIONAL SEGMENTS ARE IDENTIFIED AS SECOND PRIORITY TARGETS

IT services 1 2 High 3 4 5 18 20 Attractiveness of industry segment Global market size Market growth rate Industry profitability 2/10 16 9 8 3 7 17 21 15 4 1 11 5 19 12 6 22 6 7 8 9 13 10 11 12 13 14 15 Low Low Armenia's ability to be a significant player (scale indicates "absolute" ability) Technical skills Customer relationship/marketing skills Market concentration (only Packaged Software) Language skills High 16 17 18 19 20 21 IT consulting

Suggested first priority areas Potential second priority areas

Systems integration Networking consulting and integration Customized applications development IT education and training Software support and implementation Hardware support and implementation IT outsourcing Network infrastructure management services

14

Processing services
Applications outsourcing Business Process Outsourcing (BPO) Vertical business applications Cross industry business applications Consumer applications Information and data management Application design and construction tools Network management and security Systems management Operating systems Middleware and serverware Embedded software

(Packaged) software

22

Note: Size of bubble indicates global market size Source: McKinsey

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Armenia2020_presentation_Yerevan

A FOCUSED GROWTH STRATEGY COULD LEAD TO REVENUE GROWTH BY THE FACTOR OF 15 BY 2020
High growth - 3I Revenues USD millions
238 40 40
8,9 5,6 1,7 1,7 2,9 3,9 1,7 1,9 1,9

Medium growth
618 103 184

Slow growth

40

64

78

Share of GDP Percent

Employees Thousands
2,6

6,2

8,0 2,6 4,4 5,3 2,6 4,1 5,1

Share of workforce Percent

0,20

0,41

0,54 0,20

0,30

0,35

0,20

0,28

0,34

2002 2010 2020 2002 2010 2020 Comments* Average annual employee Average annual employee increase* of ~ 450 difficult increase* of ~ 230 possible to achieve (based on about 500 to achieve, seems balanced computer science graduates with IT specialists required in annually**, partly working as IT other sectors of economy specialists in other sectors) * Over next 8 years (higher growth phase) ** About 500 computer science graduates annually, assumed from current base of 400 Source: McKinsey

2002 2010 2020 Average annual employee increase* of ~ 200 could underutilize pool of IT specialist graduates

17

Armenia2020_presentation_Yerevan

THE STRATEGY FOR SOFTWARE AND IT SERVICES SHOULD CENTER AROUND SIX KEY ELEMENTS REQUIRED FOR LONG-TERM SUCCESS

Leverage country advantages

1 Government to continue and constantly coordinate education programs for all educational levels

2 Government to become lead user of IT and provide growth enabling conditions

Attract foreign investment

3 Actively attract key global player to position Armenia on global IT map 4 Set up dedicated agency to support domestic companies towards international markets

Focus on target segments

5 Associations to increase coordination and intensify communication with industry

Provide government support

6 Domestic companies to more actively pursue domestic and export expansion options

Source: McKinsey

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Armenia2020_presentation_Yerevan

RECOMMENDATIONS ON ARMENIA'S GROWTH MODEL

Only "Armenia can do this"

Build your competitive position on unique strength of

Armenian people, land and culture Perseverance and excellence for new learning Strongest tradition of arts and craft Genuine and differentiated products and services

Develop an export-oriented mindset

Export-led Adapt to foreign markets Learn languages and travel Compete globally

Excel in the segments you chose to compete

Aspire for leadership Focus on attractive high-value niches Measure yourself against best practices Be open for global alliances
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Source: Team analysis