1.
Pierre Gurdjian, André Andonian, McKinsey &Company Presentation on Armenia 2020 Conference Yerevan, October 25, 2003 Key Levers for Productivity Improvement in Armenia

2.
ARMENIA'S ECONOMY HAS RECENTLY GROWN AT HIGH RATES, HOWEVER IT STILL REMAINS WEAK BOTH IN ABSOLUTE AND RELATIVE TERMS Nominal GDP 2002, USD billions PPP GDP per capita 2002, USD Real GDP CAGR 1999 - 2002, percent USA Germany China India Russia Turkey Israel Iran Singapore Romania Slovenia Paraguay Azerbaijan Georgia Armenia Average Source: Global Insight; EIU 36,146 24,317 6,800 16,724 17,225 3,730 27,361 2,924 2,900 3,200 5,540 3,135 6,114 5,608 7.72 4.70 6.03 4.07 4.21 0.03 10.35 9.11 2.14 1.35 1.38 1.78 3.39 3.58 3.58 10,445.0 1,989.0 1,237.0 514.0 349.0 182.0 102.0 91.0 88.0 45,0 21.0 5.4 6.2 3.4 2.4 8,280 4.19 3,850 Estonia 6.3 12,130 5.93

3.
ARMENIA'S RECENT ECONOMIC GROWTH WAS LARGELY DRIVEN BY CONSTRUCTION AND RETAIL, FUELLED BY EXTERNAL FINANCING * Without FDI, includes remittance, grants, concessionary lending and limited capital transfers Source: McKinsey As a percent of GDP USD millions Real CAGR Percent 7.8 3.6 7.3 23.0 12.3 5.3 7.8 97 Total GDP Agriculture Industry Retail and wholesale Transport and communication Other services Construction 1,899 1,847 1,911 2,117 2,367 1998 1999 2000 2001 2002 External financing* 23.4 23.9 23.6 18.5 14.7

4.
ARMENIAN EXPORT HAS GROWN SIGNIFICANTLY TOO, ALTHOUGH FROM VERY LOW STARTING LEVEL AND ON A NARROW BASE * On a net basis, given that the industry performs only intermediate processing Source: IMF,Armenia National Statistics Service, 2002 USD millions Real CAGR Percent 12.6 60.1 34.6 16.0 3.0 7.0 3.4 Total exports Precious stones and articles* Food products Base metals Mineral and chemical products Other Textile and apparel 183 161 197 247 294 1998 1999 2000 2001 2002 Exports as percent of external assistance Exports as percent of GDP 7 8 15 -6.9 Machinery & equipment 9.6 8.7 10.3 11.7 12.9 41.1 36.7 43.7 63.0 84.5

5.
FOUR DISTINCT MODELS CAN SERVE AS DEVELOPMENT PATTERNS Source: McKinsey <ul><ul><li>Highly educated workforce </li></ul></ul><ul><ul><li>Large Diaspora and foreign assistance </li></ul></ul><ul><ul><li>Investment in education and science, but </li></ul></ul><ul><ul><li>Chronic hostility with neighbors </li></ul></ul><ul><ul><li>High rates of immigration, requiring extensive resources for job creation </li></ul></ul>&quot;Israel&quot; model <ul><ul><li>Exploration of hydro energy resources </li></ul></ul><ul><ul><li>Centralized (dictatorial) state </li></ul></ul><ul><ul><li>Highly informal economy and weak rule of law </li></ul></ul><ul><ul><li>Cheap labor and high reproductive rates </li></ul></ul>&quot;Paraguay&quot; model <ul><ul><li>Integration to more developed EU </li></ul></ul><ul><ul><li>Consistent economic liberalization </li></ul></ul><ul><ul><li>Relatively cheaper, but productive labor </li></ul></ul><ul><ul><li>Strong driving role of the private sector </li></ul></ul><ul><ul><li>Investment in education </li></ul></ul><ul><ul><li>Democracy and civil development parallel to economy </li></ul></ul>&quot;Ireland&quot; model <ul><ul><li>Initially cheap labor </li></ul></ul><ul><ul><li>Extensive investment in education </li></ul></ul><ul><ul><li>Economic liberalization </li></ul></ul><ul><ul><li>Strong role of the centralized state </li></ul></ul><ul><ul><li>High rates of investment in infrastructure </li></ul></ul><ul><ul><li>Large transit trade and intermediate processing </li></ul></ul>&quot;Singapore&quot; model

6.
ARMENIA'S PROSPERITY LEVEL IN 2020 WILL STRONGLY DEPEND ON ITS CURRENT CHOICES PPP GDP per capita/USD Source: McKinsey Real growth CAGR, 2002-2022 1990 1994 1998 2002 2006 2010 2014 2018 2022 3,850 2,690 2,120 4,460 5 10 15 % Singapore model: Armenia becomes an integration champion and business hub for the region 12,560 8,340 6,600 10,340 5,040 6,1 9,270 7,920 6,900 5,900 Ireland model: Armenia consistently integrates with European structures, attracts increasing foreign investment 4,5 Israel model: Armenia relies mainly on Russia, sees slow growth of traditional sectors and little foreign investment 5,580 6,040 6,410 2,6 Paraguay model: Regional and internal instability stalls growth, some traditional sectors decline due to increasing competition 4,860 5,260 5,300 5,090 4,690 0,1

7.
THE WELL-BEING OF ORDINARY ARMENIAN CITIZENS WILL VARY EVEN MORE PRONOUNCEDLY DEPENDING ON THE CHOSEN PATH Average nominal monthly salary,USD 2002 2020 50 100 600 Source: McKinsey 200 400 45 <ul><li>Paraguay model: No change for better </li></ul><ul><li>Average people barely make their basic ends </li></ul><ul><li>Unemployment is pervasive, especially in rural areas </li></ul><ul><li>Quality of education deteriorates </li></ul><ul><li>Population emigrates massively </li></ul>60 <ul><li>Israel model: Living like in a backward Russian province </li></ul><ul><li>Average Armenians work in small factories and shops </li></ul><ul><li>Some middle class emerges, mainly in Russian-owned industries </li></ul><ul><li>Quality of education like in Soviet times </li></ul><ul><li>Best and brightest still emigrate </li></ul>120 <ul><li>Ireland model: Living like in Eastern Europe </li></ul><ul><li>Average Armenians afford buying furniture and cheap cars </li></ul><ul><li>Large middle class emerges, both in foreign and local companies </li></ul><ul><li>Quality of education moves towards European standards </li></ul><ul><li>Emigration is reversed </li></ul>260 <ul><li>Singapore model: Becoming masters of own life </li></ul><ul><li>Average Armenians afford modern housing conditions </li></ul><ul><li>Armenia becomes predominantly middle class society </li></ul><ul><li>Quality of education is among the best in the world </li></ul><ul><li>Armenians return massively from Russia </li></ul>460

8.
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 * Productivity is defined as total value added divided by number of employees participating in value creation Source: McKinsey Productivity Greater surplus Surplus distributed Impact on economy <ul><ul><li>Higher demand </li></ul></ul><ul><ul><ul><li>Lower prices </li></ul></ul></ul><ul><ul><ul><li>Higher salaries </li></ul></ul></ul><ul><ul><ul><li>Net jobs created </li></ul></ul></ul><ul><ul><li>Higher investments </li></ul></ul><ul><ul><ul><li>Higher profits </li></ul></ul></ul><ul><ul><ul><li>Higher demand </li></ul></ul></ul><ul><ul><li>Higher exports </li></ul></ul><ul><ul><ul><li>Lower unit costs </li></ul></ul></ul><ul><ul><ul><li>Innovative products </li></ul></ul></ul><ul><ul><li>Customers (lower prices) </li></ul></ul><ul><ul><li>Employees (higher salaries) </li></ul></ul><ul><ul><li>Owners (higher profits) </li></ul></ul><ul><ul><li>Higher value added </li></ul></ul><ul><ul><li>Lower labor/ capital expenses </li></ul></ul><ul><ul><li>Growth in company x </li></ul></ul>

9.
DRIVERS OF UNEQUAL ECONOMIC GROWTH Must fix but far from enough Much less important than suggested by conventional wisdom By far the most important barriers to higher economic growth in all studied countries Source: McKinsey global institute, findings from 30 countries <ul><ul><li>Macro-political economic instability </li></ul></ul><ul><ul><li>Poorly educated workforce </li></ul></ul><ul><ul><li>Poor infrastructure </li></ul></ul><ul><ul><li>Rigidities in labour and capital markets </li></ul></ul><ul><ul><li>Culture and religion </li></ul></ul><ul><ul><li>Poor micro-economic policies </li></ul></ul><ul><ul><li>Unequal enforcement of micro-economic policies </li></ul></ul>

10.
… WHILE ACHIEVING SIGNIFICANTLY HIGHER PRODUCTIVITY WILL BE POSSIBLE THROUGH FOCUSED INITIATIVES IN PRIORITY SECTORS Negative (-5-0% CAGR) High (5-10% CAGR) Sector Employment growth potential* Low (0-5% CAGR) High (>10% CAGR) Real productivity growth potential* Mining 1 Metals 2 Telecom 3 Tourism and restaurants 4 Construction 5 Banking and insurance 6 Food processing 7 Textile and apparel 8 Industrial machinery 9 Electronics and precision 10 Construction materials 11 Health care 12 Retail and wholesale 13 Jewelry and diamonds 14 Transportation 15 1 12 13 3 15 6 9 5 8 7 10 11 4 2 14 Low (0-5% CAGR) Medium (5-10% CAGR) 16 Software and IT Services 16 2003-2010 * Compared to current employment/productivity in the sector Source: Team analysis; World Bank; UNDP

11.
… WHILE ACHIEVING SIGNIFICANTLY HIGHER PRODUCTIVITY WILL BE POSSIBLE THROUGH FOCUSED INITIATIVES IN PRIORITY SECTORS Sectors with highest total growth potential Negative (-5-0% CAGR) High (5-10% CAGR) Sector Employment growth potential* Low (0-5% CAGR) High (>10% CAGR) Real productivity growth potential* Mining 1 Metals 2 Telecom 3 Tourism and restaurants 4 Construction 5 Banking and insurance 6 Food processing 7 Textile and apparel 8 Industrial machinery 9 Electronics and precision 10 Construction materials 11 Health care 12 Retail and wholesale 13 Jewelry and diamonds 14 Transportation 15 1 12 13 3 15 6 9 5 8 7 10 11 4 2 14 Low (0-5% CAGR) Medium (5-10% CAGR) 16 Software and IT Services 16 2003-2010 * Compared to current employment/productivity in the sector Source: Team analysis; World Bank; UNDP

12.
SOFTWARE AND IT SERVICES SECTOR: GDP* SHARE – NOMINAL Georgia US Germany Ireland Israel India Russia Estonia Armenia Iran Percent * GDP 2002 data consistently from Global Insight Source: US Census Bureau, RUSSOFT, NASSCOM, Enterprise Ireland, IASH, Bitkom, ANCI, ASIROS, Bilisim, Datamonitor, Sanaray, Global Insight Turkey 8.62 Western Countries IT high growth countries CIS countries Neighbor countries Software and IT Services sector plays important role in Armenia's economy

13.
ARMENIA IS ALREADY AT A GOOD STARTING POINT FOR GROWTH IN SOFTWARE AND IT SERVICES AS PRIORITY SECTOR Productivity PPP - Percent of US level * 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 US Germany* Ireland** Israel** India* Russia* Estonia Armenia** n/a Western countries IT high growth countries CIS countries Armenia with good performance given quite young and rather fragmented sector

14.
BOTH FOREIGN SUBSIDIARIES AND DOMESTIC COMPANIES ALREADY REACH GLOBALLY COMPETITIVE LEVELS OF PRODUCTIVITY 50% value proportional to salary difference * Including Armentel monopoly ** Scarcity of experienced group leaders (project management skills) *** Little incentive for value maximization due to predominantly one-person-ownership structure Source: McKinsey, Company interviews Programming productivity Product generation and marketing/ sales productivity Productivity split Armenia programming productivity Tax, admin and regulatory issues* Process manage- ment** and staff qualification US programming productivity Foreign owned companies <ul><ul><li>Only comparison of programming productivity possible (at PPP) (further value creation steps executed abroad) </li></ul></ul>Armenia programming productivity Tax, admin and regulatory issues* Product mix (small domestic market) Strategic manage- ment (including ownership issues***) Branding discount US total productivity Domestically owned companies <ul><ul><li>Comparison of total productivity (at PPP) </li></ul></ul>Armenia product generation and marketing/ sales productivity Process manage-ment** and staff qualification ESTIMATES

15.
LEARNING FROM SUCCESSFUL COUNTRIES IN SOFTWARE AND IT SERVICES SHOWS FOUR COMMON KEY FACTORS FOR GROWTH Source: NASSCOM, Enterprise Ireland, IASH, McKinsey analysis Attract foreign investment Leverage country advantages Focus on target segments Provide government support India <ul><ul><li>MNCs build offshoring credibility and skills, e.g., TI (1983) , Citibank (1985), GE Capital (1996) </li></ul></ul><ul><ul><li>Supported by strong industry association NASSCOM </li></ul></ul><ul><ul><li>Talent – high quality, English speaking at low-cost </li></ul></ul><ul><ul><li>Offshoreable segments, e.g., customized application development </li></ul></ul><ul><ul><li>Offshored business processes </li></ul></ul><ul><ul><li>Created Software Technology Parks (with optimal infrastructure) </li></ul></ul><ul><ul><li>Subsidizing technical education </li></ul></ul><ul><ul><li>Provided fiscal incentives </li></ul></ul><ul><ul><li>Cooperated with NASSCOM </li></ul></ul>Ireland <ul><ul><li>Large investments by Dell (exports of 1 billion) built skills and reputation </li></ul></ul><ul><ul><li>English speaking, low- cost talent pool </li></ul></ul><ul><ul><li>Geographical proximity to EU </li></ul></ul><ul><ul><li>Offshored business processes </li></ul></ul><ul><ul><li>Created IDA*, an agency for attracting and facilitating overseas investments </li></ul></ul><ul><ul><li>Provided fiscal incentives </li></ul></ul>Israel <ul><ul><li>Microsoft’s first international center in Israel </li></ul></ul><ul><ul><li>High quality talent (some immigrating) </li></ul></ul><ul><ul><li>Sophisticated demand for security systems </li></ul></ul><ul><ul><li>Strong R&D base </li></ul></ul><ul><ul><li>Assistance by Jewish entrepreneurs </li></ul></ul><ul><ul><li>Security software </li></ul></ul><ul><ul><li>Creation of three-phase funding and support mechanisms for new companies </li></ul></ul><ul><ul><li>High spending on R&D and education </li></ul></ul>

16.
TWO TARGET SEGMENTS HAVE BEEN IDENTIFIED AS MOST PROMISING IN THE GLOBAL EXPORT MARKET Note: Size of bubble indicates global market size Source: McKinsey IT services (Packaged) software <ul><li>Attractiveness of industry segment </li></ul><ul><ul><li>Global market size </li></ul></ul><ul><ul><li>Market growth rate </li></ul></ul><ul><ul><li>Industry profitability </li></ul></ul><ul><li>Armenia's ability to be a significant player (scale indicates &quot;absolute&quot; ability) </li></ul><ul><ul><li>Technical skills </li></ul></ul><ul><ul><li>Customer relationship/marketing skills </li></ul></ul><ul><ul><li>Market concentration (only Packaged Software) </li></ul></ul><ul><ul><li>Language skills </li></ul></ul>Low Low High 2/10 17 5 22 13 4 18 9 8 3 12 14 6 7 21 15 1 11 19 20 16 High Suggested first priority areas IT consulting 1 Systems integration 2 Networking consulting and integration 3 Customized applications development 4 IT education and training 5 Software support and implementation 6 Hardware support and implementation 7 IT outsourcing 8 Network infrastructure management services 9 10 Processing services Applications outsourcing 11 Business Process Outsourcing (BPO) 12 Vertical business applications 13 Cross industry business applications 14 Consumer applications 15 Information and data management 16 Application design and construction tools 17 Network management and security 18 Systems management 19 Operating systems 20 Middleware and serverware 21 Embedded software 22

17.
FOUR ADDITIONAL SEGMENTS ARE IDENTIFIED AS SECOND PRIORITY TARGETS Note: Size of bubble indicates global market size Source: McKinsey IT services (Packaged) software <ul><li>Attractiveness of industry segment </li></ul><ul><ul><li>Global market size </li></ul></ul><ul><ul><li>Market growth rate </li></ul></ul><ul><ul><li>Industry profitability </li></ul></ul><ul><li>Armenia's ability to be a significant player (scale indicates &quot;absolute&quot; ability) </li></ul><ul><ul><li>Technical skills </li></ul></ul><ul><ul><li>Customer relationship/marketing skills </li></ul></ul><ul><ul><li>Market concentration (only Packaged Software) </li></ul></ul><ul><ul><li>Language skills </li></ul></ul>Low Low High 2/10 17 5 22 13 4 18 9 8 3 12 14 6 7 21 15 1 11 19 20 16 High Suggested first priority areas Potential second priority areas IT consulting 1 Systems integration 2 Networking consulting and integration 3 Customized applications development 4 IT education and training 5 Software support and implementation 6 Hardware support and implementation 7 IT outsourcing 8 Network infrastructure management services 9 10 Processing services Applications outsourcing 11 Business Process Outsourcing (BPO) 12 Vertical business applications 13 Cross industry business applications 14 Consumer applications 15 Information and data management 16 Application design and construction tools 17 Network management and security 18 Systems management 19 Operating systems 20 Middleware and serverware 21 Embedded software 22

18.
A FOCUSED GROWTH STRATEGY COULD LEAD TO REVENUE GROWTH BY THE FACTOR OF 15 BY 2020 * Over next 8 years (higher growth phase) ** About 500 computer science graduates annually, assumed from current base of 400 Source: McKinsey Revenues USD millions Share of GDP Percent Employees Thousands Share of workforce Percent Comments* High growth - 3I <ul><ul><li>Average annual employee increase* of ~ 450 difficult to achieve (based on about 500 computer science graduates annually**, partly working as IT specialists in other sectors) </li></ul></ul>Medium growth <ul><ul><li>Average annual employee increase* of ~ 230 possible to achieve, seems balanced with IT specialists required in other sectors of economy </li></ul></ul>Slow growth <ul><ul><li>Average annual employee increase* of ~ 200 could underutilize pool of IT specialist graduates </li></ul></ul>2002 2010 2020 2002 2010 2020 2002 2010 2020

19.
THE STRATEGY FOR SOFTWARE AND IT SERVICES SHOULD CENTER AROUND SIX KEY ELEMENTS REQUIRED FOR LONG-TERM SUCCESS Source: McKinsey Leverage country advantages Attract foreign investment Focus on target segments Provide govern- ment support Government to continue and constantly coordinate education programs for all educational levels 1 Government to become lead user of IT and provide growth enabling conditions 2 Actively attract key global player to position Armenia on global IT map 3 Set up dedicated agency to support domestic companies towards international markets 4 Associations to increase coordination and intensify communication with industry 5 Domestic companies to more actively pursue domestic and export expansion options 6

20.
RECOMMENDATIONS ON ARMENIA'S GROWTH MODEL Source: Team analysis <ul><ul><li>Build your competitive position on unique strength of Armenian people, land and culture </li></ul></ul><ul><ul><ul><li>Perseverance and excellence for new learning </li></ul></ul></ul><ul><ul><ul><li>Strongest tradition of arts and craft </li></ul></ul></ul><ul><ul><ul><li>Genuine and differentiated products and services </li></ul></ul></ul><ul><ul><li>Develop an export-oriented mindset </li></ul></ul><ul><ul><ul><li>Adapt to foreign markets </li></ul></ul></ul><ul><ul><ul><li>Learn languages and travel </li></ul></ul></ul><ul><ul><ul><li>Compete globally </li></ul></ul></ul><ul><ul><li>Excel in the segments you chose to compete </li></ul></ul><ul><ul><ul><li>Focus on attractive high-value niches </li></ul></ul></ul><ul><ul><ul><li>Measure yourself against best practices </li></ul></ul></ul><ul><ul><ul><li>Be open for global alliances </li></ul></ul></ul>Only &quot;Armenia can do this&quot; Aspire for leadership Export-led