Armenia2020 Updated

Prepared for Ruben Vardanian & the IdeA Foundation

January 2015

CONFIDENTIAL AND PROPRIETARY Any use of this material without specific permission of McKinsey & Company is strictly prohibited Executive summary (1/3)

▪ Armenia has shown a steady economic growth of ~7% 1 over the last decade, in line with its regional peers – With a GDP PPP per capita of USD 7,000 in 2013 , Armenia's GDP remains low in the CIS region – Growth rates of 8% p.a. have been reached before the financial crisis, mainly due to foreign financial expansion of the construction sector and domestic services – After the financial crisis, growth rates fell to ~5% p.a.; growth was mainly driven by the service sector (retail, banking, transport, and communication), expanding exports based on high commodity prices for metals and minerals, and high agricultural output

▪ Armenia's economic growth has been fueled by favorable external effects and not through strong focus on economic development, as suggested by the Singapore scenario, especially after the financial crisis and thus bears the risk of high volatility and unsustainability . – Increased private consumption, mainly driven by remittances that increased from 6% of GDP in 2003 to >20% today, thus not supporting a sustainable development of the economy – Increased exports after the crisis, but not diversified (3 products 2 account for 70% of goods exports) and focused on commodities that did profit from high market prices

1 PPP, real, 2003-13 2 Metals, and ore diamonds, alcoholic beverages

McKinsey & Company | 1 Executive summary (2/3)

▪ Several factors indicate that Armenia’s GDP growth path might not be sustainable in the near future – While FDI 1 played an important role before the financial crisis, Armenia seems to have lost its attractiveness to foreign investors – FDI steadily declined from its peak in 2008 (USD 1.1 billion) to 2013 (USD 0.4 billion) – Except for Aluminium, most commodities exported by Armenia are forecasted to have reached their peak market prices in recent years – Armenia's productivity is catching up, but is still behind its regional peers with USD 19,300 GDP PPP/capita vs. USD 41,000 as CIS average, decreasing Armenia's competitiveness – Armenia's economy is highly dependent on Russia in all dimensions – from exports and imports, to FDI 1 and remittances, which bears the risk to hinder further growth should the Russian economy continue to slow down – Thus, it is not surprising that most key sectors identified within Armenia 2020, with the exception of banking and tourism, did not fully exploit their productivity and employment growth potential

▪ In terms of creating a growth-enabling environment , such as business environment, assets, and education, Armenia compares favorably to its regional peers , but still ranks low on a global scale; regional leading examples such as Georgia show that there is still significant room for improvement

1 Foreign direct investment

McKinsey & Company | 2 Executive summary (3/3) ▪ Furthermore, growth over the last years seems to have had only limited impact on social indicators – The relatively strong economic growth over the last years could not reduce the constantly high net emigration rate in Armenia of 6 per 1,000 population in 2014 – The growth over the last decade has been supported mainly by an increase in productivity , while the economy failed to create a significant amount of new jobs (Armenia's unemployment rate 18.5% vs. 9.6% in CIS region in 2013) – Today in Armenia, every third person is poor and poverty even increased over the last years – Armenia still has a very large share of informal economy (~40% of official GDP), which could be reduced only marginally over the last decade (~45% in the early 2000s)

▪ Based on this country snapshot, Armenia should look for new models of growth to diversify its current economy and make growth more sustainable . Morocco, Chile, Georgia, and Malaysia are archetypes of economies that have a strong and sustainable growth trajectory and have succeeded in diversifying their economy

▪ The Armenian government, business leaders, and also Dolphyn can support this development by addressing 4 areas – Business environment, institutions, and policies – Financial market and availability of capital – Infrastructure – Human capital

McKinsey & Company | 3 Contents

▪ Snapshot of the Armenian economy today and its development over the last 10 years ▪ Armenia's development in context of Armenia2020's models of growth ▪ Sector deep dives – actual development vs. potential ▪ Emerging new models of growth ▪ Armenia's way forward

McKinsey & Company | 4 We have analyzed Armenia’s economy in 3 dimensions

Growth-enabling environment ▪ Is the business environment and infrastructure pro business? ▪ Is the economic environment Production of supporting the positive goods and development of social services indicators? ▪ How many goods and services have been produced? ▪ What has been produced?

Growth drivers ▪ What has fueled GDP growth? ▪ Are these growth drivers sustainable in the future?

McKinsey & Company | 5 Over the last decade, Armenia has shown a steady economic growth … GDP PPP per capita, constant 2010 USD

Financial crisis hits the ▪ Transition to market 7,500 Strong growth, Armenian economy economy fueled largely driven by 7,000 strong economic foreign-financed 6,500 growth in the first expansion of years of the new 6,000 construction sector millennium with an 5,500 average GDP 5,000 State of emergency declared growth of 6.6% p.a. 4,500 for 3 weeks following ▪ However, internal presidential elections political issues and 4,000 tensions with 3,500 neighbors constrained the 3,000 Member of WTO, focus economic 2,500 on reprivatizing owner- development 2,000 ship and transitioning into market economy Increasing exports ▪ After the financial 1,500 and private con- crisis, Armenia's 1,000 sumption drive growth recovered, 500 economic growth driven by private 0 consumption and resource-oriented 2002 03 04 05 06 07 08 09 10 11 12 2013 exports

SOURCE: IMF McKinsey & Company | 6 2002 XX Below 4% XX 4% -7% … in line with its regional peers – however, Armenia's GDP 2013 per capita remains low in CIS XX Above 7%

GDP PPP per capita, constant 2010 USD thousands CAGR, 2002-13

14.3 4.5% Russia 23.2 12.5 5.6% Kazakhstan 22.8 8.0 7.0% Belarus 16.9 5.3 Azerbaijan 16.3 10.8% 5.4 8.6% Turkmenistan 13.3 4.9 Ukraine 7.4 3.7% 3.6 Armenia 7.2 6.6% 3.4 Georgia 7.0 6.9% 2.6 Uzbekistan 5.1 6.5% 2.6 Moldova 4.4 4.9% 2.1 Kyrgyzstan 3.1 3.7% 1.4 Tajikistan 2.4 5.2%

10.0 CIS 16.6 6.3%

SOURCE: Global Insight McKinsey & Company | 7 GDP growth was driven by the services sector during the last years, however, Armenia's economy still has a strong focus on agriculture

GDP 1 composition, 2003 GDP 1 composition, 2013 Percent Percent 100% = USD 2,807 million 100% = USD 10,432 million

Agriculture Agriculture Services 24 22 34 Services 46

32 42 Industry Industry ▪ Services sector with strong growth, which is mainly driven by increased private consumption ▪ GDP contribution of agricultural sector remains high compared to other CIS countries ( CIS average 8% , with only Tajikistan and Moldova having a higher share)

1 Nominal GDP at current USD

SOURCE: World Bank McKinsey & Company | 8 Strong focus on Agriculture leads to Armenia still being in a transitional phase compared to its neighbors

Categorization of CIS countries

Exports as share of GDP Bubble size proportional Bubble size proportional 2003, 2013, % to 2003 GDP 1 to 2013 GDP 1 75 Resource 70 rich 3 65 Turkmenistan Belarus 60 Diversified 55 Ukraine 50 2 Azerbaijan Kyrgyz Republic Georgia 45 Moldova 40 Kazakhstan 35 Uzbekistan 2 30 Russian Federation 25 Armenia 20 Tajikistan 15 Pre-transition 10 Transition 5 0 10 20 30 40 50 60 70 80 90 100

Economic diversification Manufacturing and services as share of GDP, 2003, 2013, %

1 GDP per capita PPP, 2011 international $ 2 Only 2012 data available 3 Only services as share of GDP for 2012

SOURCES: World Bank McKinsey & Company | 9 While Armenia's main GDP growth driver before the crisis was the construction sector, in recent years it has been the domestic services and export-oriented sectors Agriculture Retail Transport and communication 2 Tourism Mining and quarrying Industry 1 Construction Finance and insurance Health and social work Others

CAGR GDP per capita of Armenia, PPP, in constant 2010 USD, percent 2002-13 7.2 6.8 4.8% 18 6.1 21 5.8 21 3.1% 19 13 20 16 8.0% 4.5 15 13 14 16 4.9% 3.6 24 14 14 14 12 7.9% 26 20 28 14 12 19 18.2% 7 23 12 26 7 7 5 5 10.4% 12 17 7 5 6 4 4 5 14 2 2 3 5 4 5 12.5% 6 2 5 3 4 3 3 6 3 5 3 3 3 3 2 3 2 12 13 10 1 7 7 9 12 14.2%

2002 04 06 08 10 12 2013 Growth ▪ Construction ▪ High agricultural output drivers ▪ Growth of service sector (e.g., finance, tourism) ▪ Export of metals and minerals 1 Incl. Manufacturing and electricity, gas, water supply 2 Excl. transportation of international tourists (~5% of total transportation in 2013)

SOURCE: Statistical yearbook of Armenia; Global Insight; Russian Federation Federal State Statistics Service; World McKinsey & Company | 10 Bank; IATA We have analyzed Armenia’s economy in 3 dimensions

Growth drivers ▪ What has fueled GDP growth? ▪ Are these growth drivers sustainable in the future?

McKinsey & Company | 11 Armenia's economic growth has been fueled by positive external effects, especially after the financial crisis Detailed on next slides Drivers of GDP, constant 2005 USD millions Average annual Average annual change in GDP, change in GDP, 2003-08 2009-13 ▪1 Private consumption consistently drove 1 Private consumption 332 209 GDP growth over the past decade, largely finance by Public consumption 43 32 remittances from fast-growing Russia ▪ In recent years, 1 2 Investments 332 70 exports have significantly contributed to GDP growth, driven by 2 Exports 28 204 increased service exports and market price increases of Imports 151 48 commodities

Average GDP increase 527 327 annual

1 Gross capital formation

SOURCE: World Bank McKinsey & Company | 12 1 Remittances have driven private consumption and increased significantly from 6% of GDP in 2002 to >20% of GDP today

Personal remittances received Current USD millions ▪ With its extensive diaspora, Armenia is the 15th largest remittance Country of origin recipient in the world – ▪ 90% Russia 40% of Armenian +29% p.a. ▪ 5% US 2,193 households receive 1,904 1,915 remittances from migrant 1,799 families 1,644 1,669 ▪ Share of remittances 1,440 from Russia has increased significantly over 1,169 the years – from 75% in 2004 to 90% in 2011 915 Country of origin ▪ Yet remittances are not ▪ 75% Russia being used produc- ▪ 15% US tively; typically, 435 households spend 90% 168 of remittances on current consumption

2003 04 05 06 07 08 09 1011 12 2013

Percent 6.0 12.1 18.7 18.3 17.9 16.3 16.6 18.0 17.7 19.2 21.0 of GDP

SOURCE: IMF; World Bank; UNDP; Central Bank of Armenia; ILO McKinsey & Company | 13 2 Exports were a main driver of Armenia's growth after the crisis Detailed on next page

Exports CAGR, CAGR, Percent of GDP 2003-08 2008-12 Services 1 Goods 2

-14% p.a. 32.2 +12% p.a. 29.7 28.8 8.3 27.0 23.8 24.6 9.8 9.7 23.4 20.8 19.2 -6% 17% 7.9 10.4 12.9 15.5 10.9 7.0 15.0 10.1 23.9 6.0 7.6 19.9 19.1 15.4 14.2 14.1 -18% 9% 12.2 10.7 12.9 9.0 7.9

2003 04 05 06 07 08 09 10 11 12 2013

1 Mainly travel (55% of services), transportation (22%), and IT (8%) 2 Mainly basic metals, jewelry, alcoholic beverages

SOURCE: World Bank; ICT McKinsey & Company | 14 2 However, Armenia's exports of goods are resource-oriented and thus fail to develop the economy sustainably and don't create high-quality jobs Capital-intensive manufacturing Labor-intensive manufacturing Other Primary resources R&D-intensive manufacturing

Breakdown of goods exports CAGR 2005 2012 2005-12 100% = USD 0.9 billion 100% = USD 1.4 billion ▪ High prices for metals and minerals supported ▪ Basic metals 6.3% growth over last years ▪ Chemicals ▪ Food and (see next page) ▪ Medical beverages equipment ▪ Tobacco ▪ However, resource- 26.4% based trade with ▪ Transport 5 3 8 equipment significant drawbacks 9 – Vulnerability to -13.7% global commodity 8 price fluctuations 34 50 49 – Little value add in the local economy 16.5% ▪ Increased focus on mining detracts from 25 more human-capital- 8 21.5% and R&D-intensive sectors, making Jewelry and Mining of Armenia's goal of high- apparels metals and quality job creation 1 ore more difficult to achieve

1 Republic of Armenia Government Decree, March 27, 2014: Armenia Development Strategy 2014-25

SOURCE: Oxford Policy Management; FAO; ICT McKinsey & Company | 15 2 Armenia's resource-based exports have profited from growing market prices over the last decades

Price increase between 2002 and 2013 Price increase >100% Other heating Price Aluminum machinery increase foil 300% Price Text increase Raw copper Molybdenum Scrap iron >400%

Price Scrap copper increase 500% Precious Zinc Copper ore metal ore ore

Men's Aircraft Men's Pitted Grapes Molybdenum Planes, suits coats fruits parts oreOre helicopters,

and/or 0.69% 0.57% spacecrafts 0.7% 0.64% 0.64%

Rolled tobacco Watch cases Hard and parts Packaged medica- liquor tions Fresh fish Glass bottles Water

SOURCE: The Observatory of Economic Complexity; Bloomberg McKinsey & Company | 16 Several factors indicate that Armenia’s current GDP growth path might not be sustainable in the near future

While FDI played an important role before the 1 financial crisis, Armenia lost its attractiveness to foreign investors after 2008

Forecasts for basic metals and minerals suggest that 2 commodities have reached their peak prices in 2012/2013

Armenia’s productivity is still low, even compared 3 to its regional peers

Strong link to Russia might hinder future growth as 4 Russia will most likely face difficult economic times

Sectors identified within Armenia2020 have not 5 reached their potential, suggesting that there are no structural changes in key industries

McKinsey & Company | 17 1 While FDI played an important role in Armenia’s economic development until 2009, they are declining since then

FDI inflows Current USD millions ▪ Strong increase in FDI since late 1990s sup- Growth driven by Global economic crisis and a ported by government ▪ Diaspora capital flowing into slowdown of infrastructure real estate development leads to decline – Privatization of ▪ Privatization in mining, telecom, economy 1,200 and airport infrastructure – Granting foreign 1,118 companies same 1,100 rights as local 1,000 -20% p.a. companies 900 – Investment +47% p.a. 829 guarantees for 800 foreign investors 703 700 675 – Attracting FDI 598 flowing into real 600 536 estate sector 500 437 ▪ Today, FDI account for 400 370 20% of total invest- 304 ments in Armenia 300 218 235 ▪ Main sectors attracting 200 FDI (2003-13) 111 100 – Financial services: 30% 0 – Communications: 2002 03 04 05 06 07 08 09 10 11 12 2013 22% – Metals: 14% Percent 4.7 7.8 6.6 6.2 6.8 7.3 9.6 9.6 5.8 6.9 6.0 3.5 of GDP

SOURCE: Armenian Development Agency; UNCTAD bilateral FDI statistics; Global Insight; NSSRA McKinsey & Company | 18 2 Except for Aluminium, most commodities exported by Armenia seem to have reached their peak market prices in recent years USD

3,000 2,917

2,500 2,397 2,400 2,350 Aluminium 2,250 tonne 2,153 2,171

2,000 1,846 1,873

1,669 Gold 1,571 troy oz 1,500 1,412 Iron ore 1,320 1,330 1,225 1,265 1,270 dry metric 1,208 tonne 146 164 129 135 95 70 75 80 90 Copper 3 4 4 3 3 3 3 3 3 lb 0 2010 11 12 13 14 15 16 17 2018

SOURCE: EIU Economic and Commodity Forecast, December 2014 McKinsey & Company | 19 2002 XX >7% 3 Armenia's productivity is catching up, XX Between 5 and 7% 2013 but is still behind its regional peers XX <5% Productivity, GDP PPP per employee, USD thousands CAGR, 2002-13

Kazakhstan 27.3 6.3% 53.6 31.6 Russia 4.3% 50.1 Room for improve- Azerbaijan 11.1 12.0% ment remains 38.6 ▪ Nearly 40% of 18.0 6.6% Belarus 36.3 workers are employed in Turkmenistan 12.3 9.6% 33.7 agriculture , which only accounts for 9.9 6.3% Armenia 19.3 20% of GDP 8.5 Georgia 6.9% ▪ Lack of modern, 17.8 high-productivity 7.6% Uzbekistan 7.5 sectors 16.8 ▪ Gap in produc- 11.8 3.1% Ukraine 16.5 tivity to CIS 5.7% average somewhat Moldova 6.3 11.6 overestimated due to natural resource 4.7 7.4% Tajikistan 10.4 production in some 4.3% countries leading to Kyrgyzstan 5.7 9.0 high productivity 27.9 CIS 41.0 3.5%

1 US productivity in 2013: ~ USD 117k

SOURCE: Global Insight McKinsey & Company | 20 3 The Armenian productivity is significantly lower than that of Germany across all sectors and has even declined after the financial crisis ProductivityMi 1, 2013 Germany = 100%

▪ Highest productivity is achieved in finance sector ▪ Until the financial crisis, Armenia improved its productivity from ~5-12% of Germany 's average 26 productivity Financial 26 ▪ After the financial crisis, the gap to Germany's services Construction productivity increased again 18 ▪ 2003 productivity per sector detailed in backup Real estate services 18 14 12 IT and communication Business services 11 11 9 2008: Ø 12 Trade, transport, Industry 9 2013: Ø 10 accommodation, and food services Manu- Agriculture 3 Public services, facturing education, health, 2002: Ø 5 and other services

0 5 10 15 20 25 30 35 40 45 50 55 6065 70 75 8085 90 95 100 0 Share of employees Percent 1 GDP per employee 2 Incl insurance 3 Incl forestry and fishing Note: Detailed sector allocation in backup

SOURCE: German Federal Statistics Department; National Statistical Service of the Republic of Armenia (NSSRA) McKinsey & Company | 21 4 Among the CIS countries, Armenia has one of the strongest dependencies on Russia 2013 for exports and imports 2012 for remittances and FDI, Percent of GDP >5% of GDP 2-5% of GDP <2% of GDP Detailed on next pages

Exports to Imports from Remittances FDI stock Russia Russia from Russia from Russia Armenia Azerbaijan Belarus Georgia Kazakhstan Kyrgyzstan Moldova Tajikistan Turkmenistan Ukraine Uzbekistan

SOURCE: World Bank; UN Comtrade database; UNCTAD McKinsey & Company | 22 4 Armenia's dependency on Russia has increased significantly – FDI stock held by Russian investors increased from 25% in 2002 to >50% today

FDI inflows Current USD millions

1,200 1,118

1,000 383 829 800 675 703 598 600 429 536 437 336 345 400 370 304 735 334 508 Other 218 235 283 170 200 399 countries 111 149 183 291 340 358 202 200 Russia 6 105 154 91 0 68 52 13

2002 03 04 05 06 07 08 09 10 11 12 2013 FDI stock 25 29 28 23 21 46 56 55 51 54 53 55 held by Russian investors Percent

SOURCE: Armenian Development Agency; UNCTAD bilateral FDI statistics; Global Insight; NSSRA McKinsey & Company | 23 Percent of 4 While Europe is Armenia's main trade partner, it relies total exports

increasingly on Russia for export trade < USD 50 million USD 50-100 million Export partners' trade value and share USD 100-200 million USD 200-300 million >USD 300 million ▪ Strong and North growing trade Russia America with Russia, 12 Europe 9 23 fostered by a free 42 41 12 trade multilateral agreement with 2002 2013 CIS countries 2002 2013 2002 2013 ▪ Exports to Russia expected Russia to further increase with Armenia joining the Eurasian Customs Union in 2015

Middle East ▪ Exports to the Middle East 25 have been 10 decreasing due Other to the political situation in the 14 2002 2013 13 region and deteriorating relations with 2002 2013 neighboring countries

SOURCE: Oxford Policy Management; FAO; ICT McKinsey & Company | 24 4 Armenia's high dependence on Russia might lead to a decline in GDP growth if the slowdown of Russias growth continues Forecast Impact of 1 percentage point fall in ▪ Armenia has Russias GDP growth on CCA oil experienced robust importer countries 1 GDP 2 growth rate Russia growth over the last years Remittances 5 Trade and other channels ▪ However, current Investor uncertainty 3 4 growth model is highly dependent 0 3 Russia's economy -0.1 ▪ With negative -0.2 2 forecasts for Russia's economy , -0.3 1 Armenia could face a -0.4 substantial decline in 0 GDP growth in the -0.5 near future -0.6 -1 -0.7 -2 -0.8 2011 2010 2012 2013 2014 2015 2016 2017 2018 2019

1 Armenia, Georgia, Kyrgyzstan 2 GDP, PPP, real 2010 USD 3 Escalating geopolitical tensions raise risk premiums in Russia (by ~220 basis points) and other countries, incl. the CCA oil importers (by ~75 basis points) and CCA oil exporters (by ~45 basis points).

SOURCE: IMF; Regional economic outlook Middle East and Central Asia McKinsey & Company | 25 Key sectors, detailed on 5 Many sectors did not exploit their productivity and next slides Growth potential 2003-10 employment growth potential identified in Armenia2020 Actual growth 2003-10 Productivity and growth potential for key sectors identified in Actual growth of these sectors 1 between Armenia2020 (as of 2003) 2003 and 2010 (showing only sectors for which data is available)

High High 4 1 (>10% 12 (>10% 12 CAGR) 9 6 CAGR) 12 6 8 3 10 16 16 13 1313 6 15 7 15 4 Medium 4 Medium 14 2 (5-10% 1 (5-10% 1 CAGR) 11 CAGR) 5 5 15 Real productivity Real growth Real productivity Real growth

Low Low (0-5% (0-5% CAGR) CAGR) 5 16 Negative Low High Negative Low High (-5-0% CAGR) (0-5% CAGR) (5-10% CAGR) (-5-0% CAGR) (0-5% CAGR) (5-10% CAGR)

Sector employment growth Sector employment growth

1 Mining 5 Construction 9 Industrial machinery 13 Retail and wholesale

2 Metals 6 Banking and insurance 10 Electronics and precision 14 Jewelry and diamonds

3 Telecommunications 7 Food processing 11 Construction materials 15 Transportation

4 Tourism and restaurants 8 Textiles and apparel 12 Healthcare 16 Software and IT services

SOURCE: World Bank; UNDP; NSSRA; World Travel & Tourism Council (WTTC); USAID; Enterprise Incubator McKinsey & Company | 26 Foundation We have analyzed Armenia’s economy in 3 dimensions

Growth-enabling environment ▪ Is the business environment and infrastructure pro business? Production of ▪ Is the economic goods and environment supporting services the positive development of social indicators? ▪ How many goods and services have been produced? ▪ What has been produced?

Growth drivers ▪ What has fueled GDP growth? ▪ Are these growth drivers sustainable in the future?

McKinsey & Company | 27 Top 20th percentile (best) 20th-40th percentile Examples such as Georgia show that there is room for 40th-60th percentile improvement for Armenia to build a growth-enabling 60th-80th percentile environment Lowest 20th percentile (worst) ... Detailed on next page

Business environment Assets Education 1 Control Government 3 Quality 3 Quality of corrup- effective- Rule Regulatory 2 Mono- Infra- Invest- of primary of higher tion ness of law quality polies structure ments education education Armenia

Azerbaijan

Belarus

Georgia

Kazakhstan

Kyrgyzstan

Moldova

Russia

Tajikistan

Turkmenistan

Ukraine

Uzbekistan

SOURCE: World Bank Worldwide Governance Indicators; WEF; World Bank McKinsey & Company | 28 Top 20th percentile (best) While Armenia has improved across most indicators, 20th-40th percentile there has not been a step change in performance 40th-60th percentile 60th-80th percentile Armenia's rank (out of 100 with 1 being the best) Lowest 20th percentile (worst) Change in rank ≤5 Change in rank >5

Business environment Assets Education

1 Control Government 3 Quality 3 Quality of corrup- effective- Regulatory 2 Mono- Infra- Invest- of primary of higher tion ness Rule of law quality polies structure ments education education

66 50 57 47 93 64 42 70 56 Past 1

Today 2 60 42 55 4266 42 39 58 60

Change 2,262 2,262 2,262 2,262 2,262 2,262 2,262 2,262 2,262

1 2002 data for control of corruption, government effectiveness, regulatory quality, rule of law and investments; 2006 for infrastructure and education, iiii 2008 for monopolies 2 2012-14

SOURCE: World Bank Worldwide Governance Indicators; WEF; World Bank McKinsey & Company | 29 1 Armenia is perceived as a corrupt country, hindering the growth of the economy

Armenia ranks low on the perceived corruption index … … and is struggling to improve the situation ▪ Government follows an AntiCorruption Strategy since 2003 and established an AntiCorruption '' ' Council in 2004, chaired by the Prime Minister ''' ▪ However, little progress has been made to ''' reduce the corruption – Global integrity report rates the anticorruption ''' law as “weak” and its enforcement as “very weak” 94 – Policy Forum Armenia: “most anticorruption measures are dead from the start” ''' – Armenia's rank within the corruption index ''' worsened from 2003 to 2011 (from rank 78 to ''' rank 129); progress has been made from 2011 to 2013 (rank 94), but corruption in Armenia is 177 still rated the most problematic factor for doing business

SOURCE: Transparency International; WEF; Policy Forum Armenia; GK Tribe Global McKinsey & Company | 30 2 Monopolies are highly prevalent in Armenia 2009 market shares percent

Monopolies are prevalent, 100% mainly due to widespread corruption and lack of law enforcement More than 40 36 38 6 players ▪ Mutual agreements 55 62 between entrepreneurs and judiciary prevail in all levels of government

32 ▪ Weak framework for Oligopoly (3-6) 36 43 contract enforcement makes prosecution difficult 25 ▪ Most concentrated markets Duopoly 5 15 33 6 5 are sugar, wheat, and energy/gas transmission Monopoly 19 15 15 15 4 1 ▪ Consumer welfare losses due to above-average Arme- Azer- Kyrgyz- Mol- Russia pricing USD 300 million nia baijan stan dova p.a.

SOURCE: Hrayr Maroukhian Foundation 2013; "Monopolies in Armenia" ; World Bank BEEPS McKinsey & Company | 31 3 While there have been several lighthouse educational projects in Armenia over the last years …

Example projects Description Status and size Ayb School ▪ First Armenian school community integrating the ▪ Opened in 2011 best of Armenia’s educational traditions with the ▪ USD 15 million world’s latest technological resources of investments ▪ Goal is for >1,000 students to attend across elementary, middle and high schools (70% receiving scholarships) ▪ National Education Excellence Program launched

Tumo Centre ▪ >5,000 children aged 12-18 getting lessons in ▪ Opened in 2011 for Creative animation, game development, digital media and ▪ >USD 40 million Techno- web design (free training courses) of investments logies Dilijan ▪ international co-educational boarding and day ▪ Opened in 2011 International school for students aged 13 to 19 years ▪ USD 120 million School ▪ Up to 800 students from 50 nationalities of investments

The ▪ The only US-accredited university in the CIS ▪ Opened in 1991 American ▪ > 1,000 students, of which ~half receive University of scholarships Armenia

SOURCE: Homepages; Report Armenia McKinsey & Company | 32 3 … the quality of education in Armenia is low and even worsened over the past years Enrollment rate Quality of education Percent TIMSS rank 1 90 Science: 8th out of 14 CIS countries 78 Math: 13th out of 14 CIS countries Global competitiveness rank Primary Quality of primary education education 2014 2006 1 83 85 144 Best Worst

81 85 Global competitiveness rank

Quality of Secondary 2006 2012 higher education education 1 68 86 144 Best Worst

Quality of 2006 2014 management 1 102 116 144 Tertiary school 39 education 28

Quality of 2006 2014 math and Armenia CIS science 1 55 69 144 country education average 1 Trends in international mathematics and science study

SOURCE: UNESCO EFA; World Bank; WEF; TIMSS McKinsey & Company | 33 3 High share of unemployed market entrants suggests a mismatch between education and its relevance to labor market needs

Distribution of unemployment by cause, 2010

Layoff 26 ▪ In most cases, unemployment in Armenia is not caused by job loss due to layoffs Market 52 entrants ▪ Instead, more than half of the unemployed are new 22 labor market entrants – Voluntary quit mostly youth ▪ 1/3 of respondents Youth unemployment rate (age 15-24), mentioned "inadequately Percent educated workforce" as obstacles to firm 60 38 activities in Armenia in 40 56 20 enterprise performance 1 0 survey 2003 04 05 06 07 08 09 10 11 2012

1 World Bank Business Environment and Enterprise Performance Survey (BEEPS) , 2008 SOURCE: World Bank: "Armenia Promoting Productive Employment, 2012 "; World Bank Business Environment and McKinsey & Company | 34 Enterprise Performance Survey (BEEPS), 2008 Armenia still ranks low on important Top 20th percentile (best) 60th-80th percentile 20th-40th percentile Lowest 20th percentile (worst) social indicators 40th-60th percentile Detailed on next pages

2013 1 Indicator Country ranking 1 Emigration rate -5.9/1,000 197 out of 228 Overall Population growth rate -0.1% 209 out of 228

2 Unemployment rate 18.5% 188 out of 206 Self- sufficiency Youth unemployment 33.1% 182 out of 206

Income inequality (Gini) 30.9 27 out of 141 Equity and 3 Poverty 35.8% 2 n/a health Life expectancy 74 116 out of 228

Judicial independence n/a 108 out of 142 Social Cohesion 4 Size of shadow economy 40% 124 out of 162

1 2008 data for GINI 2 Share of population below poverty line

SOURCE: World Bank, CIA World Factbook, Transparency International; Armbanks: "Armenian shadow economy share is McKinsey & Company | 35 35-40 percent", 19.06.2010 1 The relatively strong economic growth over the last years could not reduce the constantly high emigration rate in Armenia Net migration rate per 1,000 population, Republic of Armenia

-3.5 -3.4 -4.2 -4.2 -5.3 -5.0 -5.9 -6.5

2000 2002 2004 2006 2008 2010 2012 2014

Source: CIA World Factbook McKinsey & Company | 36 2 Armenia's growth has been driven by productivity gains only, while the economy failed to create new jobs Detailed on next slides Employees per capita Percent

0.6 +1% p.a. 0% p.a. 0.4 GDP PPP per capita USD thousands 1 0.2 +5% p.a. 0 8 +8% p.a. 200204 06 08 10 2013 6 4 Productivity GDP PPP per employee, USD thousands p.a. 1 2 0 +5% p.a. +7% p.a. 2002 0406 08 10 2013 20 15 10 5 0 2002 04 0608 10 2013 1 Constant 2010 USD

SOURCE: Global Insight McKinsey & Company | 37 2002 XX <-3% 2 While decreasing, Armenia still has the largest XX -3%-0% 2013 unemployment rate in the region XX >0%

Total unemployment, percent of total labor force CAGR, 2002-13

5.6 -0.3% Azerbaijan 5.4 6.8 Moldova 5.6 -1.7% 7.9 Russia 5.5 -3.2% 9.3 Kazakhstan -5.0% Decrease in 5.3 unemployment 9.6 Ukraine -2.0% rate higher than 7.7 increase in 10.2 Belarus -0.5% employees/capita 9.7 as <____> capital 12.5 Kyrgyzstan -3.5% also factor 8.4 economically 11.3 Uzbekistan 0.0% active population 11.3 and labor 11.6 participation in Turkmenistan 11.3 -0.2% (both stable over 11.8 last decade) Tajikistan 11.5 -0.2% 12.6 Georgia 15.0 1.6% 27.8 Armenia 18.5 -3.6% 11.4 CIS average 9.6 -1.6%

SOURCE: World Bank McKinsey & Company | 38 3 In Armenia, every third person is poor and poverty even increased over the last years Percent of total population ▪ In 2012, almost every third 15% person in Armenia was poor 20% ▪ From 2008 to 2012 35.0 – Poverty in Armenia 32.4 increased by 20% – Extreme poverty 27.6 increased by 15% 16.3 ▪ Increases are due to the Very poor/ 23.6 14.2 financial crisis whose effects extremely poor 1 could not be compensated by the economic growth over the last years 2 16.1 Extreme poverty could be Poor 13.4 11.4 ▪ reduced in recent years , leading to a brighter outlook for the years ahead 2008 2011 2012

1 Very poor: Consumption per adult below the lower poverty line of AMD 24,400 in 2008 and 30,500 in 2012 Extremely poor: Consumption per adult below the food poverty line of AMD 17,600 in 2008 and 21,700 in 2012 2 Consumption per adult below the upper poverty line of AMD 29,900 in 2008 and 37,000 in 2012, but above the lower poverty line

Source: Armstat: social snapshot and poverty in Armenia, 26.11.2013 McKinsey & Company | 39 4 Armenia with a high share of informal economy – in line with the trend in the region ESTIMATES Size of informal economy Percent of official GDP, 2007 1

Georgia 62 ▪ Armenia could reduce the size of its shadow Azerbaijan 52 economy over time (from ~46% in 2000), Ukraine 47 however still ranks 124 out of 162 Belarus 43 countries today ▪ As per Aristomene Armenia 41 Varoudakis, Head of World Bank’s Yerevan Tajikistan 41 office, Armenia's informal economy in Russia 41 2010 stood at 35-40%

Kyrgyzstan 39

Kazakhstan 38

1 Latest year available

SOURCE: Friedrich Schneider: “Shadow economies all over the world”, 2010; Armbanks: "Armenian shadow economy McKinsey & Company | 40 share is 35-40 percent", 19.06.2010 Contents

McKinsey & Company | 41 Armenia's growth exceeded the Singapore scenario developed during Armenia2020 X% CAGR, 2002-13; GDP PPP per capita, constant 2010 USD Armenia 2002-09 and 2009-13

13,000 Armenia Very high growth: Singapore 6.1% model of early 11,000 acceleration 6.6% ▪ Armenia with strong 5.1% growth 9,000 Robust growth: Ireland model of 4.5% before the gradual acceleration crisis, exceeding 7.7% 7,000 Singapore Slow growth: Israel scenario model of fluctuating 2.6% ▪ Growth performance rates since 5,000 No growth: 2009 Paraguay model 0.1% between of 2 lost decades Singapore 3,000 and Ireland scenario 2,000

1,000 See backup for explanation of differences in Armenia's 0 performance between this chart and chart in "Armenia & Armenian 1990 94 98 2002 06 10 14 18 2022 World" presentation of Oct 2014

SOURCE: Global Insight; Armenia2020 McKinsey & Company | 42 However, Armenia reached its strong growth not by following the Singapore model – instead, it integrated more and more with Russia

Syrian – 30 years 1 Russian: From with the right of Russia with love correspondence

Not relevant 2013 any more given recent developments in Syria 2002

2 European: Coming 3 Singapore: Dare home Armenia and to excel from European Union survival to revival

McKinsey & Company | 43 Armenia2020 – scenarios 4 development scenarios for Armenia

Syrian: 30 years with the right of correspondence 1 Russian: From Russia with love

Dominant role of a centralized state and a strong army. Russia extends its political and economic influence in the In an underdeveloped rule-of-law state, much of the post-Soviet space and becomes a guarantor of stability and economy goes into the informal sector, controlled by security in various regional conflicts. Armenia will develop strong "clans". The cheap manpower and dirigiste economically due to its highly skilled manpower, invest- measures can ensure short-term growth. This, however, ment in education and scientific research , and extensive will be followed by stagnation due to regional isolation support from the diaspora . However, this growth will not be and the lack of investment needed for the reproduction of consistent because Armenia will be affected by the chronic human and technological capital hostility of its neighbors, a low level of regional integration , active emigration , and Armenia's high transaction costs which affect the final price of its products

2 European: Coming home Armenia and 3 Singapore: Dare to excel. From survival to revival European Union Armenia, together with Azerbaijan and Georgia, meet the Armenia is rapidly transitioning to an innovation development criteria for joining the EU (depending upon its economic model through the application of the latest technologies in all situation, level of democracy and a rule-of-law state). spheres of life. This model boosts economic development due Armenia's accession to this larger and more developed to cheap manpower, large investments in education and economic space brings stable growth . In order to meet the infrastructure, as well as oconsistent liberalization of the integration requirements, Armenia liberalized its economy. It also depends upon the leading role of a centralized economy , which accelerated its development given its state, extensive transit trade, and more attention to critical relatively cheap yet productive source of manpower . stages in production The adoption of European standards strengthened democracy and civil society , as well as boosted investment in science and education

Note: Syrian scenario analysis in backup

McKinsey & Company | 44 1 Russian: From Russia with love Not realized Fully realized in Armenia in Armenia Elements of scenario Assessment for Armenia Evidence ▪ Use of Russian language ▪ Armenian is the official language ▪ Widespread knowledge of Russian and spoken as by majority language in Armenia ▪ Russian is still by far the best – 24% advanced known foreign language – 59% intermediate – 11% beginner ▪ Debt settlement with Russia ▪ Debt settlement in assets mainly ▪ 2002: debt settlement of USD 100 million in assets through transfer of energy (incl. Hrazdan thermal power plant) companies/plants in 2002 to ▪ 2014: debt settlement of USD 155 million 2014 (ArmRosgazprom) ▪ Investments in Armenia by ▪ While FDI decreased after the ▪ Today, >50% of FDI stock held by Russian diaspora living in Russia financial crisis, share of Russian investors FDI constantly increasing ▪ Establishment of a macroregional ▪ Creation of Eurasian Economic ▪ Detailed on next page market on post-Soviet territory Union as of 2015 ▪ High dependence on Russian ▪ Armenia highly dependent on ▪ Gas: domestic consumption needs 100% energy sources Russia and dependence likely to fulfilled with Russian gas further increase ▪ Oil: Russian share 30%, but likely to increase due to new cooperation agreement allowing duty-free exports of oil, gas, and diamonds from Russia to Armenia ▪ Armenia as Russia's offshore ▪ Armenian stock market growing, ▪ Stocks traded <1% of GDP (2013 USD 45 banking zone but still insignificant for region million, 14 companies traded) – Highly improved investment ▪ Armenia's rank for financial market attractiveness development – Largest financial and stock – 2003: 102th out of countries market in the Middle East – 2013: 97th out of 144 countries

1 E.g., natural, technologic, social emergencies, and terrorist attacks SOURCE: Armenia2020 Scenarios Book; Bayramov, V., Giragosian, R. ,Lukyanov, F., Kempe, I., Valiyev, A., Yakobashvili, The South Caucasus between the EU and the Eurasian Union”; Center for Security Studies, Zurich 2013; WEF Global McKinsey & Company | 45 Competitiveness Report; UN Comtrade; UNCTAD 1 The Eurasian Economic Union will create a single economic market on post-Soviet territory

▪ Internal market: development of a single market with the “4 freedoms: free movements of goods, capital, services, and people

▪ Competition: equal competitive conditions in the commodity markets of the Single Economic Space; harmonization and improvement of legislation in regard to competition policy

▪ Monetary Union: closer coordination of economic and monetary policy, incl. the potential use of a common currency in the future (5- 10 years)

▪ Energy: creation of a single energy market

▪ Sky: the Single Eurasian Sky program, outlines the creation of a single market for air services and a single air traffic zone

▪ Agriculture: coordination of agricultural policymaking between member states and ensuring collective food security

SOURCE: Press search McKinsey & Company | 46 2 European: Coming home Armenia and the Not realized Fully realized in Armenia in Armenia European Union

Elements of scenario Assessment for Armenia Evidence Renewed surge in diaspora commitment in Decline in FDI over time FDI business investments ▪ 2003: 4.3% of GDP ▪ 2013: 3.5% of GDP Opening of formal negotiations with EU Before, its decision to join the 2004: Armenia as part of EU's European Eurasian Economic Union, neighborhood policy Armenia took several important 2009: Armenia enters EU's Eastern steps leading to stronger ties partnership with the EU 2010: Armenia and EU start negotiating on Association Agreement, which might include free trade Most young adults speak 3 languages While the popularity of English is Second language growing, it is still far behind Russian Other 53% Russian 4% English

Time Legislative changes enacted to achieve EU Rule of law 2003 and 2013: Armenia 50th compliance percentile (the lower, the better) Regulatory quality 2003 and 2013: Armenia While reforms have been in 40th percentile Corruption declines, but bureaucracy increases implemented, Armenia Control of corruption 2003 and 2013: Arme- struggles to improve nia in 60th percentile Government effectiveness Armenia improved from 2003 (50th percentile) to 2013 (40th percentile) Several Armenia companies succeed to enter No Armenian company as global No Armenian company within top 20 of its the top 3 of their sector globally leading player sector (in terms of revenues) Armenia joins EU, Euro adopted as currency Armenia decided to join the n/a Eurasian Economic Union as of January 2015; Association Agreement with EU put on hold

SOURCE: 2011 Armenia census; WEF Global Competitiveness Report; World Bank Worldwide Governance Indicators; McKinsey & Company | 47 Bloomberg 3 Singapore: Dare to excel. From survival to revival Not realized Fully realized in Armenia in Armenia Elements of scenario Assessment for Armenia Evidence ▪ Economic development as most ▪ While economic development is an ▪ N/A prominent national agenda item and important topic, it is not no.1 priority institutionalized at all levels of ▪ Institutions such as NCFA and ADA 1 government; institutions created to have been created, but with mixed support economic development impact and success ▪ Focus on transparency (tax, ▪ While reform have been implemented, ▪ Rule of law 2003 and 2013: Armenia 50th percentile legislative, and judicial process) Armenia still struggles to improve (the lower, the better) ▪ Regulatory quality 2003 and 2013: Armenia in 40th percentile ▪ Control of corruption 2003 and 2013: Armenia in 60th percentile ▪ Government one of most attractive, ▪ Government not known to attract high ▪ Monthly base salary of government employees smallest, and most effective potentials USD 160 vs. USD 330 in public sector employees ▪ According to the World Bank, application statistics share low level of interest in public sector jobs ▪ Dozens of specialized export- ▪ While a few number of free zones exist, ▪ 70% of exports from low value-add products , oriented industry clusters (e.g., IT, no cluster development metals and ore, diamonds, alcoholic beverages tourism, jewelry) with active ▪ Export heavily dependent on low value- ▪ Goods export increased, but still relatively low multinational companies add products/natural resources – 2003: XX % of GDP – 2013: 14.4% of GDP ▪ Sharp increase in FDI ▪ Increase until 2008, but constant ▪ FDI net inflows as percentage of GDP decrease over last years. However, – 2002: 4.7% Armenia ranks high compared to its – 2008: 8.1% regional peers – 2013: 3.3% ▪ Armenia ranks 3 out of 8 CIS countries in terms of FDI stock as percentage of GDP ▪ Highly educated, trilingual workforce ▪ Armenia ranks constantly low on quality ▪ Quality of primary education of education – 2006: 85th out of 144 countries ▪ Widespread knowledge of Russian as – 2014: 83rd out of 144 countries second language, however, only 4% ▪ Quality of higher education with advanced proficiency of English – 2006: 68th out of 144 countries – 2014: 86th out of 144 countries 1 Armenian Development Agency SOURCE: World Bank Public Expenditure Review of Armenia, May 2014; WEF Global Competitiveness Report; World McKinsey & Company | 48 Bank Worldwide Governance Indicators; UNCTAD bilateral FDI statistics; ICT; 2011 Armenian census Contents

▪ Snapshot of the Armenian economy today and its development over the last 10 years ▪ Armenia's development in context of Armenia2020's models of growth ▪ Sector deep dives – actual development vs. potential – Tourism – Healthcare – IT – Banking ▪ Emerging new models of growth ▪ Armenia's way forward

McKinsey & Company | 49 Key sectors, detailed on Many sectors did not exploit their productivity and next slides Growth potential 2003-10 employment growth potential identified in Armenia2020 Actual growth 2003-10 Productivity and growth potential for key sectors identified in Actual growth of these sectors 1 between Armenia2020 (as of 2003) 2003 and 2010

Low Low (0-5% (0-5% CAGR) CAGR) 5 16 Negative Low High Negative Low High (-5-0% CAGR) (0-5% CAGR) (5-10% CAGR) (-5-0% CAGR) (0-5% CAGR) (5-10% CAGR)

Sector employment growth Sector employment growth

1 Mining 5 Construction 9 Industrial machinery 13 Retail and wholesale

2 Metals 6 Banking and insurance 10 Electronics and precision 14 Jewelry and diamonds

3 Telecommunications 7 Food processing 11 Construction materials 15 Transportation

4 Tourism and restaurants 8 Textiles and apparel 12 Healthcare 16 Software and IT services

1 Showing sectors for which 2010 data is available

SOURCE: World Bank; UNDP; NSSRA; World Travel & Tourism Council (WTTC); USAID; Enterprise Incubator McKinsey & Company | 50 Foundation 2003 Among the growth drivers identified in Armenia2020, the 2010 potential banking and tourism sectors have gained the most 2010 actual GDP contribution Employment Constant 2005 USD millions Thousands 125 25 2 ▪ Banking sector has Tourism and strong GDP growth of restaurants 1 192 58 3 19% p.a., driven by 291 20 – Productivity growth of 7% p.a. 56 5 – Employment growth Banking of >10% p.a. 110 10 216 12 ▪ Tourism sector has strong GDP growth of 55 49 10% p.a., driven by increased productivity Healthcare 2 173 40 ▪ All other sectors 78 46 performed below their potential in terms of 53 3 productivity and Software and employment IT services 159 6 85 5

1 2008 data 2 Changed compared to original analysis in Armenia2020 3 Estimate, based on revised actual employment 2003

SOURCE: World Bank; UNDP; NSSRA; (WTTC); USAID; Enterprise Incubator Foundation McKinsey & Company | 51 Contents

▪ Snapshot of the Armenian economy today and its development over the last 10 years ▪ Armenia's development in context of Armenia2020's models of growth ▪ Sector deep dives – actual development vs. potential – Tourism – Healthcare – IT – Banking ▪ Emerging new models of growth ▪ Armenia's way forward

McKinsey & Company | 52 The tourism sector has strongly grown over the last decade and has continuously improved its competitiveness Percent x of GDP The number of international tourists visiting … and recent improvements in Armenia has continuously increased … the sector's competitiveness Thousands could facilitate further growth ▪ Tourism is an important and Overall rank fast-growing in travel and 13991 79 1 sector tourism com- 5% of GDP in petitiveness (Worst) (Best) – 901 2013 843 +17% p.a. ▪ Tourism 58 51 – 10% CAGR regulatory 684 from 2002 to framework 2013 558 ▪ Tourism ▪ Government business actively supports 100 88 382 environ- the growth of the ment and sector through 263 infrastruc- policy changes, 162 ture infrastructure ▪ Human, improvements, cultural, 104 94 and collabo- and natural ration with the 2002 04 06 08 10 12 2013 1 resources private sector 3.4 5.3 4.8 3.2 4.9 4.9 5.0

1 Estimated based on IATA passenger growth

SOURCE: World Bank; WEF McKinsey & Company | 53 Tourism in Georgia shows that there is significant further growth potential for the tourism sector

International tourist arrivals Income per capita Visits per capita from international tourism, USD ▪ The government of 100 Armenia Georgia Georgia successfully supported the tou- 90 348 rism sector, e.g., by Georgia 80 – Opening the aviation sector 70 and attracting Georgian government foreign airlines 60 actively promotes the – Internationally country as a tourist +34% promoting 50 p.a. destination 164 Georgia as a 40 tourist Georgia opens destination 30 aviation sector ▪ Armenia could

20 Armenia increase its visitor +18% numbers to ~3 33 10 p.a. 26 million by closing the gap to Georgia 0 2002 03 04 05 06 07 08 09 10 11 2012 2002 2012

SOURCE: World Bank McKinsey & Company | 54 The Armenian government considers tourism a key sector 2013 Goal 2020 Detailed for the economy and actively supports its development next slide Goal 2030

In 2008, the Armenian government defined a tourism strategy with ambitious goals … which should be achieved by addressing several areas Description Examples 0.9 International tourist Promote Armenia ▪ Country branding strategy as a tourist destination arrivals 1.5 ▪ “Armenia, the Land of Noah”: Millions documentary on CNN 3.0 Improve accessibility and ▪ Simplified visa requirements transportation ▪ Introduction of Open Skies

n/a Improve infrastructure ▪ Armenian monument awareness Tourism income, 2007 1.4 project: development of tourism USD millions sites 3.0 ▪ Construction of roads and infrastructure, e.g., to Tatev

Improve workforce skills ▪ Partnership with World Federation 12 of Tourist Guide Association to Accommodation establish training center capacity 49 Thousand beds Improve business and ▪ Support of PPPs and private 51 investment environment sector engagement ▪ Improvement of regulations, such as taxation reductions

SOURCE: Government of America; USAID; World Bank; Ameria Group; press search McKinsey & Company | 55 A country branding strategy has been defined and is implemented together with private investors and development agencies

Goal: Increase the percentage of the most profitable segment – leisure tourism – from 15% to 35% by 2017

Example: NCFA actively promotes Armenia Branding strategy has 3 objectives as a tourist destination Update tourism product and improve ▪ Air France featured Armenia in its inflight user experience magazine ▪ Focus marketing on high-quality providers ▪ Improve workforce skills

Increase awareness in source markets ▪ Promote Armenia as a yet-to-be- discovered destination

Penetrate special-interest sales ▪ Participation at international travel fairs channels ▪ Focus sales activities on special- interest tour packages

SOURCE: NCFA; USAID McKinsey & Company | 56 The introduction of Open Skies in October 2013 sparked significant growth in passenger arrivals to the country Number of passengers Percentage increase, 2013-14 43 ▪ In October 2013, the Government of Armenia announced the 37 35 liberalization of the 34 aviation sector (Open Skies) to enable – Reduction of air ticket fares – Increased number of routes to/from 19 Armenia 17 15 – Increased frequency of flights 10 ▪ Overall goal was the connectivity and accessibility of Armenia for tourists and Armenians

JanFeb Mar Apr May Jun Jul Aug

SOURCE: Zvartnots Airport McKinsey & Company | 57 Lighthouse projects by private investors develop the tourism infrastructure and build Armenia's reputation as a tourist destination

Example projects Description Status Size Zvartnots ▪ New, ultra-modern airport, modeled New terminal Total International after Munich airport opened in investment: airport ▪ Named the Best Emerging Airport of 2006/2007 USD 100 Russia, CIS & Baltic States in 2012 million

Tatev ▪ Access to Tatev monastery by cable car Cable car in Total planned ▪ World's largest cable car operation investment: ▪ Attracting >75,000 visitors per year USD 80 million

Tufenkian ▪ The region’s first luxury boutique hotel 4 hotels in n/a hotel chain chain (Dilijan, Dzoraget, Tsapatagh, operation (Yerevan, Yerevan) with an ethnic theme Dilijan, Dzoraget, ▪ Business model focused on job creation Tsapatagh) in the regions Two Hyatt ▪ Hyatt Place – the second internationally Yerevan opened in Total planned Place hotels managed hotel in Yereven 1 – opened in January 2014; investment: Yerevan Jermuk to open in USD 15 million ▪ Second Hyatt Place will be situated in 2015 Jermuk mountain resort, a resort currenctly being developed by the Armenian government

1 After the Marriott hotel

SOURCE: Armenian Development Agency; Ministry of Economy; Web search; IDeA foundation McKinsey & Company | 58 Contents

▪ Snapshot of the Armenian economy today and its development over the last 10 years ▪ Armenia's development in context of Armenia2020's models of growth ▪ Sector deep dives – actual development vs. potential – Tourism – Healthcare – IT – Banking ▪ Emerging new models of growth ▪ Armenia's way forward

McKinsey & Company | 59 The Armenian healthcare system lacks quality and availability, Private caused by inadequate regulation and insufficient spending Public Spend in healthcare sector, percent of GDP

… and is now 1▪ Health provision Overall spend relative to the GDP has declined in below the CIS ▪ Despite several reforms by Armenia mainly due to reduced private spending … average the government, the quality and availability of healthcare provision has not improved 5.6 5.7 ▪ Financial austerity 5.4 5.5 -0.9% 5.3 prevents the government from increasing health 4.6 4.5 4.6 4.5 expenses 4.3 2.5 ▪ Limited (public and private) 3.8 3.7 insurance leads to high 4.0 3.3 private expenses and high 4.0 4.1 2.5 2.2 2.5 2.6 2.6 share of informal payments 2.0 1.8 2▪ Pharma market ▪ ~20% of the total spend on healthcare, with an expected 3.2 market growth of ~5% 2.1 1.9 2.1 1.8 2.0 1.9 1.9 1.9 ▪ While dominated by foreign 1.4 1.5 1.4 companies, successful Armenian companies are emerging 2002 03 04 05 06 07 08 09 10 11 2012 2011

SOURCE: WHO McKinsey & Company | 60 1 Government reforms have hardly improved the healthcare

provision in Armenia Detailed next slides

Recent government reforms … did not improve the overall Issues in Armenia's healthcare (examples) healthcare provision system

▪ 2006 – improving access to Rank in HDI 1 Health Index out of ▪ Low availability of primary care services and 199 countries healthcare extending basic benefits package ▪ Lack of health insurance ▪ 2008 – obstetric care state Worst system and large informal certificate program to improve payments mother and child health and reduce informal payments ▪ Low quality of services, 76 73 particularly in rural areas ▪ 2010-12 – introduction of co- 71 71 payments to reduce informal payments ▪ 2011 – extension of obstetric cure program to children ▪ 2012 – social package for civil servants, incl. support for Best additional health insurance 2000 05 10 2013

1 Human development indicator

SOURCE: WHO; UNDP McKinsey & Company | 61 1 Armenia has one of the lowest availabilities of healthcare Physicians in the region Nurses The number of health worker shas further decreased… Workers per 100,000 inhabitants Key developments 1,190 ▪ Doctors are not well paid: average salary of USD 88 per month 1 is not 840 380 887 721 777 sufficient to support a household 278 269 Particularly in rural regions, Armenia 258 285 ▪ 810 lacks doctors and nurses 562 463 492 618 ▪ Availability of physicians and adequate 2000 05 2011 2011 2011 medical facilities Armenia CIS avg. EU avg. is slowly improving, but … as well as the number of hospital beds remains on a low Beds per 100,000 inhabitants Key developments level ▪ Many former Soviet hospitals closed, ▪ Efficiency of 807 which often lacked even basic healthcare equipment provision has increased in 419 408 ▪ Today, Armenia's hospital capacity is 340 below the CIS or EU averages recent years 213 ▪ Reduction of hospitals and training of local administrative skills have improved hospital efficiencies; occupancy rate 2000 05 2011 2011 2011 increased from 32 to 61% ▪ In recent years, 2-3 modern hospitals Armenia CIS avg. EU avg. open each year

1 ASOL 2011

SOURCE: WHO; expert interviews McKinsey & Company | 62 1 Low salaries of healthcare workers and very limited insurance lead to high private health expenses with large informal payments Share of health expenses, 2011

Nonprofit ▪ Voluntary health Voluntary health institutions insurance basically insurance Other not existing 4 2 ▪ In 2002, govern- 0 ment introduced ▪ Little insurance vouchers for state coverage limits access sector employees to healthcare, 36 particularly for the poor to offer additional Private insurance; small 57 (out-of-pocket) ▪ Large share of informal effect expected payments due to Government limited insurance and low salaries of healthcare workers ▪ >50% of the population consider the Basic benefits package (BBP) ▪ ~45% of out-of-pocket healthcare sector the spending is informal 1 ▪ Providing free-of-charge, but limited primary most corrupt sector in care services for entire population ▪ Remaining spend is for Armenia ▪ Socially vulnerable groups (~18% of the popu- – Services not covered by lation) receive all health services free of charge BBP, such as dentists, ▪ Recent introduction of co-payment fees to medication, hospital care reduce informal flows – Co-payments within BBP

1 As of 2008

SOURCE: WHO; Policy Forum Armenia McKinsey & Company | 63 2 The Armenian pharma market is expected to grow by ~5% p.a., with Armenian companies increasing their market shares

Armenia pharma market forecast, 2012 CAGR Sales, USD millions 1 Percent 2011-13 2013-18 ▪ Pharma market is +5% p.a. 160 152 expected to grow by 145 138 ~5% p.a. until 2018 132 126 ▪ Today, the market is 119 113 dominated by foreign companies, with a market share of ~90% 139 128 134 5 3-5 ▪ Armenian companies 118 123 Foreign 113 with above-average 103 108 companies growth of ~10-15% p.a., driven by – Lower prices Local – Increasing companies 17 18 21 10 10-15 10 11 13 14 15 acceptance of products 2011 12 13 14 15 16 17 2018 – New product Market share launches (3-4 p.a.) of Armenian 9 9 10 10 11 11 12 13 companies Percent

1 Exclude wholesalers

SOURCE: Company interviews McKinsey & Company | 64 2 The market is dominated by retail out-of-pocket sales, as government expenses are limited to medication used in hospitals

Armenia market structure, 2012 Percent Description 100% = USD 119 million ▪ Purchasing policy set by Ministry of Health Government and implemented by hospitals through tenders, leading to challenging pricing ▪ GlaxoSmithKline is market leader together with local partner PharmaTek; Roche is a close second ~30%

▪ Primarily branded generics sold through pharmacy chains ~70% ▪ Local Armenian companies typically focus on lower-priced branded generics in higher- volume categories, e.g., anti-infectives and pain relievers Private ▪ Takeda is market leader; Sanofi recently entered with focus on OTC products

SOURCE: Market interviews McKinsey & Company | 65 Contents

▪ Snapshot of the Armenian economy today and its development over the last 10 years ▪ Armenia's development in context of Armenia2020's models of growth ▪ Sector deep dives – actual development vs. potential – Tourism – Healthcare – IT – Banking ▪ Emerging new models of growth ▪ Armenia's way forward

McKinsey & Company | 66 The information and telecommunications (ICT) sector has shown double- digit growth in recent years, mainly driven by the IT industry

Telecommunications and IT Industry turnover has increased in recent years saw different developments Constant 2010 USD, PPP, thousands have developed differently CAGR 1▪ Telecommunications – Growth of ~10% p.a. since 2010 21% p.a. 560 – Liberalization of market in 518 2004 triggered strong growth 375 310 10% 319 304 – Market saturation in recent years Telecom- 250 224 munications 2▪ Software and IT services 250 37% 214 – Strong growth of ~35% IT 95 125 p.a. since 2010 2010 11 12 2013 – Improved telecommuni- cation infrastructure and government support fueled GDP 5.4 6.1 7.8 8.1 growth and attracted contribution investors Percent

SOURCE: Business Monitor International; BuddeComm; World Bank; Global Insight; EIF; USAID McKinsey & Company | 67 Armenia's ICT competitiveness has improved significantly and the country is now considered a “rising star” Armenia CIS Network Readiness Index 2014 Lower-middle income group average

Armenia ranks higher than its peer group in all categories of the ▪ Armenia's ICT competitive- Network Readiness Index ness has improved significantly over the last years 1. Political and regulatory – Armenia now ranks 65 out environment of 144 countries (2008: 114) 7 2. Business – Considered “ rising star” by 10. Social 6 and innovation WEF impact 5 environment ▪ Armenia ranks particularly high 4 in 3. – Workforce skills 9. Economic 3 Infrastructure impact 2 and digital – Telecommunications 1 content infrastructure 0 – Ease to start new businesses 8. ▪ However, the competitiveness Government 4. Affordability remains constrained by usage – Low judicial independence – Difficulty to enforce 7. Business 5. Skills contracts usage – Low quality and availabil- 6. Individual ity of staff training and usage management schools

SOURCE: WEF McKinsey & Company | 68 1 Liberalization of the telecommunications market sparked Mobile strong growth and made services more affordable Fixed line Millions of subscribers

Both mobile and fixed-line subscribers increased with the liberalization of the market

Orange enters mobile market ▪ Liberalization of the telecommunications ArmenTel's ArmenTel reaches market fueled growth monopoly on Russian operator 100% digitalization and improved Armenia’s fixed-line ends VimpelCom acquires of fixed-line services connectivity of Armenia’s 5.1 ArmenTel UCOM enters 4.8 – Mobile phone fixed-line 4.5 penetration reached VivaCell enters market 100% in 2008 mobile market – Between 2009 and 2011, cost of Government 3.3 3.3 Internet decreased ends ArmenTel's 3.0 by ~80%, cost of exclusive rights 2.6 mobile services by for mobile ~50% services 1.5 ▪ Mobile services now is a 1.2 highly competitive 0.9 1 0.7 market ▪ Fixed-line services are still dominated by former monopolist 2 2003 04 05 06 07 08 09 10 11 12 2013

1 Market shares as of 2013: K-Telecom: 64%, ArmenTel (Beeline): 20%, Orange Armenia: 16% 2 Market shares as of 2013: ArmenTel: 74%, UCOM: 24%

SOURCE: Business Monitor International; BuddeComm; World Bank; Global Insight; EIF; USAID McKinsey & Company | 69 1 Future growth will be driven by growing broadband Internet use,

while the mobile market is relatively saturated xxx Subscribers per 100 capita

Mobile services with little growth Fixed-line services with strong growth in broadband segment

Mobile phone subscribers, millions Subscribers, millions Broadband Internet Telephone CAGR CAGR

3.5 3.5 1,61 3.3 3.4 3.4 3.4 3.4 3.5 1,50 1,55 1,59 1,38 1,44 1,27 1% 1,03 13%

2011 12 13 14f15f 16f 17f2018f 2011 12 13 14f 15f 16f 17f 2018f

111 115 115 115 115 116 116 116 14 23 27 29 31 33 33 35 20 20 20 20 20 20 20 20 ▪ Mobile services generate ~70% of the total sector ▪ Fixed-line services account for ~30% of the total sector revenues today revenues in 2013 ▪ Saturation of the mobile phone market is expected to ▪ Use of mobile phone services and remaining limit future growth monopolistic status of ArmenTel prevent growth of telephone subscriptions ▪ Strong growth of broadband services expected due to low saturation and UCOM’s recent network extensions

SOURCE: Business Monitor International; BuddeComm; World Bank; Global Insight; EIF; USAID McKinsey & Company | 70 2 The number of foreign and local companies in the IT sector increased, creating jobs for a highly skilled workforce

The increasing number of IT companies in … creates jobs for a Armenia … highly skilled workforce ▪ IT is a key sector for the Number of companies Thousands Armenian economic development due to its 8 strong growth and by providing jobs for highly 400 skilled employees 350 +15% p.a. Availability of talent and 300 ▪ a low cost base make 250 Armenia a possible 200 3 outsourcing destination for 150 programming and IT 100 services 50 ▪ However, even stronger 0 growth is hindered by 2002 03 04 05 06 07 08 09 10 11 12 2013 2003 2013 several factors – Supply of highly skilled ▪ Success of early movers like Synopsys ▪ >60% of the workforce IT graduates encouraged other investors have a master’s degree – Access to financing ▪ ~60% of revenues generated by foreign ▪ The salary in the IT companies sector is ~5 times higher – Access to interna- than the average salary tional markets

SOURCE: EIF; USAID; World Bank McKinsey & Company | 71 2 The government actively promotes the development of the IT sector, supported by development agencies and the private sector

Example interventions Enterprise incubator foundation ▪ Established 2002 with support of the World Bank ▪ Goal is to support the IT sector development, e.g., – By attracting foreign investors and channeling investments Focus areas of the IT industry – By supporting start-ups with training and financially development strategy of the Armenian – Through IT consulting government – Through workforce development ▪ Partners (examples): ▪ Building competitive ICT infrastructure ▪ Improving quality of IT graduates ▪ Providing financing mechanisms for SUN educational laboratories start-ups ▪ Attracting foreign companies ▪ Goal is to prepare skilled graduates for the IT industry ▪ Making the Armenian IT sector visible ▪ Establishment of educational and research facilities at on the global market Armenian universities and research centers ▪ Training of ~200 students between 2008 and 2009; all graduates found jobs within 3 months after program completion ▪ Partner universities (examples):

SOURCE: Government of America; USAID; EIF McKinsey & Company | 72 2 Armenian success stories show that the IT sector moves from outsourcing services to local product development companies

US-based Synopsys establishes R&D Startup PicsArt is launched in Yerevan 2004:capabilities in Armenia 2011: ▪ Synopsys is a world leader in semiconductor ▪ PicsArt is a mobile photo app combined with a design software with a revenue of ~USD 2 billion social network ▪ Synopsys selected Armenia for its major ▪ The company's main office is based in Yerevan offshore development office because of and has ~25 employees; an office in California – Low cost base has 6 employees – Government support of IT sector ▪ The numbers of users has increased significantly – Availability of skilled engineers and software and surpassed Instagram on iPhones in 2014 developers PicsArt’s user base is quickly expanding ▪ Today, Synopsys is the biggest IT company in Number of installations, millions Armenia, with ~600 employees ▪ Synopsys partners with Armenian universities 228 179 to develop highly skilled graduates, supporting >60 professors and >600 students 100 63 18 39

Jun/ Dec/ Jun/ Dec/ Jun/ Nov/ Further regional hubs and R&D 2012 2012 2013 2013 2014 2014 centers by Microsoft, VMWare, Samsung, National instruments

SOURCE: Organization's Web sites; EIF; USAID; Androidrank.org McKinsey & Company | 73 Contents

▪ Snapshot of the Armenian economy today and its development over the last 10 years ▪ Armenia's development in context of Armenia2020's models of growth ▪ Sector deep dives – actual development vs. potential – Tourism – Healthcare – IT – Banking ▪ Emerging new models of growth ▪ Armenia's way forward

McKinsey & Company | 74 The Armenian banking system has shown an impressive growth over the last decade

Domestic credit to ▪ Armenia's banking system has grown private sector Soundness of bank rapidly over the last decade and is GDP per capita, PPP 1 Percent of GDP indicators (out of 144) sound – ahead most of its CIS peers (see next slide) 373 44 95 ▪ Growth has been driven by well-func- tioning and supportive Central Bank ▪ Well-resourced and skilled CBA – the -44 ranks (the lower independent body regulating the the banking sector better) ▪ Additionally, several legislative initiatives mark the possibility of +18% p.a. +18% p.a. significant change in other sectors of the financial market 51 – Introduction of obligatory car insurance (2011) – Insurance law reforms to bring legislation close to European standards and attract international brands (ongoing) – Mandatory medical insurance (to 7 59 come) – Pension law with a mandatory component for public sector employees and shift from pay-as- you-go to multipillar pension 2002 2013 2002 2013 2002 2013 system (2014) 1 Constant 2010 USD

SOURCE: World Bank; statistical yearbook of Armenia McKinsey & Company | 75 Today, Armenia compares favorably to its peers in terms of size and health of its banking system Domestic credit to private sector, 2013 Soundness of bank indicators, 2013 Percent of GDP Rank out of 144 (the lower the better)

Ukraine 59 Armenia 51

Russian Federation 53 Georgia 92

Armenia 44 Tajikistan 100

Moldova 40 Kazakhstan 120

Georgia 40 Kyrgyzstan 131

Kazakhstan 37 Russian Federation 132

Azerbaijan 25 Azerbaijan 133

Belarus 23

Tajikistan 17

SOURCE: World Bank; WEF Global Competitiveness Report McKinsey & Company | 76 Armenia's banking system shows moderate concentration and includes several local and international reputable brands Assets of Armenian banks, AMD 2013, percent

100%=USD 2,941 billion ▪ Armenia's 22 banks 11 account for 92% of financial sector assets 10 ▪ Rest of financial sector is made up of microfinance Other 52 9 institutions (12 players), leasing companies (1 9 major player), non-bank credit institutions 8 1 ▪ Moderate concentration: top 5 players with ~50% ▪ Level of foreign ownership is high: share of foreign Mandate to finance long-term capital: 73% (2007: 38%) investment and infrastructure by leveraging diaspora resources

SOURCE: KPMG: Armenian Banking Sector overview, 2013 McKinsey & Company | 77 While Armenia ranks low on bank-related indicator, it still lacks an equity and risk capital market Detailed on next page Armenia 2014 CIS 2014 Financial Market Development Index 2014 Armenia 2006

Armenia ranks higher than its peer group in all categories of the Stock market capitalization to GDP Network Readiness Index 55 Affordability of Belarus financial services, 50 2 1-7 (best) 45 7 Availability of Russian Federation Legal rights index, 6 financial services, 40 0-10 (best) 1 5 1-7 (best) 2 35 4 Tajikistan 3 30 2 Regulation of Financing 1 25 securities 1 through local 0 exchanges, 1-7 equity market, 20 Moldova (best) 1-7 (best) 15 Ukraine 10 Azerbaijan Kazakhstan Soundness of Ease of access to Georgia banks, 1-7 (best) loans, 1-7 (best) 5 Armenia 0 Venture capital availability, 1-7 0 5 10 15 20 25 30 35 40 45 50 55 (best) Credit to GDP 3

1 2007 data 2 Historical data not available 3 Domestic credit to private sector

SOURCE: World Bank; WEF Global Competitiveness Report McKinsey & Company | 78 While Armenia's banking sector is well developed, other parts of the financial sector are still undeveloped

Private equity and venture capital Stock exchange ▪ 1 local fund: Granatus Ventures Fund I ▪ Stock exchange established in 2000 and acquired by – Fund size: USD 6 million Nordic stock exchange operator NASDAQ – 2 investments in Armenia 1 ▪ Stock market very illiquid with only few equities ▪ 1 International fund: Caucasus Growth Fund trades – Fund size – USD 40 million Tradings 2012 – Investments in Georgia, Armenia, Azerbaijan Corporate – 1 investment in Armenia: New Force, a Equities 70 bonds distribution company 8 Government bonds 22

▪ Very low market capitalization of <1% of GDP

No government support system for private equity Rudimentary state of market due to venture capital; availability of risk capital is minimal ▪ Lack of institutional investors managing long money ▪ Lack of transparency in companies/no sufficient level of corporate governance in order to qualify for stock exchange ▪ Failure to channel privatization through capital markets; many government-owned companies are making losses and are not attractive enough for a successful public placement

1 WiCastr, a wireless mobile engagement platform, SoloLearn, a mobile platform comprising a series of learning apps

SOURCE: EV consulting Armenia, Investment map; European Investment Bank: Armenia: Private Sector Financing and McKinsey & Company | 79 the role of Risk-bearing instruments"2014 Contents

McKinsey & Company | 80 Armenia could follow one of 4 new growth models, which have succeeded in diversifying their growths

Chile – economic Malaysia – export- Morocco – foreign Georgia – business- liberalization oriented manufacturing markets friendly environment

▪ Broad economic libera- ▪ Diversification away from ▪ Increased connection to ▪ Create business-friendly lization (liberalizing trade resource-based towards a foreign markets both as environment in non- and banking sector, manufacturing exports source of FDI and demand business-friendly, but pension privatization, labor economy (manufacturing, tourism) fast-growing area CIS reforms) ▪ Assisted through export ▪ Balance of cross-cutting ▪ Neoliberal approach ▪ Active state support (R&D, processing zones (EPZs), "transversal" reforms focusing on general training, financing, and aggressive courting of (e.g., free trade agree- enablers (e.g., improving marketing) of target FDI and multinational ments) and sector government services, industries corporations (e.g., through development (e.g., Special reducing corruption, ▪ Export drove growth, favorable invest-ment Economic Zones (SEZs), creating low flat tax, especially resource-based climate; investment tax vocational training) liberalizing trade law) rather manufacturing (e.g., food credits) ▪ Specialized policies for than selecting industries and beverages, basic ▪ Significant improve-ments sector development ▪ Improvements in metals) in education helped generally included infrastructure and service ▪ Growth in financial sector provide educated workforce liberalization, infrastruc- levels through as crucial enabler for required ture, and financial privatization and growth in other sectors incentives, e.g., tourism: deregulation most tax subsidies, aid for successful in areas with training and land, and relatively fewer stake- liberalized air transport holders, e.g., finance ▪ Government created vocational training institutes to produce talent for target sectors

SOURCE: McKinsey McKinsey & Company | 81 The 4 new growth models – where Armenia could be in 2030 GDP PPP per capita, constant 2010 USD X% CAGR 1

Armenia 26,000 Georgia: 7.6% 24,000 business-friendly environment 22,000 Malaysia: export-oriented 6.8% 20,000 manufacturing 18,000 Chile: economic 5.9% 16,000 liberalization Morocco: 14,000 foreign 4.9% 12,000 markets

10,000

8,000

6,000

4,000

2,000

0 2005 08 10 12 14 16 18 20 22 24 26 28 2030

1 Georgia: 2000-08; Malaysia: 1975-90; Chile: 1984-90; Morocco: 2000-10

SOURCE: Global Insight McKinsey & Company | 82 The 4 new growth models show a long-term growth, suggesting that ingredients for success can be derived from all 4 growth stories GDP, constant 2005 USD billions CAGR from start of reform to 2013 Malaysia 1975-90 Morocco 2000-10 220 Chile 1984- Georgia 2000-08 Malaysia: 5.6% 90 200 export-oriented manufacturing 180 Chile: economic 5.5% liberalization 160

140

120

100 Morocco: 4.7% 80 foreign markets

40 Georgia: 6.0% 20 business-friendly environment 0 06 08 10 12 13 1975 78 80 82 84 86 88 90 92 94 96 98 2000 01 02 04

SOURCE: World Bank McKinsey & Company | 83 High Country Economic Development strategy heat map – Medium Low overview of new growth models Chile 1984-90 Malaysia 1975-90 Morocco 2000-10 Georgia 2000-08

Level of state intervention in economy Overarching 1 strategy Market for growth Exports Exports Exports/foreign Domestic and trade Funding for growth FDI FDI FDI FDI

Export and do- Manuf., agric., Manuf., esp:.electr.Manuf., agric., Trans., infra., 2 Key industries mestic sectors mining tourism, BPO manuf., energy

Infrastructure (communication, utilities, logistics) Enabling 3 sectors Human capital (health, education) Financial services

Labor markets and property security Enabling Monetary, fiscal policy 4 policies and Promoting innovation, SMEs, or trade institutions Sustainability SEZ Strong system leaders Rigorous self-assessment/diagnostic Prioritization with quick wins Cocreation of implementation plan Implemen- Targets and routines for monitoring 5 tation Delivery unit (new or existing) Build capabilities Change story Finance linked to strategy and performance Private sector involvement

SOURCE: Team analysis McKinsey & Company | 84 OVERVIEW CHILE – GROWTH PERIOD 1984-90 Chile's growth during the 1980s was driven by economic liberalization

1 Overarching strategy 2 Export and domestic sectors 6 Impact/achievements

▪ Broad economic ▪ Exports drove strong growth across all sectors, ▪ Immediate impact on real liberalization (privatization, with strong domestic growth in support economic growth from liberalizing trade and ▪ Biggest growth in natural resource-based 1984-90 banking sectors, pension manufacturing (food and beverages, basic – 5.9% real GDP CAGR privatization, labor reforms) metals), mining (copper), and financial services – Boom in exports: from ▪ Controls on inflows of FDI to 24% of GDP to 34% increase stability 3 Enabling sectors – FDI as percent of GDP doubled on average ▪ Active state support (through Early growth in financial sector was a crucial between 1984 and1990, R&D, training, financing, and ▪ enabler for growth in all other sectors: broader and was 4 times the marketing) of targeted non- and cheaper access to capital Latin American average traditional industries ▪ Set the basis for strong particular success in salmon continued social and and wine, together ~2.5% of 4 Enabling policies and institutions economic growth GDP growth – 6.5% real GDP growth ▪ Copper industry remained throughout the 1990s nationalized to fund state ▪ Liberalization, privatization, political stability (although authoritarian), and close ties to US all – By 2009, eliminated contributed to high levels of FDI USD ~2/day poverty (down from 1/4 of population prior to the 5 Implementation reforms) – Life expectancy at birth ▪ Authoritarian, military government had total control over economy and institutions increased from 69 to 79 during most radical reform periods (Phase I and Phase II) years (largely due to ▪ Cold War politics insured high levels of investment from US and Japan drop in infant mortality) – Increased tertiary ▪ No comprehensive delivery unit, although Fundación Chile established to drive enrollment from 12-55% development of new target industries (e.g., salmon)

SOURCE: Team analysis McKinsey & Company | 85 OVERVIEW MALAYSIA – GROWTH PERIOD 1975-90 Malaysia's growth was led by export-oriented manufacturing sectors

1 Overarching strategy 2 Export and domestic sectors 6 Impact/achievements ▪ Economic development ▪ Malaysia shifted dramatically from a resource exporting economy towards a ▪ Real GDP growth of was a priority to manufacturing economy 6.8% p.a. between provide economic ▪ In 1970, ~95% of Malaysia's exports were resource based, in 1990 only 1975 and 1990 opportunities for all ~50% were natural resource-based with manufacturing taking over ▪ Per capita GDP growth racial groups and – Electronics was the largest single contributor to growth of 4.1% in the same provide funds for – Rubber and palm oil products continued as a significant but shrinking time period redistributive policies proportion of the economy ▪ The overall strategy – Mining, primarily Tin, was also a large but shrinking proportion ▪ Increase in life was to diversify – away expectancy of 6 years from a resource-based from 64 to 70 between 3 Enabling sectors economy towards a 1975 and 1990 manufacturing exports ▪ Large investments in transport infrastructure, in part funded by portfolio FDI, ▪ Increase in adult economy helped lay the ground work for export-led growth literacy a from 69.5% in ▪ This was assisted by ▪ Significant improvements in education have helped provide the educated 1980 to 82% in 1991 the development of workforce required whils<_> training centers and higher learning centers, often ▪ Major shift from EPE's, aggressive partly government funded, sprung up around EPZs to provide skilled labor resource-based courting of FDI, and economy to multinational corpo- 4 Enabling policies and institutions manufacturing rations with the aim to economy receive technology ▪ The establishment of 3 EPZs in Penang, Klang Valley, and Johore from 1972 transfer and FDI from greatly supported manufacturing these companies to ▪ FDI was deliberately courted and a favorable investment climate established spur growth through the Investment Incentives Act and Promotion of Incentives Act ▪ Multinational corporations in particular were courted to take advantage of the abundant educated labor with incentives such as pioneer status, investment tax credits, accelerated depreciation allowances, and export refinancing facilities in EPZs

5 Implementation ▪ Implementation was very top down driven with Prime Minister Mahathir personally driving certain projects ▪ The Prime Ministers Office' Economic Planning Unit (EPU) had input and a view across all development work and crucially also controlled the development budget which sits separately to the operating budget ▪ The Ministry of International Trade and Industry (MITI) played a leading role in implementing industrial policy and the EPZs and regularly sought private sector feedback in improving implementation

SOURCE: Team analysis McKinsey & Company | 86 OVERVIEW MOROCCO – GROWTH PERIOD 2000-10 Morocco's growth was focused on export and foreign markets

1 Overarching strategy 2 Export and domestic sectors 6 Impact/achievements ▪ Morocco's growth ▪ Specialized policies to promote selected sectors generally include ▪ Real GDP growth of strategy focused on liberalization, infrastructure and service enablers, and financial incentives 4.9% p.a. (2000-10) catalyzing growth in – Tourism: tax subsidies, aid for training and land, liberalized air transport ▪ Exports increased from sectors where it had a – Agriculture: land reform and introducing aggregators to help subsistence 28% of GDP to 37% of competitive advantage farmers move to commercial farming GDP (2000-07) ▪ Increased connection to – Manufacturing: special economic zones created with administrative foreign markets both as ▪ 5 fold increase in FDI efficiency, tax incentives, vocational training, services, and infrastructure source of capital (FDI) (2000-08) and demand (BPO, ▪ Stable economic manufacturing, tourism) 3 Enabling sectors growth – grew above ▪ Balance of cross-cutting 3.5% throughout global "transversal" reforms ▪ Reduced gov. ownership in financial industry and opened to foreign financial crisis ownership, increasing availability of credit and focused sector ▪ Secondary school development ▪ Built highways to facilitate internal trade and ports to facilitate external trade enrollment increased – Transversal and act as hub from 38% to 56% in reforms include ▪ Created vocational training institutes to produce talent for target sectors 2000-10 economic stability with prudent fiscal 4 Enabling policies and institutions and monetary policies, free trade ▪ Prudent monetary policy reduced inflation and interest rate volatility agreements ▪ Fiscal policy enabled debt reduction and investment in growth – Sectors developed ▪ Liberalized trade with free trade agreements with the EU, the US, Turkey, with focused Middle East incentives and ▪ Provided tax breaks and investment incentives reforms, SEZs, ▪ SEZs – clusters created to provide a more business-friendly environment vocational training, ▪ for FDI and infrastructure ▪ Privatized creation and operation of SEZs to be more flexible and efficient.

5 Implementation ▪ Reforms led by the King and Prime Minister focused on catalyzing broad support and circumventing bureaucracy ▪ Focused on quick wins with competitive advantages, high willingness to reform, and high job potential ▪ Formed committees involving stakeholders to plan sectoral reforms; committees reported to PM ▪ SEZ implementation units were private or public firms, financed by the government and private sector partners

SOURCE: Team analysis McKinsey & Company | 87 OVERVIEW GEORGIA – GROWTH PERIOD 2000-08 Georgia's growth was based on a truly neoliberal approach

1 Overarching strategy 2 Export and domestic sectors 6 Impact/achievements ▪ Since mid-1990s, ▪ Neoliberal approach focusing on general enablers rather than selecting ▪ Real GDP CAGR of gradual liberalization – industries 7.6% leading to 80% joined WTO ▪ Growth occurred in sectors sensitive to location, efficient government increase in GDP per ▪ After Rose Revolution and low taxes: driven by trade, transport, and manufacturing (notably non- capita (2000-08) (2004), focus on metallic materials) ▪ 11% increase in creating a business- secondary school friendly environment to enrollment (2000-08) attract FDI and ▪ Ease of doing business leverage location in 3 Enabling sectors ranking from 114 to 8 non-business-friendly (2005-10) but fast-growing area – ▪ Reforms focused on improving infrastructure and service levels using ▪ FDI increase from 130 on shortest route bet- privatization and deregulation million to 1.6 ween CIS and Europe ▪ Only sector with overall proactive government policy was energy due to billion(2000-08) – neoliberal policy strategic importance CAGR of 36% focusing on general ▪ Difficulties reforming controversial/complex areas such as education ▪ Time for container enablers such as and healthcare clear customs from 52 improving gov. ▪ More success in areas with relatively fewer stakeholders, e.g., finance to 2 days (2006-10) services, creating low ▪ Only 3% of Georgians flat tax, and reducing 4 Enabling policies and institutions paid bribe in 2010 corruption ▪ Time to start a busi- ▪ Believed had 1 year to ▪ Established rule of law, e.g., reduced corruption using no-tolerance ness fell from 25 to 3 capitalize on revolution approach – fired 40,000 traffic policemen and instituted jail time for petty days (2004-08) momentum – used corruption unplanned and ▪ Liberalized labor and trade laws and introduced low flat tax rate decentralized approach ▪ Ran prudent fiscal and monetary policy to promote economic stability for speed

5 Implementation ▪ Customer-centric approach to government focused on improving services and reducing corruption ▪ Focus on getting things done immediately and visibly, rather than careful planning and strategizing – encouraged public sector units to innovate and develop own initiatives, not wait for top-down instruction ▪ One consolidated budget and aligned incentives to outcomes, e.g., bonuses related to increasing process efficiency ▪ Improved public sector caliber by firing corrupt officials, increasing salaries, and providing exit opportunities

SOURCE: Team analysis McKinsey & Company | 88 Success factors from new country growth stories (1/3)

Success factors Examples

Ensure strong leadership: make sure that ▪ Malaysia: powerful prime minister, associated with 1 system leaders at the highest level are publicly and engaged in reform program committed to the transformation and are substantially engaged in driving the progress

Get the facts on the table: start with a rapid, ▪ Chile: El Ladrillo – self-assessment of economic 2 pragmatic health and performance assessment, situation in Chile creating clarity on root causes to be addressed ▪ Morocco: 6-month "country diagnostic" before start of reform program

Focus, focus, focus: focus on a few, highly ▪ Morocco : focus on target sectors 3 catalytic interventions by prioritizing visible ▪ Chile: privatization of financial sector and utilities quick wins and high returns on investment ▪ Georgia: prioritization by improving government effectiveness and eliminating corruption

Push the supporting sectors: early growth in ▪ Chile: early growth in financial sector through de- 4 financial sector allowing for cheap access to regulation and foreign capital flows as crucial capital; investments in infrastructure to lay the enabler for growth in all other sectors groundwork for export-led growth and internal ▪ Malaysia: large investments, in part funded by joint trade ventures with private sector, in transport infrastructure helped lay the groundwork for export- led growth

SOURCE: McKinsey McKinsey & Company | 89 Success factors from new country growth stories (2/3)

Success factors Examples

Institutionalize a delivery engine: use a new ▪ Malaysia: the Prime Minister's Office EPU had input 5 or existing organization to set clear targets, and view across all development work and monitor progress, hold individuals accountable, controlled development budget and intervene as necessary to remove bottle- ▪ Morocco : Implementation units for SEZs autono- necks or resolve issues mous from government – financial, operational, and pay flexibility enabling hiring of high-caliber people Align the stars for implementation: ensure ▪ Malaysia: innovative delivery-lab approach to 6 working-level collaboration in planning and breaking down silos and cocreating plans implementation across public institutions as well as the private sector Empower entrepreneurs to drive change – ▪ Chile: setup of a national incubator ("Fundación 7 both in the private and in the public sector Chile") to nurture private sector growth Learn as you go: build capabilities and ▪ Morocco: model factories for SMEs 8 capacity in private and public sectors by ▪ Georgia: improved public sector caliber by firing applying adult-learning principles and integrate corrupt officials, increasing salaries and providing learning directly into working exit opportunities Make the money support your ambitions: ▪ Malaysia: EPU holds development budget to 9 ensure that all fundings – government fund 5-year plan budgeting, private finance, and ODA – supports the strategic plan and incentivizes effective implementation

SOURCE: McKinsey McKinsey & Company | 90 Success factors from new country growth stories (3/3)

Success factors Examples

Educate workforce: educated workforce is a ▪ Malaysia: significant improvements in education 10 prerequisite for long-term growth but not its driver helped provide the educated workforce required, multinational corporations in particular were courted to take advantage of the abundant educated labor

Create a favorable business environment: ▪ Georgia: far-reaching reforms, incl. labor market, 11 create an environment that is very conducive monetary and fiscal policy, liberalized trade laws, towards businesses, incl. legislation and and anticorruption efforts, improved business institutions environment to most favorable in the CIS region ▪ Morocco: investor-friendly policies focusing on ease of trade, stability, and incentives to attract FDI resulted in 500% growth in FDI from 2000-08

Gain access to larger economic areas: ▪ Morocco: free trade agreements with the EU, the 12 integration and access to larger and wealthier US, Turkey, and the middle East led to increased trade area(s), both as a source of capital and connection to foreign markets both as source of demand capital (FDI) and demand (BPO, manufacturing, tourism)

SOURCE: McKinsey McKinsey & Company | 91 Details country analysis to be found in separate document New growth models

McKinsey & Company | 92 Contents

McKinsey & Company | 93 Research has shown that 4 areas must be addressed to ensure sustainable growth

Business environment, institutions, and policies ▪ Government capability building ▪ Establishing professional networks to support the economic growth, leveraging Dolphyn's own network and expertise Financial market and availability of capital ▪ Funding start-ups ▪ Facilitating investments Infrastructure ▪ Facilitating large-scale investments and PPPs in selected key sectors Human capital ▪ Improving quality and enrollment in education to ensure well-trained workforce and availability of talent

SOURCE: WEF; World Bank; McKinsey McKinsey & Company | 94 Armenia and Dolphyn have many opportunities to create a more sustainable growth environment (1/2) RECOMMENDATIONS Country Dolphyn ▪ Diversify away from resource-based ▪ Create a national development roadmap, exports by supporting the creation of supporting Armenia's sectors with the strongest highly skilled jobs potential for GDP and job growth (e.g., IT, tourism) Business – Support start-ups and the creation of environ- ▪ Support companies in these focus sectors in SMEs in selected sectors such as IT ment their development , e.g., by (e.g., through facilitation of credits, tax institu- – Pairing domestic institutions with skilled diaspora incentives) tions and for expert advice, source of talent, and funding – Improve the business environment policies – Being an advocate for fair market competition (e.g., reduce incentives to join the (e.g., communicate publicly if companies informal sector, remove barriers to supported by Dolphyn face unfair competition) entry and competition) ▪ Improve the business and investment ▪ Support companies in attracting more FDI climate – Connect diaspora to Armenian entrepreneurs Financial ▪ Approach multinationals in manufacturing – Support potential investors in navigating the market and tradable services and incentivize Armenian bureaucracy and avail- them to relocate activities to Armenia ability ▪ Create an incubator to provide start-ups with of capital financial and training support ▪ Attract multinationals to Armenia and support them with setting up their operations ▪ Work with private companies to realize ▪ Establish an investment board to facilitate large- large-scale investments scale investments and PPPs in selected key sectors Infra- ▪ Improve the business environment to structure attract FDI flowing into infrastructure ▪ Support companies in selected sectors such as IT to establish required infrastructure ▪ Incentivize infrastructure investments, e.g., through tax incentives

McKinsey & Company | 95 Armenia and Dolphyn have many opportunities to create a more sustainable growth environment (2/2) RECOMMENDATIONS

Country Dolphyn ▪ Improve the quality of teachers, e.g., ▪ Support the systematic improvement of through regular training post university Armenia's school system ▪ Engage employers in the design of – Get involved in the design of a modern curricul- academic curricula um that serves the needs of the economy in ▪ Institutionalize vocational training partnership with the government – Centers to train teachers and support their professional development, e.g., through classes, forums, peer learning ▪ Improve the vocational training system – Establish own vocational training institutes, potentially in cooperation with employers Human – Support training of workforce in cooperation with capital their employers ▪ Improve the higher education system – Connect Armenian universities with employers in Armenia and the diaspora to foster exchange and design of a modern curriculum incl. practical elements – Support universities to establish English as the main language to attract international students and ensure that graduates are attractive for future employers – Provide scholarships to Armenian and international students

McKinsey & Company | 96 Backup

McKinsey & Company | 97 A mismatch in GDP units showed Armenia's development worse than in reality

The updated scenario chart was based on We updated the diagram with consistent units incorrect units for the Armenia GDP development 1 15 Armenia

Singapore 10 Ireland

Israel 5 Paraguay

0 1990 94 98 2002 06 10 14 18 2022

Original data until Updated data since 2002: GDP PPP 2006: GDP PPP per Consistent units for all curves: per capita in capita in current GDP PPP per capita in constant 2002 international dollars as constant 2010 USD USD reported by IMF

1 Screenshot: Armenia and Armenian world, RVVZ and IDeA, Oct 2014

SOURCE: Armenia2020; Global Insight; World Bank; IMF; RVVZ; IDeA McKinsey & Company | 98 Armenia's GDP growth was significantly higher in nominal terms Growth rates (based on due to the relatively high inflation rate in recent years X% GDP per capita, current USD growth rates for real GDP)

Armenia ▪ 3 different units are typically 7,000 used for the GDP 6,500 – Nominal: GDP in the current value of a currency 6,000 14.6% – Real: removes effect of 5,500 inflation of the local 4.8% currency on the GDP 5,000 – PPP adjusted 1: accounts 4,500 for different purchasing power of different 4,000 20.7% currencies 3,500 ▪ Due to the relatively high inflation rate of ~5-8% in 3,000 Armenia during the last years, 2,500 Singapore 6.1% the nominal GDP per capita grew significantly stronger 2,000 than in real values Ireland 4.5% 1,500 ▪ The growth rates assumed for Israel 2.6% the 4 scenarios are based on 1,000 real GDP, i.e., do not consider Paraguay 0.1% the effect of inflation 500 ▪ Showing PPP-adjusted values 0 does not change the growth 199498 02 0610 14 18 2022 rates 1 PPP: purchasing power adjusted; can be used both in nominal and in real units

SOURCE: Global Insight; Armenia2020 McKinsey & Company | 99 Similarities of new models of growth with Armenia Similarity

Armenia Chile Malaysia Morocco Georgia

Population 2.98 million 17.62 million 29.72 million 33.0 million 4.48 million

Income level 1 7,500 21,400 22,600 7,000 6,900

Political system Semipresidential Presidential constitution- Constitutional Constitutional Semipresidential republic; 23 years al republic; 204 years of monarchy; 57 years monarchy; 58 republic; 23 years of independence independence of independence years of independence independence

Natural resources Limited: construction Limited: copper, some Metals, natural gas, Limited: phos- Farming, minerals, materials, metals, timber agriculture phates, metals, metals, fish agriculture salt, fish

Access to sea Landlocked Pacific ocean South China Sea, Mediterranean Black sea Gulf of Thailand, Sea, Atlantic Andaman Sea Ocean

External environment Strong dependence on Some border tension Border tension with Dependence on Tensions with Russia, hostility towards with Peru and Antarctica Philippines, France and Spain, Russia Turkey and Azerbaijan disputes with sovereignty conflict Singapore over raw over Western water Sahara

Presence of diaspora 5-6 million people of Less than 1 million Up to 1.5 million 4.5 million people More than 3 million Armenian descent Chileans abroad Malaysians abroad of Moroccan Georgian diaspora abroad descent abroad members

1 GDP per capita, PPP (constant 2011 international dollar)

SOURCE: Source McKinsey & Company | 100 Syria – 30 years with the right of correspondence Not realized Fully realized in Armenia in Armenia Elements of scenario Assessment for Armenia Evidence Red tape and inefficient Lowered burden of governments regulation Burden of government regulation administration in Armenia, but still high bureaucracy 2006: rank 69/144 countries (lower rank = better) 2014: rank 34/144 countries Bureaucracy: 2006 and 2014 lowest 20th percentile Strong army Military expenditures increased, however, Military expenditures Country country not led by strong army 2003: 2.7% of GDP level 2014: 4.1% of GDP Trade restrictions with No major development over last decade – n/a Turkey and Azerbaijan trade restrictions in place No liquid stock markets While growing, Armenian stock market still Stocks traded <1% of GDP (2013: USD 45 million, insignificant 14 companies traded)

Monopolies and unfair Monopolies still prevalent in Armenia Effectiveness of antimonopoly policy competition 2006: rank 114/144 countries 2014: rank 105/144 Industry Ethical behavior of firms level 2006: rank 100/144 countries 2014: rank 90/144 countries

Large informal economy Stable share of large informal economy 2003: 44% of GDP (rank 124/151 countries) 2013: up to 40% of GDP

Poorly trained labor Armenia ranks constantly low on quality of Quality of primary education education 2006: rank 85/144 countries 2014: rank 83/144 countries Quality of higher education Company 2006: rank 68/144 countries level 2014: rank 86/144 countries Low level of investments Stable investment ratio, but low compared Gross capital formation to regional peers 2003: 24% of GDP 2013: 22% of GDP Rank 9 out of 10 regional peers 2 1 Latest data available 2 Belarus, Kyrgyzstan, Kazakhstan, Georgia, Azerbaijan, Moldova, Uzbekistan, Tajikistan, Russia

SOURCE: Armenia 2020 Scenarios Book; WEF Global Competitiveness Report; World Bank; NASDAQ OMX Armenia; McKinsey & Company | 101 Friedrich Schneider: “Shadow economies all over the world”, 2010; Armbanks; PRS 3 The Armenian productivity has always been significantly lower than that of Germany across all sectors and even declined after the financial crisis ProductivityMi 1, 2003 Germany = 100%

▪ Highest productivity was achieved in construction sector ▪ Until the financial crisis, Armenia improved its productivity from ~5-12% of Germany 's

30 average productivity Construction ▪ After the financial crisis, the gap to Germany's productivity increased again

6 Finance and business services 2 2013: Ø 10 8 6 6 Industry 2008: Ø 12 Trade, transport 4 Manu- 3 2002: Ø 5 and hospitality 3 facturing Agriculture Other services

0 5 1015 20 25 30 35 40 45 50 55 60 65 70 75 80 8590 95 100 0 Share of employees Percent 1 GDP per employee 2 Incl insurance 3 Incl forestry and fishing Note: Detailed sector allocation in backup

SOURCE: German Federal Statistics Department; National Statistical Service of the Republic of Armenia (NSSRA) McKinsey & Company | 102 Productivity comparison between Armenia and Germany: Sectors matched based on data availability Aggregated categories based on data availability Individual Armenia components Individual Armenia components Finance and ▪ Agriculture, hunting and forestry ▪ Agriculture, hunting, forestry and fishing business ▪ Fishing services ▪ Mining and quarrying ▪ Mining and quarrying ▪ Electricity, gas, steam and air conditioning supply Industry ▪ Electricity, gas and water supply ▪ Water supply, sewerage, waste management and remediation activities ▪ Manufacturing ▪ Manufacturing Manufacturing ▪ Construction Construction ▪ Construction ▪ Wholesale and retail trade; repair of motor vehicles, ▪ Wholesale and retail trade; repair of motor motorcycles and personal and household goods vehicles, motorcycles Trade, transport ▪ Hotels and restaurants ▪ Transportations and warehouse economy and tourism ▪ Accommodation and food service activities ▪ Transport and communication ▪ Information and communication ▪ Financial intermediation ▪ Financial and insurance activities Finance and ▪ Real estate activities business Real estate, renting and business activities Professional, scientific and technical activities services ▪ ▪ ▪ Administrative and support service activities ▪ Public administration ▪ Public administration ▪ Education ▪ Education ▪ Health and social work ▪ Human health and social work activities Other community, social and personal service activities Arts, entertainment and recreation Other services ▪ ▪ ▪ Other service activities ▪ Activities of private households as employers and Activities of private households as employers and undifferentiated production activities of private ▪ undifferentiated production and services activities households of private households for own consumption

McKinsey & Company | 103