Armenia’s Software Advantage

McKinsey Quarterly
2004 Issue 1
p12, 3p

By Andre Andonian, Avetik Chalabyan and Pierre Gurdjian

Geopolitical problems and macroeconomic reforms are currently
preoccupying Armenia, but to achieve long-term growth and lift itself
out of poverty the former Soviet republic must also grapple with
microeconomic policy. Armenia should focus on developing the industry
sectors that have the best chance of competing globally and on
eliminating any barriers to productivity within them. Our study of this
landlocked economy in the Caucasus (Exhibit 1) suggests that software
and IT services are among its most promising sectors.

With annual growth of more than 20 percent since 1999, software and IT
companies now account for 2 percent of Armenia’s GDP — a proportion
comparable to that of India, the world’s leading offshore IT
destination. Businesses in this sector achieve much higher productivity
than the average for Armenia’s economy as a whole (11.5 percent of the
US level). Why the relatively strong performance? The software and IT
services sector is especially suited to exploit Armenia’s three
competitive advantages. First, it has a well-educated workforce with an
emphasis on science, a result of the country’s heritage as the Soviet
Union’s high-tech center. The second advantage is low wages: a software
and IT services specialist earns $2,400 to $6,000 a year, a quarter of
the average salary such a worker receives in India. The third is a five
million-strong diaspora across Europe and North America. Many of these
overseas Armenians are successful businesspeople and professionals in
the IT and software field and provide access to international business
networks as well as funding for Armenia’s development.

Foreign-owned and domestic companies in Armenia’s software and IT sector
have different average levels of productivity and somewhat different
barriers to
raising it. Some 25 foreign software companies, owned mostly by
businesspeople of Armenian descent, have set up offshore subsidiaries in
the country to develop
customized applications for their corporate parents. To attract the best
programmers and thus achieve the best labor productivity, these foreign
units offer salaries twice as high as domestic IT firms do. But labor
productivity is still only half of the US level, partly as a result of
the shortcomings of Armenia’s higher-education system, which produces
excellent programmers but not enough skilled project managers. For the
85 or so domestic companies that develop, program, market, and sell
packaged software at home and abroad, improving total productivity —
which currently stands at 25 percent of the US level — is even more
crucial. Among the managerial shortcomings these companies face is a
lack of market knowledge and business know-how. Furthermore, they don’t
always know what higher-value-added products to make for international
markets, and they sometimes don’t possess the business skills needed to
market and sell sophisticated products abroad (Exhibit 2, on the
previous page).

We recommend a series of steps in two areas to remove productivity
barriers and stimulate the growth of Armenia’s software and IT sector.
First, increasing the capacity and quality of the educational system is
critical for delivering the highly qualified graduates needed to improve
the sector’s programming and management skills. To this end, the
government should try to attract and retain teachers, professors, and
researchers by raising their salaries, which a: $100 to $200 a month are
low even by domestic standards. Partnerships between companies and
universities can also help. A large foreign-owned software company, for
example, currently supports a multidisciplinary university course that
combines semiconductor design and IT programming — important for the
development of higher value added products. One university cooperates
closely with IT start-ups by providing them with work space on its
premises. Computer science curricula should be modernized so that
technical courses are enriched by business know-how, such as project
management and business-case writing. Second, the government and the
domestic financial and high-tech sectors should team up to establish a
major investment fund and a promotional agency to channel private equity
money from the diaspora and other foreign sources into the software and
IT sector and thereby stimulate its growth.

Increasing the productivity of software and IT services alone won’t
carry Armenia’s economy to the next level, however. A handful of other
sectors — diamonds and jewelry, tourism, and health care — should also
be development priorities. Successful initiatives in the four sectors
could double their productivity, generate double-digit increases in
revenues annually through 2010, and raise their aggregate employment to
102,000, from 71,000. By first focusing on these potentially high-growth
sectors, Armenia could increase its foreign earnings and use the influx
of cash to raise domestic demand and boost other parts of the economy.

Armenia must still resolve its conflict with neighboring Azerbaijan over
the disputed Nagorno-Karabakh region and carry out macroeconomic reforms
to complete the transition to a market economy. But concentrating on
specific sectors such as software and IT services should allow Armenia
to move beyond basic stabilization and take the next steps on the road
to prosperity.

DIAGRAM: EXHIBIT 2: Armenia’s productivity gap: Estimated labor
productivity, index: total productivity for software/IT sector in United
States = 100

MAP: EXHIBIT I: Armenia in context: Major economic indicators, 2002