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The competitive advantages of nations

Applying the Diamond model to Armenia
Armen Chobanyan
United Nations Ofce for Project Services, Yerevan, Armenia, and

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Laurence Leigh
Rushmore University, Torino, Italy
Abstract
Purpose To apply the Porter Diamond Model to the case of Armenia, a small and land-locked economy, in order to draw conclusions about its current situation, future prospects and appropriate development policies. Design/methodology/approach The paper analyses the shape of the Armenian National Diamond drawing on published statistical data and the authors familiarity with the country. Findings Although controversial, the Diamond Model provides a useful basis for making appropriate policy recommendations for fostering competitiveness. The authors conclude that while achieving the required legislative and institutional framework, market liberalization and a stable macroeconomic environment are necessary, they are not sufcient conditions for ensuring continued economic growth and the achievement of sustainable development. In particular, based on the Diamond Model framework, they advocate Government policies to attract foreign direct investment with the objective of creating new industrial clusters. Practical implications The case study demonstrates that, despite possible limitations, the Diamond Model provides a valuable starting-point for analysing appropriate development policy in emerging markets such as Armenia. Originality/value This is the rst case study of its type written about Armenia. It is of value not only as a guide to policy-makers in Armenia but also as a model for development specialists and policy-makers in other industrializing economies. Keywords Armenia, Economic models, Industrial countries Paper type Case study

Introduction Porters (1990a) model of a national diamond that determines industrial competitiveness rst comprehensively elaborated in his book The Competitive Advantage of Nations (CAN) attempts a wide ranging exploration of the reasons why some nations gain competitive advantage in international markets. He argues that the shape of the diamond depends on four inuences factor conditions; demand conditions; rm strategy; structure and rivalry; and, nally, related and supporting industries. Porter also suggests that there are four stages of competitive development which characterise a nations sources of advantage in international competition; the factor-driven, investment-driven, innovation-driven and wealth-driven stages. These stages schematically describe the economic development process, as well as dene certain problems and obstacles which rms and industries face in achieving competitive advantage. Countries normally pass through these stages by increasing

International Journal of Emerging Markets Vol. 1 No. 2, 2006 pp. 147-164 q Emerald Group Publishing Limited 1746-8809 DOI 10.1108/17468800610658316

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national competitive advantage and ultimately raising economic prosperity, and Porter recommends the appropriate role that governments should play in each of them. In particular, Porter prescribes a more active role to the government in improving industrial competitive advantage in the factor-driven and investment-driven stages of development, and a rather indirect role in the innovation-driven stage. According to Porter (1990a, b) governments major role is a catalyst and challenger encouraging or even pushing companies to raise their aspirations and move to higher levels of competitive performance. Though the governments role is inherently partial, it is powerful in transmitting and amplifying the forces of the diamond (Porter, 1990b). While not ignoring the role of macroeconomic policy in promoting competitiveness, he argues that such macroeconomic factors as savings, budget decits, capital costs and currency values play a role in national economic prosperity but they are not the causal, the sufcient nor the most important inuence on competitiveness (Porter, 1990c). Since, its publication in 1990, The Competitive Advantage of Nations containing Porters model has been the subject of considerable debate. The criticism is mainly related to the alleged inapplicability of Porters (1990a, p. 679) model to small and open economies, his neglect of the role of multinational companies and foreign direct investments as well as to his assertion that economic prosperity can be ensured through a diamond that is exclusively home-based. Porter does, however, accept that, for developing countries, foreign-owned multinational companies may serve to seed industrial clusters and thus contribute to upgrading the national diamond. So even if some of this criticism may be justied, in our view the model provides a useful starting point for designing long-term economic development policies even in the case of a small, open and transition economy such as Armenia. Armenias economic development agenda Armenia started along the major path of transition reforms in 1991, immediately after declaring independence from the Soviet Union. The transition process to the market-based economy has been extremely difcult and accompanied by political cataclysms and unrest, armed conicts, economic and social shocks, as well as massive changes in its terms of trade. The beginning of the 1990s was the most difcult stage of transition reforms. Armenias economic crisis was a result of implementing a Big Bang approach to market liberalisation. The major negative consequences of transition policies in Armenia at the beginning of reforms were related to an output fall, higher ination rates leading to hyperination, a drastic increase in unemployment and a tremendous drop in incomes. Unprecedented economic recession had an unavoidable impact on social conditions resulting in a high level of poverty and inequality. The period between the mid-1990s and 2004 was characterised by economic recovery and growth after full-edge implementation of macroeconomic stabilisation policies. Trade and prices were liberalized, the legal framework for a market economy was established, most state owned enterprises were privatized, and the governments intervention in the economy was considerably reduced. As a result, some important successes have been achieved in terms of scal stability, privatisation, liberalisation of economic activities and development of basic institutions required for functioning of market economies (IMF/World Bank, 2002). These policies have been shaped by the introduction of control over ination, a sharp decrease and, starting from 1997, abolition of

inationary nancing of the budget decit (UNDP, 2003) and introduction of a oating exchange rate for the national currency. In addition the government has eliminated most of the budgetary subsidies as well as reformed basic institutions in order to enhance economic efciency. These macroeconomic measures have spurred economic growth which was 13.9, 10.1 and 11.6 per cent in 2003, 2004 and 2005 (rst half compared with previous year),, respectively , (UNDP, 2005; Statistical Service of Armenia, 2005). The ultimate goal of transition reforms in Armenia is for the country to move from a group of low-income and economically poor countries into a group of high-income developed countries as quickly as possible, while at the same time maintaining the broad vision of possible EU membership. For this purpose Armenia needs to create a comprehensive development strategy and take consistent actions to aid help the transition process and foster rapid economic growth. A large share of Armenias growth since the mid-1990s has been due to the implementation of an import substitution policy. However, that alone cannot provide the major factors for long-term sustainable economic development. Import substitution tends to draw a nation into unattractive industries or industries where it has little prospect of gaining a sustainable competitive advantage (Porter, 1990c). While protection may guarantee the home market, Armenias rms will lack advantage in international markets and they will be vulnerable to economic cycles and currency uctuations. In this regard, Armenia should adopt a catching up development strategy that is based on expansion of the internal economic capacity through export growth and boosting investments inows into the economy. However, it should be balanced by a strategy of so-called innovative development (UNDP, 2003) a type of development based on the priority of innovation and knowledge production which in the long run may become dominant with or without EU membership. Successful export expansion can be achieved through policies directed to achieving a sustainable increase in national productivity and enhancing the competitiveness of Armenian industries worldwide. For this purpose, we believe the CAN model will serve as a useful framework because competitiveness should be equated with productivity and how rms, industries and the country foster, maintain and increase productivity on a sustainable basis. It depends on the continual upgrading of human resources, capital and natural resources as well as induced technological change and innovation (Khemani, 2003). Finally, competitiveness applies to the changing organisational structure and behaviour of rms, industries and government both locally and internationally. Since, Armenia like the majority of transition countries is still in the factor-driven development stage, the role of the government should be to ensure that the economic environment will enable Armenias competitive industries to move forward to the subsequent investment- and innovation-driven stages. The determinants of Armenias Diamond Factor conditions The CAN model groups factor conditions into ve categories: human resources, physical resources, knowledge resources, capital resources and infrastructure. The shape of Armenias particular diamond is shown in Figure 1 and the state of its economy in relation to each of the six factors is discussed below.

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Governments Role

Determinants of Armenias Diamond

Governments Role

150

Maintain Favourable Geopolitical Environment Maintain Stable Macroeconomic Environment Improve Business Environment

Support in creation of exportbased clusters Support in creation of innovative-driven clusters Ensure environment for FDI growth

Factor Conditions

Demand Conditions

Firm Strategy, Structure and Rivalry

Human Resources Literate, qualified skilful, low cost Low productivity Poor management & work ethic Capital Resources Steady increase in private/public savings/investment Liberal financial & banking market Concentrated banking system Physical Resources Landlocked Poor with minerals Partly fertile for high-value agricultural crops Well located for regional transit transport Infrastructure Functional roads Functional Railway Low level of telecommunications Strong power sector Infrastructure Highly qualified scientists Deteriorated but slowly recovering R&D Dominating and growing private sector Large scale enterprises and major infrastructure privatised Poor management and corporate governance practices High level of business related corruption Low level of spillover of management know-how in the economy

Related and Supporting Industries

Low level of industrial clustering Virtual nonexistence of related & supporting industries in many sectors of the economy Small internal market limited by population size and low purchasing power Growing domestic demand in many important sectors Growing patternsin recent years in consumer earnings and consumption

Figure 1.

Human resources. One of the most important factor conditions of Armenia is its knowledgeable, specialised, skilful, educated and at the same time low-cost work force. Armenia enjoys practically a 100 per cent functionally literate labour force and widespread higher education (around 33.5 per cent enrolment rate). The active enrolment in primary and secondary education in 2000 was around 80 per cent, which is quite high by international standards even if lower than the pre-transition record. There are a large number of public and private universities offering courses and degree programmes in most of the popular specialisations including management, economics, engineering, medicine and, at the same time, covering such niches as information technology and basic sciences chemistry, physics, mathematics, biology and so forth. However, due to the low level of expenditures on general education 2.5 per cent of GDP in 2004 (UNDP, 2005) compared to 7 per cent in 1990 (World Development Indicators, 2003), lack of specialised training facilities and programmes endorsed by both the government and private sector and continuous emigration of highly skilled professionals, the educational level of the labour force seems to be deteriorating. In order to reverse this decline, drastic reforms in all levels in the education sector are currently being implemented by the government and supported by the World Bank. Co-operation and partnership with the private sector is being encouraged to ensure investments in higher education and technical training. These will be aimed at improving technical, professional and managerial skills linked to certain industries. Despite its high qualications and educational level, the cost of labour in Armenia is extremely low even compared to other countries of the former Soviet Union. For instance, in 2002 the average wage rate in Armenia was less than 40 per cent of the wage rates in Russia, Belarus and Kazakhstan (Statistical Yearbook of South Caucasus, 2004). These, in turn, were much lower than in East European countries. Nevertheless, low labour costs as a source of competitive advantage, are a temporary phenomenon and development history shows that their importance declines during the course of economic development. Additionally, the share of labour cost intotal production costs of products is continuing to fall and basing a countrys investment/export strategy only on this comparative advantage would lead to failure in the long run. Labour productivity in Armenia has shown different patterns in various sectors of the economy during the transition reforms. In the industrial sector the productivity of labour declined by 46 per cent between 1990 and 1995 and then rose rapidly, resulting in productivity being only 7.3 per cent lower in 2000 than it had been in 1990. However, this recent increase might be mainly a result of the massive dismissals of labour formally registered only in state owned enterprises in privatised enterprises during the middle years of the 1990s. Nevertheless, since 2000 labour productivity has continued to increase. For example, according to an estimate by the CBA (2005), productivity increased by 9.4 per cent in 2004 alone. The pattern in the services sector was similar to that in industry. However, in agriculture there was a steady decline in labour force productivity during transition reforms and the value added per worker in 2000 was only 52 per cent of the 1990 level (UNDP, 2002). The most productive sector of Armenias economy is clearly industry. In 2000 it had a 52 per cent higher rate than the entire economys average labour productivity. Nevertheless, the World Bank (2002) suggests that an average industrial enterprise in Armenia in 1997-1999 was about six times less productive, when

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measured in value added per employee, compared to Lithuania. Comparing productivity in terms of sales per employee, the gap is even larger. Work ethics are also major constraint on the competitiveness of industry (UNIDO, 2001), especially in developing and transition countries. The major factors determining low morale among employees of Armenian enterprises are mainly related to the low wages, even in the private sector, the workers weak bargaining power and the low level of organisation of the labour force, limited understanding of workers rights and labour laws, unavailability of adequate labour-related legislation, and autocratic management styles inherited from the Soviet regime. All these issues certainly affect employees motivation and create obstacles to improving the competitiveness of Armenian rms on the international scene. In this regard, it is essential to create an environment that is conducive to a strong and positive work ethic, continuous improvements in management expertise and guaranteed provision of adequate incentives for workers to motivate them towards more productive performance. Capital resources. Gross National Savings in Armenia have been growing since the mid-1990s. They accounted for 17.4 per cent of GDP in 2004 (CBA, 2004) more than ve times higher than in 1995. Private savings in 2002 accounted for more than 10 per cent of GDP while public savings were slightly over 3 per cent of GDP. The period 1995-2002 was characterised by stability of domestic private investment at the level of around 16 per cent of GDP while internal public investments since 1996 reached a peak of 5.5 per cent of GDP in 2002. Since, 2002, there has been a slight increase in private investment which reached a peak of 20 per cent of GDP in 2004. Despite the noticeable positive movements, the current situation in relation to domestic savings and investments is far from being optimal in terms of supporting economic growth. By the mid-1990s most of the restrictions on interest rates, capital ows and foreign ownership in banking had been removed. However, Armenia has achieved relatively slower progress in ensuring the efcient operations of nancial institutions and in raising its banking and nancial regulations to international standards. Although the reforms in the banking sector are more advanced in Armenia compared to other countries of the CIS (EBRD, 2002), creation and enforcement of regulations regarding bank supervision and solvency, full interest rate liberalisation, encouragement of a signicant presence of private banks and lending to private enterprises need to be given priority. Even less progress has been achieved in the securities markets and non-bank nancial institutions than in the banking sector. Armenia has managed to form securities exchanges and market makers although they operate with limited capacity. Some level of trading of government paper and securities has also been established and, although an adequate legal and regulatory framework has been adopted, its enforcement is far from being efcient. There were 20 commercial banks in Armenia at the beginning of 2004 with total capital equivalent to 3.4 per cent of GDP in 2004 (CBA, 2005). The concentration of the banking system is relatively low for the small Armenian economy, with the four largest banks accounting for 49 per cent and the ten largest banks for about 81 per cent of the entire banking sector assets in 2004 (CBA, 2005). A total of 12 banks are either fully owned subsidiaries of foreign banks or foreign banks have a controlling interest in them. At the end of 2000 these 12 foreign banks accounted for about 44 per cent of total assets of the system. A large gap between interest rates on loans and interest rates

on savings is the result of the high operational costs of Armenian banks, associated with the small size of most banks. High interest rates throughout the economy were also partly attributable to the inefciency of domestic borrowing by the public sector (World Bank, 2002). Physical resources. Armenias terrain is mainly highland, with mountains and fast owing rivers. Armenia cannot be considered as a country that is rich in mineral resources. The country has few forest resources and only small deposits of gold, copper, molybdenum, zinc and aluminium. These minerals are mostly concentrated in the south of the country, close to the border with Iran, and in the north near to the border with Georgia. The climate is highland continental, characterised by hot summers and cold winters. This creates certain difculties for optimal and low-cost farm production. Agricultural arable land is only 17.52 per cent of the total and the Ararat Valley is the most suitable for protable agricultural crop production such as high value vegetables and fruits. Therefore, most of the food processing industries, soft drink producers and wineries are located in Yerevan and in neighbouring regions in the Ararat Valley where they are the closest to the producers. In the rest of country, with the exception of small areas in the south and north of the country that have favourable climatic conditions, farming is mostly marginal. Armenias central geographic position in the Caucasus may allow it to serve as a regional crossroads as it did prior to independence in 1991. However, this has not been possible due to conicts with neighbouring countries and a severely deteriorated infrastructure. Armenias traditional trade route through Azerbaijan, which accounted for over 85 per cent of Armenian trade ows, was blocked in 1990/1991 as a result of the conict over Nagorno Karabakh. Turkey has also closed its border to transport. Armenia was therefore forced to re-route most of its trade through Georgia, which has been in an insecure political situation, and through a newly opened trade corridor to Iran. As the UNDP study of 30 landlocked countries (Snow et al., 2003) shows, landlocked countries are completely dependent on their transit neighbours infrastructure for access to international markets. Where a landlocked country has access to only poor quality routes, the cost of overland trade is signicantly higher than it would otherwise be. Therefore, the cost of trade for a landlocked country such as Armenia is heavily determined by the infrastructure levels, the political situation, the administration of trade and borders and the economic development of its transit neighbours. In this regard, it is important to consider both direct costs such as fees and duties and indirect costs such as the effect of delays caused by this high administrative burden. The World Bank estimates that Armenias average freight factor (the ratio of freight costs to merchandise value) is eight times greater than the EUs. If they were at the same level, Armenia would save approximately US$100 million per year. This disadvantage almost disappears when countries export services, knowledge-based technologies and information-based products, which is why they are considered so important in the recommended long-term development model for Armenia. Infrastructure. Armenias trade after independence has relied heavily on the road corridor through Georgia. This increasing dependence on the road network has been accompanied by signicant deterioration of the infrastructure, resulting from lack of maintenance and repair. However, since 1998 Armenia has accomplished several large-scale projects to restore the most important roads from south to north and from east to west of the country. These projects were nanced by the World Bank, the

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EBRD and the Armenian diaspora. Currently, all the major roads are fully functional and are considered to be some of the best in the Caucasian region. But Armenias transport difculties are complicated by the poor condition of roads in Georgia. Georgia shows little interest in maintaining the trade corridor from Armenia because it has other trade priorities. During the Soviet regime, internal movements of raw materials and products were carried out by railway networks. After the collapse of the Soviet Union rail trafc declined signicantly: in 2000 it was only 5 per cent of the pre-independence volume (Snow et al., 2003). In 2000, 44 per cent of Armenian railroads were operational and during 2000-2004 there has been a signicant increase in rail freight. Rail trafc rose by 28 per cent in 2004 alone (CBA, 2005) mainly due to an increase in the transportation of mining industry products and construction materials. The absence of a rail connection with Iran is a serious disadvantage. Such a link would dramatically reduce transportation cost and time as well as give access to the more efcient ports of Iran. Georgias primary port in Poti the major sea access point for Armenia is considered rather outdated. It lacks an appropriate infrastructure and modern facilities. All countries in the region will benet from the launch of the European Union Transport Corridor Europe Caucasus Asia (TRACECA) programme which aims to improve the integration of Europe, the Caucasus and Asia through the development of an interconnected transport network including roads, railways and ports. Armenia is placed at the centre of the inter-continental trafc route. However, Azerbaijan and Turkey have created obstacles to implementing this programme by delaying required co-operation particularly with regard to opening borders and trade routes. The low level of development in the telecommunication sector is considered to be one of the biggest obstacles to the development of Armenian high technology related industries. It is perceived to be the lowest in the Caucasian region although it was the highest during the Soviet era. This situation is mainly due to the performance of the monopolist operator in this sector ArmenTel which is owned by the Greek OTE Company. The Government granted it a monopoly in internet, land-line telephone and mobile networks, and the company should have invested heavily in telecommunications to improve its internet connections, covering the whole country with a mobile network and digitalising a large portion of telephone network including all the largest cities. However, a study of Armenian IT enterprises (UITE, 2001) concluded that it continues to fall behind neighbouring countries and the world in general in relation to both the quality and cost of telecommunications. For instance, despite company connections to the internet having reached 92 per cent in 2001, more than 50 per cent were connected via dial-up and only around 20 per cent of companies had a dedicated line. An even lower percentage of enterprises, only about 10 per cent, used wireless connections and satellites. Most companies were dissatised with the price and quality of internet and telecommunications services, citing low capacities of lines, low speed and poor connectivity. The study indicated that 87 per cent of companies involved in the IT sector identied the current state of telecommunication in Armenia as the biggest obstacle to their growth. Armenias power sector represents one of the major local industries, with annual sales of around $152 million or 8 per cent of GDP in 2003 (Statistical Yearbook of South Caucasus, 2004). In 2004, 36 per cent of total electrical power was generated by hydro plants, 36 per cent by nuclear power plants functioning on imported nuclear fuel, and

28 per cent by thermal plants operating on imported gas. After a power crisis in 1992-1994, electricity supply has become much more reliable and is available on a 24 hour-a-day basis throughout the whole country. Financial improvements in the sector have been made through improved payment discipline, better budgeting and increased tariffs for electricity. A regulatory framework for the power sector has been enforced through the enacting of an Energy Law, establishment of the Independent Energy Regulation Commission and privatisation of the electrical distribution system in 2002. As a result of these efforts, Armenia does not face energy-related constraints on economic growth in the short term (World Bank, 2002). The power supply is fairly reliable and there is a large excess capacity in the system. The excess annual average generating capacity of Armenia is conservatively estimated at 1,000 MW. That would allow the export of electricity worth over $190 million, which is equivalent to about 27 per cent of total exports in 2003. However, the current situation may not be sustainable in the long run and major investments will be needed to replace existing generation capacity and to upgrade and modernise transmission and distribution. Knowledge resources. Drucker (1995, 1999) considers a knowledge society to be far more competitive than any other known society in history. His main reasoning behind this is that, since knowledge is universally accessible, there are no excuses for non-performance or mal-performance. There will not be poor countries but ignorant ones, a description which may be equally applicable to individuals, companies and industries. The impact of knowledge resources on the competitive platform is not only a function of the quality of research facilities, educational institutions and other information providers, but also a function of a societys ability to absorb and utilise knowledge through implementing advanced production technologies (UNIDO, 2001). Unfortunately, the transition process in Armenia has not only been accompanied by a signicant deterioration in its industrial potential with output in 2000 comparable to the level of the 1970s, but also by a dramatic decline in research, scientic and technical potential. The volume of research and development activity in 1996, especially in the high-technology defence sector, where the operations of many large research units have practically ceased, was only one-eighth of the level recorded in 1990. While R&D accounted for 2.5 per cent of GDP in 1990 (the second highest in the former Soviet Union after the Russian Federation), in 1996 it had fallen to only 0.3 per cent of GDP. Despite remaining stable in absolute terms since 1999, R&D accounted for only 0.17 per cent of GDP in 2003 since GDP has been growing by around 10 per cent yearly and there has not been a corresponding increase in R&D expenditure. During 1990-1996 the number of scientists engaged in R&D decreased by 58 per cent the greatest reduction among the CIS countries (Egorov, 2000). This is explained by the closure of many larger state industrial companies which used to fund industrial R&D, extremely low nancing by the government and large-scale emigration of scientists to western countries and Russia. Since, 1999, there has been no further reduction in the number of scientists and knowledge workers. In 2003 there were around 5,000 researchers working in 99 scientic, research and development institutions (Statistical Yearbook of South Caucasus, 2004). Considering that knowledge resources despite their deterioration during the transition period are still considered as one of the most important determinants of Armenias diamond, signicant changes need to occur to maintain and rebuild the countrys potential. Government intervention alone in this sector would not be enough,

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given its scarce budgetary resources. The private sector should be fully involved in R&D, including industrial research, as should specialised research institutions and universities. It is absolutely crucial to apply R&D results in local industries which need to be receptive and exible enough to make use of technological developments. This would enable the country to produce and utilise its technological, information and R&D resources and achievements locally as well as exporting a signicant number of them. Demand conditions Armenias internal market is quite small in value terms, being limited by its population size, around 3.2 million, and low GDP per capita, estimated at $3,120 in terms of purchasing power parity in 2004 (UNDP, 2005). The domestic market does not therefore provide adequate conditions for producers in many industries to realise economies of scale. Domestic demand in Armenia in terms of both consumer expenditure and industrial consumption has been steadily increasing in line with the economic growth observed since the mid-1990s. It is especially related to demand for industrial and agricultural products for production and processing purposes in rapidly growing industries such as food processing, tobacco and drinks, diamond cutting and jewellery, and mining. The growth in these industries has created a signicant demand for certain specialised services and products in related industries. Local market demand, in both quantitative and qualitative terms, has signicantly inuenced development of local food processing, tobacco and drinks industries and increased their competitiveness in the international markets. The demand of the local market for high quality food and drinks, together with intensive home rivalry and the limited capacity of home demand in value terms, has forced companies to produce relatively low-cost but high quality processed meat and dairy products through applying efcient and innovative approaches to production, marketing and retailing. This situation has forced rms to lower prices, introduce new features, improve the quality of their products and nally to penetrate foreign markets. Firm strategy, structure and rivalry Armenia inherited from the former Soviet Union features of socialist corporate governance and an autocratic management system designed for performance within a planned economy which are completely inappropriate and inefcient in the new market environment. During the transition period since 1991, Armenia has made signicant progress in transferring state owned large and small enterprises into private ownership as well as in improving corporate governance and enterprise restructuring. By 2002, most of the large state owned enterprises in Armenia had been privatised, including the telecommunication, transport and electrical distribution networks. Armenia used voucher privatisation schemes as the main strategy for the privatisation of large-scale enterprises giving signicant preferences to insiders. It is absolutely crucial to adopt efcient corporate governance and management systems in newly created or privatised rms to make them competitive. An environment that encourages companies to set corporate goals targeted to improvement of competitiveness should be created. The management mechanisms that are needed to achieve these goals should also be put in place. Companies should be encouraged to invest in enterprise restructuring and developing advanced management practices.

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The growing signicance of the private sector observed in the economy during the transition period is seen as a positive sign and it accounted for 70 per cent of GDP in 2002. However, this progress needs to be further enhanced by the government through quantitative and qualitative measures. Reform of tax administration and business regulations as well as measures to eliminate corrupt practices have to be yet adopted and implemented. Corruption related to business operations remains high (EBRD, 2002). The rise in crime and its negative impact on the establishment of new businesses and private business development in general has been one of the phenomena of the transition process that has not bypassed Armenia. According to the EBRD assessment, the losses of Armenia and other South Caucasian transition countries from crime in 2002 were among the highest in Eastern Europe and the Commonwealth of Independent States (CIS), amounting to more than 2.5 per cent of total sales. This is a very serious constraint, especially for small rms, both during their establishment and growth, since they tend to pay an even higher percentage of their sales in bribes. Armenia enjoys one of the most liberalised price and trade systems in the CIS and Eastern Europe and in 2002 was accepted for membership of the World Trade Organisation (WTO). However, with regard to implementation of efcient competition policies and effective operation of anti-monopoly institutions to prevent abuse of market power, there is yet much to be done. Certain administrative and regulatory barriers to competition, including soft budgetary constraints and discretionary granting of various forms of subsidies to loss making enterprises, also remain, although they have been reduced considerably in recent years. Related and supporting industries The low level of industrial clustering and virtual non-existence of related and supporting industries is perhaps the weakest corner of Armenias diamond. During the Soviet era, the centrally planned economy did not provide the necessary conditions for the creation of clusters through vertical and horizontal relationships amongst suppliers, buyers, common customers, distribution channels or technologies. Normally, all these relationships between rms within an industry or among industries were co-ordinated and managed by ministries responsible for a sector and so there was a lack of horizontal cooperation between companies or industries. Somehow, during preparation of plans or realisation of industrial projects, vertical cooperation and sharing of technological advancements with related and supporting industries would be implemented so long as directives to that effect were sent from the central government. However, efcient relationships among microeconomic actors and, especially, effective geographical concentration of industries were lacking. After gaining independence, all former relationships in related and supporting industries, as well as Armenias trade ties with the former Soviet republics, collapsed. This forced most Armenian enterprises with industrial potential to be without traditional suppliers of raw materials or other industrial inputs, transportation companies, or buyers, which were situated in different parts of the former Soviet Union. This meant that it was impossible for Armenia to inherit clustering from the previous socialist system and to build on the achievements of a planned economy. Instead, entirely new relationships have had to be created.

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The non-existence of related and supporting industries is one of the key weaknesses of the industrial sector in Armenia. With a few exceptions, such as the food processing and drinks industry, and the diamond and jewellery sector, many of the countrys producers are not linked to trans-national corporations or internationally competitive rms. Therefore, they have limited access to either technology or information on international best practice. Furthermore, most of the production and service activities are vertically integrated as far as domestic suppliers are concerned, with inputs provided mainly through imports. Exceptions are again in the food, drinks and tobacco industry and mining. This practice ows directly from the fact that limited numbers of domestic producers do not create an opportunity for supporting industry to develop cost competitively. The value chain in Armenia consists mainly of individual manufacturing companies purchasing raw materials and going through all the production process up to the nal product. In many cases they even move forward to distribution channels, sales and marketing. These vertically integrated operations compete with each other in the domestic market and offer very little incentive to share information or common services facilities. The governments role in enhancing competitiveness Porter argues that government has the greatest direct inuence on national advantage in the factor and investment-driven stages. Armenia, like most transition and developing countries, is still in the factor-driven stage of development. All the successful export industries, such as diamonds and jewellery, food processing, tobacco, drinks, and mining, are based on such comparative factor advantages as cheap semi-skilled labour, natural resources, certain agricultural crop inputs and so forth. Therefore, the governments role in this stage should be to upgrade basic factors and help create advanced factors, particularly through upgrading the countrys infrastructure and educational system and beginning the development of a technological base including the acquisition of contemporary technologies and/or licences. The government should also play a role in creating and developing industrial and export clusters, as well as in generating and maintaining domestic rivalry and efcient corporate governance which stimulates dynamism and innovation. To this end, the broad policy measures that we recommend are: . creation of a geo-political environment that is favourable to sustainable economic growth; . maintenance of a stable macroeconomic environment; . continuation of the transition reforms aimed at improving the business environment; . creation and development of export-based industrial clusters and adoption of a policy for efcient clustering; . creation and development of conditions for innovative-driven clusters; and . provision of conditions for the growth of foreign direct investments and for active operations of multinational companies. Such policies will also help the Armenian economy move forward to the more advanced investment-driven and innovation-driven stages of economic development.

Geopolitical environment Political stability and social cohesion in the country as well as regional security is essential. The settlement of current conicts would avoid the competitive disadvantage of being considered as a conict zone and would dramatically improve the investment climate and reopen the blocked transportation routes. Strengthening efforts to establish a truly democratic society are also essential, since democracy is a key factor in ensuring political stability and the success of Armenias economic policies. Macroeconomic environment and poverty reduction The governments scal and monetary policies should be targeted to maintain macroeconomic stability, low ination and predictable and relatively stable currency exchange rate. Such policies should be accompanied by maintenance of an open trade regime and a favourable scal framework. A stable macroeconomic environment has been a pre-condition for achieving economic growth in recent years. In mid-2003, the Government of Armenia adopted the Poverty Reduction Strategy Paper (Government of Armenia 2003; World Bank, 2005) and started implementation of pro-poor macroeconomic policies taking into account that despite the impressive economic growth in recent years, a sizable part of the population in the country lives in absolute poverty. The policy priorities identied by the PRSP focus on: . promoting sustainable economic growth through macroeconomic stability and private sector development; . enhancing human development and improving social safety nets; implementing prudent scal policies and reforming the tax system; . improving public infrastructure; and . improving core public sector functions. In this regard, sustained rapid economic growth and macroeconomic stability are the basic requirements and pre-conditions for poverty reduction, creating economic opportunity and permitting action to address both income and non-income dimensions of poverty (IMF/World Bank, 2002). The other major conditions for successful implementation of the PRSP are concerned with the governments revenue performance, enhancing efciency of public expenditures and systems for budget management as well as the policy of the country to implement credible debt reduction strategies. The government is to follow the key policy change proposed by PRSP that intends to switch budgetary expenditures towards activities that have a high impact on poverty reduction. The government, according to the PRSP, should ensure quality of education and enhancing its accessibility through implementing strategies to improve the conditions of teachers and their skills as well as realigning the countrys education system to the rapidly growing information technology sector. The major activities of the government in the health sector should be focused on increasing accessibility to essential health services and improve efciency of the countrys health system. The PRSP identies the essential role of infrastructure including the energy, water, irrigation and transport sectors in Armenias development agenda. Enhancing efciency and transparency in these sectors are to be of primary concern of the

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government. Increases in tariffs of public utilities and irrigation may be required to ensure cost recovery and quality of these services. In the transport sector, the reorganisation and restructuring of administration and management of roads need to be addressed by the government at the same time as ensuring that sustainable nancing for their repair are found. Progress in transition reforms and improvement in business environment It is crucial to build on the signicant progress made by the country in transition reforms. To improve Armenias diamond, legislation in the banking and nancial sector, and enterprise restructuring, have been suggested. In addition, the enforcement of already adopted legislation is fundamental. Continuation with a transparent privatisation process and promotion of efcient corporate governance are also to be taken into account. Further fundamental actions are needed in enterprise restructuring and in abandoning the provision of budgetary and non-budgetary support to unprotable enterprises. Financial discipline should be reinforced by strengthening bankruptcy mechanisms, promoting innovative managerial behaviour and improving corporate governance in order to create substantial prot-making incentives. Special attention should also be paid to the continuation of essential reforms to improve the quality of infrastructure services in various sectors such as energy, communication and water supply. Economic growth requires an attractive and competitive business and investment climate. Dramatic improvements in the quality of the business environment and active policy to facilitate economic restructuring and new private entry are crucial objectives to be followed by the government (World Bank, 2002). These should include; reducing the level of corruption to create a business-friendly environment; increasing the transparency of government activities mainly by enforcing compliance to the international standards of auditing practices; focusing on the implementation of existing laws while making attempts to improve them; improving tax and customs administration which, with enhanced rates of collection, may permit lower rates; continuing the attempt to decrease the shadow economy and broadening the tax base by regularising the informal economy and building institutions capacity to provide support to businesses and especially to new entrants. Good governance is essential for the promotion of private activity and there is an urgent need to prevent the state from interfering with business operations in order to improve the investment climate, particularly for FDI by multinational companies. Export-focused industrial clusters Sustainable economic growth in Armenia should be based on steady growth and expansion in exports but take into account concerns related to import substitution policies and the small size of the domestic market. To ensure expansion of Armenias exports, the government should encourage the creation and development of clusters and, if necessary, the modication or abandonment of clusters that do not possess national competitive advantage. These clusters may be broadly divided into three groups. The rst group should be formed by clusters of already operational industries, which are based on factor conditions such as raw materials or agricultural crops or a qualied and cheap labour force and are targeted to maximise the value-added production in Armenia. These industries include diamond cutting, jewellery and textiles, which are based on advanced factors such as a specialised labour force,

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production traditions and existing technologies. It is also important to nd alternative transportation routes and new markets, and to increase quality standards of products in growing industries such as food processing, beverages, furniture, construction materials and others tied to basic factor conditions. These industries have to adopt both cost advantage and product differentiation strategies to be competitive in international markets. It is also necessary to encourage processes that add value in mining industries or in others that are based on local raw materials. For instance, the construction of a copper renery may increase the forward integration of the non-ferrous mining industry (UNDP, 2003). The second group of clusters should be formed of industries to be developed for mass production and export of manufactured products. These industries should mainly use Armenias basic factor advantages, including a functionally literate and cheap general work force. These industrial clusters will utilise imported technologies, materials and knowledge. Large investments in these clusters more desirably in the form of FDI from multinational companies are very important considering Armenias limited internal investment capacities and the unavailability of international distribution channels for penetrating foreign markets. Possible examples include leather and textile products, detergents, automotive components, etc. Finally, the third group of clusters should rely on advanced and specialised factor conditions of Armenias diamond that are yet to be built and/or upgraded. These include the telecommunications, banking, health, transportation and education infrastructure and tourism sectors. These clusters should combine advanced facilities with entrepreneurial skills. Armenia has a rich historical and cultural heritage that is yet to be opened to the world and which could provide a base for the development of activities related to tourism and culture. Penetration of international markets for activities related to the music, art, movie and theatre industries especially into the countries with high concentrations of Armenian diaspora such as the USA, Russia, France, Argentina and the Middle Eastern countries offers a signicant potential opportunity. Moreover, exporting services rather than physical products overcomes the disadvantage of Armenias remote location. Innovation-driven industrial clusters Clusters that produce fundamental knowledge and applied research and innovations should be encouraged. In the long run this would enable Armenia to become an exporter of technologies, knowledge and innovations, thus mitigating if not transcending almost all the current comparative disadvantages. To unlock the countrys scientic potential, the government should encourage partnerships between universities, research centres and private rms. Such partnerships should act as business entities and supply knowledge and information-based products and services to domestic industries and the export market. Multinational companies and FDI At this stage of Armenias economic, multinational companies and foreign direct investments should play an important role in enhancing industrial competitiveness and developing export-based and innovative-driven clusters. Multinational companies often seed the clusters and continuously upgrade them so that an entire chain of supporting and related industries can eventually develop. The cases of Costa Rica and

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Ireland are good examples of the role multinational companies play in shaping clusters and developing supporting and related industries. (OMalley and OGorman, 2001; Rodriguez-Clare, 2001). For instance, Intels decision to invest in Costa Rica became news worldwide, and it dramatically improved the countrys image as a viable economy and as an attractive location for high-tech companies. Intel has thus enhanced the countrys ability to attract FDI and the economys general competitiveness in skill-intensive industries. In the case of Ireland, the perception is that Irish business is adopting new technologies and skills and is undergoing a profound transformation of its organisational capacity because of the presence of multinational companies subsidiaries (Clancy et al., 2001). But perhaps the most important impact from the entry of a multinational company occurs when it forms partnerships with educational entities and research institutes and creates investments in improving the standards of education and science. The government should therefore encourage FDI, particularly when it is associated with this type of activity. The large and economically powerful Armenian diaspora should be an important target for these efforts and provide valuable assistance. Policies that reduce potential investors perceptions of political and economic risks are also crucial. Conclusion The experience of Armenia shows that having the required legislative and institutional framework, as well as market liberalisation and a stable macroeconomic environment are necessary but not sufcient conditions to ensure continued economic growth and the achievement of sustainable development. In this regard, appropriate medium-term and long-term economic development strategies based on increasing productivity through upgrading the national diamond and fostering competitiveness are of paramount importance. This analysis of the current state of Armenias diamond indicates that Armenias industries currently exploit general basic factor advantages. Future development requires the development of and exploitation of more advanced and specialized factor conditions along with the necessary related and supporting industries. Appropriate demand conditions and increased competitive rivalry among Armenian rms also need to be encouraged. This discussion of the sources of Armenias recent economic growth also leads to the conclusion that the import substitution policies are exhausted and the country should seek alternative development strategies targeted to export growth and innovative development. These strategies can be realised through mechanisms directed to achieving a sustainable increase in national productivity and enhancing the international competitiveness of Armenian industries. For this purpose, Porters CAN model serves as a useful framework for enhancing Armenian industries competitive advantages by dening Armenias diamond and implementing sustainable mechanisms for its improvement.
References CBA (2005), Annual Report 2004, Central Bank of Armenia, Yerevan. Clancy, P., OMalley, E., OConnell, L. and Van Egeraat, C. (2001), Industry clusters in Ireland: an application of Porters model of national competitive advantage in three sectors, European Planning Studies, Vol. 9 No. 1, pp. 7-29.

Drucker, P.F. (1995), Managing in a Time of Great Change, Truman Talley, New York, NY. Drucker, P.F. (1999), The Management Challenges for the 21st Century, HarperCollins, New York, NY. EBRD (2002), European Bank for Reconstruction and Development; Transition Report, EBRD, London. Egorov, G.N. (2000), Economic Transformation, Industrial Potential and Current Status of Integration of the CIS Countries: The Role of Science and High-technology, UNIDO, Vienna. Government of Armenia (2003), Poverty Reduction Strategy Paper, Government of Armenia, Yerevan, available at: www.gov.am/enversion/programs IMF/World Bank (2002), Poverty reduction, growth and debt sustainability in low-income CIS countries, working paper, International Monetary Fund and World Bank, Washington, DC. Khemani, S. (2003), Fostering Competitiveness, World Bank, Washington, DC, available at: www. worldbank.org/wbi/mdf/mdf1/foster OMalley, E. and OGorman, C. (2001), Competitive advantage in the Irish indigenous software industry and the role of inward foreign direct investment, European Planning Studies, Vol. 9 No. 3, pp. 204-320. Porter, M.E. (1990a), The Competitive Advantage of Nations, Free Press, New York, NY. Porter, M.E. (1990b), The competitive advantage of nations, Harvard Business Review, March, pp. 73-93. Porter, M.E. (1990c), Competitiveness; challenging the conventional wisdom, Harvard Business Review, May, pp. 190-2. Rodriguez-Clare, A. (2001), Costa Ricas development strategy based on human capital and technology: how it got there, the impact of Intel, and lessons for other countries, Human Development Report 2001, UNDP, New York, NY. Snow, T., Faye, M., McArthur, J. and Sachs, J. (2003), Country case studies on the challenges facing landlocked developing countries, Occasional Paper, Human Development Report Ofce, UNDP, New York, NY. Statistical Yearbook of Armenia (2005), Statistical Yearbook of Armenia, National Statistical Service of Armenia, Yerevan, available at: www.armstat.am Statistical Yearbook of South Caucasus: Armenia, Azerbaijan, Georgia (2004), The State Statistical Service of Azerbaijan and the State Department of Statistics of Georgia and EU TACIS Program, Yerevan, Joint publication by the National Statistical Service of Armenia, available at: www.armstat.am UITE (2001), Armenia: The State of IT Industry; Findings of the Survey of Information Technology Enterprises, Union of Information Technology Enterprises of Armenia, Yerevan. UNDP (2002), Growth, Inequality and Poverty in Armenia, United Nations Development Programme, Yerevan. UNDP (2003), Concept paper; sustainable economic policy for Armenia, Sustainable Economic Development Policy for Armenia, United Nations Development Program and Ministry of Trade and Economic Development of Armenia, Yerevan. UNDP (2005), Human Poverty and Pro-poor Policies in Armenia, United Nations Development Programme, Yerevan. UNIDO (2001), Management of technology, Selected discussion papers presented at the Vienna Global Forum, Vienna International Centre, Austria, United Nations Industrial Development Organisation, Vienna, 29-30 May.

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World Bank (2002), Growth challenges and government policies in Armenia, World Bank Country Study, Document No. 23786, World Bank, Washington, DC, available at: www. worldbank.org World Bank (2003), World Development Indicators, World Bank, Washington, DC, available at: www.worldbank.org World Bank (2005), Poverty Reduction Strategy paper; Progress Report August 2003-December 2004, World Bank, Yerevan, available at: www.worldbank.org/INTPRS1/Resources/ Armenia Further reading EBRD (2003), European Bank for Reconstruction and Development, Transition Report Update, EBRD, London. Li, J. and Lam, K. (1999), High-tech industries and competitive advantage in emerging markets: a study of foreign telecommunication equipment rms in China, Journal of High Technology Management Research, Vol. 10 No. 2, pp. 295-312. OShaughnessy, N.J. (1996), Michael Porters competitive advantage revisited, Management Decision, Vol. 34 No. 6, pp. 12-20. Statistical Yearbook of South Caucasus: Armenia, Azerbaijan, Georgia (2002), Statistical Yearbook of South Caucasus: Armenia, Azerbaijan, Georgia, The State Statistical Service of Azerbaijan and the State Department of Statistics of Georgia and EU TACIS Program, Yerevan, Joint publication by the National Statistical Service of Armenia, available at: www.armstat.am About the authors Armen Chobanyan is Programme Manager, United Nations Ofce for Project Services. Laurence Leigh is a Professor at Rushmore University, a leading global online business school. Leigh has taught marketing, business strategy and entrepreneurship extensively in both the US and Europe and is currently teaching at the American University in Beirut. In the past, he has conducted training courses for executives from emerging markets on behalf of the International Labor Organization and the Italian Government Institute for Foreign Trade. Leigh has also been active as a consultant and entrepreneur, having been involved in the development of two successful start-ups. He holds a PhD in Marketing from the University of North Carolina, Chapel Hill, an MBA from the London Business School, and a Master of Arts in Economics from Cambridge University. Laurence Leigh is the corresponding author and can be contacted at: lleigh@libro.it

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