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The competitive advantages of

nations

The competitive
advantages of
nations

Applying the Diamond model to Armenia

Armen Chobanyan

147

United Nations Office for Project Services, Yerevan, Armenia, and

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 sufficient 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 first 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 first 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 influences factor conditions; demand
conditions; firm strategy; structure and rivalry; and, finally, 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 define
certain problems and obstacles which firms 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 deficits, capital costs and
currency values play a role in national economic prosperity but they are not the causal,
the sufficient nor the most important influence 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 justified, 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 difficult and accompanied by political
cataclysms and unrest, armed conflicts, economic and social shocks, as well as massive
changes in its terms of trade.
The beginning of the 1990s was the most difficult 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 inflation
rates leading to hyperinflation, 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-fledge 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 fiscal 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 inflation, a sharp decrease and, starting from 1997, abolition of

inflationary financing of the budget deficit (UNDP, 2003) and introduction of a floating
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 efficiency. These macroeconomic measures have spurred economic
growth which was 13.9, 10.1 and 11.6 per cent in 2003, 2004 and 2005 (first 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 firms will lack advantage in
international markets and they will be vulnerable to economic cycles and currency
fluctuations. 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 inflows 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 firms, 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 firms, 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 five 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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Determinants of
Armenias Diamond

Governments Role

Governments Role

Maintain Favourable
Geopolitical Environment

Support in creation of exportbased clusters

Maintain Stable
Macroeconomic Environment

Support in creation of
innovative-driven clusters

Improve Business
Environment

Ensure environment for FDI

growth

Factor 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

Figure 1.

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

Demand
Conditions

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

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 qualifications 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 firms 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 five 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 flows and foreign
ownership in banking had been removed. However, Armenia has achieved relatively
slower progress in ensuring the efficient operations of financial institutions and in
raising its banking and financial 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
significant 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 financial 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 efficient.
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 inefficiency of domestic borrowing by the public sector
(World Bank, 2002).
Physical resources. Armenias terrain is mainly highland, with mountains and fast
flowing 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 difficulties 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 profitable 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 conflicts with neighbouring countries and a severely deteriorated
infrastructure. Armenias traditional trade route through Azerbaijan, which accounted
for over 85 per cent of Armenian trade flows, was blocked in 1990/1991 as a result of
the conflict 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 significantly 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 significant 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 financed 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 difficulties 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 traffic
declined significantly: 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 significant increase in rail freight. Rail traffic 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 efficient 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 benefit 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 traffic 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 dissatisfied 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 identified 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 significant deterioration in its industrial potential with output in 2000 comparable to
the level of the 1970s, but also by a dramatic decline in research, scientific 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 financing 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 scientific, 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, significant 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 flexible 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 significant number of them.

156
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 significant demand for certain specialised
services and products in related industries.
Local market demand, in both quantitative and qualitative terms, has significantly
influenced 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 efficient and innovative approaches to production, marketing and retailing.
This situation has forced firms to lower prices, introduce new features, improve the
quality of their products and finally 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 inefficient in the new
market environment. During the transition period since 1991, Armenia has made
significant 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 significant preferences to insiders. It is
absolutely crucial to adopt efficient corporate governance and management systems in
newly created or privatised firms 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.

The growing significance 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 firms, 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 efficient 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 firms 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, efficient 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
firms. 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 flows 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 final 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 influence 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
efficient 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 efficient 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 conflicts would avoid the competitive
disadvantage of being considered as a conflict 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 fiscal and monetary policies should be targeted to maintain
macroeconomic stability, low inflation and predictable and relatively stable currency
exchange rate. Such policies should be accompanied by maintenance of an open trade
regime and a favourable fiscal 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 identified 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 fiscal 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 efficiency 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 efficiency of the countrys health system.
The PRSP identifies the essential role of infrastructure including the energy, water,
irrigation and transport sectors in Armenias development agenda. Enhancing
efficiency 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
financing for their repair are found.

160

Progress in transition reforms and improvement in business environment

It is crucial to build on the significant progress made by the country in transition reforms.
To improve Armenias diamond, legislation in the banking and financial 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 efficient 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 unprofitable enterprises. Financial
discipline should be reinforced by strengthening bankruptcy mechanisms, promoting
innovative managerial behaviour and improving corporate governance in order to create
substantial profit-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 modification or abandonment of clusters that do not possess national
competitive advantage. These clusters may be broadly divided into three groups.
The first 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
qualified 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,

production traditions and existing technologies. It is also important to find 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 refinery 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 significant 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 scientific potential, the government should encourage partnerships between
universities, research centres and private firms. 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 sufficient 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 firms 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 defining Armenias diamond and implementing sustainable
mechanisms for its improvement.
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of Azerbaijan and the State Department of Statistics of Georgia and EU TACIS Program,
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About the authors
Armen Chobanyan is Programme Manager, United Nations Office 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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