# **1. Introduction**

Private sector growth remains one of the main challenges facing developing countries in their quest for development and poverty reduction. Extensive evidence shows that a favorable business environment helps promote the growth of firms. As shown in recent research, however, firms in developing countries face a tougher business environment than their counterparts in the developed world.

Our aim in this paper is twofold. First, we seek to go beyond the traditional menu of constraints on firm growth to find out which of these constraints is the most binding. As the growth diagnostics approach points out, developing countries have scarce resources and therefore need to focus on removing the most binding constraint. Second, we examine the effects of the most binding constraint on firm growth not only across countries but also by firm characteristics.

We first explore the relationship between the business environment and firm growth as measured by employment growth. Among 15 components of the business environment, we identify the most binding constraint using both subjective and objective measures. Our focus is on the most binding constraints for existing firms and, more specifically, the binding constraint that matters the most for firm growth. The methodology follows two steps. The first is to find out which constraints are statistically significant among all regressions after controlling for firm characteristics and country fixed effects. The second is to identify the most binding constraint. We find that besides informal sector competition, access to finance is the obstacle that matters the most for growth. This result is robust for all regions and all sectors.

Our analysis contributes to the existing literature in several ways. First, using a large sample, containing more than 39,000 firms across 98 countries, we identify the most binding constraint on firms using subjective measures, then evaluate the importance of this constraint to firm growth using objective measures and controlling for firm characteristics. The sample comes from World Bank Enterprise Surveys conducted in 2006–2010 in mostly emerging and developing countries. The surveys provide both subjective data on perceived obstacles and objective measures of many constraints.

Second, we investigate the effect of financial access variables on firm growth by using firm-level regressions across countries controlling for the effects of different firm sizes, firm ages, sectors, and regions. Our results show that having access to finance in the form of a loan, sales credit, or external finance helps micro firms the most. This finding holds not only for the full sample but also for different regions. Sales credit is important only to micro and small firms, probably because it substitutes for bank loans. Having a loan or overdraft facility and receiving external finance for investment help growth for firms of all sizes across regions.

Third, we find clear evidence that a low level of financial sector development affects the firm size distribution and therefore contributes to the phenomenon of the “missing middle” in developing countries. Firm size distribution is skewed toward small and medium-size firms—and more so in 2