returns’ to capital as a result of ‘government failures’ (such as taxes, poor property rights, corruption, labor‐capital conflicts, macro instability, etc) and ‘market failures’ (such as coordination externalities and learning externalities affecting negatively the country’s ability to adopt new technologies). The _cost of finance_ may be high because the country has limited access to external capital markets or problems in the domestic financial market. Difficulties in accessing external capital markets arise for diverse reasons such as high country risk, unattractive FDI conditions, vulnerabilities in the debt maturity structure, and excessive regulations of the capital account. Bad local finance may be due to low domestic saving and/or poor domestic financial intermediation.

**An exercise in growth diagnostics consists of reviewing and analyzing the factors found along the branches of the growth diagnostic tree in order to ascertain which of these factors are the binding constraints to growth.**<sup>**11**</sup> Although all factors may matter for growth and welfare, those that are binding are likely to provide the largest positive direct effect when released, so that even after taking into account second‐best interactions, the net impact of a policy change is positive and sizable. While this methodology seems simple, in practice it is challenging to identify indicators of scarcity that make possible a trade‐off between the potential constraints to growth. When a constraint is binding, one should be able to observe a number of phenomena: (i) the (shadow) price should be high, (ii) movements in the constraint should produce significant movements in growth, (iii) agents in the economy should be attempting to overcome or bypass the constraint, (iv) agents less intensive in that constraint should be more likely to perform well, and vice versa.<sup>12</sup> Hence, for each potential constraint it is not enough to just conclude that the levels are low but it is also necessary to observe signs of scarcity, i.e. signs of a current need for the constraint to be released in the particular economic environment of the country in question.

**Benchmarking the performance of an economy is one way of identifying factors that hold investment and economic activity in a specific country back.** First of all, it is important to select an appropriate group of comparative countries. The core group of comparators should consist of countries that share similar characteristics with the country of interest, and are going through similar development states (see Box 1). More so this set of countries should also include good performers in the region (as well as regional and income groups’ averages) to see in what dimensions they differ from the studied country. Though the group of comparators may, in fact, vary depending on the question one needs to address.<sup>13</sup> While useful for identifying problem areas, benchmarking for growth diagnostics has limitations and should be used with caution and jointly with other methods to shed light on constraints to growth. For example, comparisons are meaningful only if the indicators are constructed following procedures that are consistent across countries, and a change in the set of comparator countries for an indicator may change the conclusions from a benchmarking exercise. Moreover, evidence that a country ranks low on a given indicator does not imply that the area is a ‘binding’ constraint to growth – it is only an indication that this might be the case. There might be worse constraints that are the binding ones, or the structure of the economy in the specific country of study is simply not sensitive to that potential constraint.

**Another popular source of information is enterprise survey data, but this type of data must also be interpreted with caution.** Besides general information about the firm (including size, ownership, location, sector of economic activity, etc.) these surveys record perceptions, indicators of performance and objective business indicators, in areas such as infrastructure and services, access to land, crime, finance, business government relations, labor regulations and environment, etc. So called Investment Climate Assessment (ICA) surveys are extracted mostly from private business enterprises and aim to understand, precisely, what are the main constraints to economic activity. However, there are a number of caveats such as:

> 11 Note that we do not assume we will find one binding constraint but rather a bundle of constraints that all need to be addressed to trigger growth. However, the goal is not to present a laundry list but a few prioritized areas of concern. 12 See Hausmann, et al. (2005), Hausmann, Klinger and Wagner (2008), Rodrik (2004a and 2004b).

> 13 For example, when one would like to assess whether the cost of capital is high in a country, the group of comparators must include countries with similar credit worthiness ratings. When addressing questions about logistics and transport costs, the group of comparators must include land‐locked countries with similar types of traded goods.

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