WPS3820

# **How Important Are Financing Constraints?**

## **The role of finance in the business environment**

### **Meghana Ayyagari**

### **Asli Demirgüç-Kunt Vojislav Maksimovic***

**Abstract:** What role does the business environment play in promoting and restraining firm growth? Recent literature points to a number of factors as obstacles to growth. Inefficient functioning of financial markets, inadequate security and enforcement of property rights, poor provision of infrastructure, inefficient regulation and taxation, and broader governance features such as corruption and macroeconomic stability are all discussed without any comparative evidence on their ordering. In this paper, we use firm level survey data to present evidence on the relative importance of different features of the business environment.  We find that although firms report many obstacles to growth, not all the obstacles are equally constraining. Some affect firm growth only indirectly through their influence on other obstacles, or not at all. Using Directed Acyclic Graph (DAG) methodology as well as regressions, we find that only obstacles related to Finance, Crime and Policy Instability directly affect the growth rate of firms. Robustness tests further show that the Finance result is the most robust of the three. These results have important policy implications for the priority of reform efforts. Our results show that maintaining policy stability, keeping crime under control, and undertaking financial sector reforms to relax financing constraints are likely to be the most effective routes to promote firm growth.

#### **Keywords: Financing Constraints, Firm Growth, Business Environment**

#### **JEL Classification: D21, G30, O12**

#### World Bank Policy Research Working Paper 3820, January 2006

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirelythose of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Policy Research Working Papers are available online at http://econ.worldbank.org._

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*Ayyagari: Assistant Professor, School of Business, George Washington University, <u>ayyagari@gwu.edu</u> ; Demirgüç-Kunt, Senior Research Manager, Finance and Private Sector Development, Development Economics Research Group, World Bank, <u>ademirguckunt@worldbank.org</u> ; Maksimovic: Dean's Chair Professor of Finance, Robert H. Smith School of Business at the University of Maryland, <u>vmaksimovic@rhsmith.umd.edu</u> . We would like to thank Gerard Caprio, Stijn Claessens, Patrick Honohan, Leora Klapper, Aart Kraay, Norman Loayza, David Mckenzie, Dani Rodrik, L. Alan Winters, Rajesh Chakrabarti and seminar participants at the World Bank’s Economist Forum, George Washington University, and Indian School of Business for their suggestions and comments. This paper’s findings, interpretations, and conclusions are entirely those of the authors and do not necessarily represent the views of the World Bank, its Executive Directors, or the countries they represent.