«Research Statement April 2009 Asim Ijaz Khwaja Introduction The development process is in large part about addressing market failures. Whether it is ...»
Research Statement April 2009
Asim Ijaz Khwaja
The development process is in large part about addressing market failures. Whether it is the inability of
productive firms to obtain financing or children to receive quality education, private and public responses can
be significantly constrained by market deficiencies. A central theme in my work has been to identify and
address such limitations faced by developing countries in the process of accumulating physical, human, and institutional capital – three prominent factors that promote an economy’s development.
My primary training, at both the doctoral and undergraduate levels at Harvard and MIT, has been in applied microeconomic theory. I have built on this foundation through extensive fieldwork, comprehensive data collection, and rigorous empirical analysis in order to answer questions that are motivated by and engage with policy. This policy engagement has not only provided conceptual insights and facilitated data access but has also given me unique opportunities to design, implement, and evaluate interventions. It is this combination of theoretical and empirical analysis with fieldwork and policy engagement that allows my research to uniquely contribute to both academia and policy in three broad areas: finance, education, and institutions.
My work in finance uncovers informational and agency problems in emerging financial markets. This includes examining market manipulation, firm networks, and the impact of aggregate liquidity shocks. The empirical analysis exploits detailed secondary, though unexplored, data sources ranging from individual trade data in stock markets to credit registry databases that cover the universe of bank and institutional lending. My research has been published in leading economic journals, such as the American Economic Review and the Quarterly Journal of Economics, and is at the forefront of a new and rapidly growing field in emerging economy financial markets. Funded by a large seed grant from the Google.org Foundation to establish the Entrepreneurial Finance Lab (EFL) at Harvard, I have also begun to examine how alternative financial instruments may unleash the entrepreneurial potential in emerging economies, valued at several trillion dollars. Given the current financial crisis, the informational and regulatory issues I examine in my research are increasingly salient in developed markets, and I plan to contribute to research and policy in this area, as well.
My research in education addresses another challenge central to an economy’s growth – the development of human capital. With a mushrooming of affordable, private, “mom-and-pop” schools in many developing countries, there is a growing recognition that education is both publicly and privately provided. My work considers the nature, evolution, and implications ofhaving such an educational market. In order to do so, I have lead an ambitious and novel effort that surveys the entire educational universe – schools, teachers, parents, and children – in over one hundred villages in Pakistan, capturing its evolution over a four-year period. In the process, I have directly engaged with local policy makers on a series of feasible, market-level experimental interventions that address informational and accountability failures. With well-received initial publications, including a paper winning the George Bereday Award in 2006, this work demonstrates the value of such longer-term, comprehensive projects. I use both observational and experimental evidence in order to shed light on the dynamics of the educational marketplace, to examine supply and demand-side constraints, and to design and analyze the market-wide impact of interventions that alleviate them.
In addition to financial and human capital, institutional factors – as determined by the culture, norms, and history of a region – are also central to the development process. My research also examines such factors, from a group’s ability for collective action to its beliefs and values. My work on understanding how religious institutions like the Hajj, the annual Islamic pilgrimage to Mecca, shape beliefs and behavior is particularly salient given the current concerns about Islamic extremism. Such work has drawn both academic and policy attention, being published in the Quarterly Journal of Economics and informing discussions in Washington and Islamabad, as well as receiving coverage in media outlets such as the NY Times, Washington Post, International Herald Tribune, Economist, Al-Jazeera, BBC, and CNN. More recently, I was awarded the 2009 Carnegie Scholars Fellowship in order to continue this research and identify mechanisms that may moderate extremism and promote tolerance in a world at risk of increasing divisions.
My empirical work so far has mostly focused on Pakistan due to my familiarity with the context, as well as to reduce the large fixed costs of gathering detailed data. While this region is of particular global interest, it is also fairly representative of emerging economies in the themes I examine. Therefore, the research insights generated have broader implications for developing economies and, in several cases, for the developed world.
I am also expanding my research to other countries in ongoing work and I anticipate this will increase further.
In addition to the research I have also directly contributed to policy. This is best demonstrated in my cofounding the web-portal www.risepak.com set up to coordinate disaster relief following the 2005 Pakistan earthquake. The portal was extensively used and widely recognized, winning the 2006 Stockholm Challenge Award in Public Administration. In the coming years, I expect that my scholarship and policy engagement will remain deeply intertwined and that the positive synergies between the two will allow me to make unique contributions to both. Below I present my research in each area in more detail.
A. Finance and Firms Financial markets intermediate the matching of money to ideas. To the extent that there are failures in such markets, the effectiveness of this role will be diminished, with potentially large consequences for the economy. My research in this area, mostly developed jointly with Atif Mian (Chicago, Booth GSB), examines this question from a series of related perspectives that focus on informational and agency problems prevalent in emerging and, increasingly, in developed financial markets.1 I do so primarily by taking advantage of detailed data sources from Pakistan – ranging from individual trade data in stock markets to credit registry databases that cover the universe of formal bank and institutional lending – and developing methodologies that permit better causal inference.
There are four broad directions of enquiry that I am pursuing: uncovering market manipulation; tracing the impact of aggregate liquidity shocks; examining the nature and role of firm networks; and developing alternative instruments to help facilitate financial access.
Market manipulation It is widely believed that manipulation of financial markets is prevalent in emerging economies and imposes a substantial cost. Recent financial scandals in the US suggest that manipulation may also still be at play, though While most of my work is co-authored, both in this section and subsequent ones, for the purpose of this document 1 after explicitly identifying my coauthor(s), I shall subsequently use “I” rather than “we.”
I directly identify the presence of market manipulation in both equity and debt markets in two different papers that exploit novel micro-data from Pakistan. “Unchecked Intermediaries”2 (Journal of Financial Economics, 05, with A. Mian) uncovers manipulation by market intermediaries in equity markets. I utilize a unique dataset of all daily trades for every broker trading during a two and a half year period in the main stock exchange in the country to identify a “pump and dump” price manipulation scheme believed to be prevalent in emerging economies and also reminiscent of trading behavior on the NYSE in the 1900s. When prices are low, colluding brokers trade among themselves to artificially raise prices and attract positive-feedback traders.
Once prices have risen the brokers exit, leaving the traders to suffer the ensuing price fall. Estimating the profits generated by such trading manipulation shows that manipulating brokers earn up to 90 percentage point higher returns. Conservative estimates suggest a $100 million annual transfer of wealth from outside investors to manipulating brokers – 10 percent of market capitalization. These substantial profits may explain the resistance of brokers to governance reforms and also suggest why emerging equity markets often remain marginal, with few outsiders investing and little capital raised.
Banks offer the dominant form of firm financing in most economies and manipulation in these markets is likely to have serious consequences on an economy’s growth and productivity. Moreover, rents obtained by the politically connected are singled out as a source of corruption in developing countries. In “Do Lenders Favor Politically Connected Firms?” (Quarterly Journal of Economics, 05, with A. Mian), I identify politicallybased rent provision by exploiting an incredibly rich dataset that covers every loan by each bank to all firms borrowing in Pakistan over a seven-year period.
I find that politically connected firms receive substantial preferential treatment from public banks. A firm is classified as “politically connected” if any of its directors participated in a recent national or state election.
The results show that politically connected firms borrow one and a half times as much and have 50 percent higher default rates. Suggestive of rent provision, such preferential treatment is only observed for loans given by government banks, with private banks displaying no such favorable treatment. A contribution of this work is to empirically identify that this preferential treatment is indeed a likely result of rent-provision to the politically influential. First, using firm fixed effects (and thereby exploiting variation for the same firm across lenders and over time) shows that unobserved time-invariant firm characteristics are unlikely to be a confounding factor. Second, I am also able to provide direct evidence against alternative explanations such as socially motivated lending by government banks to politicians. This work shows political corruption in financial markets can have a tremendously adverse impact – tentative estimates using the results in this paper suggest a cost of 1.9 percent of GDP per year, quite similar to the numbers obtained in cross-country macrostudies.
The results also show rents are affected by the nature of politics. They increase with the strength of the firm’s politician and political party and fall with electoral participation in his constituency. This raises several questions on how such rents can be checked, for example, by imposing constraints on political candidacy, governance reforms, and privatization, or by their electorate not re-electing rent-seeking politicians. On a For the sake of expositional clarity, I have shortened the paper titles. Complete titles are provided in my CV.
Liquidity Crises and Booms An important and much debated question in the literature and one that is of particular concern these days is to what extent liquidity shocks can have large and real effects on the economy. While it has been argued that severe recessions like the Great Depression and the Asian Financial Crisis arose due to liquidity shocks, identifying the full impact of a bank liquidity shock has remained a challenge. This is primarily because of empirical difficulties in separating out the demand/productivity shocks that typically accompany the supply shocks.
In a series of papers, I am able to isolate the supply channel and highlight the agency problems that may underlie why liquidity shocks can have real consequences. I can do so by using methodologies that take advantage of both comprehensive data and two recent and large unanticipated liquidity shocks to the Pakistani financial markets: a liquidity crisis after the multilateral aid withdrawals due to the 1998 nuclear tests carried out by India and Pakistan; and a liquidity boom due to the reverse capital flight after 9/11. These shocks provide novel “natural experiment” settings that permit cleaner empirical analysis.
In “Tracing the Impact of Bank Liquidity Shocks” (American Economic Review, 08, with A. Mian), I find evidence of a substantial “bank lending” channel (shocks to the supply of a bank’s liquidity affect its lending) and trace its distributional consequences. Differential (across banks) liquidity shocks arising from the unanticipated nuclear tests and a dataset linking firms to all banks allow me to isolate the supply shock.
Contemporaneous demand shocks are “netted out” by comparing changes in lending to the same firm borrowing from two different banks, thereby isolating the supply-side channel. The results reveal a large bank-lending channel, with a bank decreasing its lending to firms by 0.37 percent for every percent drop in its own liquidity (deposit base).
In addition to providing improved empirical identification of the bank-lending channel, I also contribute to the literature by tracing the impact of this channel on a client firm’s overall borrowing and subsequent financial health to reveal the distributional consequences of such shocks. I find that larger firms fully compensate the initial shock by increasing their borrowing from more liquid banks and establishing new banking relationships. In sharp contrast, smaller firms bear the entire brunt of the initial shock and are unable to compensate because they are unable to access new sources of bank financing. Such firms not only see large drops in their overall borrowing from the financial sector but are also more likely to enter financial distress in the years following the shock.
These results have important policy implications: They highlight the substantial imperfections faced in interbank markets. Moreover, they show that in addition to aggregate effects, financial crises may have even more costly distributional consequences if smaller firms face the primary brunt of such shocks. In the development literature, there is suggestive evidence of far fewer middle-sized firms compared to developed economies.