- Dollars Dollars Everywhere and Not a Dime to Lend? Credit Limit Constraints on Financial Sector Absorptive Capacity
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- by Khwaja, Asim; Mian, Atif; Zia, Bilal
- The inability of developing countries to absorb and retain capital has long puzzled observers.
The unanticipated events of 9/11 simultaneously led to a surge in capital flow into
Pakistan, and an increase in aggregate demand. Yet despite rising deposit to loan ratios and
precipitous fall in cost of capital, banks showed remarkable hesitancy to expand firm credit.
We use quarterly firm-level data on debt capacity limits on all actively borrowing firms
in Pakistan to show that debt capacity constraints led to the limited absorptive capacity
of financial sector. Consistent with debt capacity hypothesis, “financial slack” positively
predicts credit growth, and this predictability shoots up immediately following 9/11. This
financial slack effect is stronger within industries receiving larger demand shocks, stronger
within smaller firms, and completely absent for firms that do not face debt capacity constraints
due to ex-ante lax regulation. A number of tests show that our results are unlikely
to be driven by unobserved firm quality or expected changes in loan demand. Tentative
estimates put the economy wide costs of these debt capacity constraints at 2.3% of GDP.
- Publication Type: WCFIA Working Paper
- Published Date: March 2007
- Field of Interest: International Economics
- Khwaja, Asim, Atif Mian, and Bilal Zia. “Dollars Dollars Everywhere and Not a Dime to Lend?” Working Paper 2008-0073, Weatherhead Center for International Affairs, Harvard University, March 2007.