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When Şebnem Kalemli-Özcan started studying economics, she realized that it was an excellent framework for understanding why people behave the way they do — something she had been interested in for a long time. During her studies, she became a true believer in the field of economics. The professor at the University of Maryland takes mentoring students and being a role model as seriously as her research.

During the pandemic recession, Kalemli-Özcan looked at the impact of nationwide lockdowns and social distancing measures on small and medium-sized enterprises (SMEs). The economist explains that people normally think of “mom-and-pop” stores but that SMEs represent a significant fraction of the economy. In the European Union, for example, it’s 99.8 percent of all employer firms. “If they go down, it means we’re going to have a serious hit to aggregate employment and aggregate output in many countries,” says Kalemli-Özcan.

In a recent paper, the economist estimated the fraction of SMEs that would have failed by end of 2020 under COVID-19 with no fresh liquidity injections – it’s a doubling from 9.4 to 18.2 percent – and analyzed the effectiveness of policy interventions to stop business failures and ensure a smooth recovery of the economy.

“The direct transfers in European countries were very effective. The speed of the funds and the implementation was very smooth,” says Kalemli-Özcan. “If your goal is to save jobs, that’s a good way to go. Direct transfers that cover firms’ payrolls and cash shortfall in the immediate run.”

Kalemli-Özcan emphasizes the need for businesses to build resilience in a (post) COVID-19 economy and the challenges SMEs face since they are critically dependent on debt for financing and therefore struggle to build up a cash cushion. “Why were some SMEs hurt more than others? The big difference is the level of debt and leverage they entered the crisis with,” says the economist. “You can’t keep your business going on a pile of debt. During the boom, there is no reason to leverage yourself up to the roof just to increase your profits. That comes and hurts you.”

COVID19 and SME failures.

A focal point of Kalemli-Özcan’s research has been economic growth and productivity in Europe, especially in the aftermath of the European debt crisis. For example, she analyzed how a decrease in corporate investment in recent years can be linked back to the crisis. “If you go back to 1999, with the introduction of the euro, southern and northern countries’ interest rates approach the same level,” explains Kalemli-Özcan. “Suddenly, everybody can borrow at lower interest rates, and firms increase their debt to finance investment projects.”

Kalemli-Özcan outlines how, when the crisis hit in 2009, small and medium-sized enterprises in many countries couldn’t undertake investment because of debt overhang (debt built up during the boom years after the introduction of the euro). Additional pressure was put on firms because of short-term debt, which they weren’t able to repay in a low-demand economy, and also couldn’t easily roll over because banks were facing a liquidity problem.

Kalemli-Özcan’s research is based on data from ten eurozone countries, and links firms to banks to sovereigns to quantify the role of financial factors behind sluggish corporate investment. It’s a striking example of her big data approach — for her paper on corporate investment, she and her co-researchers used over two million observations. Just the process of matching each firm to each bank and matching each bank to its sovereign took an entire year.

The firm-bank-sovereign matched database revealed that the debt overhang and rollover risk accounted for 60 percent of the decline in aggregate corporate investment in post-crisis Europe. It showed that the effect on corporate investment was even higher when firms were tied to a weak bank (a bank that holds sovereign debt of a sovereign under stress).

Ten years after the crisis, the de-leveraging process still affects corporate investment and, ultimately, productivity and growth. “The debt overhang is a problem that is going to have long-lasting effects. Until this process is complete, investment is going to be low,” points out Kalemli-Özcan.

To help solve this debt overhang problem, the economist suggests focusing on policies that directly target the very indebted corporate sector. “We can think of this similar to macroprudential policies that we use for banks or institutional investors, limiting their risk-taking behavior, making sure they have enough capital. If banks are giving a loan, instead of just looking at, ‘OK, is this firm large enough, can they put some collateral at the table?’ they think about, ‘OK, what is this project going to bring to the table in terms of growth and productivity?’ I believe we can design policies like that, more towards the quality of a project.”

Understanding the lack of corporate investment in Europe

Growing up in ��ü���쾱��� made Kalemli-Özcan curious to learn about the challenges emerging markets face. “When I started living in the U.S., I thought, ‘OK, why do things work really nicely here, and they don’t work there?’ The economic system, the institutional system, that’s where the differences are. Policy can do great things but can also wreck things up. Wrong economic policies, fiscal policies, monetary policies. Being from ��ü���쾱��� makes me realize that very clearly.”

One of the key topics in Kalemli-Özcan’s research is financial integration — the links between financial markets through cross-border capital flows or foreign participation in domestic financial markets. Kalemli-Özcan explains how financial integration, an important part of ongoing globalization processes, leads to efficient allocation of capital and promotes investment and growth.

“If you look at emerging markets, a lot of their growth is financed with capital flows,” says the economist. “So financial integration helps developing countries tremendously.” She adds that China, Brazil or India are all good examples of this theory. They can’t finance their growth with domestic savings, and instead need capital from abroad.

Still, capital flows are fickle, particularly for emerging markets. This is one among several reasons for the ongoing debate around the costs and benefits of financial integration. “The risk sentiment of investors can change quickly. It’s influenced by political uncertainty, economic uncertainty. The U.S. monetary policy has a unique role,” explains Kalemli-Özcan. “Emerging markets suffer from this more than advanced countries.”

If, for example, the Federal Reserve raises interest rates to reduce inflationary pressure, international investors are more likely to pull capital from emerging markets and invest it in the U.S. Also, a hike in interest rates potentially increases the value of the U.S. dollar — bad news for emerging economies that depend on external capital flows and have much of their debt denominated in USD.

The economic impact of financial integration

Kalemli-Özcan’s recent work sheds light on why emerging economies’ attempts to respond to risk-sensitive capital flows using monetary policy don’t work. “If you increase your interest a lot to stop the foreign investors from leaving, to stop your currency from depreciating, you’re going to end up slowing down your economy. Monetary policy should be used for domestic objectives and inflation, and it shouldn’t be involved in exchange rate management.”

Looking at U.S. dollar-denominated debt, Kalemli-Özcan urges caution with how much the corporate sector is allowed to borrow in foreign currency. “You shouldn’t have let the firms borrow a lot in dollars in the first place. This can be done through macroprudential policies. I prefer those over capital controls.”

Kalemli-Özcan’s research shows that institutional quality is one of the most important determinants of capital flows to emerging markets. “Protection of property rights, low corruption — no corruption is even better, and structural reforms,” she says. “The reason why capital flows are a lot north-north and not north-south is because the northern countries have good institutions.”

This holds true in her most cited research to date, which looks at the link between foreign direct investment, financial markets and economic growth in emerging economies. “Foreign direct investment comes to a country to finance its productive investment opportunities and helps that country to grow,” explains Kalemli-Özcan. FDI is more than a capital investment; it can also include the provision of technology or management. Kalemli-Özcan adds that, unlike foreign portfolio investment, FDI is a long-term commitment.

It’s not only the company which receives the foreign investment that benefits. Kalemli-Özcan’s research reveals that FDI is beneficial for the aggregate growth of the domestic economy as well — as long as the country has strong institutions and well-developed financial markets. “If you’re an investor, you want to make sure you are in an environment where you can function. This is very important in the sense that countries that want to attract FDI should really think about strengthening their institutional environment. If you look at the worldwide allocation of FDI among emerging markets right now, it will be in markets that have done a lot of structural reforms.”

Foreign investment and economic growth

Kalemli-Özcan emphasizes how important it is to her to lead by example, especially for young women in her profession. In her role as associate chair on the Committee on the Status of Women in the Economics Profession (American Economic Association), Kalemli-Özcan realized what a big difference mentoring can make.

“You try to be a role model,” says the economist. “When you do this within an institutional setup, you have resources. You can bring a lot of women together, a lot of junior women together, engineer these linkages between them.” Kalemli-Özcan says that many of her young female students are cautious about entering the field of economics because of a competitive, aggressive culture within the profession.

“The whole environment is not conducive to their productivity. The older generations had a way of dealing with this problem, and the younger generations are like, ‘We don’t want to find ways to deal with this problem and put patches on it. We want the environment changed.’ I see their point, and I think we should definitely do something about it.”

Kalemli-Özcan says her biggest mentor and role model has always been her mother, a former college math professor. She recalled an important piece of advice from her mother: “Learn from mistakes and keep moving forward. It’s ok to achieve your goals in small steps. And never ever lose your integrity.” She adds, “That’s what got me through my career and life.”

Besides her career in academia, Kalemli-Özcan was a fellow at the European Central Bank and a lead economist and advisor for the Middle East and North Africa at the World Bank. As of October 2019, she serves as a senior policy advisor at the International Monetary Fund and continues her work on policy options in emerging markets in the face of capital flow shocks.

Her energy and passion for the field of economics will guide the way towards a better understanding of finance, development and growth globally.