Employment protection and leverage adjustment speed: Evidence from China

Abstract

Stricter employment protection may affect capital structure adjustment speed in two ways. First, it may increase the cost of capital and decrease the leverage adjustment speed. Second, it increases financing needs and capital adjustment speed. Using China's 2008 Labor Contract Law as a natural experiment and the PSM-DID methodology, we find that the latter effect dominates the former. Specifically, stricter employment protection increases leverage adjustment speed, and this effect is more pronounced for non-state-owned firms and firms with larger leverage deviations. Furthermore, transmission channel tests show that employment protection increases firms’ substitution of labor with capital, driving up investment and financing needs. Finally, the increased leverage adjustment speed induced by enhanced employment protection is beneficial to firm performance.