Does changes in employment protection laws alter firms’ cash holding decisions?
Policy makers around the world have been making changes in their countries’ labour laws for decades. A recent example is French government’s labour reform bill, which caused big protests on the streets in France and made the headlines in the media.
For many firms, labour is arguably an important input to production and labour adjustment costs (i.e, hiring and firing costs) can be considerably high under strict employment protection laws (EPLs). Therefore, changes in these laws have important implications for firms’ innovation, cost of debt, capital structure, and takeover activities, which are documented by prior studies.
In our study, we extend the literature by examining the impact of employment protection laws (EPLs) on corporate cash holdings. Specifically, we aim to answer the following questions:
– How does the stringency of employment protection laws alter firms’ cash holding incentives?
– Which economic mechanisms underlie this relationship?
– Does firms’ cash response to changes in EPLs have any implications for their subsequent investment outcomes and value creation?
Holding cash is of the first-order importance to many companies around the world to pay their day-to-day expenses, meet contractual obligations, and undertake future investment opportunities. However, how the changes in EPLs can affect the firms’ cash holding decisions has not been answered. Hence, an analysis of corporate cash holdings in conjunction with EPLs is an important gap to fill in the literature. Also, since any regulatory change in labour laws has a potential to affect corporate decisions and in turn overall economic performance, it is important for policy makers to evaluate ex ante such an effect. Therefore, our empirical assessment can assist policy makers to make more informed decisions on EPLs that consider both labour markets and firms’ potential reaction to labour reforms.
Previous research shows that greater stringency in EPLs makes the firing and hiring more difficult and less timely (i.e., higher labour adjustment costs). This implies a greater burden of fixed wage costs, even during economies downturns, and hence higher levels of operating leverage and the distress risk for firms. To offset this, our research suggests that firms facing stringent EPLs should have greater precautionary demand for cash in an attempt to counteract the distress risk associated with labour adjustment cost. As theoretical models in the literature predict, firms increase cash holdings and saving propensities to reduce the impact of financial frictions in the future.
To study how the stringency of EPLs affects corporate cash holdings, we use the EPL index developed by the Organization for Economic Cooperation and Development (OECD) for its member countries. This index has been widely used in the literature as the measure of job security for workers in a country. A higher score in it represents stronger employment protection. In our data, we also have a sample of companies in 20 OECD countries from 1985 to 2007 for which the OECD’s EPL index data are available for at least 19 years.
Our research is the first to provide comprehensive evidence on how and why firms’ cash holding decisions respond to changes in EPLs around the world and how that decision impacts the subsequent outcomes in firms’ investments and the market’s reaction. More specifically, our study documents that:
- When employment protection becomes stricter in a country, firms in that country increase cash holdings significantly. Our series of tests uncover a robust positive relationship between the EPL strictness and corporate cash holdings. These findings suggest that as a greater stringency in EPLs implies increased labour adjustment costs and operating leverage going forward, this expectation gives rise to an incentive for firms to increase precautionary cash buffers as a means of creating financial flexibility.
- The positive relationship of corporate cash holdings and the EPL index becomes stronger among (i) firms in the industries with high labour turnover rates, (ii) firms without multinational operations, and (iii) firms deemed to have a greater degree of financial constraints or a higher cash flow volatility. These results support the view that firms’ concerns about labour adjustment cost—which raises operating leverage and distress risk—is the channel through which the stringency of EPLs can affect corporate cash holdings.
- Stricter EPLs give rise to a stronger incentive for firms to save cash from cash flows and equity and debt issuances. These results also suggest that firms strive to secure precautionary cash buffers in anticipation of an increase in distress risk associated with operating leverage.
- Cash buffers saved by firms in the face of increased rigidity in EPLs allow these firms to navigate industry downturns better. That is, cash holdings built by firms in response to stricter EPLs allow them to maintain capital investment during subsequent episodes of industry-wide distress, thereby creating value to these firms.
- The market’s valuation of firms’ cash buffers is also greater when they experience an increase in the EPL strictness. These results, reassuringly, highlight that firms’ optimal decision making in line with the market’s expectation underlies the positive association between corporate cash holdings and variation in EPLs.
Overall, the stringency of EPLs is an important factor that firms consider in determining the optimal level of precautionary cash buffers. Our study sheds new light on the interaction between financial market frictions and labour market frictions that influences corporate cash behaviours and the value of cash holdings.
Read the full study here