Labor costs and financialization of real sectors in emerging markets

This study examines the effect of labor costs on financialization of real sector firms by exploiting the launch of the Labor Contract Law of China as an exogenous increase in labor costs. We find that after the launch of the law, the rise in labor costs provokes real sector firms to substitute away from real capital formation toward financial capital formation, accelerating financialization of real sectors. Our findings are robust to alternative proxy and sample specifications as well as possible endogeneity concerns. We further show that after the launch of the law, firms in regions with more effective and stringent law enforcement or higher minimum wages are more likely to engage in financialization. Moreover, private firms, small firms, and firms in highly competitive industries become more financialized. We also find that after the launch of the law, labor-intensive firms are more likely to hire financial experts or acquire other firms involved in financial activities. This study provides evidence on policy drivers behind financialization of real sectors.