“The Elephant in the Room: the Impact of Labor Obligations on Credit Risk” by Xiaoji Lin
University of British Columbia
Ohio State University
University of Texas at Dallas
We study the impact of labor market frictions on credit risk. Our central finding is that labor market variables are first-order in accounting for both aggregate and firm-level variations in credit risk and capital structure. Labor market variables (wage growth or labor share) forecast the aggregate credit spread as well as or better than alternative predictors. Furthermore, firm-level labor expense growth rates and labor share can predict Moody-KMV expected default frequency (EDF) in the cross-section across a wide range of countries. These variables also explain firm-level capital structure decisions. A model with wage rigidity and risky long-term debt can explain these links as well as produce large credit spreads despite realistically low default probabilities. This is because pre-committed payments to labor make other committed payments (such as debt) riskier; this effect is amplified when debt is long-term.