Creditor Rights, Threat of Liquidation, and Labor-Capital Choice of Firms

In 2002, a legal reform introduced in India allowed secured creditors to seize and liquidate the defaulter’s assets. We study firms’ choice between capital and labor in response to these strengthened creditor rights by exploiting variation in their pre-policy proportion of collateralizable assets. We find that firms increased employment, reduced their capital investments, and substituted secured formal credit with trade credit. These results are consistent with an increased threat of liquidation for firms. We find support for our main results across regions with different pre-policy court efficiency and across industries with different elasticities of substitution between capital and labor.