Government intervention in the capital allocation process: Excess employment as an IPO selection rule in China

•We analyze the role of local employment as a selection criterion for IPOs in China.•Firms' contributions to the local labor market are positively associated with the probability of an IPO event.•This relationship is stronger for private firms than for state-owned firms.•Firms which contribute more to local employment underperform after going public.•Influence over the stock market is thus used to signal preferred employment practices.

We study the role of excessive employment as a selection criterion for initial public offerings (IPOs) in China. Using a large dataset of firms that are eligible for a public offering, we find that firms' that have more excess employment - that is, firms that hire too many people - are more likely to be selected for an IPO. This correlation is stronger for the private sector than for the state sector, suggesting that stock market capital is used to direct capital flows to private firms that comply with politicians' preferred labor practices. A third set of results corroborates the inefficiency of this selection rule by showing that firms with more excess labor underperform after the IPO. We conclude that a political system known for its interventionistic government policies uses its influence over the stock market to signal preferred employment practices.