Inelastic Demand Curves in Global Sovereign Bond Markets: Micro-Evidence and Macro Implications
AbstractThis paper studies the demand elasticity for emerging economies sovereign bonds in a liquid market
heavily used for government financing. First, we estimate shocks to the investor demand by computing
the flow-implied rebalancing (the FIR measure developed by Pandolfi and Williams, 2019) derived
from changes in the benchmark indexes followed by institutional investors. These shocks are
uncorrelated with country fundamentals. We find that higher expected inflows are positively related
with higher bond returns around these index rebalancings. Second, we take these inflows as shocks to
the available supply of bonds in these markets and estimate the residual demand curve in this market.
We show that this demand curve slopes downward and is considerably inelastic. Third, we build a
small open-economy model that allows for global investor demand shocks to affect sovereign bond
prices. We use the case of risk-neutral and deep-pocket foreign investor as our benchmark model and
show that as the demand curves in global sovereign bond markets become more inelastic, debtfinanced expansionary fiscal policy is less effective in affecting output and employment. This happens
because debt issuance in this market reduces significantly debt prices and constrains the fiscal space.
In a calibration exercise, we show that with our estimated demand elasticity, the government spending
multiplier is significantly smaller relative to the benchmark case of risk-neutral and deep-pocket