Publication: Inelastic Demand Meets Optimal Supply of Risky Sovereign Bonds
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Date
2024-03-26
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2024-03-26
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Abstract
This paper presents evidence of inelastic demand in the market for risky sovereign bonds and examines its interplay with government policies. The methodology combines bond-level evidence with a structural model featuring endogenous bond issuances and default risk. Empirically, the paper exploits monthly changes in the composition of a major bond index to identify flow shocks that shift the available bond supply and are unrelated to country fundamentals. The paper finds that a 1 percentage point reduction in the available supply increases bond prices by 33 basis points. Although exogenous, these shocks might influence government policies and expected bond payoffs. The paper identifies a structural demand elasticity by feeding the estimated price reactions into a sovereign debt model that isolates endogenous government responses. These responses account for a third of the estimated price reactions. By penalizing additional borrowing, inelastic demand acts as a commitment device that reduces default risk.
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“Moretti, Matías; Pandolfi, Lorenzo; Schmukler, Sergio L.; Villegas Bauer, Germán; Williams, Tomás. 2024. Inelastic Demand Meets Optimal Supply of Risky Sovereign Bonds. Policy Research Working Paper; 10735. © World Bank. http://hdl.handle.net/10986/41288 License: CC BY 3.0 IGO.”
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