Inelastic Demand Meets Optimal Supply of Risky Sovereign Bonds
IMF Working Papers, November 1, 2024
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- Inelastic Demand Meets Optimal Supply of Risky Sovereign Bonds
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Bibliographic details
- Authors: Matías Moretti, Lorenzo Pandolfi, Germán Villegas-Bauer, Sergio L. Schmukler, Tomás Williams
- Published: November 1, 2024
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9798400290411.001
Summary
- Presents evidence of inelastic demand for risky sovereign bonds and explores implications for optimal government debt policies.
- Uses monthly changes in the composition of a major international bond index to identify flow shocks unrelated to fundamentals that shift the available bond supply.
- Estimates an inverse demand elasticity of -0.30.
- Finds that inverse demand elasticity increases with countries’ default risk.
- Formulates a sovereign debt model with endogenous default and inelastic investors, calibrated to the empirical estimates.
- Concludes that by penalizing additional borrowing, an inelastic demand acts as a disciplining device that reduces default risk and bond spreads.
Empirical strategy and key estimates
- Data source: monthly changes in the composition of a major international bond index (used to identify flow shocks unrelated to fundamentals).
- Main empirical estimate: inverse demand elasticity = -0.30.
- Heterogeneity: inverse demand elasticity increases with countries’ default risk.
Theoretical model
- Sovereign debt model features endogenous default and inelastic investors.
- Calibration is conducted using the empirical estimates derived from index composition shocks.
- Mechanism highlighted: inelastic investor demand penalizes additional sovereign borrowing, thereby reducing default risk and bond spreads.
Policy implications and interpretation
- Inelastic investor demand can serve as a market-based disciplining device for sovereign borrowers.
- Reduced willingness of investors to absorb additional issuance raises the cost of borrowing and discourages excessive debt accumulation.
- Lower default risk and narrower bond spreads can result from optimal supply constraints in the presence of inelastic demand.
Publication and metadata
- Authors: Matías Moretti, Lorenzo Pandolfi, Germán Villegas-Bauer, Sergio L. Schmukler, Tomás Williams
- Publication date: November 1, 2024
- Series: IMF Working Papers, Working Paper No. 2024/227
- Pages: 64
- Volume: 2024
- Issue: 227
- DOI: https://doi.org/10.5089/9798400290411.001
- Stock No: WPIEA2024227
- ISBN: 9798400290411
- ISSN: 1018-5941
- Subject keywords: Asset prices, Bonds, Debt default, Demand elasticity, Economic theory, External debt, Financial institutions, Prices, Sovereign bonds
- Additional keywords: Asset prices, bond characteristics-month, bond payoff, bond price change, Bonds, convenience yield, Debt default, debt issuance, default cost parameter, Demand elasticity, Global, IMF working paper research Department, inelastic financial markets, inelastic investor, institutional investors, international capital markets, investor demand, long-term debt, price movement, price reaction, Sovereign bonds, sovereign debt, U.S. dollar, unit price
IMF Working Papers: "Inelastic Demand Meets Optimal Supply of Risky Sovereign Bonds", Matías Moretti, Lorenzo Pandolfi, Germán Villegas-Bauer, Sergio L. Schmukler, Tomás Williams, November 1, 2024.
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