rebalancings for a major sovereign bond index for emerging economies. We estimate bond price reactions to these rebalancings and map the reactions into a reduced-form elasticity. In Section 4, we formulate a structural model to back out the structural elasticity.

# **3 Empirical Analysis**

## **3.1 Index Rebalancings as Passive Demand Shocks**

In this section, we exploit monthly rebalancings in the EMBIGD to identify exogenous shifts in the available bond supply for active investors (the effective supply). The EMBIGD tracks the performance of emerging market sovereign and quasi-sovereign bonds in U.S. dollars issued in international markets.<sup>8</sup> Unlike other indexes that use a traditional market capitalization-based weighting scheme, the EMBIGD restricts the weights of countries with above-average debt outstanding by including only a fraction of their face amount of debt outstanding.<sup>9</sup> Among bond indexes for emerging economies, the EMBIGD is the most widely tracked, followed by funds with combined assets under management (AUM) of around US$300 billion in 2018 (Appendix Figure 2).<sup>10</sup> Rebalancings in the EMBIGD index, triggered by bond inclusions and exclusions, occur on the last U.S. business day of each month. J.P. Morgan announces these updates through a report detailing the updated index composition. Consequently, passive investors tracking the index adjust their portfolios by buying or selling bonds to match the new index weights.

Following Pandolfi and Williams (2019), we construct the flows implied by the rebalancings (FIR) measure for each country at each rebalancing date. The FIR quantitatively measures the relative change in passive demand for a country’s sovereign bonds resulting from index rebalancing. A 1% FIR can be interpreted as a 1% reduction in the available bond supply in

> 8The index includes bonds with a maturity of at least 2 _._ 5 years and a face amount outstanding of at least US$500 million. To be classified as an emerging economy, a country’s gross national income (GNI) per capita must be below an Index Income Ceiling (IIC) for three consecutive years. The IIC is defined by J.P. Morgan and adjusted every year by the growth rate of the World GNI per capita, Atlas method (current US$), provided by the World Bank. Bonds in the index must settle internationally and have accessible and verifiable bid and ask prices. Once included, they can remain in the index until 12 months before maturity. Local law instruments are not eligible.

> 9The J.P. Morgan Emerging Markets Bond Index Global (EMBIG) has the same bond inclusion criteria as the EMBIGD. The only difference between them is that while the EMBIG uses a market capitalization weighting scheme, the EMBIGD modifies this scheme to limit the weights of countries with above-average debt outstanding. Appendix Figure 1 plots the EMBIG country weights of both the EMBIG (a more traditional market-based index) and EMBIGD versions for December 2018. Appendix describes the rules that the EMBIGD uses to compute the weights of the instruments included in the index.

> 10Appendix Figures 3 and 4 show the high preponderance of U.S. dollar-denominated sovereign debt issued by emerging economies in international markets.

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