Capital flows and sovereign debt markets: Evidence from index rebalancings

We analyze how capital flows into the sovereign debt market affect government bond prices, liquidity, and exchange rates. To address endogeneity concerns, we construct a measure of informationless capital Flows Implied by (mechanical) Rebalancings (FIR) in the largest emerging markets local currency government debt index. FIR is associated with higher returns and greater depth in the sovereign debt market after the rebalancings. Also, larger inflows (outflows) are associated with greater currency appreciations (depreciations). Our results highlight the increasing importance of capital flows driven by demand shocks, due to the growing relevance of benchmark indexes as the preferred habitat for institutional investors.