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Mr. Serkan Arslanalp, Dimitris Drakopoulos, Rohit Goel, and Mr. Robin Koepke
This paper reviews the role of benchmark-driven investments in EM local bond markets. We provide an overview of how key EM bond benchmark indices are constructed, how they affect the behavior of investment funds, and what are the likely implications for capital flows and policy-making. Several methods are presented suggesting that the amount of assets benchmarked against widely followed EM local-currency bond indices have risen fivefold since the mid-2000s to around $300 billion. Our review suggests that the benefits of index membership may be tempered by portfolio outflow risks for some countries. This is because benchmark-driven investments may increase the importance of external factors at the expense of domestic factors, raising the risks of outflows unrelated to recipient country fundamentals. Some countries may be disproportionately exposed to these risks, reflecting the way the indices are constructed.
Mr. Serkan Arslanalp, Dimitris Drakopoulos, Rohit Goel, and Mr. Robin Koepke

How are They Constructed? Among the multitude of investment funds focused on emerging market local bonds, most are benchmarked to a small number of indices. The most widely followed benchmark indices for emerging market bonds are the J.P. Morgan Emerging Market Bond Index (EMBIG; for dollar-denominated bonds) and the J.P. Morgan Government Bond Index–Emerging Markets (GBI-EM; for local currency bonds), both of which come in several variants. Benchmark-driven investments discussed in this paper primarily refer to investment funds benchmarked to these two indices

Fabio Cortes and Luca Sanfilippo

. Morgan Government Bond Index-Emerging Markets) 3. Hard Currency Government Bond Index Spread (EMBIGSP) = (Quarter-over-quarter change in domestic Hard Currency Total Return Bond index) – (Quarter-over-quarter change in the total return overall on the J.P. Morgan Emerging Market Bond Index) Sources: Bloomberg and J.P. Morgan. Explanatory variables MSBFs Flows . Changes in MSBF emerging market allocations (dlog(msbf)) per fund per country are defined as the market value of the portfolio allocations at the end of each quarter, adjusted for price changes. To

Mr. Serkan Arslanalp and Mr. Takahiro Tsuda
Portfolio flows to emerging markets (EMs) tend to be correlated. A possible explanation is the role global benchmarks play in allocating capital internationally, the so-called “benchmark effect.” This paper finds that benchmark-driven investors indeed play a large role in a key segment of the market—the EM local currency government bond market—, accounting for more than one third of total foreign holdings as of end-2014. We find that the prominence of these investors declined somewhat after the May 2013 taper tantrum, but remain high. This distinction is important in understanding the drivers of EM capital flows and their sensitivity to different types of shocks. In particular, a high share of benchmark-driven investors may result in capital flows that are more sensitive to global shocks and less sensitive to country factors.
Mr. Serkan Arslanalp and Mr. Takahiro Tsuda

flows to EMs ( Cerutti et al. 2015 , IMF 2014, Miyajima and Shim 2014 , Raddatz et al. 2015 ). In this paper, we distinguish between two types of foreign investments in EM local currency bond markets: benchmark-driven and unconstrained. We define benchmark-driven investors as those that invest in countries through a fund that either tracks or closely follows a flagship benchmark index. In the case of EM local currency bond markets, that benchmark is usually the J.P. Morgan Government Bond Index-Emerging Markets (GBI-EM), which has a predefined list of countries

International Monetary Fund. Western Hemisphere Dept.

economies since last October, while weaker-than-expected activity in some emerging market economies has led to small downward revisions to their overall growth prospects for 2017–18. Figure 1.1. Global Growth, Financial Conditions, and Commodity Markets Sources: Bloomberg L.P.; and IMF, World Economic Outlook database. 1 Bond yield for emerging markets refers to J.P. Morgan Government Bond Index–Emerging Markets (GBI-EM). 2 Dotted lines refer to the October 2016 World Economic Outlook global assumptions. The improved outlook for advanced economies for

International Monetary Fund. Western Hemisphere Dept.

(IIF) database; and IMF staff calculations. Note: Dotted, vertical lines refer to recent market volatility episode in February 2018. EPFR = Emerging Portfolio Fund Research; VIX = Chicago Board Options Exchange Volatility Index. 1 Refers to Morgan Stanley Capital International local currency indices. 2 Refers to local currency J.P. Morgan Government Bond Index-Emerging Markets Global Diversified, which is a uniquely weighted index that limits the weights of index countries with larger debt stocks by including only specified portions of these countries

Amr Hosny

the same interpretation as the VIX global index. 3 Benchmark-driven investors as those who invest in countries through a fund that either tracks or closely follows a flagship benchmark index, like the J.P. Morgan Government Bond Index-Emerging Markets (GBI-EM) which tracks local currency bonds issued by EMs. Nigeria became the second African country after South Africa to be listed in this index in 2012M10, but was removed in 2015M10. It had a weight of 1.8 percent in the index, ahead of countries like Colombia, Philippines and Chile. 4 The VIX volatility

Fabio Cortes and Luca Sanfilippo
Unconstrained multi-sector bond funds (MSBFs) can be a source of spillovers to emerging markets and potentially exert a sizable impact on cross-border flows. MSBFs have grown their investment in emerging markets in recent years and are highly concentrated—both in their positions and their decision-making. They typically also exhibit opportunistic behavior much more so than other investment funds. Theoretically, their size, multisector mandate, and unconstrained nature allows MSBFs to be a source of financial stability in periods of wide-spread market turmoil while others sell at fire-sale prices. However, this note, building on the analysis of Cortes and Sanfilippo (2020) and incorporating data around the COVID-19 crisis, finds that MSBFs could have contributed to increase market stress in selected emerging markets. When faced with large investor redemptions during the crisis, our sample of MSBFs chose to rebalance their portfolios in a concentrated manner, raising a large proportion of cash in a few specific local currency bond markets. This may have contributed to exacerbating the relative underperformance of these local currency bond markets to broader emerging market indices.