Beyond the turmoil, central bankers dread Brexit's shadow

[FRANKFURT] Finally, a financial flare-up that the world's central banks will have seen coming.

On Friday morning London time - when the result of a UK referendum will show whether the nation has chosen to leave the European Union - the Bank of Japan and the Swiss National Bank's Singapore desk could already be selling yen and francs.

They and their peers are also primed to pump liquidity into banks fearful of running dry and to push back against capital flight from sterling. It's what comes later that monetary-policy makers are less ready for.

With the outcome of the British vote too close to judge, central bankers are reaching for measures honed during the last financial crisis to assuage investor nerves.

Yet beyond calming words, potentially coordinated among Group of Seven economies, and a flash of action should the UK tip markets into panic, the institutions may have little left to offer if the turmoil morphs into long-term downturn.

"On the market shock, we know the drill already," said Gilles Moec, chief European economist at Bank of America Merrill Lynch in London. "On the growth impact, this is where things get complicated. Monetary policy has been trying to shore up growth and it hasn't been totally successful."

The warning signs are evident. A gauge of bank borrowing costs last week hit the most extreme level since 2012, and the premium to swap foreign currencies into dollars reached the highest since late last year.

Markets are sensitive to even small changes in the outlook for the referendum. Japanese shares rose and the yen weakened on Monday, as a Survation poll for the Mail on Sunday showed the Remain camp gaining 45 per cent of support with Leave on 42 per cent. UK futures and the pound rose.

The immediate response to a so-called Brexit would likely be statements by the world's major central banks of action or a readiness to act. G-7 nations might even coordinate an announcement, as they did after the Japan tsunami in 2011.

If so, they can cite the centrepiece of preparedness - a six-way currency swap arrangement between the US Federal Reserve, the European Central Bank, the Bank of England, the Bank of Canada, the BOJ and the SNB. Those lines, established during the financial crisis and made permanent in 2013, allow central banks to offer funds to lenders in each others' currencies. That would be critical if the internationalised banking system finds itself in a global alarm.

If wider cooperation is needed, executives from the world's 60 leading central banks are due to convene at the Bank for International Settlements' annual meeting in Basel on June 25.

The BOE has already started pumping up cash cushions. Banks took 2.46 billion pounds (S$4.82 billion) last week in the first of three special tenders, with the next ones scheduled for Tuesday and June 28. The ECB still offers lenders as much as cash as they need in its regular liquidity operations, and will inject more cheap funds this week in a program intended as credit stimulus.

Not that the euro area is short on funds. Partly as a result of the ECB's quantitative easing, excess liquidity in the 19-nation bloc is at an all-time high above 800 billion euros (S$1.22 trillion).

More pain may be felt in jurisdictions where the currency is seen as a port in a storm, and policy makers there are showing bravado about their readiness to intervene.

Lars Rohde, governor of the Danish central bank, said on June 15 that he'll do "whatever it takes" to safeguard the krone's euro peg. Thomas Jordan, president of the Swiss National Bank, has pledged to prevent the franc from gaining.

Japanese finance chief Taro Aso, whose ministry is in charge of currency policy, said on Friday he'd "like to take firm action" when needed to stem any rise in the yen, coordinating "closely" with other nations to avoid surprises.

So far, so reassuring. Yet once the initial impact passes, it may become apparent that a British vote to leave the EU is a shock too far for an already slowing global economy. Europe's growth outlook is fragile enough that a downturn in the UK poses a significant threat.

The world's most-powerful central bank is well aware of that. It was on the mind of Fed Chair Janet Yellen last week, when policy makers kept rates on hold. The vote "could have consequences for economic and financial conditions in global financial markets," she said.

"My concern is about the negative feedback loop into the real economy," said Vincent Juvyns, global market strategist at JPMorgan Asset Management in Luxembourg. "I'm pretty convinced that there would be a lower growth potential in that case, both for the euro area and the UK The probability is that the ECB, for example, would be asked to do more."

Yet while Ms Yellen and BOE Governor Mark Carney might have the leeway to cut rates or resume bond purchases, their ECB counterpart Mario Draghi may be near his limit.

With a deposit rate of minus 0.4 per cent, the Frankfurt-based central bank has admitted that it probably can't go much lower. Some investors are already concerned that the 1.7 trillion euro bond-buying program faces liquidity constraints.

If nervous investors start to push up spreads on bond yields, the ECB could find itself without a tool tailor-made for dealing with it, according to Anatoli Annenkov, senior economist at Societe Generale SA in London.

An obvious instrument is the one created in 2012 the last time yields soared - Outright Monetary Transactions, a pledge to buy the debt of stressed nations in return for a reform program. On Tuesday, the German Constitutional Court will rule if that program is legal in the region's largest economy.

"If there's a nightmare scenario now, and we get a big blow out in spreads, is the OMT going to be there?" Mr Annenkov said. "When it comes to the real economy, we are at the limits of what monetary policy can do."

BLOOMBERG