The sentiment guiding international investors and policymakers over the last week could perhaps best be expressed by a sharp indrawn breath. As one opinion poll after another suggested that a majority would vote for Britain to leave the EU, Brexit has emerged as the biggest short-term risk bar none for the global economy.
The result has been a flight to safety in markets, a display of caution from central banks, and frenetic activity behind the scenes to prepare for the turbulence that could follow next Thursday’s referendum.
Added to existing questions over US and global growth, Brexit worries have fuelled a rally in the safest sovereign debt, pushing yields on German, Swiss and Japanese debt further into negative territory and sending the yield on 10-year US Treasuries to a four-year low. A sell-off in Europe’s periphery suggests investors are having renewed doubts over the EU’s institutional stability. Polish bonds are suffering from calculations that poorer members would receive less from Brussels if the UK’s departure cut the funds available.
This is nothing compared with the volatility that is likely in the immediate aftermath of the vote. Sterling — already the weakest of any major currency against the dollar this year — would be the first casualty of a decision to leave. A stampede into havens such as the Swiss franc and yen could cause problems for countries already struggling with uncomfortably strong exchange rates. There would also be a more diffuse effect on confidence, which even the US Federal Reserve felt obliged to factor into its decision this week to leave interest rates on hold.
Little wonder that other central banks are also playing it safe. The Swiss National Bank left interest rates unchanged on Thursday, warning of the uncertainty the referendum creates. The Bank of Japan, which kept policy unchanged despite weaker inflation, may have felt a rate cut would have little effect, given external pressures on the yen and government debt. Better to keep its powder dry in case it needs to ease after the referendum.
Policymakers are poised to act, however, if they need to stop markets seizing up or spiralling into a panic. The Bank of England has already begun additional liquidity auctions to prevent banks running out of funds; and has swap lines in place with other central banks to ensure access to foreign currency. The ECB has also made it clear it is ready to backstop liquidity and limit strains on the banking sector — and other central banks would be likely to take similar, co-ordinated action.
These are tools honed in the global financial crisis, which should leave policymakers relatively well equipped to cope with the referendum’s immediate fallout in markets. However, this would merely be short-term damage limitation. Central banks could not prevent a vote for Brexit inflicting long-term damage on the UK and global economy.
The shock would of course be greatest in Britain — and the BoE has made it clear that it may not be able to alleviate this simply by cutting interest rates. If sterling fell sharply, policymakers could face a combination of stalling growth and rising inflation that would involve difficult trade-offs.
Yet Brexit threatens many other countries. Close trading partners such as Ireland and those with big investments in Britain, such as the Netherlands, are most exposed, but no country is likely to gain. The OECD estimates losses to the EU overall could total 1 per cent of GDP by 2020. The single market would be smaller and the EU less stable. There is little central banks could do to mask or mitigate that reality.