Exclusive: Central banks ready to combat Greek market storm

WASHINGTON (Reuters) - Central banks from major economies stand ready to take steps to stabilize financial markets by providing liquidity and preventing a credit squeeze if the outcome of Greek elections on Sunday causes tumultuous trading, G20 officials told Reuters.

A senior U.S. official cautioned that the Greek election will not provide "the definitive signal on what happens next" in the euro zone debt crisis.

But if severe market strains emerge after an unusual confluence of three elections this weekend - there are important polls in Egypt and France as well - central bankers are on standby to ensure enough cash is flowing through the financial system.

"The central banks are preparing for coordinated action to provide liquidity," said a senior G20 aide familiar with discussions among international financial diplomats. His statement was confirmed by several other G20 officials.

Wall Street stocks jumped sharply on the news, with the S&P 500 and the Dow Industrials both up more than 1 percent. The euro added to gains and U.S. government debt prices fell, boosting yields.

Separately on Thursday, British finance minister George Osborne said the government and the Bank of England will act together with new monetary policy tools to tackle tightening credit and financial market conditions triggered by the euro zone crisis.

A move to boost liquidity by central banks could mark a dramatic backdrop to the G20 summit of world leaders, who will gather in Los Cabos, Mexico, on Monday and Tuesday, with Europe's escalating crisis topping the agenda.

Leaders will be accompanied by finance ministers playing an advisory role. The ministers, who usually keep a low profile at these summits, have scheduled a working dinner on Monday and lunch on Tuesday.

Depending on the severity of the market response, an emergency meeting of ministers from the Group of Seven developed nations could be held on Monday or Tuesday in Los Cabos, with central bankers joining by phone, a second G20 official said.

Their first line of defense probably would be a statement that policymakers are ready to take whatever steps are needed to assure market stability.

This usually is a signal for technical steps to keep cash flowing through the financial system. Currency swap lines already are in place, and they can be drawn upon to ensure there are enough dollars available if global investors rush into the safety of U.S. assets. Central banks also can hold extra auctions to flood banks with short-term cash via repurchase agreements.

Currency intervention also is possible, though less likely to be sanctioned by the G7. Japan and Switzerland might intervene to weaken their currencies if a rush to safe-haven assets pushes up the yen and the Swiss franc.

Japan already has indicated to its G7 partners concerns about yen strength and it had considered acting earlier this month, several sources with direct knowledge said.

The International Monetary Fund took the unusual step on Thursday of sanctioning currency intervention for Japan to counter stresses from Europe, noting its currency is "moderately over-valued.

As for Switzerland, it has drawn a line in the sand at 1.20 francs to the euro. Swiss National Bank Chairman Thomas Jordan and the country's finance minister, Eveline Widmer-Schlumpf, on Thursday both threatened capital controls to prevent the franc soaring if Europe's crisis deepens.

"The SNB will not tolerate this," Jordan said.

TOGETHER TO SOOTHE MARKETS, ALONE ON ECONOMIES

As if the election in Greece were not enough, investors will need to parse the impact of a presidential election in Egypt that could roil oil markets and an election in France that looks set to put socialists in control of parliament after gaining the presidency in May.

While central banks might stand together to counter credit tightness and market volatility, the bar would be far higher for coordinated monetary easing, which is considered unlikely.

The last time central banks cut interest rates collectively was in October 2008 after Lehman Brothers collapsed. In that episode, credit evaporated, with overnight interbank rates shooting above 4 percent and stock market volatility as measured by the VIX fear index hitting a record above 80.

None of these measures is approaching severe stress today.

While volatility has risen sharply since March as global stock markets lost ground, at 24 the VIX is way below crisis levels. Interbank lending costs, measured by three-month LIBOR, EURIBOR and EONIA, are near record lows.

"Presently there is enough liquidity in the system," said Erik Nielsen, chief economist at UniCredit.

He is confident European Union leaders in coming weeks will clear a roadmap for financial and fiscal union, which would reassure markets that they will take the steps needed to prevent events from spinning out of control.

Moreover, central banks have far less maneuvering room today and will harbor their resources carefully.

The policy rates for the Federal Reserve and the Bank of Japan are effectively at zero and the Bank of England rate is 0.5 percent. Only the ECB, with rates at 1 percent, could deliver a significant cut, a move recommended by the IMF. But the cut would be largely symbolic when money already is cheap and, with euro-zone inflation running at 2.4 percent, a bank with a mandate focused only on price stability faces a higher hurdle.

More significant would be a relaunch of ECB bond-buying programs. Yet the ECB has made abundantly clear that it first wants politicians to act because they hold the key to lasting solutions to Europe's sovereign debt and banking problems.

"I do not think it would be right for monetary policy to compensate for other institutions' lack of action," ECB President Mario Draghi said last Thursday.

Frustration on the ECB board is running very high over the political paralysis in Europe, a senior European policy source said. While the ECB still has instruments at its disposal, notably its bond-buying program, the more these tools are used, the less effective they become, the source said.

However, several ECB policymakers have signaled they are open to cutting rates, suggesting that the ECB would be ready to move at its early July meeting - if EU leaders provide a game plan for resolving the debt crisis at their summit in late June.

Laurence Boone, an economist at Bank of America/Merrill Lynch, said a rate cut could be accompanied by a pledge to keep rates low for a long period if inflation is restrained.

"If there was very significant market turmoil, with a free fall of the euro and financial stability shaken, then the ECB could purchase bonds," Boone said.

FED, BOJ READY TOO

Fed Chairman Ben Bernanke also has made clear that the European crisis is a significant risk for the U.S. economy and left little doubt in testimony to Congress last week that the Fed was ready to counter significant strains.

"The Federal Reserve remains prepared to take action as needed to protect the U.S. economy in the event that financial stresses escalate," he said.

This probably would mean a third round of bond buying, known as QE3, though it also could extend a program to push down longer-term interest rates, known as Operation Twist. The Fed meets next week on Tuesday and Wednesday.

Meanwhile, the Bank of Japan is expected to keep its monetary policy unchanged when it concludes a two-day meeting on Friday as it awaits the outcome of the Greek election.

But a fresh wave of global risk aversion that sends investors flocking to the yen could well lead the BOJ to expand its 40 trillion-yen asset buying program, its main policy tool after it cut rates to a range of zero to 0.1 percent during the global financial crisis.

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