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World economy vulnerable to jittery markets

Two events this week sent ripples through world markets and have raised concerns about how vulnerable the buoyant global economy would be if unprecedented international investment flows suddenly get spooked.
A man looks at an electronic stock quota
A man looks at an electronic stock quotation board at a securities firm in Tokyo, Jan. 19. The benchmark Nikkei-225 index rebounded after skidding just the day before.Kazuhiro Nogi / AFP - Getty Images
/ Source: Reuters

A geographical shift in the destination of Iran’s foreign investments is hardly the stuff of global economic meltdowns, experts reckon, nor are alleged shenanigans at just one Japanese Internet firm.

But both events this week sent ripples through world markets and have raised concerns about how vulnerable the buoyant global economy would be if unprecedented international investment flows suddenly get spooked.

Reports of an investigation into Japanese Internet firm Livedoor on Tuesday sent Tokyo share prices plummeting and chilled stock markets around the world.

Iran’s increasingly tense standoff with the international community over its nuclear program has unnerved investors all month as oil prices climbed back toward record highs in anticipation of any disruption to crude exports.

Tehran’s announcement on Friday that it was pulling a least some of its substantial foreign investments out of European banks and putting it into other foreign accounts jarred currency markets.

Economists say these events are not significant enough in their own right to destabilize a global economy set to grow at more than 4 percent this year for the fourth year running.

But any damage to financial sentiment that may force international investors to panic or even rethink massive cross-border investments is extremely worrying, they say.

“Global imbalances are growing, cross-border financing needs are increasing and a smooth-functioning financial system is now essential for this,” said Nouriel Roubini, professor at New York University and a former U.S. Treasury official.

“People are getting nervous about all sorts of asset classes,” he added. “It’s not inconceivable that mishaps on the Tokyo stock market like the one this week or this event is Iran could lead to the sort of sudden panic everyone fears.”

And there is a palpable sense of unease among top policy-makers and financiers that one or a series of these seemingly random events could turn the whole environment ugly.

In an interview with Reuters this week, the U.S. Treasury’s top international affairs diplomat, Tim Adams, said it was the risk of unforeseen events -- such as the 1998 collapse of mega-hedge fund Long Term Capital Management -- that worries him most about sustaining global economic health.

“The biggest threat is the one we can’t forecast or predict,” said Adams, joking that he was paid to worry about these risks despite the “extraordinarily positive” global economic conditions at present.

Many central bankers in the United States and Europe, meantime, have been fretting this month about how they adequately monitor huge gains in asset markets such as housing, bonds and equities and assess systemic market trading risks.

Bank of England Deputy Governor Andrew Large said on Wednesday that world markets had become “frothy” because investors seeking returns on growth have pushed up asset prices and may be underestimating the risk of a shock.

Referring to Japanese stock market fallout, European Central Bank chief economist Otmar Issing said on Wednesday the short-term panic reaction to events on the other side of the globe was “demonstrating how connected markets are.”

But why is this interconnectedness so worrying now?

Many economists say the key is the much-feared imbalances in international accounts -- characterized most clearly in a record annual U.S. current account deficit in goods, services and investment income of almost $800 billion, or more than 6 percent of national output.

These growing deficits need to be funded by overseas investment. Net increases in overseas inflows of almost $3 billion are needed every working day in the case of the United States.

So, while world growth remains strong, it is increasingly being financed by investors being comfortable in sending ever-larger proportions of their capital and savings overseas.

Rising trade surpluses in developing Asia and the major oil exporters, meanwhile, has led to a boom in governments’ foreign currency reserves to more than $4 trillion -- one measure of the scale of money flooding around the globe.

World currency markets alone now turn over almost $2 trillion in trading volumes daily.

So, small net shifts in the location of an estimated $40 billion of Iran’s foreign reserves do seem like small beer.

Yet, Iran’s actions -- in investment or nuclear policy -- or lost faith in a Japanese Internet firm are more worrying if they prompt investors to reassess the attraction and the risks of leaving their savings overseas.

And emerging markets, which the Institute of International Finance on Thursday said took in a record $358 billion of foreign money last year, could be most vulnerable.

With the average debt market returns in these markets near historic lows, many are mindful of the domino-like collapse of many developing markets after 1996 -- the previous peak in net foreign flows to these countries.

“Events in Japan in the last few days remind us just how difficult is it to anticipate where an event like this may occur and how it will affect the mood and the performance of financial participants,” said institute Managing Director Charles Dallara.