LESS than two weeks ago, screaming newspaper headlines suggested the global financial system was on the edge of the abyss.

The most visible signs of upset were the falls in share prices. Currency markets were also in upheaval. Bond markets lurched. Some commentators drew parallels with the Asian currency meltdown of 1997.

Now, the panic has subsided, currency markets have stabilised and the fall in equity markets has failed to turn into a rout. Crisis, what crisis?

But the events of the past two weeks concentrated minds. For one thing there has been a reassessment of risk and what price should be put on it. Also, questions were raised about the durability of the “yen carry” — the disparity between the rock-bottom cost of borrowing in Japan and higher interest rates elsewhere in the world that has channelled cheap capital to the West.

The yen carry has, for years, looked like a one-way bet. At its simplest, it means private investors in Japan put their money into other currencies where they earn a higher rate of interest than in a yen account.

Savings accounts in Japan have paid as little as 0.01%; compared to that, interest rates in almost every other country looked attractive. Even after a recent rise, the Bank of Japan’s official interest rate is still only 0.5%.

For an individual Japanese investor, putting money overseas looks like a great deal, and indeed it is — unless the value of the yen goes up against the currency into which the savings have gone. If that happens, he or she finds that although the yield remains attractive, the value of the investment — expressed in the saver’s domestic currency, the yen — goes down.

For an individual investor, a rise in the yen is a setback; for big funds trying to exploit the gap in yields between Japan and elsewhere, it is more serious.

A fund taking advantage of the disparity will typically borrow in yen, convert the money into, say, dollars, to buy assets such as Treasury bonds. Then that investment can be used as security to borrow more yen, which, in turn will be converted into dollars. And so on.

In some cases, money might be borrowed and invested as many as 20 times over. The return on the initial capital is potentially huge — as long as the yen doesn’t rise. If it does — even by only a small amount — the gearing effect on the initial investment of this repeated round-tripping of money between one currency and another means losses are hugely magnified.

And it is that gearing effect of the yen’s rise that contributed to the spooking of the markets two weeks ago.

The most apocalyptic visions included the unwinding of huge hedge-fund positions — forcing vast sums of yen loans to be repaid, thus driving up the Japanese currency and making life even more uncomfortable for those who had borrowed in yen.

But this picture overlooked two things. First, the substantial majority of Japanese money flowing into overseas markets is accounted for by retail investors in Japan itself. Nobody has accurate figures, but it is reckoned that perhaps three quarters of the money from Japan destined for investment in overseas bonds comes from retail investors. And these investors are not going to be rushed into liquidating their foreign holdings. At most, only one quarter of the yen carry — defined in its broadest sense as the money that flows from Japan to provide the rest of the world with cheap capital — is accounted for by professional traders exploiting interest-rate differentials.

Second, the scale of the rise of the yen has been modest. Before the recent “crisis”, it took nearly 122 yen to buy one dollar. That was in mid-February. When the yen was at its strongest, on March 5, the rate was just under 116 yen to the dollar (see chart below left). The movement? Less than 5%.

It was enough to cause a commotion. But compare it with what happened in 1998. Then, currency movements were far more violent: the yen appreciated 12% in just 72 hours.

It was one event in the toxic cocktail that was to bring the magnificently misnamed Long Term Capital Management (LTCM) to its knees. In contrast, the past fortnight’s events may have caused some hedge funds real distress, but so far nobody has gone bankrupt.

So has the recent market turbulence brought about a fundamental reappraisal of risk?

Movements in the so-called iTraxx Cross-over Index, which measures sentiment in the European markets, suggest that investors have become more wary about taking on risk: the gap between yields on high-grade and low-grade debt has widened.

But market professionals don’t appear to be too worried. A good measure of investors’ expectations in equities is given by the Vix index: it goes up when the market expects volatility in America’s S&P 500 index.

As the LTCM affair was coming to a head in 1998, the Vix index topped 48. In the wake of the September 11 attacks in 2001, it reached 47. In July 2002, when Wall Street was mesmerised by the Enron affair and insider-dealing scandals, it went to 45. Thereafter, it drifted downwards.

During this month’s mini-crisis, the index rose eight points within a couple of days — from 10 to 18. That scarcely suggests panic.

In the words of one fund manager: “Yes, people may become a bit more risk-averse for a time. But the great recycling of Japanese money — and indeed money from other places, the petro-currencies, for example — will continue.”

So the yen carry is not dead. Perhaps a greater concern is the lack of information about the state of the global financial system.

For five years the world has been awash with liquidity.

Constraints on the movement of capital — money being borrowed, lent and lent again — have been progressively reduced. In the words of HSBC’s chief economist, Stephen King, it is the very “architecture of financial markets” that we don’t fully understand.

Jim O’Neill, chief global economist for Goldman Sachs, is relatively optimistic.

But even he admits there are plenty of people who harbour concerns.

In the late 1980s it was fashionable to talk of a “wall of money” that was bound to come from Japan.

Now, says O’Neill, it has been replaced by a “wall of worry”.

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