Asian shares fell and the euro stuck near 3-week lows against the dollar on Wednesday, as investors shed riskier assets after Greece's shock call for a referendum stoked fears about the viability of a European debt deal struck just last week.
Stocks wiped out all gains made during the huge relief rally last week that followed an announcement that European leaders had agreed a basic framework to help reduce Greece's huge debts, boost the region's bailout fund and strengthen banks.
Japanese stocks led Asian losses, falling more than 2 percent, but European shares were expected to rebound from Tuesday's sharp losses on hopes that the U.S. Federal Reserve may signal more measure to aid a fragile economic recovery.
Safety bids supported government bonds but weakened Asian credit markets and pushed oil prices sharply down, while safe-haven gold rose but was capped by a firmer dollar.
Xiao Minjie, chief economist at FuNNeX Asset Management in Tokyo, said the current environment was worse than three years ago when the collapse of Lehman Brothers triggered a financial market meltdown.
Investors don't want to take risks, halting both inflows to and outflows from funds, Xiao said.
Lehman was a problem of a single financial institution. We now face an issue of sovereign debt and fiscal problems that is far more complicated to resolve.
MSCI's broadest index of Asia Pacific shares outside Japan fell as much as 1.7 percent before recouping some of the losses to fall 0.7 percent on Wednesday. Japan's Nikkei share slid 2.2 percent.
Financial bookmakers in London called the FTSE 100 index to open up 0.7 percent, while Germany's DAX was seen up 1 percent and France's CAC-40 up 1.2 percent.
European markets are seen edging up on speculative hopes of a dovish FOMC. Hopes are for some sign of further easing in the wings to ensure that the U.S. economic recovery doesn't falter, said Jonathan Sudaria, dealer at Capital Spreads.
The Federal Open Market Committee, which concludes its two-day policy meeting on later Wednesday, could begin to prepare financial markets for further monetary easing, even if it refrains from any new stimulus just yet.
With concerns easing about the risk of a hard landing in China and a double-dip U.S. recession, Europe remained a worry.
Europe remains a source of risk, said Yonghao Pu, chief investment strategist at UBS Wealth Management in a Reuters television interview.
Greek Prime Minister George Papandreou fought off a barrage of criticism to win the backing of his cabinet on Wednesday to push ahead with a referendum the government said would take place as soon as possible on a European Union debt bailout deal.
The chairman of euro zone finance ministers, Jean-Claude Juncker, said Greece could go bankrupt if voters rejected the bailout package.
For the time being, the risk of political judgments triggering sharp price swings will persist, particularly in markets with low liquidity, said Naohiro Niimura, a partner at research and consulting firm Market Risk Advisory Co.
The euro was near 3-week lows against the dollar, having suffered its biggest two-day fall since May on uncertainty about the euro zone debt deal.
But the single currency may get some respite in the short term as market focus shifts to the Fed's policy meeting. The dollar index was steady at 77.242, but off Tuesday's peak of 77.676.
DOLLAR FUNDING STRAINS
In a sign that Europe's woes may be spreading to put strains on dollar funding in Japan, the Bank of Japan offered dollars to banks in two market operations on Wednesday for the first time since July last year.
Dollar funding costs in Japan have risen, reflecting the difficulties some European banks were facing, making it cheaper for banks to raise dollars under the central bank operation.
Asian credit markets remained weak, with the retreat from risk pushing the spreads on the iTraxx Asia ex-Japan investment grade index wider by 9 basis points on Wednesday.
The flight to safety pushed up government bonds, with benchmark 10-year Japanese government bond yields falling below 1 percent as traders cited Japanese banks and life insurers as buying cash bonds. The yield curve bull-flattened, meaning as the decline in long-dated yields outpaced that of shorter and medium maturities.
U.S. gold futures jumped 1 percent, while spot gold edged up 0.4 percent. U.S. crude oil fell more than $1 to $91.05 a barrel on concerns over Greece's debt woes, before trimming some losses.
(Additional reporting by Umesh Desai and Vikram Subhedar in Hong Kong)