The euro erased initial gains and edged lower on Thursday to trade above the previous day's four-year lows as political divisions in Europe and fears of more market regulation kept investors on edge and pressured stocks.

Investors pushed Asian stocks lower with exporter's shares pulling Japan's Nikkei average to a new three-month low. The index struck an 11-week closing low on Wednesday after Germany's move to stamp on speculative trading.

The yen, which usually gains during heightened uncertainty and risk aversion, rose early which hurt exporters' shares. That rise does not augur well for high-yielding currencies like the Australian dollar, which is down more than 4 percent this week.

Germany's surprise ban of naked short-selling in some securities spooked financial markets and hammered the euro to a four-year low against the dollar.

The unilateral step suggested Europe remained unable to form a united front in addressing its debt crisis. It worried investors by increasing uncertainty over market regulation.

Worries about the crisis intensified in recent weeks and risk-averse investors have begun pulling out of Asian stocks.

Credit Suisse said in a report their foreign investors' selling in May for emerging Asia outside China and Malaysia is already the highest monthly aggregate since October 2008.

It said that if the pace of selling sustains for the rest of the month there could be net sales of $14 billion, compared with the high of $17.5 billion in August 2007, during the bear market.

We have seen a large amount of money come in and we are beginning to see some of that trickle out, said Bratin Sanyal, head of Asian equities at ING Asset Management in Hong Kong who manages $2.4 billion.

With global turmoil and growing risk aversion we are seeing some money being pulled out and flowing back into their home markets.

The MSCI index of Asia-Pacific shares outside of Japan fell 1.4 percent to a new three month low. It has now fallen 7 percent this week and nearly 10 percent this year. Industrials and materials shares were the biggest losers.

INSTABILITY TO STAY

Wall Street slipped on nervousness about the disarray in Europe and on worries the crisis would hurt growth. That came on the heels of losses in Europe for the third in four sessions.

Investors are entitled to be a little hesitant about putting a toe into the shark-filled waters, said Richard Morrow, director at E.L. & C. Baillieu Stockbroking. Only one thing is certain: this volatility is likely to stay around at least in the short term. This is a trader's market.

The euro was down half a percent on the day at $1.2352 after rising as high as $1.2433 earlier in the day on trading platform EBS.

It rebounded from a four-year low of $1.2143 on Wednesday on speculation European monetary officials might move to check its rapid fall. However, Eurogroup Chairman Jean-Claude Juncker said in Tokyo that he did not see the need for immediate action.

The Australian dollar steadied against the dollar at $0.8449 with speculators turning defensive following week long selling. It has lost more than 4 percent this week.

Australian shares gave up initial gains as Wall Street's drop weighed and worries remained that Europe's problems could hurt economic growth. The benchmark S&P/ASX 200 was down 1 percent, wallowing at a 9-month low.

South Korean assets were dealt an extra blow by rising tensions in the Korean peninsula as Seoul exchanged tough rhetoric with its northern neighbor over the cause of a navy ship sinking that killed 46 sailors from the south.

The benchmark KOSPI stock index fell 0.7 percent and the Korean won dropped to its lowest this year. But South Korean debt was firm amid the risk aversion.

Souring risk appetite also drove demand for safe haven U.S. Treasuries with the yield on the benchmark 10-year note easing to 3.36 percent after rising 2 bps the previous day on euro jitters.

ING's Sanyal said that aversion was a good omen for defensive sectors.

Some of the unloved sectors should do well. Telcos and utilities have performed poorly and are underowned. With the fear factor coming back into the market they should do well, he said. The MSCI sector indexes for telecom and utilities were flat on Thursday, outperforming the broad market.

(Additional reporting by Sonali Paul in MELBOURNE; Editing by Jan Dahinten)

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