‘This Makes No Sense’

How could the Nikkei have plunged 24 percent in the course of the past week, the steepest decline in 59 years, when the Japanese aren't really involved in the whole global mortgage mess? Unable to explain the first downward lurch on Oct. 8, when the market plummeted 9.2 percent, Japanese Prime Minister Taro Aso called it "frankly beyond the imagination." At the close of trading that day, 79 percent of the companies on the Tokyo Stock Exchange, including blue chips like Toyota and Sony, were trading below their book value (the total value of a company's equity divided by outstanding shares). That means shareholders theoretically would have been better off just closing down the companies and selling off their assets.

Japan has thus become perhaps the most striking victim of collateral damage in the credit crisis. Patrick Mohr, an equity strategist for Nikko Citigroup in Tokyo, cites figures showing that Japanese financial institutions account for a mere 2 percent of the $592 billion in credit-related write-offs worldwide in recent weeks, hardly reason to doubt the integrity of the system. Japanese share values last hit a comparable low back in 2003, when the then Financial Services Minister Heizo Takenaka tightened regulations to expose the full extent of banks' bad loans—and then pushed them to get almost $180 billion in bad loans off their books. The same banks have solid balance sheets today. As a result, says Masayuki Kubota, a senior fund manager at Daiwa SB Investments, "To see the stock valuations fall to the level we're seeing now just doesn't make sense."

The United States remains a primary market for Japanese exports, so a slowdown there translates into harder times for the Japanese. Yet until last week those fears hadn't grown into panic. Kubota says that implied volatility of options on Japan's Nikkei stock average—the "fear gauge"— soared to levels far exceeding the wake of the 2001 terrorist attacks or the Asian currency crisis in the late 1990s. "I've never seen it that high."

The hysteria was prompted, at least in part, by more bad news on the real economy. Early in the week, reports trickled out that Toyota was planning to cut its operating-profit forecast for this year by nearly 40 percent, based on a likely collapse in demand from the North American market. That pessimism also reflects the steady rise of the yen, which is eroding Japanese exporters' ability to compete in world markets. In August, Japan posted its first trade deficit since 1982.

The yen has been rising partly because of the decline of the carry trade, in which traders borrow yen at ultralow Japanese interest rates and invest the money in higher-return markets elsewhere. Last week the carry trade caved in as investors bailed out of currencies like the Australian dollar, sending its value down by 30 percent, and rushed back to the security of the yen.

Meanwhile, global investors are souring on Japanese politicians. Many were drawn to the relatively cheap stocks in the Japanese market when Junichiro Koizumi was prime minister, from 2001 to 2006, and was moving decisively to clean up ailing banks and push structural reform. This time around, no one seems to have a clear plan of action—aside from efforts by new Prime Minister Aso to launch a new stimulus package on top of measures passed a few weeks ago.