 "Nikkei drops as China worries linger; retail investors sell small caps")
The benchmark Nikkei ended 1.0% lower at 12,834.01. Early in the session, it was up as much as 1.7% on robust US data and assurances from China's central bank that it will offer funds to banks if needed.
The market turned down as investors responded to falling Dow Jones Industrial Average futures, which indicated US stocks likely will fall when trading opens on Wednesday.
"Investors who are trading in Asian trading hours are monitoring China, while they shift their attention to US futures in the afternoon," said Nobuhiko Kuramochi, a strategist at Mizuho Securities.
Also hurting sentiment was selling in small-to-mid size stocks by retail investors, triggering a sharp sell-off in the Mothers market, which nosedived 12%.
"Small caps are mainly owned by retail investors, but hedge funds also own them as they chase short-term momentum. When retail investors sell them heavily, hedge funds bear a liquidity risk and have to cut losses," said Yasuo Sakuma, portfolio manager at Bayview Asset Management.
Biochemical companies PeptiDream Inc sank 28%, Takara Bio Inc nosedived 15% and Soiken Holdings Inc tumbled 13%.
The broader Topix shed 0.9% to 1,069.28.
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Market players said that foreign investors and retail investors remained worried that China was sliding towards a liquidity crisis. They added that concerns about the US Federal Reserve's plan to scale back its stimulus also kept them from investing in risky assets.
"Worries over China's banking system and economy still weigh on the markets," said Hiroaki Hiwada, a senior strategist at Toyo Securities.
China's central bank said late Tuesday that it had given cash to some institutions facing temporary shortages and would continue to do so if needed.
In spite of the comments, the Nikkei China 50 index fell 0.6%, while companies with high exposure to China weakened, with Hitachi Construction Machinery Co falling 2.1% and Fanuc Corp dropping 1.6%.
The benchmark Nikkei has dropped more than 19% since reaching a 5-1/2-year high on May 23, hurt by slowing growth in China, fears of a pullback in US stimulus and disappointment over the Japanese government's recently unveiled growth strategy.
Goldman upbeat on long-term prospects
Goldman Sachs, however, remained upbeat on the market, reiterating its 12-month Nikkei target of 17,000, 32% above Wednesday's close.
"The Japanese market's current consolidation phase may persist until the July 21 Upper House elections," the brokerage wrote in a note.
"But beyond the elections, the market is likely to resume an upward trend, driven by reform progress, additional policy stimulus measures, positive earnings surprises, and confirmation of a domestic macro recovery," it said.
The Nikkei index is still up 23% this year, helped by Prime Minister Shinzo Abe's sweeping fiscal and monetary expansionary policies aimed at pulling the world's third-biggest economy out of a two-decade long slump.