The Nikkei average fell to a two-week closing low on Tuesday as some investors made bearish bets after a recent strong run and as concerns over China's economic growth outweighed expectations the U.S. Federal Reserve will soon launch more stimulus.
The Nikkei lost 0.6 percent to 9,033.29, while the Nikkei China 50 index, made up of Japanese companies with significant exposure to China, shed 1.2 percent.
"We have seen a fair amount of shorting today. People think the market is going to be tied up here ... on concerns over slowing growth in China. We have seen quite a lot of shorting on some China-linked names, some of the machinery, chemical, that kind of stuff," a senior dealer at a foreign bank said.
On Monday China's industrial sector posted a sharp profit drop in July, offering a fresh sign that slackening domestic and external demand has further weighed on corporate earnings.
Adding further gloom to the market, Japan's government on Tuesday cut its assessment for the export-reliant economy for the first time since October 2011, as slowing growth in the United States and China, on top of Europe's debt crisis, weighed on exports and factory output.
Construction machinery maker Komatsu Ltd <6301.T>, which has significant exposure to China, and peer Hitachi Construction Machinery <6305.T> both lost 2.1 percent.
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Banking on a quick fix by the European Central Bank to bring down high borrowing costs for Spain and Italy, investors have pushed the Nikkei up 8.5 percent since it hit a seven-week low on July 25. The index is up 6.8 percent for 2012.
Fed Chairman Ben Bernanke is due to speak in Jackson Hole, Wyoming on Friday, and may give further hints on any stimulus steps. He has used this event in the previous two years to signal further easing.
The broader Topix index dropped 1.2 percent to 746.30. Trading volume hit a one-week high, with nearly 1.63 billion shares changing hands.
Power companies sagged 5.5 percent as the worst sectoral performer after Credit Suisse cut its ratings on Chubu Electric Power Co Inc <9502.T> and Kansai Electric Power Co Inc <9503.T> to 'neutral' from 'outperform' and initiated its coverage on four other utility firms with 'underperform' rating.
Chubu Electric Power sank 10.2 percent and Kansai Electric Power shed 10 percent.
"The U.S. economy has picked up a little but that's coming from a low level, while in Europe, all the macro numbers seem to suggest the economy is not faring very well. There is some noise of stimulus in China but generally the exporters there haven't done too well. It's not exactly a healthy picture for the global economy," said Kwok Chern-Yeh, head of investment management, Japan, at Aberdeen Investment Management in Tokyo.
"If you look at the company level though, while things are slowing, there are pockets of resilience in this market where companies have done relatively well."
AOZORA BANK, SHARP SHINE
Aozora Bank <8304.T> surged 13.9 percent, however, after the mid-sized lender said it would spend 227.6 billion yen over a decade to pay back about 180 billion yen in public funds.
Embattled TV maker Sharp Corp <6753.T> jumped 9.1 percent, with traders citing short-squeeze as it was likely to survive, with Taiwan's Hon Hai Precision Industry <2317.TW> planning to take a 9.9 percent stake in the Japanese firm.
Short selling in Sharp had eased slightly, with 88.26 percent of its stock that is available to be borrowed out on loan as of August 24, down from 92.21 percent on August 22, according to data provider Markit.
The stock has risen nearly 20 percent since August 22.
Jun Yunoki, equity analyst at Nomura Securities, said he expected domestic retail investors, who had been buying the market on dips earlier, would step up their selling of Japanese equities into September as they need to pay back their margin borrowings after a six-month period.
"The six-month margin borrowings period is getting close ... around September. They are ready to offload these positions," he said.