The Nikkei share average slid 1% on Wednesday, as data showing flat bank lending in China chilled already tepid sentiment for risk assets although the benchmark managed to end a whisker above a key support level.
The Nikkei has fallen 14% since hitting a one-year peak of 10,255.15 on March 27 as a deepening sovereign debt crisis in Europe and worries about slower growth have boosted the 'safe-haven' yen.
Investor allocation in Japanese stocks fell to 19% net underweight this month from 10% in April, a monthly survey of asset managers by Bank of America Merrill Lynch showed. It was 4% net underweight in March.
An expected outflow from passive funds after a shuffle of the MSCI index also weighed on the market on Wednesday. One trader said the outflow was estimated at around $460 million.
The index broke below 8,800 - a support level that has been closely watched by market participants - for the first time since early February, although it later scrambled back up above it to close at 8,801.17.
At one point it fell as low as 8,756, a four-month low.
"The Nikkei is smashing through supports because of supply and demand. Investors have to keep selling to cover their losses as share prices have fallen," said Masayuki Otani, chief market analyst at Securities Japan.
Exporters to China were hurt by a report that new lending by China's four biggest state-owned banks was flat in the first two weeks of May.
The Nikkei China 50 underperformed the market, dropping 1.4% and construction machinery maker Komatsu Ltd sagged 2.5%.
But some said the Nikkei could be ripe for a rebound as it was deep in "oversold" territory, with its 14-day relative strength index at 24.8. Thirty or below is considered oversold.
Shun Maruyama, chief Japan equity strategist at BNP Paribas, also noted said the short-selling ratio was at a critical level.
"The past three to four days, the short-selling ratio in the Tokyo market went up to 27.9%... the highest level in the past few months," Maruyama said.
"I guess short positioning has been accumulated ... in the shorter term, I am expecting a technical rebound on short-covering."
MSCI removed Hokuhoku Financial Group Inc, Hiroshima Bank Ltd and Nippon Sheet Glass Co Ltd from the MSCI All Country World Index after the close on May 31, triggering losses of between 3.2 and 9.1%.
But those newly included in the index jumped, with Hankyu Hanshin Holdings Inc climbing 5.6% and Taiheiyo Cement Corp advancing 4.2%.
Mizuho Financial Group, the only one of Japan's three major banks to forecast a net profit increase this year. climbed 1.8%.
Mitsubishi UFJ Financial Group (MUFG) ended down 1.4% and Sumitomo Mitsui Financial Group eased 0.3%.
The broader Topix index dropped 1.2% to 738.88, with volume moderate at 1.98 billion shares traded.
