TOKYO - PRIME Minister Taro Aso warned on Friday Asia's largest economy was at risk as Tokyo stocks saw their steepest plunge in two decades and the crisis claimed the first Japanese financial institution.

The Tokyo market meltdown 'has reached a point where it affects the real economy and fundraising', Mr Aso told reporters.

Japanese government bonds plunged on Friday, pushing futures down more than a full point, with panicked investors selling debt for cash as the domestic money market joined overseas markets in grinding to a standstill.

Fears of counterparty defaults have frozen the key repurchase market and prompted dealers to seek cash to fund their books, sparking a rare sell-off in normally safe-haven government bonds as stocks sank.

The Nikkei share average plummeted 9.6 per cent and fanned fears that the strains in global credit markets were hitting Japan more severely than previously thought.

Those troubles hit home with the failure of insurer Yamato Life Insurance, the first Japanese financial institution to fall victim to the global crisis. Yamato, an unlisted insurer, failed with $2.7 billion (S$4 billion) in debt, citing losses from securities caused by the market turmoil.

The bankruptcy further fuelled selling in the JGB market with dealers fearful of another financial institution collapsing over the three-day weekend.

Tokyo markets will be closed on Monday for a national holiday, and over the last three-day weekend in Japan investment bank Lehman Brothers went bankrupt.

'The market is going into a freefall. It has reached a point where people have nothing to reverse the market's direction,' said Mr Atsushi Ito, a JGB strategist at Morgan Stanley.

The fears did not abate even after the Bank of Japan pumped a total 4.5 trillion yen (S$67.3 billion) into the market, the 18th consecutive day of cash injections.

The benchmark 10-year yield jumped as much as 12.5 basis points to 1.580 per cent, before retreating to 1.520 per cent , up sharply from the six-month trough of 1.355 per cent hit earlier this week.

December futures dropped 1.11 points to 137.35 after tumbling as much as 2.66 points in extremely volatile trade that triggered an automatic halt by the Tokyo Stock Exchange. Trade resumed some 15 minutes later.

Market liquidity was extremely low, with volume in JGB futures about 25 percent below this year's daily average.

Many investors were in a wait-and-see mood before a G7 meeting of economic powers aiming to bring an end to the global spiral of financial distress, and ahead of the three-day weekend in Japan.

'Worries about counterparty risks have frozen the money market, and that has pushed short-term JGB yields up,' said Mr Tetsuya Miura, a bond strategist at Shinko Securities.

'We can call this a new type of bad yield rise,' Mr Miura said in his note to clients.

Higher rates have reduced market players' capacity to secure cash in the repurchase market, where bonds are swapped for cash.

Investors began shying away from the repurchase market after the collapse of Lehman Brothers, which caused some defaults.

The five-year yield climbed 8 basis points to 1.100 per cent while the two-year yield rose 5 basis points to 0.845 per cent .

Analysts said that as long as repurchase rates remain high, even a rate cut by the Bank of Japan may not bring yields lower.

'The correlation between repo rates and short- and mid-term JGB yields shot up this week,' said Mr Katsutoshi Inadome, fixed-income strategist at Mitsubishi UFJ Securities.

'This means that an impact of a BOJ rate cut will not go beyond the overnight rate, keeping JGB yields elevated. As such, a rate cut would not benefit the economy,' Mr Inadome said.

Longer-dated bonds surged, despite the sell-off in the rest of the yield curve, as long-term yen swap rates fell sharply.

Derivative desks were frantically hedging against interest rate exposure tied to structured financial products they sold to investors, traders said.

The 30-year swap rate plunged 60 basis points on the week, dragging the 30-year swap spread to around minus 45 basis points and as low as minus 60 basis points on Friday from minus 10 basis points a week ago.

The 20-year yield declined 7.5 basis points to 1.985 per cent and the 30-year yield dropped 9.5 basis points to 2.080 per cent . -- REUTERS

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