The architect of Japan’s resurrection from its “lost decade” of economic slump, called on the Bank of Japan to increase liquidity in money markets immediately, and attack the economic imbalances that are causing the “yen carry trade”.

Heizo Takenaka, the driving force behind Japan’s recent economic reforms, said that the momentum towards serious financial reform in Japan was now effectively leaderless and in terminal decline.

The former Financial Services czar said that Japan needed to embark on a massive round of privatisations and should accelerate plans to create a near-$1 trillion “sovereign fund” to manage the country’s vast foreign exchange reserves more aggressively.

Mr Takenaka – famous for forcing Japan’s banks to solve their non-performing loan problems – also launched an unprecedented public attack on Prime Minister Shinzo Abe. He told an audience of business leaders at the World Economic Forum in the North Eastern Chinese city of Dalian that the newly appointed cabinet was “old fashioned” and increasingly incapable of driving reform.

But he reserved his strongest attack for the Bank of Japan – a Barclays Capital survey of financial institutions, hedge funds and other groups published yesterday found that only 16 per cent of investors said that they were “confident” they understood the BoJ’s objectives.

If the central bank fails to act fast, Mr Takenaka told The Times, Japan risks falling back into the mire of deflation, policy errors and ultra-thin interest rates that will allow the indefinite extension of the so-called “carry trade” – the practice of borrowing the Japanese currency at rock-bottom interest rates to fund investments in other currencies or assets.

The yen carry trade is believed by some to be behind the inflation of a large number of asset bubbles across the globe. Yen have been liberally borrowed by hedge funds and private equity firms in their efforts to enhance their “leverage” for buying assets. On the individual investor level, the yen carry trade has turned tens of thousands of previously conservative Japanese savers into highly speculative investors.

Last month, at the height of the market turmoil and the sudden surge of the yen, currency traders reported massive unwinding of the yen carry trade as investors panicked to exit an investment that had suddenly turned sour.

William Rhodes, the senior vice chairman of Citigroup, said that the full impact of the recent market turmoil will not be clear for several months, suggesting that it was only when positions in sub-prime mortgages and other financial instruments are unwound that the extent of the damage will be clear.

Acknowledging that the yen carry trade had probably played its part in the sub-prime investment strategies of some funds, Mr Takenaka said that the only way to end the carry trade was for the BoJ to lead the macroeconomic normalisation of Japan. It must do this, he said, via the mass purchase of government bonds from a range of corporate and institutional holders, ending deflation and allowing interest rates to rise naturally in the wake of all that.

Despite a falling consumer price index, the BoJ appears ready to raise interest rates in an effort to “normalise” Japan’s monetary environment before its current governor, Toshihiko Fukui, retires next year. Although rates must normalise soon, said Mr Takenaka, to raise rates now would represent a huge error. “Deflation continues but the central bank wants to raise rates: it’s just impossible to explain,” he added.

His comments come as the BoJ yesterday defied its counterparts in the United States and Europe by draining ¥200bn (£900m) of liquidity from the financial system.

The European Central Bank, responding to rising fears of a credit crunch, pumped more than €42 billion into the money markets, while the Federal Reserve provided emergency cash to the tune of $31.25 billion.

Since the sub-prime debacle hit financial markets last month, the BoJ has repeatedly drained liquidity while others were increasing it and declined to join-in co-ordinated efforts to stabilise capital markets.

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