Back in mid-July, when Japan’s bench-mark stock index was bounding towards a seven-year high, the financial services minister was perfectly clear: a US fund’s failure to buy a Japanese Worcestershire sauce-maker would not destroy market confidence.

“It is impossible that the defeat of a foreign investment fund in only one court case would discourage overseas investors from participating in the Japanese stock market,” said a bullish but utterly mistaken Yuji Yamamoto.

The following day, with the minister’s words on every newspaper’s front page, Tokyo stocks embarked on a collapse that would see nearly £485 billion annihilated in four months. And in what is now officially the world’s first post-sub-prime bear market, overseas investors have, by a massive margin, been the heaviest sellers.

Between the peak of the market in July and the 16-month low plumbed this week, a Prime Minister has resigned, allowing the sense of political chaos to deepen. His successor, Yasuo Fukuda, has brought a new financial services minister, Yoshimi Watanabe, with him but the new faces have yet to inspire much confidence.

One senior Blackrock fund manager told The Times that Tokyo is suffering financial turmoil that dwarfs sub-prime in terms of value-destruction. It has passed relatively unnoticed globally, he suggested, because the reasons are simply too frightening to absorb: “The biggest financial crisis in the world is not sub-prime. It is the crisis in Japanese corporate and political governance,” he said.

Within the past few months, the Government and the nation’s listed companies have turned the market into a minefield. Many fund managers blame the Bank of Japan for its decision to raise interest rates before the economy had convincingly escaped deflation. But entire industries have been devastated by other policy shifts. A protectionist backlash, meanwhile, has been indulged by the authorities and allowed a once-promising mergers and acquisitions market to wither.

The mistake, say seasoned Japan investors, is to look at the fundamentals of Tokyo stocks for an explanation of the new bear market. Relative both to other major markets and to their own history, they are, say the analysts in unison, cheap.

Certainly, there are some grim weather conditions. The financial sector has taken a knock from the US mortgage debacle and it became evident yesterday that the worst may not be over.

The Tokyo stock market - big, liquid and 28 per cent-owned by foreigners - has also been the unwitting shock-absorber of troubles on Wall Street and in the City. Big global funds facing redemptions have sucked investment from Tokyo to cover the damage elsewhere. The problem for Japanese shares has been that their domestic investors are extremely quiet. “The institutions,” said Peter Tasker of Arcus Investment, “haven’t the intestinal fortitude to buy into a falling market.” Retail investors have not been active in Japan since the 2006 arrest of the Livedoor president and the collapse of the most widely held internet company stock in Japan.

Japan is also an economy that will feel the pain of a serious downturn in the US and many Tokyo blue chips will also be hurt as the yen rises against the US dollar.

But beneath all that, analysts say that corporate Japan offers plenty of strong “buy” signals. Over 50 per cent of exports by value are to Asia. Corporate balance sheets are spectacularly strong. Even dividends, with which Japanese companies are notoriously tight-fisted, have begun to creep higher. But investors have, for the time being, been forced to ignore all that, amid what many are calling Japan’s new “political risk”.

When the Government slashed the rates at which consumer finance companies could lend, it was because a handful of operators had allowed debt collectors to become heavy-handed. The cut barred several million Japanese from access to any credit.

When tough earthquake codes were imposed on new buildings two months ago, there was an onslaught of resubmitted building plans. The result has been a 70 per cent drop in housing starts since September, far worse than anything caused by the US sub-prime debacle. Perhaps even more damaging has been the perception that Tokyo has done little to make itself a hub of international M&A activity.

Mr Yamamoto’s speech in July followed a tussle between Steel Partners Japan fund and its buyout target, Bulldog Sauce. Steel Partners’ bid was thwarted by a highly controversial poison pill defence strategy.

Since then, more than 200 companies have installed similar defences and, as a market catalyst, the prospect of M&A activity has effectively disappeared.

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