The Japanese economy is continuing to slow due to rising energy and raw material costs and cutbacks in capital spending and consumption, the Bank of Japan (BoJ) warned today.

The warning came as Asian stocks fell to a two-year low as investor confidence waned in the region’s financial sector in the face of high inflation, a stricter lending environment and massive volatility from overseas markets.

Hong Kong's Hang Seng index fell by 3.2 per cent, down 711.02 points at 21,303.44, while Japan’s Nikkei average slid 2 per cent, losing 255.60 points to close at 12,754.56.

The Japanese central bank said that international financial markets remained unstable and Japanese domestic demand may face downside risks on rising commodity prices.

The bank revealed that the annual rise in core consumer prices was running at around 1.5 per cent due to food and fuel inflation, and would probably rise further before gradually slowing.

However, it concluded that there was a relatively high likelihood that the Japanese economy would remain on a sustainable growth path with price stability.

Global financial markets remained unstable and there were downside risks to the American and world economies. As the economy’s capacity to generate income weakened due to rises in commodity prices, that could weigh on domestic private demand.

In a response to the rapidly changing economic conditions, the BoJ announced a number of changes to its procedures, including moving from half-yearly to quarterly economic forecasts from its policy board members.

It said it would also include its assessment on the economy and resultant financial risks alongside the announcement of decisions by its monetary policy board.

The BoJ left its overnight call rate target unchanged at 0.5 per cent for the 20th meeting in a row.

As Asian stock markets fell, Chinese banks were among the biggest losers as worries about their subprime-related investments resurfaced.

Local reports suggested this morning that Japan’s three biggest banks had some 4.7 trillion yen (£22.2 billion) in debt securities issued by Fannie Mae and Freddie Mac, the struggling US mortgage providers, as of March 31.

Jackson Wong, investment manager at Tanrich Securities, said: “The stock market feels the financial crisis is here all over again. The US is in very big trouble and is having a hard time getting out of it.”

He added: “The troubles in the financial sector in the US triggered fears on Chinese banks. It’s a domino effect.”

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