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In one of the most spectacular slides in its history, the Japan's Nikkei lost 7.3% to close at 14,483.98 on Thursday. This was the index’s worst loss in a single trading day in two years. In fact, the last time Japanese stocks suffered a crash of comparable magnitude was on March 15, 2011. On that day, the market felt the full force of the disaster caused by an earthquake and tsunami whose effects are far from over now.

The major factors responsible for such a massive decline seem to be news from China and the U.S. China’s HSBC preliminary purchasing managers’ index (PMI) declined from 50.4 in April to 49.6 in May. This was hugely unexpected, with the index falling below 50 for the first time in seven months.

On the other hand, Fed Chairman Ben Bernanke provided strong indications that the monetary stimulus program which has been fuelling U.S. growth for some time now will be gradually tapered off. In fact, this could happen immediately following the Central Bank’s meeting scheduled for June. Both of these factors combined to create a substantial amount of uncertainty, ultimately leading to losses for indices worldwide.

For the Nikkei, this has transpired following spectacular run for the index, up nearly 40% in 2013. Expectations for corporate earnings are up as a result of a weak yen. In fact, increased competition from Japanese suppliers as a result of a weaker currency is one reasons for the weak showing by the Chinese manufacturing sector.

The market's strong momentum is primarily attributable to the policies introduced by Japanese Prime Minister Shinzo Abe. Popularly known as “Abenomics”, these measures aim to lift the world’s third largest economy out of a quagmire of deflation and sluggish growth.

What is 'Abenomics'?

Abe rode to office promising to end economic stagnation by firing “three arrows.” Traditional government spending would be one part of his strategy. Abe envisioned spending huge amounts on public works. He would also act on reforming government regulations to raise investment and employment.

But the primary weapon of “Abenomics” has been monetary stimulus, targeting an inflation rate of 2% and 3% growth every year. Following in the footsteps of Bernanke and Draghi, Bank of Japan governor Haruhiko Kuroda aims to increase Japan’s monetary base to twice its current size by 2014. Bonds, exchange traded funds and other securities in excess of $150 trillion yen will be purchased by the end of 2014. In fact Kuroda has said he will do “whatever it takes” to achieve his inflation target.

These bold measures have successfully powered up the Japanese market and boosted household spending, which increased at the fastest pace in nearly a decade. Their impact has also been felt in the U.S., particularly in the ETF segment. WisdomTree Japan Hedged Equity (DXJ - ETF report) and iShares MSCI Japan Index (EWJ - ETF report) have led the pack, followed by products like MAXIS Nikkei 225 Index ETF (NKY - ETF report) and iShares S&P/TOPIX 150 Index (ITF - ETF report). Of course, they felt the brunt of Thursday’s decline, iShares MSCI Japan declining the lowest, by 6.5%.

Market watchers feel this is only a temporary phenomenon which would blow over once global worries ease. What was of greater concern was that the stock market slide was preceded by a sudden hike in government bond yields. Yields on 10-year government bonds suddenly inched dangerously close to 1%.

The Bank of Japan reacted with surprising speed and aggression by injecting 2 trillion yen, around $19.4 billion, in order to reduce volatility. This move ultimately resulted in bond yields falling to 0.85%. It is not the first time that Japan’s central bank has intervened directly in the debt market. This has developed into a pattern, with such interventions occurring several times over the past few weeks.

Actually, it is imperative for the government to keep bond yields low at all costs. This is not just because it wishes to move investors away from debt and towards equity. Government debt is nearly double the size of the economy. If rates go up, debt servicing will become increasingly difficult. Already the government has to sell an ever increasing amount of bonds in order to keep up with its debt financing requirements. In fact, simply paying interest on government debt takes up a quarter of total government spending.

This is why hyper-aggressive monetary stimulus and government spending cannot cure Japan’s long term ailments. In fact, some observers fear that a burgeoning stock market and a weakening yen may dissuade Abe from taking the tougher measures he had spoken about. Even growth has hit 3.5% in the last quarter, the deflation problem still remains unsolved.

Clearly, the ultimate sustainability of “Abenomics” rests on his third arrow: “Structural Reforms”. Labor market reforms in favor of women and the young is one such area. It is they who can sustain consumption in a country marked by an ever-graying populace. Very few domestic avenues for productive investment exist for Japanese companies. Only then will the economy remain largely unaffected by temporary global factors. Until then, the sustainability of “Abenomics” remains a matter of conjecture.

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