"This decline in the Nikkei index really affects the Japanese economy very badly," said Hiroshi Kuribayashi, economist at Barclays Capital in Tokyo.

"When the Nikkei went up in the first half of this year, it was the major reason for optimism among corporate managers. Now it is heading down to crucial levels," he said.

Tokyo's Nikkei index tumbled a steep 454.03 points, or 2.6 percent on Friday, to end at 16,871.73.

It was the second steep fall in two trading days. On Wednesday, when the marketwas last open, the Nikkei lost another 3.4 percent. The market was closed Thursday for a national holiday.

Such heavy falls bring haunting reminders of the tough financial crisis last year, when the Nikkei slid to 12-year lows. That threatened to push banks and insurance firms, which have huge stock market portfolios, to the edge of collapse.

But in the first months of this year, the Nikkei suddenly seemed like the world's best buy.

At its peak in mid-July, the market was up 33.9 percent since the start of the year, making it one of the world's best performing major indices. It coincided with two straight quarters of growth, the first economic growth for 18 months.

Some of those gains have now been lost and banks and insurance firms will be feeling the effect.

"This is really tough for life insurance companies. It could bring real trouble for financial institutions and it will have a large deflationary impact," said BARC Lays' Kuribayashi.

As the Nikkei rose, foreign investors poured their money into Japan this year and that in turn, drove the Japanese yen up against other major currencies.

Now, the strong yen is beginning to hurt. It makes Japanese exports more expensive and threatens to close off a key route to recovery. Some investors may have been too confident, Kuribayashi said.

"With the yen nearing 100 or 90 to the dollar, it is going to be trouble. Foreign investors will start to lose their confidence and the market will decline again.

"The problem is, the Japanese economy is not yet on an autonomous recovery path. That could take at least another year."

By 5 PM (0800 GMT), the yen was trading at 104.41-44 to the dollar, against 103.83 yen in New York late Thursday.

There is no doubt investors on the Nikkei have been unnerved by the steep falls on the Dow Jones, which provides a strong lead for the Tokyo market. The Dow lost 2.0 percent on Thursday and the Nasdaq dived 4.0 percent.

"The plunge in New York stock prices dealt a severe blow, especially the fall on the Nasdaq," said Kazunori Jinnai, deputy general manager of the equity department at Daiwa Securities Co. Ltd.

"It caused heavy selling of high-technology and telecommunications shares, which had led the market here," he said.