Tokyo's benchmark Nikkei Stock Average of 225 selected issues fell 799.55 points, or 5.78 percent, to close at 13,026.06. On Wednesday, it had gained 6.17 percent, or 803.97 points its second-largest points gain this year.
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In the late afternoon, the dollar bought 122.36 yen, down 5.82 yen from late Wednesday in Tokyo but above its late New York level of 120.25 yen. The dollar now has fallen a total of 13.40 yen in three days in Tokyo.
Wednesday's surge by the Nikkei was spurred by optimism that Japan will fix its fragile banking system and spend more money to lift its slumping economy.
But Thursday's plunge came when many stock investors came to question how effective the plan will be, said Fumikazu Onishi, a strategist with Nikko Securities.
"People began to question how effective the proposed steps will be when implemented, though they contain stricter disclosure requirements for banks and other measures better than now," Onishi said.
Onishi said the wild fluctuations in recent yen-dollar exchange rates also dealt a big blow to Japanese exporting companies, dampening overall sentiment.
Media reports say legislation designed to strengthen the nation's ailing banks is expected to pass the upper house and become law by the end of the current parliamentary session Oct. 16. The powerful lower house passed the legislation last Friday.
Export-oriented issues, including auto and high-technology shares, were losers after the yen's dive to near 120 yen against the dollar. A stronger yen makes Japanese exports more expensive in dollar terms abroad.
Among losing blue chips was Sony, which dropped 8.7 percent, or $6.40, closing at $66.80. Shares of Toyota Motor closed at $22.90, down $2.50, or 9.97 percent.
Trading was fairly heavy, with an estimated 527 million shares changing hands on the first section, compared with Wednesday's turnover of 631 million. Declines outnumbered advances 971 to 210, with 111 issues unchanged.
The broader Tokyo Stock Price Index of all issues listed on the first section shed 45.48 points, or 4.34 percent, to 1,001.50. On Wednesday, it had gained 50.03 points, or 5.00 percent.
Meanwhile, concern about U.S. markets, fears that the U.S. economy could slow more quickly than previously thought and increasing prospects tha Japan's bank recapitalization bills may be passed soon were among negative factors for the dollar, traders said.
"U.S. hedge funds continued their selling while Japanese institutional investors bought dollars on dips, but all of them were afraid of betting on one direction," said Katsuaki Tanaka, trader at Nippon Credit Bank.
On Wednesday, the dollar plunged 8 percent against the yen, its largest one-day drop in percentage terms in a quarter-century.
The dollar ranged between 120.25 yen and 123.50 yen in Thursday's trading.
The yield on the benchmark No. 203 10-year Japanese government bond rose to 0.780 percent from Wednesday's close of 0.770 percent, driving its price down to 109.13 yen from 109.28 yen.