The government on Wednesday rejected a U.K.-based hedge fund's request to raise its stake in Japan's largest electricity wholesaler, citing a potential threat to national security.

The move, however, raised questions in the market about Japan's willingness to open up to foreign investors.

The Children's Investment Fund, or TCI, was seeking to raise its stake in Electric Power Development Co., known as J-Power, from the current 9.9 percent to 20 percent. TCI is already the largest shareholder in J-Power.

By law, foreign investors need state approval before taking more than a 10 percent stake in a Japanese company in sectors such as electrical power that are deemed critical to national security. The government's decision was the first such rejection under the Foreign Exchange and Foreign Trade Law.

The fund has 10 days to respond. If it doesn't abandon its attempt, the government will issue an order to the fund.

John Ho, head of TCI's Asian operations, criticized the government's decision, saying Wednesday was "a sad day for Japan" and that the decision would have a significant negative impact on Japan's energy sector and economy.

However, Ho said TCI remains committed to seeing J-Power improve its corporate governance and value, noting the company continues to hold its current 9.9 percent in the utility.

J-Power is "the Rolls-Royce of global utility companies," Ho said in reference to the company's technological expertise.

Ho ruled out a rush decision before the deadline.

"(We'll) think about it, look at all the options and see what's available for us," he said.

The government said in a statement that there were concerns TCI could cut investment and maintenance costs at key facilities, even though the fund has not expressed any position on the matter.

"If investment is not made toward key facilities in the long run, it could knock out power," trade minister Akira Amari told reporters, adding that TCI's plan was rejected to protect Japan's energy security.

"This is what other countries in the world do," Amari said. "If you say, 'Japan should open up at the expense of such risks,' I'd like to hear the reason."

Amari responded confidently when asked whether the TCI case would adversely affect the inflow of foreign capital.

"I don't think so at all. This case is a one and only," he said. "If you say Japan is exclusive because of this case, I'd like to know which country is not exclusive."

The wrangling between J-Power and TCI has been closely watched as a test of how open Japan is to foreign investment. Foreign investors have been shut out in high-profile takeover attempts recently, raising concerns that overseas investors will be discouraged at a time when Japan badly needs foreign capital to buoy its slowing economic growth.

Analysts note that the attempts by the government and private firms to restrict foreign share ownership by activists in Japanese firms has led non-Japanese investors, who view the move as a kind of protectionism, to dump Japanese stocks.

Toru Shimano, an economist with Okasan Economic Research Institute Co., said the unclear reasoning behind the latest decision would have a "negative" impact on future foreign investment in Japan.

"They didn't explain well what is good and what is bad about TCI's investment. The decision underscores the Japanese market's uncertainties. Investors may think Japan is a lifeless place (to invest in)," he said.

"The decision came in the absence of specific rules," Shimano said, adding that the government should clarify what should be considered vital to national security and prepare for similar requests in the future.

Chief Cabinet Secretary Nobutaka Machimura countered criticism that a decision against TCI's bid may dent foreign investment, saying many countries regulate sensitive industries such as electricity. "I don't think investors are that ignorant about those sensitive issues," he told reporters Wednesday.

The U.S. and Britain, among others, limit stakes in entities considered vital to national security.

According to the trade ministry, the government approved 763 other cases of foreign investors raising stakes in sensitive sectors over the past three years.

J-Power is building its first nuclear plant in Oma, Aomori Prefecture, with commercial operations slated to start by March 2012. The utility also operates transmission lines connecting Hokkaido, Honshu, Shikoku and Kyushu. J-Power is the only utility operating power plants nationwide.

The government's decision follows a Finance Ministry panel's recommendation Tuesday that TCI's increased stake could hinder the smooth running of J-power's projects.

"We cannot deny the possibility that it could affect the planning, operation and maintenance of key facilities such as power transmission lines and implementation of Japan's nuclear power generation and nuclear fuel-cycle policies," the panel said in a statement Tuesday.

A panel member said it is doubtful TCI's goal of seeking investment returns within a three- to five-year time frame would be consistent with J-Power's 20- to 25-year plans for the operation of nuclear plants and power transmission facilities.

The fund said earlier Tuesday that it would forgo voting rights on matters such as nuclear power and power transmission systems if the government allows it to raise its stake. The fund also suggested that the government transfer control of the utility's nuclear plant to a state-run firm to fend off any influence by public shareholders.

The panel rejected the proposal on grounds that returning the recently privatized J-Power to state control would buck recent trends.

TCI, which manages more than $10 billion in assets, asked to buy a larger stake in J-Power in January. The U.K.-based fund started buying J-Power shares in 2005.