FROM THE OFFICE OF PUBLIC AFFAIRS

Thank you very much for giving me this opportunity to speak before you.  This is an important conference series for Japan and the United States.  The U.S. Treasury has benefited from your past conferences, and I know this one is no different in that respect. 

From the very start of his Administration, President Bush has placed great importance on our relations with Japan.  The alliance between our two countries is now as strong as it has ever been.  Japan’s support in Afghanistan, in Iraq, and in the war against terrorist financing has been invaluable.  This support is greatly appreciated in the United States.  

We also appreciate Japan’s strong support for the new “G7 Agenda for Growth” recently agreed to by finance ministers and central bank governors at the IMF and World Bank meeting in Dubai. It is a milestone agreement.  It reflects our mutual goal of raising economic growth, creating jobs, and improving people’s lives.

A return to full growth potential in Japan is important for Japan, but it is also important for the world economy. The Bush Administration fully supports Prime Minister Koizumi’s reform agenda, including tackling the deflation problem and resolving the non-performing loan problem.

I have been struck by the close connection between these two problems in Japan, and I spoke about this connection candidly a year ago during a visit to Japan.  Now is a good time to review progress on addressing these two issues.  We are at a kind of transition point. The renewed efforts at bank reform have been underway for some time. The new, and impressive, team at the Bank of Japan has been on the job for six months. Prime Minister Koizumi has just won a new, 3-year term as LDP President.  He has named his cabinet.  And the Japanese economic recovery has strengthened.

Deflation and Monetary Policy

Let me first discuss the deflation issue. Deflation has persisted in Japan for about seven years now, at least since 1997.  Deflation plays havoc with corporate balance sheets.  It raises the real value of debts.  It erodes the value of collateral.  Even though nominal interest rates are near zero, Japanese real interest rates are too high.  They discourage investment.

But deflation does something else. Because of the very low nominal interest rates, it causes delays in crucial decisions for lenders. By the time a borrower fails to make interest payments, the deterioration of the business is often so far advanced that reviving the business is impossible.  This makes the non-performing loan problem worse.

What causes this deflation? In the short run, many things affect deflation: excess capacity, changes in oil prices, changes in taxes. But fundamentally, inflation is a monetary phenomenon. For this reason I was very pleased when, back in March 2001, the Bank of Japan began its current policy of increasing the growth rate of the monetary base, the part of the money supply that is under direct control of the central bank. 

Since this new policy was adopted, the monetary base has increased by a cumulative 68 percent, or at an average 24 percent per year.  While these are impressive figures, experience suggests that even larger rates of growth, maintained over time, may be required to bring deflation to an end.

It is important to observe, therefore, that in the five months in which Mr. Fukui has been Governor of the Bank of Japan, the average seasonally adjusted annual growth rate of the monetary base has picked up to 40 percent.  This is a welcome development.

To be effective, the rapidly growing base monetary base must work its way through to broader measures of money, and ultimately to prices.  This is where the debate about monetary policy in Japan centers.  Although the monetary base has grown rapidly, changes in these broader measures are at best faint, and Japanese deflation persists.  For example, the broader measure of the money supply, M2 + CDs, has scarcely budged, growing by less than 7 percent since quantitative easing began.  True, M2 + CD growth has increased slightly recently, but this is too short a time to call a new trend.   

One clear factor behind the sluggish growth of broad money is the continued decline in bank lending. Even after netting out bad debt disposal and securitization, bank loans are down 13 percent in the past three years and 2 percent during the past year.  Some of the reduction in total outstanding loans is healthy restructuring of balance sheets. But the weak growth in loans also reflects a banking system hobbled by non-performing loans.

This point underlines the extent to which Japan’s policy challenges are interrelated.  Overcoming the problems of the banking sector would do a great deal to enhance the effectiveness of monetary policy and therefore overcome deflation. 

In recent months there is evidence that the rate of deflation has begun to diminish.  To be sure, some of this reflects special factors such as higher world oil prices. But even after correcting for these, the rate of deflation appears to have come down a bit.  This is good news, though it is too early to declare victory in the seven year war against deflation.

The Banking Sector

Let me turn now to the problems of the banking sector.  A healthy and efficient financial system is essential – not simply in funding new activities, but also in liquidating, restructuring, and moving resources on to new more productive uses.   A banking system that is hobbled by bad loans can do neither of these tasks well.

Recent positive developments in Japan on non-performing loan disposal and borrower resolution are encouraging.  Japan now has more effective bankruptcy laws and procedures for securitization, which improve the structure for private turnaround efforts. Early entrants into the distressed debt market were foreign firms.  They earned very high returns on the few transactions that took place.  But over time a market for distressed debt has developed, with domestic firms participating.  Competition has led to a narrowing of margins.

Initially, the interest in distressed debt was primarily for the underlying property collateral.  But there is increasing interest in acquiring and turning around businesses.  The Industrial Revitalization Corporation of Japan (IRCJ) is perhaps the most visible.  But Japanese banks have also started their own restructuring affiliates, and a number of private equity firms have begun operations. 

All of these developments are good news, but transactions are still relatively few.  Two obstacles may be standing in the way of an increased number of transactions.

The first of these is the apparent lack of incentives that banks and borrowers have to restructure, particularly at a time early enough to allow viable businesses to be preserved.  Bank classification and provisioning are key.  As I mentioned at the start of this talk, because of the very low level of nominal interest rates, by the time a loan becomes non-performing, there is often little scope for a successful turnaround.  The best opportunities for restructuring and revitalizing a company are at an earlier stage.

Bank provisions against troubled but performing loans are based on historical averages in Japan.  These are low – particularly in the current business environment of deflation.   As a result, banks face an additional, un-provisioned, loss if they sell or restructure a troubled loan, and this may cause them to wait rather than act.

Japan does not lack for restructuring expertise – either in the private sector, or in the IRCJ, which has established an excellent institution and team.  But I believe the incentives have to be right too.

The second obstacle to a more rapid resolution of the banking problem is resources.  This was the conclusion reached by the IMF’s Financial System Stability Assessment for Japan. Although capital adequacy ratios of Japan’s major banks are well above the 8 percent Basel requirement, reliance on deferred tax assets and preferred stock is very high. 

The recent experience with Resona Bank illustrates what is possible.  The intervention was quickly and quietly done, without disrupting depositor confidence.  A new president, from outside the bank, was brought in and appears to have the control and the ability to change the direction of the bank.  And the size of the capital injection recognized that the losses might go beyond existing provisions.  This gave the bank the ability to deal promptly with its loan book. 

The Resona action provides a number of opportunities: to remake a failed bank, to accelerate the resolution of the non-performing loans, to free up the underling assets, and to use new institutions such as the IRCJ.  I hope that this experience, as well as the painful lessons of dealing with bank crises in other countries, including the United States, will guide the framework that Japan develops and the conditions that it imposes on the banks that receive new funds.

Conclusion

In sum, I have tried to emphasize why the problems of deflation and the banking sector in Japan are closely linked.  Since I last spoke on this topic in Japan I believe that good progress has been made in addressing both problems and I have tried to point out this progress in some detail tonight.  There are also promising improvements in the Japanese economy: less deflation and more growth. This progress shows how good economic policies implemented by effective economic leaders can have a beneficial effect on peoples’ lives.