FROM THE OFFICE OF PUBLIC AFFAIRS

II. The Challenge of Growth in Japan

All in Bonn, I think, recognized that an important evolution has taken place in Japan's approach to the crisis. Moves to implement more ambitious plans for strengthening the financial sector have been particularly welcome. In that context it has nonetheless been troubling that -- as the G7 identified -- if anything, the uncertainties facing the economy have increased and growth forecasts have been revised further downward.

It is now very widely recognized that the overarching challenge of policy in Japan today is the creation of strong domestic demand-led growth. The tools that can be enlisted to meet that challenge are three-fold:

1. Fiscal and Monetary Policy

On the macroeconomic front, Japan is now implementing two large supplemental stimulus budgets, and will soon pass a more expansionary initial FY99 budget. These fiscal measures, effectively implemented, should provide some cushion for domestic demand in this period of weak private sector confidence and negative private sector growth. In monetary policy, the Bank of Japan has also recently taken steps to stimulate growth.

As the G7 agreed last week, the outlook for price stability in our countries as a whole remains favorable. The goal of price stability, of course, also means avoiding deflation. The government will need to ensure that the promised fiscal stimulus is fully implemented and sustained over the next few years. Its boost to the economy should also be accommodated by monetary policy. And going forward it will be important to think creatively about the best use of all the tools of fiscal and monetary policy to create an expectation of confidence and renewed growth.

2. Financial Stabilization

As the emerging market economies are learning -- and as many of the industrial countries have learned in recent years -- it is crucial to the efficacy of any other policies to promote growth to remove the bottleneck that is presented by an economy that is mired in debt. When Japan announced its Financial Stabilization Plan in July, there were four critical priorities for addressing decisively the problems in the Japanese financial sector. First, strengthening the major banks; second, resolving insolvent institutions; third, disposing of nonperforming assets; and fourth, improving disclosure and supervision.

Visitors to Japan have recently been encouraging to see the implementation of that plan start to achieve progress on all four fronts:

• 15 of the 17 top Japanese banks are to receive approximately Y7.5 trillion in public capital out of the Y25 trillion in available funds.
  

• although they are still operating, two major insolvent banks have been put under government control, while a number of smaller institutions have failed and been dissolved.
  

• legislation has been passed to ease auction rules and securitization of bad loans. There are plans to securitize bad debts held by the government and some securitization has begun.
  

• and to strengthen supervision and disclosure, the FSA has completed a round of inspections which raised the amount of disclosed loans by nearly 15 percent and has imposed new provisioning targets on major banks applying for public funds.
  

All of this marks welcome progress. But, as the G7 affirmed, it will be vital to continue to press ahead with the implementation of the Financial Stabilization Program in those areas where the greatest problems remain. Critically:

• banks are still undercapitalized. With loss estimates ranging from Y15-25 trillion, it will be critical to ensure further recapitalization next year. Banks also need to add more equity capital through new offering to the public and private sector.
  

• and a mountain of bad assets still stands in the way of cleansing bank balance sheets once and for all. We see it as very important that the authorities start to actually sell off government holdings of bad assets -- in part based on our own experience in Savings and Loans crisis, when we did this too late. And that they move to pass the proposed legislation to ease settlement of competing claims and provide incentives for lenders to forgive debts or give up their relevant recourse rights. As the government has recognized, they also need to further step up the regulatory pressure on banks to recognize and write off such assets.

3. Structural Reform and Market Opening

As Prime Minister Obuchi has recognized, a third part of laying the foundation for restored domestic growth in Japan will be deregulating and liberalizing the Japanese economy.

Prime Minister Hashimoto's "Big Bang" financial reform plan is a far-reaching and inspired initiative, covering many of the important areas of financial deregulation, experience in the United States and elsewhere suggests that this is only the start. Indeed, if anything, the available evidence suggests that the potential returns to such measures in Japan are even higher. The Japanese EPA has estimated that deregulation in just 8 industrial sectors could raise Japanese growth rate by nearly 1 percent a year over the next five years.

We have thus been glad to note the revived interest in deregulation here in Japan in recent months. The work of the Prime Minister's Economic Strategy Council has identified the importance of structural economic reform, and we hope that many of the ideas contained in the report can be adopted and implemented as rapidly as possible. And, in light of Japan's large current account deficit, steps to open markets and ensure free and fair competition are a critical priority.

These three things -- supportive macroeconomic policy, financial sector restructuring and structural reform and market opening -- will be mutually reinforcing in their support for domestically driven growth in Japan. And in all likelihood the benefits of the whole will be greater than the sum of the parts.

While a strong case can be made that excessive capital inflows may have contributed importantly to the recent problems in emerging markets, it seems clear that the problem for the next years will be increasing confidence in these countries. This is my last stop on a 5 nation trip through Asia. At each stop it was clear that national authorities saw what happened in Japan and other countries as crucial for their economies, and stressed the importance of close cooperation for shared growth and currency stability in Asia. One thing is certain; trade is better than aid. That is why strong growth and open markets in the industrial countries are now so important.

III. The Global Structural Reform Challenge

But even as we work our way through the current financial crisis it is essential to think about ways of resolving future crises. In some cases reforms will take years -- and in others it might not yet be appropriate to put in place necessary changes. But it will be important to consider carefully what the experience of the past year has taught.

If you study any auto accident it is always the case that it could have been better avoided in a number of different ways. If the driver had been driving less recklessly -- or wearing a seat-belt - - it might not have happened. If the road had been better designed, and the markings clearer -- it might not have happened. If other drivers had been more attentive, or the weather less treacherous - - it might not have happened.

So, too, is it a mistake to look for one single cause in considering the roots of the recent crises. If capital had been used better, the crisis would not have happened. If the macro and micro conditions determining how capital is used had been better, the crisis would not have happened. If problems had been better understood by investors -- and the authorities had acted earlier to address them -- it would not have happened.

In the event, all of these elements came together and were then compounded by a crisis of confidence and large-scale run for the exits. The upshot was a situation which had many of the elements of a bank run, when people are spending more time thinking about other people than about the fundamentals.

This, then, was a different kind of crisis -- calling for a different kind of response. It had a common element with almost all financial crises: money borrowed in excess and used badly. But it was also profoundly different because, relative to most of the crises we have seen in the past -- the problems that had to be fixed were much more microeconomic than macroeconomic, and involved the private sector more and the public sector less.

This diagnosis has informed the response to the crises in Asia and elsewhere in the past year and must also inform the international community's efforts to prevent and better contain crises in the future. Let me highlight three areas:

1. An Intangible Infrastructure for a Global Capital Market

The G7 last week reiterated its commitment to increasing transparency and disclosure in the global financial systems as a core form of insurance against future crises. And here I think one example highlights better than any other the kind of change we are seeking.

If you ask why the American financial system succeeds, at least my reading of the history would be that there is no innovation more important than that of generally accepted accounting principles: it means that every investor gets to see information presented on a comparable basis; that there is discipline on company managements in the way they report and monitor their activities; that there are whole groups of people all seeking to refine the way in which we measure and understand how companies' prospects are being described and presented.

GAAP are not a single institution. They are not a single magic bullet. They are an ongoing process that really is what makes our capital market work and work as stably as it does. And very much the same kind of thing is necessary globally.

Important steps have already been taken to enhance the transparency of global markets and progress in this critical effort was continued last weekend as the G7 agreed to strengthen the IMF's Special Data Dissemination Standard to include much fuller information on central bank reserves, and asked the IMF to strengthen the SDDS further in future, with more complete data on countries' external debt and international investment position.

Steps to encourage and promote improved banking regulation and supervision in emerging market economies will also be critical. That means pressing for greater opening of domestic financial market to foreign providers of financial services -- and the experience and greater diversification that they afford. And, as the G7 has recognized, it will mean our following up on the agreement of the Basel Principles, with effective surveillance of national authorities' progress toward implementing these principles and building more effective systems.

In this context let me highlight the G7's decision to take the initiative in convening a Financial Stability Forum to ensure that national and international authorities and relevant international bodies and expert groups can better foster and coordinate their respective responsibilities to promote international financial stability.

2. Avoiding Excessive and Potentially Destabilizing Capital Flows

The root cause of crises is not so much the weakness of financial systems as it is the inflow of capital that is excessive relative to the maturity of the system in which it must be absorbed. This points up a number of lessons for safe global practice.

We need to work to ensure that countries to pace the opening of the capital account to the development of the domestic financial system. We have seen -- once again -- in recent months in Asia the danger of opening up the capital account when incentives are distorted and domestic regulation and supervision is inadequate.

The corollary to this is a need for improved surveillance to highlight and discourage excessive reaching for capital inflows by countries that may not be in a position to safely absorb it. We saw this in Mexico, with the increasing resort to issuing dollar-denominated tesobonos before the crisis; we saw it in Thailand, with the Bangkok Offshore Banking Facility; and we saw it Russia, in the government's efforts to court foreign investors to invest in domestic GKOs.

On the other hand, every ill-judged credit has both a lender and a borrower. In this context the G7 last week endorsed the recommendations of the Basle Committee on Banking Supervision on how best to mitigate the risks involved in dealing with highly-leveraged institutions. As we go forward there is broad agreement on the need to consider the supervisory and other implications arising out of the operations of such institutions and of offshore centers.

3. More Effective Crisis Response

Countries shape their own destiny. No amount of external support will succeed where the domestic commitment to reform is lacking. But -- as the Korean example so clearly demonstrates -- where the domestic will is present, conditioned provision of finance can make an important difference. And recent events have pointed up a number of key issues for developing the most effective systems for this kind of response.

One is developing the capacity to respond in a strong way to bank-run-type situations. In the fall of 1997 the United States and Japan worked together to produce innovation in this area with the creation of a new IMF facility -- the Supplemental Reserve Facility. This progress has since been continued with the IMF's development of a new contingent short term credit line which, like the SRF, will carry premium interest rates and shorter maturities to maximize countries' incentive to seek alternative, private sources of finance.

Another will be finding ways to work more effectively with the private sector so that it is doing its share in responding to crises and mitigating their effects. This means a great many things. But in a sense, it adds up to a system that can safely fail. Countries need bankruptcy laws. And they need effective judicial institutions to enforce them. That is part of being part of a global capital market. And when severe difficulties arise -- as we saw in Korea -- it may often involve an important role for voluntary participation of private sector creditors.

Finally, we will need to improve the capacity of the IMF and other international financial institutions to address the very difficult challenges and conflicts that responding effectively to crises can present. Notably, the need for credible policies to contain the crisis and increase confidence will need always to be considered alongside the sometimes competing need to respect national sovereignty and prevent a domestic backlash against external providers.

IV. Concluding Remarks

The United States and Japan are the world's largest economies. Ours is the most important economic partnership in the world. Together we have an enormous stake in seeing the global economy prosper. That means creating and sustaining prosperity in our own economies. And it means cooperating to build the right kind of international financial system for the 21st century. This is a momentous challenge but working together, I am sure it is challenge that we can meet. Thank you.