FROM THE OFFICE OF PUBLIC AFFAIRS

It’s a pleasure for me to speak before the Japan Society, an organization that has done so much to promote cooperation and understanding between our two countries. 

This is a particularly appropriate venue because the Bush Administration made a deliberate decision to change the tone and approach of the US-Japan economic policy relationship.  We chose to move from the confrontation and hectoring that characterized the past to a more supportive, cooperative relationship.

Now, two years into that policy, I can report to you that our political and security alliance and our economic relationship with Japan are as strong as they have ever been.  Japan has been a steadfast ally of the United States, and we have worked together closely on issues of international concern.

Our cooperation to bring about Afghan reconstruction is a particularly good example.  Japan hosted the first pledging meeting of the Afghan Reconstruction Steering Group.  We collaborated to fund the Kabul-Kandahar-Herat road, a major transportation infrastructure project that will form a basis for a national economy.

The Bush Administration has encouraged Japan to step forward and play its rightful role as a strategic and international partner.  At the same time, the Administration has recognized that Japan’s ability to play that role depends substantially on its economic performance.  This is one of the reasons why restoring vibrant growth in Japan is so important.

The Japanese economy has struggled throughout the last 12 years, and many observers now believe it is headed into yet another downturn.  The cost in lost income and employment opportunities has been high.  If the Japanese economy had managed to grow at 3% over the past 12 years instead of the 1.1% that it actually managed since 1991, Japanese output would be 25% greater than it is today. 

Public finances would also be in far better shape.  The Japanese fiscal deficit and burgeoning public debt are the result of falling tax revenues and over $1 trillion spent trying to stimulate the economy.  Japan’s fiscal difficulties carry over into international affairs.  Budget pressures have led the Japanese to substantially cut their foreign aid in the last two years.

When an economy struggles, the effect spills over into the public mood, in increasing pessimism and dissatisfaction.  A recent Nikkei survey found that 84% of those polled expected the economy to fail to improve or deteriorate further.  Eighty-three percent felt uneasy about their current or future employment.  Economic recovery consistently tops the list of the public’s policy priorities.   And dissatisfaction with the economy played an important role in making Mr. Koizumi Prime Minister.

Rather than trying to prop the economy up in the short term with government expenditure, the Prime Minister has concentrated on the challenges that Japan faces in restoring vibrant, sustained growth.  These are:

• Resolving the problems of the banking system
• Eliminating deflation
• Carrying out fundamental economic and structural reform
• Reducing the deficit

I’d like to take these in reverse order, building up to the banking system problem.

Fiscal Consolidation

Limiting the deficit and bringing Japan’s rapidly growing public debt under control is a challenge that Prime Minister Koizumi has clearly identified.  Cutting fiscal deficits, particularly in a weak economy, requires hard choices. But a transparent, credible medium term plan to cut the deficit – one that increases household and investor confidence – can do much to assure that fiscal consolidation enhances growth rather than holding it back.
 

Economic and Structural Reform

The second challenge – economic and structural reform – is one of re-invigorating the private, domestic Japanese economy.  This requires opening up new opportunities for investment and growth.  It also requires reversing the drop in the productivity growth rate in Japan, which has fallen farther and faster than in any other G7 country.

All of us have been greatly impressed by the prowess of Japanese export manufacturers – in electronics, optics, automobiles, and a host of other goods.  Indeed, where Japanese firms have faced foreign competition, they have often become world productivity and technology leaders.

But Japan combines industries where productivity is the highest in the world with industries that lag strikingly behind their counterparts in other countries.

In many cases these lagging industries have extensive regulation on products, technologies, and companies.  Regulation has sheltered these industries from competition, not only from foreign companies, but also from domestic new entrants. 

But industries that don’t face competition fail to innovate.  And they fall further behind.  Unfortunately, many of these regulated and lagging industries – business services, medical services, communications, and financial services – are industries that offer the greatest potential for growth in today’s economy.
 
Structural reform and deregulation that removes barriers to competition, new entry, and new product introduction is the strongest tool for pushing productivity and growth upwards.  The deregulation of Japan’s cellular telephone industry provides a vivid example.  It is now an industry in which Japan is world-leading.  Prime Minister Koizumi is absolutely right when he says “no growth without structural reform.”

Overcoming Deflation

Eliminating deflation is the next challenge.  Deflation raises the burden of debts, discourages investment, and leads households to postpone expenditures.  Although Japanese deflation has been modest – about 1% for the consumer price index and 2% for the broader GDP deflator – deflation has been strikingly persistent.  And, with wages currently falling by more than 1% per year, deflation is now endemic and firmly embedded in expectations.
 
Deflation is a monetary phenomenon and the monetary policy of the Bank of Japan will play a central role in overcoming deflation.  In March 2001 the Bank of Japan made a commitment to expand liquidity until the consumer price index was stable or increasing year-on-year.   Since the change in policy the BoJ has increased bank reserves and currency in circulation by 43 percent.  Most of this increase came from a rapid start, however, and BoJ’s efforts to increase the money supply have flagged recently.  And Japanese prices continue to fall.

The persistence of deflation, despite BoJ’s efforts, should not be discouraging.  As my former University of Chicago colleague, Milton Friedman, says, monetary policy operates through many channels, often with considerable lags. 

It has been some time since a major country has had to deal with deflation.  But experience in Sweden and the United States during the 1930’s suggests that increases in the money supply that are larger than Japan has had so far and that are sustained over time are necessary to break deflation’s grip. 

Sweden is a particularly good example.  Like Japan, Swedish prices declined steadily without a deflationary spiral.  When the Central Bank announced a commitment and took action to eliminate deflation, it increased base money by 92 percent between 1931 and 1936.  It still took almost 3 years from the beginning of the monetary easing for Swedish prices to begin to rise again.

The deflation problem is also intertwined with the other challenges that Japan faces.  Persistent deflation increases the burden of debts, exacerbating the bank bad debt problem. 

Banking difficulties also make the task of monetary policy in overcoming deflation more difficult.  Weakened banks do not increase their lending when the central bank provides more reserves, blocking a principal channel through which monetary policy works. 

Sometime soon, perhaps in the coming week, Prime Minister Koizumi will appoint a new Governor of the Bank of Japan, along with two new Deputy Governors.  Actions by the Bank of Japan are a critical component in meeting Japan’s challenges and restoring vibrant growth.   But they are not a magic bullet.  Simultaneous action on all fronts will be needed if Japan is to restore vibrant growth.

Banking Sector: Dealing with Bad and Troubled Loans

I have saved the banking problem to last because it is the most complicated and persistent of the challenges that Japan faces.

The financial system – the flow of funds from savers to investors – is the lifeblood of a modern economy.  A banking system that is hobbled by bad and troubled debts loses the critical ability to gauge and fund new business opportunities.  This creates a tremendous obstacle to economic growth.

Many countries have had banking problems.  As a result, there is now a clear basis – expensively won – for understanding the steps necessary to clean up a troubled banking system.  These steps involve:

- recognizing the full extent of bad and troubled loans,

- closing banks that are insolvent,

- assuring that  the remaining banks accurately gauge the risks of their loan portfolios, have sufficient reserves against loss, and maintain enough capital to operate prudently, and

- ensuring that the new management of the remaining banks have the skills and the incentives to run their banks well.

Many actions are necessary to bring these results about, and Japan has made considerable progress – more than it is often given credit for.  The Government’s Financial Revival Program, announced on October 30 is an important step forward. 

The Revival Program sets out a much more specific and detailed set of measures than previous Japanese bank reform programs.  These cover how required loan provisions should be calculated, how collateral should be valued, what should count in bank capital, and what conditions should accompany the use of public funds to strengthen banks.

Implementation of those measures is, of course, key.  The Financial Services Agency has already put into effect several of the measures under its jurisdiction.  Full and effective implementation of the Government’s October 30 program would markedly increase the incentives for Japanese banks to deal with their bad debt problems.

A crucial point, however, is that a banking crisis is not simply a bank problem.  The problems of non-performing and troubled borrowers are at least as serious in their effects on the economy as a whole.    And, along with cleaning up the banks, the problems of the distressed borrowers must be dealt with. 

Borrowers who are not able to make payments on their loans are the owners and employers of productive assets—property, buildings, capital equipment, and workers— that are not being used efficiently. 

In addition, at Japan’s current low interest rates many performing borrowers are able to meet their interest payments, but little else.  They can’t invest, they can’t expand, nor can they enter new fields of activity.   And they have no realistic prospect of ever repaying their loans.

The name given to these companies – “zombie firms” – is telling.  These are companies that don’t live, in the sense of growing, innovating, or making money.  But nor do they die.   Productive assets, including much of Japan’s workforce, remain frozen in place, often in excess capacity industries, worsening deflationary pressures.

Efforts to address the problems of distressed borrowers have progressed very slowly in Japan.  The Resolution and Collection Corporation, or RCC, was set up to receive bad loans from failed though still operating banks.  But the RCC has long seen its role as that of a collection agent, rather than a resolution mechanism.  As a result, it has become a warehouse, not a halfway house.

This may be about to change.  The Financial Revival Program provides clear instructions to the RCC to move beyond collection and sell loans where it has been unable to make collections.

The Japanese Government has also decided to create an Industrial Revitalization Corporation that would purchase loans to major companies that are judged to have viable businesses.  Mr. Tanigaki has been named Minister for Industrial Revitalization, and there is legislation before the Diet to establish the IRC this spring.

The IRC is interesting and promising in a number of ways.  First, the focus is explicitly on corporate restructuring and turnaround, not on collection.  Second, the IRC will work with borrowers at an earlier stage, before they are bankrupt or in danger of bankruptcy, where there is likely to be a greater chance of success.  Third, Minister Tanigaki has said that he plans to appoint experts from the private sector to run the IRC and to make up its decision-making council.

As anyone in the industry will tell you, corporate restructuring is inherently difficult.  There are many failures as well as successes.  The United States, with the RTC, did not choose the restructuring approach.  Instead, we chose to sell assets quickly.  But other countries have opted for a restructuring approach to bad debt workout.  Some of them – notably Sweden and Korea – have had success with this approach.

Experience across a number of countries suggests that the restructuring approach can be successful when the institutions in charge are:

• Well-funded, with the ability to take (and therefore recognize) losses on particular transactions

• Independent, with the ability to make hard-headed commercial judgments.  This is important not just at the beginning, but throughout the restructuring process.  The ability to change course midway or abandon a failed restructuring effort is crucial.

• Given a fixed termination date.  A sunset provision not only assures that decisions are made quickly, it also assures that decisions are actually made.

• Transparent in their operations.  In both Sweden and Korea, the public was given considerable detail about the operations of the restructuring entities, which built public support.

• Able to draw on experts from the private sector and employ the services of private firms in the restructuring process.

The Japanese government is now in the process of designing and establishing the Industrial Revitalization Corporation.  I hope that they will draw on international best practice based on the lessons of restructuring entities elsewhere.

There is one additional point that I would like to make that deals with the social and political environment surrounding restructuring and with the role of foreign investors.

Dealing with distressed borrowers is a wrenching experience.  Huge losses must be recognized, mostly by the taxpayer.  Bankruptcies throw people out of work.  Companies pass from one set of owners to another, often at a fraction of their original value.  Buyers are sometimes foreign, leading to complaints that national assets are moving into foreign hands.  These are highly charged issues wherever they occur.

They certainly were in United States in the late 1980’s – when it was our skyscrapers and golf courses, and the buyers were often Japanese.    Book titles of the period – “Selling Out...,” and “Yen! Japan’s New Financial Empire” – reflected and fed that fear.  These fears were irrational, and in hindsight seem quaint.

Japanese concerns about foreigners benefiting from distress are similarly misplaced.  It’s true that the initial interest in distressed debt purchases and corporate workouts in Japan was from foreign firms – many of them American – drawing on the experience they had accumulated in other countries. 

But already there are new Japanese institutions in this market – affiliates of big companies like Nomura’s Jafco or much smaller firms like Akusa Capital.  Seminars on corporate restructuring, such as the one given recently by PriceWaterhouse Coopers, now attract huge Japanese audiences.

Corporate restructuring is not about nationality, nor is it about instant profit.   Corporate restructuring is fundamentally about freeing viable businesses from the death grip of overextended, failed companies.  And it is risky.

But there are already examples of successes – Denon in electronic equipment and Victoria Sportswear in retailing.  Sogo, which recently came out of court-ordered rehabilitation, will make the largest number of new job offers of any department store this spring.

Japanese banks have recognized what many of the critics of foreign involvement overlook – the valuable skills that restructuring experts can bring to the process of loan workout.  UFJ has teamed up with Merrill Lynch and Sumitomo-Mitsui will work with Goldman Sachs in corporate restructuring efforts.  This is clearly a win-win situation for Japan.

Conclusion

The United States fully supports Prime Minister Koizumi’s resolve to overcome these four challenges facing Japan.  Returning the Japanese economy to its full growth potential is critically important to Japan in order to assure employment, income security, and fiscal sustainability. 

Why is this so important to the United States?  It is because we clearly recognize that a vibrant international economy requires strong performance from each of the major economies.  We realize that today many countries depend on the United States as a source of growth for the world economy.  But continued world economic growth needs more than a single engine.  It needs the powerful engine of a vigorous Japanese economy.  We can’t applaud with one hand clapping.

Nor is our interest simply a matter of economics.  A healthy, vibrant Japan is a Japan that is able to take is proper place on the world stage – a critical factor in the security of this region, and of the world as a whole.