Amid the chorus of international criticism of Japan's incompetence as financial institutions bit the dust this week, a senior European diplomat begged to differ. "I think the government has handled this very skilfully," he said over breakfast on Wednesday, even as the radio in his apartment broadcast news of a fall on the Tokyo Stock Market.

"The Japanese government have known for a long time that major financial and security companies and banks were sitting on enormous levels of bad debt," he said. "They let it be known last year after the "jusen" crisis (when tax money used to wind up failed mortgage societies known as "jusen" provoked a public outcry) that some companies would go to the wall. It is all to do with the painful process of deregulation. There will be more big profile bankruptcies. Not everything can be saved. But this had to happen."

Japan has been struggling all week to get just this message across. Mr Nobuaki Tanaka, a senior official in the Japanese foreign ministry, put the collapse of Yamaichi and three other financial houses in Tokyo this month in the context of Japan's determination to deregulate its financial sector by next year.

"We believe that these incidents that we have seen over several days are inevitable," he said in an interview in his office. "It is a plight we have to go through. We have to overcome the difficulties at all costs. We need the economic restructuring of the financial sector. We need increased disclosure about information about these financial institutions. In order to make Japan a viable international powerhouse we have to make these things happen.

"The finance ministry policy has completely changed," he added. "In the past we tried to salvage one of the big ships in the fleet when the ship is about to be sunk. Now we just leave it to sink unless it would affect the entire fleet. Our mission is to ensure that it doesn't spread into a financial crisis."

The challenge Japan faced, he said "is whether we can open up in the service sector, including in the financial area. We are introducing the big bang next April and we hope that this will bring Tokyo's status up to that of New York and London."

A leading Japanese academic agreed with the diplomat that the situation had been engineered by bureaucrats as part of a controlled, long-term plan to deregulate the financial sector. "Yes I think this has been handled well, and for the long-term benefit," said Prof Kenzo Uchida of Tokai University, whose bookshelves are lined with the many volumes he has written on Japanese politics.

"The general public is feeling panicked, and the panic they feel is intensified by the previous comfortable situation of the banks and securities firms," he said. "But for Japan to survive it is inevitable that inefficient companies have to fail. The reason for the current confusion is that the people of Japan were not aware of what was going on. Secrecy is a big problem in Japan and the public didn't know about this particular bag of worms."

The "bag of worms" was the corruption which came to light following the collapse of Yamaichi, the fourth-largest securities brokerage in Japan. Authorities are preparing criminal charges over hidden debts of more than $2 billion (£1.3 billion), which had been manoeuvred through hidden accounts to deceive securities regulators.

"In a way, the exposure of wrong-doing helps to calm the public," said a foreign business analyst. "Every time there is a corporate failure here, the television shows prosecutors coming out of a building with cardboard boxes full of incriminating documents. The message is that human avarice is to blame, not the system." (Sure enough on Thursday, Tokyo TV news showed investigators carrying boxes from Yamaichi headquarters).

It has long been suspected that Japan's powerful finance ministry manipulated the financial scene. "If you look behind the headlines to what Japan's economic leaders actually do, they are revealed as having an impressive delicacy of touch in crafting and implementing complex policies demanding co-operation and even self-sacrifice from various competing interest groups," wrote Eamonn Fingleton in Blindside; Why Japan is Still on Track to Overtake the US by the Year 2000.

"The future for Japan's economy is OK but the timing is bad," said Prof Uchida. The Yamaichi collapse, Japan's biggest post-war financial failure, came the same weekend that South Korea, previously the most successful Asian tiger economy, applied to the International Monetary Fund for a humiliating bailout.

It looked for a day or two as if Japan was next. There was talk of a Tokyo meltdown and Japan having to sell off the US Treasury bonds it had accumulated, something which could raise US interest rates and slow down economies all over the world.

Officials say this will not happen. Japan is quite different from the ailing Asian economies, said Mr Tanaka. "We are the largest creditor in the world, while all these small countries are net financial debtors. Although we have a huge amount of American bonds, we have still many means to exhaust before we do that [sell bonds]."

The Tokyo stock market fell after the Yamaichi debacle but did not collapse, as it had in 1989 when the Japanese bubble burst. By yesterday, the situation had steadied considerably, spreading a rare confidence through south-east Asian markets.

Japanese policy-makers still have a major struggle on their hands to restore confidence in a financial sector whose 19 big banks are owed 16.1 trillion yen £8.5 billion in problem loans, according to Bank of Japan Governor, Mr Yasuo Matsushita, yesterday. They know what they are doing but they cannot control psychology and the stakes, and risks, are high.

Tokyo share prices rose yesterday after a rare assurance by the Bank of Japan and the finance ministry on Wednesday evening. "The financial system is the basis of the economy and society. We will take all possible measures to ensure its stability," the joint statement said. The assurances did not wipe away concerns by potential lenders to Japanese banks, and the yen weakened slightly to 127 against the dollar.

Prime Minister, Mr Ryutaro Hashimoto, said in Canada that he felt "shame" that regulators had been unaware of Yamaichi's problems, but added: "The most striking thing about this incident is that the market decided not to tolerate such deception, and when you lose the trust of the market, you meet the appropriate fate."