A modest long-term economic growth outlook rather than often-cited high government debt represents a significant constraint on long-term Japanese defense spending and provides Tokyo with enhanced incentives to strengthen its alliance with the United States and defense cooperation with regional and extra-regional partners. High Japanese government is only moderately constraining in terms of short- and medium-term defense spending. Government debt is extremely high in gross terms, but much less so in net terms, that is, after accounting for the government’s holdings of financial assets. Importantly, Japanese government is largely owned to residents and it is denominated in local currency and to residents. This sharply reduces the risk of sovereign debt distress and provides the government with greater fiscal flexibility than what high gross government debt may imply. Moreover, nominal and real interest rates of close to zero also suggest that the government retains significant room to borrow. Japan would need to see a significant widening of the real interest rates/ real GDP growth differential for public debt to move onto an irreversibly unsustainable path. Finally, if the Bank of Japan were forced to sell government bonds at a loss or if its net interest margin were to turn on negative in the face of higher interest paid on its liabilities (reserves) than it earns on its assets, this would translate into losses and reduced central bank transfers to the government budget. But a sharp increase in nominal interest rates, as opposed to a normalization of the policy rate, is becoming less likely as inflation has been steadily declining. More importantly, as long as the increase in nominal interest rates does not translate into higher real interest rates, government debt dynamics will remain unchanged. In this context, raising annual defense expenditure by one percentage point of GDP is not going to break the bank.
Japan’s gross government debt stands at 250% of GDP. Net government debt is 160% of GDP. Net public sector debt is 120% of GDP. Only 14% of Japanese debt securities are owned by non-residents and they are denominated in Japanese yen. The IMF forecasts the fiscal deficit to fall to 3.7% of GDP this year and 3% of GDP next year in the context of a slight decline of the gross debt-to-GDP ratio. The Bank of Japan’s budget contribution to the government is only 0.3% of GDP. If the Bank of Japan were to suffer financial losses in the context of higher interest rates, the direct fiscal impact would be limited. After hitting a four-decade high in 2023, inflation fell to 2.6% in December and is set to fall to the Bank of Japan’s two-percentage inflation over the course of 2024, thus limiting the need to make major adjustment to nominal interest rates. The central bank may yet to decide to raise its policy rate from -0.1% to zero, but this will have virtually no effect on government debt service or debt dynamics.
Japan’s strong international creditor position means that it has ample scope to draw on international financing and resources to support defense spending. In addition to running a large current account surplus of 2-4% of GDP, which translates into a roughly equivalent increase of net foreign assets, Japan is the world’s largest net international creditor in dollar terms. This provides it with significant leeway to draw on foreign resources, if necessary, to support defense spending without jeopardizing its international financial position. In principle, the Japanese government could purchase 4% of GDP worth of foreign defense equipment without jeopardizing Japan’s international financial position, even though it would add to government debt unless it is funded through higher taxes or reduced expenditure.
Japan’s net international credit position is equivalent to 70% of GDP. While some smaller economies have a stronger net external position as a share of GDP, Japan is the greatest international creditor in dollar terms with net international claims exceeding $3 trillion (or 50x times annual defense spending). The Bank of Japan alone holds $1.3 trillion of high-grade foreign assets. Japan’s current account surplus has averaged more than 2.5% of GDP annually in the past four decades, and it is set to account for 3-4% of GDP this year, or more than $100 billion annually. As far as the balance-of-payments constraint is concerned, Japan has ample scope of scope to tap external resources to support defense spending increases. A strong external financial position allows the government to provide significant scope to engage in international financial diplomacy in support of its alliance and security policies. While external lending would add to the government’s gross debt burden, its net debt would remain unchanged as long as it creates a repayable loan. Moreover, if the government provides loans in Japanese yen, it can provide very attractive financing terms to borrowers, not least given the lower yen funding costs.
The more significant economic-financial constraint on medium- and long-term defense spending relates to Japan’s modest growth potential, not its external financial or fiscal position. Japan’s nominal GDP at purchasing power parity is a very rough proxy for the broader resource base from which defense spending is sourced. Japan has the world’s fourth-largest economy in terms of purchasing power after China, the United States and India. Naturally, a country’s economic resource base does not translate one-for-one into actual mobilization, let alone defense spending that is effective in military terms. Varying levels of per capita income also affect the level of “extractable” resources. Politically, a government needs to be able to raise taxes, cut non-defense expenditure or borrow, domestically and internationally. The government bureaucracy needs to spend the resource efficiently and effectively. As for Japan, it is financially well-positioned to raise medium-term defense expenditure as a share of GDP. However, Japan’s modest long-term growth outlook means that a relatively stagnant economic resource base will nevertheless limit the extent to which Japan can increase the resources allocated to security in absolute yen or dollar terms. This does not mean Tokyo would not be able to mobilize very significant resources in an emergency. But it does mean that a slowly expanding resource base does put greater limits on long-term defense spending than in other countries, including China. Not only is Japanese defense spending much lower than China’s, China’s defense spendings is also expanding at a much faster clip in dollar terms.
China is the world’s largest economy in PPP terms at $35 trillion, followed by the United States with $28 trillion and India with $14 trillion. Japan is the world’s fourth-largest economy at $6.7 trillion. Japanese real economic growth has averaged 0.6% of GDP over the past decade. This compares to 1.8% in the United States. Chinese real economic growth averaged 10% over the past four decades, but is projected to decline to 3.5-4.0% over the medium term. But Chinese growth will continue to exceed Japan’s growth rate by a factor of four. In nominal dollar terms at market exchange rates, the United States spent $880 billion, China $290 billion and Japan$46 billion in 2022. If China grows 4% in real terms and the United States grows 2%, while Japan grows 1% and if military spending as a share of GDP remains unchanged, the financial resources directed toward defense will be 50%, 20% and 10% higher a decade from now, respectively. To match the increase in Chinese spending, Japan would need to increase defense spending as a share of GDP from 1% (roughly the current level) to 4% over the next decade. While Japan has some scope to raise defense expenditure, such a significant increase would be challenging to implement, economically, financially and politically.
In view of the deteriorating security environment and China’s increasing military prowess and assertiveness, Tokyo is fully aware of its relative resource constraints and the need to strengthen its alliances with the United States as well as other regional and extra-regional powers if it wants to balance China. In the context of increasing geopolitical tensions in East Asia and beyond, Japan is undergoing a very significant shift in defense policy and spending. China’s increasing assertiveness, North Korea’s enhanced military capabilities and more recently Russia’s war in Ukraine have accelerated Japan’s shift towards a more resource-intensive defense policy. In 2022, the Kishida government published its National Security, National Defense Strategy and Defense Buildup Program, referring to China as an “unprecedented strategic challenge”. The new national security and defense strategy involves not just higher defense spending and the acquisition and enhancement of critical weapons systems, such as counter-strike capabilities, but also inter-service integration. The Japanese government committed to a significant increase in defense spending from a baseline of 1% of GDP. While the economic constraints on a significant increase of Japanese defense spending are more than manageable, Japan will not be able to match increasing Chinese defense expenditure due Japan’s much more modest economic growth potential. This is providing Tokyo with greater incentives to strengthen its alliance with the United States in the military and economic realm as well as other countries in Asia and further afield, including Europe and Australia.
Japan intends to spend more than $315 bn on defense in FY 2023-27. This would represent an overall increase of 60% compared to 2022. Broader national security spending (not just spending controlled by the Ministry of Defense, e.g. coast guard) is supposed to roughly double from historically 1% of GDP to 2% of GDP over the next decade. This would make Japanese defense expenditure the third- or, depending on whether Russia will sustain its increased level of defense expenditure, fourth-largest largest in the world, after the United States and China. But even at these higher level, defense expenditure in dollar terms will remain much smaller than China’s and barely keep up with projected Chinese spending increases over the next few years.
The United States remains Japan's indispensable security guarantor. Japan and the United States have been treaty allies since 1951. US-Japanese defense cooperation has intensified over the years, including significant revisions to defense guidelines in 1978, 1997, 2015, which have provided the Self-Defense Forces greater operational flexibility and have allowed for greater coordination and inter-operability with the U.S. forces in case of an attack as well as in case of U.S. forced engaging in military action near Japan. In 2017, the Abe government helped revive the Quadrilateral Security Dialogue (Quad) alongside Australia, India and the United States, which is committed to a Free and Open Indo-Pacific and is meant to counter China. In the economic realm, Japan joined the Biden administration’s Indo-Pacific Economic Framework (IPEF), which is focused on non-market access trade issues. Japan was also the driving force behind saving the Trans-Pacific Partnership (TPP), a high-quality free-trade agreement among countries in Asia and the Americas after the United States pulled out of TPP negotiations under the Trump administration and salvaged trans-Pacific trade cooperation by establishing the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTTP).
Concerns about America’s reliability as an ally has also led Japan to pursue closer defense cooperation with other countries in Asia and beyond. Aside from the Quad, Tokyo has signed “Reciprocal Access Agreements”, which among other things provides for shared military training an cooperation, with Australia and the UK. Similar agreements are also being negotiated with the Philippines and France. Japan has also signed “Acquisition and Cross-Servicing Agreements” (or similar agreements) with Canada, France, Germany and Italy. Revealingly, Japan, the UK and Italy have also agreed to develop a next-generation fighter jet. Tokyo has also been seeking to foster closer economic and defense ties through South-East Asia, most notably with Vietnam.