Key Takeaways:
KSG assesses that Japan’s economy is resilient and shows promise that it can meet rising challenges, distinguish itself in alliances, and offer opportunities for investment. However, KSG also assesses that if not properly managed, there is a limited but highly impactful risk that certain economic pressures may inhibit Japan’s military spending and alliance commitments. KSG assesses subsequent challenges following these risks to be significant but not insurmountable if the US continues to support Japan.
KSG assesses that the most significant potential impact of Japan’s economic issues would be on bilateral relations with East Asian allies. If Japan’s economy suffers, these security partnerships are more likely to weaken and become less effective at deterrence against China and North Korea.
Relations between Japan and China are likely to become increasingly strained. KSG further assesses that the close economic relationship between Japan and China may circumscribe Japan’s engagement with the West. Consequently, Western oil and gas companies may have increased opportunities if China restricts exports of oil to Japan.
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Background:
On 14 August, 2024, Japanese Prime Minister Fumio Kishida announced that he would step down as leader of Japan’s ruling Liberal Democrat party in September. Although Kishida stated the economy was one of his top priorities when he assumed his office in 2021, it remains a challenge at the time of his departure. The combination of a recent scandal and long-term economic problems is likely to have prompted his resignation.
Further exemplifying fears that Japan’s economy may be weaker than expected, on 5 August, 2024, the US and Japanese stock markets suffered a significant single-day loss. The Dow Jones Industrial average fell by over 1,000 points, losing 2.6% of its value. Japan’s Nikkei average fared worse falling more than 12%, its worst day since 1987. Despite the quick rebound in the Nikkei, Japan’s economic status appears to be slipping in other metrics. Although its economy has recovered from this ‘mini crash’, Japan’s ageing population suggests that other economic challenges lie ahead. These two events thus raise the possibility that there may be economic threats in Japan’s future.
In addition to being an economic power, Japan is an important military power in the Indo-Pacific. Consequently, the United States and its allies are considering Japan as an addition to AUKUS Pillar 2, which would strengthen Japan’s already powerful military. However, as Japan’s defence commitments increase, so too could economic strain. This report assesses the degree to which the Japanese economy is resilient enough to support these likely increases in military spending, alliance commitments, and growing competition with China over territorial interests in the Indo-Pacific.
KSG assesses that Japan’s economy is resilient; it shows promise that it can meet rising challenges, offer opportunities for investment, and distinguish itself as a strong alliance partner. However, KSG also assesses that if not properly managed, there is a limited but highly impactful risk that certain economic pressures may inhibit Japan’s military spending and alliance commitments. These pressures are: significant social welfare spending, an ageing population, labour shortages, and defence procurement issues. KSG assesses subsequent challenges following these risks to be significant but not insurmountable if the US continues to support Japan.
Strengths of the Japanese Economy:
Budget Overview:
Figure 1 depicts Japan’s budget for fiscal year 2024. 49% of Japan’s public spending is dedicated to social security and managing debt. Only 7%, around $54 billion USD, is devoted to defence. In comparison, in 2023, Germany allocated 55 billion Euros for defence - about 12% of its budget.
Data from Japan’s Ministry of Finance, Chart by KSG
KSG assesses that overall, Japan’s economy is resilient; economic indicators reveal that Japan is likely to be able to maintain its strong capabilities in manufacturing and technology, and maintain its alliance commitments. These qualities are also likely to make Japan an appealing partner for investment and defence projects as they have in the case of AUKUS. Several of these key indicators are as follows:
Significant recent GDP growth*: In 2022 and 2023, nominal GDP growth averaged 3.5% - more than double the growth rate from 2013 to 2019. If such trends continue, or at least remain comparable to similarly-sized economies in Europe, Japan is likely to retain its position as a significant economic player. As its economy grows, potential burdens from defence procurement and social spending are likely to become more manageable.
(*As KSG assesses below, there are some reasons to suspect growth could be challenged over the longer-term).
Manufacturing strength: Japan is likely to be a strong partner for AUKUS because of its manufacturing status and potential. GDP from manufacturing has steadily increased in Japan over the last 20 years. Japan is also the third-largest steel producer, and the third-largest ship builder. KSG assesses that this is highly likely to be a key advantage for Japan, an island nation in a region where the navy is essential for security. Moreover, manufacturing comprises 20% of the Japanese economy and 15% of its workforce. Japanese companies are also already involved with the production of materials vital to the defence industry: carbon fibre for aeroplanes, and titanium sponge for missiles and aircraft engines. The House of Commons Foreign Affairs Committee similarly concludes Japan should join AUKUS given its previous collaboration with the UK and Italy on the Tempest aircraft. KSG assesses these factors are also likely to make Japan competitive economically in the longer term as Japan possesses “some of the world’s leading manufacturers and robotics companies”. KSG assesses strength in robotics will be valuable as Western companies and governments automate and integrate robotics with more of their workforce and their military.
Research and Development (R&D): In 2022, Japan spent 3.65% of its GDP on research and development. In comparison, in 2021, French domestic R&D spending was 2.22% of GDP. It is this level of innovation which likely matches Japan with AUKUS’ research priorities. Therefore, KSG assesses that as foreign investments in military R&D increase – as they are likely to do because of AUKUS and bi-lateral security partnerships with the US – Japan’s status as a defence asset is likely to increase as well. KSG assesses R&D funding is likely to be an economic and military strength into the future as technological and AI-centred solutions to social and security problems become more paramount. Japan’s 2024 defence budget plans to spend 1 trillion yen on R&D - up from 232 billion the year before - and to acquire autonomous weapons systems.
Exports: The weakness of the yen has been an advantage for the manufacturing sector and the export of goods. In 2024, goods exports were up 11.9% from last May, due to both the weakness of the yen and “the global competition for technology”. From 2020 to 2022, exports to the US grew 21.4%, 152% to Australia, and 16% to Taiwan and China. Subsequently, KSG assesses that as Japan becomes more closely linked to the US and Western alliance partners economically, Japan’s role as a manufacturing and exporting power may increase and subsequently grow the economy. For instance, if Japan’s manufacturing sector is focused on producing dual-use technologies or parts for weapons systems, Japan could become a supplier of valuable equipment and services to allies in the Indo-Pacific.
Economic Weaknesses and their Risks to Defence Commitments:
While KSG does assess Japan’s economy is resilient to pressures, certain economic pressures are significant. They are likely to challenge specific aspects of Japan’s economy and defence procurement. If not properly managed, they may then pose a risk to Japan’s alliance commitments.
Overall Economic Risks:
Inflation and Increasing Prices: Following global trends, Japan appears to have struggled with inflation. Japan’s inflation rate has increased since 2021, and has caused an increase in real terms in prices for Japanese consumers. As of July 2024, light and water charges were up 6.6% since the previous year. Food prices have also increased 4.1% from one year ago. Responding to inflation, the BoJ changed its monetary policy in March 2024, and raised the interest rate to 0.25% in July. Japan’s prior policy of keeping interest rates very low while inflation increased means there is a moderate risk inflationary pressures will persist. KSG assesses that if inflation worsens and consumer prices increase, the Japanese government may face growing domestic dissatisfaction at defence spending, and citizens call for devoting resources elsewhere.
Aging Population and Productivity: KSG assesses that Japan’s ageing population poses problems for both the economy and its military. Japan has the oldest population in the world: 28.7% of the population is 65 or older, and the European Parliament projects that by 2036, this age group will represent a third of Japan’s population. Consequently, Japan is highly likely to face a pressing twin challenge: an increased need to spend on social security, and a reduced percentage of the population being a productive working age. Combined with Japan’s existing labour shortage, this creates a serious risk for Japan’s longer-term economic prospects. As Japan’s population ages, it is highly likely to increase ongoing recruitment challenges for the Self Defense Force – a problem exacerbated by Japan’s proclivity for pacifism post-World War II.
The Yen’s Value: KSG assesses this is likely to be the greatest current threat to Japan’s defence plans. The yen’s value against the dollar has been steadily declining for the past three years. In June 2024, the yen was briefly at 160.82 against the US dollar – its weakest level since 1986. Moreover, originally the Japanese 2022 defence budget was calculated at 108 yen to 1 dollar; as the value is now much higher military equipment has become more expensive. Consequently, KSG assesses that if the yen continues to become cheaper against the dollar, it could pose challenges to Japan’s ability to procure equipment from the US; European nations are looking to partner with Japan but the same economic challenges which apply to the dollar are highly likely to apply to the Euro as well. In addition, the US accounted for 97% of Japan’s arms imports from 2019-2023 and thus has immense market dominance. KSG assesses the yen’s weakness could thus endanger both Japan’s defence procurement goals which may harm its ability to support its alliance partners by having insufficient weaponry and equipment for its own defence.
Specific Risks – Defence Procurement Problems:
Japan has proposed a combination of tax measures, a “Defense Enhancement Fund”, and spending cuts to finance its military expenditure; however it is currently unclear how these measures will be financed. Currently, Japan can produce all of its ships and 87.1% of its armour systems domestically. However, Japan relies on the US for aircraft and missiles – this is significant because improving long-range missile capacity is a key aspect of Japan’s 2022 National Security Strategy. Thus, Japan relies on the US for the equipment which is of greatest value. This creates significant opportunities for US defence companies but creates challenges for Japan. While the US benefits by supplying Japan with weapons, and while the US has an interest in increasing Japan’s defence in response to China, KSG assesses that Japan’s reliance on foreign arms manufacturers poses risks; its dependence on other states for vital equipment places it at risk if shipments of this equipment are disrupted in any way, or if this equipment become more expensive. Moreover, under many current agreements, Japan is restricted from performing anything beyond minor repairs to weapons systems supplied by foreign companies. Furthermore, domestic defence companies have struggled to survive in the current status quo; in the last 20 years over 100 Japanese defence companies have failed. Thus, Japan’s capacity to obtain equipment and support alliance partners may be slightly compromised by these practices as alternative domestic suppliers are limited.
Global and local economic pressures are likely to compound these procurement challenges. KSG assesses that Japan’s F-35 program is an example of a potential procurement challenge as the equipment could become more expensive. The Japanese Air Self-Defense Force is the F-35’s largest international customer – with an order of 127 F-35s. In 2020, Japan’s Ministry of Defense confirmed their plan to produce F-35 Lightning II’s locally; the cost of producing them in Japan had become lower than that of importing them from Texas. However, while the F-35A models are produced locally, the B models are not. Consequently, the yen’s decreasing value is especially salient for procurement of F-35s. These planes are expensive to manufacture and as of July 2024, the price of the aircraft may rise due to US inflation. According to the US Defense Security Cooperation Agency, in 2020, the US State Department approved a possible sale of 63 F35As and 42 F-35Bs to Japan at an estimated cost of $23.11 billion, and $23 billion is roughly half of Japan’s annual defence budget. Thus, KSG assesses there is a potential risk that large defence purchases from US suppliers could consume an increasing percentage of Japan’s defence budget and thus leave fewer resources for maintaining its forces, or procuring other pieces of vital equipment - long-range missiles for instance. These risks are likely to extend to other vital aspects of Japan’s defence strategy, like long-range missiles.
Looking Forward
Cooperation with the United States and Partnerships like AUKUS:
Because of Japan’s overall economic resilience and potential, KSG assesses that Japanese economic issues are unlikely to inhibit Japan’s Indo-Pacific security engagement alongside the US. KSG assesses ties between the US and Japan are highly likely to deepen and the US is highly likely to support the US-Japan security partnership into the long-term. Therefore, as long as Japan’s economy remains prosperous enough to support increases in defence spending to better defend itself, economic issues are unlikely to place a strain on US-Japan military cooperation.
KSG assesses that Japan is likely to be included in AUKUS Pillar 2, as multiple members appear to be strongly considering Japan’s involvement. Consequently, Western technology companies and defence companies are highly likely to benefit through either increased demand or international cooperation on new projects.
KSG assesses that there is a low-likelihood but moderate to high impact risk that if pressure from the Japanese government increases on the US to divert more resources and support to the Indo Pacific, domestic opposition in the US could increase. Isolationist members of Congress could argue resources are better spent at home or more directly around Taiwan and Japan has too much support from the US. If Trump is re-elected in November the likelihood of this risk will increase, as he has previously asked Japan to pay for the presence of US forces. Consequently, European and Australian defence companies and technology companies may have more opportunities to secure support from the Japanese government.
Greater Cooperation in East Asia:
The pattern of bi-lateral and multilateral agreements which Japan undertakes with other East Asian states is likely to increase. KSG assessed that the Reciprocal Access Agreement between the Philippines and Japan was a move to counter China’s regional presence. Japan and South Korea have also signalled their intention to increase bilateral ties (and trilateral alongside the US). These trends are likely to continue among nations resistant to China’s growing influence in South Eastern Asia. Furthermore, KSG assesses the United States will actively encourage Japan and other East Asian states to take the lead where possible in deterring China’s growing military presence and territorial disputes to avoid global military overstretch.
KSG assesses the most significant potential impact of economic issues would be on bi-lateral relations Japan has in East Asia. Without the US as a security guarantor, the balance of economic and military power shifts to China’s favour during stand-offs between Japan, the Philippines, and South Korea – either as individuals or in joint military efforts. KSG thus assesses any economic strains Japan possesses are more acutely felt when deterring China without the US.
If the United States is compelled to play a greater role in Indo-Pacific security through Japanese economic issues and/or Japan being unable to provide significant deterrence against Chinese military patrols, the US could be forced to shift resources from its other theatres of active involvement. Consequently, European states may face increased burdens to supply Ukraine if the US changes focus. Moreover, the US will divert resources from the Middle East which may increase threats to global shipping as the US cannot provide as much security assistance in the Gulf.
Opposition to China and North Korea:
KSG assesses that Japan’s close relationship with the US, and possibly the rest of AUKUS, is highly likely to complicate the regional economic situation. It is unlikely that Japan will change its economic strategy in relation to China: cautious adaptation in a context of rising tensions. China is Japan’s largest trading partner, and Japan is China’s second-largest trading partner (behind the US). While the two countries are economically linked, the withdrawal of Japanese businesses from China indicates that economic ties are shifting. Because of the strong economic linkages and the capacity for China to threaten Japan’s EEZ, KSG assesses Japan’s actions against China are likely to be restricted; these restrictions are most likely to take the form of limiting provocative military exercises, or joining a significant number of joint economic-military partnerships with other states.
KSG assesses there is a low to moderate likelihood that if Japan and the US become a more unified force opposing China, China may attempt to restrict the flow of oil to Japan - one of Japan’s main Chinese imports. Consequently, US oil and gas companies have opportunities to fill this gap.
As Japan’s military exercises and defence-related economic partnerships with the US and West increase, KSG assesses that regional disputes and threats from China and North Korea, and possibly Russia too, are likely to increase. KSG expects neither China nor North Korea is likely to want to be ‘fenced in’ by the West and Japan; consequently, they are likely to become more assertive around Japan’s maritime borders and in their airspace. For instance, on 27 August, China breached Japan’s airspace for the first time with a surveillance plane. As such incursions increase, there is a very low likelihood but high impact risk of mistaken attacks against Chinese aircraft and naval assets.
Increased maritime disputes between Japan and China may also threaten freedom of navigation for commercial shipping near Japan, which could endanger global supply chains and may prompt a further increase in US naval patrols; this in turn may increase insurance costs for vessels which cross into the Pacific and South China Sea.
KSG assesses that North Korea is a lower-likelihood high impact threat. KSG does not expect that Japan’s increasing defence-related spending and industrial focus will significantly increase North Korean military posturing or weapons testing near Japan. However, this pattern should be monitored closely as North Korea’s behaviour may change considerably if it feels threatened.