US Reportedly Pushes Japan to "Step Up" Defense Spending; Tokyo Weighs 3.5% GDP Target as Bond Market and Yen Come Under Pressure First

Under pressure from the US, Japan is considering setting a new medium-term defense spending target, planning to raise defense spending to 3.5% of gross domestic product (GDP), aligning with NATO and other US allies. If this idea becomes reality, it could cause turmoil in financial markets, as investors are currently deeply worried about Sanae Takaichi's fiscal spending plans. According to people familiar with the matter, Japanese defense officials have indicated during talks with the US side a willingness to significantly increase defense spending. The people said one option under consideration is to follow South Korea's pledge to raise defense spending to 3.5% of GDP within 10 years. According to one of the people, a lower target such as 3% is also possible. In response to this news, Japanese Ministry of Defense press secretary Kimihito Akinaga denied that Japan had told the United States it intended to significantly raise defense spending to 3.5% of GDP. "Japan's defense buildup is based on our own independent judgment, upholding the basic principle that we must defend our country ourselves," Akinaga said at a press conference on Tuesday. "It is also not a matter of first setting a predetermined spending figure. What matters is the substance of our defense capabilities." Like other US allies, Japan has been under pressure from the Trump administration to strengthen its defenses and reduce reliance on the US military. Sanae Takaichi has accelerated the increase in defense spending by two years to nearly 2% of GDP for the fiscal year ending in March this year. Until 2022, Japan's defense spending had long had an unwritten cap of about 1% of GDP, underscoring how quickly Japan's defense thinking has shifted in recent years. Japan is expected to release a new five-year defense budget plan by the end of this year. Although Sanae Takaichi has promised to pursue "proactive and responsible fiscal policy," if the 3.5% target is finalized, expectations of large-scale bond issuance could unsettle the market. After the news emerged, Japanese defense stocks IHI Corp. and Kawasaki Heavy Industries both rose. Japanese government bonds extended their decline, with the benchmark 10-year yield rising to its highest level since 1996, while the yen weakened to 155.44 against the dollar. "The bond market reaction already reflects concerns about fiscal issues, and it is difficult for investors to take an optimistic view of this kind of news," said Daisuke Aiba, an analyst at Iwai Cosmo Securities Co. "In addition, there are questions about whether Japan really has the capacity to expand its currently limited defense capabilities." The Japanese government's borrowing costs are already high, with bond yields hovering near 30-year highs. Driven by inflation and fiscal spending concerns as well as market expectations that the Bank of Japan may need to raise interest rates faster, the benchmark 10-year government bond yield earlier this month touched 3% for the first time since 1996, while a year earlier it was only half that level. US defense officials have largely avoided publicly pressuring Japan to commit to a 3.5% defense spending target, but have made clear they expect Japan to increase investment substantially. "We are eagerly looking forward to Japan stepping up," Elbridge Colby, US undersecretary of defense for policy, said last month when discussing Tokyo's defense spending. In June, Sanae Takaichi's Liberal Democratic Party noted that 3.5% has become the global standard for defense spending, but did not propose how Japan would afford spending at that level. "We will comprehensively review spending and revenue," Finance Minister Satsuki Katayama said on Tuesday. "While closely monitoring tax revenue, we will determine a level of fiscal spending consistent with steadily reducing the debt-to-GDP ratioincluding, of course, defense spending." According to people familiar with the matter, in talks between defense officials of the two countries, Japan has said it is likely to align with other US allies, but avoided discussing details. The people requested anonymity because the matter is sensitive. The people said some Japanese officials have said they are not yet ready to make a formal commitment and would deny the target's existence if it were made public. In public, Japanese Defense Minister Shinjiro Koizumi has also said spending will depend on military needs rather than numerical targets. Behind Japan's caution about setting an explicit target is concern over the scale of funding needed to reach 3.5%. When Japan set a 2% target in 2022, it said it would continue to measure spending based on that year's GDP. Shinjiro Koizumi said in April that defense spending and related expenditures of 10.6 trillion yen ($68.8 billion) for this fiscal year amount to 1.9% of 2022 nominal GDP. He said that measured against the Cabinet Office's forecast for nominal GDP this fiscal year, spending would be 1.5%. Under that forecast, a 3.5% budget would reach 24 trillion yen, more than double the current amount. Since NATO members pledged in June last year to reach 3.5% by 2035, spending 3.5% of GDP on defense has become a global benchmark for US allies. As a national security hawk and a strong advocate of the US-Japan alliance, Sanae Takaichi has made clear she wants to further strengthen military power. "Japan needs to proactively pursue a fundamental strengthening of its defense capabilities," she said in parliament this year. But she also has ambitious economic plans. This year Sanae Takaichi announced a growth plan aimed at achieving combined public and private investment of more than 370 trillion yen by 2040, which could put pressure on the country's finances. At the same time, a sharp increase in defense spending could test investors' confidence in Japan's ability to control its debt. After scrapping the unwritten cap on defense spending in 2022, Japan made major investments in long-range strike capabilities, such as land-based and sea-based Tomahawk missiles. In budget requests for the fiscal year starting next April, Japan's Ministry of Defense requested a record 8.9 trillion yen, up 0.9% from the previous year. But many items in the budget requests have not yet been given estimated costs, meaning the final budget could be much higher. A weak yen has also eroded Japan's purchasing power for weapons procured from overseas. Even if Japan commits to 3.5%, it would still lag behind NATO countries. For NATO, the target applies to so-called "core" defense spending, such as weapons and military salaries. Members have also pledged an additional 1.5% of GDP for defense-related spending, such as protecting critical infrastructure. Japan, by contrast, calculates core and non-core spending together in its defense budget, meaning that even if Japan raises defense spending to 3.5% of GDP, its military spending as a share of GDP would still be lower than that of NATO countries. Robert Ward, Japan head at the International Institute for Strategic Studies, said Japanese policymakers and the bureaucracy have already laid the groundwork for a substantial increase in defense spending. He noted that the main question now is when Japan will reach 3.5%. "Whether it is five years or ten years, given the importance of the US-Japan alliance, I don't see any other option," Ward said.