Japan is reportedly planning to double its defense spending to 3.5% of GDP, a claim denied by the Ministry of Defense, while Japanese bond yields still hit a 30-year high.

Japan is reportedly planning to double its defense spending to 3.5% of GDP, a claim denied by the Ministry of Defense, while Japanese bond yields still hit a 30-year high.

On Tuesday, the 25th local time, news broke that Japan was considering a significant increase in its medium-term defense spending target, causing further volatility in the already pressured Japanese government bond market. Market concerns about the sustainability of Japan's fiscal policy intensified sharply, and the long-term interest rate indicator reflected in the benchmark Japanese bond yield hit a 30-year high. With Prime Minister Sanae Takaichi simultaneously pushing for tax cuts and military expansion, the challenges facing Japan's debt management are prompting heightened investor caution.

According to Bloomberg, sources familiar with the matter revealed that Japanese defense officials have signaled a willingness to significantly increase defense spending in talks with the United States. One proposal is to match South Korea's commitment to increase defense spending to 3.5% of GDP within ten years; another, lower target is 3%.

Following the announcement, Kimihito Aguin, press secretary of the Japanese Ministry of Defense, immediately denied the report at a press conference, stating that Japan had not expressed any intention to significantly increase spending to 3.5% of GDP in the United States, and emphasized that defense construction was "based on Japan's own independent judgment" and "should not be based on pre-set spending figures."

Despite denials from Japanese officials, the market reacted swiftly and sharply to the news. The yield on Japan's benchmark 10-year government bond hit a new high since 1996 on Tuesday, closing at 3.04%, more than double the level of a year ago; the yen weakened against the dollar to 155.24, a more than one-week low. Meanwhile, the defense sector bucked the trend, with IHI Corp and Kawasaki Heavy Industries rising 1.8% and 0.9% respectively, after both stocks had fallen by more than 2% earlier in the day.

Increased pressure to issue more debt: Defense spending may more than double the current level

If the target of defense spending reaching 3.5% of GDP is achieved, Japan's government bond supply will face a historic shock.

According to reports, Japanese Defense Minister Shinjiro Koizumi stated in April that defense and related expenditures for the current fiscal year will amount to 10.6 trillion yen (approximately US$68.8 billion), equivalent to about 1.9% of nominal GDP in 2022. Based on the Cabinet Office's forecast for nominal GDP this fiscal year, the actual percentage is only 1.5%. Using the same benchmark, a 3.5% target would correspond to a budget of approximately 24 trillion yen, more than double the current level.

The Ministry of Defense has submitted a record budget request of 8.9 trillion yen for the next fiscal year, a 0.9% increase over the current fiscal year. However, many items in the budget request do not specify concrete amounts, meaning the final budget could be much higher. Furthermore, the continued weakening of the yen is eroding Japan's actual purchasing power for weapons and equipment from overseas, further increasing potential spending demands.

Fiscal contradictions: Tax cuts and military expansion proceed simultaneously, with funding sources in doubt.

The Kaohsiung City government currently faces a financial dilemma: the military expansion plan and tax reduction commitments are being pursued simultaneously, both of which require substantial financial support.

The Takashi City Cabinet approved this week a temporary reduction in the food consumption tax, lowering the sales tax on food and beverages from 8% to 1% for a period of two years, starting next April. The reduction involves approximately 5 trillion yen (about US$32.3 billion). The government claims it will not issue new debt for this purpose, but a specific financing plan has been postponed until the end of the year.

Japanese Finance Minister Satsuki Katayama said on Tuesday that the government will "comprehensively review spending and revenue" and "closely monitor tax revenue while determining a level of fiscal spending consistent with a steady reduction in the debt-to-GDP ratio." She also mentioned following the example of the U.S. Department of Government Efficiency (DOGE) to intensify efforts to cut redundant subsidies and spending. However, given that only three potential reduction items were identified in the voluntary reviews by various departments, these statements have failed to dispel market concerns.

Sanae Takaichi also announced a public-private partnership investment growth plan of over 370 trillion yen aimed at 2040, further exacerbating concerns about Japan's fiscal space.

Bond market pricing logic: Bank of Japan's normalization coupled with fiscal risks

The continued rise in Japanese government bond yields reflects the market's pricing in multiple overlapping risks. The 10-year yield broke through 3% earlier this month for the first time since 1996, driven by factors including inflationary pressures, expectations of fiscal expansion, and market anticipation that the Bank of Japan may accelerate its interest rate hikes.

Daisuke Aiba, an analyst at Cosmo Securities, said, "The bond market reaction already reflects fiscal concerns, and investors are finding it difficult to take a positive view of this kind of news. In addition, it is also a question whether Japan truly has the capacity to further expand its defense capabilities beyond its current limited scope."

Robert Ward, chair of Japan studies at the International Institute for Strategic Studies, believes that Japanese policymakers and bureaucrats have laid the groundwork for a significant increase in defense spending; the only question is timing. He said, "Whether it's five or ten years, given the importance of the US-Japan alliance, I don't think there's any other option."

Behind the official denial: The dilemma of policy signals and market communication

There is a clear discrepancy between the Ministry of Defense's denial statement and the information disclosed by informed sources.

According to Bloomberg, citing sources familiar with the matter, some Japanese officials have indicated they are not yet ready to make a formal commitment and will deny any targets if they are made public. Defense Minister Shinjiro Koizumi has also publicly insisted that the size of the spending should be determined by military needs, not monetary objectives.

This statement reflects the dilemma faced by the Japanese government between pressure from the bond market and the expectations of its allies. Last month, U.S. Under Secretary of Defense for Policy Elbridge Colby stated explicitly, "We urgently hope that Japan will increase its investment," but the U.S. has generally avoided exerting public pressure.

It is worth noting that the ruling Liberal Democratic Party (LDP) in Takashi City stated in an internal document in June that 3.5% has become the global standard for defense spending, but did not offer specific suggestions on how to raise the corresponding funds. Japan's new five-year defense plan is expected to be released by the end of this year, at which time the market will receive clearer policy signals.

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