Reportedly, the US urges Japan to "increase" defense spending; Tokyo considers a 3.5% GDP target, bond market and yen come under pressure first

According to Zhitong Finance APP, under pressure from the United States, Japan is considering setting a new medium-term defense spending target, aiming to raise defense expenditures to 3.5% of GDP, in line with NATO and other U.S. allies. If this proposal is implemented, it may trigger volatility in financial markets, as investors are already concerned about Sanae Takaichi's fiscal spending plans.

Sources reveal that Japanese defense officials have expressed their willingness to significantly increase defense spending during talks with the U.S.

One of the options under consideration is to follow South Korea's commitment to boost defense spending to 3.5% of GDP within ten years. According to one source, a lower target such as 3% is also possible.

In response to the news, Japanese Ministry of Defense spokesperson Masahito Agata denied that Japan had indicated to the U.S. its intention to sharply increase defense spending to 3.5% of GDP.

"Japan's defense build-up is based on our own independent judgment, adhering to the principle that we must defend the country ourselves," Agata said at a press conference on Tuesday. "It's not about pre-setting a specific spending number. What matters is the substantive content of our defense capabilities."

Like other U.S. allies, Japan has long faced pressure from the Trump administration to boost its defense strength and reduce its reliance on U.S. armed forces. Sanae Takaichi had already accelerated defense spending by two years to reach nearly 2% of GDP as of the fiscal year ending this March.

Until 2022, Japan maintained an informal limit on defense spending at around 1% of GDP, underscoring how quickly its defense posture 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 "active and responsible fiscal policy," settling on a 3.5% target could unsettle the market amid expectations of large-scale bond issuance.

Following the news, Japanese defense stocks IHI Corporation and Kawasaki Heavy Industries both rose. Japanese government bonds continued to decline, with the benchmark 10-year yield rising to its highest level since 1996, and the yen depreciated to 155.44 against the dollar.

"The bond market reaction reflects concerns about fiscal issues, making it hard for investors to be optimistic about such news," said Daisuke Aiba, an analyst at Iwai Cosmo Securities Co. "Moreover, there are doubts about whether Japan really has the ability to expand its currently limited defense capabilities."

The Japanese government's borrowing costs are already high, with bond yields hovering around 30-year highs. Concerns over inflation and fiscal spending, as well as expectations that the Bank of Japan may need to raise rates more quickly, saw the benchmark 10-year JGB yield reach 3% earlier this month for the first time since 1996, double the level of last year at this time.

U.S. defense officials have largely refrained from publicly pressuring Japan to commit to the 3.5% defense spending target, but have made it clear they expect a significant increase in Japanese defense spending.

"We are eagerly awaiting Japan's efforts," said U.S. Deputy Secretary of Defense for Policy Elbridge Colby last month when discussing Tokyo's defense spending.

In June, Sanae Takaichi's ruling Liberal Democratic Party noted that 3.5% had become the global standard for defense spending, but did not make suggestions on how Japan could afford this level of spending.

"We will comprehensively review expenditures and revenues," Finance Minister Satsuki Katayama said on Tuesday. "While closely monitoring tax revenues, we will set a level of fiscal spending—including defense expenditures—that is consistent with steadily reducing the debt-to-GDP ratio."

Sources say that during talks between the two countries' defense officials, Japan has expressed the likelihood of aligning with other U.S. allies, but avoided discussing details. These individuals requested anonymity due to the sensitivity of the matter.

According to these sources, some Japanese officials said they were not ready to make a formal commitment, and if such a target became public, they would deny its existence. In public, Minister of Defense Shinjiro Koizumi also stated that spending would depend on military needs rather than a fixed monetary goal.

Japan's cautious approach to setting a clear target is rooted in concerns about the amount of funding needed to reach 3.5%. When Japan set the 2% target in 2022, it said that spending would continue to be measured against that year’s GDP. In April, Koizumi stated that the current fiscal year's 10.6 trillion yen (USD 68.8 billion) defense and related spending equals 1.9% of 2022 nominal GDP.

He said that, based on the Cabinet Office's projections of nominal GDP for this fiscal year, spending would be 1.5%. Under the same projection, a 3.5% budget would reach 24 trillion yen—more than double the current amount.

Since NATO member states committed in June last year to achieve 3.5% by 2035, allocating 3.5% of GDP for defense has become a global benchmark among U.S. allies.

As a national security hawk and staunch advocate of the U.S.-Japan alliance, Sanae Takaichi has made it clear she wants to further strengthen military capabilities.

"Japan needs to proactively pursue a fundamental strengthening of its defense capabilities," she stated in parliament this year.

But she also has ambitious economic plans. This year, Sanae Takaichi announced a growth plan targeting over 370 trillion yen in combined public and private investment by 2040, a plan that could strain national finances. A sharp increase in defense spending at the same time could test investors' confidence in Japan’s ability to control its debt.

After scrapping the informal defense spending cap in 2022, Japan made major investments in long-range strike capabilities, such as land- and sea-based Tomahawk missiles. In the budget request for the fiscal year beginning next April, the Ministry of Defense applied for a record 8.9 trillion yen, up 0.9% from the previous year.

However, many projects listed in the budget request have yet to disclose estimated costs, meaning the final budget could be much higher. The yen’s weakness has also diminished Japan's purchasing power for weapons from overseas.

Even if Japan commits to 3.5%, it will still lag behind NATO countries. For NATO, the target applies to so-called "core" defense spending, such as weapons and military salaries. Member states also commit an additional 1.5% of GDP to defense-related spending, such as protecting critical infrastructure.

Japan, on the other hand, aggregates both core and non-core spending in its defense budget, so even if defense spending rises to 3.5% of GDP, the proportion of military expenditure to GDP will still be lower than among NATO nations.

Robert Ward, Japan Chair at the International Institute for Strategic Studies, said Japanese policymakers and bureaucrats have already laid the groundwork for substantial growth in defense spending. He noted that now the main question is when Japan will reach the 3.5% goal.

"Whether it's five years or ten years, given the importance of the U.S.-Japan alliance, I don't see any other option," Ward said.