United States of America
China
Europe
South Korea
Taiwan (Republic of China)
Australia
United Arab EmiratesStructural economic recovery largely intact
Japan’s GDP expanded by 1.6% in the first three quarters of 2025, well above the Bank of Japan’s potential growth estimate of around 0.5%. The outperformance can be partially attributed to a low base a year ago when auto production and exports were disrupted by a safety scandal. But the structural recovery in private investment and consumption has maintained solid momentum. Gross capital formation posted its fastest year-over-year growth since 2014, led by transport and machinery equipment. This surge was underpinned by strong corporate earnings, while tax incentives for industrial automation and EV-related investments likely outweighed the drag from higher interest expenses. Meanwhile, private consumption has risen for six consecutive quarters as inbound tourism supported durable goods and tourism-related services sales, while robust wage growth helped offset rising living costs for domestic households. Externally, the frontloading effect was relatively muted in Japan. The trend is largely due to Japan’s heavy reliance on automobile exports to the US where Section 232 tariffs have remained in place since early Q2. This contrasts with markets where delayed full implementation of reciprocal tariffs to Q3 triggered a rush to ship goods ahead of higher tariffs. Meanwhile, trade restructuring, particularly the pivot toward tech goods exports to emerging Asia, has supported growth.
Looking ahead to 2026, we expect Japan’s economy to moderate as the impact of US tariffs filters through. However, growth could remain above potential, supported by the structural recovery in domestic activity and increased fiscal support. Despite the trade agreement, Japanese automakers’ decision to absorb tariffs on US-bound shipments to protect market share may erode corporate profits and potentially make firms more cautious about increasing capital expenditure. The decision could also temper the pace of wage hikes in the manufacturing sector. Nevertheless, overall wage growth across the economy—where services account for roughly 80% of employment—should remain supported by resilient domestic services activity and structural labour market tightness. In the meantime, the newly formed Takaichi administration has approved a ¥21.3 trillion stimulus package (representing around 3.3% of GDP) that focuses on inflation countermeasures, capital expenditure in crisis management and growth, and increased defence spending. The package is still pending parliamentary approval, which is likely to occur by year-end and may be amended during negotiations with opposition parties given the ruling coalition’s lack of a majority in both houses. However, given the broad expansionary stance across most parties, significant cuts are unlikely and the stimulatory effects should largely filter through in 2026.
Renewed concerns over fiscal sustainability
Japan’s current account surplus continued to improve in 2025, widening from 4.7% of GDP in 2024 to 5.0% during the first three quarters of 2025. The improvement was driven primarily by reduced imports due to a pickup in yen strength and lower coal and crude oil prices. Meanwhile, stronger exports of semiconductor manufacturing equipment to Southeast Asian markets mitigated the decline in automotive exports that were hit by tariffs. The services trade deficit also narrowed as a surge in inbound tourism boosted the travel services surplus, partially offsetting higher costs for foreign software, digital tools and other business services. In addition, the primary income surplus further strengthened, supported by higher returns on equity investments.
However, rising interest rates and political momentum for fiscal expansion have reignited concerns over Japan’s fiscal position. Persistently elevated inflation above the BOJ’s 2% target, combined with rate hikes and the BOJ’s decision to reduce JGB purchases, has pushed government bond yields to multi-decade highs across most maturities. On the positive side, Japan’s fiscal position has improved in recent years. For the first time since FY2007, the primary deficit narrowed to around 1% of GDP in FY2024. The improvement largely reflects surging tax revenues as yen depreciation and post-pandemic inflation boosted corporate and consumption tax receipts, while higher wages lifted income tax collections. The shrinking primary deficit, together with strong nominal GDP growth, reduced the public debt-to-GDP ratio from a peak of 216% in FY2022 FY to 207% in FY2024, according to government estimates.
However, these improvements risk being reversed. Prolonged inflation has fuelled household dissatisfaction, which resulted in the ruling coalition losing its parliamentary majority and in calls for fiscal expansion across most parties. The limited effectiveness in easing inflation burden from temporary relief measures, such as cash handouts and subsidies, has sparked demands for more permanent changes like fuel and consumption tax cuts. Both measures are included in the recently drafted supplementary budget under the Takaichi administration. Yet implementing these changes without securing alternative revenue sources or cutting expenditure would inevitably heighten fiscal sustainability risks.
Signs of a return to “Abenomics” and deteriorating relationship with China
Japan’s ruling Liberal Democratic Party (LDP) elected Sanae Takaichi, a key figure in former Prime Minister Abe’s cabinet and runner-up in last year’s LDP presidential race, its new leader on 4 October. She succeeded Shigeru Ishiba after his resignation following the party’s loss of its upper house majority. But her path to becoming Prime Minister was far from smooth, complicated by Komeito’s exit from the coalition’s decade-long alliance, though later resolved by a new partnership with the Japan Innovation Party. Takaichi has been a vocal supporter of Abenomics but also signalled respect for the Bank of Japan’s independence in monetary policy normalisation amid persistent inflationary pressures and a weak yen. Consequently, her economic stimulus approach is expected to lean heavily on fiscal measures, exemplified by the massive fiscal package approved a mere one month after taking office. In line with Abe’s legacy, Takaichi has also advocated assertive foreign policy stances, including accelerating plans to raise defence spending to 2% of GDP and amending constitutional rules that prohibit Japan from possessing armed forces.
Meanwhile, Japan and China have been at loggerheads following Prime Minister Takaichi’s remarks that a Chinese military attack on Taiwan could constitute a “survival-threatening situation” for Japan. This could be a potential scenario that could justify Japan’s use of force under its 2015 security legislation which broadened the scope for collective self-defence under three new conditions. Although Takaichi has pledged to avoid similar comments going forward, Beijing condemned the statement as interference in its internal affairs and raised the issue at the United Nations. On the economic front, China has retaliated by suspending imports of Japanese seafood and imposing a tourism boycott, which has weighed on Japan’s exports and inbound consumption. Any further escalation of tensions risks disrupting ICT and advanced manufacturing supply chains. Drawing on precedents such as China-US trade tensions and the Japan–Korea dispute in 2019, China might restrict rare earth exports—critical for EV batteries and semiconductors—while Japan could tighten controls on precision equipment and specialty chemicals essential for chipmaking.
