Japan's 43.5 trillion yen defense buildup is being scaled back due to the weakening yen, which is making it more expensive to import military equipment.
At the same time, Bank of Japan (BOJ) Governor Kazuo Ueda plans to dismantle the central bank's ultra-easy monetary policy settings and exit the decade-long accommodative regime sometime next year. This plan requires quite a fortune, and the weakening yen makes the BOJ's exit plan more difficult and risky.
Since the defense plan was revealed in December 2022, the yen has weakened by 10 percent against the dollar. The yen was trading at 108 yen to the dollar when it began developing its defense procurement plans in December, a rate last seen in summer 2021, said eight people familiar with the matter.
However, the currency has since depreciated to 151 yen per dollar. As of writing, the yen has risen quite a bit to 150.25 but is still beyond the 150 threshold.
The yen fell to its lowest level one year after the BOJ made a small change to its bond-buying program, raising the cap from 0.5 to one percent. Economists say this minor tweak is insufficient to close the gap between Japan's interest rates and those of other countries, however, especially since it's not a rigid ceiling but only a reference.
Due to budget cuts, Japan now prioritizes spending on advanced U.S.-made frontline weapons, such as missiles that could deter Chinese aggression. It has shifted its focus away from support aircraft and other secondary equipment made mainly by Japanese companies.
The defense ministry initially discussed an order for 34 Chinook transport helicopters made by Kawasaki Heavy Industries in December. The order was halved to 17 in the defense budget request for the fiscal year starting April 2024. This is due to a 5 billion yen increase in the cost per aircraft, half of which was attributed to the weak yen.
"The price has risen considerably, and that is because the weaker yen and inflation have significantly pushed up costs," a company spokesperson said.
Japan also canceled a planned purchase of two ShinMaywa Industries US-2 seaplanes for search and rescue missions after the price per aircraft doubled to 30 billion yen in three years.
BOJ's exit plan also affected
Based on interviews with six sources familiar with the BOJ's thinking, Governor Ueda intends to gradually unwind the bank's ultra-loose monetary policy while maintaining the dovish rhetoric of his predecessor.
The plan is to continue this method until the BOJ's 2 percent inflation target is seen, which is one percent lower than the inflation recorded in September 2023.
The weak yen is a side effect of the BOJ's ultra-low rates. If it continues to fall, it would pressure the BOJ to exit its stimulus program sooner than it would like. However, Ueda understands the challenge as a former BOJ policymaker, so he will tread carefully even at the cost of the yen dropping even further.
Ueda must be discreet in making changes, as any signs of the BOJ's shift towards exiting its stimulus program could trigger a bond sell-off, jeopardizing its plan for a soft landing, inflicting significant losses on investors and increasing the cost of funding Japan's massive public debt.
"There's a lot of hurdles to clear before an exit, which means you don't want to get markets too excited about the chance of an early lift-off," a third source said.
In order to exit its ultra-loose monetary policy, the BOJ will likely end yield curve control and negative rates. At the same time, it will keep a loose promise to intervene in the market if bond yields rise sharply, according to sources.