A Summer of Reckoning for Japan's Economy

The Diplomat

3 days ago

Aside from the question of growth, the question is whether policymakers can reorient the country's future trajectory before serious problems set in.
Japan's economy in 2025 stands at an uncertain juncture. Exports are slipping, the yen is tumbling, and Prime Minister Ishiba Shigeru is racing against time to avert a trade cliff with the United States. The once-reliable playbook of industrial exports and fiscal stimulus is looking increasingly outdated in the face of shifting geopolitical alliances, aging demographics, and mounting trade tensions.
Yet beneath the surface of weak GDP figures and softening trade data lies a more complicated and paradoxical reality. Japan continues to maintain near-full employment, stable domestic consumption, and world-class infrastructure, all while carrying the highest public debt-to-GDP ratio in the developed world. Its rural economy is quietly innovating, and major firms are adapting supply chains for resilience rather than efficiency.
The question confronting policymakers, businesses, and global investors alike extends beyond the question of growth to the question of whether it can reorient the country's future before a tipping point is reached.
For every member of the National Diet, the current talk of the day is how to handle the trade headwinds and tariff tensions with the United States. Japan's exports have now declined for two consecutive months, with June's drop driven largely by weakened semiconductor and auto shipments to China and the U.S. Washington's threatened 35 percent tariffs on Japanese imports could tip the economy into a technical recession. This sent the Japanese government scrambling to hold high-level talks in Washington ahead of the August 1 deadline, resulting in a last-minute deal, announced on July 22, that will see the tariff rate lowered to 15 percent – including for Japanese automotive exports. Yet this outcome can't hide the reality that Japan's reliance on global exports is again proving to be a vulnerability. The United States remains Japan's most important trade partner, leaving Tokyo dependent on an increasingly volatile U.S. administration.
Underneath these immediate trade tensions is the persistent issue of government debt. Japan's public debt now stands at over 260 percent of GDP, the highest among developed nations. Despite this, bond yields remain remarkably low, and the country continues to finance its massive spending domestically. How long this can last, however, is unclear. Inflation remains above the Bank of Japan's 2 percent target, wages have only modestly increased, and social spending pressures, particularly from an aging population, are intensifying. A recent Deloitte analysis highlighted how a strong yen, combined with cautious consumer spending, is squeezing corporate margins. The yen's appreciation has helped tame import costs and rein in inflation, but at the same time, domestic consumers remain hesitant, dampening firms' ability to pass on costs or foster volume growth.
With these challenges confronting Japan in both the short and long term, policymakers are beginning to pivot toward 'economic security.' This includes, for example, reducing reliance on single-source suppliers, especially from China, and investing more in semiconductors, batteries, and hydrogen. This marks a major shift from past decades, when Japan heavily outsourced manufacturing to reduce costs. The World Economic Forum also highlighted a grassroots dimension to this strategy, showcasing how rural areas are leveraging traditional practices and renewable energy to build local resilience. For example, some prefectures are powering microgrids through biomass and geothermal power projects rooted in centuries-old forest management techniques. With these types of investments and innovations, Japan has demonstrated the know-how to maintain a technological edge over its rivals.
While the government continues to pursue measures to stimulate domestic growth and address foreign trade issues, redefining economic success in Japan will require addressing its demographic realities. With 29.3 percent of the population over age 65, Japan faces both a labor shortage and a narrowing tax base. For the United States, a sinking birth rate barely makes headlines due to the large influx of immigrants each year. For Japan, however, accepting foreigners into the country comes with immense challenges. Sanseito, for example, enjoyed its best-ever showing in the July 20 upper house election on a platform of opposition to what it described as a 'silent invasion' of immigrants. Even tourism has become a sticking point: the government has established a national body to rein in overtourism after a record-breaking 36.8 million tourists came to Japan in 2024.
Animosity toward foreigners is only one side of the coin of Japan's demographic crisis. With a birthrate of 1.15 in 2024, Japan entered its 18th consecutive year of deaths outpacing births, with a population drop of nearly a million people. This population decline is closely tied to Japan's entrenched work culture, which continues to discourage family formation and work-life balance. Add to that the phenomenon of 'nominication,' company-sponsored after-work drinking parties meant to strengthen team bonds, which remain a key part of corporate life. While intended to foster workplace cohesion, these gatherings often reinforce work-first priorities and eat into personal time, making parenthood feel like an increasingly difficult choice for many young professionals.
Meanwhile, another trend offers an illustration of changing attitudes: younger workers are now hiring 'resignation agencies' to quit their jobs for them, paying about $350 to bypass the anxiety and discomfort of direct confrontation with their bosses. These resignations are often driven by harassment, unpaid overtime, or inflexible workplace expectations.
The real question now becomes: will there be a tipping point for Japan? This will come when demographic decline and fiscal strain begin to feed on each other, setting off financial instability or other social problems.
On the financial front, the recent bond market data is worrying: yields on Japan's 10‑year government bonds recently hit their highest levels since 2008 at around 1.59 percent, while 30‑year bonds soared to 3.21 percent, reflecting investors' growing concern over potentially unsustainable debt levels. Even the typically stable auctions for long-term bonds are now failing to find buyers: the 20‑year bond auction recorded its weakest demand since 2012, signaling a dangerous erosion of investor confidence. Should global conditions tighten, say via a U.S. rate spike or tariff shock, Japan could face a debt sell-off that forces either painful fiscal adjustments or, worst-case, a credit rating downgrade, diminishing the government's ability to roll over its debt. Economists warn such a downgrade could push Japan toward default.
A further collapse in workforce numbers, paired with shrinking consumer demand, risks a vicious cycle of lower tax revenues, higher debt-servicing costs, and reduced capacity to invest in innovation. In that scenario, societal confidence, measured through voter turnout, trust in institutions, or the stability of public services, could erode, marking a true crisis for Japan's social contract.