Japan Facing Political Instability, U.S. Tariffs, and Regional Insecurity

Agora Strategy Executive Briefing on Japan

By Dr. Elli Katharina Pohlkamp

Executive Summary

• Prime Minister Ishiba’s weakening position after the Upper House election loss is triggering political instability, complicating fiscal planning and heightening the likelihood of a leadership transition or snap elections, with immediate consequences for economic policymaking.
  

• Japan deepens security ties with Indo-Pacific partners and the EU amid regional tensions, while the newly signed U.S.–Japan trade deal reduces looming tariffs to 15%, restoring temporary stability in bilateral relations and shielding Japan’s automotive sector from harsher blows.
  

• Tokyo accelerates investment in digital infrastructure, secure supply chains, and decarbonization under its Economic Security framework, while the EU–Japan Competitiveness Alliance and new tariff template position Japan as a rule-making hub in an increasingly fragmented global economy.

  
  

Implications for International Business

• European firms may benefit from smoother regulatory entry and expanded R&D collaboration as the EU–Japan agreement aligns standards on digital governance, energy infrastructure, and strategic technologies — positioning Japan as a hub for Asia-facing innovation under EU-compatible frameworks.
  

• With policymaking under strain, companies operating in Japan should prepare for potential delays in fiscal measures, tax incentives, or energy policy shifts — requiring greater agility in navigating bureaucratic or sector-specific uncertainty in the lead-up to the 2026 general election.

State of Play

The ruling coalition led by Prime Minister Shigeru Ishiba suffered a major setback in the House of Councillors election held on 20 July 2025. For the first time since 1955, the LDP–Komeito coalition lost its majority in the Upper House, ending its legislative dominance. While Ishiba initially took a bold stance asserting that he would remain in office to navigate critical U.S. tariff negotiations, his position has rapidly deteriorated. Ishiba’s eventual resignation now appears possible – at the latest following the party’s internal review of the election outcome in August.

The electoral defeat reflects broader public discontent, with inflationary pressures, wage stagnation, and rising rice prices fueling skepticism towards the government’s economic stewardship. Voter turnout reached around 58%, and fringe parties such as Sanseito, which promote nationalist and anti-immigration agendas, enjoyed significant gains, expanding their representation to at least 14 seats.

The emergence of smaller opposition groups pledging tax relief and welfare expansion has intensified scrutiny of Japan’s fiscal trajectory. Financial markets have already reacted, with the yen weakening and government bond yields rising, as investors anticipate heightened political gridlock and the risk of increased fiscal deficits. Internal LDP resistance to more drastic efforts like a massive stimulus suggests that only modest interim measures are likely, with any significant budgetary turnaround delayed until after the autumn Diet session.

With the government lacking a majority in either chamber, broader negotiations with opposition parties will be necessary to move forward on key issues. A cabinet reshuffle had been widely expected in early autumn to restore factional unity and reset the policy agenda ahead of the 2026 general election. However, with the prime minister possibly on his way out, this process may be overtaken by a deeper leadership transition within the LDP. In practice, Japan faces a period of slower, more fragmented policymaking, shaped by intraparty turmoil, intensified parliamentary obstruction, and growing concessions to opposition demands on fiscal, trade, and welfare policy. A leadership contest, or even snap elections, could soon follow—further weakening the LDP-led coalition’s already fragile political footing.

Key Issues

Japan’s Geopolitical Outlook: Overcast

Japan’s strategic orientation remains firmly anchored to the United States, its principal post‑war ally and security guarantor. The U.S.–Japan alliance—enshrined in the 1960 bilateral security treaty—continues to form the backbone of Tokyo’s defence strategy, with deep operational integration through forward‑deployed U.S. forces and joint military planning. However, renewed tensions over proposed U.S. tariffs escalated this summer, only to be defused on 22 July when both sides agreed to a new trade deal. Under its terms, U.S. “reciprocal” tariffs on Japanese automobiles will be reduced to 15%, down from the previously threatened 25%, while other sectoral tariffs remain at current levels—such as the 50% steel/aluminum levy under Section 232. Japan also committed to purchasing more U.S. agricultural products, including rice and beef, and to invest roughly $550 billion in the U.S., with an estimated 90% of returns staying onshore. The deal was viewed positively in Tokyo—not only for forestalling a harsh tariff regime but also for signaling a reset in alliance economic cooperation.

Simultaneously, Japan is recalibrating its regional security posture in the Indo-Pacific. Its Free and Open Indo-Pacific strategy—emphasizing maritime security, infrastruc-ture connectivity, and the rule of law—continues to guide Tokyo’s engagement with regional partners. Japan has expanded security cooperation with ASEAN, India, and Australia, while actively promoting multilateral norms in contested maritime spaces. In the South China Sea, Japan maintains a principled opposition to unilateral changes to the status quo and has stepped up capacity-building support to littoral states, particularly the Philippines and Vietnam. Tokyo regularly conducts joint maritime drills and freedom of navigation operations in coordination with U.S. and regional forces, underscoring its commitment to preserving open sea lanes and deterring China’s militarization of disputed territories.

Tensions are also rising around the Taiwan Strait, which Tokyo now explicitly identifies as a critical geostrategic concern. Increased activity by China’s People’s Liberation Army, including large-scale air incursions and amphibious exercises, has triggered alarm, prompting budget increases for missile defense, electronic warfare, and space surveillance. While Japan remains cautious to avoid direct confrontation, the blending of Chinese assertiveness with the risk of a Taiwan contingency pushes Tokyo toward greater security alignment with Washington and regional democracies.

Against this backdrop, the EU–Japan Summit on 23 July in Tokyo takes on heightened strategic significance. Hosted by the Prime Minister and attended by European Commission President Ursula von der Leyen and European Council President António Costa, it focused on coordinated responses to regional instability, Indo-Pacific maritime security, and institutionalized defense cooperation. Japan’s recent accession to the EU’s Security and Defence Partnership has formalized its role as Brussels’ principal Asian security partner. Summit deliverables are expected to include joint initiatives on critical technologies, critical raw materials, cybersecurity, and resilience against grey-zone threats. As global supply chains become more politicized and the rules-based order erodes, European–Japanese cooperation is increasingly viewed as a strategic anchor in a fragmented multipolar landscape.

Geoeconomic Initiatives and Incentives

Japan’s economic performance in 2025 reflects ongoing structural and external pressures, despite moderate headline growth. The economy expanded by just 1.2% in the second quarter, driven largely by export resilience and public investment. However, the yen remains weak—recently stabilizing around ¥147.8 to the U.S. dollar following early-year volatility and a brief rebound ahead of the U.S.–Japan trade deal—exacerbating energy and food import costs and weighing on household purchasing power. Inflation has moderated from last year’s peak but remains above the Bank of Japan’s (BoJ) 2% target, complicating gradual monetary tightening. With policy rates now at 0.5%, the BoJ faces a narrow path between inflation control and sustaining domestic demand. Wage growth remains uneven, and consumer sentiment is dampened by high living costs and macroeconomic uncertainty.

The broader corporate environment is characterized by elevated input costs, labor shortages, and long-term productivity challenges. Key industries—particularly logistics, construction, healthcare, and semiconductors—are under pressure from rising demographic constraints. In response, the government has sped up industrial modernization programs under the Economic Security Promotion Act. It prioritizes AI integration, digital infrastructure, and domestic capacity building in areas such as semiconductors, robotics, and hydrogen technologies. Moreover, the Ministry of Economy, Trade and Industry (METI) continues to lead strategic investments in frontier technologies, with a view toward long-term economic resilience.

Supply chain security now constitutes a cornerstone of Japan’s geoeconomic strategy. The government has launched a series of public-private initiatives to diversify sourcing and production, with special focus on semiconductors, batteries, rare earths, and pharmaceuticals. Japanese firms are receiving financial and regulatory support to expand operations in ASEAN and India, while Tokyo negotiates bilateral frameworks with Australia, Taiwan, and the EU to enhance transparency and redundancy in critical supply chains. The newly launched Supply Chain Resilience Platform—a METI-led initiative—aims to strengthen traceability, logistics capacity, and dual-use infrastructure resilience, especially in the context of growing tensions on East and Southeast Asian maritime routes.

Japan is simultaneously leveraging its participation in multilateral trade and economic frameworks to bolster its strategic position. It plays an active role in regional trade blocs like the Comprehensive and Progressive Agreement for Trans-Pacific Partnership and the Indo-Pacific Economic Framework, particularly on standards for digital trade, supply chain transparency, and decarbonization. Japan is also a founding member of the Regional Comprehensive Economic Partnership, allowing it to balance China through institutional engagement. These platforms are not only hedges against U.S. protectionism but also vehicles for rule-making leadership in the Indo-Pacific.

Following the recent U.S.–Japan trade deal, Tokyo is accelerating its engagement with regional and transatlantic frameworks to buffer long-term exposure to American tariff volatility. The deal and so called flat-rate tariff arrangement breaks with Washington’s past “sector-by-sector” targeting approach and gives Tokyo “diversified leverage” in navigating future U.S. trade policy. The sentiment in Tokyo has been cautiously optimistic: officials welcome the clarity and predictability of the 15% rate but remain aware that the agreement is not a comprehensive exemption and could be subject to political reversal. Nearly 30% of Japan’s U.S.-bound auto exports are expected to benefit immediately, helping avoid major disruptions in one of the country’s core export sectors.

Beyond Asia, Japan is expanding energy and infrastructure partnerships with the Middle East and Africa, including through sovereign wealth fund-backed initiatives to co-develop hydrogen hubs and critical raw material projects. Japan is also coordinating with the EU on connectivity standards and sustainable investment criteria under the Global Gateway framework. Its state-backed lenders (e.g. JBIC, JICA, NEXI) play a central role in financing outbound investment aligned with Japan’s security and supply chain priorities.

Domestically, Japan is working to contain long-term fiscal risk. However, yield curve control and institutional trust in government bonds have helped preserve macroeconomic stability for now. Fiscal stimulus remains narrowly targeted toward strategic industries and energy affordability, while METI is exploring tax reform and productivity-linked incentive schemes to unlock private-sector capital. Concerns remain that Japan may face additional fiscal pressure if U.S. tariffs escalate again in an election year context. The trade deal offers short-term relief, but analysts warn it sets a precedent for future tariff-based negotiation tactics—keeping markets wary of renewed volatility.

The digital economy is an increasingly vital pillar of Japan’s geoeconomic relevance. The government is a vocal proponent of data free flow with trust and has launched bilateral frameworks on digital standards with the EU, the U.S., and Singapore. Tokyo’s regulatory leadership in AI ethics, privacy, and cross-border data sharing—aligned with European values—positions it as a global norm-setter in digital governance, offering compatibility for EU-based digital firms, platforms, and fintechs.

This evolving geoeconomic posture has created strong momentum for deeper integration with Europe. In addition to a longstanding Economic Partnership Agreement, the new EU–Japan Competitiveness Alliance —to be formally launched at the July 23 summit— will provide a structured platform for industrial cooperation, regulatory alignment, and joint investment in strategic sectors like digital technologies, clean energy, secure connectivity, critical materials, and innovation funding. It is designed to promote joint standards, facilitate industrial synergies, and coordinate responses to coercive economic practices by third countries. The agreement will also serve as a strategic complement to the newly revised U.S. trade framework, offering Japan diversified leverage in its external economic relations.

Combined, the two frameworks with the EU position Tokyo at the center of an emerging rules-based counterweight to transactional, protectionist trends in global trade—while reinforcing resilience in key Japanese export sectors. The new tariff template gives Japan room to negotiate future agreements with both U.S. and other partners like the EU, reinforcing its global trade policy autonomy. Alongside the EU–Japan Competitiveness Alliance, Tokyo is signaling its commitment to structured, multilateral economic frameworks—a clear offset to the transactional protectionism seen in recent U.S. trade policy.

For European businesses, these trends translate into expanding opportunities across both traditional and emerging sectors. Companies offering solutions in hydrogen, offshore wind, battery storage, and carbon-neutral industrial processes are well positioned to partner with Japanese firms benefiting from green transition incentives. Advanced logistics systems, digital infrastructure, and AI-driven supply chain technologies are in growing demand amid Japan’s resilience agenda. In parallel, the new EU–Japan agreement offers a framework for public-private co-financing and co-development — particularly relevant for small and medium-sized enterprises and mid-cap innovators seeking to enter Asia via a trusted regulatory environment. Moreover, Tokyo’s intensifying engagement in Southeast Asia—both bilaterally and via regional trade frameworks—opens avenues for trilateral cooperation. European firms with regional exposure may find strategic alignment in supply chain diversification, infrastructure investment, and joint venture financing through Japanese industrial and development banks.