On July 21, the Japanese Cabinet approved the "Basic Policies for Economic and Fiscal Management and Reform 2026," also known as the "Basic Policies 2026," elevating strategic areas such as AI, semiconductors, defense, quantum technology, energy, and robotics while shifting the fiscal goal towards stabilizing the debt balance/GDP ratio.
The "Basic Policies" is an annual crucial roadmap for Japan's government on economic and fiscal matters, influencing subsequent budgets and industrial policy priorities. The familiar fiscal anchor in the past has been the primary balance, which is whether the government can cover its daily expenses with tax revenue without considering interest payments.
This shift is unsettling the market not because Japan is starting to value AI but because the Cabinet is attempting to change the fiscal narrative from "Can we balance the budget this year?" to "Can future growth contain the debt?" If investors believe that investments can lead to productivity gains and increased tax revenue, it will be seen as a growth policy. If investors are skeptical, it may be priced as fiscal easing.
The divide is already evident in government bonds and the exchange rate. The Cabinet advocates for a "responsible and proactive fiscal policy" to support strategic investments, boost the growth rate, and make debt-to-GDP stability a core objective. However, Nomura Institute of Capital Markets Research economist Toshihide Kinoue warned in an article on July 21 that the original proposal had already caused fluctuations in the yen and bond markets, with the 10-year Japanese government bond yield briefly reaching 2.9%. He suggested that mere textual revisions may not be sufficient to restore trust.
Fiscal Anchor Shifts from Annual Balance to Debt Ratio
The official document places the stabilization of the debt balance/GDP ratio at the core, emphasizing multi-year fiscal management, budget reform, and reducing reliance on supplementary budgets.
The debt/GDP ratio is more of a long-term checkup indicator than a one-year deficit. As long as nominal economic growth outpaces the long-term interest rate, there is a chance for the debt ratio to stabilize or even decrease. If interest rates rise faster, even if the government claims expenditures are for growth, the debt burden will increase.
The new narrative that the Kishida Cabinet is attempting to convey is that Japan's long-term low growth, aging population, and labor shortage have already constrained its potential growth rate. Relying solely on expenditure compression makes it difficult to break out of this cycle. Instead of mechanically pursuing a specific year for achieving a primary balance in fiscal spending, it is better to allocate fiscal space to areas that can enhance productivity.
Bond investors' concerns also lie here. The primary balance target is straightforward and observable, serving as a constraint on budget impulses. With this anchor weakened, the government needs to establish new credible rules to prevent the perception of "multi-year management" as merely deferring constraints to the future.
¥370 Trillion Is Not Solely an AI Budget
The most easily misinterpreted figure in the market is ¥370 trillion. In public reports, this figure is often summarized as the scale of public and private investments in strategic areas such as AI and semiconductors by fiscal 2040. However, the Cabinet Office had previously provided a more detailed explanation: the investment scale for 62 key products and technologies by fiscal 2040 exceeds ¥370 trillion, with "Physical AI+Semiconductors" accounting for approximately ¥78.5 trillion.
This differentiation is crucial. ¥370 trillion is not a one-time additional budgetary allocation by the government, nor is it entirely dedicated to AI and semiconductors. It resembles more of a long-term industrial investment portfolio covering AI, semiconductors, defense, quantum, energy transformation, robot applications, among other areas.
The Japanese AI narrative also differs from that of the United States. The U.S. market is more focused on large models, cloud capital expenditure, and computing power competition, while Japanese policy leans towards integrating AI into factories, energy systems, urban infrastructure, and elderly care services to address labor shortages, rising maintenance costs, and manufacturing efficiency bottlenecks.
Semiconductors play another role. Japan hopes to reclaim part of its industrial position in the global AI infrastructure expansion through materials, equipment, advanced manufacturing, and domestic supply chain reconstruction. For the fiscal standpoint, this transformation must ultimately translate into investment, employment, profits, and tax revenues.
This chain is quite long. The policy framework must translate into projects, projects into capacity, and capacity into productivity and tax revenue. Any delay in any part of this chain may prompt the bond market to demand higher interest rates as compensation.
The Bond Market Trades Trustworthiness
While the Japanese stock market may initially trade on policy tailwinds, the bond market trades on fiscal credibility. As long as investors doubt a softening of fiscal rules, long-term yields will rise, thereby constraining policy space in return.
This is also the crux of the current controversy. The government aims to justify expansion through growth, but the market will first examine interest costs. If long-term rates continue to rise, Japan's fiscal expenses will increase, squeezing the space available for strategic investments. As growth investments have yet to materialize, financing costs have already escalated, putting pressure on the policy narrative.
The yen is also on the same track. A decrease in fiscal credibility may weaken exchange rate confidence; if strategic investment raises long-term growth expectations, it may also attract funds back to Japanese assets. For overseas investors, pricing of Japanese assets will no longer only consider the Bank of Japan's policy but also the credibility of the fiscal anchor.
AI and semiconductor optimism cannot be understood in isolation. The relevant sectors may receive policy support expectations, but if Japanese government bond yields rise too quickly, both growth stock valuations and yen asset risk premiums will be affected. The market is not trading on whether "Japan is investing in AI" but on whether Japan can prove that these investments will have a return.
Nominal Growth Rate Determines Success of New Framework
This new framework ultimately has to pass two tests: whether the nominal growth rate can remain consistently above the long-term interest rate, and whether subsequent budgets can control the pace of government debt issuance.
If the coming budget cycles show that strategic investment is merely packaging more expenditure into a growth narrative without clear projects, outputs, and fiscal constraints, the concerns of the cautious camp will prevail. Japanese government bond yields, the yen, and overvalued technology sectors may all come under pressure again.
If AI, semiconductor, and infrastructure investments begin to translate into corporate capital expenditure, productivity improvements, and tax revenue growth, while the government still manages to sustain a declining debt-to-GDP ratio, the market will gradually reprice this shift as a growth policy, rather than fiscal recklessness.
Proving the new fiscal anchor adopted by Japan this time around will be more challenging. The basic fiscal balance can be calculated from the budget table, but beating the interest rate in growth terms requires real economic realization. With the Suga administration staking its bet on strategic investment, government bond yields will continue to provide the market's verdict.
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