According to recent media reports, China has instructed state-owned banks to reduce their holdings of US Treasuries further, thereby accelerating a long-standing diversification of its foreign exchange reserves. US Treasury data indicate that China’s holdings have declined from more than $1.3 trillion in the early 2010s to approximately $680-to-$780 billion by the end of 2025.

This reduction represents more than a routine portfolio adjustment; it reflects a structural recalibration of financial exposure with significant geopolitical implications. As China diminishes its role as a major purchaser of US sovereign debt, important questions arise regarding how Washington will finance its expanding fiscal deficits.

The United States may increasingly depend on alternative large-scale buyers, more active participation by the Federal Reserve, or greater absorption of US debt by allied economies in Europe and Asia. However, several European economies appear reluctant to expand their exposure at scale.

Consequently, the adjustment burden created by China’s retrenchment is more likely to fall disproportionately on Japan.

Japan occupies a distinctive position within the US-led financial architecture. It is simultaneously a key security ally, a major reserve holder and home to institutions with the balance-sheet capacity to absorb substantial quantities of foreign sovereign debt, including the Bank of Japan and the Government Pension Investment Fund. Owing to geopolitical, strategic and alliance-related considerations, Tokyo may find it difficult to decline implicit expectations to increase its purchases of US Treasuries.

This shift, while seemingly technical and financial, carries significant macroeconomic, political, and strategic consequences for Japan. Greater Treasury absorption would exert downward pressure on the yen, complicate domestic monetary policy, and constrain fiscal space.

Over time, these pressures could affect Japan’s economic stability, its monetary policy autonomy, and its long-term capacity to finance military modernization while sustaining its strategic standing in the region.

Paradoxically, a financial adjustment initiated in Beijing may indirectly limit Tokyo’s ability to build the very capabilities intended to counterbalance China’s regional influence.

Reallocation and the structural weakening of Japan’s monetary autonomy

China’s retreat from US Treasuries alters the distribution of demand in the global sovereign bond market. In practical terms, the decline of one large buyer necessitates the rise of others. Among advanced economies, Japan is uniquely positioned – by virtue of its persistent current account surplus, deep financial institutions, and alliance commitments – to fill part of this vacuum.

However, large-scale Treasury accumulation requires a consistent conversion of yen into dollars. This dynamic exerts structural downward pressure on the yen. For Japan, whose economy is heavily dependent on imported energy and food, a weaker currency translates directly into imported inflation and declining real household purchasing power.

What appears as a portfolio decision in reserve management becomes, domestically, a cost-of-living issue with macroeconomic and political ramifications.

More importantly, sustained Treasury absorption constrains the policy freedom of the Bank of Japan. To maintain the feasibility of overseas asset purchases without destabilizing domestic markets, Japan must keep domestic yields suppressed. This logic reinforces the continuation – or at least the shadow – of yield curve control and ultra-low interest rates.

Consequently, Japan’s monetary policy becomes indirectly tethered to US fiscal conditions. If US deficits widen and Treasury issuance increases, Japan’s capacity to maintain internal policy normalization diminishes.

This is not an overt loss of sovereignty but a functional limitation. The central bank’s latitude to respond to domestic inflation, wage stagnation or asset bubbles becomes narrower because higher domestic rates would both strengthen the yen (making Treasury accumulation costlier) and stress Japan’s own heavily indebted public sector.

Thus, Japan’s macroeconomic management becomes subtly subordinated to external financial requirements originating in US debt markets. Over time, this dynamic erodes the flexibility needed for Japan to undertake major structural adjustments, including those required to finance a substantial expansion in defense capability.

Balance sheet strain, economic frictions and the erosion of fiscal space

The absorption of US Treasuries at a time of elevated global yields introduces another layer of vulnerability: mark-to-market risk. As yields rise, the market value of existing bond holdings declines. Japanese banks, insurers, and pension funds – already deeply intertwined with government debt markets – face balance-sheet pressure similar to stresses observed in parts of the US banking system in 2023, albeit in slower and more diffuse form.

For institutions such as the Government Pension Investment Fund, increased exposure to US sovereign debt at higher yields may appear attractive from a nominal return perspective. Yet the currency risk, valuation volatility, and duration exposure introduce systemic fragility. Financial institutions become more sensitive to shifts in US monetary policy, inflation expectations, and political fiscal debates – factors entirely outside Japanese control.

Simultaneously, the domestic economic consequences of a structurally weaker yen accumulate. Imported inflation reduces real wages, dampens consumption, and increases public dissatisfaction. Japan’s demographic challenges – aging population and slow labor force growth – already limit potential output expansion. Added inflationary pressure without corresponding wage growth constrains tax revenues and increases the political difficulty of raising taxes to fund defense modernization.

Japan’s government debt exceeds 250% of GDP, the highest among advanced economies. While domestically held, this debt is sustainable only under conditions of low interest rates.

If the government seeks to expand defense spending significantly – consistent with recent strategic commitments – it must either increase borrowing or reallocate spending. Both options become politically and economically more difficult in an environment in which the central bank’s policy flexibility is constrained and household purchasing power is declining.

Thus, a feedback loop emerges: greater Treasury absorption weakens the yen; a weaker yen worsens domestic economic conditions; weaker domestic conditions limit fiscal capacity; limited fiscal capacity restricts defense expansion.

Financial dependence and constraint on military modernization

Japan’s contemporary security posture is defined by its effort to increase defense spending, revise doctrinal constraints, and enhance deterrence capacity in response to China’s growing military presence. These ambitions require sustained fiscal commitment over decades. Advanced military capabilities – missile defense, naval expansion, cyber capabilities and aerospace modernization – are capital-intensive and technologically demanding.

However, the financial architecture described above reduces Japan’s long-term ability to fund these initiatives without incurring political and economic strain. Defense spending competes directly with social spending in a rapidly aging society.

If real wages stagnate and imported inflation persists, public tolerance for higher taxes or reduced welfare expenditure diminishes. Political leaders, even after decisive electoral victories, operate within these economic constraints.

The strategic irony becomes clear. China’s reduction of US Treasury exposure is motivated by a desire to insulate itself from financial coercion and increase autonomy. Yet the secondary effect is to increase Japan’s exposure to the same financial system China is exiting.

As Japan becomes a larger marginal supporter of US debt markets, it indirectly imports the financial risks associated with US fiscal expansion and monetary policy volatility.

In this configuration, Japan evolves into a critical but vulnerable pillar of the dollar system. Any future attempt by Tokyo to reduce its exposure – whether for economic or political reasons – would risk destabilizing global bond markets, thereby limiting its own freedom to adjust. This path of dependence effectively locks Japan into a role where financial stability takes precedence over strategic flexibility.

Consequently, Japan’s capacity to finance a stronger military becomes contingent not only on domestic political will but also on the stability of US fiscal policy and global dollar demand. China, by contrast, incrementally shifts reserves into assets such as gold and diversifies exposure, increasing its resilience against external shocks. The divergence in financial strategy translates, over time, into divergence in strategic autonomy.

The result is subtle but significant: While Japan seeks to strengthen its deterrence posture, the financial adjustments occurring at the global level constrain the economic foundations required to sustain that posture. China’s move is not confrontational but structural. It does not weaken Japan directly; it reshapes the financial environment in which Japan must operate.

China’s retrenchment from US Treasuries should not be interpreted solely as a signal about the future of the dollar or the trajectory of Sino-American rivalry. Its deeper significance lies in how it redistributes financial responsibility within the US-led system, with Japan emerging as a principal absorber of the resulting adjustment.

This shift may weaken Japan through three reinforcing mechanisms:

• the erosion of monetary autonomy,
• increasing balance-sheet and macroeconomic strain and
• the narrowing of fiscal space available for sustained defense expansion.

he cumulative effect is a gradual reduction in Japan’s strategic flexibility at a time when it seeks to enhance its military capabilities to counterbalance China’s regional influence.

In this context, the move reflects a long-horizon strategic logic. By reducing its own exposure to dollar leverage while indirectly increasing Japan’s dependence on the same financial architecture, China improves its relative position without direct confrontation. Financial statecraft thus operates as a subtle instrument shaping the strategic environment of East Asia.

The implications are not those of immediate crisis, but of incremental constraint. Over time, Japan may find that the economic costs associated with sustaining the financial architecture underpinning its alliance commitments limit the resources available for independent strategic maneuver. By contrast, China’s diversified reserve strategy enhances its financial and strategic autonomy.

Accordingly, the regional balance of power may be influenced as much by sovereign portfolio decisions as by conventional measures of military capability. For this reason, US policymakers must exercise strategic prudence in encouraging greater Japanese absorption of US Treasuries, as excessive reliance on this channel risks undermining the economic foundations that enable Japan to contribute effectively to regional security.

Don’t kill the hen that lays the golden eggs.