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US contractors to gain most from Japan's record defense spending

America-friendly changes on deals prove a blow for domestic manufacturers

Japan is increasingly buying cutting-edge equipment, such as F-35A stealth fighters, through the U.S. Foreign Military Sales program. (Courtesy of the Air Self-Defense Force)

TOKYO -- Japan plans to spend record sums on defense in fiscal 2018 but the gains will flow not to high-tech Japanese manufacturers but to US companies backed strongly by President Donald Trump.

This has dismayed Japanese corporates that watched Mr Trump successfully sell prime minister Shinzo Abe a huge order of defense equipment last November, partly in response to the rising threat from North Korea's missile and nuclear program.

Donald Trump "is a businessman after all," a source at an industrial manufacturer involved in the defense business said, "And so the U.S. mops up our defense funding once again," the person said.

The growing North Korea threat has shocked Japan into beefing up systems including missile defense, leading the government to propose 5.19 trillion yen ($46.8 billion) in defense spending in the year ending March 2019 -- the most ever.

Crucially, Mr Trump's "America First" policy on trade and national security has led to little-noticed changes in how Japan goes about buying that equipment.

Our way

In the past, Japanese manufacturers typically purchased licenses to manufacture American equipment. These arrangements were viewed as a win for both sides. Japan's defense sector could easily build up its manufacturing and technology base while drawing on Japanese-made parts and keeping costs under control, and American companies received licensing fees.

But recently, far more acquisitions have been made through the U.S. Defense Department's Foreign Military Sales program, which is meant to route contracts for classified equipment through Washington.

The FMS approach has become more prevalent as concerns about technological leaks and protecting the American defense industry have intensified. Japan spent 43.1 billion yen on FMS acquisitions in fiscal 2011; in fiscal 2016, that figure reached 485.8 billion yen.

The price of FMS contracts is set by the U.S. government, and Japan must pay in advance. Delivery dates are not set, and the content of the deals can change as the U.S. demands. What is more, licensing deals are, in principle, banned under such arrangements.

While FMS contracts give Japan access to cutting-edge defense equipment, the imbalance of power between buyer and seller has caused tensions in Japanese government circles.

Japan's Board of Audit notified the defense ministry's acquisitions agency last September that Japanese parts slated for inclusion in F-35A stealth fighters ordered by the country were in fact left out.

Delivery of American-made materials needed for the components had encountered a delay. The U.S. has also failed to settle cases in which Japan has overpaid for equipment up front. The Board of Audit has spoken with the U.S. regarding these shortcomings, demanding improvement.

Losing out at home

Meanwhile, the share of Japan's 1.8 trillion yen defense market attributable to imports has only grown, curbing opportunities for domestic players. Little change is in sight: Japan is set to deploy two Aegis Ashore missile defense systems -- worth around 100 billion yen each -- starting in fiscal 2019 through an FMS deal. Outfitting the systems with high-performance radar equipment could drive that cost even higher. The defense purchases Trump has urged Japan to make would also likely fan the country's FMS spending.

Defense Minister Itsunori Onodera seems to regard the increase as inevitable. "Deploying advanced American equipment through the FMS program is critical to strengthening Japan's defense capabilities" amid heightened tensions on the Korean Peninsula, he said.

Yet reliably profitable defense operations are a valuable asset in Japan's manufacturing sector. Mitsubishi Heavy Industries, Japan's top defense-sector player, brings in around 400 billion yen in defense revenue each year. And while defense operations as a percentage of overall sales are in the single digits at peers such as Kawasaki Heavy Industries, they nevertheless provide a stable source of income when shipbuilding and plant construction operations falter.

In addition to making costs difficult to control, more FMS deals could deprive these companies of cutting-edge technologies. Those without proprietary tech could face high hurdles to joint defense development with non-U.S. countries.

Onodera has said Japan "must take sufficient measures to ensure the rise in FMS procurement does not impact the domestic defense sector's production or technological base." But with defense funding limited, "medium- to long-term research and development tends to fall by the wayside," an official at the acquisitions agency said. As the North Korean threat intensifies, Japan's dependence on the U.S. for defense looks only likely to deepen.

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