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increase its defense spending. Under Prime Minister Abe, the defense budget has expanded by 7% but has been kept at roughly 1% of GDP, in keeping with historical guidelines. This is small by international standards and more likely than not will rise in the coming years (Chart 24). The composition of spending is also likely to shift from operating costs towards procurement, which is currently a very small part of the budget (Chart 25). Chart 24: Military spending % of GDP as of 2015—Japan's is low by int'l Chart 25: Breakdown of Japan's defense-related expenditures standards 6 100% 5 4 50% 2 0% 2000 2003 2004 oOo Oke © ooo Oo NN NN 2009 2012 2013 2014 2015 2016 ot QoQ NN 2001 2002 mJP R&D, facility development, maintenance etc. 0 m JP procurement of equipment JP UK AU CH FR KR US RU m= JP personnel and food provisions. mwU.S Forces Japan-related cost Source: BofA Merrill Lynch Global Research, World Bank Source: BofA Merrill Lynch Global Research, Ministry of Defense TPP and trade policy: potential for linkages with other regional players Trump and his aides have made it clear that they consider the Trans Pacific Partnership (TPP) to be a “bad deal.” Media have reported that President Obama is not considering pushing the deal through a lame duck Congress. This means the deal is likely dead in its current form. While negative for Japan, the expected withdrawal of the US from TPP could spur new arrangements with regional partners. One potential positive is the prospect of improved economic and trade linkages with other key players in the region, including Russia and even China. Three upcoming events are worth monitoring closely (Table 2): first, the 19- 20 November APEC Summit in Lima, Peru, where we are likely to see vigorous discussions on the future of the TPP as well as further progress on the Regional Comprehensive Economic Partnership (RCEP); second, the 15 December Abe-Putin Summit, in Yamaguchi prefecture; and third a potential trilateral summit between Japan, China, and Korea, which onshore media now say is being scheduled for 19-20 December, though it may not happen given the unfolding leadership upheaval in Korea. Bullish bottom line - don’t underestimate the recovery We are optimistic on Japan and think the acceleration in GDP and inflation in 2017 will be much stronger than consensus expects. For the first time since 2013, fiscal and monetary policy will be lined up in the same expansionary direction. The global export cycle has turned and is now tracking modest expansion. Meanwhile, the headwinds to domestic demand are finally turning into tailwinds. Unlike in the past, we think the risks of a policy error are low. Assuming that external risks are kept at bay, we think Japan will surprise with the strength of its recovery. Bankof America 10 Japan Economics Viewpoint | 18 November 2016 Merrill Lynch HOUSE_OVERSIGHT_014419