Australia has been warned it is at grave risk of becoming a second-rate military power in the Asia-Pacific, and undermining the crucial United States alliance, unless the Abbott Government immediately increases defence funding.

A sobering new analysis of the nation's military capability by the Lowy Institute for International Policy paints a gloomy picture of a defence force in serious decline after years of funding neglect.

The Labor Government's "Force 2030'' policy has been estimated to cost up to $275 billion to build during the next two decades - requiring an injection of more than $146 billion over and above annual defence budgets.

"Yet in the four years since Force 2030 was announced, only $18 billion of funding has been committed to new defence capabilities," the paper said.

It also argues that Australia must decide quickly whether it wants to be a capable military power or a narrow focused humanitarian force such as the New Zealand Defence Force.

"The ADF (Australian Defence Force) may have already reached a point where short term savings measures have caused some military capabilities to decline below their regeneration point for expected conflict warning times," the paper said.

"The army, for one, has already signalled that without further augmentation it will not be able to concurrently sustain separate brigade and battle group sized deployments, as mandated by government."

The paper urges the new Coalition Government to take responsibility for charting a new course.

"If Australia is to have strategic weight in a more challenging region, it must start facing up to risks and make difficult choices on defence policy now," it said.

The paper's authors, former Army Major James Brown and international security expert Rory Medcalf warn that as the Australian Defence Force steadily declined so regional defence forces improved rapidly.

"Although Australia still has a more professional military than its neighbours, some countries in the region are acquiring advanced fighters and submarines, and developing sophisticated reconnaissance systems," Lowy said.

"Maintaining a regional defence edge is now more difficult for Australia and the ADF will need to raise its levels of capability, or face a relative decline."

The Lowy paper calls on the government to take a three-pronged approach to defence funding;

- Decide urgently what it wants the ADF to do

- Either fund "Force 2030" or reduce capabilities to match spending

- Review the US alliance and America's Asian pivot

The Lowy paper warns that if defence funding remained below 2 per cent of economic activity (GDP), significant cuts would need to be made.

It suggests the following theoretical cutbacks indicate the scale of the savings push;

- Cut Army's planned armoured vehicle fleet by 25 per cent to save $3 billion

- Reduce fighter aircraft numbers and flying hours to save $4 billion

- Shrink the Defence Materiel Organisation by 50 per cent to save $4 billion

- Build eight instead of 12 submarines to save $9 billion

"Any of these cost saving options would be politically difficult, and could seriously add risk to Australian interests and even lives in future security contingencies," the Lowy paper warns.

###