Even though Israel and Iran have signalled their intention to walk back down the escalation ladder following their limited but direct ‘tit-for-tat’ strikes against each other since April 13, the world remains on edge due to concerns about the conflict swarming the entire Middle East.

A crucial energy supplier and a key shipping passageway, the region has been in the headlines since the beginning of Israel’s assault on Gaza after Hamas attacked the Jewish state on Oct 7.

Ever since, Israel has laid a siege on the Gaza Strip and massacred more than 34,000 Palestinians, including thousands of children, besides causing widespread devastation and hunger. Half of the Gaza population “is experiencing catastrophic hunger as the threat of famine looms”, the United Nations (UN) says, with Israel planning a ground operation in Rafah.

The chances of the immediate escalation between Israel and Iran into a full-scale war seem to be diminishing for the time being. Still, UN Secretary-General Antonio Guterres painted a dark picture of the situation in the Middle East a day before the retaliatory Israeli attack on Isfahan on Friday, warning that spiralling tensions over the conflict in Gaza and conflict between Iran and Israel could devolve into a “full-scale regional conflict”.

“The Middle East is on a precipice. In recent days, we have seen a perilous escalation in words and deeds. One miscalculation, one miscommunication, one mistake, could lead to the unthinkable — a full-scale regional conflict that would be devastating for all involved,” he said, calling on all parties to exercise “maximum restraint”.

‘A crisis in the Middle East adds to complications, potentially requiring the State Bank to increase the interest rate’

Hence, the prospects of a wider regional conflict have forced many countries grappling to contain inflation to mull measures in recent weeks to mitigate the potential economic fallout from such an eventuality as traders speculate possible ramifications of escalation for commodities.

The ongoing conflict in Gaza has only had a limited impact on oil prices, leading to significant shipping delays and rerouting. An escalation, however, would lead to a significant spike in oil prices and disrupt supply. Oil prices have already risen due to the incorporation of risk insurance premiums and higher shipping costs.

A Chase Securities note for its investors notes that “The spike in oil prices holds profound implications for Pakistan’s economy, especially concerning inflation dynamics and the precarious balance of the current account. These developments underscore the critical need for astute economic management and strategic planning.”

The impact of higher oil prices will extend beyond the energy sector, exerting inflationary pressure on the national economy. It would also further push out the prospect of an interest rate cut in response to volatile market conditions.

Likewise, the potential supply-chain disruptions in the Red Sea and the Strait of Hormuz would pose additional risks to trade and economic stability, according to economic and trade analysts. They say the impact would also be felt on inflation and growth projections.

Ahmed Jamal Pirzada, a University of Bristol economist, notes that an escalation of conflict in the Middle East will predominantly affect Pakistan’s economy through its effect on energy prices and what it would mean for monetary policy in advanced economies.

“The recent economic news both in the US and the UK already suggests that it may take longer than what was previously expected for the central banks in these countries to cut interest rates by enough. Yields on US government bonds increased this week after inflation numbers turned out to be higher than expected — up from 3.1 per cent in January to 3.5pc in March,” he points out.

Mr Pirzada says that these developments are not encouraging for Pakistan as these make any decision to cut the interest rate in response to the recent decline in inflation all the more complicated.

“If monetary policy deviates too much from the trend in advanced economies, it would once again bring the exchange rate under pressure, thus reversing the decline in inflation. A crisis in the Middle East will further add to this complication, potentially requiring the State Bank of Pakistan (SBP) to even increase the interest rate,” he noted.

Moreover, Mr Pirzada believes that such events will also have implications for economic growth and, as a result, debt sustainability. “The SBP data already shows a contraction in the industrial sector and a stagnation in the services sector during the second quarter of FY24. The growth in GDP of only one person cent is due to improved performance in the agriculture sector.

“Any disruption in the global economy, which affects international commodity prices and turns the policy environment even more contractionary, may result in another year of negative growth. As the International Monetary Fund (IMF) itself underscores, slower economic growth will undermine its own assessment that Pakistan’s debt is sustainable,” he concludes.

Pakistan’s economy contracted by 0.2pc during the last fiscal year and is projected to grow by 2pc this year. The multilateral lenders say the country’s growth would remain subdued to below 3.5pc over the next few years. This low growth scenario depends on a new IMF programme and the implementation of structural reforms.

Pakistan’s economy is vulnerable as it scrambles to recover from soaring inflation exacerbated by uncontrolled fiscal deficit and balance of payments troubles. In its World Economic Outlook report, the IMF adjusted Pakistan’s inflation forecast upward to 24.8pc for this fiscal year and 12.7pc for the next.

Though the current account deficit has shrunk to just 1pc of the economy, it is achieved at the cost of economic growth and jobs to advertise a possible default. A recent IMF report on the Middle East and North Africa region has clubbed Pakistan with six nations facing serious conflicts this year

and said that conflicts and tight macroeconomic policy conditions would affect their economic outputs.

“Beyond West Bank and Gaza, six economies — Iraq, Pakistan, Somalia, Sudan, Syria, and Yemen — faced conflicts at the beginning of 2024,” reads the report, released on the sidelines of the World Bank-IMF spring meetings.

The report adds that the conflict in Gaza and Israel had worsened an already challenging environment, and disruptions to shipping through the Red Sea had added to uncertainty.

It also underlines that an uneven recovery against a backdrop of armed conflicts, hydrocarbon dependence, and persistent structural challenges characterised the economic growth outlook for the region and Pakistan.

“The situation is fluid, and the full impact on the country’s economy, international trade, inflation, and prices is yet to be seen. However, what is clear is that the ongoing conflict and disruptions have significant implications for the economy,” Haroon Sharif, a former investment minister, says.

The Middle East conflict follows the biggest shock to commodity markets in recent years — the Ukraine war — which spiked global energy and commodity prices and drained the meagre Forex reserves of Pakistan and other similar economies in the last two years.

“The initial worry about the economic consequences of the deteriorating situation in the Middle East is likely to be focused on energy (as the region heavily influences global oil and gas production),” Mr Sharif notes.

Furthermore, the escalating conflict in the Middle East would have negative implications for the current account balance, quicken inflation, introduce fresh uncertainty and challenges for rate cuts, affect international trade, and affect the fragile GDP growth prospects, he adds. Besides, the uncertain conditions will force Saudi Arabia — and others — to cancel their recently announced investment plans in Pakistan.

Published in Dawn, The Business and Finance Weekly, April 22nd, 2024