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War in the Middle East could damage the global economy

Like the Middle East wars of the past, the conflict between Israel and Hamas that erupted last week has the potential to cripple the workings of the global economy and even drive it into recession if more countries are drawn into it, according to Bloomberg.

This risk is real as the Israeli army prepares to invade Gaza in response to an attack by the group’s militants. There are fears that militants in Lebanon and Syria who support Hamas will join the fighting.

Further development of the war could bring Israel into direct conflict with Iran, the supplier of arms and money to Hamas, which the US and the European Union have classified as a terrorist group. In that case, Bloomberg Economics estimates that oil prices could soar to $150 a barrel and global growth could fall to 1.7 per cent – a recession that would reduce global output by about $1 trillion.

The Middle East is a crucial energy supplier and a key sea route, so a conflict in this region could shake the entire world. For example, in 1973, the Arab-Israeli war led to an oil embargo and years of stagflation in industrialised countries.

The global economy has become very vulnerable today. The wider implications could extend from renewed unrest in the Arab world to next year’s US presidential election, where petrol prices play a key role in voter sentiment.

All of these potential consequences depend on how the war develops in the coming weeks or months. Bloomberg Economics looked at the possible effects on global growth and inflation under three scenarios.

Scenario 1: Conflict Confined to Gaza

In 2014, the killing of three Israelis by Hamas triggered a ground invasion of the Gaza Strip that killed more than 2,000 people. The fighting did not extend beyond the Palestinian territory, and its impact on oil prices and the global economy was insignificant.

Tehran has increased oil production by 700,000 barrels a day this year as the prisoner swap and unfreezing of assets signalled a thaw in relations with the US. If those barrels disappear under U.S. pressure, Bloomberg Economics estimates oil prices will rise by $3-4.

The impact on the global economy in such a scenario would be minimal, especially if Saudi Arabia and the UAE compensate for the loss of Iranian barrels with their spare capacity.

Scenario 2: Proxy War

Hezbollah, an Iranian-backed political party and militia that is a powerful player in Lebanon, has already exchanged fire with Israeli troops on the border and said it struck an Israeli army post with guided missiles. If the conflict spreads to Lebanon and Syria, where Iran also supports armed groups, it will effectively become a proxy war between Iran and Israel, with increasing economic costs.

An escalation of the conflict in this direction would increase the likelihood of direct conflict between Israel and Iran, which would likely drive up oil prices. During the short but bloody war between Israel and Hezbollah in 2006, the price of oil jumped by $5 per barrel. On top of the shock of a limited war scenario, a similar move today would push prices up 10%, to about $94.

Egypt, Lebanon and Tunisia are in a state of economic and political stagnation. Israel’s response to the Hamas attack has already sparked protests in a number of countries in the region.  A repeat of the Arab Spring, a wave of protests and uprisings that toppled governments in the early 2010s, cannot be ruled out.

The global economic impact in this scenario is driven by two shocks: a 10 per cent jump in oil prices and a de-risking of financial markets similar to what happened during the Arab Spring. We capture the latter in the form of an eight-point rise in the VIX index, a widely used measure of risk aversion.

Together, they add up to a 0.3 percentage point decline in global economic growth next year (about $300 billion in lost output), which would slow growth to 2.4 per cent. With the exception of the Covid crisis in 2020 and the global recession of 2009, this would be the weakest growth in three decades.

Higher oil prices would also increase global inflation by about 0.2 percentage points, keeping it at 6% and keeping pressure on central banks to maintain tight monetary policy even in the face of unsustainable growth.

Scenario 3: Iran – Israel War

A direct conflict between Iran and Israel is an unlikely but dangerous scenario. It could trigger a global recession. A sharp rise in oil prices and a fall in risk assets would deal a significant blow to economic growth and lead to higher inflation.

In such a scenario, increased tensions between the superpowers would further exacerbate the situation. The US is a close ally of Israel, while China and Russia are deepening ties with Iran. Western officials say they fear that China and Russia will use the conflict to divert attention and military resources from other parts of the world. Since one-fifth of the world’s oil supply comes from the Persian Gulf region, oil prices will skyrocket.

The price of oil may not quadruple, as it happened in 1973 when Arab countries imposed an embargo in retaliation for U.S. support for Israel in that year’s war. But if Israel and Iran start firing missiles at each other, oil prices could rise along the lines of what happened after Iraq invaded Kuwait in 1990. At today’s much higher starting point, such a jump could lift oil to $150 a barrel.

The spare production capacity of Saudi Arabia and the UAE may not save the day if Iran decides to close the Strait of Hormuz, through which a fifth of the world’s oil supply passes daily. In addition, financial markets would see a sharper risk-off, perhaps comparable to the 16-point jump in the VIX index in 1990.

The sheer number of Israeli casualties increases the likelihood of bloody retaliation and regional war. However, the balance of probabilities does tilt in favour of containing the conflict, which will have a high cost in human casualties but limited economic and market consequences.

Hopes for a more stable Middle East are dashed. In recent years, the rapprochement between Saudi Arabia and Iran, peace treaties between Israel and several Arab states, and the prospect that the Saudis will soon follow suit have raised hopes that decades of confrontation in the region will end.

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