IIF’s pessimistic scenario forecasts dire results for the Middle East if a regional war breaks out

The recent escalation in hostilities in the Middle East between Israel and Hamas has heightened the risk of a wider and prolonged conflict that would significantly impact the global economy and have dire consequences for the Middle East, the Institute of International Finance (IIF) says in a new report released on February 15.

The region, a crucial transport corridor for 35% of the world’s oil and 13% of natural gas exports, is on the brink of a conflict that could disrupt global commodity prices, trade and economic growth.

The Israel-Hamas war has brought the Middle East to the edge of a wider conflict with the potential for higher commodity prices and lower trade volume.

Attacks on ships in the Red Sea crisis, which helps transport 12% of global trade, have already disrupted the flow of goods and have more than doubled freight rates since end-2023. While an energy supply disruption has not yet occurred, the risks are rising, and could lead to a surge in energy prices, says IIF.

The think-tank believes there are two scenarios: that the fighting is contained and the conflict ends with a resumption of traffic through the Red Sea with a 70% possibility; and that the fighting expands and results in a major regional war.

“In our pessimistic scenario, with 30% probability, we assume that the conflict escalates into a full-blown war with Hezbollah, and to a lesser extent with Iran, that could lead to a disruption of oil and gas shipping in the Strait of Hormuz,” IIF says. “In such a scenario, energy prices surge, leading to higher inflationary pressures and weaker global growth.”

The fallout from the worst-case scenario could result in higher global commodity prices, higher inflation, a delay in monetary easing in advanced economies, and, ultimately, lower global growth, says IIF.

In October, IIF outlined what it saw as the three most likely scenarios stemming from the war in Gaza:

1) a quick and precise response by the Israeli Defence Forces (IDF), which would focus on retrieving hostages while targeting Hamas’ leadership and military infrastructure;

2) a large-scale operation that could lead to a larger regional conflict; and

3) a quick ceasefire leading to the release of hostages and some sort of peace treaty.

“The conflict has largely followed our second scenario, though it had, until recently, remained constrained to the Gaza Strip. Repeated strikes from Iran’s “Axis of Resistance” against US military targets, as well as against ships crossing the Bab-el-Mandeb strait, and the Western response to those actions, have considerably escalated the situation,” IIF said.

The attacks on cargo ships in the Red Sea are particularly alarming for the global economy, says IIF. Repeated attacks by the Houthis have reduced the traffic in the Suez Canal and sent global transportation costs soaring.

The Red Sea trade route accounts for 12% of global trade, especially containerised goods, and is the primary shipping lane connecting Asia to Europe. LNG transport from Qatar to Europe has been particularly badly hurt. The number of ships passing through the Suez Canal has fallen drastically, from 75 per day in November 2023 to around 45 per day in January 2024.

According to the International Energy Agency (IEA), in 2023, about 10% of global seaborne oil and 8% of (LNG) trade also transited the Red Sea, making it a key corridor connecting the oil fields in the Middle East and customers in Europe.

Ships have had to reroute around Africa’s Cape of Good Hope, which adds about two weeks to the voyage, increases the risks of supply chain bottlenecks, and leads to higher freight costs and renewed inflationary pressures.

Under the baseline scenario, the report anticipates a potential easing of tensions and resumption of normal trade activities through the Red Sea in the coming months.

“In this scenario, Western strikes succeed in sufficiently degrading the Houthis military capabilities or, at the very least, sufficiently raise the costs for the Houthis. This would allow for the resumption of trade across the Red Sea in the next couple of months,” says IIF. “We also assume a continuation of limited clashes between Israel and Hezbollah. Finally, ongoing efforts by the international community, led by the USA, will help prevent further escalation in the conflict.”

But in the pessimistic scenario the US and the UK are not able to degrade the capacity of the Houthis and their attacks on shipping in the Red Sea continue or escalate into a full blown war. That would include the launching of rockets and missiles into Israeli cities and Israeli heavy bombardment of major cities in Lebanon.

The Houthis may also target oil tankers and carriers which transport raw materials, such as iron ore and grain, having a heavy impact on  commodity prices.

So far Tehran has repeatedly said it would like to avoid a wider regional war, but the evolution of the war in Gaza and Lebanon could drag Iran into direct confrontation with Israel and/or the USA against its will. In this scenario shipping would also be affected by the Strait of Hormuz unrest, and that would choke global oil supply, causing a price shock worldwide.

Impact on the global economy

Under the baseline scenario the impact on the global economy is minimal. The unrest in the region remains a short-lived development without major consequences other than causing inflation to rise.

“Under our baseline scenario we expect global growth to moderate from 3.1% in 2023 to 2.8% in 2024, with high real interest rates and slightly tighter fiscal policies in most advanced economies restraining economic activity,” says IIF. “Growth in the USA will slow from 2.5% in 2023 to 2% in 2024. Slower growth will likely be viewed as a positive by the Fed. The Euro Area is expected to flirt with a mild recession, as higher borrowing costs squeeze demand for loans. We also expect China’s growth to slow, as tepid consumer sentiment and continued downturn in the property sector weigh on demand and activity.”

While the escalation in the conflict has raised shipping costs, a steady supply of container ships coming into the market and weaker demand for goods (especially in the US and China) should keep supply pressures at a minimum. IIF reports that a high frequency indicator developed by the New York Fed shows that current supply chain pressures, as of January 2024, are at their historical average and commodity prices have also largely remained steady over the past few months.

Oil and natural gas prices are also expected to remain stable as the increased costs are offset by lower demand on the back of slower global growth, thanks to the polycrisis. Energy prices are forecasted to remain at around current levels through the end of this year, due to lower global demand, an increase in the supply of oil and gas by non-OPEC+ countries as well as ongoing LNG imports to Europe that are keeping its tanks unusually full. Likewise, lower demand from the slowing Chinese economy will also keep a lid on most commodity prices.

IIF’s pessimistic scenario paints a much darker picture. IIF expects global growth to be 0.4 percentage points lower than in the baseline scenario, with global growth falling to 2.4% in 2024, primarily due to a greater disruption of shipments through the Suez Canal and the Strait of Hormuz, emphasising the role they both play as major global chokepoints.

“This is particularly true if Iran or one of its proxy forces begin militarising oil by disrupting shipments through the Strait of Hormuz. About 30% of global oil consumption passes through this strait, with a large portion of the oil exports from Saudi Arabia, Iraq, Iran, the UAE [and] Kuwait, and Qatar’s LNG, passing through it as well,” says IIF.

The potential impact of a disruption on energy prices will depend heavily on how long and how bad the conflict is.

“While it is difficult to predict by how much and for how long energy prices would rise, we assume that oil and natural gas prices surge by 40% in 2024,” says IIF, adding that the global trade volume will fall to 0.8% (as compared to 1.6% in the baseline scenario) due to continued attacks on cargo ships, which would also feed into inflation.

For advanced economies the upshot of the conflict will be for central banks to keep their prime rates higher for longer, acting as a drag on investment and growth.

Red Sea crisis Global Growth, Inflation, Trade and Oil Prices Scenarios for 2024 IIF

Impact on the Middle East

The impact of the Red Sea crisis on the Middle East will also be limited in the baseline scenario and limited to those countries that were directly affected in the fighting, namely Israel, Egypt and Lebanon.

“Nonetheless, geopolitical uncertainty will still have an adverse impact on many of the countries in the region, through lower private consumption and investment, lower tourism, higher import costs, and a rising risk premia that is increasing borrowing costs. In this baseline scenario, we expect overall growth in the Middle East, including Israel, to be 1.6%, with countries like Lebanon and Israel registering a small contraction in output,” says IIF.

Egypt would be one of the countries worst affected and would see growth moderate to 2.8% with the current account deficit forecast to widen to around 3.5% of GDP, negatively affected by falling transportation and tourism receipts.

The negative impact on the six Gulf Cooperation Council (GCC) countries will be limited, but probably could see a modest increase in inflation, falling tourism and weaker private investment.

Non-oil real GDP growth in the GCC countries is expected to remain strong at around 4% in Saudi Arabia and the UAE. However, oil production cuts may extend beyond March of this year, in the context of the next OPEC+ agreement, dragging overall growth to down to 2% in Saudi Arabia and 3% in the UAE, according to IIF.

“Finally, the normalisation of relations between Israel and other countries in the region, most notably Saudi Arabia, will be postponed indefinitely. With Saudi authorities recently stating that no normalisation will occur until a two-state solution is found,” IIF said.

“Under our pessimistic scenario, the consequences for the Middle East region would be dire,” says IIF.

The major factors that would affect the region’s economic activity include:

1) the extent and duration of the wider war;

2) additional cuts in oil production due to attacks on oil tankers under the assumption of tighter sanctions on Iran; and

3) prolonged tight monetary policy in the six GCC countries (due to their peg to the dollar).

“A wider regional war involving Hezbollah could destroy whatever is left of the Lebanese economy, while heavily damaging Israel’s infrastructure, leading to a contraction in output of at least 20% in Lebanon and 4.5% in Israel,” says IIF. A wider war could also aggravate the precarious economic situation in Egypt. Cargo passing through the Suez Canal dropped by more than 40% in January of this year, compared to a year earlier.”

Egypt is heavily dependent on Suez Canal receipts which are also a major source of hard currency, and the pound is already facing a widely anticipated devaluation.

Iran’s sanction bound economy is also weak and the costs of a full blown war would cause a contraction of about 5% in fiscal year 2024, inflation would accelerate to over 100%, driven by a sharp depreciation of the parallel exchange rate, and Iran’s limited readily available FX reserves (which exclude frozen reserves) would be depleted by March 2025, according to IIF.

Damage would be done to the other Middle Eastern countries as well, including Iraq, Syria and Yemen, especially if Western strikes intensify or begin to target more critical infrastructure in these countries.

Sectors like tourism, particularly in Saudi Arabia, the UAE, Oman, Bahrain, Egypt and Jordan, that are important sources of income would also be heavily depressed.

“While the GCC countries are unlikely to be involved in the war, their economies could suffer if oil and/or LNG shipments are disrupted for a prolonged period (either via the Suez Canal or through the Strait of Hormuz),” says IIF. “The expected large loss in the volume of hydrocarbon exports in Saudi Arabia and other oil exporters in the region would more than offset gains from higher energy prices, leading to lower overall growth, wider fiscal deficits, and deteriorating their current account balances.”

Red Sea crisis for selected Middle Eastern Economies that could be affected by the War IIF