Prolonged Israel-Iran conflict could derail Pakistan’s economic stability

LAHORE: If the Israel-Iran conflict continues and global oil and shipping prices remain elevated, Pakistan’s economy could face significant external shocks.

Such a development could undermine key assumptions underpinning the budget, affect its implementation, and alter the expected outcomes of levies such as the petroleum development levy and the proposed climate tax. The budget appears to rely on the assumption of stable or slightly declining international oil prices to meet macroeconomic projections, including inflation, the fiscal deficit and the trade gap.

A sustained spike in global oil prices -- possibly pushing Brent crude to $90-$100 per barrel or more -- would increase the cost of imports, devalue the rupee and jeopardise fuel subsidy forecasts. This scenario would also distort the projected import bill and adversely affect inflation and interest rate trajectories. The State Bank of Pakistan, in its latest monetary policy announcement on Monday, chose to maintain the policy rate at 11 per cent, despite earlier expectations of a rate cut prior to the escalation in Middle East tensions.

The proposed increase in the petroleum levy -- from Rs60 to Rs100 per litre -- would become politically difficult to implement. Even without this hike, a combination of rising global oil prices and a weakening rupee could see petrol and diesel prices climb to Rs310-330 per litre. With the full levy increase, prices could exceed Rs350 per litre, potentially triggering public backlash and protests, particularly from the transport sector. This would likely fuel an inflationary spiral, as elevated fuel prices ripple through the broader economy.

The government may be compelled to phase in the petroleum levy or delay it altogether, depending on how the oil markets evolve in the coming weeks. Meanwhile, the proposed 2.5 per cent climate tax on electricity and other items -- an indirect and regressive measure -- would further raise utility costs. With energy prices already elevated, any additional pass-through resulting from oil and gas hikes would add to the burden, intensifying load-shedding and worsening the circular debt crisis. While the government may still move ahead with these plans, pressure from industry groups and political allies could lead to revisions or delays, particularly if international energy prices remain high.

An extended conflict would drive up prices of imported oil and LNG, pushing inflation back into double digits despite the current tight monetary stance. If fiscal measures like the petroleum levy are rolled back under political pressure, revenue shortfalls may force the government to borrow more or delay development spending. In such a scenario, the IMF may insist on alternative tax measures or expenditure cuts to ensure targets remain on track.

Even if the Israel-Iran conflict does not escalate into a full-scale war, another week of heightened tensions could have a substantial impact on commodity prices. Iran controls access to the Strait of Hormuz, through which nearly 20 per cent of global oil supply passes. This chokepoint introduces a “risk premium” into oil futures. Should tensions persist, prices could rise by $3-$10 per barrel depending on developments such as missile strikes, tanker seizures, or disruptions to shipping.

As a key OPEC+ member, any disruption to Iranian oil exports -- whether through conflict or renewed US sanctions -- would further tighten global supply. LNG shipments from Qatar may also be affected if vessels perceive heightened risks in the Gulf. Meanwhile, gold and silver typically benefit from increased demand during geopolitical uncertainty.

The conflict could also erode investor appetite for risk, leading to weaker prices for commodities like copper, aluminium and zinc, especially if global economic slowdown becomes a concern. However, short-term supply chain disruptions could produce price spikes in certain industrial materials.

Although Iran and Israel are not major exporters of food grains, any disruptions to shipping through the Red Sea or the Strait of Hormuz could increase freight costs globally, raising the prices of commodities such as grain, sugar, and edible oils. Countries like Pakistan, India and China may see volatility in prices of palm oil, wheat, and pulses, depending on changes in shipping routes and insurance premiums. Industrial raw materials -- including petrochemicals and fertilisers -- would also face upward pressure due to higher input costs.