Conflict, stagflation, SDR allocation, and counter-cyclical policy

While conflict in Iran is raging, and sending shockwaves to security situation in the region, oil shock, among other negative consequences produced for trade and gas supply will likely be a nightmare for net-oil importing developing countries like Pakistan in particular, already under high debt distress, and facing serious balance of payments crisis as a result of twice being inundated severely by climate change-induced floods in 2022, and then last year, and previously because of global supply shock during the pandemic causing severe imported inflation.

The situation is also likely to get difficult for developed countries. A March 4, Bloomberg article ‘Iran war oil shock threatens to unleash wave of global inflation’ pointed out that ‘…a 1 percent drop in supply pushes prices up by about 4 percent. That suggests a prolonged closure of the Strait [of Hormuz] would raise prices by 80% from pre-war levels – taking them to around $108 a barrel. In a severe scenario, Bloomberg Economics assumes prices would stay that high into the fourth quarter of the year. …Sharply higher oil prices impact the economy through multiple channels. They add to costs for consumers and businesses, reducing spending power and taking a chunk out of growth. They also add to inflation, pushing up prices for transport, and anything with petrochemicals as an input. For central banks, what matters is the size of the impact and – crucially – whether inflation expectations stay anchored or not. If they do, that could allow Fed Chair Jerome Powell, ECB President Christine Lagarde and their peers to look through the transitory impact on inflation and focus on the risks to growth – with potential to cut rates. If they don’t, concern about workers demanding higher wages, businesses raising prices – and the result an inflationary spiral – may force them to hike.’

Higher interest rate will once again put developing countries like Pakistan facing higher debt repayments, and would likely add to imported inflation, and pressure on twin deficits. Here, while higher oil import payments will negatively impact the current account, fiscal deficit may also face widening pressure from rising need to provide fuel-related subsidy, given austerity policies over the years have already pushed close to 45 percent of the population below poverty line.

Moreover, the article highlighted scenarios for inflation, and GDP in the US, Euro Area, and the UK in response to the extent of oil shock. Against oil price at USD 80 per barrel, inflation is likely to rise by 0.3 percent in the US and by 0.5 percent for Euro Area, and the UK, respectively. Economic growth, at this price level of oil, will not likely to produce any impact in the US, while it is likely to decrease by 0.3 percent in both Euro Area, and the UK, respectively. At oil price at USD 108 per barrel, ‘Bloomberg Economics’ in the same article expected inflation to increase by 0.8 percent in the US, and by 1.1 percent, respectively, in Euro Area, and the UK, while growth is likely to decrease by 0.1 percent in the US, 0.6 percent in Euro Area, and by 0.5 percent in the UK.

This will likely have repercussions for trade, and imported inflation for Pakistan since the country is a major trader with the US, Euro Area, and the UK, both in terms of exports and imports. Moreover, reduction in growth, and increase in these areas will also likely negatively impact workers’ remittances to Pakistan, as a large portion of remittances comes from there, in addition to the Middle East, which anyways is likely to have even higher negative consequences – since conflict in Iran has reportedly already spiralled to many countries in the Middle East region – in terms of both inflation and growth, producing similar negative consequences for Pakistan.

A March 3, New York Times (NYT) article ‘Global economy is facing the prospect of another profound shock’ pointed out with regard to a fast-intensifying conflict situation in Iran, and how it might impact global economy as ‘Any event that extends the conflict or threatens sources of oil and gas is likely to lift energy prices to levels that would sow inflation. That could prompt central banks worldwide to raise interest rates, pushing up the costs of mortgages, car loans and other borrowing. And that would choke off consumer spending and business investment – a classic pathway to a downturn. …At the center of concern for the moment is the fate of energy produced in the Middle East, source of 30 percent of the world’s oil and 17 percent of its natural gas. Any disruption to that flow would almost certainly trigger trouble in the world’s largest importing nations — major economies in East Asia and Europe.’

Overall, there is a serious case rising for stagflation – low level of economic growth, and high inflation rate – especially for developing countries in particular; those that are net-oil importers like Pakistan. So, on one hand there is a high risk of inflation rising in both developed and developing countries since oil prices affect everyone although in varying degrees given deeper level of green economies in developed countries in general, but on the other hand serious balance of payments (BOP) crisis is also likely due to quick, and deep capital flight that happens from developing to safer environments of developed countries, accentuated by high debt repayment needs likely generated as a result of rise in policy rate to deal with inflation.

Pakistan, being in an International Monetary Fund’s (IMF’s) extended fund facility (EFF) programme to deal with macroeconomic imbalances, and in which regard it has only reached some semblance of macroeconomic stability, and after paying a lot of economic growth sacrifice, could only ill-afford another bout of shock. Moreover, such a shock will likely also dampen otherwise much-needed green investment needed to create resilience in the economy against climate shocks, given the country is among the top-ten climate change vulnerable countries. This will likely diminish the impact of another IMF programme in the shape of resilience and sustainability facility (RSF) that the country is implementing for some time now.

Here, it also needs to be pointed out that funding through the RSF programme is re-routed money that fell into the lap of already rich, advanced countries given the lack of needed imagination needed while allocating special drawing rights (SDRs) by IMF during the pandemic in August 2021, where it employed the usual quoting-sharing formula, rather than making the allocation needs-based. While such mistake should not be repeated, another allocation of SDRs by IMF needs to be made at the earliest, and in fact is long due, given the lackluster provision, for instance by Pakistan at around USD 2.7billion back in August 2021 was only peanuts for the country under serious debt distress.

This perhaps became a reason for the country to approach IMF for a Stand-By Arrangement (SBA), and later on EFF programme n(ongoing), both of which had procyclical, austerity-based conditionalities, which have likely exacerbated the poverty, and income-inequality situation – as recently released figures by country’s planning ministry indicated – a situation, which could have been avoided had the IMF provided meaningful level of SDR allocation, and also worked significantly towards fixing serious shortcomings in the global sovereign debt architecture. In turn, this could have likely allowed the country to take the counter-cyclical approach, which is not to say that the lack of ‘ambition’ of country’s own domestic economic policy also meaningfully contributed in country taking on such a prolonged austerity path.

Hence, it is important that the impact of the current serious oil shock that is fast-unfolding – where FT indicated on March 3 the following: ‘Brent crude rose above $85 a barrel’ – and the inflationary shock that will likely follow, should be made less painful by IMF issuing a meaningful amount of SDRs to developing countries, especially those that are highly oil import dependent, and are also significantly climate change vulnerable, like Pakistan. This is indeed important given the country cannot afford another episode of pro-cyclical policy as inflation rises, and the central bank once again make the mistake of going over-board by implementing monetary, and fiscal austerity policies. Medium-term economic growth is already averaging around the population growth rate, and poverty, and income inequality levels have been rising, along with country being in significant debt distress, both of which require not over-emphasizing contractionary monetary policy, and deep fiscal consolidation.

In addition to oil prices, Pakistan is likely going to face gas price hike. A March 3, Financial Times (FT) article ‘In charts: how serious is the Middle East gas price shock’ pointed out in this regard, ‘Gas prices in Asia and Europe have surged as the conflict in the Middle East spreads, with shipping through the Strait of Hormuz at a virtual standstill and Qatar’s liquefied natural gas output halted after Iranian strikes on its flagship Ras Laffan production facility. …In sheer volume, this shock could be worse than in 2022. The 80bn cubic metres in annual supply lost from Russia compares to roughly 120 billion cubic metres that could be lost from the Middle East due to the effective closure of the Strait of Hormuz and shutdown of two Israeli gasfields. …Pakistan received 99 per cent of its LNG imports from Qatar and the UAE in 2025…’

Moreover, on the bright side, as per the article, the impact at the moment is far less as compared to the heights reached in 2022, but cautioned this could change in case the conflict gets prolonged. Nonetheless the pace of increase in gas prices is significant. The article pointed out in this regard ‘However, it all depends on how long the disruption lasts. A prolonged conflict could have a “comparable effect” to the Ukraine war, according to Natasha Fielding at Argus Media, but “if this is a temporary, week-long disruption then there would be no comparison to the watershed moment of 2022”. …While gas prices are up almost 80 per cent in Europe since Friday, the surge to about €57 per MWh is modest compared with 2022, when they reached €343/MWh.’

Both domestic policy, and IMF programme conditionalities need to be more mindful of this recent economic history, not to mention the misgivings of neoliberal, and austerity policies in terms of reaching sustainable macroeconomic stability, and economic growth already quite evident for a number of years now; and the country needs to take the direction of counter-cyclical policy even in the wake of inflation causing oil shock. For this, as indicated meaningful level of enhanced SDR allocation needs to be made by IMF, along with creative management of price, and imports through putting in place price, and import controls.

Hence, following China’s successful implementation, ‘dual-track’ pricing mechanism is adopted to control prices of essential commodities for consumption, and production, while non-essential imports are controlled, so that foreign exchange is used rationally to make important imports for consumption, and production, especially exports, and in deepening the basis for import-substituting industry. Moreover, the IMF should take a lead in improving global sovereign debt restructuring mechanism so that foreign exchange usage, and built-up could be managed better.

Controlling imports is also important to better manage exchange rate since higher inflationary expectations may feed into buildup of higher returns on bonds, increasing burden on foreign exchange reserves in terms of interest payments. More than that, the country owes large foreign exchange repayments over the medium-term, and any spikes in inflation, and likely increases in interest rate by Federal Reserve, and other banks will only enhance debt repayment burden.

A March 4, NYT article ‘Energy price fears ripple through global markets’ pointed out in this regard, ‘Global market volatility continued for a third day on Wednesday, as concerns grew over the rise of energy costs stemming from the war in Iran. …Analysts at Goldman Sachs estimated that oil shipped via the strait was running at about 15 percent of normal. The effects have already begun to feed through to products like gasoline, with consumers facing sharply higher prices at the pump. …The energy price surge has caused investors to begin raising inflation expectations, while dialing down expectations for central bank interest rate cuts. Anxiety about inflation is especially acute in Asia and Europe because of their dependencies on energy imports. The risks look like a “textbook supplyside shock,” which could bring higher inflation, tighter financial conditions, weaker real incomes and lower growth, according to a note by Daleep Singh, the chief global economist at PGIM Fixed Income. The 10-year U.S. Treasury yield continued to climb, approaching 4.1 percent.’

Noted economist, Mohamed El-Erian talking to CNBC media outlet on March 2, pointed out with regard to possibility of conflict generating stagflationary pressures, and other challenges facing global economy, as ‘So I think in terms of economics, a lot will depend on the duration and spread of the conflict. The longer it last, the more it spreads, the more stagflationary it is for the global economy. ….keep an eye on the duration of the conflict, because that is going to both fuel inflation, disrupt supply chains, and undermine growth at a time when policy flexibility is limited…’

For Pakistan, the conflict comes, therefore, at a very crucial time, with deep growth sacrifice paid over a number of years for some semblance of stability, but with limited economic institutional – governance, and incentive structure reforms, including that of improving the capacity of public service – poses a strong challenge to the country in terms of now consolidating growth, mainly to deal with fast rising poverty, and income inequality levels. This leaves the country in need of strong internalization of the serious misgiving of application of over-board austerity policies, and adopting a more balanced approach, striking a healthy balance with reducing aggregate demand, and boosting aggregate supply, especially in terms of building resilience, given the climate change related severe disaster shocks the economy is facing more often than not in recent years.

Copyright Business Recorder, 2026