The Israel and Gaza war: Economic repercussions

The tragic loss of life and the risks to peace in Israel, Gaza, and the rest of the region clearly are foremost on people’s minds. We provide here a brief discussion of the possible economic repercussions, bearing in mind the extreme uncertainty characterizing the situation. The repercussions of the crisis are dependent on the extent and duration of the fighting, associated geopolitical tensions, and the possible occurrence of terrorist attacks. While the overall reaction of financial markets has been relatively muted so far, the risks of an intensification and broadening of the conflict are material, and their potential fallout could be severe, especially for countries in the region.

Energy markets

From a global economic perspective, energy is the most important short-run issue. Oil prices were already elevated at the time of the attack on Israel, and these developments raise the probability of supply disruptions (particularly if the crisis involves Iran or if unrest takes a toll on production in Iraq) and market nervousness more generally. Oil prices have risen by about $5 a barrel since the start of the conflict, even though oil production does not seem to have been affected. Oil supply shocks would take a toll on economic activity in energy-importing countries and on the global economy more generally, with IMF estimates suggesting that a 10% increase in oil prices could weigh down global growth by 0.15 percentage point.¹ A number of oil importers in the emerging and developing world, such as Pakistan, already face a challenging economic outlook. Disruptions to gas supplies are also possible (there were some production stoppages in Israel’s Tamar field), and we have seen upward pressure on European gas prices. Increased tensions in the Middle East could also reverberate to the supply of European gas from countries in the region.

In addition to the negative impact of energy price shocks on economic activity, rising energy prices would further complicate the task of central banks around the world trying to bring inflation back to target. IMF estimates suggest that a 10% increase in global oil prices could increase inflation globally by 0.4 percentage point.

Global risk aversion

Rising geopolitical tensions generally take a toll on global risk sentiment, widening spreads and putting further upward pressure on the dollar. The ensuing tightening in global financial conditions can have severe repercussions for economies with external vulnerabilities. Among those, there are several emerging markets and developing economies that were already facing external debt problems and loss of confidence by international investors. In addition to the impact through financial markets, rising tensions and the possibility of acts of terrorism beyond the region have the potential to take a toll on confidence more generally, and hence on aggregate demand.

Over the past two weeks, financial market reactions have been muted, with a very modest decline in global stock prices and a small widening of spreads. U.S. long-term interest rates, which normally decline on rising risk-off sentiment, have actually risen, possibly reflecting concerns that higher energy prices will raise inflationary pressures, thus leading to tighter monetary policy. But the risk remains that an intensification and widening of the conflict would trigger a more pessimistic financial market reaction.

Regional outlook

The Israeli economy starts in a strong position and has shown remarkable resilience to periods of strife and outright war in the past. The economy has grown at a fast rate since the global financial crisis of 2008-09 (4.2% on average, and 2.2% in per capita terms), and its GDP exceeded $500 billion in 2022 ($54,000 in per capita terms). The country has a net external creditor position exceeding 30% of GDP, and foreign exchange reserves exceeding $200 billion. This notwithstanding, the country is clearly affected through multiple channels, including the impact of military mobilization on labor supply, reduced tourism, and the impact of increased security concerns on public spending needs, investment, and capital flows. The shekel, which had weakened in the months prior to the attacks on concerns related to the Supreme Court controversy, has depreciated by about 5% in nominal effective terms since early October, and the Bank of Israel has taken measures to stabilize financial markets, including through the announcement of a program to sell up to 30 billion USD in foreign exchange reserves.

Other countries in the region start in a weaker situation. Lebanon is still mired in a financial crisis of extreme severity, with a GDP decline exceeding 50% since 2018. Jordan has high external debt (its net external liabilities exceed 110% of GDP) and persistent regional strife could take a severe toll on domestic stability and tourism, which is an important source of foreign exchange. Egypt is similarly dependent on tourism flows for hard currency receipts, and is facing a difficult macroeconomic outlook, with wide spreads on its external debt and pressures on its heavily managed exchange rate. The economic situation in Gaza, which was very difficult to start with, is dramatic, with large short-run needs of emergency aid and daunting prospects for reconstruction and future economic activity more generally. And of course, the fading of prospects for a more durable normalization of relations with Israel and lower regional tensions is bad news for a broader set of countries in the Middle East and beyond.