Research
Eurozone: Economic repercussions of a Middle East war
An escalation of the Israel-Hamas war to a broad regional conflict could have a serious impact on the European economy. Escalation could not only result in skyrocketing energy prices, but also push up food prices and interest rates.
Summary
Escalation risk
The Israel-Hamas war is a major humanitarian disaster. The war has not yet escalated to a broader regional conflict, but the risk of escalation remains. An escalation could have substantial economic ramifications for Europe.
Shortly after the outbreak of the Israel-Hamas war, we argued that there is a significant risk of an escalation that would involve an increasing number of parties. Since then, Israel has started ground operations in Gaza. Other militia and rebel groups in the region, such as Hezbollah in Lebanon and the Houthi movement in Yemen, have also increased their military activity, though this has not required an increase in action by either Israel or the US. That said, the US has brought considerable armament to the region. Hezbollah leader Hassan Nasrallah recently alleviated immediate concerns that Hamas would significantly scale up its operations. However, this does not mean that medium-term risks have receded.
A spreading of the war to the broader region could have major implications for fiscal, monetary, and industrial policy, and for markets. The severity will depend on the scale of the conflict. It would mean volatile and higher commodity prices, higher inflation, higher interest rates, lower asset markets, and a weaker euro.
In this publication, we describe the economic impact of two escalation scenarios for the eurozone, using the National Institute Global Econometric Model (NiGEM). Though the results of this macroeconomic global trade model are certainly insightful, they by no means include the impact of all the moving parts an escalation would set in motion. In a follow-up publication we will dive into Europe’s structural weaknesses that make it ill-prepared to deal with a widespread war in the Middle East. In fact, Europe is ill-prepared to deal with all kinds of major geopolitical shifts and supply disruptions in future. Besides outlining these weaknesses, we will consider solutions in that forthcoming article.
Three scenarios
As developments in the war are highly uncertain, we have drawn several scenarios for how the war could escalate. We have analyzed and calculated the channels through which the eurozone economy would be impacted in each scenario.
In short, in our baseline scenario, we assume that the war will remain mostly contained to Israel and Hamas, with incidental attacks between Israel and Hezbollah and Israel and Yemenite Houthis. In our soft escalation scenario, Hezbollah significantly ups its attacks, the US gets more actively involved, and Egypt is dragged into the conflict. In our hard escalation scenario, the war expands to the broader region, actively involving Iran and Saudi Arabia as well. Please see the box below for a more detailed description of the two escalation scenarios.
Two escalation scenarios
Soft escalation scenario
In the soft escalation scenario, Hezbollah increases the number of attacks, and Syria, Jordan, and Egypt become actively involved. We assume that the latter will make it too dangerous or impossible for shipping companies to navigate through the Suez Canal. We also factor in that the oil flow through the SUMED pipeline next to the canal is interrupted. Consequently, cargos will need to reroute around the Cape of Good Hope, which takes some two weeks longer and would drive up freight costs. With about 15% of world trade, 4.5% of crude oil, 9% of refined products, and 8% of liquefied natural gas (LNG) tankers running through the Suez Canal, it is a crucial passage. Moreover, the SUMED pipeline transports about 80% of oil going from the Middle East to Europe.
Hard escalation scenario
In the hard escalation scenario, the war evolves into a widespread regional conflict, dragging in Iran and (its rival) Saudi Arabia. If Iran gets actively involved, the US will likely strengthen enforcement of international sanctions on oil exports from Iran, triggering retaliation by Iran through harassment and/or trying to stop oil and LNG cargos shipping through the Strait of Hormuz. Iran could also choose to target the Saudi oil infrastructure with drones or get involved through its proxies in Yemen. Saudi Arabia has already intercepted a missile fired by Iran-backed Houthi fighters in Yemen. When under attack by Iranian drones, Saudi Arabia is unlikely to stand idly by.
To put things into perspective, consider that about 3% of global oil is produced in Iran – half of which goes to China. On top of that, about 17% of global oil flows through the Strait of Hormuz, as well as LNG from Qatar (home to over a quarter of global LNG production).
“First order” economic impact of an escalation
Before moving on to the economic implications of both escalation scenarios, it is important to keep in mind that, from several perspectives, the cyclical starting point for the economy is worse than at the time of the 2021-2022 Russian gas crisis (see the box at the end of this publication). Dwindling pandemic buffers, structural government deficits, a drop in corporate margins, as well as higher inflation, mean that a new energy shock could pull the economy into a deeper recession with possibly more damage to the labor market and demand.
That being said, higher deficits and interest costs are unlikely to prevent governments from lending a hand if a new energy price shock hits. Indeed, if anything, recent policy announcements show that governments are set to continue to support both firms and households to cope with the shock of the permanently higher energy prices and the higher cost of living well into next year and even beyond. Though some measures introduced during the energy crisis are being withdrawn, others are being extended and even new ones are being introduced – such as the energy subsidies for German industry.
Baseline scenario
Israel exploits two natural gas fields, from which a part of the country’s natural gas is exported to the Mediterranean through Egypt. Israel has temporarily shut down one of its fields (Tamar), but is restarting operations. Given that Israel produces only 0.5% of global natural gas, this has had just a minor impact on global energy prices.
Apart from gas, the war could also have an impact on the global potash and phosphate fertilizer trade. Accounting for 6% to 8% of global exports, Israel is an important player in these markets. The war could lead to a marginal increase in energy and fertilizer prices, impacting farmers around the globe. At the same time, lower import demand from Israel for grains and oilseeds may lead to lower global market prices for these products. All in all, we have seen only limited impact on global commodity prices and financial markets. In our baseline scenario, we do not expect this to change.
Soft escalation scenario
Commodity prices
As a result of a blockade of the Suez Canal, Brent oil would go up to USD 100 per barrel and the TTF gas price would rise to EUR 80 per megawatt hour (MWh) in summer and EUR 100 per MWh in winter (see figures 1 and 2). Furthermore, in the short term, the global food price index would rise by 3% to 5%, before reversing in the medium term. Given the difficulty of quantifying the impact of supply chain disruptions and higher freight costs on goods (other than food and energy commodities), the results below should be seen as a conservative estimate.
Financial markets
During a press conference on October 26, European Central Bank President Christine Lagarde did not explicitly outline the ECB’s reaction in case of another energy price shock, but suggested it would look at both inflation and economic impact, as we are facing “a completely different economy today.” Still, interest rates will increase somewhat in the soft escalation scenario. We project that risk premia will rise similarly to developments seen just prior to the Second Gulf War in 2002, with an extra rate hike by the ECB to stem upward inflation pressure. This means that the policy rate will be some 25 basis points higher in 2024 than it would be in the baseline scenario. Finally, we project the euro to depreciate by up to 5% against the US dollar by 2025.
Result
As a result, in the soft escalation scenario, we project eurozone inflation to be some 0.6% and 0.2% higher in 2024 and 2025, respectively, than in our baseline scenario (see table 1). Weaker purchasing power, higher interest rates, and somewhat higher uncertainty lower demand. The blow to GDP should be slightly softened, however, by the decrease in imports due to the terms of trade shock. Overall, economic growth would be slightly lower in both 2024 and 2025. This would essentially lengthen the stagflation outlook – with high inflation and low growth, yet low unemployment – with growth coming in at just 0.4% in 2024 and 1.2% in 2025.Figure 1: TTF gas price scenarios
Figure 2: Oil price scenarios
Hard escalation scenario
Energy prices
If Iran, and by default Saudi Arabia, get actively involved, the oil price will rapidly increase and temporarily reach over USD 150 per barrel. The gas price would shoot up to EUR 120 per MWh in the short term and to EUR 135 per MWh in the winter of 2024. Gas price developments do naturally also depend on the winter of 2023/2024 and on the state in which European gas stocks will emerge from this winter.
Food prices
Shipment of wheat and fertilizers will also be significantly hampered, given that the Middle East and North Africa are important players in these markets. Furthermore, the major increase in energy prices will inform food prices. We assume the global food price index will increase by 10% in the short term, which will then be reversed in the medium term.
Financial markets
Interest rates will rise much more than in the soft escalation scenario, as risk premia will double and central banks will hike more. We project three hikes of 25 basis points by the ECB in 2024. Finally, we project the euro to depreciate against the US dollar by up to 25% by 2025.
Government spending
Especially in the hard escalation scenario, we are likely to see an increase in pressure from both within European borders and the US for Europe to increase military spending. Indeed, the US would have to devote time and means to the Middle East war, requiring Europe to take care of itself more when it comes to defense. The call for financial public support will likely be more significant than in the soft escalation scenario and second round effects are also expected to be greater. Demand is likely to suffer more, but given the higher input price increase, firms are still expected to raise consumer prices more to make ends meet than in the soft escalation scenario. Moreover, energy-intensive production in Europe will be scaled back and this lowered production will mean higher prices and/or higher transportation costs to obtain products from elsewhere.
Result
In the hard escalation scenario, we project inflation in the eurozone to rise a lot more than in the soft escalation scenario. It is estimated to reach 5.5% in 2024 and 3.5% in 2025. This is some 2.3% and 1%, higher, respectively, than in our baseline scenario. Weaker purchasing power, higher interest rates, higher uncertainty, and lower production would have a large impact on demand. While a major fall in imports due to the terms of trade shock would support the headline GDP figure, the eurozone economy would suffer substantially. Economic growth would be some 0.7% and 0.9% lower in 2024 and 2025, respectively, resulting in a GDP contraction of 0.1% in 2024 and growth of just 0.5% in 2025.
Table 1: Scenario analysis of key economic variables
A weak(er) starting point
When the previous energy price shock (largely the result of a cut in the Russian gas supply) hit the eurozone back in 2021 and 2022, its economy was still recovering from the pandemic and there were several “favorable” conditions. First, several economies continued to “benefit” significantly from post-Covid pent-up demand, backlogs, and the need to replenish inventories. Second, pandemic savings acted as a buffer during the height of the energy crisis. Third, governments took measures in 2022 and early 2023 to alleviate the impact of energy prices on households and businesses.
This time around, these conditions no longer apply. Inventories have been rebuilt, backlogs have declined, and global demand has cooled. Pandemic savings have been largely eroded by the bout of inflation that followed, and government support measures have now been partially unwound. Moreover, the EU budget rules have been suspended since 2020 but are slated to be reactivated, albeit in an adjusted form, as of 2024.
Meanwhile, economic activity has gradually slowed down over the course of this year, with GDP declining by 0.1% QOQ in the third quarter. Going by the recent short-term indicators, we expect GDP to decline in Q4 as well. This would already technically make 2H a recession (see figure 3). Higher interest rates and uncertainty will continue to weigh on growth and may also affect investment spending, even without an escalation of the war. Forward-looking indicators, such as the purchasing managers indices, indicate that European manufacturing firms cut employment in September 2023, the first cut in personnel since the early 2021 lockdowns.
In a recent article we argued that any recession is likely to be mild as long as the labor market remains tight, as firms will hoard labor to avoid future hiring costs.
However, in the event of a significant escalation of war in the Middle East, firms may no longer feel comfortable doing so. In such a scenario, we could see a more significant impact on unemployment, and hence consumption, especially considering that consumers can no longer rely on an abundance of pandemic savings and businesses are now in a weaker position to handle a new energy price shock. So far, consumer confidence has been mainly bogged down by concerns over inflation rather than “jobs”, but if another inflationary shock hits and unemployment is added to those concerns, consumer confidence could plummet to historical lows (see figure 4).
Figure 3: Even without escalation of the war, the economy is now in a mild recession scenario
Figure 4: Even with record-low unemployment, consumer confidence hit cyclical lows in 2022
Conclusion
Using a macroeconomic global trade model, we have simulated the economic impact of two escalation scenarios. In short, in the soft escalation scenario, Europe’s open economy is mainly impacted by elevated energy prices and somewhat higher interest rates. In the hard escalation scenario, energy prices will rise even more, and food prices and interest rates will also rise significantly. In the soft escalation scenario, we see a prolonged period of weak growth. In the hard escalation scenario, growth will actually turn negative for the year 2024 and barely recover in the following year.
The outcome of this model offers insight into the economic impact of different scenarios in the short term. That being said, these models also very much depend on the assumptions you feed into them. They are by no means perfectly accurate projections of the impact of an inherently complex set of events. Indeed, apart from the fact that the war need not precisely follow either one of our scenarios, Europe has to cope with various strategic weaknesses that could amplify the ramifications of an escalation. These weaknesses are difficult to account for in the model.
In a follow-up publication, we will discuss how and why 1) relatively weak military capabilities to defend or project power, 2) a high dependence on non-EU countries and lack of strategic raw materials, 3) a rising risk of social and political instability, and 4) high government debt and the latent risk of fragmentation, could amplify any fallout from a deterioration in the global security order. Besides outlining these weaknesses, we will also contemplate where we will have to look for “solutions” for this increasingly complex problem.