(Yicai) April 7 -- The conflict in the Middle East has caused significant disruptions to global financial and energy markets, but has had relatively limited impact on China so far. However, the risk of a significant increase in energy prices remains high with the prolonged duration and expanded scope of the war, which will test the resilience of global economic growth, and external risks may have negative effects on the Chinese economy.

Impact of Middle East Conflict on Global Financial Markets

Stock markets worldwide are generally under pressure and showing significant differentiation. The MSCI Emerging Markets Index fell 8.4 percent from March 2 to April 3, while the MSCI Developed Markets Index dropped 4.7 percent. The performance of the Chinese mainland stock market has been relatively stable, with the Shanghai Stock Exchange Composite Index falling 6.8 percent.

Treasury bond yields in major economies generally rose. The United Kingdom 10-year treasury bond yield surged 54 basis points in the period, the United States 10-year treasury bond yield jumped 34 bps, the German and Japanese 10-year treasury bond yields rose 34 bps and 27 bps, respectively, and the China 10-year treasury bond yield climbed 4 bps, fluctuating at a low level.

The US dollar index rose 2.6 percent to 100.2 from March 2 to April 3, while the Swiss franc, euro, Japanese yen, and British pound softened 3.9 percent, 2.5 percent, 2.2 percent, and 2.1 percent, respectively, against the greenback. The central parity rate of the Chinese yuan appreciated 0.4 percent.

The relative resilience of China's financial market is mainly thanks to the asymmetric impact of the tense situation in the Middle East. The proportion of oil and gas in the country's energy consumption is relatively low, with its dependence on overall imports and imports from the region also being relatively low.

In 2024, oil and gas accounted for 27 percent of China's energy consumption, with the proportion of relevant overall imports and such imports from the Middle East to its gross domestic product standing at 2.1 percent and 0.8 percent, respectively. The proportion of oil and gas imports from the Middle East to the GDP of South Korea was 4.1 percent, to South Africa was 2 percent, to India was 2.1 percent, and to Japan was 1.7 percent.

Risk of Surge in Energy Prices Remains High

There is significant uncertainty regarding the duration and scope of the US-Israel-Iran conflict. According to the predictions of Goldman Sachs and UBS Securities, three scenarios have been generally set for the trend of Brent crude oil prices based on the possible evolution paths of the war: benchmark, unfavorable, and extreme. Prices will grow significantly from the average of USD69 per barrel last year in all scenarios.

Goldman Sachs predicted that oil prices will reach USD150 to USD160 per barrel in the extreme scenario of ongoing transportation disruptions, the conflict in the Middle East remaining unsolved by the end of the third quarter, and the risk of further damage to major oil and gas infrastructure, with the annual price at around USD130 per barrel.

Given the mutual destruction of energy infrastructure during the conflict, the recovery of oil production capacity in the Middle East is slow, so high oil prices may not quickly fall as the conflict subsides, Goldman Sachs said.

The power of this round of supply interruption is equal to the sum of the two oil crises in the 1970s and the natural gas crisis caused by the Russia-Ukraine conflict in 2022, noted Fatih Birol, executive director of the International Energy Agency.

Rising Energy Prices Test Global Economic Resilience

The threat of inflation has led to a decline in expectations of monetary easing. The market's focus on the Federal Reserve is no longer on "when to cut interest rates," but on "whether to cut interest rates." In addition, the debate on the European Central Bank and the Bank of England has shifted from focusing on "whether to raise interest rates" to examining "the speed of interest rate hikes," while the focus on the Bank of Japan continues to be on "when to restart interest rate hikes."

The global economic outlook is facing downside risks. The Organization for Economic Cooperation and Development released its first economic outlook report since the outbreak of the Middle East conflict on March 26. Based on the assumption that the turbulence in the energy market will gradually ease and the prices of oil, natural gas, and fertilizers will decline from the middle of this year, the global economic growth will likely slow to 2.9 percent this year from 3.3 percent last year, it noted.

Remain on guard for risks in the stock and private credit markets. Before the outbreak of the conflict, there was a dispute over whether the artificial intelligence bubble was about to burst. AI development has a significant demand for energy consumption.

Long-term disruptions in energy supply and growth, lower than expected returns on investment in AI, or increasing losses in private capital markets may trigger broader risk repricing in financial markets, which could have an adverse impact on private demand, the OECD noted.

The share of US AI firms in stock and corporate bond issuances has continued to grow, with these companies and related industries increasingly seeking financing in the less transparent private debt and equity markets, which may lead to highly correlated defaults in multiple credit products.

Several large private equity credit funds have experienced redemptions and net outflows of funds, indicating potential liquidity pressures, which may be transmitted to banks by increasing the utilization rate of credit lines, causing concerns about financial stability.

Negative Spillover Effects of External Risks

The conflict might affect the stability of China's overseas market demand environment. In the benchmark scenario without considering energy price shocks, the global commodity trade growth rate will drop to 1.9 percent this year from 4.6 percent last year, according to a report by the World Trade Organization released on March 19.

If oil and gas prices continue to remain high this year, the predicted trade growth rate will be lowered to 1.4 percent, the WTO noted, adding that under the scenario of sustained high energy prices, the import growth rates of Europe and Asia will decrease to 0.3 percent and 2.6 percent from 2.1 percent and 6 percent.

Some institutions refer to the experience during the Covid-19 pandemic and note that supply chain restructuring may prompt orders to shift to China under the impact of high oil prices. But unlike that period, the high oil price shock caused by the Middle East crisis has a global impact, and China may find it difficult to remain immune.

It is expected that the transfer of orders will have a limited boosting effect on China's exports, and its export share may continue to fluctuate in the range since the Covid-19 outbreak.

The uncertainty in China's reflation. The heightened tensions in the Middle East have led to prolonged high oil prices beyond market expectations, which could increase imported inflationary pressures and accelerate the rebound in China's price levels.

Rising oil prices will gradually be transmitted to the producer price index and hasten the return of the PPI growth to positive territory. However, the correlation between the crude oil price growth and China's consumer price index growth remains unstable, primarily due to the country's weak effective demand and intense competition in midstream and downstream markets, which makes it difficult for companies to smoothly pass on rising upstream costs, squeezing profit margins and potentially dampening production and investment willingness.

If high oil prices suppress overseas demand while domestic demand remains insufficient, it may exacerbate the imbalance between strong supply and weak demand, further hindering China's price recovery.

The willingness of the foreign direct investment may also be affected. Overseas market demand plays a significant role in China's economic growth, contributing 33 percent to its GDP growth last year.

Should the Middle East conflict drive up oil prices and subsequently weaken overseas market demand, it could further drag on China's economic growth, intensify operational challenges for businesses, and impact foreign capital allocation in the country.

Stay alert for the contagion effect of the financial market. A prolonged and expanded Middle East crisis might force major global central banks to pivot monetary policies, tightening global financial conditions and heightening stability concerns.

A US private credit crisis, an AI bubble burst, and possible yen carry-trade liquidation triggered by accelerated Japanese monetary normalization will likely spill over into China's financial markets through cross-border capital flows and sentiment channels.

(The author of this article is Guan Tao, chief global economist at BOC International China.)

Editor: Martin Kadiev