Global risks persist despite markets' optimism after the Iran conflict

Risks to the global economy persist, and it is far too early to celebrate finger on the pulse

Two months ago, this column wondered who was right about the Iran conflict, the market or the experts. 

The experts saw the conflict stretching out and oil prices rising to $120 per barrel or more. The price of oil in the markets stayed below $100 per barrel for the most part, indicating that the conflict would not last more than six weeks. The markets have been proved right, the experts wrong. 

The markets were right then. But were they right in pricing Brent crude oil futures at as low as $72 per barrel right up to December until two days ago? Had the ceasefire and the resumption of oil flows through the Strait of Hormuz indeed ushered in a period of plentiful oil? Can we see the inflation rate trending down and central banks cutting interest rates? There is exuberance in the markets — the S&P 500 has risen 9 per cent since the Iran conflict erupted on February 28. It is almost as if the Iran conflict never happened. 

The experts are divided at the moment. Some go with the market’s bearish view on oil prices (assuming there is no return to a full-scale war). Others see the price of oil in the coming months in the $80-$100 per barrel range. The bearish view is hard to comprehend. 

Oil prices were contained at below $100 per barrel because nations have drawn on their strategic reserves to offset the fall in output. Following the ceasefire, there has been a surge in oil supplies through the Strait of Hormuz.  Much of the surge represents oil already loaded on tankers and stuck in the Strait during the conflict. It is not the result of any additional output of oil in the region. Nevertheless, the oil market seems to price the surge in supply as though production in the region will soon return to normal levels. 

The Bank for International Settlements (BIS) provides a sobering corrective to the market’s exuberance. (Annual Report, 2026). It underlines several risks facing the world economy. The biggest risk is that oil prices stay elevated. 

The report says: “Physical damage to energy infrastructure means supply losses are likely to persist even after the end of the conflict…. Even without a blockade, global oil and gas supply could remain well below pre-conflict capacity for months or even years.” The BIS places the disruption to supply at 10 million barrels a day, or 13 per cent of normal supply. Such a disruption must be expected to “drive a persistent premium in oil and natural gas prices.” 

Even as supply is disrupted, nations will use the ceasefire period to shore up depleted reserves. United States Vice-President J D Vance captured the sentiment correctly, if somewhat tactlessly, when he said the pause in the conflict was meant to “refill the world’s oil economy”, “to refill some stocks”. How oil prices can trend downwards in such a situation is hard to comprehend. 

There are three other risks that the BIS report highlights. First, the inflationary impact of the damage that has already happened will be hard to shake off in the near future. Global inflation has already jumped by half a percentage point since the conflict started, with several commodities seeing double-digit price growth. The impact of these price increases on intermediate and final goods will be felt even after oil prices normalise. The BIS report remarks wryly, “The dichotomy between buoyant market sentiment and uncertainty about the conflict’s macroeconomic fallout is striking.” 

Secondly, the investment boom in artificial intelligence (AI) is beginning to bear a disquieting resemblance to financial manias of the past —  such as the canal mania of the 1830s, the British railway mania in the 1840s, the electrification exuberance of the late 1920s (roaring 20s), and the dotcom boom of the late 1990s. The top five AI firms are set to invest a trillion dollars from 2025 through 2026. There are signs that the AI build-up is already running into bottlenecks in electricity, semiconductors, and grid  equipment. If the payoffs to the massive investments do not materialise, the boom could turn into a bust. 

The AI boom is based on substantial borrowings. Equity valuations in AI-related firms are well above historical benchmarks. If a rise in inflation results in a hike in US interest rates or the AI-led boom turns into a bust, there will be huge corrections in both the debt and equity markets. Household exposure to equities in the US is much higher than in the past, so the macroeconomic impact of any equity correction will be significant. 

A third risk relates to sovereign debt. The biggest holders of government securities in advanced economies today are not banks, but non-banking financial institutions (NBFIs). Their share of sovereign debt rose from 44 per cent in 2021 to 53 per cent in 2025, with hedge funds emerging as important players.  Many NBFIs are highly leveraged and they use short-term repo financing. Any rise in the interest rate and a fall in the value of government securities will result in large mark-to-market losses, heavy selling and a steep rise in yields. 

A fair reading of the BIS report is that the worst-case scenario — of oil prices rising above $120 per barrel — has been avoided but that doesn’t mean the world economy is out of the woods. 

What does this bode for the Indian economy? The outlook on the current account deficit — projected at around 2 per cent of gross domestic product  — is unlikely to change much, going by the BIS report. What does change after the measures announced by the government and the Reserve Bank of India on June 5 is the position in respect of capital flows to finance the deficit. 

Consequent to the elimination of the long-term capital gains tax on government securities for foreign investors (FIIs) on June 5, FII inflows into debt securities leapt from $0.4 billion in May to $5.8 billion in June. However, the measures announced have been unable to stem equity outflows. Net equity outflows increased from $3.4 billion in May to $5.2 billion in June.  This is in keeping with the exodus of FII money from emerging markets in general. 

Banks report that the Foreign Currency Non-Resident (FCNR) deposit scheme has drawn around $7 billion in deposits in its very first month. The measures are widely expected to bring in capital flows of $50 billion. These expectations are not yet fully reflected in the value of the rupee. The rupee is currently trading at 95-96 to the US dollar, compared with its low of  96.3 in May and 95.4 on June 5. 

The RBI’s Financial Stability Report (June 2026) says the “balance of risks has shifted favourably” after the cessation of conflict in Iran. True. However, as the latest flare-up in West Asia underlines, it’s far too early to celebrate. 

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