Middle East Conflicts: Impacts on China's Prices and Policies
Author: YUAN Haixia and ZHANG Hanwen
Since late February 2026, the outbreak and continuous escalation of the US-Iran conflict have posed severe challenges to shipping security in the Strait of Hormuz, driving international crude oil prices significantly higher. As of early May, Brent crude oil prices rose over 50% from pre-conflict levels. The resulting imported inflation has, to some extent, driven a price recovery in China. However, given the context of insufficient effective demand domestically, the sustainability of this price recovery requires close monitoring, alongside vigilance against potential quasi-stagflation risks. Based on input-output table calculations, this paper finds that Chinese upstream and downstream industries exhibit a notably graded, diminishing reliance on crude oil, with over half of the national sectors showing double-digit dependency. Oil price volatility thus exerts a strong amplification effect on the national economy. Consequently, this paper focuses on the transmission mechanism of geopolitical conflicts to China's price system via the crude oil channel, analyzes the price, industry, and macroeconomic impacts under different shock scenarios, and proposes policy recommendations across three dimensions: short-term emergency management, demand-side stimulation, and medium-to-long-term structural reforms. This aims to provide policy references for guiding a stable price recovery and mitigating quasi-stagflation risks.
Transmission of Middle Eastern Geopolitical Shocks to China's Prices and Macroeconomy
The US-Israel-Iran conflict has persisted for over two months. Although the intense hostilities have temporarily eased, the war of attrition surrounding the blockade of the Strait of Hormuz continues, with its spillover effects increasingly apparent. On the one hand, military strikes on energy infrastructure have expanded to Gulf countries. While the strikes are temporarily suspended, the resulting supply gaps are difficult to fill in the short term. On the other hand, Japan, South Korea and other production-oriented economies in Southeast Asia see oil and gas dominate their energy mix, with low self-sufficiency and heavy reliance on imports from the Persian Gulf. A prolonged blockade beyond expectations could trigger severe shocks once their strategic oil reserves are depleted, and even disrupt the global economy and international trade. The imported inflation triggered by energy supply shortages has gradually spread across the price system, directly affecting China's price trajectory.
Imported Inflation: Q1 Price Recovery and Geopolitical Outlook
Since the beginning of the year, driven by imported inflation alongside robust AI-related demand and the post-holiday resumption of work, China's price levels have shown structural improvement. In March, the year-on-year (YoY) PPI turned positive for the first time in 41 months, and the April YoY growth further expanded to 2.8%. However, CPI YoY growth was only 1.2%, widening the PPI-CPI divergence. While China's deflationary pressures have seen a marginal easing, the economy remains fundamentally constrained by insufficient effective demand. With weak resident employment and income expectations, and weak investment returns persist, it is difficult for imported cost pressures to transmit smoothly to mid-to-downstream sectors and final consumption. Thus, the probability of triggering broad-based inflation remains low.
Looking ahead, following the inconclusive first round of negotiations held in Islamabad in April, market bets on the US and Iran reaching a peace agreement on Polymarket have gradually declined. As of May 12, the market's implied probability of reaching an agreement by the end of June was only 39%. Given that the deep-seated contradictions regarding core interests between the two sides are difficult to bridge in the short term, the most realistic outcome is likely an extension of the ceasefire through limited progress, and "fighting while negotiating" may become the norm.
This paper models three scenarios based on the evolution of the war and the resulting international oil price movements to calculate the impact of imported inflation on price levels. According to input-output table calculations—assuming upstream price increases can be fully passed on to downstream sectors, and ignoring transmission lags, financial market dynamics, and expectation effects (i.e., an ideal frictionless scenario)—a 10% increase in oil prices theoretically drives up PPI by a maximum of approximately 0.65 percentage points and CPI by 0.25 percentage points.
In the baseline scenario, if the conflict evolves into a "negotiated conflict" lasting more than two months, using the current USD 105/bbl as the price pivot during the stalemate phase, this represents an approximate 52.2% increase from the February average of USD 69/bbl. This would drive up PPI by about 3.4 percentage points and CPI by about 1.3 percentage points. Projected YoY PPI and CPI would rise to approximately 2.5%–2.6%, approaching China's price levels from August 2022.
In the baseline scenario, if the Middle Eastern conflicts evolve into a state of "fighting while negotiating" and last for more than two months, crude oil will take USD 95/bbl as the price pivot during the stalemate phase. This represents an increase of approximately 37.7% from the average price of USD 69/bbl in February. Driven by rising oil prices, the PPI and CPI will rise by 2.4 and 0.9 percentage points respectively. In addition, improved domestic market order, partial price increases driven by the booming AI industrial chain, and supply constraints on energy and mineral products will also provide support for domestic prices. However, restricted by weak domestic demand, the year-on-year growth of PPI and CPI may see a moderate decline after a phased upward trend. In the extreme scenario, if talks collapse entirely and the conflict escalates into an unavoidable ground war, oil prices could spike to USD 120/bbl or higher. This would drive up PPI by nearly 4%, outpacing a CPI level of about 3.1%. Under this scenario, extreme vigilance is required regarding quasi-stagflation risks triggered by imported inflation.
In the optimistic scenario, relevant coordinating parties may help the US and Iran reach a temporary agreement. With the gradual reopening of the Strait of Hormuz, crude oil prices are expected to fall back to around USD 80/bbl. Correspondingly, the PPI will be lifted by about 1 percentage point to 0.1% YoY, and the CPI will gain roughly 0.4 percentage points to 1.7% YoY.
In the extreme scenario, if the negotiations collapse entirely and the conflicts escalate comprehensively with a ground war becoming inevitable, crude oil prices may surge to USD 110/bbl or even higher. Under this scenario, the growth of PPI will approach 3%, outpacing the CPI growth of around 2.8%. Extreme vigilance is required regarding quasi-stagflation risks triggered by imported inflation.
Supply Chain Effects: Divergent Industry Impacts on Energy and Chemicals
According to calculations using the Leontief inverse matrix, approximately half of the industries in China's national industrial classification maintain a double-digit dependency ratio on crude oil (measured by the total consumption coefficient, the same applies hereinafter). Volatility in crude oil prices exerts a strong amplification effect on the national economy1.
Reliance on crude oil shows a gradient decline across China's upstream and downstream industries. Excluding crude oil extraction itself, the first-tier industries most sensitive to crude oil price movements are mainly energy and chemical industries, including the manufacture of chemical raw materials and products, processing of petroleum, coal and other fuels, manufacture of non-metallic mineral products, and manufacture of rubber and plastic products, as well as the transportation, warehousing and postal services sector directly affected by refined oil prices. All of these sectors have a crude oil dependency ratio of more than 45%. Production in these industries has been partially affected by the conflict since March. According to the Mysteel data, Chinese oil refineries have implemented preventive production cuts since the outbreak of the conflict. By the end of April, the capacity utilization rate of atmospheric and vacuum distillation units at refineries had dropped cumulatively by more than 10 percentage points to 63.43%2. Meanwhile, midstream energy-intensive industries such as chemicals, tires and building materials have successively announced cost-push price increases. Calculations by CICC show that energy and chemical-related industries collectively drove a month-on-month increase of approximately 1.5% in the Producer Price Index (PPI) in April3.
The second-tier industries include agriculture, forestry, animal husbandry and fishery (greatly affected by fertilizer prices) and midstream and downstream manufacturing industries, typically equipment manufacturing (automobiles, general equipment, electrical machinery) and textiles and apparel. These industries either use petrochemical materials for parts and fabrics or rely heavily on fossil fuels for mechanized operations. By contrast, modern service industries excluding transportation (finance, education, real estate, information technology) and some consumer services (accommodation and catering) generally have low sensitivity to crude oil production and prices, with crude oil dependency ratios mostly below 5%.
Q2 Pressure: Margin Squeeze and Crowded-Out Consumption
Currently, the ramifications of this conflict have not yet come to light. Given that geopolitical uncertainties remain high and supply chain transmission operates with a lag, energy supply shortages have not yet fundamentally constrained short-term production. The conflict's economic effects are likely to be concentrated in the second quarter.
On the one hand, the downward transmission of crude oil prices faces bottlenecks. From January to March this year, the profit share of downstream industries declined by 5.93 percentage points year-on-year, which has likely reflected the margin squeeze on downstream sectors caused by higher raw material costs. If the PPI-CPI divergence continues to widen, narrowing profit margins for mid-to-downstream industries could suppress their willingness to expand capacity, exerting pressure on industrial investment and business sentiment in related sectors.
On the other hand, examining external demand, given the resilience of China's energy supply and its comprehensive manufacturing supply chain advantages, short-term energy and chemical product exports are still benefiting from overseas supply substitution dynamics as Association of Southeast Asian Nations (ASEAN), Japan, and South Korea face oil shocks and capacity deficits. In March, China's chemical product exports to Japan and South Korea surged by 20.3% and 43.4% respectively, significantly above their three-year averages. However, in the long term, if the Middle East conflict remains in stalemate or escalates further, persistently high energy prices and shipping costs will markedly suppress global production and trade. According to WTO global trade scenario forecasts for 2026, if oil prices continue to rise throughout the year, global merchandise trade growth could decline by 0.5 percentage points to 1.4%,4which would subsequently pressure China's exports.
For domestic consumption, rising crude oil prices transmit more directly to prices of essential consumer goods such as refined oil products, transportation services, agricultural inputs and grain. Against the current backdrop of weak resident employment and income expectations, sustained price increases will generate a consumption crowding-out effect. While suppressing household consumption willingness, this could further dilute the stimulus effects of pro-consumption policies, and slow the pace of recovery.
Policies for External Shocks and Price Stability
Although imported inflation can induce a marginal easing of China's deflationary pressures, the sustainability of a price recovery ultimately depends on the improvement of effective demand and the rebalancing of supply and demand structures. Therefore, policy focus should center on price regulation, domestic demand stimulation, and the prevention of extreme risks.
Cope with Imported Inflation via Mechanisms and Price Reforms
In the short term, the release of Strategic Petroleum Reserves (SPR) is the most direct and rapid instrument for countries to counter surging energy prices. Authorities should closely monitor global commodity price volatility and flexibly deploy tools such as SPR releases to smooth domestic market price fluctuations and prevent the spread of panic. To address the oil price surge, the National Development and Reform Commission (NDRC) reactivated temporary regulatory measures on March 23, 2026, moderately controlling the upward adjustment range of retail gasoline and diesel prices within the established institutional framework. Simultaneously, for sectors most directly hit by oil price shocks—such as transportation and logistics, textiles, and light industry—policymakers should study and implement phased, targeted tax and fee reductions or subsidy policies to buffer rising cost pressures and maintain operational stability.
From a medium-to-long-term perspective, the fundamental solution to price stability lies in deepening price formation mechanism reforms in key sectors, systematically reducing institutional transaction costs and factor misallocation costs in the economy. Examples include accelerating oil and gas systemic reforms, ensuring fair and open access to pipeline infrastructure, and lowering intermediary costs. Moreover, authorities should refine the coordinated operation of multi-tiered electricity markets—particularly by improving supporting mechanisms like capacity markets and ancillary service markets—so that energy prices can more comprehensively reflect actual supply and demand, reliable capacity, and systemic regulation value.
Speed Up Implementation of Annual Policy Tools
It is recommended to strengthen the synergy between fiscal policy and quasi-fiscal instruments, coordinating the use of ultra-long special treasury bonds, local government special-purpose bonds, and policy-based financial instruments with a keen grasp of timing, scope, and efficacy.
In terms of timing, policymakers should seize the golden window in the second quarter. They need to speed up bond issuance, fund utilization and investment-loan linkages to generate tangible work outcomes promptly. Approval processes should be streamlined for eligible projects to facilitate direct funding. According to the NDRC data, the 1 trillion yuan of ultra-long special treasury bonds will be fully allocated by end-June. To date, nearly 90% of the ultra-long government bonds related to equipment renewals have been issued, indicating a significantly advanced pace. Furthermore, it is advised to complete the allocation of 60% of project construction special-purpose bonds in the first half of the year, alongside the rapid integration of policy-based financial instruments, keeping the deployment cycle within 3 months. Simultaneously, efforts should be made to improve mechanisms for financing alignment and project reservation so as to prevent mismatches between fund allocation and project readiness.
Regarding "scope", authorities must clarify boundaries and investment directions, promoting functional complementarity among various funds to build synergy. Investments should focus on key areas such as new quality productive forces, green development, and public livelihoods.
When it comes to efficacy, policies must enhance coordinated guarantees and incentive guidance to bridge the "last mile". Mechanisms for progress monitoring, use-of-proceeds adjustment, and comprehensive performance evaluation should be strengthened. For projects with lagging progress or substandard returns, funding allocations should be adjusted promptly to strictly prevent funds from sitting idle. Incentive and constraint mechanisms must be refined, with detailed standards for error tolerance and correction, and robust risk-and-return sharing mechanisms must be established to make investments financially viable and attractive for social capital, thereby boosting the confidence of private investors to actively participate.
Boost Domestic Demand and Consumption to Ease Quasi-Stagflation Risks
Currently, China's real estate sector is emerging from the bottom and entering into a new cycle, though it remains a drag on economic performance. Micro-entities, particularly residents, still hold weak expectations, and insufficient effective demand remains the core bottleneck constraining a sustained and healthy price recovery in China.
On the government expenditure front, local governments have long shouldered heavy expenditure responsibilities for infrastructure and livelihoods. However, with declining land sales revenue and mounting debt repayment pressures, the ongoing resolution of existing local debt has objectively constrained investment expansion in recent years, stifling the release of effective demand. China's debt resolution has now entered a medium-term critical phase. While debt swaps can alleviate short-term liquidity stress, they cannot entirely resolve local debt issues. Moving forward, comprehensive debt restructuring measures—such as revitalizing state-owned assets, enlisting financial institution support, and utilizing asset management companies (AMCs) for diversified restructuring—are necessary to achieve sustainable local debt resolution and further invigorate the economic vitality of local entities. In the medium to long term, it is vital to establish a long-term debt mechanism, which includes driving the transformation and functional restructuring of local government financing vehicles (LGFVs) through state-owned enterprise reform, thereby boosting the endogenous momentum for debt resolution and development. Concurrently, it is recommended to continuously deepen fiscal and tax system reforms, steadily promote the upward shift of central-local fiscal powers and expenditure responsibilities, and optimize transfer payment mechanisms, to regulate local borrowing behavior from the root and build a solid foundation for sustainable debt development.
Against the backdrop of weak confidence among micro-entities, policy must operate from the income side to boost residents' real purchasing power and inflation expectations. It is recommended to accelerate the research and implementation of urban and rural resident income growth plans. For instance, state-owned enterprises should leverage their demonstration effect in income distribution by directing wage growth toward frontline workers and critical positions. In terms of fiscal and tax policy, authorities should optimize and implement tax incentives for corporate employee training, R&D input, and the hiring of key employment groups, directing policy incentives toward human capital enhancement. Deepening income distribution reforms to increase the share of labor compensation in primary distribution, alongside optimizing the individual income tax system, will help unleash consumption potential.
Meanwhile, considering the existing shortfalls in China's government expenditure on public livelihoods—where livelihood-related spending accounted for 53.7% of total fiscal expenditure in 2023, still leaving a significant gap compared to major developed countries like the US, Germany, France, and Japan (which hover around 60% to 70%)—it is recommended to intensify efforts to "invest in people." This includes perfecting the social security system, removing household registration restrictions for flexible employment workers to participate in social insurance, advancing provincial-level pooling of basic medical, unemployment, and work-related injury insurance, and narrowing benefit disparities. By promoting people-centered new urbanization and facilitating the equalization of public services, the consumption demand of the "new citizen" demographic can be continuously unlocked.
Flexible and Targeted Policies with Ample Policy Tools for Evolving External Conditions
In an extreme scenario with the conflict escalating, domestic supply chain stability and people's livelihood will face much tougher tests. Macroeconomic policy must be guided by the principles of "ensuring supply, stabilizing prices, strengthening security, and anchoring expectations," with the prioritization of energy security and social stability overriding short-term economic growth.
It is advised to trigger the national SPR release mechanism and make full efforts to increase domestic coal and oil and natural gas output to ensure the supply of primary products. If necessary, temporary price intervention measures can be implemented on essential commodities crucial to the national economy and people's livelihoods, such as retail gasoline, diesel, and electricity, thereby severing the transmission chain of energy prices to the broader economic system.
In the meantime, policymakers may consider tools such as issuing special treasury bonds to establish an "Energy Transition Relief Fund" targeting energy-intensive industries like steel, non-ferrous metals, and chemicals. This fund would focus on supporting chemical and building material enterprises in carrying out energy-saving technological upgrades during high-oil-price periods, accompanied by appropriate fiscal subsidies. To safeguard basic livelihoods and maintain social stability, cash subsidies or consumption vouchers could be issued to low-income groups and workers in severely affected sectors, alongside a compensation mechanism linked to the CPI.
YUAN Haixia is Dean and Research Fellow of the Research Institute CCXI International Credit Rating Co., Ltd
ZHANG Hanwen is Research Fellow of the Research Institute CCXI International Credit Rating Co., Ltd