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As an oil importer, Pakistan is vulnerable to the US-Israeli war on Iran. The recent hike in fuel prices will spike YoY inflation and has already triggered public anger, but this painful step was necessary to protect the economy. Our inflation model shows a sharp YoY increase in headline inflation in March, driven by food inflation. Our model shows that average inflation in FY26 could increase from our previous assessment of 7.4% to 9.4%.
Other vulnerabilities depend on how long the conflict lasts. If it continues for months, Pakistan will have a BoP problem; the FX stability (rupee-$ parity and SBP’s FX reserves) could disappear; falling remittances from the GCC could further threaten Pakistan’s BoP; and $ support from the GCC could also be withheld. While these are valid downsides, the hidden upside (our growing military ties with the Saudi Arabia) that has kept Pakistan’s BoP so comfortable in FY26, is likely to soften the blow to Pakistan’s economy.
More importantly, we do not see the conflict extending for months. There are growing concerns about the stockpiles of offensive and defensive weaponry on both sides; there is the danger of tipping the global economy into a recession; and most importantly, Americans are increasingly angry about being dragged into another military conflict in the Middle East by Israel.
In our view, Trump is likely to stop the US offensive when he realizes he is losing public support in the US, just before the midterm elections. Delusional as he is, Trump could declare victory and withdraw from the conflict, very much like President George W. Bush did in his disastrous war against Iraq in 2003. Assuming the conflict only lasts for another week or so, Pakistan should be able to weather the fallout. As discussed in our last paper, the GCC and the Middle East region are likely to experience a significant realignment in the global order, with Israel identified as the primary threat to the region. This hidden upside for Pakistan may be the lasting impact of the Israeli war on Iran.
Israel and the US attacked Iran on Feb 28th with a stated goal of regime change. As has happened before, Israel scuttled US negotiations with Iran, and compelled it to join its war against Iran. Since daily events are shifting the media (and social media) narrative of what is likely to happen, it is important to focus on the underlying factors that made this war inevitable.
Israel initiated this war to eliminate its archenemy. This is part of the plan for Greater Israel, which Netanyahu is pursuing to change the entire Middle East region (from Egypt to Iraq). Interim goals are to control the main shipping routes (the Suez Canal and the Persian Gulf) and neutralize dangers like Saudi Arabia and Pakistan (and perhaps Türkiye). The Abraham Accords are part of this Israeli plan to gain the recognition of the Arab world without any commitment to a Palestinian state. After Israel’s genocide in Gaza, regional countries are beginning to realize the threat posed by this fascist state.
However, some leaders have bought into Netanyahu’s plan for regional dominance: India’s proxy war against Pakistan (using Afghanistan), and Abu Dhabi’s alliance with Israel to undermine Saudi Arabia’s foreign policy in the region. Israel and the US have the military advantage in the war, but by expanding the war to the entire GCC, Iran seeks to show how vulnerable these petro-states are, and to play a long game that the US does not have an appetite for.
Pakistan is torn between the visceral support from Pakistanis for the Iranian people and their anger against the US and Israel, and its deep friendship with the GCC – especially the Kingdom. There are growing indications that Saudi Arabia is wary of the threat posed by Israel, which is the main reason it chastised Abu Dhabi to behave itself in the region. It could also be the rationale for the Saudi-Pakistan defence pact signed in September 2025.
In view of how this war against Iran has angered Pakistanis, the GoP and the Establishment will have to distance themselves from the US. Since Iran, Saudi Arabia, and Pakistan have a common enemy in Israel, we suggest that Pakistan should take the lead in creating a defence alliance with Iran and the Kingdom (and the GCC and Türkiye), to create a united front against the ludicrous ambitions of Israel. Despite Netanyahu’s best efforts, we do not see regime change in Iran, but a more dangerous scenario of Iran splintering; this will adversely impact the GCC, Türkiye, Iraq, and Pakistan. A common regional front against Israel that is anchored to the creation of a sovereign state of Palestine, is the only path towards a lasting peace in the Middle East.
There is a significant divide regarding AI between tech-supporters and those who fear that their jobs and careers are at risk. We use a simple demand-supply analysis of the labor market for non-tech and tech white-collar workers to gauge how the introduction of AI could impact these two cohorts.
From the perspective of non-tech workers, the outlook is dire, as a comparative static analysis shows that such firms will reduce demand for non-tech workers. This results in lower employment and wages. However, some redundant workers will retool for the AI era, while the older workers may just drop out of the labor market as their job prospects decline.
For tech workers, the outlook is positive as new jobs open up, offering higher wages. This polarization of the job market is likely to affect all countries that adopt AI, with political repercussions. We argue that it is useful to distinguish between the salaried class (who sell their services) and the owners of capital (Big Tech and firms), who make the decision to shift to more efficient AI-powered online platforms. The shift towards AI will favor the owners of capital, but keep most of the salaried class vulnerable – this also includes senior management and CEOs.
Even for tech workers who see an upside in the shift to AI, the gains may be short-lived. As more and more people retool to AI, the labor supply curve will shift to the right; so, while employment in the tech sector will definitely increase, salaries may not stay that high.
Big Tech companies are investing record sums in AI, which suggests that for this investment to be profitable, labor redundancies and retooling have been factored in. Since the tech jobs created will be much smaller than redundant non-tech jobs, this could create political tensions. At this point, policymakers in the West are not focused on possible job losses, as President Trump has a close affinity to Big Tech, and doesn’t care much for the working class. This could change as the AI momentum gains strength.
There are two fundamental disconnects in Pakistan’s economy. In the external sector, we focus on FY22 (a crisis year where the current account (CA) deficit hit $17.5 bln) and FY25 (which posted a unique CA surplus of $1.9 bln), and identify the implications of these forces on SBP’s FX reserves and the rupee parity. However, when one looks at FY26, the relationship totally breaks down. This anomaly, a growing cumulative CA deficit and a steady (almost mechanical) increase in SBP’s FX reserves with a linear appreciation of the rupee, is unprecedented. So is the aggressive purchasing of $s by SBP (especially in September and October 2025) without the slightest impact on key FX parameters.
The other disconnect concerns the MoF’s fiscal policy and the SBP’s monetary stance. Most analysts focus on monetary policy solely through the lens of interest rates, ignoring other instruments the central bank can use. If one considers tools like liquidity injection/absorption (via open market operations) and bank regulations on minimum cash holdings and/or required government securities held against bank deposits, it is clear that SBP is easing its monetary policy. However, the EFF insists on an austere fiscal policy, which has resulted in a severe squeeze on the salaried class. With lower take-home pay and constrained household spending, the policy signals are truly mixed.
The external-sector disconnect could be explained by military exports of hardware and services, whereas the policy disconnect stems from the IMF program, which is losing traction within government circles. The growing calls for economic growth require a less austere fiscal policy. However, that may not be the fundamental disagreement between GoP and the IMF. We argue that the institutional reforms listed in the IMF’s Governance and Corruption Diagnostic (GCD) assessment may be the real reason for the loss of traction in Islamabad. Listing the likely resistance to fundamental reforms from key stakeholders (politicians, bureaucrats, moneyed interests, senior government officials, and the Establishment), this paper suggests that the scope of the reforms is so daunting that the authorities would prefer to stall the EFF than implement these changes that would undermine the powerful elites in Pakistan.
Scrapping the EFF and ignoring the 15 priority steps required by the GCD would be a tragic mistake. At a time when Trump’s global chaos is creating tailwinds for Pakistan, this is the time to do the tough stuff. However, there appears to be no appetite to do the right thing.
The US National Security Strategy document, released in November, clearly spells out America’s foreign policy priorities. It is a candid and easy-to-read paper that builds on several recurring themes: (1) US foreign policy is no longer geared towards being the global policeman, but will focus on national interests; (2) the US will no longer lecture countries on free speech, free press, democracy, human rights and climate change; (3) the US will no tolerate freeloaders, especially amongst its allies; (4) multinational institutions will no longer play a role in global affairs; and (5) the Trump administration will reindustrialize the American economy and uplift the working middle class.
Within a regional framework, it states the following:
For a strategy document that covers US interests globally, the document is conspicuously silent on its military alliances like NATO and the Quad. This suggests that the Trump administration is not interested in military alliances, as it does not view Russia and China as enemies that must face its military strength. The document also reverses the policy to view India as a counterweight to China.
As Iran struggles to calm public protests, experts have said that the theocratic regime may not survive. If so, we argue that the US may shift its military assets from the GCC to the Western Hemisphere, leaving a vacuum that Pakistan could fill. With growing regional interest in Pakistani military hardware and services, the country is well-positioned in 2026.
Expectations that the EFF may allow for a gradual shift towards a growth phase have been dashed. The IMF’s December 2025 Staff Paper, released last week, reads pretty much the same as the May version. The full-year FBR revenue target remains the same (Rs 14 trn), but the federal primary surplus has been increased by Rs 1 trn. The projected fiscal deficit for FY26 is now 4% of GDP, one of the lowest in recent memory. Direct taxes as a percentage of GDP have increased by almost 50 bps in FY26 compared to FY25, and now stand at 5.53% of GDP. If the direct tax base is not increased this year, the burden on the salaried class and corporates will increase further.
This is disappointing as the lead-in to the approval of the 2nd review had been peppered by statements by senior government officials that the current economic strategy was not supportive of growth and job creation. The much-talked-about tax relief for the salaried class is not on the cards, and the third consecutive year of austerity and low growth will not be easy on the hybrid government.
The government has not commented on the new Staff Paper, except to dismiss the view that the new structural benchmarks are not “new conditions” but a continuation of the progress already made. It has also promised that if there is a revenue shortfall this fiscal year (which seems likely), the burden of the shortfall will fall on agri inputs (pesticides and fertilizer) and household purchases via a higher GST rate. This means food prices may increase, which could threaten the IMF’s average inflation projection of 6.3% in FY26. We argue that if this happens, the window to cut interest rates in 2H-FY26 will close.
We expect some pushback against the ongoing austerity, but the GoP should remain firm in its resolve to see the EFF through. The action plan from the Governance & Corruption Diagnostic (GCD) assessment should be released soon, and we expect it to be fully endorsed by businesses and corporations. These are tough institutional reforms that focus on FBR’s operations, GoP’s regulation & oversight functions, the judicial backlog, asset declaration by senior civil servants, and the quality of top management of key state institutions. If these reforms are implemented sincerely, they may convince businesses and professionals to stay the course; if not, the ongoing economic frustration could jeopardize the EFF.
Against a fiscal deficit target of 5.7% of GDP, GoP delivered 5.4% in FY25. Pakistan’s fiscal deficit has been falling since FY23, and this trend is likely to continue in the ongoing EFF. Looking deeper into this fiscal surprise, we do not see much expenditure restraint, as federal and provincial governments have spent freely – especially the Government of Punjab. With three IMF revenue targets unmet in FY25, a blame game has started between the center and Punjab, which will have to be settled before negotiations with the IMF begin next month.
The real game-changer has been the sharp increase in direct taxes (squeezing the salaried class) and abnormally high SBP profits. We show that sales tax collection has lagged, which follows GoP’s failed efforts to get traders and businessmen into the tax net. In FY25, just SBP profits and revenues from PDL matched the revenue collected via GST.
Analysts are confident that Pakistan’s macro stability and comfortable BoP should ensure that the 2nd EFF review will be smooth sailing. We acknowledge the fiscal improvement, comfortable BoP, and low inflation, but argue that lopsided policies and opportunistic revenues contradict the EFF’s objectives. The government’s capitulation to traders/businessmen is understandable, as this segment makes up the core of PML-N’s support base in Punjab. However, the government had committed to doing just that to the IMF.
Without the one-off SBP profits (Rs 2.6 trn), the fiscal situation in FY25 would have been very different. This one-off can be traced to a fiscal distortion, whereby the government’s credit need was so high that Pakistan’s commercial banks could not fund it. Hence, SBP stepped in to generate liquidity that banks then on-lent to the government. As of July 2025, SBP has injected over Rs 14 trn into the system, when good practice demands that the central bank’s net intervention in the money market should be zero. This proves that fiscal policy still dominates monetary policy.
We believe the IMF will insist that GoP continue to narrow the fiscal deficit and secure other sources of deficit financing. This will reduce bank financing to the government, which should match the reduction in artificial liquidity injected by SBP. This means SBP profits in FY26 could collapse. The lopsided fiscal burden will also have to be fixed this year, which means PML-N will have to take on its political base. President Trump may have a soft spot for Pakistan, but we doubt he will go out of his way to tell the IMF to look the other way as Pakistan’s scheming politicians continue to plunder the country.
Pakistan’s external sector will not be as comfortable as it was in FY25. There are concerns that workers’ remittances could fall this year, while the textile sector will have to deal with a poor cotton crop, enhanced GST on inputs, and the loss of captive power. Even SBP has flagged its concern that if the incentives given to banks to increase inward remittances were to be withdrawn, the record-breaking $ 38.3 bln realized in FY25 will not be sustainable.
SBP’s FX reserves have increased even though the monthly trade deficit has been trending up since December 2024. This is because of the steady stream of remittances and last-minute inflows from official creditors at the end of June. With a stable rupee and low inflation, domestic demand has picked up and is now driving imports. In the past month, SBP has weakened the rupee not just to build FX reserves, but also to signal the need to contain imports. However, Pakistanis have dollarized their savings in the past, so if SBP does not strike the right balance with the rupee, we may see a return to dollarization. This could be facilitated if remittances from Saudi and the UAE start shifting to the hundi/hawala system.
In our view, the austerity of the ongoing EFF is likely to be watered down as the political cost of a stagnant economy increases. We do not expect a policy-driven growth boost in FY26, but some of the restrictions on non-filers could be eased, while industries like textiles, cement, and autos may get relief from the measures announced in the FY26 budget.
This has happened before. Pakistan somehow manages to get lucky, and uses this luck to halt and often reverse much-needed structural reforms: we saw this happening after 9/11; we witnessed the strong growth when oil prices collapsed in mid-2015; then we had the Covid-19 boom; and finally, the global elevation after the 4-day war with India in May. But there is an irony about all this: the lucky breaks are celebrated by insiders, but also keep undermining the creation of a strong foundation for future growth.
The global turmoil is not just about the tariff rates the US had imposed, or their global reach, but the last-minute reprieves and contradictory statements made by Trump. Unless you are an importer in the US, it is hard to know what the current tariff incidence is. Mainstream media has nothing positive to say about this Trump-driven turmoil, but it also doesn’t have the depth to understand how the US, as the issuer of the global reserve currency, suffers from persistent overvaluation of the dollar, and how this has de-industrialized the US economy.
There are competing models of how currencies reach their equilibrium level. The trade model says that countries that run persistent external deficits should witness currency weakness. The financing model focuses on global investments in financial instruments, and claims that currency equilibrium is achieved when global investors are indifferent between dollar and non-dollar investments. The Triffin Dilemma focuses on the reserve currency (the US$), and shows that the trade and financing models don’t work because there is always strong demand for dollars as global trade grows.
Since global trade volumes have increased sharply in the past several decades, the dollar is persistently overvalued, which makes the US manufacturing sector less competitive. The Triffin Dilemma basically says that for the country issuing the global reserve currency, there is a conflict between domestic economic goals and its global obligations.
An overvalued dollar allows the US to keep interest rates low and gorge on cheap imports, but it also makes US manufacturing less competitive. The era of globalization has seen parts of the US reduced to ghost towns with impoverished residents, which explains Trump’s popularity with diehard MAGA supporters.
Stephen Miran, the head of the Council of Economic Advisers, had released a paper in November 2024 where he spelled out Trump’s tariff plan that is currently playing out. His assessment that US manufacturing needs to be rebuilt, and blue-collar jobs need to return, has strong political overtones but also has common sense logic. Using the Triffin Dilemma and simple language, Miran argues that Trump is trying to address the structural bias against US manufacturing by forcing trading partners to share the economic burden of issuing the global reserves and the defense shield the US provides to Europe and Southeast Asia.
However, Miran’s arguments are not water-tight, while Trump’s rambling narrative on tariffs has created utter confusion about what the US is trying to achieve. In simple terms, if Trump wants to create blue-collar jobs and reduce the US trade deficit, he must sharply increase the price of imported goods even if it spikes US inflation and hurts US tech firms. If he wants to impose tariffs and keep domestic prices down, he needs to depreciate the dollar and move away from being the global currency. He cannot do both.
We argue that Trump’s political instinct is to prioritize domestic goals over global obligations. However, his insistence that the dollar remains the global currency and US prices remain low, will not bring back blue-collar jobs to the US. Trump desperately needs a consistent economic roadmap, as his desire to achieve contradictory goals will only serve to isolate the US. With time, the rest of the world will find alternative trade and security arrangements where the US has no role. This means Trump is accelerating the demise of US power.
Trump’s tariff announcement was worse than anticipated. Across the board and not sparing allies, even close ones like Israel and Taiwan. Analysts were quick to point out that the tariffs computed by the White House were flawed, but we think that point is irrelevant. Trump will never acknowledge his mistake and will only double down.
What’s more important is how this tariff war is being perceived by the Trump administration. On paper, it is moderate (only half the alleged tariffs imposed by countries on US exports) and unbiased (friend and foe are seen as one). The world is scrambling to respond, with indications that China will impose counter-measures against the US, while the UK may let this one slide. The EU is talking big, but is unlikely to deliver.
The pain is already being felt. Not the rise in US retail prices, but the job losses in Canada, which are likely to happen in Mexico. For export-led countries, the challenge is existential. Pakistan has been aspiring to be an export-led country for decades, but has never managed to achieve it. Perhaps that is a blessing now. In our view, Trump’s tariffs will not be as disruptive to Pakistan as they will to most other countries. Some local analysts are already looking at the opportunities it could create for our exports of textiles and garments against countries like China and Bangladesh.
While the US will be willing to consider side deals on a bilateral level, US tariffs are here to stay. This means most OECD countries will slip into recession, and global trade flows and investment could become more regional. Trump’s tariff war is really about how developed nations are able to manage the resulting economic pain. The US is better placed than the EU and export-led countries in Southeast Asia. We also predict a shift in power within the Trump administration, as globalists like Elon Musk are eclipsed by nationalists like Steve Bannon.
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