Overview

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India-Pakistan relations have rapidly deteriorated following the terrorist attack in Kashmir carried out by the militant Kashmir Resistance group. India is blaming Pakistan for supporting the militants in the historically contested region which has faced territorial spats before. Pakistan denies involvement.

India's assertive response, encompassing diplomatic downgrades and the unprecedented suspension of the Indus Waters Treaty, has been met with strong condemnation and reciprocal actions from Pakistan. The situation is characterized by escalating military rhetoric, border incidents (including the contested downing of an Indian drone), and deeply entrenched, conflicting narratives. This confluence of factors points towards a sustained period of heightened tension with implications for regional stability, economic activity, and the intricate supply chains that traverse South Asia.

• Elevated and protracted supply chain risks: The closure of borders and airspace, coupled with increased military activity, creates significant and potentially long-lasting disruptions to transportation and logistics. Businesses relying on routes through India and Pakistan, or sourcing/manufacturing within these countries, face increased costs and delays.
• The Indus Waters Treaty as a critical economic and political flashpoint: India's suspension of the treaty represents a significant departure from established norms and carries substantial risks, particularly for Pakistan's agricultural sector and overall economic stability. This issue has the potential to escalate the conflict further and could indirectly impact businesses through commodity price volatility and social unrest.
• Conflicting narratives and the risk of miscalculation: The deeply entrenched and opposing narratives from both sides, amplified by media and public sentiment, increase the risk of miscalculation and unintended escalation.
• Regional economic integration under threat: The current crisis represents a major setback for regional economic integration efforts. Businesses that were anticipating greater cross-border trade and investment opportunities in South Asia will likely face a more fragmented and challenging environment in the near to medium term.

Scenarios for the upcoming six months

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Scenario 1: Heightened volatility and regional supply chain disruption (Probable)

This scenario envisions a continuation of the current elevated tensions without a significant military conflict but with persistent instability that might in the short term escalate with retaliatory strikes before simmering down to the current level of tensions. Diplomatic channels remain largely frozen, and sporadic border incidents, potentially including further claims of drone incursions or minor skirmishes, continue to fuel mistrust. The suspension of the Indus Waters Treaty remains a contentious issue, with Pakistan pursuing international legal avenues but without immediate resolution. Both nations maintain a high level of military readiness and engage in assertive rhetoric, deterring significant de-escalation.

• Business impacts:
  
  • Increased insurance and freight costs (Very Likely): The sustained high-risk perception leads to increased insurance premiums for cargo and assets in the region. Shipping and air freight companies factor in potential disruptions and security risks, leading to higher transportation costs.
  • Increased crude oil price volatility (Very Likely): The proximity to the Middle East makes the region vital for global oil transit. Rising tensions or perceived threats to shipping in the Arabian Sea and Indian Ocean heighten crude oil price volatility.
  • Localized supply chain bottlenecks (Likely): While a full-scale conflict is avoided, intermittent border closures, heightened security checks, and transportation delays due to military movements create localized disruptions in supply chains, affecting industries reliant on regional logistics.
• Key Indicators:
  
  • Sustained high levels of military deployment and activity along the Line of Control (LoC) between Indian and Pakistani controlled regions.
  • Continued absence of high-level diplomatic engagement or dialogue.
  • Pakistan actively pursuing legal action regarding the Indus Waters Treaty without bilateral resolution.
  • Sporadic reports of border incidents or accusations from either side.

Scenario 2: Controlled De-escalation and tentative economic re-engagement (Less probable)

In this scenario, a combination of sustained international pressure, internal economic considerations in both nations, and back-channel diplomacy leads to a gradual and controlled de-escalation. While deep mistrust persists, both sides agree to resume limited diplomatic engagement and explore mechanisms for managing border tensions. The Indus Waters Treaty issue remains unresolved but is parked for future discussion. Some initial steps towards resuming limited cross-border trade or allowing specific humanitarian corridors might be considered.

• Key Indicators:
  
  • Resumption of formal diplomatic talks at the foreign secretary level or above.
  • Agreement on mechanisms for de-escalation and managing border tensions.
  • Initial steps towards restoring limited cross-border trade or transit.
  • Public statements from leaders emphasizing the need for dialogue and peaceful resolution.
  • Increased engagement of international mediators or organizations.

Scenario 3: Significant military conflict and regional economic disruption (Least probable)

This scenario, while the least probable given the nuclear deterrent and international pressure, envisions a significant military escalation. A major border incident, a perceived existential threat, or a severe miscalculation leads to sustained military conflict. Bilateral dialogue regarding the suspension of the Indus Waters Treaty is halted with Indian threats to move forward with construction plans of dams and water storage projects that have the potential to limit water flows to Pakistan. The conflict is geographically contained but has widespread regional business implications.

• Key Indicators:
  
  • Large-scale military mobilization and offensive operations across the border.
  • Widespread damage to critical infrastructure, including transportation hubs and energy facilities.
  • Significant international condemnation and potential sanctions.
  • Direct targeting of major economic centers or assets.
  • A breakdown of communication and command structures, leading to uncontrolled escalation.

Integrating the India-Pakistan crisis into the global power competition

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The India-Pakistan crisis provides an opportunity for China to increase its regional influence. China's Belt and Road Initiative (BRI) has significantly increased its economic and strategic stakes in Pakistan for example through the flagship project of China-Pakistan Economic Corridor (CPEC). China's relationship with Pakistan is also a strategic counterweight to India's growing regional influence which China aims to contain.

The U.S. has been shifting its focus towards the Indo-Pacific, primarily to counter China's growing influence. While the U.S. values its strategic partnership with India, its involvement in the India-Pakistan crisis appears more reactive than proactive with the withdrawal from Afghanistan also reducing the U.S.'s direct land based concerns. The absence of a U.S. ambassador in both countries and Trump's comments (“India and Pakistan will sort it out, one way or another”) indicate a degree of detachment from the immediate crisis although the U.S. has urged restraint from both parties after recent border incidents. This could be interpreted as a strategic calculation, prioritizing other global concerns. If the crisis escalates and India perceives a continued lack of U.S. support U.S.-India relations could come under strain.

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