Beyond the optics of stability, India's economy faces rising external risks

Rising oil prices and limited fiscal space heighten risks of inflation, slower growth, and macroeconomic instability as the West Asia crisis unfolds

The devastating consequences of the United States’ misadventure in Iran are not yet fully apparent in the Indian economy. The adverse effects of rising energy prices and supply disruptions on economic growth, inflation, employment, exchange rate depreciation, and the balance of payments are still unfolding. The full impact has not entirely been felt, as the government has cushioned the effects due to elections in Assam, Kerala, Tamil Nadu and the Union Territory of Puducherry. 

 

However, the absorptive capacity of the government is limited, and its resilience is fast running out, despite running down its foreign exchange reserves by $10.3 billion in one week through March 27, thereby bringing the reserves down to $688 billion. In fact, the rupee’s depreciation by 9.9 per cent in FY26 is the worst performance among Asian currencies.

 

Continued hostility in West Asia will unveil the façade of normalcy, and with limited fiscal headroom available, sustaining such operations will be difficult. Hopefully, the two-week ceasefire will bring the curtains down. On the other hand, if the hostilities prolong, the price of crude oil will keep rising, and, combined with supply disruptions, India may face a severe energy shortfall, adversely impacting every sector of the economy. With options running out, the government may increase energy prices to reflect market realities once the elections are over. It may not take much time for the “Goldilocks” economy to be caught in a “stagflationary” spiral.

 

While a ceasefire has been declared, it is not clear if hostilities will end or the extent of the damage they will cause to the Indian economy. One estimate suggests that an increase of $20 per barrel will reduce global economic growth by 0.2 to 0.4 percentage points, from 3.3 per cent to 2.7 per cent. The growth rate of the Indian economy is estimated to decline by 0.8 to 1 percentage points, while inflation will rise by 0.8 to 1 percentage points.

 

While this may approximate the impact of prices, issues relating to availability remain, and the consequences may be even more severe. After energy prices are reset and input cost escalation is taken into account, inflationary conditions are likely to reappear in the economy. The human suffering cannot be captured merely by these growth and inflation numbers.

 

The West Asia conflict has led to India’s manufacturing PMI dropping to a near four-year low of 53.9, from 57.9 in the previous month. The reduction in the excise duty on petrol and diesel is likely to add to the fiscal woes of the government, which is already stressed.  Even when prices ease, the scarcity of oil and gas will continue to haunt households and businesses. 

 

The impact goes beyond the transportation sector. Many small and medium industries are faced with the spectre of closure. The effects will also be felt in agriculture due to the non-availability and higher prices of fertilisers, which may require the government to increase subsidies. Energy-intensive small and medium enterprises are likely to bear the brunt, particularly in sectors such as transportation, metallurgy, chemicals, and cement. As it is not possible to transition to renewables in the short run, hardships and black marketing in scarce items may intensify. The longer the hostilities drag on, the more pronounced the adverse effects will be on growth, employment, exchange rate depreciation, the current account deficit, and overall human suffering.

 

The lack of fiscal buffer in the country increases the macroeconomic instability risks.  Due to the base revision of gross domestic product (GDP), the revised estimate of fiscal deficit for 2025-26 is pegged higher at 4.8 per cent of GDP, against the 4.4 per cent. The budgeted deficit for 2026-27 is estimated at 4.8 per cent after the base revision, compared to 4.3 per cent. 

 

The target of reducing the debt-to-GDP ratio to 50 (±1 per cent) of GDP by 2030 is also in danger of being breached. What is of concern is that, despite the passage of fiscal responsibility legislation at the Union and state levels, in none of the years except 2007-08 was the target of containing the fiscal deficit at 6 per cent of GDP achieved.

 

Furthermore, except in the Covid year, when household sector financial savings touched 11.1 per cent, in none of the years did it come close to the 10 per cent of GDP assumed by the 12th Finance Commission while setting the Fiscal Responsibility and Budget Management targets. While claims are made about fiscal consolidation since the Covid year, the aggregate fiscal deficit in 2023-24 was 8.8 per cent of GDP, even as the household sector’s net financial savings were just about 5.2 per cent of GDP.

 

This has escalated the cost of borrowing for industry. In fact, since 2021-22, the aggregate fiscal deficit has been much higher than the household sector’s financial saving, creating a stagnant investment climate due to elevated cost of borrowing.  Almost 90 per cent of the financial institutions are owned by the government and this helps in government borrowing. The periodic infusion of liquidity only helps to keep the cost of government borrowing low. Who cares if the Reserve Bank of India has a conflict of interest in managing multiple, often conflicting, roles?

 

In an environment of constrained fiscal space, a sharp increase in energy prices can trigger a crisis. It was when Saddam Hussein invaded Kuwait in 1990 that oil prices doubled, and the accumulated fiscal imbalances escalated into a crisis of unprecedented magnitude. Thanks to market-based reforms since that crisis, the economy has gained resilience, and we are in a much better position to face such a shock than in 1991.

 

But the problems cannot be wished away. The elevated levels of deficits and excessive government borrowing, aided by financial repression will constrain corporate investments by enhancing their cost of borrowing. The situation is far from normal than it looks at present and, the longer we delay the fiscal adjustment, the more intense the problem will become. In the immediate context, it is important to raise the prices of petroleum products to reflect the market reality.

 

The government will have to think carefully about whether it needs to continue with Rozgar Melas or schemes such as providing free foodgrains to 813 million people under the Pradhan Mantri Garib Kalyan Anna Yojana, especially when multidimensional poverty has declined to 11.28 per cent of the population. One hopes the government will not miss the opportunity offered by this crisis to undertake much-needed reforms.

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The author is former director, NIPFP.  The views are personal