Iran shock shows India's external vulnerability, tests growth ambitions

Going by the revised gross domestic product (GDP) series, the Indian economy grew by 7.2 per cent, 7.1 per cent, and 7.6 per cent in FY 24, FY 25, and FY 26, respectively. This is a truly impressive growth record in an environment marked by the Ukraine conflict, high interest rates in Western economies, and Trump tariffs. 

 

Even a tariff rate of over 50 per cent on much of India’s exports to the United States could not stop the Indian economy in its stride. With the inflation rate at an extremely benign 3 per cent, it appeared that India was finally set on a 7 per cent growth trajectory even in a difficult global environment. The conflict in Iran, now paused for two weeks, threatens to undermine these expectations. 

 

The truly unsettling element in the scenario has been the fall in the exchange rate of the rupee. The fall predates the Iran conflict. The conflict has merely accentuated an underlying trend. The nominal effective exchange rate of the rupee has fallen by 8.5 per and the real effective exchange rate by 8.1 per cent in the period from February 2025 to February 2026 (trade-weighted 40 currency basket). The latter is well beyond the Reserve Bank of India’s (RBI’s) comfort zone of 5 per cent.

 

A growth rate of over 7 per cent, an inflation rate below 3 per cent and a current account deficit of 0.8 per cent scarcely justify a fall of this order. The fall has to do entirely with capital flows. There was a net foreign portfolio investment (FPI) outflow of ₹1.52 trillion in FY26. These are the highest FPI outflows ever in any given year. They exceed the outflows of ₹1.22 trillion in the Covid-impacted year of 2021-22. 

 

In 2021-22, the growth outlook was nowhere as positive as it is today. The inflation rate was running at 5.5 per cent. The banking system was under considerable stress. The flight of foreign institutional investors (FIIs) was entirely understandable. Why would FIIs want to exit an economy growing at over 7 per cent, with inflation at 3 per cent and banking system indicators that are highly favourable?

 

The outflows are perceived to have happened on account of the punitive tariffs imposed on India by the Trump administration. FIIs were said to perceive the US administration’s stance towards India as a big negative for the economy. It was a risk factor that argued against staying exposed to India.

 

The tariff issue was resolved with the Indo-US interim trade agreement in February 2026. In the same month came the judgment of the US Supreme Court striking down the Trump administration’s tariff regime. For the present, India, like everybody else, is subject to tariffs of 10 per cent on its exports to the US.  It cannot be that the tariff factor is material to the exchange rate of the rupee any more.

 

The material factor is the war in Iran. It has changed the outlook far more drastically than the Trump tariffs had done. The impact on growth and inflation are still manageable. Several agencies now project India’s growth at 6.5-7 per cent or even 6 per cent, down from 7 per cent earlier. Inflation is projected at 4.5 to 5 per cent, which is within the RBI’s tolerance band. Neither projection is scary.

 

It is the current account position that is seriously impacted by higher oil prices. Analysts see the current account deficit (CAD) going up to 1.8 per cent of GDP if oil prices remain at $85 per barrel throughout the year. That is what the RBI has assumed for FY 27 in its April Monetary Policy Report. If oil prices are above $100, CAD could be higher than 2 per cent.

 

That does change the perspective drastically for foreign investors. India’s policymakers have always believed that a CAD of up to 2.5 per cent is manageable. What investors will focus on, however, is a significant worsening in relation to the past five years. When FIIs see CAD increasing steeply from an average of 0.8 per cent of GDP in the past five years to around 2 per cent, expectations of a depreciation in the rupee are inevitable. As FIIs head for the exit to protect their returns, these expectations will prove self-fulfilling.

 

It is clear that improvements in the fundamentals of the Indian economy in recent years have concealed an important vulnerability:  The impact of oil prices above $100 a barrel on the CAD. This vulnerability was not noticed because world prices have stayed below

 

$100 for most of the past five years, except for about four months in 2022 after the Ukraine conflict erupted. They have stayed below $80 over the past two years. 

 

The conviction in the markets had been that oil prices would stay in the mid-60s under President Donald Trump. The rise in oil prices to well over $100 a barrel over the past month has upset all calculations.  No surprise that, until the announcement of the ceasefire in Iran, the downward pressure on the rupee seemed relentless. 

 

There is not much the government can do about the prices of oil and related products. It can at best focus on ensuring supply and cushioning the price impact on consumers. So far, it has done a good job on both counts.

 

As for the exchange rate, intervention by the RBI can only manage the fall in the rupee, it cannot prevent it. If the ceasefire does not last and oil prices stay elevated for a long period, the RBI may have little choice but to increase the policy rate. The cumulative reduction in the RBI’s policy rate of 125 basis points since February 2025 is now beginning to look somewhat imprudent. With the economy growing at around 7 per cent, it may have been wiser to have exercised restraint, given the enormous uncertainties in the international environment ever since President Donald Trump assumed office in January 2025.

 

There is an important lesson here for policymakers. If we are to effectively manage risks in the economy, if stability is not to be compromised, it is necessary to rein in aspirations for GDP growth. In a troubled global environment, a growth rate of close to 7 per cent is not something to be sniffed at. Macroeconomic policies that seek to accelerate the growth rate at the current level of savings and investment expose the economy to avoidable risk.

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