Crisis response: Things could get tough if the conflict continues

Fragile West Asia ceasefire and oil risks test India's economy, as the RBI balances rupee stability, inflation control, and growth amid rising global uncertainty

As the fragile two-week ceasefire between Iran, on one side, and the United States (US) and Israel, on the other, nears its end, the path forward remains uncertain. However, it is encouraging that both sides are willing to talk. A US delegation led by Vice-President J D Vance is expected to travel to Islamabad for a second time in two weeks. The last round of talks did not yield a deal. Given the issues involved and the positions both sides have taken, it is unclear if a durable solution can be reached in the days ahead. US President Donald Trump’s decision to impose a blockade in the Strait of Hormuz has complicated matters even as Israel and Lebanon started engaging diplomatically. It would thus be important to see how things pan out over the coming few days.

 

An early resolution is critical, particularly for India. As Reserve Bank of India (RBI) Governor Sanjay Malhotra noted in an address last week at Princeton University, West Asia accounts for about half of India’s imports of crude oil, about two-fifths of inward remittances, and one-sixth of exports. Mr Malhotra also discussed the RBI’s approach to policy management, which is worth discussing here especially because the central bank has faced criticism from economists and commentators over its intervention in the currency market. In the context of the Asian financial crisis, he said the RBI intervened when it was warranted and did not commit to an indefensible peg. Clearly, the approach has not changed much, even though the RBI has built large foreign-exchange reserves.

 

Its stated policy is that it intervenes in the market only to contain excess volatility. The RBI, for instance, this week partially rolled back restrictions in the market for currency derivatives. It was communicated that such measures were temporary. In fact, the RBI is allowing a gradual rupee depreciation, which is warranted. India is facing a deficit in its balance of payments, and the rupee needs to depreciate to correct the imbalance. An early resolution to the conflict will help contain the deficit in the current account and reduce pressure on the rupee. However, the external financial position is only one aspect. The crisis would also affect inflation and growth outcomes. Higher prices of crude oil have not yet been reflected in the inflation numbers due to limited pass-through. But if the crisis prolongs, pump prices will have to be adjusted. In the present context, the governor noted: “The appropriate monetary policy response to such a supply shock is to look through the first-round effect to the extent that it does not feed into second-round dynamics.” The real concern for central bankers in such a situation is second-round effects, which can materialise if supply disruption persists over a longer period. However, containing these, to an extent, also depends on how expectations are managed.

 

A rule-based monetary policy and clear communication from the central bank can be effective. The average headline-inflation rate and volatility in India have, for instance, come down significantly since the adoption of the flexible inflation-targeting framework about a decade ago. Nevertheless, the central bank needs to be vigilant. The impact of the crisis could be greater because, along with higher prices, the availability of gas, for example, is also an issue that is affecting economic activities. Thus far, both the central bank and government have managed the situation well. However, things could get tough if the crisis continues.