India Amid the West Asia Conflict: Caught in a Squeeze

Elevated risks of wider energy supply disruptions from a prolonged Iran conflict are prompting a reset of India’s macro realities. The baseline now shifts to a more realistic, yet manageable, Brent average of $80 per barrel, with higher pressure in the first quarter. Accordingly, growth estimate is trimmed by 40 basis point to 6.6% for 2026-27, while inflation raised by 30 bps and the current account deficit by 40 bps to 4.3% and 1.7%, respectively.

A more adverse terms-of-trade shock, with Brent crude above $100 per barrel, could push the current account deficit beyond 2.5% of GDP and drive a balance of payments deficit of about $85 billion. The eventual growth, inflation and fiscal impact will largely hinge on how a sustained crude shock is distributed between oil marketing companies, the government and end consumers. With under-recoveries already exceeding about ₹3 trillion at current prices, the burden is likely to fall disproportionately on the government, implying a minimum fiscal cost of about 0.5% of GDP.

The Reserve Bank of India is likely to allow calibrated rupee depreciation while keeping a check on rates through market interventions. The trade-offs are not easy. The dollar/rupee could move towards 96, while the 10-year government bond yield may drift higher towards 6.95%.

The macro impact and scenarios in detail:

Source: Emkay Research estimate

* CAD and BoP estimates assume dynamic analysis, with fall in non-oil export and import demand, remittances and capital flows
** CPI inflation assumes 30% burden sharing via pump pass through of petroleum-related products (rest to be absorbed by OMCs and Govt)
*** GDP growth impact could be amplified owing to supply shock cross-sectoral hit

The West Asia conflict is entering a more precarious phase, despite recent indications of de-escalation. Attacks on energy infrastructure have heightened the risk of broader and persistent supply disruptions. India faces an adverse terms-of-trade shock from rising energy prices, with around 45% of crude oil and 55% of gas imports sourced from the region and limited domestic strategic reserves.

A prolonged conflict implies a broader supply shock, with global stagflationary tail risks and heightened volatility affecting exports, remittances and capital flows. Early signs of strain in domestic gas supply are already visible, while short-term inelastic oil demand constitutes a direct macro shock.

While oil and natural gas prices have edged higher, they remain below levels that would typically reflect a disruption of this scale and duration. Brent at $80–85 per barrel remains manageable, but the macro impact becomes more acute and non-linear if prices average north of $100. Under such conditions, the current account deficit could widen beyond 2.4% of GDP, with the balance of payments deficit worsening significantly.

Burden sharing
The eventual growth, inflation and fiscal outcomes will largely depend on how the crude price shock is distributed between oil marketing companies, the government and end consumers.

Price absorption by oil companies, while limiting pass-through to retail inflation, effectively carries a fiscal cost through reduced dividend and corporate tax transfers to the government. At current Brent prices, retail pump prices of diesel and petrol would need to rise sharply for oil companies to earn normalised margins, with annualised losses on auto fuels already tracking about ₹3 trillion after adjusting for refining gains.

Model estimates suggest that if the government were to fully absorb these losses through excise cuts and additional subsidies, the fiscal cost could rise to around 1.1% of GDP. Even under a more balanced scenario of burden sharing, the effective fiscal impact is estimated at about 0.5% of GDP, implying a crowding out of other policy spending.

In a sustained shock scenario, the most feasible outcome is a degree of burden sharing across all three agents, with oil companies absorbing the first leg of the adjustment, followed by the government and eventually consumers. The distribution of this burden will determine the relative impact on inflation, fiscal balances and growth.

Policy trade-offs
There is no simple playbook for a monetary policy response to an energy price shock. Prior to the conflict, policy had been focused on improving transmission through ample liquidity that kept overnight rates below the policy rate. The current environment complicates this approach.

While direct pass-through remains limited under managed fuel pricing, second-round effects through inflation expectations, growth shocks and tighter financial conditions are now shaping the policy trade-offs. The bar for a conventional rate hike remains high in the face of a supply shock.

At the same time, the RBI must assess whether it can continue to maintain abundant liquidity and sub-repo overnight rates. The rupee remains under steady pressure despite consistent intervention, largely through forward markets, with the associated liquidity impact deferred through bond purchases.

A sharp interest rate defence appears unlikely at this stage. The more probable approach is calibrated rupee depreciation alongside continued liquidity support, with rates managed through market operations.

The adjustment, therefore, is unavoidable. The question is how it is distributed across fiscal balances, inflation outcomes and the exchange rate, as the economy absorbs a sustained external shock.