The Iran Crisis and India’s Gathering Fiscal Storm

As the war in West Asia continues to drive up crude prices and fiscal pressures, India’s economic resilience is being severely tested.

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It has been nearly three months since the West Asian conflict began, and its ripple effects are striking us harder than the scorching summer sun in the subcontinent. The unfolding situation has already shaken the government’s risk management framework. For years, India benefited from a prolonged “Goldilocks” phase of economic stability, which helped cushion temporary disruptions. Yet no modern economy is built to withstand relentless external shocks whether from unending wars or recurring natural disasters. Growth flourishes only in an environment of peace and stability.

India’s vulnerability to turmoil in West Asia is hardly new. From the oil shocks of the 1970s to the Gulf War of 1991 and the Iraq conflict of 2003, every major disruption in the region has rattled India’s balance of payments, fuelled inflation and forced difficult fiscal trade-offs. Despite decades of diversification, the Indian economy remains deeply exposed to the geopolitics of energy chokepoints such as the Strait of Hormuz.

Cost Cutting

With the conflict unresolved, Prime Minister Modi has urged citizens to practice self-restraint, reviving COVID-era habits like remote work, virtual meetings, reduced travel, and deferring gold purchases. These steps aim to cut fuel imports, ease transport inflation, conserve foreign exchange, and safeguard India’s Rs. 690 billion reserves. Digital operations and limited travel also lower congestion, emissions, and business costs. By curbing crude demand, the country can soften inflation and free resources for infrastructure and welfare. This demand-side discipline complements RBI’s interventions, offering immediate relief while renewable transitions remain long-term. Its success depends on how faithfully citizens adopt it.

To curb inflationary pressures, the government reduced excise duties on petrol and diesel to offset soaring crude oil prices and kept fertilizer costs in check despite conflict-driven surges. These measures, however, have strained public finances and derailed the 4.3 percent fiscal deficit target.

At its 623rd meeting in Mumbai, the RBI Board approved a record surplus transfer of Rs. 2.87 trillion to the Central Government for FY2025–26, surpassing last year’s payout of Rs. 2.69 trillion. This marks the highest dividend in the bank’s history, offering temporary fiscal support amid severe external shocks and reinforcing the RBI’s role as both monetary authority and stabilizer. The payout reflects strong financial performance, with net income before provisioning rising 26.3 percent from Rs. 3.13 trillion in FY25 to Rs. 3.95 trillion in FY26. Expenditure grew 27.6 percent, gross income 26.4 percent, and transfer to the Contingent Risk Buffer (CRB) surged 143.8 percent to Rs. 1.09 trillion. The RBI’s balance sheet expanded 20.6 percent to Rs. 91.97 trillion.

Strategic Interventions

This surplus was driven by strategic interventions and favourable global dynamics. Large-scale forex operations - nearly $180 billion sold to defend the rupee - generated trading gains as dollar holdings were liquidated at high valuations. Elevated global interest rates boosted returns on foreign debt and currency assets, while a 10 percent dollar depreciation and 60 percent gold rally enhanced reserve values. Domestically, Rs. 9 trillion in government securities purchases expanded the balance sheet and interest earnings, while sovereign swaps moderated currency depreciation.

Under the revised Economic Capital Framework, the CRB was set at 6.5 percent of the balance sheet, down from 7.5 percent, to maximize surplus transfer during geopolitical stress. With the balance sheet expanding sharply, this required a larger nominal allocation of Rs. 1.09 trillion. A higher buffer would have reduced the dividend, while a lower one could have unlocked over Rs. 3.5 trillion but would have left the RBI exposed. The chosen balance safeguards resilience while still delivering a record payout.

This payout provides crucial non-tax revenue support to the Government. In the Union Budget, total dividends from PSUs, banks, and the RBI were projected at Rs. 3.16 trillion. The current payout amounts to 90.8 percent of the projections. While PSU banks like State Bank of India and Life Insurance Corporation of India add would receipts, falling oil PSU dividends will be offset, keeping the budgeted targets intact.

Yet fiscal strain persists. To shield farmers, the government-maintained urea price controls, absorbing global cost increases. As a result, the fertilizer subsidy bill for FY27 is projected to rise by Rs. 70,000 crore to Rs. 2.41 trillion marking a 40 percent jump, thereby offsetting gains from the RBI’s record transfer.

The full impact of the ongoing war is yet to unfold, but it is already clear that the government will miss its fiscal deficit target of 4.3 percent, which was premised on average crude oil prices of $85 per barrel. Every $10 increase in crude prices widens the deficit by about 40 basis points. With crude currently hovering around $100, the fiscal strain is expected to be considerably higher, pushing the deficit well beyond initial projections.

Alternative Measures

As the evolving global scenario is beyond India’s control, several policy adjustments merit attention. First, sourcing and supply chain diversification should be deepened by maintaining the shift toward Atlantic Basin crude and Russian imports, while securing long-term LNG and fertilizer feedstock agreements outside the Strait of Hormuz. Second, the continuous pursuit of the reform agenda remains essential. Third, dynamic subsidy management and exploration of direct benefit transfer options for subsidy disbursement are necessary. The government should also concentrate on accelerating adoption of high-efficiency alternatives like Nano Urea that can reduce bulk chemical imports and ease fiscal pressure without undermining crop yields.

On the monetary front, RBI’s use of its Rs. 690 billion reserves and swap operations has helped moderate currency volatility, but persistently high crude prices above $120 per barrel and continued rupee weakness may necessitate policy rate hikes to anchor inflation expectations. Aligning these monetary measures with government-led energy conservation is vital to safeguarding India’s external balance and macroeconomic stability.

The trajectory of the West Asian conflict is in uncertain terrain. Even in the best-case scenario of hostilities ending soon and the Strait of Hormuz reopening, supply chains would take at least three months to normalize. This disruption has already slowed India’s growth momentum in the first half of FY27, posing a significant hurdle to the Viksit Bharat mission.

The ongoing crisis has once again exposed structural fault lines in the way India’s economy has evolved. While the country has shown resilience against international pressures, it remains far from achieving the kind of global economic dominance that China commands. The government continues to push forward with reforms, but these efforts have yet to gain the full traction and recognition they deserve. Amid these challenges, RBI’s strong institutional framework has proven to be a critical shield, helping stabilize the economy during external shocks. Without a realignment and reinforcement of the domestic ecosystem, the vision of a Viksit Bharat will merely remain an aspirational one.

(The author is a Chartered Accountant with a leading company in Mumbai. Views personal.)