By: Anit Mukherjee
The Iran War and effective closure of the Strait of Hormuz have been a stress test for the Indian economy. Several years of relatively high growth, lower inflation, foreign exchange reserve, and fiscal consolidation were threatened by the conflict, which risked India’s supplies of 30% of crude oil and 50% natural gas imports, remittances from almost 10 million Indians, and about $200 billion in annual two-way trade with the Gulf.
In response, India attempted a balanced but robust administrative, fiscal, and monetary policy response to the initial shock of disruption to energy supplies. A first priority was to ensure adequate availability of cooking gas for households and expanded piped gas connections in urban areas. The government then reduced excise duties on petrol and diesel to cushion the rise in global crude prices and increased biofuel blending mandates to moderate import demand. The Reserve Bank of India (RBI) managed the depreciation of the rupee without resorting to interest rate hikes and introduced incentives to attract foreign exchange to offset the foreign portfolio investment (FPI) outflow. This was a textbook case of managing a temporary shock through policy coordination.
Even during the crisis, India’s merchandise exports recorded their highest ever levels of $45.2 billion in May. New free trade agreeements, particularly with the EU and the UK, are expected to add approximately 1% to GDP, and when combined with labor market reforms, the impact could rise to almost 3%. Finally, the RBI transferred a record dividend of nearly $30 billion to the central government — nearly 90% of budgeted non-tax revenue — alleviating some of the immediate fiscal pressures resulting from the increase in fuel and fertilizer subsidies.
At the same time, India’s policy response also exposed vulnerabilities that need to be addressed in the months ahead. While withstanding the short-term shock, the impact of the crisis has been noticeable. Although real gross domestic product growth in the fiscal year 2025-26 was a high of 7.7%, the RBI estimates that it will decline to around 6.6 percent for fiscal year 2026-27. Inflation increased from 2.7 to 3.9% between April and May. That is still within the RBI’s comfort zone, but food inflation running at 4.7% is a cause for concern. Meanwhile, fuel subsidies announced during the crisis will add up to nearly 0.6 percent of GDP and fertilizer subsidies a similar amount, bringing the total close to 1.2% of GDP. And while the rupee has stabilized after falling nearly 9% this year, further FPI outflows may compel RBI use its reserves to support the currency. Predictions of a lower-than-average monsoon coupled with a shortage in fertilizer supply may have an impact on food prices, and consequently, on inflation.
As crude oil prices moderate and energy supplies become more predictable, there is an opportunity to address three key challenges. First, there is a need to roll back the emergency subsidies on fuel and fertilizer to ensure that the country’s fiscal deficit target is met. This will send a signal to investors concerned about the ability of the government to manage its expenditure, provide space for the RBI to set interest rate in line with inflationary expectations, and ensure that public investment in critical sectors such as infrastructure and energy continue as planned.
Second, FPI outflows need to be balanced through higher inflows of FDI to manage the pressure on the rupee. The 20-year tax holiday for data centers announced in February’s Union budget is already attracting investment from hyperscalers such as Google, Meta, and Amazon. Encouraging greater levels of FDI in manufacturing through the PLI scheme can help crowd in domestic private capital, which has been lagging behind public capital expenditure over the last decade.
Finally, while a surge in FDI in AI infrastructure is a positive for the economy as it emerges out of the crisis, the impact of AI on the India’s labor market is not yet clear. Certain jobs in India's technology services sector are already being substituted by AI, while other firms are pivoting toward AI-complementary skills and moving up the value chain. As India tries to return to the high growth rates achieved over the past year, dealing with the disruption in labor market will be as important as managing the fiscal and monetary impact of the crisis.
Anit Mukherjee is Senior Fellow for the Global Economics & Development program at ORF America.