Indian Economy: Downside risks materialising

With the conflict in West Asia continuing for nearly two months, we see increasing downside risks to our base case gross domestic product (GDP) growth outlook for the current fiscal. If disruptions extend through April, we expect GDP growth to slow to 6.8% this fiscal, compared with our earlier projection of 7.1%, and inflation to surge to 4.7%.

This would still be a reasonably favorable outcome given the nature of the shock and India is expected to remain a growth outperformer in calendar year 2026.

However, the conflict significantly tightened India’s financial conditions in March through capital outflows, a sharp depreciation of the rupee and rising bond yields. Domestic liquidity also tightened because of tax outflows. The Crisil Financial Conditions Index declined to -1.4 from 0 in February, falling out of its comfort zone of one standard deviation from the long period average.

The impact of the West Asia conflict remains partially obscured in inflation data, as consumers have been largely shielded through unchanged petrol and diesel prices.

Headline retail inflation printed at 3.4%, only 20 basis points (bps) above the February level, while core inflation was unchanged at 3.7%. However, higher energy and commodity prices, increased freight and transportation costs, transit delays and rupee weakness will exert upward pressure on inflation. Even if the conflict resolves soon, energy prices are likely to remain elevated due to the infrastructure damage in West Asia.

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) kept the policy rate unchanged and maintained its neutral stance in April. It projects GDP growth of 6.9% and Consumer Price Index (CPI) inflation of 4.6% for the current fiscal, with downside risks to growth and upside risks to inflation. We expect the committee to maintain an extended pause, as room for rate cuts is rapidly diminishing.

Government bond yields have remained stubbornly high since 2025 despite a 125-bps cumulative repo rate cut and historically low inflation—an outlier in India’s otherwise healthy growth-inflation narrative. This reflects elevated government borrowing, particularly from states, in fiscal 2026.

Due to rising fiscal pressures, we expect yields to remain elevated compared with the last fiscal. As the West Asia conflict is rapidly transitioning from our base case projections of early March to an alternative downside scenario for most Indian macros, greater fiscal pressure and market borrowing, along with rising inflation, reduces monetary policy space.

Both the Centre and the states could borrow more as the West Asia conflict reduces revenue and increases expenditure. Weaker foreign capital flows into debt going forward add upward pressure to yields, which could rise to 6.9% by March 2027 (up from our base case of 6.6%).