FY26 became a stress test for India’s external accounts, showing that diversification and reserves can buffer shocks but not eliminate structural vulnerabilities.
Part 2 of a three-part series on India's economic transformation in FY26
India’s economic evolution has culminated in a growth model anchored in domestic demand. By FY26, private consumption had reached 56 percent of GDP — a characteristic that should insulate the economy from external turbulence. In 2025, that assumption was tested with unusual severity. Two shocks struck consecutively. First, a trade policy shock from the United States, which raised tariffs on Indian goods to as high as 50 percent. Second, a commodity price shock rooted in cascading geopolitical instability culminated in an oil crisis that sent Brent crude past US$120 a barrel in early 2026. One hit the export side of India's ledger; the other hit the import side. For an economy running a structural merchandise trade deficit, the import side is the greater vulnerability — and the one where classical adjustment mechanisms work least effectively.
For an economy running a structural merchandise trade deficit, the import side is the greater vulnerability — and the one where classical adjustment mechanisms work least effectively.
The tariff arc unfolded in three acts. On 2 April 2025, the US announced a 26 percent levy on Indian exports as part of a broader “reciprocal tariff” regime; the Sensex fell 2,200 points in a single session. By August, a further 25 percent was added to penalise India's continued purchases of Russian oil — bringing total duties to 50 percent and making India one of the most heavily tariffed US trading partners. After months of stalemate, with agriculture as the primary stumbling block, an interim deal in February 2026 cut effective tariffs to 18 percent, and the Nifty surged 5 percent at the open. However, the framework remains legally incomplete and the agricultural question unresolved.
The oil story ran on a different, slower fuse. Through most of 2025, soft crude prices provided the benign backdrop to the disinflation described in Part 1 of this series. That backdrop shattered in March 2026, when US-Israel strikes on Iran and the effective closure of the Strait of Hormuz sent Brent from US$80 to US$120 in under a week. India imports 85 percent of its crude, roughly half of which transits through the Hormuz Strait. Estimates show that a US$10 increase in crude prices could widen India’s current account deficit by 40–50 basis points.
The damage was real, but unevenly distributed across the three channels through which external shocks enter an economy: trade volumes, the current account, and the exchange rate. On trade, the headline numbers proved surprisingly resilient. Total exports reached a record high of US$825 billion in 2025 and continued to grow in H1 FY26. Services exports reached an all-time high of US$387.5 billion in FY25, growing 13.6 percent. These were largely insulated from the tariff because the US levies targeted goods. However, the merchandise picture was more strained: the pace of export growth to the US slowed from 35 percent in March 2025 to 5.76 percent by January 2026 as the tariffs began to bite. Prior to the interim trade deal, engineering exports alone were estimated to face a US$4–5 billion hit. SMEs in textiles and leather lost competitiveness against lower-tariffed Vietnam and Bangladesh.
On the current account, the April-February period saw the trade deficit widen from US$91 billion in 2024-25 to US$109 billion in 2025-26. Strong services surpluses covering roughly two-thirds of the merchandise deficit and substantial remittances of US$73 billion (April-December 2025) did the heavy lifting. However, this reading was supported by soft oil through mid-2025 and front-loaded exports ahead of tariff deadlines. The merchandise trade deficit hit a record US$310 billion in April-February, possibly driven by high oil import costs.
Figure 1: Currency Depreciation against USD (since January 2025)
Source: Created by the author using IMF Data
On the currency front, vis-à-vis the US dollar, the rupee has depreciated from roughly 85.6 to 93.2 over the last year, ranking among the worst performers. Three forces combined: the interest rate differential widened as the RBI cut 125 basis points while the Fed held steady, draining FPI outflows of INR 152 lakh crore from equities; the tariff and oil shocks deteriorated the terms of trade; and a global risk-off rotation toward US mega-caps added a geopolitical premium. The RBI managed the decline by drawing on its US$700 billion reserve buffer, smoothing the pace of depreciation rather than defending a level. Reserves fell, but remained among the world's largest. This led the IMF to reclassify India's exchange rate regime from "stabilised" to "crawl-like," acknowledging that the RBI was allowing the rupee to function as a shock absorber.
Classical trade theory offers a clear prediction here. The Marshall-Lerner condition holds that a currency depreciation improves the trade balance if the sum of export and import price elasticities exceeds one. If it does not, depreciation perversely widens the deficit — India would sell roughly the same volume at lower dollar prices and buy roughly the same volume at higher rupee prices.
India's trade structure creates an asymmetric elasticity problem that makes this test instructive. On the export side, the largest category, IT and business services, is invoiced in dollars and benefits from depreciation on the cost side (rupee-denominated salaries and overheads). However, its demand is driven by client budgets and project pipelines, not relative pricing. A weaker rupee does not generate new outsourcing contracts; it improves margins on existing ones. Goods exports are more price-elastic in theory, but India's key merchandise categories — gems and jewellery, petroleum products, pharmaceuticals — face demand conditions that are only partially price-sensitive.
In India's case, the Marshall-Lerner condition appears to hold weakly at best, and the J-curve, if it exists, has a tail longer than a single fiscal year can resolve.
On the import side, inelasticity is starker still. Crude oil, the dominant import, cannot be substituted in the short run. Here, demand is determined by industrial activity and transport needs, not by price. Electronics imports, which are another large category, are similarly rigid. The rupee's fall, therefore, raised the import bill without proportionally boosting export volumes. The empirical evidence from FY26 is consistent, where the merchandise trade deficit widened by nearly 19 percent in the first eleven months despite the depreciation. The services surplus expanded, but that owed more to structural demand for Indian IT than to exchange rate effects. In India's case, the Marshall-Lerner condition appears to hold weakly at best, and the J-curve, if it exists, has a tail longer than a single fiscal year can resolve.
India's policy response has been to reduce exposure on both flanks. On trade, the interim US deal at 18 percent buys time but is not a settlement. More structurally significant is the expanding web of FTAs: agreements signed with the UK and Oman, negotiations concluded with New Zealand and expected to be signed later this month, the EFTA pact going operational, and the India-EU FTA expected to take effect in early 2027. UNCTAD ranked India third in the Global South for trade partner diversification. This is Vinerian trade diversion as a deliberate strategy, but the tension between strategic diversification and allocative efficiency is present. FTAs with smaller economies cannot replicate the scale of US market access, and India's manufacturing competitiveness under the PLI scheme remains a work in progress.
The disinflation of 2025 and the oil shock of 2026 are not separate stories — they are chapters of the same story, viewed from opposite ends of the commodity cycle. The institutions held. The vulnerabilities, however, are structural, and they will recur.
On energy, India has begun diversifying crude sourcing — increasing imports from the US, UAE, and West Africa while reducing reliance on Russia and West Asian suppliers. Strategic reserves cover roughly 74 days of consumption, but these are buffers, not solutions. Nor is manufacturing competitiveness a sufficient answer in isolation – India's export basket will need to shift toward higher-value goods if depreciation is ever to function as a meaningful adjustment mechanism rather than merely inflating the import bill. Another durable hedge against Hormuz-type disruptions is structural — accelerating renewable deployment and reducing the oil intensity of GDP growth. India had achieved 266.78 GW from non-fossil-fuel sources by December 2025, comprising 52 percent of installed power capacity. The Iran crisis may now compel policymakers to build on this far more aggressively than they otherwise would.
Part 1 of this series showed what India's macro framework could achieve under favourable conditions. This piece shows what happens when those conditions are withdrawn. The disinflation of 2025 and the oil shock of 2026 are not separate stories — they are chapters of the same story, viewed from opposite ends of the commodity cycle. The institutions held. The vulnerabilities, however, are structural, and they will recur.
Arya Roy Bardhan is a Junior Fellow with the Centre for New Economic Diplomacy at the Observer Research Foundation.
Part 3 examines the domestic financial architecture that held India's markets together through this turbulence.
The views expressed above belong to the author(s). ORF research and analyses now available on Telegram! Click here to access our curated content — blogs, longforms and interviews.
Arya Roy Bardhan is a Junior Fellow at the Centre for New Economic Diplomacy, Observer Research Foundation. His research interests lie in the fields of ...
Read More +
PREV
