The Donald Trump administration might insist that the attacks on Iran won’t turn into a “forever war”, but the last three weeks and the Pentagon’s plans to request US Congress for an additional $200 billion for the war should make something fairly clear to Indian policymakers: this conflict is radically different from June 2025’s ‘Twelve Day War’. And its impact on the Indian economy is going to be far greater than a straightforward supply-side shock.The rupee’s exchange rate has become a real-time indicator of how India is being hit by the war in West Asia. After falling past 90- and 91-per-dollar in December as the India-US trade deal seemed nowhere in sight, it crossed 93 on Friday on concerns over the conflict’s escalation in the Gulf, with global crude oil prices above $100 per barrel and the price of India’s crude oil basket at $156.29/bbl.Absorbing the shockAccording to Kanika Pasricha, Chief Economic Advisor at Union Bank of India, “overshooting in the currency is bound to happen” at a time when the US dollar is strengthening, India is seeing capital outflows, and investors are risk averse.“This is not the time when any fundamental analyst can stick and point to a certain exchange rate level. For the Reserve Bank of India (RBI), maybe it does not want to catch a falling knife. In the tussle between the rupee and interest rates, the exchange is the shock absorber and its intervention strategy will continue in the same vein,” Pasricha said.Graphs, Data and Perspectives | Amid West Asia war, why central banks are between a rock and hard placeOf course, the extent of intervention is contingent on the ammunition the RBI possesses. According to former RBI deputy governor Michael Patra, the central bank should target foreign exchange reserves of $1 trillion. “Punting against such a level should be beyond the reach of the opportunistic and/or the faint-hearted,” Patra wrote in a column for website BasisPoint Insight earlier this month.As per latest data, the RBI’s forex reserves stood at $710 billion as on March 13, nearly triple the level during the taper tantrums of 2013. But “no amount of FX reserves will be adequate in the case of a prolonged conflict at the current level of intensity”, according to Vivek Kumar, Economist at QuantEco Research, adding that emerging market central banks such as the RBI will use reserves strategically to smoothen volatility, without coming in the way of the broader exchange rate trend. “At the end of the day, FX movement is also one of the parts of the necessary macro adjustment,” Kumar said, noting that the RBI’s reserves are placed comfortably “for now”.The real economyWhile the West Asia crisis has given rise to concerns about macroeconomic fundamentals of current account deficit, inflation, and growth in New Delhi’s policy circles, it has also served a reminder of the Covid-19 pandemic, with the resultant supply-chain disruptions and energy shock hurting small and medium-sized businesses in particular. The current crisis also comes at a time when India’s growth was seen picking up on the back of the government’s concerted consumption push and continued public spending on infrastructure.Story continues below this adThe energy crisis has already begun to reflect in prices of perishables and items produced by small-scale units such as knitwear, elastics, paper, laundry, and packaging materials. Government officials are closely monitoring the evolving situation for prices and supply chain. But higher inflation (from 3.21% in February) is likely to force the RBI to go on a prolonged pause after it cut the policy repo rate by 125 basis points in 2025.“We are still trying to assess and understand the durability and impact of the energy price shock. Yes, oil prices are elevated, but India’s inflation is still in check. And going by the Chief Economic Advisor’s comments to the Standing Committee on Finance – that crude oil prices of up to $90 per barrel will not have much of a macroeconomic impact on India – it seems to suggest that the government will absorb some of the cost from the higher prices,” Union Bank’s Pasricha said.Absorbing (some) costThe government (through higher fertiliser subsidy) and oil marketing companies (OMCs) are already absorbing much of the cost increase and shielding households. Yes, household gas cylinders are Rs 60 more expensive and prices of premium petrol and bulk diesel consumed by industrial users have been increased. However, pump prices of ordinary petrol and diesel remain unchanged.But the longer the war goes on, the bigger the hit the government’s coffers will take — either through reduced dividend from OMCs (their margins are at four-year lows) or lower tax collection if the excise duty is reduced.Story continues below this adAlso Read | Desperate measures: Why Trump suspended sanctions on Iranian oil at sea“At this stage, ensuring energy security and cushioning the impact on consumers is paramount, and this will involve a trade-off between fiscal and inflation risks,” Nomura economists noted on March 13, estimating a fiscal burden of 0.6% of GDP in 2026-27 from lower excise duties and higher fuel and fertiliser subsidies. This is around Rs 2.3 lakh crore, assuming 10% nominal growth in 2026-27 over the statistics ministry’s latest estimate of GDP.But there are some hits households have already taken and will have to withstand more of them as the war continues, including lower remittances from family members abroad and fall in stock portfolio gains — the Sensex and Nifty are both down more than 8% since the war began in West Asia. Further, the longer the crisis goes on, the more worrying the employment situation will become, especially in the labour-intensive, small-scale production units.The policy responseIf the RBI should let the rupee weaken gradually, it only makes sense the government also lets fuel prices rise — also gradually — the longer the war continues. Why? The same way imports become more expensive with a weaker rupee and help lower domestic demand, more expensive fuel domestically also helps ease demand for imported energy. This is necessary because of the problems India was already facing before the war began: capital outflows from financial markets, weak foreign direct investment (FDI), and higher trade deficits – all of which were exerting pressure on the rupee.Also Read | Tariffs, AI, war, oil: what next for Indian stock marketsConsider the following: in the first nine months of 2024 – just before it became clear that Donald Trump was likely to return to the White House – India saw foreign portfolio investment (FPI) and FDI inflows of $37 billion on a net basis, with the RBI net buying foreign currency to the tune of $32 billion.Story continues below this adThe tide then turned dramatically. Since October 2024, there has been net outflow of FPI and FDI to the tune of $33 billion. Meanwhile, the RBI has had to net sell foreign currency worth $96 billion to defend the rupee. Containing the trade deficit via lower demand for energy imports through continued rupee depreciation and price increases is needed given the foreign outflows and weak FDI. Otherwise, pressure on the rupee will continue to build and the vicious cycle will continue.Of course, the best solution is that the war ends today and normalcy is restored to disrupted supply chains and facilities as quickly as possible. Absent that, the government and the RBI need a plan that keeps the economy and households running as smoothly as feasible, given the circumstances.