The West Asia conflict is well into its third month. The good news: We are not seeing the shortages that were initially feared by May. The sobering realisation: This is because a rapid, and unsustainable, drawdown of inventories has cushioned the shock. While 14 million barrels a day of crude and its derivatives have been taken off-stream — the largest energy supply shock in history — the majority of this has been offset by running down global inventories.This has two implications. First, if the Strait of Hormuz does not open in the coming weeks, inventories risk approaching their operational minimums and shortages will become real. Second, the price damage has likely already been done. Even when the Strait opens, supply will take a while to normalise, and demand is likely to significantly outstrip supply as inventories are rebuilt. The upshot is that crude is expected to stay above $100/barrel in the coming quarters.AdvertisementAlso Read | No quick-fixes, problem of weak rupee runs deepWhat does all this mean for India? Policymakers are faced with three near-term objectives. First, how to scout for more crude, LNG, and LPG on the high seas to prevent shortages. Second, how to efficiently distribute the terms of trade shock from higher prices between the public and private sectors. Third, how to contain rising balance of payments (BoP) pressures.On the first objective, India has been able to diversify such that May imports — while still below pre-conflict levels — are higher than previous months. On the second, the government has borne the bulk of the burden thus far. Retail prices have just started moving up and will need to continue moving up, albeit slowly, to both elicit the desired behavioral response from the private sector and conserve fiscal space to deal with the broader challenges the economy will confront if the Strait remains closed.Instead, the biggest near-term challenge is the external sector. For the first time in three decades, the BoP has been in deficit for two consecutive years, and we are on course for a third consecutive deficit. Unsurprisingly, therefore, the rupee has been under sustained pressure for more than two years. Unlike previous BoP episodes, however, this time is different. In earlier episodes, pressures started with a widening of the current account deficit (CAD), and the trigger was a sudden retrenchment of capital flows to finance a ballooning CAD. The sequence has been reversed this year. The CAD has been very benign, averaging less than 1 per cent of GDP over the last three years. Instead, rupee pressures have originated from a sharp slowing of capital flows over the last two years. Expectations of a much wider CAD in the wake of the West Asia war are acting as a force multiplier, not the original cause. It’s important to make this analytical distinction — whether the source of pressures is the current or the capital account — because it informs the policy response, as we discuss later.AdvertisementA collapse in FDI is at the heart of the capital flow story, with net FDI, which typically averages 1.5 per cent, completely drying up over the last two years. What’s driving this? Between 2010 and 2025, India’s net FDI is remarkably well correlated with US 10-Year Treasuries — a proxy for global financial conditions. When yields are low, India tends to get a gush of FDI; when yields harden — like the last two years — net FDI dries up. Recall, FDI is typically governed by both (global) “push” and (country-specific) “pull” factors. India’s FDI trajectory suggests it has largely been governed by push factors since 2010. The last time it was driven by pull-factors was in 2005-10 when a strong corporate capex cycle catalysed strong FDI. The near-term outlook on global financial conditions is sobering. Sticky inflation — and the prospect of rate hikes in the US — along with its precarious fiscal situation, is likely to keep US yields elevated. If history is any guide, this does not augur well for net FDI into India.Why does this matter? Because the days of a very benign CAD are behind us. Crude prices in triple digits will take India’s CAD for 2026-27 close to $100 billion. Financing this, in the wake of a drying up of capital flows, will be the central macroeconomic challenge this year. So what can policymakers do ?The first line of defence, as we have long argued, is to let the rupee depreciate and act as a shock absorber. A weaker rupee will disincentivise imports by making them more expensive and make exports more competitive (“expenditure switching”) and, if foreigners believe the rupee has overshot, re-attract capital. Theoretically, large negative terms of trade shock from crude prices and a sharp slowdown in FDI both argue for a much more depreciated equilibrium real effective exchange rate (REER). To policymakers’ credit, they have let the REER depreciate by 12 per cent from its highs to facilitate this adjustment.But while the rupee depreciation is a necessary condition, will it be sufficient in the current environment? Recall, the source of the pressures is a drying up of capital flows. The conventional wisdom is that if the rupee is deemed to have overshot, capital flows will be attracted back. But what does overshooting mean in the current environment? Faced with a large BoP gap, to what extent will the rupee — if it is the only instrument being used — need to depreciate to close this gap? That is the question that foreign investors will be asking, and it’s not clear that any value of the rupee will be seen as being oversold, thereby impeding the typical stabilising role that a weaker rupee plays in re-attracting capital.So, while a weaker rupee may help narrow the current account, if the depreciation is too rapid, it increases incentives for foreigners to hedge their existing stock of foreign assets in India (FPI, ECBs, FDI). That hedging, in itself, increases rupee depreciation pressures, further increasing the desire to hedge — and risking a self-fulfilling spiral.While rupee depreciation is a necessary condition, it may not be a sufficient one, given the perceived size of the BoP gap. Instead, it will need to be complemented by capital augmentation measures, which is the original pressure point. The objective should be to attract a sufficiently large quantum of near-term capital inflows — even if this involves a subsidised swap — both to augment FX reserves but, more importantly, serve as a circuit breaker in the foreign currency market, and change exporter, importer and investor behaviour.A weaker rupee and an influx of capital should hopefully tide over BoP pressures. If not, “expenditure compression” to narrow the CAD through tighter fiscal and monetary policy may be needed as a last resort. But this comes with trade-offs. Back in 2013, when the rupee was under pressure, it was clear the economy was overheating, and the obvious response was to tighten fiscal and monetary policy, narrow the CAD and take the pressure off the BoP. The current context is very different: Core inflation has averaged just 2-3 per cent for the last two years, suggesting the economy still has slack and is far from overheating. Further, the economy is still awaiting a private capex cycle, and risk aversion is only likely to increase amidst heightened geopolitical uncertainty. In this environment, fiscal compression that translates into fuel and fertiliser subsidies cannibalising public capex risks making policy pro-cyclical. More generally, when the source of the pressures is the capital account, expenditure compression that narrows the CAD by slowing growth risks further alienating capital inflows.Stepping back, it’s important to realise that this BoP episode is different. The pressure point is the capital account, not the current account. Some rupee depreciation is inevitable and unavoidable. But a weaker rupee also needs complementary measures. Squeezing the current account could be counterproductive because slowing growth could further turn off capital inflows. Instead, the focus should be on capital augmentation measures.The biggest lesson from this episode must be that attracting strong and stable foreign capital is an urgent macroeconomic imperative for India, for both macro stability and growth. In the current storm, attracting capital may necessitate a subsidy. But, in the medium term, attracting capital flows — and re-creating an India pull factor — will require sustained economic reform that eventually translates into a private capex cycle and higher growth. There is no escaping that imperative.Sajjid Z Chinoy is Head of Asia Economics at J.P. Morgan. All views are personal.