India: Consuming Through the Shock or Adjusting to It?

Every country facing an adverse external shock must answer the same question: should it smooth the shock by borrowing and drawing down savings, or should it adjust immediately by reducing domestic consumption and investment?

The recent rise in oil prices following geopolitical tensions in West Asia has brought this question back to the centre of Indian macroeconomic policy. India imports most of its crude oil requirements, and higher oil prices represent a deterioration in the country’s terms of trade. The nation must now devote a larger share of its income to paying for the same quantity of imported energy. As a result, national purchasing power falls.

The economic question is not whether India is poorer as a consequence of higher oil prices. It is. The question is how quickly that reduction in purchasing power should be reflected in domestic consumption.

One possible strategy is to smooth the adjustment. Households routinely do this when faced with a temporary income shock. A family that expects its income to recover next year does not immediately cut consumption when earnings fall temporarily. Instead, it borrows or draws down savings. Countries can behave in much the same way. They can finance a temporary increase in imports through capital inflows, foreign borrowing, or the use of accumulated foreign exchange reserves.

In the current context, the RBI’s actions appear broadly consistent with such a smoothing strategy. By intervening in foreign exchange markets and preventing a sharp depreciation of the rupee, it is limiting the immediate increase in domestic fuel prices and other imported costs. This helps contain inflation, reduces pass-through into wholesale and consumer prices, and lowers the likelihood that monetary policy will need to tighten aggressively. The country effectively uses part of its accumulated foreign exchange savings to cushion households and firms from the external shock.

This approach has several advantages. It avoids unnecessary volatility, protects economic activity, and recognises that many external shocks prove temporary. If oil prices retreat or geopolitical tensions ease within a few months, forcing households and businesses to undertake painful adjustments today may turn out to have been unnecessary.

Economists often describe this as consumption smoothing. Countries save during good times precisely so that they can draw on those savings during bad times.

The alternative philosophy is more cautious. According to this view, a deterioration in the terms of trade should be reflected relatively quickly in domestic spending decisions. If the country has become poorer, households, firms and governments should consume less. Attempting to maintain previous living standards through external borrowing merely postpones adjustment while increasing vulnerability.

This perspective has deep roots in India’s economic history. The balance of payments crisis of 1991 remains an important reference point for policymakers. Large current account deficits financed by volatile capital inflows can suddenly become unsustainable if investor sentiment changes. What begins as a temporary effort to smooth consumption can evolve into a dependence on foreign financing.

From this perspective, exchange rate depreciation performs a useful economic function. A weaker currency raises the domestic price of imports, encouraging conservation and substitution. It reduces domestic demand for foreign goods and services while improving incentives for exports. The resulting adjustment helps keep the current account deficit within sustainable limits.

Many recent public statements by Prime Minister Narendra Modi appear closer to this second philosophy. His emphasis on reducing import dependence, promoting domestic production, increasing energy self-reliance, and encouraging disciplined economic management reflects a longstanding concern that excessive dependence on foreign financing creates strategic and macroeconomic vulnerabilities.

At first glance, these two approaches appear contradictory. One appears to advocate maintaining consumption despite an external shock, while the other emphasises adjustment and restraint.

In reality, the difference is often less about objectives than about expectations regarding the duration of the shock.

Suppose policymakers believe that higher oil prices are temporary and that foreign investors will soon return to Indian markets. In that case, drawing down reserves and preventing excessive exchange-rate volatility may be entirely sensible. The economy avoids unnecessary disruption while waiting for conditions to normalise.

Suppose, however, that policymakers believe the shock will persist for several years. In that scenario, continued intervention becomes progressively more costly. Foreign exchange reserves decline, current account deficits widen, and the economy becomes increasingly dependent on external financing. Eventually, some combination of currency depreciation, tighter monetary policy, slower consumption growth, or reduced investment becomes unavoidable.

The optimal policy therefore, depends less on ideology than on diagnosis.

How persistent is the increase in oil prices? How long will geopolitical tensions last? Is the current weakness in foreign capital inflows a temporary reaction to global uncertainty, or does it reflect a more durable reassessment of investment opportunities across emerging markets? These are ultimately empirical questions rather than philosophical ones.

India today occupies an unusually comfortable position from which to make these choices. Foreign exchange reserves remain substantial by historical standards, external debt indicators are manageable, and inflation is relatively contained. This gives policymakers room to smooth shocks in a way that would have been impossible in earlier decades.

At the same time, reserves are not infinite and external borrowing is never costless. A country cannot permanently consume more than it produces simply because it possesses accumulated savings. The logic that applies to households also applies to nations: savings can bridge a temporary gap between income and expenditure, but they cannot eliminate the need for adjustment if the underlying reduction in income proves permanent.

The debate, therefore, is not between prudence and recklessness. It is a debate about time horizons. One approach treats the current external shock as temporary and seeks to spread its costs over time. The other assumes that the shock may persist and therefore advocates earlier adjustment.

India’s actual policy is likely to lie somewhere between these extremes. The RBI appears willing to use reserves to cushion the immediate impact of higher oil prices and volatile capital flows. At the same time, broader government policy continues to emphasise self-reliance, export growth, domestic production and energy security. The combination suggests neither unconditional support for domestic consumption nor a willingness to impose immediate austerity.

Ultimately, the success of this middle path will depend on whether the current external pressures prove temporary or permanent. If oil prices fall and capital inflows recover, today’s intervention will look like a prudent use of national savings. If the shocks persist, however, India may eventually be forced to undertake the adjustment that it is currently attempting to defer.