RBI: US-Iran Deal Shifts Risk Balance Favourably, But Oil Price Spikes Could Raise FX Volatility

The Reserve Bank of India's latest Financial Stability Report highlights a favourable shift in the balance of risks following the US-Iran interim peace deal, while cautioning about potential exchange rate volatility if crude oil prices surge due to supply chain issues.

With the cessation of hostilities in West Asia following the signing of an interim peace deal between the US and Iran, the balance of risks has shifted favourably, said the Reserve Bank of India's (RBI's) half-yearly Financial Stability Report.

It, however, cautioned that exchange rate volatility could rise if crude oil prices increase due to delayed normalisation of supply chain disruptions.

While headwinds from the West Asia conflict are receding, the report said the Indian economy and financial system remain vulnerable to geopolitical tensions.

A sharp correction in global equity markets, particularly if triggered by a reassessment of corporate earnings growth and elevated valuations in AI-related stocks, could spill over into domestic markets, it cautioned.

Oil Prices and Exchange Rate Volatility

"Exchange rate volatility may rise if oil prices increase due to the delayed normalisation of supply chain disruptions and additional demand to replenish inventory," the report said.

It highlighted that India's macroeconomic fundamentals are stronger compared with many of its peers and previous crisis episodes, providing important buffers to withstand external shocks.

While low inflation, high growth and ample buffers have helped preserve macro-financial stability, RBI Governor Sanjay Malhotra said the central bank will remain vigilant to evolving external and domestic risks.

"(We) are committed to further strengthening the guardrails that protect our economy and financial system from potential shocks," he said.

Strengthening Financial System Resilience

The report noted that despite an uncertain global backdrop, the potential for external shocks to generate systemic financial stress and spill over into the real economy remains contained.

"The balance of risks has shifted favourably, supported by the cessation of hostilities in the West Asia conflict and the recent policy measures by the government and the Reserve Bank of India aimed at strengthening capital inflows," it said.

Earlier in June, the government decided to eliminate all taxes on income and capital gains from government securities for foreign portfolio investors (FPIs) to boost overseas investment and support the rupee.

The RBI, meanwhile, announced concessional swap windows to attract foreign capital.

The measures are expected to draw $55 billion to $60 billion in foreign capital.

"A robust and resilient financial system, underpinned by strong bank and non-bank balance sheets with adequate capital and liquidity buffers, provides a strong foundation," the report said.

Challenges and Future Outlook

Malhotra acknowledged that the risk of adverse external shocks has increased, with geopolitical conflicts and fragmentation emerging as key challenges for policymakers.

"In this environment, preserving financial stability, strengthening the financial system and building systemic resilience have become more important than ever," he said.

He said the financial system remains a key source of strength and support for the real economy and India's growth momentum.

Malhotra said the regulator recognises that maintaining public confidence in the financial system requires more than prudential soundness, with policies that promote fair conduct and improve customer experience being equally important.

"We want to foster a financial system that is not only resilient and stable, but also efficient, inclusive, and dynamic -- a system which supports businesses and households to participate and grow in a well-functioning economy," he added.

The report noted that the interim peace deal has laid the groundwork for a cessation of hostilities and the normalisation of supply chains, which could provide a boost to growth.

It added that the significant moderation in crude oil prices following the agreement should help ease pressure on the current account deficit (CAD).

"India's CAD has remained modest, averaging less than 1 per cent of GDP over the past three years," the report said.

Fiscal Implications and Bond Market

Another key macroeconomic variable that could face pressure is the fiscal deficit.

The report said elevated energy and commodity prices could strain fiscal balances due to limited pass-through of higher oil prices, excise duty cuts, and increased subsidy expenditure.

Any fiscal slippage could potentially push up government bond yields and add to already high debt-servicing costs.

However, the expected revival in foreign portfolio investor (FPI) debt inflows following recent policy measures, along with lower energy prices, could boost demand for government bonds and help ease pressure on yields, it added.