By Renu Kohli
The US tariff shock has elicited much analysis and commentary. Summarily, this posits slower growth through the trade channel, with indeterminate effects upon inflation, subject to trade diversion and export substitution. A majority see limited growth damage because of a relatively smaller export share and the superior shield of domestic demand. Optimism has also arisen because of opportune openings from the dislocation of Chinese exports to the US, with whom a bilateral deal expects to occupy some of the vacated spaces. The confidence and financial channels, the more immediate and powerful transmitters of the tariff shock, have attracted limited attention. The attempt here is to broaden the analytical framework to all three — trade, financial, and confidence channels — for evaluating the potential macroeconomic consequences for India.
The uncertain layers are many. Trade policy uncertainty, which escalated months before “Liberation Day” in early April, has soared and spilled to financial markets, raising contagion risks. It continues to mount each day with more imponderables like counter-retaliations, especially by China, and ultimate trade deals among the three major demand blocs, including the European Union (EU). Continuous US policy shifts create endless speculation about the endgame. Rapid morphing of the trade war to US bond and currency markets with hefty rise in yields and the unpredicted fall of the dollar has damaged credibility of the reserve issuer and anchor of the international monetary and financial system. Crisis risks have risen. Trade policy uncertainty is no longer just that, but larger. There is a broader loss of confidence with a trust deficit. The uncertainty can only be described as infinite!
These uncertainties arrive atop existing domestic policy uncertainties that, along with other factors, have long depressed business investment as well as foreign direct investments (FDIs) that turned negative last year. Yet another layer of uncertainty is formed by the abrupt turn in trade and industrial policy. Exceedingly protectionist for last several years and promoting import substitution and incentive-supported domestic manufacturing, the unexpected turn to embracing openness just months ago, while positive, creates confusion and uncertainty.
Uncertainty is the enemy of investment and, to an extent, of consumption. It is costly and undermines confidence. The confidence channel, therefore, is the first point of transmission. The tariff turmoil has already dented business confidence and sentiments, stalling current investments. Companies are no longer sure of any business feature. Think of a steel manufacturer who created capacities, is planning expansion in certain policy settings, sure of input prices and their source, final sales price, margin, and markets, but suddenly confronts new levies abroad, a turnabout in domestic policy environment. It is impossible to fathom the relative favourability of India’s bilateral trade deal over competitors who are negotiating hard too. How competitive will the product finally be?
The shock continues to play out through this channel, deterring trade and investments because of persisting uncertainty, especially from constantly changing scenarios and second-order effects like counter-retaliations, major currency movements, and diverting trade apprehensions.
The financial channel closely tracks the confidence network, which it also impacts by shaping beliefs. Asset price movements (stocks, bonds, currency), their volatility, and relative pricing directly influence investor and business earnings as well as household wealth. Uncertain and rapid changes in share prices, rupee appreciation/depreciation, and raised interest rates impact revenues, margins, funding costs, and access. India’s financial market integration and exposures make this pipeline an instant and forceful conductor of foreign shocks. It thus leads and outweighs transmission via the trade channel that has longer lags and delayed impact.
Indeed, the financial channel impact has been starkly visible. One, it prompted fresh outflow of foreign portfolio capital from debt and equities in the first fortnight of April, with moderate resumption recently. This plays out in a backdrop of a -$15 billion net outflow (including FDI) in October-December 2024 and -$4.6 billion net in January-March. Portfolio choices of global investors exiting US markets are uncertain. Prospective FDI could be limited by the imminent slowing of world output and a vulnerable backdrop of accelerated exits from India. Two, stock indices fell, recovering since, but ~15% below the end-September value (Nifty 50).
Three, the rupee-dollar exchange rate weakened marginally (~0.7%) in this while, a tumultuous one for the dollar that shockingly plunged and remains weak, partly supporting the rupee. From its peak 5% depreciated value on February 10 — `87.58 to the dollar — over end-September, the rupee has gained some 2%, limiting the fall. Finally, local bond yields have remained calm, moderating in line with the two-stage, 50-basis point policy rate cut, barely reacting to the hefty jumps in US yields.
The trade channel transmission is yet to show up in hard data. There are reports of anxious exporters and manufacturer bodies about an uncertain outlook, front-loaded orders, and tariff cost-sharing demands from buyers. Bilateral deals with the US, UK, and the EU will take time, and trade-related uncertainties will persist for a lengthy period.
The negative demand shock will play out through all three channels amidst an ongoing economic slowdown. The growth impact remains to be seen. There’s a discernible underlying tendency in the world — “each country for itself” — where all but few are indebted, struggling to grow, and “doing anything it takes” to retain, replace, or create sources of demand. It’s useful to remember that “tariff wars” do not take long to morph into “currency wars”. Indeed, the decline in domestic inflation provides an opening for maintaining a competitive exchange rate with the advantageous coincidence of monetary easing should the interest rate route be circumscribed by widened spreads.
There is palpable nervousness, visible in the initial public offering market, for example. Manufacturers’ business sentiments had fallen back for Q1FY26 after a small, two-quarter lift as per the Reserve Bank of India survey. Consumer confidence in the current economic situation has been pessimistic for six long years. The 2008 crisis and subsequent reversal of world trade is a good guide — business sentiments then plunged deep, not restoring to former strength until the post-Covid rebound (FY22), from which they had already begun to slide and intensify in Q1FY24. Forthcoming surveys will provide an insight. As the last decade and some shows, business confidence feeds into actual investment. Optimism can hold back transformation into real fixed asset creation that, above all, requires assurance.
The writer is senior fellow, Centre for Social and Economic Progress, New Delhi.
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