Grim future for world economy

https://www.thehindubusinessline.com/opinion/grim-future-for-world-economy/article70793434.ece

The global economy is vacillating between sharply swinging narratives from the US administration under President Donald Trump and responses from Iran. Markets have reacted with volatility, oscillating between expectations of an imminent ceasefire and fears of prolonged confrontation. Investors are struggling to price in the long-term implications beyond immediate headlines.

In the immediate term, the announcement of a five-day war interregnum (now extended to 10 days) from the US side has provided some respite for markets. Yet it remains uncertain whether this pause can evolve into a lasting amicable resolution.

Historically, the US has rarely accepted outright submission in armed operations of this nature. The current context makes any decision to de-escalate even trickier, as America stands at a critical inflection point where its global hegemony, both economic and geopolitical, is visibly eroding. The stated objectives of the operation in Iran, including regime change, full control over nuclear capabilities, and access to oil reserves, remain largely unfulfilled. Given the asymmetric nature of the conflict, Iran retains leverage through its ability to disrupt oil supplies and maintain elevated prices, using these as bargaining tools to extract concessions.

Even in a scenario of quicker de-escalation, disruptions to crude and gas supplies, along with damage to infrastructure in the Strait of Hormuz region, will take considerable time to repair. Consequently, it is reasonable to assume that oil prices may remain elevated for longer than many market participants currently anticipate.

Irrespective of how the war fares, efforts to combat the growth and inflation fallouts are likely to be actively considered. Wars have historically been followed by lagged economic rebounds, often fuelled by substantial government spending on reconstruction, infrastructure, and defence.

However, in the current environment, such efforts face significant headwinds from peak levels of public debt and the pressing need for higher defence budgets, which constrain fiscal space for other forms of stimulus. Stagflation is imminent, with demand compression and recession as a likely outcome.

Borrowing costs have risen due to structural factors including declining global savings rates and early signs of de-dollarisation pressures, while bond markets demand higher risk premiums for sovereigns with record debt burdens.

According to the Institute of International Finance (IIF) Global Debt Monitor, global debt surged by nearly $29 trillion during 2025, pushing the worldwide total to a record $348 trillion. Of this increase, advanced economies accounted for the majority, with governments (both in advanced and emerging markets) contributing a substantial share. Continued fiscal expansion and regulatory adjustments are expected to drive further debt accumulation, raising legitimate concerns about long-term sustainability.

In the US, the public debt-to-GDP ratio has climbed to approximately 122 per cent as of late 2025. Pre-Supreme Court rulings on tariffs had already projected a $175 billion tax refund alongside a federal fiscal deficit reaching $1.9 trillion in 2026 (around 5.8 per cent of GDP). Commitments to defence, infrastructure, and entitlements leave limited room for additional stimulus without pushing yields higher and crowding out private investment.

Similar constraints appear elsewhere. The Eurozone’s average debt-to-GDP stands near 90 per cent, while the UK’s ratio is about 105 per cent amid a 4.7 per cent deficit. Japan leads with a ratio exceeding 250 per cent and persistent 4-5 per cent deficits, even as it contemplates further stimulus in 2026.

China’s official figure hovers around 80 per cent, but including significant hidden local government obligations paints a more strained picture alongside 3-4 per cent deficits. Emerging markets average 65-70 per cent, though outliers such as India (around 85.5 per cent, or ₹325 lakh crore by FY27E) and Brazil (near 90 per cent) face tighter margins.

With the Iran conflict potentially anchoring oil prices in the $90-100 range for an extended period, governments may prioritise targeted measures such as energy subsidies and elevated defence budgets, limiting stimulus and necessitating further borrowing. This could result in higher bond yields, renewed inflation, or even sovereign credit downgrades in vulnerable cases.

Narrow policy options

In India, policy challenges confronting both fiscal and monetary authorities are formidable. Central and State government debt combined could approach ₹325 trillion (around 83 per cent of FY27 GDP estimates), with the Centre’s debt alone reaching ₹214 lakh crore in FY27E, nearly four times the level of FY14. The budgeted fiscal deficit for FY27 stands at ₹17 lakh crore, while the combined Centre-plus-States figure may reach ₹29-30 lakh crore, leaving scant room for counter-cyclical stimulus. The additional ₹9-10 lakh crore annual oil import burden will ultimately be distributed across industries, oil marketing companies, households, and government budgets through some combination of higher prices, subsidies, and taxes.

Rising subsidy demands and increased allocations for defence and livelihood support will necessitate difficult expenditure trade-offs. Scope for further taxation of households appears limited, pushing reliance toward higher levies on corporates, sin goods, and premium products.

For the RBI, pre-existing challenges have been magnified. Despite substantial liquidity injections and rate cuts, 10-year G-sec yields have firmed to around 6.85 per cent, while the rupee has weakened to record lows near 94 against the dollar. The credit-deposit ratio has climbed above 82.5 per cent, constraining banks’ ability to expand lending amid sluggish deposit growth. India’s current account deficit could exceed $100 billion in FY27E under sustained $100 oil and current exchange rates, approaching the FY08 peak. Persistent declines in foreign investment flows could result in a balance of payments deficit for a third consecutive year, potentially reaching 3.3 per cent of GDP (a two-decade high).

Drawdowns from RBI forex reserves may accelerate depreciation. The combination of rising inflation, currency weakness, and slowing growth risks constraining both portfolio and direct investment inflows, can place the RBI’s multiple objectives of price stability, financial stability, government financing support, and liquidity management, under considerable strain.

Cloudy market outlook

Indian equity markets are navigating elevated uncertainties surrounding corporate earnings, capital flows, and valuations. Foreign portfolio investors (FPIs) have been net sellers of around $43 billion in equities since September 2024. Domestic institutional flows into equity mutual funds have shown resilience, aggregating $59 billion over the period. However, systematic investment plan (SIP) data indicates that the number of outstanding SIPs (103 million as of January 2026) has stagnated since October 2024, while average SIP assets under management have grown 20 per cent, suggesting greater participation from affluent segments and attrition among smaller investors facing negative returns. Monthly mutual fund flows declined to ₹230 billion in February 2025 from an average of ₹400 billion in late 2024, reflecting reduced smaller-ticket participation.

Resilient domestic flows have not fully offset FPI outflows, resulting in valuation compression: the Nifty’s trailing price-to-earnings multiple has fallen 14 per cent from September 2024, to around 20x. Should FPI retrenchment continue, falling valuations and moderating retail enthusiasm could exert sustained downward pressure.

An optimistic scenario might involve: (a) a sudden halt to hostilities due to massive economic costs, (b) FPIs returning to perceived value despite earnings risks, or (c) a substantial expansion of domestic flows to counterbalance outflows. However, these outcomes appear low-probability at present.

The writer is CEO and Co-Head of Equities & Head of Research, Systematix Group. Views are personal