- By: Agreima Tyagi & Shivani Chaudhry
In August of 2025, the United States further heated up its trade tensions with India when it imposed a 25% duty on nearly all imports. While often characterized in reports as a trade war, its actual implications go far deeper than mere bilateral trade. For India, such tariff shocks are not just about cancelled contracts or diminished export volumes; they reverberate through the financial system, shaping creditworthiness, balance sheets, and the banking sector’s ability to absorb risk. These are the invisible ripples that matter most, as they test the fiscal foundations on which India’s long-term economic prospects depend. With efficient tariff rates on select inputs touching 50% (Reuters, 2025a; Yale Budget Lab, 2025; CSIS, 2025), labour-intensive sectors like gems and jewellery, textiles, clothing, seafood, and engineering products find their margins continuously squeezed like never before. Survival for many of these exporters has become far from guaranteed. Since these industries constitute a large clientele of banks from India, the implications reach the financial sector immediately. Exporters rely greatly on foreign-currency packing credit, bill discounting, and cash-credit lines. Delayed or cancelled orders, warehouses full of unsold stocks, and hedging costs accumulation with fluctuating currencies bring banks face to face with greater utilisation of working-capital limits, decreasing repayment capabilities, and enlarged risk of default. The Reserve Bank of India (RBI) has already mitigated the impact. By June 2025, it had reduced the policy repo rate by 100 basis points, with a 50 bps reduction in June, to 5.50%. Simultaneously, it reduced the cash reserve ratio (CRR) by 100 bps, injecting around ₹2.5 trillion of permanent liquidity into the economy (Reuters, 2025b). These measures conformed to the old monetary easing playbook: low cost of borrowing, give leeway to banks to borrow and lend, and keep credit flows steady when the external environment is belligerent.
Channels of transmission of Tariff Shocks to the Banking System
Tariff shocks are actual disturbances and not mere theoretical policy changes, and they transmit fast through the entire economy and to banks. The shock is first observed by exporters whose orders can fall or simply get canceled and create a ripple effect through to financial institutions who administer their activities. For micro, small, and medium entities (MSMEs), who contribute over 45% of India’s merchandise trade (Ministry of Commerce, 2024), it has an instantaneous and stinging effect. These entities’ margins are thin and thus sensitive to change in foreign demand and potentially can have their cash flows severely impaired by it. Lower revenues create difficulty repaying working capital loans and thus increase defaults on loans. The 2018 U.S.–China’s war to impose tariffs provides clear evidence to support this statement: export-based MSMEs’ non-performing asset (NPA) percentage in India increased from 8.7% to 9.5% over only two quarters and illustrates how easily trade disturbances can jeopardize asset quality.
Liquidity pressures compound this risk. Trade uncertainty triggers foreign portfolio investors to retreat to safer markets, leading to equity outflows. In July 2024 alone, India experienced $1.8 billion in net FPI withdrawals (NSDL, 2024). Such movements weaken the rupee, raise borrowing costs for corporates, and force them to rely more heavily on domestic lenders. With external commercial borrowings already amounting to $44.3 billion in FY24, this “fly home” demand for liquidity places strain on Indian banks. The RBI may respond by injecting liquidity, but banks themselves often raise lending rates to ration scarce credit, squeezing smaller firms in particular. Currency depreciation adds another layer of stress. While a weaker rupee can provide some competitive relief for exporters, it simultaneously increases the repayment burden on companies with foreign-exchange borrowings. Import-dependent industries such as electronics, chemicals, and pharmaceuticals face a double bind: higher costs for raw materials coupled with reduced repayment capacity. The strain on margins soon translates into pressure on loan books. Finally, the effects are not confined to corporations. Layoffs in export industries depress household incomes, which weakens repayment capacity for mortgages, automobile loans, and credit card debt. During the global trade slowdown of 2020, India’s personal loan delinquency ratio rose from 1.9% in 2019 to 2.4% in just six months (TransUnion CIBIL, 2020). What begins as an external trade shock can therefore seep into retail loan portfolios, threatening the stability of banks on both the corporate and consumer sides.
Lessons from Previous Crises
India’s experience with earlier crises provides important lessons for understanding and responding to the current situation. The 2008 global financial crisis, the 2013 taper tantrum, and several other episodes have shaped the RBI’s crisis management playbook. In 2008, when global credit markets froze, the RBI responded with aggressive liquidity easing. Repo rate was reduced by 425 basis points, CRR reduced by 400 basis points, and refinance was given on a target basis for export support. The objective was simple, to stabilize exchange rate, and to allow credit to flow into productive sectors. This bold intervention assisted India to ride through a global storm that had put advanced economies into an icy grip. The taper tantrum of 2013 was a clear test. In response to U.S. Federal Reserve cues for tapering quantitative easing, the episode elicited capital flight out of emerging markets, including India. The RBI reaction was more cautious: temporarily, it adjusted short-term interest rates to prop up the currency while selectively easing credit to exporters and priority sectors. The experience was one of honing interventions — shielding macroeconomic stability from the temptation to provide excess liquidity. The current tariff war is of a different nature. It is not a financial contagion, as it wasn’t in 2008, nor is it even largely a capital account shock, as it wasn’t in 2013. It is a trade flow shock, spurred by geopolitics rather than business cycles. This makes it even more deep-seated and unpredictable. MSME NPAs, at 8.2% as on March 2025, may rise further, and even a one-percentage-point rise would considerably sap banks’ profitability and provisioning cushions. Large corporations looking for domestic lenders may crowd out the small borrowers unless banks actively re-balance their books. The risks thus are structural, not transient.
Policy Tightrope: Managing Risks Without Worsening Instability
The challenge for policymakers is how to fund the banking system without triggering moral hazard or generating inflationary pressures. More liquidity lowers the cost of borrowing, but runs the risk of encouraging reckless lending if banks assume that government or central bank support will always be forthcoming. Experiences in advanced economies since 2008 show the way that prolonged periods of easy money can encourage asset bubbles and riskier lending. India cannot be allowed to go down this path. Inflation only makes life more difficult. Trade slowdowns are typically disinflationary, but currency devaluation adds costs to core industries, creating inflationary pockets while aggregate demand weakens. Monetary management here is a delicate balance. The strength of India’s reaction now is its reversibility. By cutting the repo rate and CRR, the RBI has provided relief now without committing itself to permanent fixes. If trade tensions subside, these interventions can be reversed. That flexibility draws on the lessons of 2008 and 2013: respond quickly to prevent systemic stress, but unwind support cautiously after stability has been re-established. The focus must remain on the maintenance of credit quality, avoiding indiscriminate lending, and the prevention of financial discipline distortion by way of liquidity infusions.
The U.S.–India tariff war is a double test: mettle of exporters and the structural strength of India’s banking system. The RBI and government reaction till now shows both lessons of history and realities of the times. Cutting policy rates and cutting reserve requirements have provided space to the banking system, but these are short-term palliatives, not for all time solutions. If interventions are too long or too aggressive, they may contaminate credit channels, overprice assets, and perpetuate moral hazard. The best policy, history has taught, must be aggressive but reversible. Liquidity injections must first calm markets and later be narrowly directed to most distressed sectors. Gradually, normalcy must be restored through tightening once pressures from abroad relent. Short term, India needs to stay stimulus-biased or risk a credit freeze. Long term, though, stability in its banking system will have more to do with sound credit judgment, strong provisioning, and responsiveness in adjusting policy instruments to respond to changing conditions. Stabilization of the market during trade wars demands speed but it’s speed in terms of quality design, implementation, and reversibility that will be the driving force behind resilience.
References
- CSIS. (2025). India–U.S. trade tensions and global implications. Center for Strategic and International Studies.
- Ministry of Commerce. (2024). Export performance and MSME contribution to India’s trade. Government of India.
- NSDL. (2024). Monthly foreign portfolio investment report. National Securities Depository Limited.
- Reuters. (2025a). U.S. hikes tariffs on Indian exports to 25%. Reuters.
- Reuters. (2025b). RBI cuts repo rate and CRR to boost liquidity amid tariff shock. Reuters.
- TransUnion CIBIL. (2020). CIBIL insights: Retail loan delinquency trends. TransUnion CIBIL.
- Yale Budget Lab. (2025). Global tariff tracker: Effective trade barriers in 2025.
Author: Agreima Tyagi (Student of Economics) & Shivani Chaudhry (Associate Professor, School of Social Sciences), CHRIST University, Delhi NCR