Do it yourself

Past four weeks have marked a watershed in the geopolitics of South Asia. A terrorist attack in Pahalgam (J&K, India) on 22^nd April 2025, resulted in the brutal killing of 26 tourists (25 Indian and 1 Nepalese). The terrorists were believed to be from groups actively supported by the Government/Army establishment of Pakistan; and operating from the Pakistan Occupied Jammu & Kashmir (PoJK) and Pakistan.

The Government of India responded to the attack by (i) taking several diplomatic and economic measures against Pakistan over the next couple of weeks, and (ii) targeting terror infrastructure in PoJK and Pakistan, on 7^th may 2025, reportedly killing 70-100 terrorists and their allies. A number of terrorist training camps and hideouts were also destroyed in the targeted precision airstrikes by the Indian Airforce (IAF). The operation was code named “Operation Sindoor”.

Pakistan escalated the conflict by launching artillery and air attacks on civilian areas in the states of J&K and Punjab, killing several civilians. Indian forces retaliated by targeting critical Army and Airforce establishments across Pakistan.

On 10^th May afternoon, the Director Generals of Military Operations (DGMOs) of both sides agreed for a temporary cessation of hostilities. The temporary ceasefire has since been extended thrice on 12^th, 14^th and 18^th May, respectively.

There have been claims and counterclaims of the damage inflicted to each country during this operation. The President of the United States (POTUS) has claimed that he facilitated the “immediate and complete” ceasefire. There are claims of Chinese and Turkish defense experts and equipment actively participating in the conflict from the side of Pakistan. During the conflict, the International Monetary Fund (IMF) approved a US$1.3bn loan to Pakistan, with all members, except India, voting in favor; and India abstaining. This explicit support for Pakistan from several countries is being widely seen as a diplomatic setback for India.

Notwithstanding, subsequent to the ceasefire, Prime Minister Modi has enunciated a “new doctrine” for engagement with Pakistan in future. He categorically stated that any act of Pakistan supported terrorism in India will be treated as an Act of War and accordingly responded by Indian forces; ending the extant policy of retrain.

The situation as of this morning is filled with an uneasy calm. Tension is palpable on both sides of the border and Line of Actual Control in J&K (LoC). This heightened tension raises some critical questions for investors in India, especially related to India’s security, fiscal policy, and economic strategy. Some of the key questions, from an investor’s viewpoint could be listed as below:

Does the latest conflict, and subsequent response from both sides, increase the geopolitical uncertainty in the region materially, requiring India to be in a state of high continuously, notwithstanding the ceasefire declaration?

In my view, post the 22^nd April 2025, the region has regressed into much greater geopolitical uncertainty. India will likely need to maintain heightened vigilance despite the ceasefire. The underlying issues, particularly Pakistan’s alleged support for terrorism, remain unresolved. India’s new anti-terror doctrine suggests an aggressive and alert stance. Continued cross-border violations and Pakistan’s advanced foreign-origin missile and drone capabilities further underscore the need for constant readiness. The Indian government has explicitly stated it remains “fully prepared” and “ever-vigilant,” indicating that the ceasefire does not equate to a relaxation of security measures.

Frequent escalations, aggressive posturing, and targeted invasions may be the new normal at the Indo-Pak border and LoC.

Does the new normal mean material rise in security and defense spending for India?

Yes, increased spending on internal security and defense capabilities is highly likely. India’s response to the Pahalgam attack, including Operation Sindoor, and the need to counter Pakistan’s evolving military capabilities (e.g., Chinese-supplied drones and missiles) suggest a necessity for enhanced defense infrastructure and equipment. India already ranks fifth globally in military spending, with $86.1 billion in 2024, compared to Pakistan’s $10.2 billion. The recent crisis, coupled with ongoing tensions with China, may necessitate aggressive investments in advanced weaponry, border infrastructure, and cybersecurity, especially given the likely multidomain nature of the future conflict (airstrikes, drones, cyber operations). The Indian Air Force’s (IAF) planned mega military exercise post-ceasefire further indicates sustained or increased defense expenditure.

Could additional defense spending materially impact the fiscal balance of India?

Additional defense spending would definitely have an adverse impact on India’s fiscal balance. The fiscal deficit target, currently set at 4.4% of GDP for FY26BE, might witness some upward revision.

It would be challenging for the government to balance increased defense spending with austerity measures in social sector spending and general government spending (salaries are set to rise materially after the pay commission report next year). Also, the trade deals with the UK and the US may also impact revenue adversely in the short term.

In my view, the capex on non-defense infra could be hit negatively, further impacting the growth potential. The interest coverage ratio of the government of India (FY25AE ~2.65x) is already moderate. A further rise in borrowing may make it unsustainable, possibly impacting the sovereign rating.

What measures could be taken to maintain fiscal balance?

In my view, managing a potential increased fiscal deficit will likely involve a mix of additional revenue generation, expenditure rationalization, and borrowing; though the government will aim to avoid excessive borrowing to maintain investor confidence and avoid credit rating downgrades.

The government may consider higher dividends from cash rich Public Sector Undertakings (PSUs). The Finance Ministry has a history of pressing PSUs for surplus capital to meet fiscal targets; though it may constrict their growth capex and hence affect future growth outlook.

Temporary rise in the incidence of tax on higher income taxpayers and luxury consumption through additional war/infra cess may be implemented. Past budgets have used targeted levies, such as a 1-4% infrastructure cess on cars, increased excise duties on aviation fuel (from 8% to 14%), or higher taxes on tobacco products, to raise revenue without broad tax hikes.

A compliance window (Amnesty Scheme) for undeclared income or a new dispute resolution scheme, as proposed in 2016, could also be used to generate additional funds.

Selling stakes in state-run enterprises could provide funds for additional defense funding. However, it may not be easy considering the past experience. Administrative austerity measures (travel restrictions, equipment purchases, etc.) and capex reallocation by prioritizing defense infra over other infra, and seeking external emergency support could be some of the measures the government may consider.

The government may avoid measures that directly burden rural or middle-class voters, focusing instead on high-income groups, luxury goods, or corporate tax tweaks (e.g., rationalizing corporate tax for new manufacturing firms).

Obviously, fiscal balancing would be a tightrope walk for the finance minister, especially with global economic uncertainties like U.S. tariffs looming.

Could defense production companies be asked to cut margins in “national interest”?

In my view, asking defense PSUs to cut margins in the name of national interest is plausible, though complex, proposition. These companies have seen sky-high valuation multiples due to strong order books and defense modernization demands. Historically, the government has influenced PSU pricing or margins during crises, as seen in austerity measures or subsidy pressures on OMCs. A patriotic appeal could be made, especially post-Operation Sindoor, to align these firms with national security goals. However, forcing margin cuts risks eroding investor confidence, as these stocks are very popular with investors. It could also impact their ability to invest in R&D or capacity expansion, critical for long-term defense self-reliance. The government would need to balance this with incentives, like guaranteed orders or export support, to mitigate financial strain. While plausible, this move would face resistance from market participants.

Conclusion

The ceasefire, while a temporary de-escalation, does not address the structural instability of India-Pakistan relations, particularly over Kashmir. India’s assertive posture, coupled with domestic political pressures (elections, welfare commitments), suggests a delicate balancing act. Overcommitting to defense spending could strain fiscal discipline, while populist measures risk long-term economic stability. The government’s reliance on PSU dividends and targeted taxes is plausible but not sustainable without structural reforms. The role of U.S. mediation, though downplayed by India, highlights external influences on domestic policy, which could complicate nationalist narratives.

(PS: The South Block of Raisina Hills in New Delhi houses offices of the Prime Minister and Defense Minister, and External Affairs Ministers). The North Block of Raisina Hills Houses office of the Finance Minister)

·         India and Pakistan took several steps back from their respective aggressive positions over the weekend. The entire Indian leadership greeted the world on the Birth Anniversary of Lord Buddha, showing commitment to his doctrine of non-violence, tolerance and empathy.

·         The Indian Meteorological Department (IMD) assured that the south west monsoon is on track to enter Kerala coast five days before the scheduled date.

·         Japanese financial giant Sumitomo Mitsui Banking Corp. announced acquisition of 20% stake in Yes Bank, marking one of the most successful revivals of a troubled entity since acquisition of the government managed deal of Satyam Computers by Tech Mahindra.

·         The US and Chinese leaderships agreed on a 90 day pause to the tariff hikes; rationalize tariffs and work on a sustainable terms of trade agenda. USD rallied and a global risk rally ensued.

·         The prospects of a Russia and Ukraine peace accord appear to be improving.

Indian equities rallied hard, marking one of the best trading sessions in many months. Benchmark Nifty gained ~3.82%. The IT Services sector (+6.7%) led the rally on the hope of better global demand prospects. Realty (+5.93%), metals (+5.86%), energy (+4.2%) sectors also did very well. Gold prices (-Rs200/gm) eased.

The question in the minds of several market participants this morning could be “will this risk rally continue or will we gradually retrace back to 22500-24500 range?” A contingent question may be, “should investors be deploying fresh funds or take some money off the table using the latest sharp rally in prices?”

In my view, the Monday stock market rally in India could be a function of three factors – (i) Covering of short positions created last week in anticipation of escalation of hostilities between India and Pakistan; (ii) fear of missing out (FOMO) stimulating the sentiments of investors who were sitting on fence for the past few months; and (iii) good technical and speculative positions by traders as the benchmark indices and several stocks break out of their strong resistance zones.

Notwithstanding, I do not find any reason for a change in investment strategy, at this point in time, since no new evidence has emerged about a material change in the geopolitical or macroeconomic conditions. The events that have driven the latest risk rally have been well within the realm of extant forecast, speculations and/or assessment of market participants. The escalation of Indo-Pak hostilities and a swift de-escalation, may have surprised the markets, but it hardly changes the investment thesis of Indian equities.

I continue to believe that the collective wisdom of the market in India has appeared to have assimilated all the known events and anticipated developments regarding the economy and earnings, that could have sustainable impact on the stock prices. A major surprise, like the outbreak of Indo-Pak conflict escalation last week may only cause the market to breach these extremes temporarily.

The markets may continue to cement the cyclical bottom in the 22500-24500 range, for next few months, as additional evidence of earnings recovery and improvement in the macroeconomic conditions emerges. We may also have more clarity on the global economic and geopolitical conditions in this period. A sustained and strong up move could be expected after a firm bottom is established on the basis of the visibility about the future earnings trajectory and macroeconomic growth and stability.