If the government does not increase oil prices, inflation may not rise steeply. Yet, even without the hike, managing inflation expectations could be a major challenge for the central bank. Also, irrespective of the pass-through, the rupee would weaken and the current account deficit would widen.

A report by Credit Suisse says, Even where price controls mute the pass-through of oil prices to domestic fuel prices, inflationary expectations could deteriorate in anticipation of discrete price hikes.

The report, which has made an Asia-wide analysis, notes that even if oil prices remain at around $130 per barrel, Korea and Indias current account deficits could widen this year while the Philippines and Thailands current account surpluses could narrow.

Though monetary policies are not excessively loose everywhere in non-Japan Asia, the report says that central banks in the region will rapidly appreciate their currencies to combat inflation.

Inflationary expectations have significantly deteriorated in Indonesia and the Philippines. Elsewhere in Asia, long-term expectations are still generally well anchored, but this cannot be taken for granted if oil prices continue to rise.

However, a recent Citi report says sustained oil price increase could further weaken the rupee. The report says as the 10th largest oil importing nation in the world (oil imports are close to 70% of its crude oil requirements), a continued uptrend in prices is likely to have repercussions on Indias balance of payments.

A $1/bbl increase in oil prices is likely to increase the import bill by $700 million. If WTI touches $150/bbl, the current account deficit would widen to $61.3 billion or 4.7% of GDP. This would lead to a drawdown in reserves and much further currency weakening.

As far as fiscal policy options are concerned, currently, to compensate oil marketing companies for the under recoveries, the government is likely to issue oil bonds to the tune of Rs 630 billion (1.2% of GDP) in FY09, the Citi report says.

As every $1/bbl increase in oil prices raises the under recoveries by $1 billion, bond issuances could more than double to Rs 1.5 trillion (2.8% of GDP), if prices rise to $150/bbl.