FOR months the Indian government has been battling the phantom of inflation, launching a series of measures – including trying to suck liquidity out of the system by raising the cash reserve ratio (CRR), jacking interest rates, curbing forward trading in several commodities and forcing steelmakers to cut-back on price hikes – moves that, however, failed to tame inflation.

Despite unveiling a series of measures, inflation has been rising steadily; India’s headline inflation rate – as measured by the wholesale price index (WPI) – rose to a record high of 7.83 per cent for the week ended May 3.

And now, in the midst of this messy battle, actual inflation (as against fears of inflation and scare mongering) is finally raising its ugly head, leaving the government bereft of crucial weapons, already spent fighting the phantom.

Last week, when international oil prices topped the $135-mark (for a barrel), saw one of the most formidable threats on the price front: the Indian rupee breached the 43 (to the dollar) mark for the first time in 13 months, plunging to 43.21. The currency has in recent weeks abruptly reversed its year-long northward journey, and started tumbling against the dollar.

The weakening Indian currency threatens to upset the government’s plans and could trigger off a nasty round of sharp price hikes. Analysts worry that inflation will soon touch the eight per cent mark, and there could be the possibility of it touching double-digits later this year.

For the United Progressive Alliance (UPA) government, which has just completed four years in office, nothing could be more tragic. Elections to several important states – including Madhya Pradesh, Rajasthan, Delhi and Chhattisgarh – will he held over the coming weeks and general elections are less than a year away.

The Reserve Bank of India (RBI), the country’s central bank, under pressure from the government, has been raising interest rates over the past two years, tightening liquidity, though prices were ruling modestly. Now with wholesale and consumer prices heading northwards, the limitations of fiscal measures are becoming apparent.

The UPA government has also stubbornly refused to raise the retail price of petrol, diesel, kerosene and LPG (liquefied petroleum gas), for fear of alienating the electorate and triggering off inflation. But now with oil prices topping $135, the state-owned oil marketing companies are in dire straits.

If they are not allowed to raise the retail price over the next few months, the oil companies have warned the government, the country may have to go in for drastic measures, including rationing of petroleum products.

But with crucial elections staring it in the face, the last thing the government would want to do now is to raise petroleum prices. Bankers expect the RBI to further tighten liquidity, by going for a 25 to 50 basis points hike in the CRR.

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WITH international oil prices showing no signs of cooling, the rupee will continue to remain under acute pressure. According to market analysts, if oil prices touch $150 a barrel, the rupee will fall to 44 against the dollar.

Combined with the spurt in international food and commodity prices, the currency is set to lose all the gains of the previous year. The Indian rupee gained 12 per cent against the dollar in 2007, hurting Indian exporters. But it has already lost nearly nine per cent against the dollar this year – it fell by six per cent in May – and has emerged as the second-worst performing currency in Asia after the South Korean won.

The Indian currency peaked in November, touching 39 to the dollar, as foreign institutional investors (FIIs) poured money into the stock markets. Last year, FIIs net investments into the stock markets added up to a record $17.4 billion. But this year, with hardening interest rates in the US, many FIIs have been pulling out funds from India. They have so far sold a net $3 billion this year, adding to the plight of the rupee.

The RBI has for over two years maintained a hands-off policy in the foreign exchange market; it has not intervened significantly by selling dollars to ease pressures on the rupee. India’s foreign exchange reserves add up to nearly $313 billion; more than $100 billion were added to the kitty in 2007 alone.

The biggest buyers of dollars in the market are oil companies, who use it to fund their crude acquisitions. India imported nearly $72 billion of oil last year, which was about 25 per cent more than in the previous year. The country imports 70 per cent of its oil requirements.

The escalating oil bill is widening the trade deficit, which has already jumped from $59 billion in 2006-07 to $80 billion in 2007-08. The current account deficit also widened to $5.4 billion for the October-December quarter, from $4.7 billion in the previous quarter. With oil prices having shot up by 40 per cent so far in 2008, the current account deficit will balloon further.

Soaring international prices for fuel, food and fertilisers means that the deficit will continue to grow. The government pays international market prices for fuel, food and fertiliser, but populist policies – and pressures from its Leftist supporters – prevent it from realising the same from consumers back home.

The result: the deficit keeps widening and threatens to upset the government’s finances. According to estimates, a one per cent fall in the value of the rupee adds Rs70 billion (about 0.15 per cent of the GDP) to the government’s fiscal deficit, as it is forced to sell expensive imported oil, food grains and fertilisers at ridiculously low prices to consumers and farmers.

Rising inflation and a weakening rupee will discourage FII inflows. The Indian economy is also expected to slow down this fiscal to around eight to 8.5 per cent. For the financial year ended March 31, 2008, gross domestic product (GDP) grew by 8.7 per cent, as against 9.6 per cent in the previous year.

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THE RBI is expected to ease restrictions on overseas corporate borrowings, to lessen the burden on the rupee. These restrictions were imposed when the rupee was gaining strength against the dollar.

Companies that went in for overseas borrowings of more than $20 million could not repatriate it to India, while those borrowing less than that sum had to get the central bank’s permission.

With domestic interest rates on the rise last year, many companies were borrowing cheap abroad and repatriating the funds. This resulted in increased forex flows, adding to the kitty, but not helping the economy in any way.

But the sharp about-turn in the direction of the rupee has taken most exporters and corporates by surprise. Many companies had hedged their foreign exchange cash flows for periods ranging from 12 months to 18 months, and the falling rupee has caught them unawares.

Jewellery exporters had hedged raw materials such as diamonds and gold at Rs40-40.5 to the dollar, expecting the rupee to strengthen to 38. But with the weakening currency, they are having to book losses.

Some exporters had taken pre-shipment dollar-loans, attracted by the lower interest rates, and converted them into rupees. Now they will have to pay more for the dollars needed to repay their loans.

The RBI, in a bid to prevent corporates from shifting to other centres like the Dubai Gold and Commodities Exchange – which last year launched a rupee futures contract - plans to unveil rules for exchange-traded futures for currencies and interest rates, later this month. Trading could begin later this year.

Once the rules are in place, eligible exchanges will be allowed to deal in currency futures. Importers, exporters and companies with forex exposures can buy hedges through exchanges. The currency future will allow the participant to buy or sell a currency at a future date on the basis of an exchange rate fixed on the last trading day.

Exchange-traded currency futures will hopefully bring greater transparency in the pricing of hedges, and will also help in their price discovery. The Indian rupee is a partially convertible currency. The government is keen to go in for full convertibility, but opposition from its Left supporters has prevented it from exercising this option.