The price that Indian consumers pay for petrol is now almost back to where it was five years ago. The sharp increase in domestic energy prices in recent weeks is most easily explained by the unexpected rise in global crude prices this year. It is time for Indian policymakers to worry.

India had to work hard to regain economic stability after the run on the rupee in July 2013. The scare was preceded by at least three years of irresponsible fiscal management that pushed inflation into double digits and generated the widest current account deficit since the macroeconomic crisis of 1991. Two Union finance ministers—P. Chidambaram, followed by Arun Jaitley—stabilized public finances. The Reserve Bank of India (RBI) tightened monetary policy after September 2013 to bring down core inflation. The collapse in global oil prices allowed the Narendra Modi government to shed a large part of the fuel subsidies in the federal budget. It also kept minimum support prices for food items on a tight leash—though that led to painful rural deflation.

The Indian current account deficit, as a percentage of gross domestic product, does not seem like a formidable problem right now. However, it has been widening in absolute terms. The external gap in the four trailing quarters to December 2017 was around $40 billion. The annual trend is starker—the current account deficit is likely to have trebled from $15 billion in fiscal 2017 to an estimated $50 billion in fiscal 2018. Many in the financial markets are penciling a further increase of $25 billion in the current fiscal year that began three weeks ago.

How easily can India fund a $75 billion external gap this year? It has been funding its current account deficit in recent years with stable inflows from foreign direct investment. That will no longer be enough in case the recent predictions of a higher external gap turn out to be true. It is thus highly likely that dependence on more volatile portfolio investment in domestic equities and bond markets will increase in importance. A lot, then, depends on the way these portfolio inflows behave in the coming months, especially given the fact that US interest rates are clearly going up. Historical experience suggests that portfolio flows to emerging markets such as India get hit when the US tightens its monetary policy.

It is still likely that global oil prices will retreat in the coming months, and the macroeconomic pressure will ease as a result. However, it is important to note that the Indian central bank has increased the base price of crude in its inflation forecast model—from the earlier $55 a barrel to $68 a barrel now. That is one sign that Indian policymakers are perhaps not expecting a sharp decline in global oil prices from their current levels. Meanwhile, yields in the bond market have also begun to inch up once again.

A lot depends on the political response from the Narendra Modi government in the months leading to the next general election before its term ends in May 2019. The Modi government has till now (quite correctly) passed on higher global oil prices to consumers. Fuel subsidies neither benefit the poor nor do they help meet climate change goals. The risk of a political backlash from the middle class cannot be ruled out in case oil prices keep climbing—feeding into general inflation. The United Progressive Alliance government led by Manmohan Singh decided to absorb higher global oil prices in the budget or through off-balance bonds issued to public sector oil companies. The first move led to further fiscal deterioration, while the second was an accounting fudge.

The Indian economy is on the recovery path. Consumer spending is strengthening but there are also some signs that private sector investment is gradually coming out of a long slump. The trick of keeping growth on track even when there are growing risks to economic stability is not an easy one to pull off. Compared to the summer of 2013, India still has modest levels of fiscal deficit, current account deficit and inflation. A large foreign exchange stash also provides better insurance against a sudden global shock.

However, rising global oil prices and a tighter US monetary policy call for greater prudence rather than policy adventurism. The choices the Modi government makes in the coming months need to be seen against this backdrop of a higher growth momentum combined with macroeconomic pressures.

How should the government respond to rising global crude prices? Tell us at views@livemint.com

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