There has been a sea change in the economic environment during the last three months. When the Union Finance Minister presented the Budget, there was buoyancy all around with the economy estimated to grow almost at 9 per cent and the inflation rate was still not a concern though food prices were in the uncomfortable zone. It was hoped that a better monsoon would take care of the food situation.

Indeed, some of us had cautioned that off Budget liabilities could spoil the party, and in these columns I had speculated that these could add up to 2 per cent of GDP. However, within three months, the optimism has given way to apprehension, if not despondency.

Capital inflows have slowed, and, in fact, the last few weeks have seen significant outflows. The wholesale price index has climbed to 11.42 per cent during the week ended June 27, and is not likely to go down in the near term.

The Indian rupee is one of the few currencies depreciating against the US dollar. Although the Finance Minister has stated that the prices will stabilise in three months, there are suspicions that the problem is deep-rooted.

Growth forecasts are being revised downwards and the problem seems to last much longer than anticipated. The manufacturing sector is likely to grow at a much slower rate due to increase in interest costs and slackening world demand and even the service sector will not exhibit the past buoyancy.

The major factor spoiling the party is surely the sharp surge in crude oil prices. I had cautioned that increasing oil prices will create a serious problem that could plunge the country into a fiscal crisis. Immediate and drastic measures were necessary.

Instead, the government chose to effect marginal increases in prices of petroleum by Rs 5 per litre, diesel by Rs 3 per litre, and cooking gas by Rs 50 per cylinder. Many state governments substantially neutralised this by reducing their sales tax rates. This demonstrates that first, we are unwilling to insulate pure market decisions from political vagaries, and second, we do not really care for allocative consequences of our pricing decisions.

An important fallout of the increasing crude oil prices is the sharp rise in unfunded liabilities. In a recent article Shankar Acharya alluded to the darkening sky in the Indian economic scene. In his view increase in the prices of fuel, food and fertilisers has created an additional fiscal burden and he estimates the total deficit at the Centre relative to GDP at 6-7 per cent and aggregate fiscal deficit at 9-10 per cent.

Similarly, Standard and Poor's estimates that the total fiscal liabilities of the Central government could be as high as 6.2 per cent of GDP and, together with states, the liabilities could work out to 8.7 per cent.

My own assessment is that unfunded liabilities are much more. If the crude oil prices remain at $140 per barrel, the projected under-realisation is estimated at Rs 3,00,000 crore (Rs 300 billion). The recent increase in prices is estimated to realise about Rs 21,000 crore (Rs 210 billion).

The increased realisation from duty cuts will commensurately reduce revenue from customs and excise and will not alter the deficit. Asking the oil-exploring and -marketing companies to bear a part of the increase will result in lower realisation of revenues from corporation tax and dividends. Even if the recent price increases and absorption by oil-extracting and -marketing companies are assumed to generate a net amount of Rs 50,000 crore (Rs 500 billion), we are left with unfunded liabilities amounting to Rs 2,50,000 crore (Rs 2500 billion).

This works out to 5.5 per cent of GDP. Along with an under-budgeted subsidy amount of 2 per cent of GDP and food subsidy of about 1 per cent, we have off budget liabilities amounting to 8.l5 per cent of GDP. To this we have to add the additional liability arising from pay revision and loan waiver.

As stated by Martin Feldstein, "Fiscal deficits are like obesity. You can see your weight rising...and...clothing size is increasing, but there is no sense of urgency in dealing with the problem. That is so even though the long-term consequences...include an increased risk of a sudden heart attack as well as of various chronic conditions like diabetes".

The adverse impact of the large fiscal deficits and off Budget liabilities on economic growth may not be severe in 2008-09, but is likely to intensify and last longer. The hardening interest rates and lower international demand are likely to decelerate both manufacturing and service sectors.

With exports unable to keep up with increasing important bills, the current account imbalance is likely to widen and the rupee depreciation may continue even against the weak dollar.

Although no one expected such a steep rise in crude oil prices, it is difficult to defend total reluctance to make necessary adjustments. Between May 2004 and June 2008, the crude oil price increased by 241 per cent, but the increase in the price of petrol was just 50 per cent, diesel 60 per cent, and cooking oil much less at 43 per cent.

Thus, the inflation rate has been artificially kept low, but beyond a point, adjustment is inevitable. The headline inflation rate touched 11.42 per cent last week and of this, 3.54 points were on account of fuel alone.

By not increasing fuel prices in tandem with international prices, we have suppressed the inflation rate but that will show up as higher unfunded liabilities. Those who oppose increase in prices to protect the interests of the poor should realise that they actually hurt them.

This also implies that the price situation is not likely to ease in the coming few months. Hopefully, the food prices are likely to ease as wheat procurement during the 2008-09 season at 22 million tonnes is twice that of the previous year.

However, on the administered prices of petroleum products, the government is caught between the devil and the deep sea.

If it raises the prices, the headline inflation rate will increase sharply and the media will cry hoarse every Friday. If it fails to increase the prices, it will increase the fiscal deficit - open or hidden - and accentuate macroeconomic and external imbalances.