Citi is looking at a scenario that seemed inconceivable a year ago, but is obviously worth contemplating now: ôWhat if oil prices reach $200 a barrel?ö

Oil prices have doubled over the past 12 months. Two weeks ago, it hit a record high of $135.09 on the futures market.

Oil prices reaching $200 a barrel by year-end would certainly push shares of oil expenditure in nominal GDP to above the peak levels of 1980 for most Asian economies, and the regionÆs growth could be cut by at least another 1.5 percentage point, Citi says. It further concludes that growth of economies with high energy intensities û such as Indonesia, Malaysia, Thailand and Taiwan û would be affected more, while growth in China and India might be shielded by oil subsidies.

Under this scenario, Citi says the average inflation rate could rise by another 3.5 percentage points, defying the notion that supply-driven inflation could go away on its own. Rates would move up much more rapidly across the region. Current accounts would probably worsen in most Asian economies, posing particular challenges for India, Korea, the Philippines, Taiwan and Thailand, as well as their currencies. Indonesia and Malaysia already indicated imminent fuel price adjustments, while India would probably find high fuel subsidies hard to swallow given its already massive fiscal deficit.

As it is, policymakers in Asia are already facing the growth-and-inflation dilemma in the region, Citi notes. While economic activity is moderating, inflation rates have climbed higher in recent months. Most central banks are torn between the need to tighten to fight inflation and the urge to ease to limit the slowdown in growth.

Asian central banksÆ responses to this macroeconomic challenge have been somewhat different across the region. China, India and Taiwan have maintained modest tightening steps, for example.

Reluctance to tighten in the face of rising inflation could lead to either forced aggressive policy action later or a blowing-up of inflation, according to Citi.

While Citi has some sympathy over the argument of supply-driven inflation, it believes the lack of decisive monetary policy could also yield at least two possible consequences.

The first consequence is the credibility of the central banksÆ monetary policy could suffer, especially in India, Indonesia, Korea, the Philippines and Thailand, which have adopted inflation targeting mechanisms. Second, supply-driven inflation could spread quickly, as long as monetary conditions are loose. In some economies, including China, Korea and Thailand, core inflation has already begun to show an uptrend. So far, energy and food are still the two most important contributors to AsiaÆs high inflation.

What are the macroeconomic consequences of higher oil prices?

As a first step, Citi applies the Oxford Economic Forecasting (OEF) model to simulate a $10 increase in oil prices. ôThe simulation results may not reflect accurately what would happen in the real economy. Yet they are useful for guiding and organising our thoughts,ö Citi says.

According to the model, a $10 increase in oil prices reduces GDP growth by an average of 0.4 percentage points, raises CPI by 0.5 percentage points, reduces current account balances by 0.6 percentage points of GDP, and lowers fiscal balances by 0.1 percentage points of GDP.

Recent experiences suggest that these estimates, especially those for growth and inflation, are probably too large, Citi says.

A key reason is that the simulation results are based on historical correlations. But the coefficients have probably shifted significantly over time, particularly during the last decade or two. One possible reason is that the recent surge in oil prices has been steady, but not abrupt, which provides time for the economies to adjust and adapt. Another possible factor is the declining proportion of energy in production.

Citi concludes that an increase in oil price by $10/barrel would slow Asian economic growth by an average of 0.22 percentage point. And oil prices rising to $200 before year-end (or an average $142 a barrel for 2008 from last yearÆs $72 a barrel) could reduce AsiaÆs GDP growth by another 1.5 percentage points. At present, Citi forecasts an average GDP rate of 7.5% for Asia in 2008 compared with 8.7% in 2007.