India?s oil-product demand appears poised for a sharp decline as the economy is battered by slowing industrial growth, a weakening currency and fiscal constraints on the government.

Fuel demand rose 4.1% in the first 10 months of 2011 from the same period a year earlier, running ahead of the International Energy Agency?s forecast for an increase of 3.6% for the

whole year.

Even if November and December prove weaker than the same months in 2010, it?s still likely India, the world?s fourth-largest crude user, will beat the IEA forecast this year. But the agency also forecasts that India?s oil-product demand will rise a further 3.6% in 2012 to 3.58 million barrels a day, a number that looks increasingly optimistic.

This is especially the case since the breakdown of the IEA forecasts shows it expects next year?s strongest demand to be in the first two quarters, which is exactly when India is likely to be struggling economically.

India?s economy may even slow more than it did after the global financial crisis in 2008, when gross domestic product slipped to 6.8% before rebounding to 8.5% two years later. The government now expects 7.5% GDP growth for this fiscal year a figure some analysts expect to slow to little better than 6% in 2012.

But New Delhi?s ability to stimulate demand, as it did in 2008, is constrained by a lower ratio of tax revenues, a larger fiscal deficit and still high inflation that means it hard to cut interest rates.

Inflation, as measured by the wholesale price index, dropped to 9.11% in November, down from October?s 9.73% and levels above 10% earlier in the year, but still well above the 5%level the Reserve Bank of India is said

to prefer. While inflation is clearly on a downward trend, there isn?t too much scope to cut interest rates immediately, although it?s now virtually certain the central bank won?t be adding to the 13 rate hikes delivered since 2010.

The main problem for the economy would appear to be industrial output, which fell 5.1% in October from a year earlier, the first negative reading for more than two years and a shot across the bows of oil demand.

Diesel is also sold under government price controls, which does insulate demand to some extent as the full extent of higher oil prices of rupee depreciation isn?t felt by consumers.

However, the pain is just shifted elsewhere, initially to the largely state-controlled refining sector and then to government itself, who has to give bonds to refiners to compensate for losses selling fuels below cost.

Refining margins have slumped in India, hit by the rupee?s decline of almost 22% since the start of August.

At the beginning of August, a barrel of diesel had a retail price of $147.60 in New Delhi while it cost $132.75 in Singapore, the regional price benchmark. But by Wednesday, a barrel of diesel fetched only $121 at the pumps in India, while costing $124.21 in Singapore.

The longer refiners have to sell diesel at a loss, the bigger the compensation demands become and the less able the government is to afford them, especially since the federal government?s tax-to-GDP ratio has dropped to below 10% from 11.9% in 2007-08.

Raising diesel prices at a time of economic slowdown and still elevated inflation is also something the government will be very reluctant to do, leaving it in something of a Catch-22 situation.

That could be exacerbated if the rupee weakens further, which is a possibility, if not the base case, given India?s current account deficit, weakening export growth and increasing worries among foreign investors over both the strength of the economy and the apparent political paralysis in government.

In this case, India could face a vicious cycle of rupee weakness boosting fuel costs, while cutting economic growth and increasing the cost of diesel subsidies at the same time.

The author is a Reuters market analyst. The views expressed are personal