The RBI is likely to continue with limited quantitative easing. The RBI has aggressively cut interest rates after the crisis began. Although there is still room to cut the cash reserve ratio (CRR), and we think they will cut it by 150 bp by mid-2009, the bulk of the rate cuts is behind us. Further, the large fiscal deficit means a big increase in the supply of government securities, which the market would find increasingly difficult to digest.
Limited QE can help maintain adequate liquidity in the system, provide temporary financing to the government, and may keep long bond yields from ratcheting up. In a deflationary environment, such a policy is more desirable to keep money growth from shrinking, as demand for money falls due to lower levels of transactions.
If QE is followed on a large scale, however, it could severely compromise macro health. We do not think the RBI can indefinitely fund a structurally higher fiscal deficit by printing money, as it would lead to a large monetary overhang, which could stoke inflation and weaken the currency as demand returns.