Economic Reforms of 1991
ECONOMIC REFORMS OF 1991
ECONOMIC REFORMS OF 1991 The immediate factor that triggered India's economic reforms of 1991 was a severe balance of payments crisis that occurred in the same year. The first signs of India's balance of payments crisis became evident in late 1990, when foreign exchange reserves began to fall. With the onset of the Gulf War, world oil prices starting increasing, and remittances from Indian workers in the Gulf region fell sharply as many of these workers left the region. From a level of U.S.$3.11 billion at the end of August 1990, foreign exchange reserves dwindled to $896 million in January 1991. The rapid loss of reserves prompted the Indian government to initially tighten restrictions on the importation of goods. However, it was increasingly clear by the beginning of 1991 that the import compression, by limiting the imports of capital and intermediate goods, was restricting the rate of economic growth and of exports. Furthermore, it was evident that the payments crisis was no longer primarily due to the trade deficit, but was driven by adverse movements in the capital account, in particular the drying up of commercial loans and a net outflow of deposits held in Indian banks by nonresident Indians, reflecting a loss of confidence in the government's ability to manage the balance of payments situation. The new government of Prime Minister P. V. Narasimha Rao, who assumed office in June 1991, moved swiftly to deal with the situation. It implemented a macroeconomic stabilization program on an urgent basis, along with a comprehensive and far-reaching overhaul of the policies governing India's and industrial sectors.
The decision to embark on the reforms following the crisis of 1991 was primarily motivated by the beliefs of former finance minister Manmohan Singh (prime minister since 2005) that the roots of the financial crisis were structural in nature and lay in the import-substituting industrialization strategy followed by India's governments since 1947. The main elements of this strategy were inward-looking trade and foreign investment policies, along with extensive bureaucratic controls over production, investment, and trade, and a substantial public sector presence in the economy, going beyond the conventional confines of public utilities and infrastructure.
The trade regime was highly restrictive, as nearly all imports were subject to discretionary import licensing or were channeled by government monopoly trading organizations. The only exceptions were commodities listed in the open general license (OGL) category. Capital goods were divided into a restricted category and the OGL category. While import licenses were required for restricted capital goods, those in the OGL could be imported without a license, subject to several conditions. The most important of these were that the importing firm had to be the "actual user" of the equipment and could not sell the latter for five years without the permission of the licensing authorities.
Regarding industrial policy, the two key components of the regulatory framework were the Industries Development and Regulation Act of 1951 and the Industrial Policy Resolution of 1956. The first piece of legislation introduced the system of licensing for private industry. The licensing system governed almost all aspects of firm behavior in the industrial sector, controlling not only entry into an industry and expansion of capacity, but also technology, output mix, capacity location, and import content. The principal aim of this act was to channel investments in the industrial sector in "socially desirable directions."
The system of controls was reinforced in the 1970s with the introduction of the Monopolies and Restrictive Trade Practices (MRTP) Act in 1970 and the Foreign Exchange Regulation Act (FERA) in 1973. The MRTP Act stipulated that all large firms (those with a capital base of over 20 million rupees) were permitted to enter only selected industries, and that too on a case-by-case basis. In addition to industrial licensing, all investment proposals by these firms required separate approvals from the government. The FERA provided the regulatory framework for commercial and manufacturing activities of branches of foreign companies in India and Indian joint-stock companies with a foreign equity holding of over 40 percent.
The industrial licensing system, in conjunction with the import licensing regime, led to the elimination of the possibility of competition, both foreign and domestic, in any meaningful sense of the term. As it became increasingly complex over time, it led to a wasteful misallocation of investible resources among alternative industries and also accentuated the underutilization of resources within these industries, thus contributing to high levels of inefficiency in the industrial sector. As J. Bhagwati (1993) noted, "the industrial-cum-licensing system . . . had degenerated into a series of arbitrary, indeed inherently arbitrary, decisions where, for instance, one activity would be chosen over another simply because the administering bureaucrats were so empowered, and indeed obligated, to choose."
The 1991 Reforms
The economic reform program specifically targeted the highly restrictive trade and industrial policies. Quotas on the imports of most machinery and equipment and manufactured intermediate goods were removed. A large part of the import licensing system was replaced by tradable import entitlements linked to export earnings. Furthermore, the "actual user" criterion for the imports of capital and intermediate goods was removed. There was also a significant cut in tariff rates, with the peak tariff rate reduced from 300 percent to 150 percent and the peak duty on capital goods cut to 80 percent. The industrial licensing system was abolished altogether, except for a select list of environmentally sensitive industries. Sections of the MRTP Act that restricted growth or merger of large business houses were eliminated. The list of industries reserved for the public sector was reduced from seventeen to six, and private investment was actively solicited in the infrastructural sector. Foreign ownership restrictions were liberalized, and foreign direct investment was actively encouraged, particularly in the infrastructural sector.
The Indian Economy in the Post-Reform Period
Since the 1990s, the Indian economy has grown at a rate of 5–6 percent per annum, far exceeding the "Hindu rate of economic growth" observed for much of the previous decades since independence. Much of the increase in economic growth can be attributed to the strong performance of the manufacturing sector, in contrast to the 1970s, when the manufacturing sector's performance was dismal (see Figure 1). A significant positive feature of economic performance in the 1990s has been control of the inflation rate, which has fallen to less than 3 percent, significantly below the historical average of around 5 percent. The performance regarding inflation is particularly noteworthy given that, in the context of the Indian economy, the control of inflation is considered to be among the most effective antipoverty measures.
Another positive development in the 1990s was the large increase in foreign exchange reserves over the decade (see Figure 2). In 2001 foreign exchange reserves stood at U.S.$54,106,000,000, a fiftyfold increase to its level at the height of the 1991 economic crisis. The buildup of foreign exchange reserves reflects the sharp decline in the current account deficit as well as the large net capital inflows during the 1990s. The improvement in the balance of payments can be mainly attributed to the large inward remittances through legal channels, as nonresident Indians took advantage of a market-determined exchange rate that was steadily depreciating.
The wide-ranging trade and industrial policy reforms have clearly had a positive effect on India's engagement with the world economy. The openness of the economy—defined as exports plus imports as a ratio of gross domestic product (GDP)—had nearly doubled in less than a decade, and the openness ratio stood at 23 percent in 2000, a significant achievement for an economy that had remained closed to international trade for much of its post-independence period.
The 1991 reforms freed Indian entrepreneurs from the shackles of bureaucratic controls and from a policy regime that encouraged unproductive rent-seeking activities at the cost of activities aimed at increasing productivity and output. The Indian business class responded to the new opportunities provided by the reforms by significantly increasing their investments in productive capital. The surge in private investment observed in the aftermath of the reforms, if continued, promises sustained economic prosperity for India and for its many citizens.
Agrawal, P., S. V. Gokarn, V. Mishra, K. S. Parikh, and K. Sen. Economic Restructuring in East Asia and India: Perspectives on Policy Reform. London: Macmillan, 1995.
Bhagwati, J. India in Transition: Freeing the Economy. Oxford: Oxford University Press, 1993.
Joshi, V., and I. M. D. Little. India's Economic Reforms, 1991–2001. Oxford: Clarendon Press, 1996.