“After four decades of planning for industrialisation, we have now reached a stage of development where we should welcome, rather than fear, foreign investment. Our entrepreneurs are second to none. Our industry has come of age. Direct foreign investment would provide access to capital, technology and markets. It would expose our industrial sector to competition from abroad in a phased Manner”
— Manmohan Singh, Minister of Finance, Budget Speech, 24th July 1991.
Introduction:
For three decades after gaining Independence in 1947, India followed an economic strategy with a strong bias in favour of the public sector, strict government controls over private sector investment and insulating the economy from the rest of the world through a combination of import licensing and high tariffs. A process of liberalizing the control regime had started in the first half of the 1980s, under Prime Minister Indira Gandhi, and was intensified in the second half of the decade under Prime Minister Rajiv Gandhi. However, these changes were incremental rather than structural. In essence, the basic control system remained in place, but it was made more flexible at the margin. Industrial licensing continued, but some industries were exempted from industrial licensing. Import licensing continued, but several items were made freely importable and this list was slowly widened. Foreign technology continued to require government approvals, but these were given more freely.
The Reforms of 1991:
India was a latecomer to economic reforms, embarking on the process in earnest only in 1991, when a new Congress-led coalition government, under Prime Minister Narasimha Rao, with Dr Manmohan Singh as Finance Minister, had to deal with an exceptionally severe balance of payments crisis. Foreign exchange reserves had run down to $1.1 billion by the end of June 1991, barely enough for 2 weeks of imports, and there were widespread fears that India might be forced to default on its external debt payments. The new government moved decisively to contain the crisis through a classic stabilization program consisting of a reduction in the fiscal deficit and a currency devaluation. To support these efforts it negotiated an International Monetary Fund (IMF) loan in 1991, along with structural assistance loans from the World Bank and the Asian Development Bank.
Stabilization Process and Macroeconomic Reforms:
The stabilization component of what was attempted in 1991 was conventional but very effective. India was able to end the IMF program much earlier than expected. Structural reforms were broadly in the area of Industrial licensing and regulation, foreign trade and investment, and the financial sector. The structural reforms were a distinct departure from the incremental changes attempted earlier. They signalled a clear shift toward a much more market-oriented economy, with a much larger role for the private sector and greater openness to trade and foreign investment. The reforms were consciously designed to be a holistic mutually reinforcing set of changes that could achieve the desired transformation. From 1991 onwards India adopted the LPG model. The major reforms initiated since 1991 can be discussed below:
1. Abolishment of Industrial licensing: Industrial licensing, which was earlier applicable for all industries except a defined list, was now abolished for all but a handful of industries. This meant investment in new plants and capacity expansion in existing plants could now be undertaken for a very wide range of industries without any approval from the central government. Since the location of industries was previously specified in the license, the abolition of industrial licenses meant that location was left to investors to decide, setting the stage for different states to compete with each other to attract private investment.
2. Reducing the number of industries reserved for the Public Sector: The list of 18 industries earlier reserved exclusively for the public sector was reduced to 8, and this was further pruned later to 3 which include Railways, Atomic Energy and Specified Minerals. This effectively ended the earlier perception that the public sector must “occupy the commanding heights of the economy”.
3. Abolishment of MRTP Act: Earlier, the Monopolies and Restrictive Trade Practices (MRTP) Act provided that all investments by companies with total assets exceeding Rs 1 billion needed special scrutiny to ensure that it would not increase the concentration of economic power. In the era of LPG, it was felt that the existing Monopolies and Restrictive Trade Practices Act, 1969 has become obsolete in certain respects and there is a need to shift our focus from curbing monopolies to promoting competition. Further, the competition Act 2002 has been enacted on January 14, 2003, and the main objectives of the Act are to provide for the establishment of a commission to prevent practices having an adverse effect on competition, to promote and sustain competition in markets in India, to protect the interests of consumers, etc.
4. Encouraging more FDI: Foreign Direct Investment (FDI) was earlier allowed only in a defined list of high priority industries and each application needed to be cleared on a case-by-case basis, with foreign equity limited to 40%. FDI was now freely allowed up to 51% in this list and higher limits were considered on the merits of each case. The government also announced that it would seek foreign investment pro-actively in areas where it could make a major contribution. In the budget speech 2014-15, Finance Minister Arun Jaitley clarifying the FDI policy states, the policy of the NDA government is to promote FDI selectively in sectors where it helps the larger interest of the Indian Economy. As per the current policy under the “Make in India” programme, 100% FDI is permitted in all the 25 Sectors covered under it except for media (26%), defence (49%) and Space (74%).
5. Inflows of FIIs: In 1992, qualified foreign institutional investors (FIIs) were allowed to bring in capital to purchase shares in listed companies through the stock exchange. There was a cap of 24% on the total equity in an individual company that could be held by FIIs. While liberalizing portfolio equity flows, short-term bank debt, which had been the source of destabilizing movements in many countries, remained under strict control.
6. Automatic Approval of FTAs: Foreign technology agreements, which earlier needed individual approval, became eligible for automatic approval provided royalties and technology fees were within specified parameters. The RBI grants automatic approval by the means of the regional offices to Indian industries for foreign technology collaboration. The payments pertaining to the technology transfer should not exceed US$ 2 million. The royalty to be paid is restricted to 5 % in case of domestic sales, 8 % in case of exports and the total payment should be 8 % on sales for a period of 10 years.
7. Liberalization of Trade Policy: There was a very substantial liberalization in trade policy. Capital goods, raw materials, components and other intermediate goods needed for production were made freely importable against tradable import licenses called Eximscrips, which were issued to exporters at 30% of the full value of exports (40% for some items). This system was quickly replaced by a system in which all items except consumer goods could be freely imported using foreign exchange purchased from the market. However, consumer goods remained on the banned list and were finally liberalized only in 2002.
8. Exchange Rate Reforms: The rupee was devalued twice in July 1991 leading to a 20% depreciation in its value. The partial convertibility of the rupee on the trading account was announced in the 1992-93 budget that was subsequently broadened to full convertibility on the current account by August 1994.
9. Tax Reforms: A Committee on Tax Reforms was appointed, under the chairmanship of Raja Chelliah, to make recommendations for the reform of both direct and indirect taxes. It recommended a switch towards a regime of low tax rates with a broader base, a reduction in the number of indirect tax rates, and a gradual reduction in customs duties to expose Indian industry to competition from abroad. The reduction in import duties was made possible by the devaluation in 1991 and the subsequent shift to a flexible exchange rate.
10. Financial Reforms: Financial sector reforms were seen as an essential accompaniment to industrial liberalization, and a Committee on the Financial System was appointed under M. Narasimham to make recommendations in this area. It recommended liberalization of controls over the interest rates charged by banks for different types of loans, a reduction in preemption of credit via high statutory liquidity requirements, etc. It also recommended abolishing government controls on capital issues in the stock market and on the pricing of these issues, leaving both to be regulated by a statutorily empowered Securities and Exchanges Board of India.
In January 1993, a package of financial sector reforms was announced that included permission to new private sector banks including foreign joint ventures. In the financial sector, the objective was to provide operational flexibility and functional autonomy to banks and other financial institutions so that they could allocate resources more efficiently.
Conclusion:
Judge by many of the externally visible signs, the story of the Indian reforms has been a remarkable success. Making an overall assessment of the reforms, one can say that on the growth front, reforms have indeed delivered beyond expectations, while simultaneously macroeconomic stability has been more or less successfully maintained. But the resultant growth and stability have had a fairly limited impact on poverty and seem to have aggravated both interpersonal and inter-regional inequality. The growth has also had an extremely low employment generation potential.
Additional Notes:
Economic Reforms: The term ‘economic reforms’, has meant different things in different countries in different situations. The reforms ultimately refer to the behavioural pattern in a given economic system and not just to changes in economic policies called policy reforms. It is the interaction between the policy reforms and the changes in an economic system that determines the success or failure of the reform process. Kornai stated, “Reforms mean diminishing the role of bureaucratic coordination and increasing the role of the market”. The term is also used to describe “significant changes in a sizeable number of economic policies as part of a package of policy changes”.
Reform Package: The reform package outlined by Manmohan Singh in 1991 has three distinct components: Fiscal stabilization to check the growing fiscal deficit. Internal liberalization to increase domestic competitive pressures. Integration with the global economy by removing controls on foreign trade and exchange rates, lowering tariffs, attracting FDI, etc.
The policy changes brought into force since July 1991 fall broadly into two categories. The first set of measures is part of what is normally known as stabilization policy. The second sets of measures come under the category of structural reform policies. As C. Rangarajan rightly points out, while the stabilization policies were intended to correct the lapses and put the house in order in the short term, the structural reform policies were intended to accelerate economic growth over the medium term. Structural reform policies cannot succeed unless a degree of stabilization has been brought.
Political environment: The country had gone through two unstable minority governments in the previous 18 months which had failed to manage the balance of payments.
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