CHAPTER 10

The Economic Policy Regime in India Prior to 1991

The Indian economy struggled during its initial stages after independence. Due to many political, societal, and personal hindrances, the economy was stagnant. It took many years for the economy to stand up and work for itself. The postindependence period (1950 to 1990) was a very critical time for the country. It includes various steps that were important for the betterment of the country. In this chapter a bird’s eye view of important economic decisions taken between 1950 and 1990 has been presented. The rapid economic development strategy of postindependent India had been one of self-reliant industrialization under centralized investment planning. It had emphasized basic and heavy industries and adopted public sector as a major instrument in the institutional framework of a mixed economy where private ownership of means of production was permitted in a democratic political setup. India had a major setback in her planning process when she turned inward following the BoP crises from 1956 to 1957. The explicit strategy of an import substitution (IS) was desired then, reflecting the economic logic of export pessimism that characterized the thinking of Indian planners. Domestically driven import-substituting industry needed cheap imports for the manufacture of goods for the Indian market. Industry was averse to the rise in import prices consequent upon the devaluation.

Under this strategy, the activist state, acting on behalf of the society, assumed heavy responsibility of not only initiating economic development, which the private sector was deemed unwilling or unable to undertake, but also shaping the entire pattern of investment. The direct involvement of the state in economic development resulted not only in heavily regulated markets and private economic activities in a functioning market economy but also in a significant extension of the public sector into diverse economic activities going well beyond the traditional economic rationale provided by market failures.

The activist state needed to transfer financial resources from private savers to itself in order to finance its own expanded activities as also to finance private sector activities in the priority sector. Initially, indirect taxes (excise and customs) were used as instruments to mobilize resources while allocation of private investment was sought to be controlled through industrial licensing. Later, commercial banks were nationalized in 1969 to acquire control over private savings in the form of bank deposits. The instruments of administered interest rates and progressive hike in cash reserve ratio (CRR) and statutory liquidity ratios (SLR) were used to transfer the private savings to the government. These were rechanneled through publicly owned term-lending institutions to finance investments in PSEs and government approved private corporate investments. Apart from keeping the administered interest rate artificially low in order to induce private investment, the activist state enacted labor legislations to protect the interest of the industrial workers.

In view of the aforementioned, the evolution of the postindependence economic policy can be grouped under three broad categories:

1. I.Direct, discretionary, and quantitative controls on the private sector
2. II.Extension of the public sector
3. III.Rigid regulation of the external sector: foreign capital and trade policy

These features interacted in the institutional setup of functioning markets and private ownership of means of production to generate perverse incentives that constricted the operation of market forces and private economic agents.

Direct, Discretionary, and Quantitative Controls on the Private Sector

In general, controls were operated by the Industrial Licensing Committee, the Import License Committee, the Foreign Collaboration Committee, and the Capital Issues Committee and also involved the Directorate General Technology Development (DGTD) for “indigenous angle clearance.” Although much of the personnel of the committees were the same, for most of the period, they met separately as the application went through the various stages of clearance. Needless to say, it was an involved and time-consuming process. A license refers to a written permission granted by the government to a firm that mentions what product can be manufactured by the firm. Further, license also includes various other particulars such as the place where factory is to be located; what products are to be produced; what is the maximum quantity that can be produced; and what are the conditions for the expansion of production. The government resorted to the licensing system so that it could maintain control over industries as per the Industries (Development and Regulation) Act, 1951. The stated objectives of the licensing policy were as follows:

1. I.Regulate the industrial sector, particularly the private sector, in the desired direction as per the objectives of the five year plans.
2. II.Check the concentration of ownership of industries in a few hands.
3. III.Emphasize balanced regional development.
4. IV.Encourage small-scale industry.
5. V.Encourage new entrepreneurs to set up industries.

Licensing regime means regulations and accompanying bureaucracy, which means red tape imposed substantial administrative burden, and there was no certainty that an application for a license would be approved within a timeframe or in what timeframe. Entrepreneurs needed to deal with various government departments and officers. The stated objective was to increase industrial production but on the ground it restricted expansion, production of new articles, and so on. Similarly, the stated objective was to check the concentration of economic power in a few hands, but actually it didn’t succeed. An undue concern with the problem of monopoly has prevented an economically sensible expansion of the industrial sector, by holding back the expansion of firms that could utilize economies of scale. New licenses were granted to big houses thanks to all the pervasive corruption. They were also allowed to grow at the expense of new players. Bribery was a culture in the “license raj.” For bribes, licenses were issued in areas reserved for the public sector or for small-scale industries.

Life under license raj was characterized by scarcity of resources. The specialty of license raj was that licenses were themselves made a commodity, and a scarce one, at that. Hence, if a company wanted to expand production, it needed a license to do so, which was not easily available. A “market” for licenses developed; licenses had a price. Business competition under the license raj meant getting licenses before competitors. Often businesses acquired licenses, not to produce, but to stop the other from expanding. Given this situation, entrepreneurs used to say that the art of managing government relationships was most critical to business success (Agarwal 2016).

The licensing procedure did not enable the government to economize on the use of imports but had quite perverse effects. The licensing system led to a loss of government revenue, at least potentially. The objection to the policy that was pursued is really that the government was neither consistent in the criteria it followed nor did it devise a system that had the capacity to operate efficiently. It is difficult to escape the conclusion that both the economic strategy and the chosen instruments of economic control largely failed to tackle the problems facing the economy.

To sum up, the following criticisms have been leveled against the licensing procedure:

1. I.There was a lack of clear guidelines.
2. II.There were long delays in the process of approving or rejecting applications.
3. III.No systematic rules were followed to implement the objective of locational dispersion of industry.
4. IV.The system did not succeed in controlling the growth of monopoly and reducing the concentration of economic power in industry.
5. V.The government was neither consistent in the criteria it followed nor did it devise a system that had the capacity to operate efficiently.

Private sector: Private industrial activity was sought to be guided toward socially desirable activities under the Industries (Development and Regulation) Act, 1951. The important policy instruments used for this purpose included industrial licensing, controls over capital issues, price and distribution controls, and restrictions on foreign collaborations as well as imports of technology. The government nationalized private sector assets in areas such as insurance, banking, coal, and wheat, as well as significant parts of the steel industry. Large industrialists in the private sector were controlled stringently through the Monopolies and Restrictive Trade Practices (MRTP) Act, 1969, in relation to the quantities and types of goods they could produce.

Controls unintentionally offered incentives to divert resources to directly unproductive rent-seeking activities aimed at preempting the entry of potential competitors. The resulting noncompetitive markets did not offer incentives for improving productivity or quality. Thus, the private industrial units had neither the freedom to adjust to market signals nor incentives generated by competition to improve efficiency. Controls did not lead to “planned” allocation of private investment either. The Indian economy saw the growth of industries during the mid- and the late 1970s. It was clear back then that India would never be able to master and transcend this sector of the economy because the industrial sector requires technological advancements, intellectual theories, and finances. Since India lacked all those, it was inevitable that the economy cross over this sector and move directly to the service sector. Due to the large population, service providing was far more promising than industrial success. The following were some of the most prominent features of the Indian industrial sector between 1950 and 1990.1

1. I.Lack of technical knowledge
2. II.Excess of obsolete techniques and machinery
3. III.Lack of sufficient finances to acquire advanced machinery
4. IV.Provision of a lot of employment opportunities
5. V.Poor contribution to the national income
6. VI.Intense regional imbalance and dissatisfaction among workers

One may summarize the failure of discretionary control as follows:

1. I.Disincentive for investment and entrepreneurship
2. II.Growth retarded for a variety of reasons; industries struggled for funds for investment either directly or through banks
3. III.Corruption and favoritism
4. IV.Failure of the delivery system

Labor legislation: Businesses had to have government approval for laying off workers and for shutting down. The Industrial Disputes Act 1947, protects less than 10 percent of India’s workforce in a manner that makes it very difficult to retrench unionized workers.

Extension of the Public Sector

The emphasis of the Second Five-Year Plan (1956 to 1961) was on government-led industrialization. The public sector must grow not only absolutely but also relatively to the private sector. The whole picture on control mechanisms that were in place was meant to augment the growth of the public sector. In order to enable the activist state to guide the course of development toward socially desirable goals, the Industrial Policy Resolutions of 1948 and 1956 reserved strategic domestic industries, and government monopoly was established in armaments, atomic energy, railroads, minerals, iron and steel industries, aircraft, manufacturing, shipbuilding, and telephone and telegraph equipment. This extended the boundary of the public sector activities beyond those justified by the perceived market failures, namely, electricity; telecommunications; rail, road, and air transport network; and other public utilities. Over the years, the central and state governments formed agencies and companies engaged in finance, trading, mineral exploitation, manufacturing, utilities, and transportation, like Hindustan Insecticides, Ashoka Hotel Corporation, Tyre Corporation of India, Air India, Gas Authority of India Limited (GAIL), Steel Authority of India Limited (SAIL), Oil and Natural Gas Corporation (ONGC). Thus, the government built new state-owned enterprises as diverse as jute mills, hotels, and steel plants.

Public sector units were expected to operate efficiently and generate resources for further investment. Instead, they were saddled with the multiplicity of often-conflicting objectives; had to accept politically driven inappropriately administered prices for their products and services; and were subjected to bureaucratic and political interference, which made their efficient operation difficult. They also faced the “soft-budget constraint” with neither penalty for losses nor rewards for efficient functioning. The poor performance of public sector units had a multiplier effect through inefficient, low-quality, and often irregular and fluctuating supplies of infrastructure services and universal intermediate inputs (like iron and steel and financial services), which partly contributed to the inefficiencies of the private sector units. At the macro level, they became a drain on the exchequer through their recurring losses instead of generating resources for investment.

Over and above, some of the important policy measures extending the scope of the public sector were as follows:

1. I.In 1956: life insurance business nationalized
2. II.In 1969: large commercial banks nationalized
3. III.MRTP Act, 1969: designed to provide the government with additional information on the structure and investments of all firms with assets of more than Rs. 200 million in Indian currency, to strengthen the licensing system, decrease the concentration of private economic power, and place restraints on business practices considered contrary to public interest
4. IV.In 1973: general insurance business nationalized

The rationale for a large public sector producing capital goods no longer held since in an open economy there was no equivalence between the size of the capital goods sector and the investment rate. But the economy had been resilient.

External Sector: Rigid Foreign Capital and Trade Policy

India’s policy regime was complex and cumbersome. There were different categories of importers, different types of import licenses, alternate ways of importing, and so on. The importers were broadly grouped into three categories: (a) actual users of industrial products and nonindustrial products, (b) exporters, and (c) others. The actual users in the first category included enterprises/persons who used to get import license for items earmarked for their own use and not for further sales. These users were entitled to various types of import licenses and could import goods and commodities under these modes alone. Different types of licenses that used to be issued in the pre-reform period can be categorized as (a) open general license (OGL), (b) automatic license, (c) supplementary import license, and (d) import through government-owned canalized agencies. In the OGL category the components and spare parts required by importers were usually imported to India on the basis of this license. These imports were used by the importers in their manufacturing activities. The list of such products that fell under OGL, Restricted Items List, and Banned List used to be released by the government in their annual export–import policy (Mehta 1997).

The instruments used were often extremely complex and detailed and had undergone changes from time to time. The formal nature of an instrument and the way in which it was actually deployed might also be different. Moreover, quite an elaborate institutional structure had also been built up for the administration of some of these rules. Whatever the merit and demerits of the economic strategy that has been pursued by the government, its implementation had been very poor. The failure of implementation can be observed at both an aggregative and at the specific sectoral or project level. The most critical failures at the aggregative level are, perhaps, the failure to achieve the planned rates of investment and of domestic resources mobilization, with its consequent continued dependence of foreign aid.

The license raj created a scarcity of foreign reserves. The balance of payment crisis arose in the 1970s and worsened toward the end of the 1980s. India followed a protectionist policy and adopted different instruments. These instruments, to a large extent, were dictated by the objectives of the protectionist policy. The principal objectives of this protectionist policy were as follows:

1. A)Stabilize balance of payments
2. B)Encourage industrialization
3. C)Fulfill the objectives of self-reliance
4. D)Help in reallocation of resources
5. E)Provide budget revenue
6. F)Increase employment

The selection of instruments adopted for achieving the objectives of the protectionist policy can be classified in two broad groups: (a) tariff and (b) nontariff measures. These instruments were basically used to bring about changes in price, volume, or other parameters related to tradable commodities and services. The import and export policy determines in great detail the import procedures that are applicable to specific products, license, importers’ entitlement, as well as other details relevant for the imports of goods and commodities by different categories of importers. India’s import and export policy was guided by the Import and Export Control Act of 1947. In 1977, two additional orders, that is, the Import Control Order and Export Control Order, were introduced and the subsequent annual policy of import and exports was based on these legislations. A long-term trade policy, for 3 years, was announced in 1985 by the government and some concrete steps toward liberalization were taken within the framework of economic reforms (Mehta 1997). Licensing system and controls had virtually shut off imports with high tariffs, low import quotas and outright banning of import of certain products. For example, the import tariff for cars was around 125 percent in 1960. India in 1985 had the highest level of tariffs in the world. Nominal tariff rates as a percentage of values in 1985 were 146.4 percent for intermediate goods, 107.3 percent for capital goods, 140.9 percent for consumer goods, and 137.7 percent for manufacturing goods.2

Import substitution policies proved to be inefficient. Policymakers were convinced that the basic model of import substitution needed a change. The overall trade regime remained severely protectionist. Tariffs remained high and the effective rates of protection did not fall in the 1980s. Also, there was no drop in the percentage of manufactured imports subject to nontariff barriers (Kotwal and Wadhwa 2011). The Foreign Exchange Regulation Act (1974) reduced the power of multinational corporations by reducing the foreign equity participation of foreign companies from 51 percent to 40 percent. This meant that multinationals would have fewer powers in company boards. This ultimately led to the departure of companies like Shell, Coca Cola, IBM, and Caltex.

Consequences: The strategy of self-reliant industrialization that has been characterized as “economic nationalism” resulted in a restrictive trade policy regime that had the same elements as that of the Nurksian strategy of import substitution-driven industrialization. This has been achieved by keeping the exchange rate overvalued, which discriminated against exports, and using tariffs and quotas on imports as instruments to contain the resulting excess demand for foreign exchange. The import requirements of basic and heavy industry–oriented industrialization put further pressure on the balance of payments and resulted in progressively more restrictive controls on imports of commodities and capital and perpetual shortage of foreign exchange in the face of nonexpanding exports.

The government attempted to close the Indian economy to the outside world. The Indian currency, the rupee, was inconvertible and high tariffs and import licensing prevented foreign goods reaching the market. India also operated a system of central planning for the economy, in which firms required licenses to invest and develop. The labyrinthine bureaucracy often led to absurd restrictions—up to 80 agencies had to be satisfied before a firm could be granted a license to produce, and the state would decide what was produced, how much, at what price, and what sources of capital were used. The government also prevented firms from laying off workers or closing factories. The central pillar of the policy was import substitution, the belief that India needed to rely on internal markets for development, not international trade—a belief generated by a mixture of socialism and the experience of colonial exploitation. Planning and the state, rather than markets, would determine how much investment was needed in which sectors.

The complex structure of differential indirect tax rates as also administered interest rates and labor legislation led to distortions in relative product and factor prices and resulted in not only inefficient allocation but also misallocation of resources out of line with relative scarcities of capital and labor. The Indian government used the public sector dominated financial system as an instrument of public finance with a complex set of regulations on fixed deposit and lending rates, and channeled credit to the government and priority sectors at below market rates. All these amounted to tax on financial intermediation, which not only reduced the allocative efficiency of intermediation but also resulted in the loss of efficiency and lower real growth of the economy at 3.5 percent per annum despite the doubling of the rates of domestic savings and investment over the 30-year period 1950 to 1980.

These regulations made maximization of working capital and cash–credit loans and project financing as the primary objectives of banks and financial institutions. Monitoring debtors and recovering loans got low priority encouraged by budgetary support. As a result, lending occurred with inadequate project appraisal and favored companies established in line with government dogmas, and loan amounts did not have any relation with perceived risks and expected returns. In addition, there was no uniform system of accounting practices, no provisioning for nonperforming assets (NPAs), and no valuation of securities held in the bank.

The failure of particular targets of industrial output to be reached during the planned periods, as well the delays in completing various industrial projects on target. Critical shortfalls in the production of steel, fertilizers, and other input continue to be a feature of economic life in India. The failure of public sector industries to reach their investment and output targets has been amply documented in various reports (Agarwal 2016).

The failure of implementation at both the macro- and micro-levels is obviously not unrelated. It has to be borne in mind that the Indian economy is not a centrally planned economy but a mixed economy, with the government having direct control over that small part of it that constitutes the public sector. While some of the criticisms that have been leveled against the government economic policy tend to give the picture of a distinctly dirigisme regime, in fact, the government has used both macro- and micro-levels related allocative policy, with greater emphasis on the later.

It has been recognized that the Indian economy suffers from severe structural imbalances and discontinuities between sectors. The characteristic tendency of the government is to try to manipulate the outcome of an economic process without being able to influence the major forces behind that outcome. For the nonagricultural sector, the government has tried to operate two distinct types of control, both of which can be said to belong to the type that bypasses the price mechanism. The tendency of the government is to undertake unnecessarily wide and detailed controls that its administrative capacity cannot handle. While great emphasis is laid on all these objectives, in practice, the operation of the policy has probably been most influenced by the need to conserve foreign exchange.

Beginning of liberal policies: The trajectory of economic policies favoring India’s growth was path dependent. From 1947 to 1975 the policy consensus favored an important role of the state within a relatively closed economy. Private enterprise survived during this period but India’s trade declined. Changes in the policy consensus favoring economic deregulation began to appear in the mid-1970s, which prepared the ground for the tectonic policy shifts beyond 1991. Path dependence ensured that new policy ideas building upon the lessons of the past took quite some time to get embedded within politics and result in policy outcomes. This is a story of how powerful social actors who derive benefits from a certain set of policies oppose a change in the social equilibrium. Financial crises were critical for the major policy shifts in India. They aided the convinced technocracy and the executive to overcome political opposition to policy change. It became clear to the policy elite that the promotion of Indian agriculture and the private sector was critical in the context of hard budget constraints in 1966 and in 1991, respectively. The financial crises of 1966 and 1991 are critical for explaining India’s green revolution in the early 1970s and its tryst with globalization in the 1990s (Mukherji 2009).

The intellectual impetus for deregulation came from the weight of reports commissioned by the government over several decades. From the 1960s on, there was a large body of work within the government in response to the dissatisfaction with the licensing regime. The Indian development strategy recognized the significance of a liberal trade policy in the early 1980s, which was manifested in the form of a number of important recommendations made at that time by several committees. The notable ones focused on a shift in emphasis from control to deregulation through simplification of the import licensing system (Alexander Committee 1978), clear recognition of dynamic comparative advantages associated with export growth (Tandon Committee 1980), the need to harmonize foreign trade policies with other macroeconomic policies, advantages of an export-led growth strategy, a phased reduction in effective protection (Abid Hussain Committee 1984), and the need to discourage inefficient import substitution (Narasimham Committee 1985). Notwithstanding these concerns, the trade regime continued to be characterized by a licensing system that together with a high tariff structure protected the economy from external competition. In addition, the trade performance was constrained by restrictive foreign investment policies (RBI 2003).

The success of East Asian economies had made the government more receptive to the aforementioned recommendations. When a new government came to power in December 1989, there was a renewed focus on industrial reforms. There undoubtedly was some liberalization. The result of such thinking was to reorient economic policies. The roots of the liberalization program can be traced to the late 1980s, but the reach and force of the reform program was rather limited. Some industrial deregulation favoring the Indian private sector was achieved. The telecommunications sector was moved in the direction of private sector orientation. Parts of the Department of Telecommunications (DOT) were corporatized into the government-owned corporate entity Mahanagar Telephone Nigam Limited (MTNL). Since 1991, the Indian economy has been constantly undergoing drastic economic reforms. These reforms have resulted in a shift from the inward-oriented policy of the past to an outward-looking policy. There is nothing like a crisis to concentrate the mind—it provided an urgency to revamp the Indian economic architecture. It should not mean concealing politically difficult decisions.

Endnotes

1. 1.toppr. n.d. “Indian Economy (1950–1990).” https://www.toppr.com/guides/economics/indian-economy-1950-1990/industrial-policy/, (accessed April 27, 2019).
2. 2.Indiabefore91.in. n.d. “License Raj.” http://indiabefore91.in/license-raj, (accessed April 27, 2019).