CHAPTER 11

Economic Reforms in India

This chapter explains the concept, nature, need, and objectives of economic reforms in India. In any discussion on economic reforms, there ought to be three strands: (i) Why were reforms necessary and what was wrong with the earlier system? (ii) What reforms have been introduced? (iii) What remains to be done?

States do not function in a vacuum, but in specific social and political settings. The state (i.e., the government) does things that it should not and does not do things that it should. It is given “The Indian state has systematically underestimated the prevalence and the cost of “government failure.” It often intervenes, arbitrarily or to correct supposed market failures, without any clear evidence that the market is failing, and so ends up damaging resource allocation and stifling business drive. At the same time, the Indian state does not deliver in the areas that fall squarely in its province, such as administering law and order, ensuring macroeconomic stability, delivering speedy justice, making sure that public services are provided, and creating an effective and adequate safety net for poor people. Both the state and the state–market relationship need urgent reform, which is no easy task in the context of India’s political economy, with its democratic turbulence and powerful vested interests” (Joshi 2016).

The concept: The New Economic Policy (also known as economic reforms) is a set of policies and administrative procedures introduced in July 1991 to bring about changes in the economic direction of the country. It has two major components: stabilization and structural reforms.

The stabilization part has three components:

1. I.Management of balance of payments
2. II.Control of inflation
3. III.Fiscal correction

The structural reforms part has seven components:

1. I.Exchange rate adjustment
2. II.Liberalization of imports
3. III.Rationalization of tariff structure
4. IV.Delicensing/removal of licensing restrictions
5. V.Financial sector reforms
6. VI.Disinvestments of public sector shares
7. VII.Foreign direct investment

It must be noted that while the stabilization policies were intended to correct the lapses and put the house in order in the short term, the structural reform was intended to accelerate economic growth over the medium term. Structural reform policies cannot succeed unless a degree of stabilization has been brought about. But stabilization by itself will not be adequate unless structural reforms are undertaken to avoid the recurrence of the problems. Structural reforms were broadly in the areas of industrial licensing and regulation, foreign trade and investment, and the financial sector. In relation to foreign trade policy, the aim was to liberalize the regime with respect to imports and try to bring about a closer link between exports and imports. Yet another objective was to reduce the tariff rates.

Implications of reforms: The three pronged approach has major implications for the functioning of the economy and its future direction. They imply a complete and a sudden break from the past, and several issues arise related to the following:

1. A)The desirability of the pattern of development sought
2. B)The timing of the various policies, and more importantly, their sequencing (and in fact the wisdom of the frequent changes in policy that has the effect of creating uncertainties in the Indian economy)
3. C)The relative importance attached to the different aspects of policy, in as much as domestic priorities related to the provision of education, health, and employment; globalization of the economy
4. D)The likely impact of the package of policies

In the wake of economic reforms the following three terms are frequently used: deregulation, privatization, globalization

1. A)Deregulation describes the process of removing rules imposed by the government that limit the economic freedom of individuals.
2. B)Privatization means removing the state and its agents from economic activities and letting these be undertaken by private individuals.
3. C)Globalization, however, has a much broader range; indeed, it has become a buzzword for many different phenomena. A comprehensive definition would define globalization as the process of increasing both the scope and the actual incidence of interaction between people from all parts of the globe.

Objectives: Economic reforms were intended to enable Indian industry to develop an outward orientation, and to allow freer play to market forces. Indian industry was to become more competitive, acquire modern and up-to-date technologies so that costs could be controlled and quality improved, establish production capacities that would allow cost advantages, become export oriented, and through investments by international companies tie in with the growing intra-firm trade of multinational companies. Reforms intended to achieve the following:

1. I.Stabilization and macroeconomic balance through fiscal, monetary, and exchange rate policies
2. II.A liberalized trade regime with no import licensing and tariff rates comparable to that of other industrializing developing countries
3. III.An exchange rate system that makes the rupee convertible, at least for current account transactions of the balance of payments
4. IV.A competitive financial system with sound regulations
5. V.An industrial sector free of many controls
6. VI.An autonomous, competitive, and streamlined public enterprise sector

There is a common thread running through all these measures. The objective is simple: to improve the efficiency of the system. The regulation mechanism involving a multitude of controls has fragmented capacity and reduced competition even in the public sector. The thrust of the economic reforms is toward creating a more competitive environment in the economy as a means to improving the productivity and efficiency of the system. This is to be achieved by removing the barriers to entry and the restrictions on the growth of firms.

The policy of economic reforms placed overwhelming reliance on private initiative and enterprise to achieve objectives. Public investment expenditures would over time play a secondary role. There are essentially two aspects to economic reform: internal and external economic policies. Each, in turn, has two aspects. In internal policymaking, one aspect is debureaucratization and easing of controls; the other pertains to privatization of public enterprises, following the neoliberal philosophy of laissez-faire and reliance on the market for all investment decisions, with minimum government intervention in the economy. Though these policies and procedures have a macroeconomic thrust, their impact on micro-level economic activities cannot be ignored. From this point of view the New Economic Policy will have its repercussions on the entire gamut of economic development.

1. A)Market orientation: The economic reform seeks to allocate the resources on the basis of the market forces of demand and supply. The government relaxed most of the regulations and controls to promote competition. The measures initiated to provide market orientation to the economy included delicensing, deregulation, disinvestment, dereservation of the industries exclusively reserved for the public sector, and liberalization of the foreign trade and investment policy.
2. B)Selective government intervention: The scope of government intervention was largely confined to the socially relevant areas. The government strengthened the institutional mechanism to facilitate functioning of markets. The government provided various inducements to the private sector to align its objectives with the national objectives through various economic policy measures like tax rebates, subsidies.
3. C)Indicative planning: The government replaced directive planning with indicative planning in the Eighth Plan (1992 to 1997). Under indicative planning there is no element of compulsion; the government uses persuasive economic policy measures to influence the activities of the private sector. The government pursues market-friendly policies for the mobilization and allocation of resources.

Problems faced by the economy prior to economic reforms: Before considering the various steps for restructuring the economy, it is important to be clear as to what were the most serious problems facing the Indian economy in 1990. Consider the following:

1. I.A large fiscal deficit, the underlying cause of which is expenditure outpacing revenues
2. II.A huge foreign debt, with a high debt-service ratio, and debt-exports ratio, which caused a downgrading of the country’s credit rating and serious repayment problems
3. III.Low levels of efficiency economy wide, which resulted in a huge wastage of resources
4. IV.More contemporaneously, a recessionary situation in the industrial sector, stagnant agricultural output, and poor growth prospects in the economy as a whole, coupled with a serious inflationary problem

The situation that the nation and the economy had to face in mid-1991 was grim. The BoP situation had deteriorated so sharply and the foreign exchange reserves had fallen so low that the possibility of default in payment was imminent. On the domestic side, while the Indian economy had done extremely well in terms of real growth between 1985 and 1990, the fiscal situation had deteriorated sharply. The budget deficit as well as the overall fiscal deficit had sharply increased contributing on the one hand to a large increase in money supply and on the other to a sharp increase in interest payments. The country thus entered the 1990s with a fiscal deficit that was simply unsustainable.

Need for economic reform: The reforms were imperative for the following reasons:

1. I.The downgrading of India’s credit rating made commercial loans difficult.
2. II.Funds flow from West Asia dried up following the Kuwait crisis, there were large withdrawals of NRI deposits during the early part of 1991, and foreign direct investment was low.
   Aid for poorer countries was getting scarce because of larger claims by the former Soviet states and increased demands in the United States for domestic spending. Compulsions of efficient use of aid made the case for reforms stronger.
3. III.Following the collapse of old attitudes worldwide and the emergence of a global market, India had no other alternative but to initiate economic policy reforms.
4. IV.However, reforms cannot be wholly attributed to these economic compulsions. The necessity for macroeconomic reforms had been steadily gaining credence in the 1980s. The control system under the “permit raj” had become unpopular. The timing was, therefore, ripe for an assault on the system and would be greeted with a sense of relief.

It is well known that structural adjustment involves hard choices. The choices are described as being hard because they often have implications that find disfavor with the populace at large, at least in the short run.

The evolution of the process of economic reforms: Though the process of relaxation of regulation of industry began in the early 1970s and of trade in the late 1970s, the pace of reform picked up significantly only in 1985. Major changes were announced between 1985 and 1988 with the process continuing to move forward thereafter. Indeed, during this latter period, liberalization had begun to take a somewhat activist form. In turn, GDP growth and the external sector registered a dramatic improvement in performance. The substantial yet half-hearted reforms of the 1980s gave way to the more systematic and deeper reforms of the 1990s and beyond. This time around, there was a fundamental change in approach. Until 1991, restrictions were the rule and reforms constituted their selective removal according to a “positive list” approach. But starting with the July 1991 package, absence of restrictions became the rule with a “negative list” approach taken to their retention. While the move toward this new regime has been decidedly gradual, with the process still far from complete, the shift in the philosophy is beyond doubt.

The economic reforms package: It is important to understand clearly what the economic reforms package is and equally important what it is not. Economic reforms can be briefly summed up as a package consisting of three separate sets of policies:

1. I.The stabilization of the economy, meaning thereby, the bringing into balance the aggregate demand and supply; the imbalance was in the main caused by large and endemic deficits in the Central Government’s budget during the 1980s, which got reflected in the spiral of inflation at home and deficit in external payments abroad. The policies adopted in this context relate to budgetary and credit policies.
2. II.A restructuring of the Indian economy with a view to making Indian industry internationally competitive. The policies adopted in this context range from industrial and foreign trade policies to issues like the lending policies of financial institutions (including banks), the pattern of government expenditure and public investment, including the policy related to the public sector, and the approach on sick units and with regard to subsidies generally and the subsidization of small business and farms in particular.
3. III.The globalization of the Indian economy, throwing open (in stages) the import of all commodities (including consumer goods), reducing the customs tariffs, allowing free inflow of foreign capital (including short-term capital), opening up the service sector to foreign capital (especially in the matter of banking, insurance and shipping) and full convertibility of the rupee.

Thematically, the ingredients of the reform process are the following:

1. I.Eliminating quantitative restrictions on exports and imports
2. II.Bringing down and rationalizing tariffs, eliminating export subsidies, so that trade policy is neutral and equates the effective exchange rate for exports to the effective exchange rate for imports
3. III.Eliminating overvaluation in exchange rates and making the exchange rate market determined
4. IV.Reforming the public sector through disinvestments or through leasing and management contracts; in any case, eliminate public sector monopolies and introduce greater competition
5. V.Reforming monetary policy and transit to market-determined interest rates; reform the financial sector
6. VI.Bringing down budgetary deficits, target government subsidies better, and reform the tax structure so that indirect taxes become more transparent; simultaneously, bring down rates of direct taxation, while broadening the base
7. VII.In industry, removing barriers to entry and exit
8. VIII.Reforming the agricultural sector by making output and input prices market determined
9. IX.Targeting government expenditure on primary health, primary education, and the development of infrastructure; introduce social safety nets as protection against the effects of structural adjustments

Operation of economic reform: In a single stroke, the “Statement of Industrial Policy” dated July 24, 1991, changed the entire policy scenario:

1. I.Did away with investment licensing and myriad entry restriction on monopolistic and restrictive trade practices (MRTP) firms
2. II.Ended public sector monopoly in many sectors, and today, only railway transportation and atomic energy remain on it
3. III.Initiated a policy of automatic approval for foreign direct investment (FDI) up to 51 percent. The automatic approval of FDI up to 100 percent is given for all manufacturing activities in Special Economic Zones (SEZs) except those subject to licensing or public sector monopoly. Subject to licensing, defense is now open to private sector for 100 percent investment with FDI (also subject to licensing) up to 26 percent permitted.
4. IV.The policy of continuity with change, trimmed the licensing to only five sectors with all of them having justification on health, safety, or environmental grounds: (a) arms and ammunition, explosives and allied items of defense equipment, defense aircraft and warships; (b) atomic substances; (c) narcotics and psychotropic substances and hazardous chemicals; (d) distillation and brewing of alcoholic drinks; and (e) cigarettes/cigars and manufactured tobacco substitutes.
5. V.Did away with entry restrictions on MRTP firms. Again, the policy was notable for its unequivocal renunciation of the past approach: The MRTP Act 1969, has been repealed. The provisions related to merger, amalgamation, and takeover have been repealed. Similarly, the provisions regarding restrictions on acquisition of and transfer of shares will be appropriately incorporated in the Companies Act, 1956. These changes are now in place.

External trade: The July 1991 package also made a break from the 1980s approach of selective liberalization on the external trade front by replacing the positive list approach of listing license-free items on the open general license (OGL) list with a negative list approach. It also addressed tariff reform in a more systematic manner rather than relying on selective exemptions on statutory tariffs. In subsequent years, liberalization has been extended to trade in services as well.

Merchandise trade liberalization: The July 1991 reforms did away with import licensing on virtually all intermediate inputs and capital goods. Today, except for a handful of goods disallowed on environmental, health, and safety grounds and a few others that are canalized, such as fertilizer, cereals, edible oils, and petroleum products, all goods can be imported without a license or other restrictions.

A major task of the reforms in the 1990s and beyond has been to lower tariffs. This has been done in a gradual fashion by compressing the top tariff rate while rationalizing the tariff structure through a reduction in the number of tariff bands. The 1990s reforms were also accompanied by the lifting of exchange controls that had served as an extra layer of restrictions on imports. As a part of the 1991 reform, the government devalued the rupee by 22 percent against the dollar from Rs. 21.2 to Rs. 25.8 per dollar. In February 1992, a dual exchange rate system was introduced, which allowed exporters to sell 60 percent of their foreign exchange in the free market at higher price and 40 percent to the government at the lower official price. Importers were authorized to purchase foreign exchange in the open market at the higher price, effectively ending the exchange control. Within a year of establishing this market exchange rate, the official exchange rate was unified with it. Starting in February 1994, many current account transactions, including all current business transactions, education, medical expenses, and foreign travel, were also permitted at the market exchange rate. These steps culminated in India accepting the IMF Article VIII obligations, which made the rupee officially convertible on the current account.

Liberalization of trade in services: Since 1991, India has also carried out a substantial liberalization of trade in services. Traditionally, services sectors have been subject to heavy government intervention. Public sector presence has been conspicuous in the key sectors of insurance, banking, and telecommunications. Nevertheless, considerable progress has been made toward opening the door wider to private sector participation, including foreign investors, in them.

Until recently, insurance was a state monopoly. On December 7, 1999, the Indian parliament passed the Insurance Regulatory and Development Authority (IRDA) Bill, which established an Insurance Regulatory and Development Authority and opened the door to private entry, including foreign investors. Though the public sector dominates in the banking sector, private banks are permitted to operate in it. In addition, foreign banks are allowed to open a specified number of new branches every year.

The telecommunications sector has experienced much greater opening to the private sector, including foreign investors. Until the early 1990s, the sector was a state monopoly. The 1994 National Telecommunications Policy provided for opening cellular as well as basic and value-added telephone services to the private sector, with foreign investors granted entry. Rapid changes in technology led to the adoption of the New Telecom Policy in 1999, which provides the current policy framework.

The infrastructure sector has also been opened to foreign investment. FDI up to 100 percent under automatic route is permitted in projects for the construction and maintenance of roads, highways, vehicular bridges, toll roads, vehicular tunnels, ports, and harbors. In the construction and maintenance of ports and harbors, automatic approval for foreign equity up to 100 percent is available. Only railways remain off limits to private entry. Since 1991, several attempts have been made to bring the private sector, including FDI, into the power sector but without perceptible success.

Impact of economic reforms: Trade liberalization had a much more visible effect on external trade in the 1990s than in the 1980s. Liberalization also had a significant effect on growth in some of the key services sectors. This growth was mostly due to the fast growth in communication services, financial services, business services, and community services. The most disappointing aspect of the 1990s experience, however, has been a lack of acceleration of growth in the industrial sector. This is largely due to labor laws; industry in India is increasingly outsourcing its activities so that growth in industry is actually being counted in terms of growth in services.

Investment into industry, whether domestic or foreign, has been sluggish. Foreign investors have been hesitant to invest in the industry for much the same reasons as the domestic investors. At the same time, the capacity of the formal services sector to absorb foreign investment is limited. The information technology sector has shown promise but its base is still small. Moreover, this sector is more intensive in skilled labor than physical capital. Therefore, the solution to both trade and FDI expansion in India lies in stimulating growth in industry.

Labor issues lie at the heart of the success or failure of a structural adjustment program. The final impact on people in general and the poor in particular is the real yardstick by which the success of an adjustment program should be judged. The impact of the ongoing reforms on individuals, poverty, and income distribution continues to be the source of much controversy; a particular matter of concern is whether the poor bear a disproportionate share of the burden of the cost of adjustment, especially in the short run.

The absence of an exit policy for labor is the ostensible reason for the reluctance of some foreign investors to enter India. The economic reforms undertaken so far have attempted to usher in an era of high growth, with the underlying assumption that such growth would necessarily filter down, thereby enhancing economic welfare across the board. The assumption of effective percolation has been guided by the further presumption of existence of strong forward and backward linkages.

Globalization is centered on the integration of international markets for goods, services, technology, finance, and labor. It is underpinned by the opening up of national economies to global market forces and a corresponding reduction in the scope of the state to shape national macroeconomic policies. Indeed, the end of geography symbolizes the thrust of globalization with far-reaching implications for regional, national, and local economies. In this respect, globalization is expected to unfold through trade and finance with profound consequences for the structure of BoP, investment, growth, income distribution, employment, and poverty. However, the nature of interaction between the new phenomenon and economies (at the different levels) poses critical questions for the prosperity or the marginalization of developing countries and their poor. In this frame, a critical analytical issue is the extent to which globalization will undermine the state and its capacity to formulate macroeconomic policies.

Problems associated with economic reform: A market economy with information deficiencies and inadequate institutions hurts both the consumers and the state. It can lead to serious sociopolitical fallouts (Smith 2016). Only in crisis times does the polity reform, but then there are endemic problems to make reforms a constantly recurring topic. Reforms are always partial as political courage is in limited supply. In India’s peculiar electoral cycle, where every 6 months there is an election somewhere, the central leadership loses heart with the first reversal in a state election, no matter how small the state. The courage to face unpopularity and think in five-year cycles is rare. But reform and restructuring are constantly required in any economy, let alone India, which is far short of realizing its potential.

The ground situation is abysmal in terms of malnutrition, open defecation, waste management, stagnation in manufacturing, and continual crisis in farming, where four-fifths of farms are unsustainable in terms of affording their owners a decent livelihood.

The public sector gets too much mollycoddling, nonperforming loans of a grossly inefficient public sector undertaking (PSU) banking sector, all these stand witness to the root of India’s problems, but will not be reformed any time soon.

The state has weak competence. Despite that, governments of all political persuasion load it with more tasks—new entitlements (food security while public distribution system (PDS) shops constantly fail), environmental regulations (without correcting chronic underpricing of water, power, and public land), and additional rewards and perks (without improving incentive structures or efficiency enhancing arrangements). Nothing is removed as having lost utility—only left as a continuing expense while more is added. The state cannot deliver good quality education at any level—primary, secondary, or tertiary. The consumers go away to private providers if they can afford or molder in colleges where they are barely functionally literate after 3 years. There is not much hope that the state will be reformed any time soon. The bureaucracy may not see the need for any urgent reforms. It is the politician who has to raise the standard of reforms. It would need a horrendous crisis, of a magnitude one would not wish, before Indian politics changes its ways (Desai 2016).

To ensure permanent change will require deeper reforms, however. If wholesale ministerial corruption is reportedly much reduced, there is still little clarity over how political parties are financed. Making India less bureaucratic would also be a boon. A certain brand of tycoon has thrived because getting things done often requires sharp elbows and sharper business practices. Magnates who are politically astute will still have an edge if knowing how to dodge a price cap imposed on a ministerial whim, for example, is a surer guide to success than knowing how to run a factory. Such shenanigans have not stopped. A decent financial system is the best defense against cronyism.1

Endnote

1. 1.The Economist. April 19, 2018. “The Humbling of India’s Tycoons.” https://www.economist.com/leaders/2018/04/21/the-humbling-of-indias-tycoons, (accessed July 17, 2019).